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Chapter 5
Bonds and Bond Pricing
Key features of bonds
Bond valuation
Measuring yield
Assessing risk
Bond types
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What is a bond?
A long-term debt instrument in which a
borrower agrees to make payments of
principal and interest, on specific dates,
to the holders of the bond.
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Key Features of a Bond
(Terminology)
Par value face amount of the bond, which
is paid at maturity (assume $1,000 unless
otherwise stated).
Coupon interest rate stated interest rate
(generally fixed) paid by the issuer.
Percentage of the par value
Multiply by par to get dollar payment of interest.
Maturity date years until the bond must be
repaid.
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Key Features of a Bond
(Terminology)
Yield to maturity - rate of return earned on
a bond held until maturity (also called the
promised yield).
The required rate of return (r
d
) that makes the
PV of the future payments to be received from
the bond equal to the price paid for it.
The r
d
used in the formula that would make
both sides equal to each other.

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Financial Asset Valuation
( ) ( ) ( )
PV =
CF
1 + r
. . . +
CF
1 + r
1 n
1
2
2
1
CF
r
n
.
0 1 2 n
r
CF
1
CF
n
CF
2
Value
...
+ +
+
Price of any financial asset = PV of its future cash flows
Present Value of Cash Flows as
Rates Change
Bond Value = PV of coupons + PV of par
Bond = PV annuity + PV of lump sum
As interest rates increase the PVs
decrease
As interest rates increase, bond prices
decrease and vice versa
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What is the value of a 10-year, 10%
annual coupon bond, if r
d
= 10%?
$1,000 P
$385.54 $38.55 ... $90.91 P
(1.10)
$1,000

(1.10)
$100
...
(1.10)
$100
P
B
B
10 10 1
B
=
+ + + =
+ + + =
0 1 2 10
r
100

100 + 1,000

100

P
B
= ?
...
Relationship Between Price and
Yield-to-maturity
600
700
800
900
1000
1100
1200
1300
1400
1500
0% 2% 4% 6% 8% 10% 12% 14%
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Valuing a Bond Example 1
Suppose you are looking at a bond that has a
10% coupon rate, annual coupons, and a face
value of $1000. There are 5 years to maturity
and the YTM is 11%. What is the price of this
bond?

Value = PV of annuity + PV of lump sum
Value = 100[1 1/(1.11)
5
] / .11 + 1000 / (1.11)
5

Value = 369.59 + 593.45 = 963.04

100 PMT,1000 FV, 5 N, 11 I/Y, CPT PV
=> -963.04
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Valuing a Bond Example 2
Suppose you are looking at a bond that has a
9% coupon rate, semi-annual coupons, and a
face value of $1000. There are 20 years to
maturity and the YTM is 9%. What is the price of
this bond?

Value = PV of annuity + PV of lump sum
Value = 45[1 1/(1.045)
40
] / .045 + 1000 / (1.045)
40

Value = 828.07 + 171.93 = 1000.00

45 PMT,1000 FV, 40 N, 4.5 I/Y, CPT PV
=> -1000.00
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Bond Prices: Relationship Between
Coupon Rate and Yield to Maturity
1. If YTM = coupon rate, par value = bond price

2. If YTM > coupon rate, par value > bond price
Why?
Selling at a discount, called a discount bond

3. If YTM < coupon rate, par value < bond price
Why?
Selling at a premium, called a premium bond
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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
Reinvestment Rate Risk
Uncertainty concerning rates at which cash
flows can be reinvested
Short-term bonds have more reinvestment rate
risk than long-term bonds
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Figure 7.2
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YTM with Semiannual Coupons
Suppose a bond with a 9% coupon rate and
semiannual coupons, has a face value of
$1000, 20 years to maturity and is selling for
$1197.93. What is the YTM? Is the YTM
more or less than 9%?

45 PMT; 1000 FV; -1197.93 PV; 40 N; CPT I/Y =>
3.5639%

YTM = 3.5639%*2 = 7.13%

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What is the value of a 10-year, 10%
annual coupon bond, if r
d
= 10%?
P
B
=
0 1 2 10
r
100

100 + 1,000

100

P
B
= ?
...
( )
1000
10 . 1
1000
10 .
) 10 . 1 (
1
1 100
10
10
= +
(

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Relationships between price and face
value and between coupon rate and YTM
c > YTM Price > Face Value
Premium Bond
c = YTM Price = Face Value
Bond trades at par
c < YTM Price < Face Value
Discount Bond

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Bond values over time
At maturity, the value of any bond must
equal its par value.
If r
d
remains constant:
The value of a premium bond would
decrease over time, until it reached
$1,000.
The value of a discount bond would
increase over time, until it reached
$1,000.
A value of a par bond stays at $1,000.
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Callable bond
In general, if a bond sells at a
premium, then (1) coupon > r
d
, so (2) a
call is likely.
So, expect to earn:
YTC on premium bonds.
YTM on par & discount bonds.
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What is interest rate (or price) risk?
Interest rate risk is the concern that rising cost
of debt (r
d
) will cause the value of a bond to fall

% change 1 yr r
d
10yr % change
+4.8% $1,048 5% $1,386 +38.6%
$1,000 10% $1,000
-4.4% $956 15% $749 -25.1%

The 10-year bond is more sensitive to interest
rate changes, and hence has more interest rate
risk.
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What is reinvestment rate risk?
Reinvestment rate risk is the concern that r
d

will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.

EXAMPLE: Suppose you just won
$500,000 playing the lottery. You
intend to invest the money and
live off the interest.
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Reinvestment rate risk example
You may invest in either a 10-year bond or a
series of ten 1-year bonds. Both 10-year and
1-year bonds currently yield 10%.
If you choose the 1-year bond strategy:
After Year 1, you receive $50,000 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 10% interest rate, and
$50,000 annual income.
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Conclusions about interest rate and
reinvestment rate risk
CONCLUSION: Nothing is riskless!
Short-term AND/OR
High coupon bonds
Long-term AND/OR
Low coupon bonds
Interest
rate risk
Low High
Reinvestment
rate risk
High Low
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Evaluating default risk:
Bond ratings
Bond ratings are designed to reflect the
probability of a bond issue going into
default.
Investment Grade Junk Bonds
Moodys
Aaa Aa A Baa Ba B Caa C
S & P
AAA AA A BBB BB B CCC D
The Bond Indenture
Contract between the company and the
bondholders and includes:
1. The basic terms of the bonds
2. The total amount of bonds issued
3. A description of property used as security, if
applicable
4. Sinking fund provisions
5. Call provisions
6. Details of protective covenants
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Bond Classifications
Registered vs. Bearer Forms
Security
Collateral secured by financial securities
Mortgage secured by real property, normally
land or buildings
Debentures unsecured
Notes unsecured debt with original maturity
less than 10 years
Seniority
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Bond Ratings
Investment Quality
High Grade
Moodys Aaa and Aa, S&P AAA and AA
Medium Grade
Moodys A and Baa, S&P A and BBB
Speculative
Low Grade
Moodys Ba, B, Caa and Ca, S&P BB, B, CCC, CC
Very Low Grade
Moodys C and S&P C no interest being paid
Moodys D and S&P D in default

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Bond Characteristics and
Required Returns
The coupon rate depends on the risk
characteristics of the bond when issued
Which bonds will have the higher coupon,
all else equal?
Secured debt versus a debenture
Subordinated debenture versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond
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Government Bonds
Treasury Securities: Federal government debt
T-bills pure discount bonds with original maturity of
one year or less
T-notes coupon debt with original maturity between
one and ten years
T-bonds coupon debt with original maturity greater
than ten years
Municipal Securities: Debt of state and local
governments
Varying degrees of default risk, rated similar to
corporate debt
Interest received is tax-exempt at the federal level
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Bond Markets
Primarily over-the-counter transactions
with dealers connected electronically
Extremely large number of bond issues,
but generally low daily volume in single
issues (Thin Market, illiquid)
Treasury securities are an exception
(Deep Market, liquid)
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Inflation and Interest Rates
Nominal rate of interest (R): percentage
change in dollars, all periodic rates to now
Real rate of interest (r): percentage
change in purchasing power, consumption
Expected inflation (h): expected
percentage change in prices, CPI
Nominal rate of interest includes our
desired real rate of return plus an
adjustment for expected inflation
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Inflation and Interest Rates
Intuitive Example
You are offered an investment that pays a 25%
return per year risk free. Is it a good deal?

What if inflation is 25% per year?

The implication here is that your investment will
just offset inflation and you wont be able to
consume more stuff one year from now than you
can consume today. So a 25% return in this
case does not seem like such a good deal.
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The Fisher Effect
Defines the relationship between real rates
(r), nominal rates (R), and inflation (h)

(1 + R) = (1 + r)(1 + h)
Or,
1 + R = 1 + h + r + r*h
R = h + r + r*h

Approximation: Only use it outside of class
R r + h if r*h is very small

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Fisher Effect Example
A 20 oz Diet Coke costs $1 and I drink 10
a day. One year from now they are
expected to cost $1.05 each. If I invest
today I would like to be able to consume
10% more Diet Cokes in a year. What
nominal rate do I need to get on my
investment?
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Fisher Effect Example
a. Direct Calculation
Today: 10 x $1 = $10.
In a Year: 11 x $1.05 = $11.55
Target Nominal Rate: 15.5%
b. Fisher Equation
Real Rate = 10%, Inflation = 5%
1 + R = (1 + .10)(1 + .05) => R = 15.5%


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Factors Affecting Required
Return
Default risk premium remember bond
ratings
Taxability premium remember municipal
versus taxable
Liquidity premium bonds that have more
frequent trading will generally have lower
required returns
Anything else that affects the risk of the
cash flows to the bondholders, will affect
the required returns
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