Bond Prices and Yields

Chapter 14
McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
 Bond Characteristics

Face or par value

Coupon rate
Zero coupon bond
Compounding and payments
Accrued Interest
Indenture

14-2
 Provisions of Bonds

Secured or unsecured
Call provision
Convertible provision
Put provision (putable bonds)
Floating rate bonds
Sinking funds

14-3
 Valuation Fundamentals
Valuation is the process that links risk and return
to determine the worth of an asset.
There are three key inputs to the valuation
process:
1. Cash flows (returns)
2. Timing
3. A measure of risk, which determines the required
return

6-414-4
 Bond Pricing

PB  
T
C t

ParValue T

t 1 (1 r ) (1 r )
t T

PB = Price of the bond

Ct = interest or coupon payments
T = number of periods to maturity
y = semi-annual discount rate or the semi-annual
yield to maturity

14-5
Price: 10-yr, 8% Coupon, Face = $1,000

20
1 1000
P  40 
t 1  1.03
t 20
(1.03)
P  $1,148.77
Ct = 40 (SA)
P = 1000
T = 20 periods
r = 3% (SA)

14-6
 Bond Prices and Yields

Prices and Yields (required rates of

return) have an inverse relationship
When yields get very high the value of
the bond will be very low.
When yields approach zero, the value of
the bond approaches the sum of the
cash flows.

14-7
 Prices and Coupon Rates

Price

Yield

14-8
 Yield to Maturity

Interest rate that makes the present

value of the bond’s payments equal to
its price.
Solve the bond formula for r

PB  
T
C t

ParValue T

t 1 (1 r ) (1 r )
t T

14-9
 Yield to Maturity Example

950  
20
35 1000

t 1 (1 r ) (1 r )
t T

10 yr Maturity Coupon Rate = 7%

Price = $950
Solve for r = semiannual rate r = 3.8635%

14-10
 Yield Measures

Bond Equivalent Yield

7.72% = 3.86% x 2
Effective Annual Yield
(1.0386)2 - 1 = 7.88%
Current Yield
Annual Interest / Market Price
$70 / $950 = 7.37 %

14-11
 Default Risk and Ratings

Rating companies
Moody’s Investor Service
Standard & Poor’s
Duff and Phelps
Fitch
Rating Categories
Investment grade
Speculative grade

14-12
Factors Used by Rating Companies

Coverage ratios
Leverage ratios
Liquidity ratios
Profitability ratios
Cash flow to debt

14-13
 Protection Against Default

Sinking funds
Subordination of future debt
Dividend restrictions
Collateral

14-14
 Duration

A measure of the effective maturity of a

bond.
The weighted average of the times until
each payment is received, with the
weights proportional to the present value
of the payment.
Duration is shorter than maturity for all
bonds except zero coupon bonds.
Duration is equal to maturity for zero
coupon bonds.

14-15
 Duration: Calculation

wt  CF t (1  y )
t
Price
T
D   t wt
t 1

CFt  Cash Flow for period t

14-16
Duration Calculation: Spreadsheet 16.1

8% Time Payment PV of CF Weight C1 X

Bond years (10%) C4

.5 40 38.095 .0395 .0197

1 40 36.281 .0376 .0376

1.5 40 34.553 .0358 .0537

2.0 1040 855.611 .8871 1.7742

sum 964.540 1.000 1.8852

14-17
 Duration/Price Relationship

Price change is proportional to duration

and not to maturity.
P/P = -D x [(1+y) / (1+y)
D* = modified duration
D* = D / (1+y)
P/P = - D* x y

14-18