1

Bond Basics
Bonds are simply long-term IOUs that

represent claims against a firms assets.

Bonds are a form of debt
Bonds are often referred to as fixedincome investments.

Key Features of a Bond

Debt instrument issued by a corp. or

government.

Key Features of a Bond

Par value = face amount of the bond, which is

paid at maturity (assume $1,000).

=
4

Key Features of a Bond

Coupon rate stated interest rate

(generally fixed) paid by the issuer.

Multiply by par to get dollar payment of
interest.

Key Features of a Bond

Maturity date when the bond must be

repaid.
Yield to maturity - rate of return earned on a

bond held until maturity.

What is interest rate risk?

Interest rate risk is the concern that interest

rates will change, and therefore, a reduction

in the value/price of a security.

Interest rate risk example

Suppose you just inherited $500,000. You
intend to invest the money and live off the
interest.

Interest rate risk example

You may invest in either a:
10-year bond
series of ten 1-year bonds
Both bonds currently yield 5%.

If you choose the 1-year bond

strategy:
After year 1, you receive $25,000
in income and have $500,000 to
reinvest. But, if 1-year rates fall
to 3%, your annual income would
fall to $15,000.

If you choose the 10-year bond

strategy:
You can lock in a 5% interest
rate, and $25,000 annual income.
10

Interest Rate Risk

Price Risk
Change in price due to changes in
interest rates
Long-term bonds have more price
risk than short-term bonds
Low coupon rate bonds have more
price risk than high coupon rate
bonds
11

12

Bond Value
Bond Value = PV(coupons) + PV(par)
Bond Value = PV(annuity) + PV(lump sum)
Remember:
As interest rates increase present values

decrease
(

r PV )

As interest rates increase, bond prices decrease

and vice versa

13

Bond Valuation
Compute
Computethe
thevalue
valuefor
foran
anIBM
IBM Bond
Bondwith
withaa
6.375%
6.375%coupon
couponthat
that will
willmature
maturein
in55years
years
given
giventhat
thatyou
you require
requirean
an 8%
8%return
returnon
onyour
your
investment.
investment.
What
What are
arethe
theannual
annualinterest
interest payments
payments($)?
($)?

14

IBM Bond Timeline:

2009
0

2010
1

63.75

2011
2

63.75

2012
3

63.75

2013
4

63.75

63.75
1,000.00

15

IBM Bond Timeline:

2009
0

2010
1

63.75

2011
2

63.75

$63.75
$63.75Annuity
Annuityfor
for55years
years

2012
3

2013
4

63.75

63.75

63.75
1000.00

$1000
$1000Lump
LumpSum
Sum in
in 55years
years

16

IBM Bond Timeline:

2009
0

2010
1

63.75

2011
2

63.75

$63.75
$63.75Annuity
Annuityfor
for55years
years

2012
3

2013
4

63.75

63.75

63.75
1000.00

$1000
$1000Lump
LumpSum
Sum in
in 55years
years

= 63.75 PMT 1000 FV 8% I

5N

= PV = 935.12
17

Most Bonds Pay Interest Semi-Annually:

What is the value of a bond with a semi-annual

coupon with 5 years to maturity, 9% (nominal)
coupon rate if an investor desires a 10% (nominal)
return?

18

Most Bonds Pay Interest Semi-Annually:

e.g. semiannual coupon bond with 5 years
to maturity, 9% annual coupon rate.
Instead of 5 annual payments of $90, the bondholder
receives 10 semiannual payments of $45.
2013
0

2014
1

45

45

2015
2

45

45

2016
3

45

45

2017
4

45

45

45

45.00
1000.00

19

Most Bonds Pay Interest Semi-Annually:

2013
0

2014
1

45

45

2015
2

45

45

2016
3

45

45

2017
4

45

45

45

45.00
1000.00

Compute
Computethe
thevalue
valueof
ofthe
thebond
bondgiven
giventhat
thatyou
you
require
requireaa10%
10%s-a.
s-a. return
returnon
onyour
yourinvestment.
investment.
Since interest is received every 6 months, we need to use
semiannual compounding

VB =
45 - PMT
1000 - FV
5% - I
10 - N

20

Most Bonds Pay Interest Semi-Annually:

2013
0

2014
1

45

45

2015
2

45

45

2016
3

45

45

2017
4

45

45

45

45
1,000

Compute
Computethe
thevalue
valueof
ofthe
thebond
bondgiven
giventhat
thatyou
you
require
requireaa10%
10%s-a.
s-a. return
returnon
onyour
yourinvestment.
investment.
Since interest is received every 6 months, we need to use
semiannual compounding

= PV = 961.39
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Semiannual Bonds
Coupon rate = 14% - Semiannual
YTM = 16% (APR)
Maturity = 7 years
Value of bond?
Number of coupon payments? (2t or N)
14

= 2 x 7 years

Semiannual coupon payment? (C/2 or PMT)

$70

= (14% x Face Value)/2

Semiannual yield?
8% = 16%/2

(YTM/2 or I/Y)

22

Semiannual Bonds
Semiannual coupon =

$70
Semiannual yield
=
8%
Periods to maturity =
14

Bond Value C
2

Bond value =
1 14
] / .08 +
70[1 11/(1.08)

14

(1.08)14 = 1000
1000
/
(1.08)

B 70
14
0
.
08
(
1
.
08
)

917.56

1-

1
1 YTM

YTM

2t

F
1 YTM

2t

Using the calculator:

14
N
8
I/Y
70
PMT
1000
FV
CPT PV = -917.56

Using Excel: =PV(0.08, 14, 70, 1000, 0)

23

Yield to Maturity
2013
0

-1,000

2014

2015

80

80

2016

2017

80

80

80
1,000

If bond Sells at a DISCOUNT (less than

$1,000) then YTM > Coupon Rate

If bond Sells at a PREMIUM (more than

$1,000) then YTM < Coupon Rate

24

Valuing a Discount Bond

with Annual Coupons
Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 5 years
YTM = 11%
Price= ?

25

Valuing a Discount Bond

with Annual Coupons
Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 5 years
YTM = 11%
Using the formula:
B = PV(annuity) + PV(lump sum)
B = 369.59 + 593.45 = 963.04

Using the calculator:

5
N
11
I/Y
100
PMT
1000 FV
CPT PV = -963.04

1
1

(1.11)5
B 100
0.11

1000
(1.11)5

Using Excel: =PV(0.11, 5, 100, 1000, 0)

Note: When YTM > Coupon rate Price < Par = Discount Bond
26

Valuing a Premium Bond

with Annual Coupons
Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 20 years
YTM = 8%
Price = ?

27

Valuing a Premium Bond

with Annual Coupons
Using the calculator:
20
N
8
I/Y
100
PMT
1000 FV
CPT PV = -1196.36

Coupon rate = 10%

Annual coupons
Par = $1,000
Maturity = 20 years
YTM = 8%
Using the formula:
B = PV(annuity) + PV(lump sum)
B = 981.81 + 214.55 = 1196.36

1000
(1.08) 20

B 100
20
0.08

(1.08)

Using Excel: =PV(0.08, 20, 100, 1000, 0)

Note: When YTM < Coupon rate Price > Par = Premium Bond
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Yield to Maturity

If an investor purchases a 6.375% annual

coupon bond today for $900 and holds it

until maturity (5 years), what is the
expected annual rate of return (YTM)?
2013
0

-900
??
+ ??

2014

2015

63.75

63.75

2016
3

63.75

2017
4

63.75

63.75
1000.00

900
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Yield to Maturity
If an investor purchases a 6.375% annual coupon

bond today for $900 and holds it until maturity (5

years), what is the expected annual rate of return ?
Will it be >< than 6.375%?
2013
0

-900
??
+ ??
900

2014

2015

63.75

63.75

2016
3

63.75

2017
4

63.75

63.75
1000.00

YTMB = 63.75 PMT

1000 FV
5N
-900 PV
I=?

30

rd=?

1
90

PV1
.
.
.
PV10
PVM

887

...

9
90

10
90
1,000

Find rd that works!

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INPUTS
OUTPUT

10
N

I/YR
10.91

-887
PV

90
PMT

1000
FV

32

Types of Bonds
Vanilla fixed coupons, repaid at maturity
Zero Coupon pay no explicit interest but

instead, sell at a deep discount

Convertible can be converted into to stock

33

Types of Bonds
Junk Bonds below investment grade

34

Government Bonds
Treasury Securities = Federal government

debt

Treasury Bills (T-bills)

Pure discount bonds
Original maturity of one year or less
Treasury notes (T-notes)

Coupon debt
Original maturity between one and ten years

Treasury bonds (T-bonds)

Coupon debt

Original maturity greater than ten years

35

Tax Consequences
A taxable bond has a yield of 8% and a
municipal bond has a yield of 6%
If you are in a 40% tax bracket, which

bond do you prefer?

8%(1 - .4) = 4.8%
The after-tax return on the corporate bond is

4.8%, compared to a 6% return on the

municipal

At what tax rate would you be indifferent

between the two bonds?

8%(1 T) = 6%
T = 25%
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Bond Ratings
Moodys , Standard & Poors and Fitch

regularly monitor issuers financial

condition and assign a rating to the debt
Investment
Grade
Below
Investment
Grade
(Junk)

AAA
AA
A
BBB
BB
B
CCC
CC
C
D

Best Quality
High Quality
Upper Medium Grade
Medium Grade
Speculative
Very Speculative
Very Very Speculative
No Interest Being Paid
Currently in Default

37

Bond Ratings
Investment
Quality
High Grade
Moodys Aaa and S&P AAA capacity to pay is

extremely strong
Moodys Aa and S&P AA capacity to pay is very
strong

Medium Grade
Moodys A and S&P A capacity to pay is strong,

but
more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is
adequate, adverse conditions will have more
impact on the firms ability to pay

38

Bond Ratings Speculative

Low Grade
Moodys Ba, B, Caa and Ca
S&P BB, B, CCC, CC
Considered speculative with respect to

capacity
to pay. The B ratings are
the lowest degree of speculation.

Very Low Grade

Moodys C and S&P C income bonds with

no interest being paid

Moodys D and S&P D in default with
principal and interest in arrears
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What affects Bond

prices?
Risk
Interest rates

40

What is the term structure of interest

rates? What is a yield curve?

Term structure: the relationship

between interest rates (or yields) and

maturities.
A graph of the term structure is called

the yield curve.

41

Draw a normal yield

curve

42

Hypothetical Treasury Yield Curve

Interest
Rate (%)
15

Maturity risk premium

10

Inflation premium

1 yr
10 yr
20 yr

8.0%
11.4%
12.65%

5
Real risk-free rate

Years to Maturity

0
1

10

20
43

What factors can explain the shape

of this yield curve?
This constructed yield curve is upward

sloping.
This is due to increasing expected
inflation and an increasing maturity
risk premium.

44

Current Yield Curve

Bloomberg

45

Default risk
If an issuer defaults, investors receive

less than the promised return.

Influenced by the issuers financial
strength and the terms of the bond
contract.

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