Introduction to Fixed Income Valuation

Valuing bonds is a fairly simple process because they are basically annuities. You can solve most bond
valuation problems using either the TVM functions of the financial calculator or the bond functions (or even
the cash flow functions). It's important to practice using the calculator so that you're proficient with it by
exam day.
The bond functions are the most efficient for semiannual bonds and the instructions are stamped on the
back of the HP calculator. CFAI is aware of both the information on the back of the HP and the card insert for
the TI, so they are allowed in the exam center.

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 Annual-Pay Bonds
Annual pay bonds pay interest only once per year and return the principal amount (face value) at maturity.
Most bonds pay interest semiannually, so you should only make an annual coupon assumption if explicitly
indicated in the problem.
Eurobonds (or Eurodollar bonds) are one type that typically pays interest annually. If the question specifies a
Eurobond, know that it is an annual pay bond.
Note that, like all investments, the value of a bond (V0) is simply the present value of its future cash flows.
The cash flows are periodic interest payments, coupons (C), and the principal repayment (PM), with the last
coupon, at maturity: maturity of the bond
P0 = C / (1+r)1 + C / (1+r)2 + ….. + (C + PM) / (1+r)M

Note that annual-pay bonds should be solved using the TVM functions because the bond functions are preset
for semiannual compounding. It is not a good idea to switch the bond functions back and forth because there
is no visual indicator to tell the user which convention is set and could lead to miscalculations if the setting is
wrong. Remember the sign differences based on the cash in/out convention of the calculators.

2
 Example
A bond pays a 6% coupon annually on $1,000 principal with a maturity of 5 years. If the yield-to-maturity is
5%, what is the price of this bond in dollars?

3
 Example
A bond pays a 6% coupon annually on $1,000 principal with a maturity of 5 years. If the yield-to-maturity is
5%, what is the price of this bond in dollars?
Pay particular attention to the fact pattern for clues as to whether this is an annual-pay bond or a
conventional bond. In this case, it pays a coupon annually. Only make this assumption if explicitly directed by
the fact pattern.
The bond pays a 6% coupon with a face value of $1,000 (this is another convention where most bonds are
assumed to have $1,000 face value).
6% x 1,000  60 PMT
1,000 FV
5 I/Y
5 N
CPT PV  $1,043.29
Note that, since the coupon is higher than the YTM, the bond sells for a premium. Students should be aware
of the relationship between coupon, YTM, and price as a check of their work and a means to eliminate
answer choices quickly.
And here’s how the price is expressed as a percent of par, e.g., $104.329, which is the more commonly used
approach to quoting bond prices. 4
 Semiannual Bonds
Once again, bonds should be presumed to pay semiannual coupons unless the problem explicitly state
otherwise.

P0 = C/2 / (1+r/2)1 + C/2 / (1+r/2)2 + ….. + (C/2 + PM) / (1+r/2)2M

You must half the coupon, half the YTM, and double the number of periods.

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 Example
A 10-year, 5% corporate bond has a 6% yield. What is the price of this bond quoted as a percent of par?

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 Example
A 10-year, 5% corporate bond has a 6% yield. What is the price of this bond quoted as a percent of par?
In this example, we're not given any direction as to whether this is a semiannual or annual-pay bond. It does
say corporate, so we should assume semiannual coupon payments. It also neglects to tell us what the face
value is. We have two choices:
1. Assume a face value of $1,000 by convention OR
2. Calculate the price as a percent of par (bonds are commonly quoted in this way)
Solving using the TVM functions:
5/2  2.5 PMT
100 FV
6/2  3 I/Y
10 x 2  20 N
CPT PV  92.56% of par
Note that, since the YTM > Coupon, the bond sells at a discount.
7
 Zero-Coupon Bond
Zero coupon bonds are a special case where a bond pays no interest. Instead, they are sold at a deep discount
and all the return is collected when the bond matures and it is redeemed at face value.

P0 = 0/2 / (1+r/2)1 + 0/2 / (1+r/2)2 + ….. + (0/2 + PM) / (1+r/2)2M  P0 = PM / (1+r/2)2M

The value of a zero coupon

Although no periodic bond is the present value
coupon payments are made, of the principal discounted
the bond is still assumed to by the YTM
be semiannual.

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 Example
An investor is considering purchasing a 3-year, zero-coupon bond that is yielding 8%. What price should the
investor expect to pay for the bond with a $1,000 face value?

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 Example
An investor is considering purchasing a 3-year, zero-coupon bond that is yielding 8%. What price should the
investor expect to pay for the bond with a $1,000 face value?
0 PMT
100 FV
8/2 4 I/Y
2x3 6 N
CPT PV  79.03% of par = .7903 x 1,000 = $790.30
Remember to clear your calculator before beginning each problem

10
 Traditional Yield Measures
These are the most common yield measures and the most likely to appear on the exam. You should know at
least these:
Yield-to-Maturity (YTM)

P0 = C/2 / (1+YTM/2)1 + C/2 / (1+YTM/2)2 + ….. + (C/2 + PM) / (1+YTM/2)2M

YTM and YTC require the
Yield-to-Call (YTC) financial functions of the
calculator: (CPT  I/Y)
P0 = C/2 / (1+YTC/2)1 + C/2 / (1+YTC/2)2 + ….. + (C/2 + PM) / (1+YTC/2)2M

Another yield measure that is commonly seen in fixed-income markets is the current yield (also called
the income yield or interest yield). It is calculated as the annual coupon rate divided by the flat price:

Current Yield = C / P0

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 Question
An investor purchased an A-rated corporate bond, callable in 20X7 at 102, for 99.01 on January 1, 20X4. This
bond matures on January 1, 20X9. The yield-to-maturity of the bond is 8.20% and its current yield is 8.03%.
The bond's coupon rate and yield-to-call are closest to:
Coupon YTC
a. 7.95% 8.33%
b. 8.12% 8.36%
c. 7.95% 8.93%

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 Question
Choice "c" is correct.
Step 1: The current yield (CY) is the annual coupon (C) stated as a percent of the purchase price of the bond
(PB):
CY = C / P0
0.0803 = C / 99.01
C = 0.0803 x 99.01 = 0.0795 or 7.95%
Step 2: With the coupon correctly determined, we can compute the yield to call. This is the yield if we
assume that the bond will be called at the first opportunity (January 1, 20X7):
-99.01 PV
7.95 / 2  3.975 PMT
102 FV
3x26 N
CPT I/Y  4.4647
Step 3:
YTC = Periodic yield x 2
= 4.4647 x 2 = 8.93% 13
 BEY vs. EAY
The bond equivalent yield (BEY) is equivalent to the stated annual rate (SAR) or annual percentage rate
(APR) and is found by simply doubling the six-month periodic rate. This approach to annualizing the yield is
the conventional method used in the bond market for the purpose of quotation:

BEY = 2 x six-month periodic yield

The effective annual yield (EAY), also called the effective annual rate (EAR), is a compounded yield measure.
When comparing bond with different payment streams (semiannual vs annual vs monthly), the EAR is the
appropriate basis for the purpose of comparison:

EAY = (1 + periodic yield)m – 1, where m = # of compounding periods per year

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 Question
An investor is considering purchasing one of three 5-year bonds with the following characteristics.

Which of the bonds would the investor most likely prefer?

a. Bond A.
b. Bond B.
c. Bond C.

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 Solution
Choice "c" is correct.
Since the timing of each bond's cash flows is different, we must compare them on an effective annual yield
basis.
Bond A: has a periodic yield of 3.425% [-98.54 PV; 6.5/2 = 3.25 PMT; 100 FV; 10 n (N); Solve for i (CPT I/Y) =
0.03425]
EAY = (1 + periodic Rate)2 – 1
= (1.03425)2 – 1 = 0.0697 or 6.97%
Bond B: has a periodic yield of 6.9% [-97.33 PV; 6.25 PMT; 100 FV; 5 n (N); Solve for i (CPT I/Y)].
EAY = (1 + periodic Rate)1 – 1
= (1.069)1 – 1 = 0.069 or 6.9%
Bond C: has a periodic yield of 0.574% [-97.72 PV; 6.35/12 = 0.52917 PMT; 100 FV; 5 x 12 = 60 n (N); Solve for
i (CPT I/Y)] = 0.00574]
EAY = (1 + periodic Rate)12 – 1
= (1.00574)12 – 1 = 0.071 or 7.1%
Bond C has the highest EAY and is therefore the preferred bond. 16
 Reinvestment Rate Risk
The YTM implicitly assumes that the cash flows from the bond are reinvested at the YTM. In reality, this never
happens because interest rates change over time.
 If interest rates fall, the coupons will be reinvested at lower rates and the realized (true) return will be less
than the YTM.
 If interest rates rise, the coupons will be reinvested at higher rates and the realized (true) return will be
higher than the YTM.
The risk of realizing a yield that is different than the YTM is called reinvestment rate risk. This risk is greatest
for bonds with:
- big coupons,
- long maturities,
- selling at premiums to par.
Note that a zero coupon bond – save for the maturity factor – is the opposite of this:
- no coupon,
- sell at deep discounts
And, in fact, have no reinvestment risk (you will realize their YTM if you hold to maturity, unless they default).
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 Question
George Sanchez, CFA, just bought some AA-rated U.S. corporate bonds for clients' portfolios for 101.50. The
bonds pay an annual coupon rate of 9% of par value semiannually and mature in ten years. Sanchez is
concerned, however, that he will only be able to reinvest the coupon payments at 6% over the life of the
bonds. If he is correct, what bond equivalent true return would his clients receive if they hold the bonds until
maturity?
a. 6.36%
b. 7.93%
c. 3.97%

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 Solution
Choice "b" is correct.
Step 1: The first step is to calculate the future value of the bonds' cash flows assuming the reinvestment rate
Sanchez expects. Since the bonds make semiannual coupon payments, calculate the future value of twenty
payments of $4.50 each reinvested at 3%. Add to that the repayment of principal at maturity to determine
the future value of all cash flows from the bonds:
F.V. of $4.50/period for 20 periods at a 3.0% reinvestment rate $120.92
+ Repayment of principal at maturity +100.00
Future value of all cash flows $220.92
Step 2: Next, calculate the periodic true return as the interest rate that will turn 101.50 (the present value of
the bond as a percentage of par) into 220.92 over 20 periods:
101.50 +/- PV
220.92 FV Periodic
20 N true
0 PMT return
CPT I/Y  3.965
Step 3: Finally, calculate the bond equivalent true return as twice (for semiannual payments) the periodic
true return: 2 × 3.965 = 7.93% 19
 Solution
Choice "a" is incorrect. Rather than calculating the future value of the coupon payments reinvested at 3.0%
semiannually, this figure simply uses the total of the coupon payments, $90.00.
Choice "c" is incorrect. 3.97% is the periodic true return. Double this figure to arrive at 7.94, which is the
bond equivalent true return.

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 Yield Spreads
The G-spread is simply the YTM minus the yield on the corresponding Treasury security:
G-spread = YTMcorporate_bond – YTMgovernment_bond
This measures the credit spread at a single point on the yield curve.
- Ignores the term structure of interest rates (i.e., assumes the yield curve is flat)
- Ignores the effects of embedded options
The zero-volatility, or static, spread measures the spread over the entire yield curve. It makes more sense to
use individual spot rate rates to discount each of the bond's expected cash flows as spot rates accurately
capture the risk entailed by each corresponding cash flow (i.e., for each time horizon, there is a specific spot
rate unless the yield curve is flat). Therefore, practitioners tend to favour the use of Z over G.
- but like the G-spread, it does not incorporate embedded options.
The OAS does account for embedded options and is the appropriate spread measure for callable, putable,
and mortgage-backed bonds. Stated simply, the OAS removes the cost of the option from the z-spread, so
the OAS is the spread on top of the spot rate curve that the bond would offer if it were option-free.
Exam tip  The bond with the highest OAS is the preferred investment choice.
 Question
Given the spread data below, which bond(s) are most likely to be either callable or mortgage-backed?
Bond G-Spread Z-Spread Option-Adjusted Spread (OAS)
A 120 basis points 123 basis points 85 basis points
B 120 basis points 132 basis points 60 basis points
C 120 basis points 122 basis points 122 basis points
D 120 basis points 129 basis points 156 basis points
a. A and B only.
b. C only.
c. D only.
 Solution
Choice "a" is correct.
Often, the Z-spread will equal or only slightly exceed the G-spread.
If the bonds contain embedded call options, the OAS will be significantly less than the Z-Spread. Callable
bonds or bonds such as mortgage-backed securities give the borrower the right to prepay or "call" their debt
early. The investor has essentially sold an option to the bond issuer. The difference between the Z-Spread
and the OAS (in basis points) is the value the investor receives for the embedded option:

OAS = z-spread – Call option value (bps per year)

 Solution
Choice "b" is incorrect. This is most likely a conventional bond with no embedded options. In such cases, the
Z-Spread equals the OAS.
Choice "c" is incorrect. The OAS is significantly higher than the Z-Spread. This difference indicates that the
bond has an embedded put option, which benefits the investor. Such a feature would allow the investor to
redeem the bond prior to its maturity. The investor has essentially bought an option from the bond issuer.
The difference between the OAS and the Z-Spread (in basis points) is the value the investor pays for the
embedded option.

OAS = z-spread + Put option value (bps per year)

Note that the Z-Spread is 9 basis points higher than the G-spread. Z-Spreads tend to be higher than G-
spreads when the yield curve is relatively steeper, when principal is repaid relatively faster, when the coupon
is relatively higher and when the bond has a relatively longer maturity.
 Forward Rates
Forward rates are interest rates expected in the future. Forward rates are made more complicated by the
notation used to describe them. The tfm rate is the yield on a t-year bond m-years in the future:
- The one-year rate, one year from now (1f1)
- The two-year rate, one year from now (2f1)
- The one-year rate, two years from now (1f2)
Forward rates are derived from the spot yield curve by the following formula, which says you can either buy a
three-year bond or buy a one-year bond and roll it over into a two-year bond a year later. These holding
period returns must be equal:
(1 + 3s0)3 = (1 + 1s0)1(1 + 2f1)2

HPR on HPR on HPR on a 2-

a 3- a year zero
year 1-year coupon
zero zero bond, 1
coupon coupon year from
bond bond now
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 Calculate a Spot Rate Given Forward Rates
Spot rates are simply the geometric averages of forward rates. Once again, the notation is the biggest hurdle
to get over.
(1 + 3s0)3 = (1 + 1s0)1(1 + 1f1)1(1 + 1f2)1

HPR on HPR on HPR on HPR on

a 3- a 1- a 1- a 1-
year year year year
zero zero zero zero
coupon coupon coupon coupon
bond bond bond, bond,
1 year 2 years
from from
now now

Spot rates and forward rates are generally presented as annual (BEY) rates on the exam, thus when deriving
spot or forward, when doing calculations candidates should always:
- Divide the given (BEY) yields by 2
- Don’t forget to multiply the output (periodic) rate by 2, to state your result in BEY terms.
 Question
Given the following table of zero-coupon Treasury rates.
Maturity Six-Month Spot Rates Forward Rates
0.5 4.00 ?
1.0 4.80 ?
1.5 5.50 ?
2.0 6.10 7.90
2.5 ? 9.10
Presented on a bond equivalent basis, the 6-month forward rate that is expected to prevail in 12 months and
the 30-month spot rate are closest to:
Forward Spot
a. 3.45% 6.70%
b. 6.90% 8.50%
c. 6.90% 6.70%
 Solution
Choice "c" is correct.
The six-month forward rate expected to prevail in 12 months corresponds to the 1.5 maturity.
An investor could either invest in the 1.5 maturity spot rate or invest in the 1.0 maturity and roll it over one
more period. The calculation is shown below:
(1 + 3s0/2)3 = (1 + 2s0/2)2(1 + 1f2/2)1
(1 + 5.5%/2)3 = (1 + 4.8%/2)2(1 + 1f2/2)1
(1.0275)3 = (1.024)2(1 + 1f2/2)1
(1 + 1f2/2)1 = (1.0275)3/(1.024)2
(1 + 1f2/2)1 = 1.0345
1 + 1f2/2 = (1.0345)1/1
1 + 1f2/2 = 1.0345
1f2/2 = 1.0345 – 1
1f2/2 = 0.0345
1f2 = 0.0345 x 2
1f2 = 0.0690 or 6.90%
 Solution
The 30-month spot rate can be solved using a similar approach. Since spot rates are geometric averages of
forward rates:
(1 + 5s0/2)5 = (1 + 4s0/2)4(1 + 1f4/2)1
(1 + 5s0/2)5 = (1 + 6.1%/2)4(1 + 9.1%/2)1
(1 + 5s0/2)5 = (1.0305)4(1.0455)1
(1 + 5s0/2)5 = 1.1790
1 + 5s0/2 = (1.1790)1/5
1 + 5s0/2 = 1.0335
5s0/2 = 1.0335 – 1
5s0/2 = 0335
5s0 = 0335 x 2
5s0 = 0670 or 6.70%
 Question
Given the following Eurodollar forward rates:
1-Year Eurodollar Forward Rates
1s0 6.45%
1f1 6.15%
1f2 5.90%
What is the value of a three-year, 6 percent coupon Eurodollar bond.
a. 100.21
b. 99.53
c. 98.81
 Solution
Choice "b" is correct.
Since spot rates are geometric averages of forward rates, each of the bond's cash flows can be discounted by
the compounded forward rates to arrive at the bond's price. Recall that a Eurodollar bond makes annual
coupon payments. So, the value of the bond can be computed as follows:
P0 = C / (1+1s0)1 + C / (1+1s0)1(1+1f1)1 + (C + PM) / (1+1s0)1(1+1f1)1(1+1f2)1
= 6 / (1.0645)1 + 6 / (1.0645)1(1.0615)1 + (6 + 100) / (1.0645)1(1.0615)1(1.0590)1
= 5.6364 + 5.3099 + 88.5817 = 99.53