Chapter

Six Continued
Tuesday, January 30, 2018 11:30 AM

Yield to Maturity (YTM)

• Bond has 3 years to maturity, 8% annual coupon rate, face value
of $1,000
• Price= $1053.46

(1,053.46) 80 80 80… $1000

1 1 1000
$1053.46 = 80 +⎯⎯− ⎯⎯⎯⎯⎯⎯⎯⎯⎯3 + ⎯⎯⎯⎯⎯⎯⎯⎯
𝑟 𝑟(1 + 𝑟) 2 (1 + 𝑟) 2
Find r=YTM

Trial and Error

• Bond is selling at a premium, so YTM < 8%
○ Try r=5%
1 1 1000
𝑃𝑉 𝑜𝑓 𝐵𝑜𝑛𝑑 𝑎𝑡 5% = 80 +⎯⎯⎯− ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯ 3 + ⎯⎯⎯⎯⎯⎯⎯= $1082
.05 .05(1.05) 2 (1.03) 2
• 1082 > 1053.46 -> YTM > 5%

1 1 1000
𝑃𝑉 𝑜𝑓 𝐵𝑜𝑛𝑑 𝑎𝑡 6% = 80 +⎯⎯⎯− ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯ 3 + ⎯⎯⎯⎯⎯⎯⎯= $1053.46
.06 .06(1.06) 2 (1.06) 2
• Therefore YTM = 6%

6.4 Bond Rates of Return

• Rate of return = Total income per period per dollar invested
Example; You buy a $1000 par, 3-year, 8% annual coupon bond for
$1053.46. One year later you sell it for $1100. What is your rate of
return?
𝑐𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑝𝑟𝑖𝑐𝑒 𝑐ℎ𝑎𝑛𝑔𝑒
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

80 + (1100 − 1053.46)
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯ = .12 𝑜𝑟 12%
$1053.46. One year later you sell it for $1100. What is your rate of
return?
𝑐𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑝𝑟𝑖𝑐𝑒 𝑐ℎ𝑎𝑛𝑔𝑒
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

80 + (1100 − 1053.46)
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯ = .12 𝑜𝑟 12%
1053.46
KLMNLO NVPKR KWXOYR
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯+ ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯
POQRSTUROT POQRSTUROT

= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 𝑦𝑖𝑒𝑙𝑑

80 1100 − 1053.46
⎯⎯⎯⎯⎯⎯⎯⎯+ ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯
1053.46 1053.46

= 7.6% + 4.4% = 12%

Yield to Maturity and Rate of Return

Example: Buy a 3 year, $1000 face, 8% coupon bond for $1053.46 (YTM
= 6%). Suppose YTM does not change and you sell the bond one year
later. What rate of return have you earned on your investment?
• 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐵𝑜𝑛𝑑 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟?
1 1 1000
○ 𝑃𝑟𝑖𝑐𝑒 = 80 +⎯⎯⎯⎯− ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯ 3 + ⎯⎯⎯⎯⎯⎯⎯
0.06 0.06 (1.06) ^ (1.06) ^
○ = $1036.67Y Years left in the bo
• 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛
80 1036.67 − 1054.46
○ 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 = ⎯⎯⎯⎯⎯⎯⎯⎯+ ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯
1053.46 1053 .46
○ = 7.6% + (−1.6%) = 6%
§ Same as yield to maturity

Bond Selling at Premium

• 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒 > 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 > 𝑌𝑇𝑀

Bond Selling at Discount

• 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒 < 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑖𝑒𝑙𝑑 < 𝑌𝑇𝑀

Bond Prices Over Time

ond
Bond Prices Over Time

Taxes and Rate of Return

• Taxes reduce the rate of return on an investment
• To calculate the after-tax rate of return on the investment, convert the cash flows to thei
tax values
Example: You bought an 8% annual coupon bond for $1000 (par value = $10
sell it one year later for $1,047. Your marginal tax rate is 35%.
80 + (1047 − 1000)
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯ = 12.7%
1000

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝐶𝑜𝑢𝑝𝑜𝑛 (𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡) = $80
𝑇𝑎𝑥 = .35 𝑥 80 = $28
𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑖𝑛𝑐𝑜𝑚𝑒 𝑓𝑟𝑜𝑚 𝑐𝑜𝑢𝑝𝑜𝑛 = 80 − 28 = $52
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛 = 1047 − 1000 = 47
𝑇𝑎𝑥 = .35 (.5 𝑥 47) = $8.22
𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑖𝑛𝑐𝑜𝑚𝑒 = $47 − 8.22 = $38.78
52 + 38.78
𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑟𝑒𝑡𝑢𝑟𝑛 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯ = .0908 𝑜𝑟 9.08%
1000

6.5 The Yield Curve

• Yield curve or term structure of interest rates; graph of the relationship between time to
and yield to maturity, for bonds that differ only in their maturity dates
• To properly assess this relationship, bonds must have the same coupon rate and same ris
 ir after

000). You

o maturity

sk
 • Yield curve or term structure of interest rates; graph of the relationship between time to
and yield to maturity, for bonds that differ only in their maturity dates
• To properly assess this relationship, bonds must have the same coupon rate and same ris

Nominal and Real Rates of Interest

• Real Return Bond (RRB) or Indexed bond: bond with variable nominal coupon payments,
determined by a fixed real coupon payment and the inflation rate (payments are linked to
inflation)
• Fisher effect: The nominal interest rate is determined by the real interest rate and the ex
rate of inflation
○ 1 + 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = (1 + 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒) ∗ (1 + 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖

The Determinants of the Yield Curve

• Generally the yield curve is upward sloping with long term rates higher than short term, b
curve is sometimes downward-sloping or humped. Why do long term and short term rate
○ Expectations theory: a major factor determining the shape of the yield curve is expe
future interest rates. An upward sloping yield curve tells you that investors expect s
term interest rates to rise; downward sloping, the short term rates will fall.
• Interest rate risk: the risk in bond prices due to fluctuations in interest rates. An increase
decreases in bond prices and vice versa
• Different bonds are affected differently by interest rate changes
○ Longer term bonds are more sensitive to changes in interest rates than shorter term
(have greater interest rate risk)
○ Lower coupon bonds are more sensitive to changes in interest rates than higher co
bonds (have greater interest rate risk)
o maturity

sk

xpected

𝑖𝑜𝑛 𝑟𝑎𝑡𝑒)

but the
es differ?
ected
short

causes

m bonds

oupon
 ○ Longer term bonds are more sensitive to changes in interest rates than shorter term
(have greater interest rate risk)
○ Lower coupon bonds are more sensitive to changes in interest rates than higher co
bonds (have greater interest rate risk)

• Liquidity premium or liquidity preference theory: the yield curve will tend to be upward-s
because of the liquidity premium needed to induce investors to buy riskier longer bonds
Yield Curve: Sept 29 2017- 1 year spot rate, r1= 1.41%, 2 year spot rate, r2 = 1.52%

0 1 2
1.41

1.52%
§ Invest $1 for 1 year spot rate
□ 1 𝑥 1.0141 = $1.0141
§ Invest $1 for 2 years at spot rate
□ 1 𝑥 (1.0152) ^ = $1.0306
§ The extra return you earn in the second year is the forward rate, f2
□ (1 + 𝑟1)(1 + 𝑓2) = (1 + 𝑟2) ^
□ (1.0141)(1 + 𝑓2) = (1.015) ^
(1.0152) ^
□ 𝑓2 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯ − 1 = .0163 𝑜𝑟 1.63%
1.0141
§ Expected 1-year spot rate, 1 year from now = 1r2

• Expectations theory: shape of yield curve solely determined by expectations about future
m bonds

oupon

sloping

e short-
 □ (1.0141)(1 + 𝑓2) = (1.015) ^
(1.0152) ^
□ 𝑓2 = ⎯⎯⎯⎯⎯⎯⎯⎯⎯ − 1 = .0163 𝑜𝑟 1.63%
1.0141
§ Expected 1-year spot rate, 1 year from now = 1r2

• Expectations theory: shape of yield curve solely determined by expectations about future
term interest rates
○ 1r2 = f2 = 1.63%
• Liquidity preference theory: Investing in short term bonds is riskier than investing in shor
bonds, so investors demand a risk premium on long term bonds
○ 1r2 < f2
○ 1r2 < 1.63%

6.6 Corporate Bonds and the Risk of Default

• Both corporations and the Government of Canada can borrow money by issuing bonds
○ Corporate borrowers can run out of cash and default on their borrowings
○ Typically, national governments don’t go bankrupt if they can print more money or
taxes to cover debts. If they have borrowed in a foreign currency (sovereign debt) a
a financial crisis, they may be unable to repay the debt. This concern shows up in th
that investors demand on such debt.
• Default risk (or credit risk) is the risk that a bond issuer may default on its bond
• The default premium or credit spread is the difference between the promised yield on a c
bond and the yield on a Canada bond with the same coupon and maturity. It is the additio
investors require for bearing credit risk.

Default Premium
• British Columbia Ferry Services Inc. Bond , 5.021% coupon bond, maturity of March 20, 20
January 24th 2017 price -> 122.917, YTM 3.385%
• Government of Canada 5% coupon bond that has a maturity date of June 1st 2037. Janua
2018 ask price was -> 140.925, YTM 2.354%
• Default premium for BC Ferry Services Inc. Bond
○ 3.385 - 2.354 = 1.031 %

•
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ary 24th
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