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RE8013 Financial Management Notes

Lesson 3: Bonds and their valuation

A bond is a security sold by governments and corporations to raise


money from investors today in exchange for promised payment.
Corporate bonds are issued by corporations.
Sovereign bonds are issued by national governments.

Bond certificate – determines the terms of the bond


Maturity date – the final repayment date
Term – the time remaining until the repayment date
Coupon – the promised interest payments of a bond
Face Value – the amount used to compute the interest payments
(face value is usually repaid at maturity)
Coupon Rate – determines the amount of each coupon payment

𝐶𝑂𝑈𝑃𝑂𝑁 𝑅𝐴𝑇𝐸 𝑋 𝐹𝐴𝐶𝐸 𝑉𝐴𝐿𝑈𝐸


CPN =
𝑁𝑈𝑀𝐵𝐸𝑅 𝑂𝐹 𝐶𝑂𝑈𝑃𝑂𝑁 𝑃𝐴𝑌𝑀𝐸𝑁𝑇𝑆 𝑃𝐸𝑅 𝑌𝐸𝐴𝑅

Yield to Maturity of a bond is the discount rate that sets the present
value of the promised bond payments equal to the current market price
of the bond.

Zero-coupon Bonds
These bonds always sell at a discount (a price lower than face value), so
they are also called pure discount bonds.
Treasury Bills are US government zero-coupon bonds with a maturity of
up to one year. (US Treasury notes - maturities of 1 – 10 years, US
Treasury Bonds with maturities over 10 years)

Risk-free Interest Rate with Maturity n, rn, equals the YTM on a default-
free zero-coupon bond that matures on date n.
Zero-coupon Yield Curve is a plot of the yield of risk-free zero-coupon
bonds as a function of the bond’s maturity date.

Let yield to maturity of a coupon bond be y

1 1 𝐹𝑉
P = CPN x (1 − ) +
𝑦 (1+𝑦)𝑁 (1+𝑦)𝑁
Discounts and Premiums
Discount bond (current < face value)
- An investor will earn a return both from receiving coupons and a
face value that exceeds the price paid for the bond
- Yield (YTM) > coupon rate

Par Bond (current price = face value)


- Yield = coupon rate

Premium bond (current price > face value)


- An investor will earn a return from receiving coupons but will
receive a face value less than the price paid for the bond
- Yield (YTM) < coupon rate

Holding all things constant, a bond’s YTM will not change over time.
Also, the price of discount/premium bond will move towards par value
over time.
If a bond’s YTM has not changed, then the internal rate of investment
equals its YTM even if you sell the bond before maturity (???)

Interest Rate Changes and Bond Prices


There is an inverse relationship between interest rates and bond prices.
Eg. As interest rates and bond yields rise, bond prices fall (???)

Bonds with high durations are highly sensitive to interest rate changes
while shorter term bonds are less sensitive.

Corporate Bonds
Bonds are issued by corporation. Credit Risk – Risk of default.

Corporate Bond yields –


Investors pay less for bonds with credit risk than identical default-free
bonds. The yield of bonds with credit risk is higher that identical
default-free bonds.

Forward Interest Rates


- An interest rate that can be guaranteed today for a
loan/investment in the future
-