Chapter 5: Bond
5.1 Bond Terminology
• Bond
• Bond certificate
– Terms of the bond
– Amounts and dates of all payments to be made.
• Payments
• Term
5.1 Bond Terminology
• Face value (par value or principal amount)
– Notional amount used to compute interest
payments
– Usually standard increments, such as $100
– Typically repaid at maturity
• Coupons
What is a Bond?
• A bond is a long-term debt security (promissory
note).
• The bond is issued by the borrower (i.e. the
issuer) who promises to make payments of
predetermined fixed interest per year and
principal (the face value) at maturity to the
lenders (i.e. the bondholders).
• Issuers or Borrowers: Corporations,
Government, State and Local Municipalities,
Foreign governments or corporations.
Characteristics of Bonds
Bonds pay fixed coupon (interest) payments at fixed
intervals (usually semiannually) and pay the par value
(face/principle value) at maturity.
In practice, bonds usually have a face value of $100,
$1,000 or $100,000 denominations.
-$P $I $I $I $I $I $I+$FV
0 1 2 ... n
5.1 Bond Terminology
• Coupon rate
– Set by the issuer and stated on the bond
certificate.
– By convention, expressed as an APR, so the
amount of each coupon payment (CPN), is
Coupon Rate Face Value
CPN
Number of Coupon Payments per Year (Eq. 5.1)
Table 5.1 Review of Bond Terminology
5.2 Zero-Coupon Bonds
• Zero-coupon bonds
• A bond that pays no annual interest and it makes only one payment at maturity;
it provides compensation to investors in the form of capital appreciation.
• These bonds are issued at a substantial discount from the $1,000 face value
with a zero or very low coupon rate.
• All of the return (for zero coupon bond) or most of the return (for very low
coupon rate bond) comes from appreciation of the bond.
– Only two cash flows
• The bond’s market price at the time of purchase
• The bond’s face value at maturity
– Treasury bills are zero-coupon U.S. government
bonds with maturity of up to one year.
5.2 Zero-Coupon Bonds
• A one-year, risk-free, zero-coupon bond with a
$100,000 face value has an initial price of
$96,618.36.
– If you purchased this bond and held it to maturity,
you would have the following cash flows:
5.2 Zero-Coupon Bonds
• Yield to Maturity (YTM, a rate of return of a
bond) of a Zero-Coupon Bond
– The discount rate that sets the present value of
the promised bond payments equal to the
current market price of the bond
– Yield to Maturity of an n-Year Zero-Coupon Bond:
1/ n
Face Value
1 YTM n (Eq. 5.2)
Price
Example 5.1
Yields for Different Maturities
Problem:
• Suppose the following zero-coupon bonds are trading at the
prices shown below per $100 face value. Determine the
corresponding yield to maturity for each bond.
Maturity 1 year 2 years 3 years 4 years
Price $96.62 $92.45 $87.63 $83.06
Example 5.1
Yields for Different Maturities
Solution:
Plan:
• We can use Eq. 6.2 to solve for the YTM of the bonds.
• The table gives the prices and number of years to maturity
and the face value is $100 per bond.
Example 5.1
Yields for Different Maturities
Evaluate:
• Solving for the YTM of a zero-coupon bond is the same
process we used to solve for the rate of return in Chapter 4.
• Indeed, the YTM is the rate of return of buying the bond.
5.3 Why Bond Prices Change
• Zero-coupon bonds always trade for a discount.
• Coupon bonds may trade at a discount or at a
premium
• Most issuers of coupon bonds choose a coupon
rate so that the bonds will initially trade at, or
very close to, par.
• If investor’s required rate of return is equal to the
coupon interest rate, the bonds will trade at par
value.
• After the issue date, the market price of a bond
changes over time.
5.3 Why Bond Prices Change
• Interest Rate Changes and Bond Prices
– If a bond sells at par the only return investors will
earn is from the coupon payments that the bond
pays.
– Therefore, the bond’s coupon rate will exactly
equal its yield to maturity.
– As interest rates in the economy fluctuate, the
yields that investors demand will also change.
Bond Trading at Par Example
• Suppose our firm decides to issue 20-year bonds
with a par value of $1,000 and annual coupon
payments. The return on other corporate bonds
of similar risk is currently 12%, so we decide to
offer a 12% coupon interest rate.
• What would be a fair price for these bonds?
Note: When the required rate of return (interest rate) equals the coupon
interest rate, the bond value (or price) equals the par value.
Figure 5.3 A Bond’s Price vs. Its Yield to
Maturity
Premium Bond:
Priced above Par
YTM < Coupon Rate
Par Value
Coupon Rt = YTM
Discount Bond:
Priced below Par
YTM > Coupon Rate
Premium Bonds
• When the market value of a bond is above
the par or face value, these bonds are
known as premium bonds.
• Suppose interest rates fall immediately after
we issue the bonds. The return on bonds of
similar risk drops to 10%.
• What would happen to the bond value?
Discount Bonds
• When the market value of a bond is below
the par, these bonds are known as discount
bonds.
• Suppose interest rates rise immediately
after we issue the bonds. The return on
bonds of similar risk rises to 14%.
• What would happen to the bond value?
Suppose coupons are semi-annual
Table 5.3 Bond Prices Immediately
After a Coupon Payment
Summary:
Par, Discounts and Premiums
• If YTM = coupon rate = par value
12% = 12% then $1,000 = $1,000
• If YTM < coupon rate
10% = 12% then $1,170.27
(premium bond)
• If YTM > coupon rate,
14% = 12% then $867.54
(discount bond)
31
Note:
• Long-term bonds have greater interest rate
risk than do short-term bonds.
• In other words, a change in interest rate will
have relatively greater impact on long-term
bonds.
5.4 Corporate Bonds
• Credit Risk
– U.S. Treasury securities are widely regarded to be
risk-free.
– Credit risk is the risk of default, so that the bond’s
cash flows are not known with certainty
• Corporations with higher default risk will need
to pay higher coupons to attract buyers to
their bonds.
5.4 Corporate Bonds
• Corporate Bond Yields
– Yield to maturity of a defaultable bond is not
equal to the expected return of investing in the
bond
– A higher yield to maturity does not necessarily
imply that a bond’s expected return is higher.
– Investors pay less for bonds with credit risk than
they would for an otherwise identical default-free
bond
5.4 Corporate Bonds
• Bond Ratings
– Several companies rate the creditworthiness of
bonds
• Two best-known are Standard & Poor’s and Moody’s
– These ratings help investors assess
creditworthiness
Table 5.6 Bond Ratings and the Number of U.S. Public Firms with
those Ratings at the End of 2009
(cont.)
Table 5.6 Bond Ratings and the Number of U.S. Public Firms with
those Ratings at the End of 2009 (cont.)
5.4 Corporate Bonds
• Bond Ratings
– Investment-grade bonds
– Speculative bonds
• junk bonds
• high-yield bonds
– The rating depends on
• the risk of bankruptcy
• bondholders’ claim to assets in the event of
bankruptcy.
