Welcome

Bonds

Reza Bilgin
[email protected]
 Bond
• Negotiable fixed income security
• Pays the face value (Par Value) at the maturity
• Coupon or zero
• Bearer or registered
 Bond
• Fixed income security
• Pays the face value at the maturity
• Coupon or zero
• Bearer or registered
• Negotiable
A Basic Zero Coupon Bond
A Basic Coupon Bond
 Bond Terminology: US Treasury
• Treasury Bills (Zero coupon bonds matures in a year or less)
• Treasury Notes (Coupon bonds mature in 2 to 10 years)
• Treasury Bonds (Coupon bonds mature in more than 10 years
usually up to 30 years)
A Basic Zero Coupon Bond
A Basic Coupon Bond
A Basic Coupon Bond
 Bond Terminology
• Bond Certificate: A document which states the bond conditions
and at times the owner name
• Face / par value / Principle Value: The price of the bond at the
issuance date which is also printed on the bond certificate
• Settlement date: The date on which a bond is exchanged for funds
• Coupon rate: The annual interest rate printed on the bond
• Maturity date: The date mentioned on the bond certificate as
payment date
• Redemption: The date on which the issuing agency retires the
bonds (can be maturity date or call date)
• Redemption value (% of par value): The amount paid to the owner
of the bond when retired. The default is 100% or at par value.
 Bond Terminology
• Yield to redemption or Yield to maturity: The rate of return earned
from payments of principal and interest, with interest
• compounded semi-annually at the stated yield rate.
• Price: Price of the bond (Important note: price is expressed in
terms of dollars per $100 of par value)
• Term: Time remaining till redemption date
 Bond Types: Bearer Bond
• Owned by the holder (bearer)
• Coupons for interest payments are physically attached to the
security
• It is the bondholder's responsibility to submit the coupons to a
bank for payment
• Are negotiable
• Stopped in US since 1982
A Bearer Bond
 Bearer Bond Fraud
• Legitimate bearer bonds do exist but extremely rear
• Nigerian prince
• Deep discount
• Stolen
• Found
Bearer Bond Fraud
EE Saving Bond
Bond Terminology
 Zero-Coupon Bonds
• Only two cash flows
• The bond’s market price at the time of purchase
• The bond’s face value at maturity
• Treasury bills are zero-coupon U.S. government bonds with
maturity of up to one year
 Example: Zero-Coupon Bonds
• A one-year, risk-free, zero-coupon bond with a $100,000 face
value has an initial price of $96,618.36
• If you purchased this bond and held it to maturity, you would
have the following cash flows:
 Yield to Maturity of a Zero-Coupon Bond
• The discount rate that sets the present value of the promised
bond payments equal to the current market price of the bond
• Yield to Maturity of an n-Year Zero-Coupon Bond:
 Exercise: Yields for Different Maturities
• Suppose the following zero-coupon bonds are trading at the
prices shown below per $100 face value. Determine the
corresponding yield to maturity for each bond.

Maturity 1 year 2 years 3 years 4 years

Price $96.62 $92.45 $87.63 $83.06

 Exercise: Yields for Different Maturities
• Suppose the following zero-coupon bonds are trading at the
prices shown below per $100 face value. Determine the
corresponding yield to maturity for each bond.

Maturity 1 year 2 years 3 years 4 years

Price $96.62 $92.45 $87.63 $83.06

 Exercise: Yields for Different Maturities
• Suppose the following zero-coupon bonds are trading at the
prices shown below per $100 face value. Determine the
corresponding yield to maturity for each bond.

Maturity 1 year 2 years 3 years 4 years

Price $98.52 $96.59 $94.23 $91.48

Zero-Coupon Yield Curve
Treasury Yield Curve
 Exercise: Price of a Zero-Coupon Bond
• Given the yield curve, what is the price of a 5-year risk-free
zero-coupon bond with a face value of $100?
 Exercise: Price of a Zero-Coupon Bond
• Given the yield curve, what is the price of a 3-year risk-free
zero-coupon bond with a face value of $900?

P = 900 / (1.02)3 = $848.09

• Note that the price given in Example is $94.23 per $100 face
value, which is a standard format for bond price quotes. We
can answer the problems using that information: e.g
$94.23*9=$848.09.
 Coupon bonds
• Pay face value at maturity
• Also make regular coupon interest payments
• Two types of U.S. Treasury coupon securities are currently
traded in financial markets:
• Treasury notes
• original maturities from one to ten years
• Treasury bonds
• original maturities of more than ten years
 Coupon Rate
• Set by the issuer and stated on the bond certificate
• By convention, expressed as an APR, so the amount of each
coupon payment, CPN, is:
Existing U.S. Treasury Securities
 Return on Coupon Bonds
• Return on a coupon bond comes from:
• The difference between the purchase price and the principal value
• Periodic coupon payments
• To compute the yield to maturity of a coupon bond, we need
to know the coupon interest payments, and when they are
paid
 Exercise: The Cash Flows of a Coupon Bond or Note
• Assume that it is May 15, 2010 and the U.S. Treasury has just
issued securities with May 2015 maturity, $1000 par value and
a 2.2% coupon rate with semiannual coupons. Since the
original maturity is only 5 years, these would be called “notes”
as opposed to “bonds”. The first coupon payment will be paid
on November 15, 2010. What cash flows will you receive if you
hold this note until maturity?
 Coupon Bonds Cash Flow
• Yield to Maturity of a Coupon Bond:
• Cash flows shown in the timeline below:

• Coupon bonds have many cash flows, complicating the yield to

maturity calculation
• The coupon payments are an annuity, so the yield to maturity
is the interest rate
 Exercise: The Cash Flows of a Coupon Bond or Note
• The face value of this note is $1000. Because this note pays
coupons semiannually, from Eq.(6.1) you will receive a coupon
payment every six months of CPN=$1,000 x 2.2%/2=$11. Here
is the timeline based on a six-month period and there are a
total of 10 cash flows:
 Exercise: The Cash Flows of a Coupon Bond or Note
• The face value of this note is $1000. Because this note pays coupons
semiannually, from Eq.(6.1) you will receive a coupon payment
every six months of CPN=$1,000 x 2.2%/2=$11. Here is the timeline
based on a six-month period and there are a total of 10 cash flows:

• The face value of this note is $1000. Because this note pays coupons
semiannually, from Eq.(6.1) you will receive a coupon payment
every six months of CPN=$1,000 x 2.2%/2=$11. Here is the timeline
based on a six-month period and there are a total of 10 cash flows:
 Exercise: The Cash Flows of a Coupon Bond or Note
• Assume that it is January 15th, 2010 and the U.S. Treasury has
just issued securities with January 15th, 2019 maturity, $1000
par value and a 3% coupon rate with semiannual coupons.
Since the original maturity is only 9 years, these would be
called “notes” as opposed to “bonds”. The first coupon
payment will be paid on July 15th, 2010. What cash flows will
you receive if you hold this note until maturity?
 Exercise: The Cash Flows of a Coupon Bond or Note
• Consider the five-year, $1000 bond with a 2.2% coupon rate
and semiannual coupons described in Example 6.3.
• If this bond is currently trading for a price of $963.11, what is
the bond’s yield to maturity?
 Exercise: The Cash Flows of a Coupon Bond or Note
• Consider the five-year, $1000 bond with a 2.2% coupon rate
and semiannual coupons described in Example 6.3.
• If this bond is currently trading for a price of $963.11, what is
the bond’s yield to maturity?

Given: 10 -963.11 11 1,000

Solve for: 1.50
Excel Formula: =RATE(NPER,PMT,PV,FV)=
RATE(10,11,-963.11,1000)
 Exercise: Computing a Bond Price
• Consider again the five-year, $1000 bond with a 2.2% coupon
rate and semiannual coupons in Example 6.4. Suppose interest
rates drop and the bond’s yield to maturity decreases to 2%
(expressed as an APR with semiannual compounding). What
price is the bond trading for now? And what is the effective
annual yield on this bon
 Exercise: Computing a Bond Price
• Consider again the five-year, $1000 bond with a 2.2% coupon
rate and semiannual coupons in Example 6.4. Suppose interest
rates drop and the bond’s yield to maturity decreases to 2%
(expressed as an APR with semiannual compounding). What
price is the bond trading for now? And what is the effective
annual yield on this bon

Given: 10 1.0 25 1,000

Solve for: -1,009.47
Excel Formula: = PV(RATE,NPER,PMT,FV)=PV(.01,10,11,1000)
 Exercise: Computing a Bond Price
• Consider the nine-year, $1000 note with a 3% coupon rate and
semiannual coupons described in Example 6.3a.
• If this bond is currently trading for a price of $1,038.32, what is
the bond’s yield to maturity?
 Exercise: Computing a Bond Price
• Consider the nine-year, $1000 note with a 3% coupon rate and
semiannual coupons described in Example 6.3a.
• If this bond is currently trading for a price of $1,038.32, what is
the bond’s yield to maturity?

Given: 18 -1038.32 15 1,000

Solve for: 1.26
Excel Formula: =RATE(NPER,PMT,PV,FV)=
RATE(18,15,-1038.32,1000)
 Exercise: Computing a Bond Price
• Consider again the five-year, $1000 bond with a 3% coupon
rate and semiannual coupons in the previous Example 6.
• Suppose interest rates increase and the bond’s yield to
maturity increases to 4.0% (expressed as an APR with
semiannual compounding).
• What price is the bond trading for now?
 Exercise: Computing a Bond Price
• Consider again the five-year, $1000 bond with a 3% coupon rate and
semiannual coupons in the previous Example 6.
• Suppose interest rates increase and the bond’s yield to maturity
increases to 4.0% (expressed as an APR with semiannual compounding).
• What price is the bond trading for now?

Given: 18 2.0 15 1,000

Solve for: -$925.03
Excel Formula: = PV(RATE,NPER,PMT,FV)=PV(.02,18,15,1000)
 Coupon Bond Price Quotes
• Prices and yields are often used interchangeably
• Bond traders usually quote yields rather than prices
• One advantage is that the yield is independent of the face
value of the bond
• When prices are quoted in the bond market, they are
conventionally quoted per $100 face value
 Why Bond Prices Change
• Zero-coupon bonds always trade for a discount
• Coupon bonds may trade at a discount or at a premium
• Most issuers of coupon bonds choose a coupon rate so that
the bonds will initially trade at, or very close to, par
• After the issue date, the market price of a bond changes over
time
• If a bond sells at par the only return investors will earn is from the
coupons that the bond pays
• Therefore, the bond’s coupon rate will exactly equal its yield to
maturity
• As interest rates in the economy fluctuate, the yields that investors
demand will also change
A Bond’s Price vs. Its Yield to Maturity
Bond Prices Immediately After a Coupon Payment
Exercise: Determining the Discount or Premium of a Coupon Bond
• Consider three 30-year bonds with annual coupon payments.
• One bond has a 10% coupon rate, one has a 5% coupon rate,
and one has a 3% coupon rate.
• If the yield to maturity of each bond is 5%, what is the price of
each bond per $100 face value?
• Which bond trades at a premium, which trades at a discount,
and which trades at par?
Exercise: Determining the Discount or Premium of a Coupon Bond
• Consider three 30-year bonds with annual coupon payments.
• One bond has a 10% coupon rate, one has a 5% coupon rate,
and one has a 3% coupon rate.
• If the yield to maturity of each bond is 5%, what is the price of
each bond per $100 face value?
• Which bond trades at a premium, which trades at a discount,
and which trades at par?
Exercise: Determining the Discount or Premium of a Coupon Bond
• Consider three 30-year bonds with annual coupon payments.
• One bond has a 12% coupon rate, one has a 6% coupon rate,
and one has a 2% coupon rate.
• If the yield to maturity of each bond is 6%, what is the price of
each bond per $100 face value?
• Which bond trades at a premium, which trades at a discount,
and which trades at par?
Exercise: Determining the Discount or Premium of a Coupon Bond
• Consider three 30-year bonds with annual coupon payments.
• One bond has a 12% coupon rate, one has a 6% coupon rate,
and one has a 2% coupon rate.
• If the yield to maturity of each bond is 6%, what is the price of
each bond per $100 face value?
• Which bond trades at a premium, which trades at a discount,
and which trades at par?
Exercise: Determining the Discount or Premium of a Coupon Bond
• Consider three 30-year bonds with annual coupon payments.
• One bond has a 5% coupon rate, one has a 3% coupon rate,
and one has a 2% coupon rate.
• If the yield to maturity of each bond is 4%, what is the price of
each bond per $100 face value?
• Which bond trades at a premium, which trades at a discount,
and which trades at par?
Exercise: Determining the Discount or Premium of a Coupon Bond
• Consider three 30-year bonds with annual coupon payments.
• One bond has a 5% coupon rate, one has a 3% coupon rate,
and one has a 2% coupon rate.
• If the yield to maturity of each bond is 4%, what is the price of
each bond per $100 face value?
• Which bond trades at a premium, which trades at a discount,
and which trades at par?
The Effect of Time on Bond Prices
 Exercise: The Effect of Time on the Price of a Bond
• Suppose you purchase a 30-year, zero-coupon bond with a
yield to maturity of 5%. For a face value of $100, the bond will
initially trade for
• If the bond’s yield to maturity remains at 5%, what will its
price be five years later?
• If you purchased the bond at $23.14 and sold it 5 years later,
what would the rate of return of your investment be?
 Exercise: The Effect of Time on the Price of a Bond
• Suppose you purchase a 30-year, zero-coupon bond with a
yield to maturity of 5%. For a face value of $100, the bond will
initially trade for
• If the bond’s yield to maturity remains at 5%, what will its
price be five years later?
• If you purchased the bond at $23.14 and sold it 5 years later,
what would the rate of return of your investment be?
 Exercise: The Effect of Time on the Price of a Bond
• Suppose you purchase a 20-year, zero-coupon bond with a
yield to maturity of 10%. For a face value of $800, the bond
will initially trade for
• If the bond’s yield to maturity remains at 10%, what will its
price be five years later?
• If you purchased the bond at $118.91 and sold it 5 years later,
what would the rate of return of your investment be?
 Exercise: The Effect of Time on the Price of a Bond
• Suppose you purchase a 20-year, zero-coupon bond with a
yield to maturity of 10%. For a face value of $800, the bond
will initially trade for
• If the bond’s yield to maturity remains at 10%, what will its
price be five years later?
• If you purchased the bond at $118.91 and sold it 5 years later,
what would the rate of return of your investment be?
800
P(20 years to maturity) = 1.10 20 = $118.91
1/5

( 191.51
118.91 ) -1 = 10.0%
 Exercise: The Effect of Time on the Price of a Bond
● Suppose you purchase a 20-year, zero-coupon bond with a
yield to maturity of 5%. For a face value of $500, the bond will
initially trade for
● If the bond’s yield to maturity remains at 5%, what will its
price be eight years later?
● If you purchased the bond at $188.44 and sold it 8 years later,
what would the rate of return of your investment be?
 Exercise: The Effect of Time on the Price of a Bond
● Suppose you purchase a 20-year, zero-coupon bond with a
yield to maturity of 5%. For a face value of $500, the bond will
initially trade for
● If the bond’s yield to maturity remains at 5%, what will its
price be eight years later?
● If you purchased the bond at $188.44 and sold it 8 years later,
what would the rate of return of your investment be?
P(12 years to maturity) = = $278.42
500 1/8
P(20 years to maturity) =
1.05 20
= $188.44
(278.42
188.44 ) -1 = 5.0%
 Interest Rate Risk and Bond Prices
• Effect of time on bond prices is predictable, but unpredictable
changes in rates also affect prices
• Bonds with different characteristics will respond differently to
changes in interest rates
• Investors view long-term bonds to be riskier than short-term
bonds
 Exercise: Interest Rate Risk and Bond Prices
• Consider a 10-year coupon bond and a 30-year coupon bond,
both with 10% annual coupons.
• By what percentage will the price of each bond change if its
yield to maturity increases from 5% to 6%?
The Interest Rate Sensitivity of Bonds
 Exercise: The Interest Rate Sensitivity of Bonds
• Consider a 5-year coupon bond and a 40-year coupon bond,
both with 5% annual coupons.
• By what percentage will the price of each bond change if its
yield to maturity increases from 5% to 6%?

Yield to 5-year, 5% Annual 40-year, 5% Annual

Maturity Coupon Bond Coupon Bond

5%

6%
The Interest Rate Sensitivity of Bonds
Bond Prices and Interest Rates
 Exercise: Coupons and Interest Rate Sensitivity
• Consider two bonds, each pays semi-annual coupons and 5
years left until maturity.
• One has a coupon rate of 5% and the other has a coupon rate
of 10%, but both currently have a yield to maturity of 8%.
• How much will the price of each bond change if its yield to
maturity decreases from 8% to 7%?
 Exercise: Coupons and Interest Rate Sensitivity
• Consider two bonds, each pays semi-annual coupons and 5 years left
until maturity.
• One has a coupon rate of 5% and the other has a coupon rate of 10%,
but both currently have a yield to maturity of 8%.
• How much will the price of each bond change if its yield to maturity
decreases from 8% to 7%?

Given: 10 4 2.50 100

Solve for: -87.83

Excel Formula: =PV(RATE,NPER,PMT,FV)=PV(.04,10,2.5,100)

 Exercise: Coupons and Interest Rate Sensitivity
• Consider two bonds, each pays semi-annual coupons and 5
years left until maturity.
• One has a coupon rate of 4% and the other has a coupon rate
of 12%, but both currently have a yield to maturity of 8%.
• How much will the price of each bond change if its yield to
maturity decreases from 8% to 7%?
 Exercise: Coupons and Interest Rate Sensitivity
• Consider two bonds, each pays semi-annual coupons and 5
years left until maturity.
• One has a coupon rate of 4% and the other has a coupon rate
of 12%, but both currently have a yield to maturity of 8%.
• How much will the price of each bond change if its yield to
maturity decreases from 8% to 7%?

Yield to 5-year, 5% Annual 40-year, 5% Annual

Maturity Coupon Bond Coupon Bond
Given: 10 4 6 100
8%
Solve for: 116.22

7% Excel Formula: =PV(RATE,NPER,PMT,FV)=PV(.04,10,6,100)

 Bond Prices in Practice
• Bond prices are subject to the effects of both passage of time
and changes in interest rates
• Prices converge to face value due to the time effect, but move
up and down because of changes in yields
Yield to Maturity and Bond Price Fluctuations over Time
 Corporate Bonds
• Credit Risk
• U.S. Treasury securities are widely regarded to be risk-free
• Credit risk is the risk of default, so that the bond’s cash flows are not
known with certainty
• Corporations with higher default risk will need to pay higher
coupons to attract buyers to their bonds
 Corporate Bond Yields
• Yield to maturity of a defaultable bond is not equal to the
expected return of investing in the bond
• A higher yield to maturity does not necessarily imply that a
bond’s expected return is higher
• Bond Ratings
• Several companies rate the creditworthiness of bonds
• Two best-known are Standard & Poor’s and Moody’s
• These ratings help investors assess creditworthiness
Bond Ratings
Bond Ratings
 Bond Ratings
• Investment-grade bonds
• Speculative bonds
• junk bonds
• high-yield bonds
• The rating depends on
• the risk of bankruptcy
• bondholders’ claim to assets in the event of bankruptcy
 Corporate Yield Curves
• We can plot a yield curve for corporate bonds just as we can
for Treasuries
• The credit spread is the difference between the yields of
corporate bonds and Treasuries
Corporate Yield Curves
 Exercise: Credit Spreads and Bond Prices
• Your firm has a credit rating of A.
• You notice that the credit spread for 10-year maturity debt is
90 basis points (0.90%).
• Your firm’s ten-year debt has a coupon rate of 5%.
• You see that new 10-year Treasury notes are being issued at
par with a coupon rate of 4.5%.
• What should the price of your outstanding 10-year bonds be?
 Exercise: Credit Spreads and Bond Prices
• Your firm has a credit rating of AAA.
• You notice that the credit spread for 10-year maturity debt is
60 basis points (0.60%).
• Your firm’s ten-year debt has a coupon rate of 4%.
• You see that new 10-year Treasury notes are being issued at
par with a coupon rate of 3.65%.
• What should the price of your outstanding 10-year bonds be?
Yield Spreads and the Financial Crisis
Yield Spreads and the Financial Crisis