Bond Prices and

Yields

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Objective
To review the principles of bond pricing and to
examine the determinants of credit risk.

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Bond Characteristics
Bond Pricing and YTM
Taxation Issues
Default Risk and Ratings

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Know your bond

Characteristics

Face or par value

Coupon rate
Zero coupon bond
Compounding and payments
Indenture
Issuers

Provisions of Bonds

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Secured or unsecured
Call provision
Convertible provision
Retractable and extendible (puttable) bonds
Floating rate bond

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Bond Pricing

= price of the bond

= interest or coupon payments
=
number of periods to maturity
= the appropriate semi-annual compounding discount rate

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Solving for Price: 30-yr, 8%

Coupon Bond, Par = $1,000
= 40 (SA)
= 1000
= 60 periods
= 10% (SA)

= $810.71
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Bond Prices at Different Interest Rates (8% Coupon

Bond, Coupons Paid Semiannually

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The Inverse Relationship Between

Prices and Discount rate

Prices and discount rates (required rates of return) have an inverse

relationship
When discount rates get very high the value of the bond will be very
low
When discount rates approach zero, the value of the bond approaches
the sum of the cash flows
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Yields
Yield to maturity

bond equivalent yield

Yield to first call

Effective Annual Yield
Current Yield (Annual Interest/Market Price)

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Yield to Maturity
Interest rate that makes the present value of the

bonds payments equal to its price

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For bonds with annual coupon payment, solve the bond

price formula for

For bonds with semiannual coupon payment, solve the

bond price formula for

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Yield to Maturity Example

30 yr Maturity Coupon Rate = 8%,
Current price = $1,276.76
Solve for = 6.0%

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Yield Measures

Effective annual yield

(1.03)2 - 1 = 6.09%
Current yield (annual interest/market price)
$80 / $1,276.76 = 6.27 %
Note: contrary to what is used in industry, out
textbook refers to as the yield to maturity

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Yield to Call
Example: Suppose a 8% coupon, 30-year maturity bond is
selling for $1150, and is callable in 10 years at a call price
of $1100. Yield to maturity and yield to call will be
calculated using:

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Bond Prices and Yields for a Callable Bond

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Holding-Period Return: Single Period

Holding period return:

Example: ; ; years, semiannual compounding
P0 = $1000
In 6M the rate falls to 7%, P =$1068.55
1
Holding period return
=10.85% (semiannual)

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Holding-Period Return: Multiple Period

Compound yield vs. YTM

Requires actual calculation of reinvestment income

Solve for the Internal Rate of Return using the following:
Future Value: sale price + future value of coupons
Investment: purchase price

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Example

Two-year bond selling at par, 10% coupon paid once a

year. First coupon is reinvested at 8%, then
F
=9.01%
Similarly, if first coupon is reinvested at 10%, the
realized holding period return is 10%

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Growth of Invested Funds

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Price Paths of Coupon Bonds

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Zero-Coupon Bonds and Taxation Issues

For constant yields, discount bond prices rise over time and
premium bond prices decline over time
Original issue discount (OID) bonds price appreciation
(based on constant yield) is taxed as ordinary income
Price changes stemming from yield changes are taxed as
capital gains if the bond is sold

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Example: Tax

30-year bond with 4% coupon rate, issued at an 8% YTM; if sold one year later, when
YTM=7%, for a 36% income tax and a 20% capital gains tax:
P0=549.69;
P1(8%)=553.66;
P1(7%)=631.67
Income tax (553.66 549.69) 0.36
40 0.36 15.83

CG tax (631.67 553.66) 0.20 15.6

Total tax 15.83 15.6 31.43
After tax income 40
(631.67 549.69) 31.43 90.55
Rate of return 90.55 / 549.69 16.5%

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What Is a Credit Rating?

Independent, third-party opinion of an entity or security credit quality
through an economic cycle.
Does not consider pricing or market risk of securities the credit rating
is only one aspect of investors decision-making process
Ratings are based on analysis of information that is not audited or
verified by the rating agency. Ratings are not buy, hold or sell
recommendations.
Short-term ratings are based on capacity to make timely payment of
liabilities
Long-term ratings are an assessment of the ability to fulfill total
obligation for principal and interest commitments in a timely manner
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Why Do Ratings Matter?

The credit market is actually larger (both in size and
volume) than the equity market in Canada
Ratings matter for a lot of different sectors

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Buy side (insurance companies; pension funds)

Used as part of their investment making decisions
Sell side (investment banks)
Two ratings required for public issues in the U.S.
Now virtually impossible to distribute a new public debt issue
without credit ratings in Canada

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Why Do Ratings Matter?

Investors (retail and corporate)

Issuers (the ones paying the interest)

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Confirm and/or supplement their own internal credit analysis

Provide quantitative estimates of default and recovery for internal risk and
capital models
Gain entry into various debt markets
Ensure widest possible investor audience, and therefore the most optimal
pricing and terms

Regulators (want efficient markets with transparent info)

Suppliers, customers, employees, governments, etc.
You (pension fund; bond funds; corporate bonds, even equities can be
impacted by rating decisions)

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The Rating Industry

John Moody started assessing railway bonds in 1908

No regulation, no oversight, no independent research

When it existed, financial information was not timely and of dubious quality
Initially scorned, Moodys ratings soon became a factor in the trading and
selling of bonds

Poors followed with ratings in 1916, Standard Statistics was formed in

1922 and Fitch Publishing in 1924
But investors still saw large company debt as equivalent to T-Bills

June 21, 1970, the mighty Penn Central Railroad filed for bankruptcy

Panic ensued, investors fled corporate bonds & bond ratings quickly became seen as essential

Since then, we have witnessed a lot of globalization

CBRS, Thomson BankWatch, IBCA, Duff & Phelps ...

And regulation has also changed immensely in recent years

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Bond Rating Classes

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Ratings & Default Rates

Investment Grade

AAA

AA

Speculative Grade

BBB

BB

Best
Credits

Average
Credits

Hardly ever
default

Sometimes
default

0.3%

0.6%

1%

3%

12%

CCC

CC C D

Worst
Credits

Frequently
default
30%

> 50%

(Estimated cumulative default rates over 7 years by rating category)

CREDIT RATINGS & THE CANADIAN FIXED INCOME MARKET

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Factors Used by Rating

Companies
Methods are proprietary
Accounting ratios

Coverage ratios
Leverage ratio
Liquidity ratios
Profitability ratios
Cash flow to debt

Other qualitative factors

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Protection Against Default

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Sinking funds
Subordination of future debt
Dividend restrictions
Collateral

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