Valuing Bonds:

Bond Pricing and Bond

Yield
Dr. Himanshu Joshi
FORE School of Management
New Delhi

Major Classes of Financial Assets or

Securities

Money market
Bond market
Equity Securities
Indices
Derivative markets

The Bond Market

Treasury Notes and Bonds

Inflation-Protected Treasury Bonds
Federal Agency Debt
International Bonds
Municipal Bonds
Corporate Bonds
Mortgages and Mortgage-Backed
Securities

Risk in Fixed Income

Securities

Risk of Debt Securities

Interest Rate Risk: debt securities,
which pay fixed coupon rates, suffer
a price decline when interest rates
go up unexpectedly, because the
stated coupon is inadequate to
compensate for the prevailing higher
Fixed
Prevailing
level
of
interest
rates.
Incom
Interest Rate
e
Securit
y
Prices

In the Market

Risk of Debt Securities

Likewise reinvestment of fixed
contractual coupons becomes risky
when market interest rate decline.

Reinvestme
nt Risk

Prevailing
Interest Rate
In the Market

Bond Price

Bond Price
This bond was issued near par value of 100 in
the middle of January 2007. price quoted here
is for the year 2009 (January to December).
Fluctuation in bond price may be due to:
(a) An increase in interest rate in the market.
(b) An increase in unanticipated inflation rate.
(c) A fall in risk premium that causes investors
to prefer riskier securities than treasury
securities.

Credit Risk
Treasury securities do not carry
credit risk. However there are
corporate bonds that carry significant
amount of credit risk: that the issuer
may be unable to service all or some
of the promised obligations due to
financial distress, reorganization,
workouts, or bankruptcy.

Liquidity Risk
Some debt securities may trade in
illiquid markets (few dealers, wide bidoffer spreads, low depth, and so on).
Emerging market debt and some high
yield debt fall into this category.
Liquidity refers to the ease with which
a reasonable size of a security can be
transacted in the market within a short
notice, without adverse price reaction.

Liquidity Risk
The seller or the buyer will face following:
1. High Transaction costs such as fees and
commissions,
2. Bid-offer spreads
3. Market impact costs, which refer to the
possibility that following the placement
of a buy (Sell) order the market makers
may increase (Decrease) the prices at
which they are willing to trade.

Contractual Risk
Debt securities may be callable by the issuer at the issuers
option.
Holders of mortgage loans have the right to prepay their old
mortgages if they can refinance them at a cheaper rate.
This implies that prepayment should increase when
mortgage rates in market drop.
The lender will want to charge a higher interest rate to
account for the fact that he or she is giving the borrower a
valuable option to call away the loans when interest rate fall
in the market.
This is call risk in the mortgages.
Hence mortgages must trade at a yield higher than similar
non callable treasury debt securities.

Inflation Risk
Inflation risk is the risk that money obtained in the future will be
worth less than when it is invested, which is almost always the
case.
The real risk is how much this risk will be. On the other hand, it is
possible, in some cases, to take advantage of deflation that occurs
when interest rates rise.
A good example is when interest rates are rising, newly issued
fixed-income securities start to pay more, while prices of things that
generally require borrowing, such as real estate, start declining.
Thus, for instance, one could buy 4 week T-bills as a way to save for
a house or for a down payment. As the T-bills expire, they can be
re-invested at progressively higher rates (while rates are rising).
In the meantime, real estate prices are falling because it is
becoming more expensive to borrow the money to pay for it. So the
money earned on the T-bills becomes even more valuable than the
interest rate itself suggests when used to purchase real estate.

Event Risk
Some debt securities may be sensitive to events
such as hostile reorganizations or leveraged buyouts
(LBOs). Such events can lead to a significant price
loss.
In October 1988 RJR Nabisco was taken over through
an LBO. The resulting company took on heavy debt
to finance the takeover. As a result Moodys rating for
RJR Nabiscos debt from A1 to B3.
The prices of RJR Nabisco dropped about 15%, and
yield spread went from about 100 BPS above
treasury to 350 BPS above treasury.
In corporate debt market this risk is called event risk.

Event Risk (Protection)

Investors often require protection
against this type of risk by requiring
a right from the sellers of bonds that
allows investors to sell (Put) the
bonds back to the seller at par value.
Waga and Weltch (1993) examined
the bondholder losses for 16 firms
experiencing LBO were nearly 7%
within 20 day window surrounding
the even date.

Tax Risk
If debt securities were originally
issued with certain tax exemption
features and subsequently there
developed an uncertainty regarding
their tax status, it could to lead to a
price loss.

Foreign Exchange Risk

Concept of carry trade
Depending upon the currencies in
which the investor is domiciled, debt
securities may pose FX risk as well.
Central bank of China and Japan hold
significant amount of U.S government
debt as investments, and consequently
they are subject to the risk that the
dollar could depreciate.

Coupon Rate on a Bond..

r = Real risk free interest rate +
Inflation premium+ Default risk
premium + Liquidity Premium +
Maturity Premium

 Bond Pricing

Bond Characteristics
Face or par value
Coupon rate
Zero coupon bond
Compounding and payments
Accrued Interest
Indenture

Bond Indenture: Illustration

A bond with par value of $1000 and
coupon rate of 8% might be sold for
$1000. the bondholder is then entitled to a
payment of 8% of $1000 = $80 per year,
for the stated life of a bond say, 30 years.
The $80 payment typically comes in two
semiannual installments of $40 each. At
the end of 30 year life of the bond issuer
also pays the $1000 par value to the
bondholder.

Accrued Interest and Quoted Bond

Prices
The bond prices that you see quoted
in financial pages are not actually the
prices that investors pay for the
bond.
This is because the quoted price
does not include the interest that
accrues between coupon payment
dates.

Accrued Interest

Accrued Interest = Annual Coupon Payment Days since last coupon

payment
2
Days Separating coupon payments

Example: Suppose that the coupon rate is

8% on bond of par value $1000. 30 days
have been passed since the last coupon
payment. If the quoted price of the bond
is $990, then what should be the invoice
price?
Bonds are quoted net of accrued interest in the financial pages and thus appears as &1000 at the maturity. In
contrast to the bonds, stocks do not trade at flat prices with adjustments for accrued dividends. Whoever
owns the stock when it goes ex-dividend receive the entire dividend on the ex-day. And the stock price reflect
value of the upcoming dividend. The price therefore falls after the ex-dividend date.

Bond Pricing
The price of any financial instrument
is equal to the present value of the
expected cash flows from financial
instrument.
Determining the price require:
1. An estimate of the expected cash
flows.
2. An estimate of the appropriate
required yield.

Bond Pricing
The required yield refers to the yield for
financial instruments with comparable risk, or
alternative (or substitute) investments.
The first step in determining the price of a bond
is to determine its cash flows.
The cash flows of a bond that the issuer can not
retire prior to its stated maturity date. (a non
callable bond) consist of:
1. Periodic coupon payments to the maturity date.
2. The Par (or maturity) value at maturity.

Bond Pricing
T

ParValue
C
PB

T
t
(1 r )
t 1 (1 r )
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

Bond Pricing
You may recall that PV of an annuity was:
PV = c/y [ 1 1/(1+y)N ]
Where 1/y [ 1 1/(1+y)N ] is called an
annuity factor.
And also PV of Terminal Value is:
Par Value * 1/(1+r)N
Where 1/(1+r)N is called PV factor.
So Price = Coupon* Annuity factor (r,
T) + Par Value* PV factor (r, T)

Bond Pricing bond price.xlsx

8% coupon, 30-year maturity bond

with par value of $1,000 paying 60
semiannual coupons of $40 each.
Suppose that interest rate is 8%
annually or 4% per six months
period. Then
Price = $40* Annuity factor (4%,60)
+ $1000* PV factor (4%,60)
Price = $909.94 + $95.06 = $ 1000

The Inverse Relationship Between Bond Prices

and Yields

Bond Prices at Different Interest Rates (8%

Coupon Bond, Coupons Paid Semiannually)

Complications
The framework for pricing a bond
discussed here assumes that:
1. The next coupon is exactly six
month away.
2. The cash flows are known.
3. The appropriate required yield can
be determined.
4. One rate is used to discount all the
cash flows.

Coupon Rate, Required Yield and

Price
Coupon Rate <
Yield

Price < Par

Discount

Coupon Rate = Yield

Price = Par

Par

Coupon Rate > Yield

Price > Par

Premium

Relationship Between Bond Price and Time if

Interest Rates are Unchanged zbb1.xlsx
If the required yield does not change
between the time the bond is purchased and
the maturity date, what will happen to the
price of the bond?
For a Bond Selling at Par: as the bond moves
towards maturity it will continue to sell at par
value. Its price will remain constant as the
bond moves towards the maturity date.
Bond Selling at Discount: ?
Bond Selling at Premium: ?

Reasons for the change in the Bond

Price
1. There is a change in the required yield owing
to changes in the credit quality of the issuer.
2. There is a change in the price of the bond
selling at a premium or a discount, without
any change in the required yield, simply
because the bond is moving towards the
maturity.
3. There is a change in the required yield owing
to a change in the yield on comparable
bonds. (i.e., change in the required yield by
the market)

Computing the Yield or IRR on any

Investment
The yield on any investment is the
interest rate that will make the
present value of the cash flows from
the investment equal to the price (or
cost) of the investment.
Mathematically, the yield on any
investment, y, is the interest rate
that satisfies the equation:
P = CF1/(1+y) + CF2/(1+y)2 +..
CFN/(1+y)N

Computing Yield
P = t=1N CFt/ (1+y)t
Where:
CFt = Cash flow in year t
P = Price of the investment
N= Number of years

Computing Yield for a Zero Coupon

Bond
Y = [M/P]1/n -1
Q. A 10 year zero coupon bond with a
maturity value of $1000, selling for
$439.18, calculate Y?
Y = [$1000/$439.18]1/10 -1
=1.042-1 = 0.042..

Measuring Yields

Current Yield
Yield to Maturity
Yield to Call
Yield to Put
Yield to Worst

Current Yield of a Bond

Current yield relates the annual coupon interest
to the market price.
Current Yield = Annual $ Coupon Payment/ Price
Example: 8%, 30 year bond currently selling at
$1276.76.
Current Yield = $80/$1276.76 = 0.0627 or
6.27%.
YTM = 6.09%.
Coupon Rate (8%) > Current Yield (6.27%)>YTM

(6.09%)

Determining the Appropriate

Required Yield
We will discuss later how one can
decompose the required yield for a
bond/security into its component
parts.

One Discount rate applicable to all

the cash flows
A bond can be viewed as a package
of zero coupon bonds, in which
case a unique discount rate should
be used to determine value of each
cash flows.

Current Yield
Limitations?

Current Yield Limitation..

The current yield calculation takes into
account only the coupon interest and no
other source of return that will affect an
investors yield.
No consideration is given to the capital
gain/loss that the investor will realize when
bond is purchased at a discount/premium.
No consideration on reinvestment of
coupon interests.

Yield to Maturity
In practice, an investor considering the
purchase of a bond is not quoted a promised
rate of return.
Instead the investor must use Bond Price,
Maturity Date, Coupon Payments, to infer the
return offered by the bond over its life.
YTM is often interpreted as a measure of true
average rate of return that will be earned if it is
bought now and held until maturity.
Bond price used in the function should be the
reported flat price, without accrued interest.

Yield to Maturity
Interest rate that makes the present
value of the bonds payments equal
to its price
Solve the bond formula for r
T

ParValue
C
PB

T
t
(1 r )
t 1 (1 r )

Yield to Maturity
15 year 7%- Semiannual pay bond
with par value of $1000 selling at
$769.42.
Coupon = 7% of $1000 = $70 annual
Cash flow 1. $35 semiannual
payments for 30 periods.
Cash flow 2. $1000 principal amount
to be received 30 periods from now.

Current Yield vs. YTM..

1. Yield to maturity calculation takes into
account not only the current coupon
income but also any capital gain or loss
that the investor will realize by holding
the bond to maturity.
2. YTM consider timing of the cash flows.
3. It also consider re-investment of the
Coupon interests, however, assumes that
reinvestment is made on the YTM only.

Relationship among the Coupon

rate, Current Yield, and YTM
Bond Selling at:

Relationship

Par

Coupon rate = Current Yield =

YTM

Discount

Coupon Rate < Current Yield <

YTM

Premium

Coupon Rate > Current Yield

>YTM

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

The Inverse Relationship Between Bond Prices

and Yields

Yield to Call
What if the bond is callable, and may be
retired prior to the maturity? (YTM is not
Relevant).
The price at which a bond may be called
back is referred to as the call price.
For some issues, the call price is the same
regardless of when the issue is called.
For other callable issues, there is a call
schedule that specifies a call price for each
call date.

Figure 14.4 Bond Prices: Callable and

Straight Debt

Example 14.4 Yield to Call

Yield to Call Example:

Consider an 18-year 11% coupon bond with a
maturity value of
$1000 selling for $ 1,169. suppose that the first call
date is 8 years from now and that the call price is
$1,055.
(1)The Present Value of the coupon payments is
found using the annuity formula:
$55 [1- 1/(1+y)16]/y
(2) The Present Value of the Call price is found using
the PV formula
$1055 [1/(1+y)16]

Yield to Put
When bondholders can force the issuer to buy
the issue at a specified price. As with callable
issue, putable issue can have a put schedule.
The schedule specifies when the issue can be
put and the price, called the put price.
The YTP (yield to put) is the interest rate that
makes the present value of cash flows to the
assumed put date plus the put price on that
date equal to the bond price.
PV of Cash Flows to put date + PV of Put Price =
Bond Price

Yield to Worst..
A Practice in the industry is for an
investor to calculate the yield to
maturity, yield to every possible call
date, and the yield to every possible
put date.
The minimum of all of these is called
Yield to Worst.

Can the YTM be Negative?

Swiss government bonds are now
being quoted with negative yields for
all maturities up to 10 years. This
prompts the question: Who, in their
right mind, would pay a government
for the privilege of lending the
government money?

Can YTM be Negative?

The zero or negative bond yields are almost
certainly related in part to the desire by large
cash-holders to ensure a return of cash, even
if doing so guarantees a small nominal loss.
At a time when inflation risk is perceived to
be low and there are concerns about the
safety of commercial banks, it could make
sense for a large holder of cash to lend the
money to the government at a small negative
yield.

Can YTM be Negative?

That being said, its important to remember that we
arent really dealing with 0% or negative bond
yields, we are dealing with 0% or negative yields to
maturity. The bond yields
(promised coupon)
themselves are still positive.
To further explain, consider the simple hypothetical
case of a 1-year bond with par value of $100 that
pays interest of $2 at the end of the 1-year
duration. If the bond is trading at its par value then
both the yield and the yield to maturity (YTM) will
be 2%, but both yields will be something other than
2% when the bonds price deviates from $100.

Can the YTM be Negative?

For example, if the bonds price rises to $103
then the yield falls to 1.94% ($2/$103) and
the YTM falls to negative 0.97%. The YTM in
this example takes into account the fact that
if the bond is held until maturity then the
buyer of the bond at $103 will receive a $2
interest payment plus a $100 principle
payment, or a total return of $102 versus an
outlay of $103. The $1 loss on the $103
investment equates to a return of negative
0.97%.

Implication of Negative
YTM..
An implication is that someone who doesnt plan
to hold until maturity can still make a profit on a
bond with a negative YTM. For example, someone
who buys a Swiss government bond with a YTM of
negative 0.1% today will have the opportunity of
selling at a profit if the YTM subsequently falls to
negative 0.2%. The current ridiculous valuations
of some government bonds could therefore be
partly explained by the belief that valuations will
become even more ridiculous in the future, thus
enabling todays buyers to exit at a profit.

Yield Spread Measures for Floating

Rates Securities
The coupon rate for a floating rate security
changes periodically based on the coupon reset
formula which has its components as the
reference rate and the quoted margin.
Since the future value for the reference rate is
unknown, it is not possible to determine the
cash flows.
This means that YTM can not be calculated.
Instead
there
are
several
conventional
measures used as margin or spread measures
cited by market participants for floaters.

Yield Spread Measures for Floating

Rates Securities: Discount Margin
Method
Step 1. determine the cash flows assuming that the
reference rate does not change over the life of the
security.
Step2. select a margin spread.
Step3. discount the cash flows found in step 1 by the
current value of reference rate plus the margin selected
in step 2.
Step 4. Compare the present value of the cash flows as
calculated in step 3 with the price. If the present value is
not equal to the securitys price, go back to step 2 and
try a different margin.
For a security selling at par, the discount margin is simply
the spread over the reference rate.

Example..
floating rate yield.xlsx
A six year floating-rate security
selling for 99.3098 pays a rate based
on some reference rate plus 80 BPS.
the coupon rate is reset every six
months. Assume that current value
of the reference rate is 10%.
Cash flow = 10.8/2*100 = 5.4