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20 November

Investors’

Investors’ Guide

Guide

How do you price a corporate bond?

The price and the yield of fixed-rate bonds

A corporate fixed bond is a debt security (issued by a company) which is easily tradable on

the over-the-counter market. In this type of transaction, the issuer promises to give the

bondholder a regular fixed coupon and, when the bond matures, to repay the principal

borrowed.

The price of fixed-rate corporate bonds is the result of both supply and demand factors but is

also influenced by the interest-rate environment. The theoretical formula behind the price of a

fixed-rate corporate bond is as follows:

n

Ck F

Price = ∑(1+ r)

k =1

k

+

(1+ r)n

Where: C is the coupon value

n is the number of periods to maturity

r is the yield or discount rate

F is the face value (or nominal value) of the bond

Example:

A 3-year bond has a coupon of 3.8% and yields 4.5%.

Using the above formula, we can calculate its price:

3.8 3.8 100 + 3.8

+ 2

+ = 98.08

(1 + 4.5%) (1 + 4.5%) (1 + 4.5%)3

The above formula illustrates that, when interest rates go up, the price of a bond goes down.

Similarly, when interest rates go down, the price of a bond rises. This can be understood

intuitively: imagine you have bought a bond with a 5% coupon (an interest rate of 5%). If

interest rates increase to 6%, the price of your bond will go down as investors sell it to buy

newly issued bonds with a higher coupon.

The yield of a bond is the implied value of r for a given price. However, there are many ways to

assess this yield. One of these methods is to use the yield to maturity – the yield investors

receive if they hold the bond until redemption.

If the yield to maturity is lower than the coupon rate, the bond is said to sell at a premium. If

the yield to maturity is the same as the coupon rate, then the bond is selling at par. And, if the

yield to maturity is higher than the coupon rate, the bond is selling at a discount.

A corporate bond typically has a higher yield than a AAA-rated government bond. This stems

from a number of risks embedded in the pricing of corporate bonds:

• Liquidity risk: corporate bonds are less liquid than highly rated government-bond issues.

So, in order to compensate for the lower liquidity, they must offer bondholders a higher

yield.

• Credit risk: AAA-rated government bonds bear no credit risk, as there is no doubt that the

US Treasury will always repay its debt. However, companies can go bust or restructure

their debt. Hence, corporate bonds must offer their holders a higher yield in order to

compensate for this credit risk. The credit risk itself stems from both business risk and

financial risk. Business risk typically relates to industry characteristics, competitive position

04 October 2006

Investors’ Guide

Investors’ Guide

and management. Financial risk is concerned with financial policy, profitability, capital

structure, cash flow protection and financial flexibility.

The spreads to governments & swaps

Spread Spread to

to government

swaps

Swaps

Time

As highlighted by the above graph, spreads can be calculated relative to two different curves:

the government curve; or the swap curve. The swap curve is typically located between the

AAA-rated government-bond curve and the corporate-bond curve. The swap curve plots the

interest rates at which AA-rated banks would lend to each other.

In short, when the market views the credit and liquidity qualities of the issue as increasing, the

spread tightens. However, when the market believes that the bond’s credit quality is declining

or the bond is becoming less liquid, the spread widens.

Different measures of the spread for fixed-coupon bonds

There are several definitions of the spread, but they all share the same concept. The spread of

a corporate bond is the extra yield earned over a benchmark. All of these are expressed in

basis points (100 bps being 1%). We set out a few of them below and, in Appendix 1, explain

where to find them on Bloomberg. The definitions of the various spreads can vary between

market participants, and we have decided for sake of clarity to use Bloomberg’s definitions.

This spread is the difference between the yield of a fixed-rate corporate bond and the yield of

a government bond with similar maturity denominated in the same currency. This is the most

straightforward spread to calculate. However, it is somewhat imprecise, as it is generally

impossible to find a government bond with exactly the same maturity.

Example:

A Tesco 6.625% October 2010 yields 5.17% and a gilt (UK government bond) 4.75% June

2010 yields 4.75%.

The spread to gilt (government) is therefore 5.17% - 4.75% = 0.42% or 42 bps.

• The spread to interpolated swap curve

This spread is calculated relative to the asset swap curve.

04 October 2006

Investors’ Guide

Investors’ Guide

It is very unlikely that the bond will mature in an exact number of years. An interpolated value

is therefore calculated. For instance, if a bond matures in 4.5 years, the reference swap yield is

calculated by averaging the 4-year and the 5-year swap rate.

Example:

A France Telecom bond matures in 4.2 years and yields 2.9%.

The 4-year swap is 2% and the 5-year swap is 3%.

We calculate the interpolated swap for 4.2 years:

(4.2 - 4)(3% - 2%)

2% + = 2.2%

(5 - 4)

The spread to interpolated swap curve is 2.9% - 2.2% = 0.7% or 70 bps.

• The asset swap spread, also called the gross spread

This is the spread that bondholders will receive by exchanging their fixed-rate bonds for

floating-rate securities, using the swaps market. As such, this spread represents the

incremental risk of the corporate bond over the inter-bank credit risk. Swap rates are based

on the risk of major international banks.

To calculate the spread, we look at the various cash flows (coupon and repayment of

principal) of the bond. Each cash flow is then discounted using the relevant zero coupon rate

implied by the swap curves. The price given by the calculation assumes that the bond has the

same risk as a major bank. It is then compared with the market price of the bond. The yield to

maturity is calculated for both prices, and the difference represents the asset swap spread.

Example:

A Telefonica bond matures in 2 years, has a 5% annual coupon and trades at par (yield to

maturity of 5%).

The zero coupon 1-year swap is 4.5%, and the zero coupon 2-year swap is 4.7%.

We calculate the price of the bond, using the zero coupon swap curve to discount cash flows

according to the formula from page 1:

5 100 + 5

+ = 100.57

(1 + 4.5%) (1 + 4.7%)2

Using 100.57 as a price, the yield to maturity is calculated by solving the following equation

for r using a trial and error methodology.

5 100 + 5

100.57 = +

(1 + r ) (1 + r )2

That gives: r = 4.69% .

As a result, the asset swap spread is: 5% - 4.69% = 0.31% = 31 bps.

• The Z-spread, also called the zero-volatility spread

The Z-spread, also derived from the swaps market, represents the number of basis points that

need to be added to each individual implied zero swap rate to equal the bond price. This is

determined using trial and error. This measure is becoming the market standard.

As with the asset swap spread, the calculation of the Z-spread involves discounting the

coupons and the final repayment of the bond. A spread of 20 bps means that 0.2% needs to

be added to each discount rate to get the market price.

Example:

A Telefonica bond matures in 2 years, has a 5% annual coupon and trades at par (yield to

maturity of 5%).

The zero coupon1-year swap is 4.5%, and the zero coupon 2-year swap is 4.7%.

5 100 + 5

We solve the following equation: + = 100

(1 + 4.5% + z ) (1 + 4.7% + z )2

Therefore: z=30.5 bps.

04 October 2006

Investors’ Guide

Investors’ Guide

• The option-adjusted spread

The option-adjusted spread is the spread at which a bond would trade if it had no embedded

options. It is calculated by using the following formula: the spread minus the component of

the spread due to any option. The most common options are a put and a call. There are

different methodologies to calculate the cost or benefits of a call or a put.

This spread is particularly useful for comparing straight bonds and bonds that have

embedded options, because it removes the cost or benefit of the option from the spread.

In Bloomberg, the option-adjusted spread is calculated relative to a government bond.

Different measures of the spread for floating-rate notes

The pricing of floating-rate notes (FRNs) is slightly different from those of fixed-rate bonds.

With an FRN, the coupon paid to the bondholder is floating: it is regularly re-adjusted

(generally quarterly, half-yearly or yearly). The coupon is a reference rate plus a quoted

margin which is fixed for the life of the security. This type of instrument’s price is usually close

to 100 but can be higher or lower if the credit risk of the issuer has changed. The FRN is

subject to the same risks as a fixed-rate corporate bond (liquidity and credit risks) but

typically has a shorter maturity.

This is the amount that needs to be added to a reference rate in order to determine the

coupon. The quoted margin is usually fixed over the life of the bond and is specified in the

documentation of the security. It can be seen as a floating bond’s equivalent of the coupon of

a fixed bond.

• The discount margin

This measure assesses the average margin that an investor in an FRN can expect to receive

over the life of the instrument. It will change daily, according to market conditions and any

change in the credit risk of the issuer. It can be seen as a floating bond’s equivalent of a fixed

bond’s yield to maturity.

It does not take into account a possible change of the reference rate or additional features of

the security (such as caps and floors).

Stephane Zeisel

Credit Analyst

Erwan Pirou, CFA

Credit Analyst

04 October 2006

Investors’ Guide

Investors’ Guide

Fixed-coupon bonds

• The spread to government (YAS or RV <Go> )

• The spread to interpolated swap curve (YAS or RVS <Go>)

• The asset swap spread, also called the gross spread (YAS or ASW <Go>)

• The Z-spread, also called the zero-volatility spread (YAS or ASW <Go>)

• The option-adjusted spread (YAS or OAS1 <Go>)

Floating-rate notes

• The quoted margin (YA <Go>)

• The discount margin (YA <Go>)

This document has been issued and approved by Barclays Bank PLC. Although information in this document has been obtained from sources believed to be reliable, we do not

represent or warrant its accuracy, and such information may be incomplete or condensed. This document does not constitute a prospectus, offer, invitation or solicitation to buy or

sell securities and is not intended to provide the sole basis for any evaluation of the securities or any other instrument, which may be discussed in it. All estimates and opinions

included in this document constitute our judgement as of the date of the document and may be subject to change without notice. This document is not a personal

recommendation and you should consider whether you can rely upon any opinion or statement contained in this document without seeking further advice tailored for your own

circumstances. This document is confidential and is being submitted to selected recipients only. It may not be reproduced or disclosed (in whole or in part) to any other person

without our prior written permission. Law or regulation in certain countries may restrict the manner of distribution of this document and persons who come into possession of this

document are required to inform themselves of and observe such restrictions. We or our affiliates may have acted upon or have made use of material in this document prior to its

publication. You should seek advice concerning any impact this investment may have on your personal tax position from your own tax adviser.

© Barclays Bank PLC 2006. All rights reserved. Issued for companies including Barclays Bank PLC (Reg. No. 1026167), Barclays Stockbrokers Limited (Reg. No. 1986161), a

member of the London Stock Exchange and PLUS, Barclays Sharedealing (Reg. No. 2092410), Barclays Bank Trust Company Limited (Reg. No. 920880) and Gerrard Investment

Management Limited (Reg No. 2752982), a member of the London Stock Exchange. All of these companies are registered in England and have their registered office at: 1 Churchill

Place, London E14 5HP. All of these firms are authorised and regulated by the Financial Services Authority.

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