Chapter 5

Chapter 6 in the 5th edition

Bond Characteristics
Interest Rates and Bond Prices
Current Yield and Yield to Maturity
Bond Rates of Return
The Yield Curve
Corporate Bonds and the Risk of Default.
 Bond Characteristics
Lets discuss claim to ownership !

Governments and corporations borrow money for

the long term by issuing securities called bonds.
 Terminology

The interest payment paid to the bondholders is called

the coupon.
The payment at the maturity of the bond is called the face
value or par value.
The date on which the loan will be paid off is the maturity
date.

Default since the above features a contractual obligations,

an issuer who fails to keep them is subject to legal action
on behalf of lender/bondholders.
All amounts become due when the bond issue is in
default.
 Coupon Rate vs Discount Rate

The coupon rate is the annual interest payment

divided by the face value of the bond.
The interest rate (or discount rate) is the rate at
which the cash flows from the bond are discounted
to determine its present value.

Note: The coupon rate and the discount rate are NOT
necessarily the same! When they are not, the price of
the bond is not the same as its face value.
 Interest Rates and Bond Prices
Price of a bond
The price of a bond is the present value of all its future cash
flows, that is, it is the present value of the coupon
payments and the face value of the bond. In calculating
the PV, the appropriate opportunity cost has to be used.

Example: Calculate the current price of a 6.5 % annual

coupon bond, with a $1,000 face value which matures in 3
years. Assume a required return of 5.1%.

In this case, the first coupon payment is $65 (6.5% of

$1,000), the second payment is the same and the third
payment is the final payment: a coupon of $65 plus the
face value $1,000.
Interest Rates and Bond Prices
0 1 2 3

$65 $65 $1,065

65 65 1,065
PV
(1.051)1 (1.051) 2 (1.051)3
PV $1,038.05
 Interest Rates and Bond Prices
Example
Calculate the current price of a 6.5 % annual coupon
bond, with a $1,000 face value which matures in 3
years.
0 Assume a1 required return 2 of 6.5%. 3

$65 $65 $1,065

65 65 1,065
PV
(1.065)1 (1.065) 2 (1.065)3
PV $1,000
 Interest Rates and Bond Prices
Example
Calculate the current price of a 6.5 % annual coupon bond,
with a $1,000 face value which matures in 3 years.
Assume
0
a required
1
return of 15%.
2 3

$65 $65 $1,065

65 65 1,065
PV
(1.15)1 (1.15) 2 (1.15)3
PV $805.93
Interest Rates and Bond Prices
From the three examples shown, notice how
bond price varies with interest rates. When
interest rate goes up, bond price decreases.
Coupon Rate Interest Rate Price of Bond
6.5% 5.1% $1,038.05
6.5% 6.5% $1,000.00
6.5% 15.0% $ 805.93
Interest Rates and Bond Prices
Notice.

When the coupon rate is equal to the required

return, the bond sells at face value [at par].

When the coupon rate is higher than the

required return, the bond sells above face value
[at a premium].

When the coupon rate is lower than the

required return, the bond sells below face value
[at a discount].
Interest Rates and Bond Prices
The relationship between bond price and
the discount rate.
 Semi-annual payments:
Semi-annual coupon payments implies that the
annual coupon payment is paid in two equal
installments, every six months.
Thus, the time line must be in six-month periods.
And, we need to compute the six-month required
return.
Example: Calculate the current price of a 6.5 %
semi-annual coupon bond, with a $1,000 face
value which matures in 3 years. Assume a
required return of 6%.
Interest Rates and Bond Prices

0 1 2 3 4 5 6

$32.50 $32.50 $32.50 $32.50 $32.50 $1,032.50

32.50 32.50 32.50 1,032.50

PV ...
( 1.03 )1 ( 1.03 )2 ( 1.03 )5 ( 1.03 )6
PV $1,013.54
Time Value of Money TMV , Discounted Cash Flow
DCF techniques are used routinely in finance. Bonds,
common stocks, preferred shares, projects investments,
firms, mergers, convertible bonds, options, futures,
forwards etc can all be valued using DCF. Some are

more complex valuations. The process is similar.

1. Identify the cash flows. (Pay attention to the
periods).
2. Determine the risk of the cash flows.
3. Determine a discount rate that reflects the risk of
the cash flows (riskier cash flows require higher
discount rates.)
4. Value the cash flows according to the discount rate
that reflects the risk of the cash flows (opportunity
cost of capital.)
 Current Yield and Yield to
Maturity
Current Yield: Annual coupon payments
divided by bond price.
= Coupon Payments
Bond Price
You are buying a bond with:
Coupon Payments = $100 per year.
Price of $1,136.16.

Current Yield = $100 = 0.088 = 8.8%

$1,136.16
 Current Yield and Yield to
Maturity
Yield To Maturity: Interest rate for which the
present value of the bonds payments equal the
price (market value).

A 3-year, 10% annual coupon bond, with a face value of

$1,000 sells for $1,136.16.

$100 $100 ($100 $1,000 )

PV
( 1 r)1 ( 1 r)2 ( 1 r)3

Solving for r, we calculate the YTM to be 5%

Current Yield and Yield to Maturity
Price of 10% Coupon Bond vs Discount Rate

$1,250

$1,200
Price

$1,150

$1,100

$1,050

$1,000
3.0% 4.0% 5.0% 6.0% 7.0%

Discount Rate
 Bond Rates of Return
Rate of Return: Earnings per period per dollar
invested.
You buy a $1,000 par, 3-year, 10% annual
coupon bond for $1,136.16. One year later, you
sell it for $1,130.
Rate of return = coupon income + price change
investment
= $100 + ($1,130 - $1,136.16)
$1,136.16
= 0.083 = 8.3%
Bond Rates of Return
 The Yield Curve
A graph of the relationship between time to
maturity and yield to maturity, for bonds that
differ only in their maturity dates.

.. We will draw it on the board

 The Yield Curve
Real Return Bond: The bonds with variable
nominal coupon payments, determined by a
fixed real coupon payment and the inflation
rate.
Fisher Effect: The nominal interest rate is
determined by the real interest rate and
expected rate of inflation.
Expectations Theory: An explanatory theory
that shows why there are different shapes of
the yield curve.
 The Yield Curve
Interest Rate Risk
Interest rate risk is the risk in bond prices due
to fluctuations in interest rates.

Different bonds are affected differently by

interest rate changes.

Longer term bonds get hit harder than the

shorter term bonds. Lower coupon bonds get
hit harder than bonds with higher coupons.
 The Yield Curve
3,000 When the interest rate equals the
6.5% coupon rate, both bonds
2,500 30 yr bond sell at face value

2,000
$ Bond Price

1,500

1,000
3 yr bond
500

-
0 2 4 6 8 10
YTM
 Corporate Bonds & the Risk of
Default
Default Risk: Both corporations and the Government
of Canada borrow money by issuing bonds.
Corporate borrowers can run out of cash and default on
their borrowings.
The Government of Canada cannot default it just prints
more money to cover its debts.
Default risk (or credit risk) is the risk that a bond issuer
may default on its bonds.
The default premium or credit spread is the difference
between the promised yield on a corporate bond and the
yield on a Canada bond with the same coupon and
maturity.
 Corporate Bonds & the Risk of
Default
The safety of a corporate bond can be judged
from its bond rating.
Bond ratings are provided by companies such as:
Dominion Bond Rating Service (DBRS).
Moodys.
Standard and Poors.

Bonds rated BBB and above are called investment grade

bonds.
Bonds rated BB and below are called speculative
grade, high yield, or junk bonds.
Four Cs
 Bond Ratings
High Grade Medium Grade Low Grade Very Low Grade

Moodys Aaa Aa A Baa Ba B Caa Ca C D

DBRS (S&P) AAA AA A BBB BB B CCC CC C D

Moodys DBRS
Aaa AAA Debt rated Aaa and AAA has the highest rating. Capacity to pay
interest and principal is extremely strong.
Aa AA Debt rated Aa and AA has a very strong capacity to pay interest and
repay principal. Together with the highest rating, this group
comprises the high-grade bond class.
A A Debt rated A has a strong capacity to pay interest and repay principal,
although it is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than debt in high
rated categories.
Bond Ratings (concluded)
Baa BBB Debt rated Baa and BBB is regarded as having an
adequate capacity to pay interest and repay principal.
Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing
circumstances are more likely to lead to a weakened
capacity to pay interest and repay principal for debt in
this category than in higher rated categories. These
bonds are medium-grade obligations.

Ba, B BB, B Debt rated in these categories is regarded, on balance, as

Ca, C CC, C predominantly speculative with respect to capacity to pay
interest and repay principal in accordance with the terms of
the obligation. BB and Ba indicate the lowest degree of
speculation, and CC and Ca the highest degree of
speculation. Although such debt will likely have some quality
and protective characteristics, these are out-weighed by
large uncertainties or major risk exposures to adverse
conditions. Some issues may be in default.

D D Debt rated D is in default, and payment of interest and/or

repayment of principal is in arrears
 Summary
Coupon rate is the bonds coupon divided
by its face value.
Current yield is the bonds coupon divided
by its current price.
Yield to maturity measures the average
return to an investor who purchases the
bond and holds it until maturity.
Bond prices and yield to maturity vary
inversely.
 Summary
Bond prices fluctuate in response to changes
in interest rates. This risk of price change is
called interest rate risk.
Long term bonds have greater interest rate risk
than short term bonds.
Investors use bond ratings to determine the
risk of default on a bond.
The additional return that investors demand
for bearing credit risk is called the default
premium