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04 October 2006

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

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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

Yield Corporate bond

Spread Spread to
to government
swaps

Swaps

AAA government bond

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.

• The spread to government


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.

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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.

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• 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.

To assess an FRN, the market generally considers the following:

• The quoted margin


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

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Appendix 1: Bloomberg codes


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>)

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