CHAPTER 3

INTRODUCTION TO FIXED-INCOME VALUATION

 1. INTRODUCTION
The fixed-income market is a key source of
financing for business and governments.
Similarly, the fixed-income market represents
a significant investing opportunity for
institutions and individuals.
Understanding how to value fixed-income
securities is important to investors, issuers,
and financial analysts.

2
 2. BOND PRICES AND
THE TIME VALUE OF MONEY
• Bond pricing is an application of
discounted cash flow analysis.
Bond price should be equal to the value of all
discounted future cash flows.
• On an option-free fixed-rate bond, the
promised future cash flows are a series of
coupon interest payments and repayment
of the full principal at maturity.
• The market discount rate is used to obtain
the present value.
The market discount rate is the rate of return
required by investors given the risk of the investment
in the bond. 3
Formula for calculating the bond price given
the market discount rate:

where

PV is the present value (price) of the bond

PMT is the coupon payment per period

is the future value paid at maturity, or the

FV
bond’s par value

r is the required rate of return per period

is the number of evenly spaced periods to

N
maturity
4
Examples. Calculate the value of a) an annual 4%
coupon paying bond and b) a semiannual 8%
coupon paying bond. Both have five years to maturity
and a market discount rate of 6%:
a)

The bond price is 91.575 per 100 of par value.

b)
The bond price is 108.530 per 100 of par value.

5
 Premium, Par and Discount Bonds
The price of a fixed-rate bond, relative to par value, depends
on the relationship of the coupon rate to the market discount
rate.
If the bond price is
higher than par • This happens when the coupon
value, the bond is rate is greater than the market
said to be traded at discount rate.
a premium.
If the bond price is
lower than par value, • This happens when the coupon
the bond is said to rate is less than the market
be traded at a discount rate.
discount.

If the bond price is • This happens when the coupon

equal to par value, rate is equal to the market
the bond is said to
be traded at par.
discount rate.

6
PREMIUM, PAR AND DISCOUNT BONDS
 Another five-year bond has a coupon rate of 8% paid
annually. If the market discount rate is again 6%, the price
of the bond is…

 What if the coupon rate is 6%?

 What if the coupon rate is 2%?

 Coupon rate < market discount rate  Discount bond

 Coupon rate > market discount rate  Premium bond
 Coupon rate = market discount rate  Par bond
7
EXAMPLE 1

8
 Yield-to-Maturity
• If the market price of a bond is known, the following equation
can be used to calculate its yield-to-maturity:

The yield-to-maturity is the internal rate of return on a

bond’s cash flows. It is the implied market discount rate.
The yield-to- • The investor holds the bond
maturity (YTM) to maturity.
is the rate of • The issuer does not default
return on the on coupon or principal
bond to an payments.
investor • The investor is able to
provided three
reinvest coupon payments at
conditions are
that same yield.
met:

Therefore, the yield-to-maturity is the promised yield.

9
Example. Suppose that a four-year, 5% annual
coupon paying bond is priced at 105 per 100 of par
value. The yield-to-maturity is the solution for the
rate, r, in this equation:

where r = 0.03634, or 3.634%.

The bond is traded at a premium because its

coupon rate is greater than the yield required by
investors.

10
• The price of a fixed-rate bond will change whenever
the market discount rate changes.
The bond price is inversely related to the market discount rate.
When the market discount rate increases, the bond price
decreases (the inverse effect).

For the same coupon rate and time-to-maturity, the percentage

price change is greater when the market discount rate goes
down than when it goes up (the convexity effect).
For the same time-to-maturity, a lower-coupon bond has a
greater percentage price change than a higher-coupon bond
when their market discount rates change by the same amount
(the coupon effect).
For the same coupon rate, a longer-term bond has a greater
percentage price change than a shorter-term bond when their
market discount rates change by the same amount (the
maturity effect).
11
Relationships between Bond Prices and Bond
Characteristics
Discount Rates Discount Rates
Go Down Go Up
Coupon Maturit Price at
Bond Price % Price %
Rate y 20%
at Chang at Chang
19% e 21% e

A 10% 10 58.075 60.950 4.95% 55.405 –4.60%

100.00 104.33
B 20% 10 4.34% 95.946 –4.05%
0 9
141.92 147.72 136.48
C 30% 10 4.09% –3.83%
5 8 7

D 10% 20 51.304 54.092 5.43% 48.776 –4.93%

100.00 105.10
E 20% 20 5.10% 95.343 –4.66%
0 1
148.69 156.10 141.91
F 30% 20 4.99% –4.56%
6 9 0
12
EXAMPLE 3

13
 Constant Yield Trajectory
constant-yield price trajectory illustrates the change in the price of a fixed-
income bond over time. This trajectory shows the “pull to par” effect on the
price of a bond trading at a premium or a discount to par value.

14
 Pricing Bonds with Spot Rates
• Because the market discount rates for the cash flows
with different maturities are rarely the same, it is
fundamentally better to calculate the price of a bond by
using a sequence of market discount rates that
correspond to the cash flow dates. Spot rates are
yields-to-maturity
These market
on zero-coupon
discount rates are
bonds maturing at
called “spot rates.”
the date of each
cash flow.

General formula for calculating a bond price given

the sequence of spot rates:

where Z1, Z2, and ZN are spot rates for period 1, 2, and N,
respectively.
15
Example. Suppose that the one-year spot rate is 2%,
the two-year spot rate is 3%, and the three-year spot
rate is 4%. Calculate the price of a three-year 5%
annual coupon paying bond:

The bond price is 102.960.

The present values of the individual cash flows

discounted using spot rates differ from those using
yield-to-maturity, but the sum of the present values
is the same. Thus, the same price is obtained using
either approach.
16
EXAMPLE 4

17
3. PRICES AND YIELDS: CONVENTIONS FOR
QUOTES AND CALCULATIONS
Bond price
consists of two
components

Flat (clean) price

Accrued interest (AI)
(Pc)

The sum of flat price and accrued interest is the full

(dirty) price (Pf).

Bond
dealers Buyers pay the
usually full price for the
quote the bond on the
flat price. settlement date.
18
• When a bond is between coupon payment dates, its
price has two parts: the flat price (PVFlat) and the
accrued interest (AI). The sum of the parts is the full
price (PVFull),
• Accrued interest is the proportional share of the
next coupon payment:
where t is the number of days from the last coupon
payment to the settlement date; T is the number of days
in the coupon period; t/T is the fraction of the coupon
period that has gone by since the last payment; and
PMT is the coupon payment per period.

The two most

30/360 is Actual/
common conventions
common for actual is
to count days in bond
corporate common for
markets:
bonds. government
(Days in the bonds.
month/Days in a year)
19
• The full price of a fixed-rate bond between coupon
payments given the market discount rate per period
(r) can be calculated as:

where N – t/T represents the time before the

appropriate payment is made and FV is the face
value of the bond.

• The above formula can be simplified to:

where PV is the value of the bond on the most

recent coupon payment date and can be calculated
using the standard bond price formula (slide 5).
20
Example. A 6% German corporate bond is priced for
settlement on 18 June 2015. The bond makes
semiannual coupon payments on 19 March and 19
September of each year and matures on 19
September 2026. Using the 30/360 day-count
convention, calculate the full price, the accrued
interest, and the flat price per EUR100 of par
value if the YTM is 5.80% (2.90% per six months):

• The value of the bond after the latest coupon (19

March) is

The present value of the bond is EUR101.6616.

21
Example (continued):

• The full price on 18 June 2015 is

• The accrued interest is

• The clean/flat price is

22
 Matrix pricing

Matrix pricing is an estimation process used

for bonds that are not actively traded.

In matrix pricing, market discount rates are

extracted from comparable bonds (i.e., bonds
with similar time-to-maturity, coupon rate,
and credit quality).

Example. An analyst is pricing a three-year, 4%

semiannual coupon corporate bond with no active market
to derive the appropriate YTM. He finds two bonds with a
similar credit quality: A two-year bond is traded at a YTM
of 3.8035%, and a five-year bond is traded at a YTM of
4.1885%. Using linear interpolation, the estimated YTM of
a three-year bond will be 3.9318%:

23
 Matrix pricing
Example 6

24
Matrix pricing is also used in underwriting new
bonds to get an estimate of the required yield
spread over the benchmark rate.
• The benchmark rate is typically the yield-to-
maturity on a government bond having the
same, or close to the same, time-to-maturity.

The spread is the difference between the yield-

to-maturity on the new bond and the
benchmark rate.
• The yield spread is the additional compensation
required by investors for the difference in the
credit risk, liquidity risk, and tax status of the
bond relative to the government bond. This
spread is sometimes called the “spread over
the benchmark.”
25
Yield Measures for Fixed-Rate Bonds
• Investors use standardized yield measures to allow for
comparison between bonds with varying maturities.

For money market

For bonds maturing in
instruments of less than
more than one year:
one year to maturity:
• An annualized and • These are annualized
compounded yield-to- but not compounded.
maturity is used.

• An annualized and compounded yield on a fixed-rate bond

depends on the periodicity of the annual rate.
The periodicity of the annual market discount rate for a zero-
coupon bond is arbitrary because there are no coupon payments.
The effective annual rate helps to overcome the problem of
varying periodicity. It assumes there is just one compounding
period per year.
26
• Another way to overcome a problem of varying
periodicities is to calculate a semiannual bond
equivalent yield (i.e., a YTM based on a periodicity of
two).
General formula to convert yields based on different
periodicities:

where APR is the annual percentage rate and m and n are

the number of payments/compounding periods per year,
respectively.

• For example, converting a YTM of 4.96% from a

semiannual periodicity to a quarterly periodicity gives
a YTM of 4.93%:

27
 OTHER YIELD MEASURES

Street True yield- Governme Current Simple

conventio to- nt yield: yield:
n yield-to- maturity: equivalen The sum of The sum of
maturity: The t yield: coupon coupon
The internal Restateme payments payments
internal rate of nt of a received plus the
rate of return on yield-to- over the straight-
return on the cash maturity year line
the cash flows using based on a divided by amortized
flows, the actual 30/360 the flat share of
assuming calendar of day-count price the gain or
the weekends to one loss,
payments and bank based on divided by
are made holidays actual/actu the flat
on the al price
scheduled
dates (no
28
weekends
 YIELD MEASURES FOR FLOATING-RATE NOTES

The interest The principal on the floater is typically non-

payments on amortizing and is redeemed in full at
a floating-rate maturity.
note vary The reference rate is determined at the
from period to beginning of the period, and the interest
period payment is made at the end of the period.
depending on
the current
level of a The most common day-count conventions
for calculating accrued interest on floaters
reference are actual/360 and actual/365.
interest rate.

29
 The required margin
The specified yield (i.e., discount margin)
spread over the is the yield spread
reference rate is called over, or under, the
the “quoted margin” reference rate such
on the FRN. that the FRN is priced
at par value on a rate
reset date.
Simplified FRN pricing model:

where PV is the present value/price of the FRN, Index is the

annual reference rate, QM is the quoted margin (annualized),
FV is the value at maturity, m is the periodicity of the FRN,
DM is the annualized discount margin, and N is the number of
evenly spaced periods to maturity.
30
Example. Suppose that a five-year FRN pays three-
month Libor plus 0.75% on a quarterly basis.
Currently, three-month Libor is 1.10%. The price of
the floater is 95.50 per 100 of par value. Calculate
the discount margin:

95.50 …

Solving for DM, DM = 1.718%, or 171.8 bps

31
• There are several important differences in yield
measures between the money market and the bond
market:

Money market Money market

The rate of
instruments often are instruments
return on a
quoted using having different
money market
nonstandard interest times-to-
instrument is
rates and require maturity have
stated on a
different pricing different
simple interest
equations than those periodicities for
basis.
used for bonds. the annual rate.

• Quoted money market rates are either discount

rates or add-on rates.
“Discount rate” has a unique meaning in the
money market. It is a specific type of quoted rate.
32
 Pricing formula for
money market •
instruments quoted on
a discount rate basis:

Pricing formula for FV

PV =
( )
money market
instruments quoted on Days
an add-on rate basis: 1+ × AOR
Year

where Days is the number of days between settlement

and maturity; Year is the number of days in a year (365
or 360); DR is the discount rate, stated as an annual
percentage rate; and AOR is the add-on rate, stated as an
annual percentage rate.

33
Examples: Suppose that a 91-day US Treasury bill (T-bill)
with a face value of USD10 million is quoted at a discount
rate of 2.25% for an assumed 360-day year. Enter FV =
10,000,000, Days = 91, Year = 360, and DR = 0.0225.
Find the price of the T-bill:

• Suppose that a Canadian pension fund buys an 180-day

banker’s acceptance (BA) with a quoted add-on rate of
4.38% for a 365-day year. If the initial principal amount
is CAD10 million, calculate the redemption amount due
at maturity:

34
 ( )(
Year FV − PV
)
The discount rate is
calculated using the DR= ×
formula: Days FV
The add-on rate is
calculated using the
formula:
AOR= ( )(
Year
Days
×
FV − 𝑃𝑉
PV )
The first term for both formulas, Year/Days, is the
periodicity of the annual rate.
The second term for the add-on rate is the interest
earned, FV – PV, divided by PV, the amount invested.
However, for the discount rate, the denominator in the
second term is FV, not PV. Therefore, by design, a
money market discount rate understates the rate of
return to the investor.
35
Examples. Suppose that an investor is considering an
investment in 90-day commercial paper quoted at a
discount rate of 5.76% for a 360-day year. Its FV = 100
and PV = 98.560. Find the paper’s AOR based on a 365-
day year:
or 5.925%
This converted rate is called a “bond equivalent yield.”

Now suppose that an analyst prefers to convert money

market rates to a semiannual bond basis. The quoted rate
for a 90-day money market instrument is 10%, quoted as
a bond equivalent yield (its periodicity is 365/90):
or 10.127%

36
 4. THE MATURITY STRUCTURE OF
INTEREST RATES
The difference between yields on two bonds might
be due to various reasons, such as:
• currency denomination • credit risk
• liquidity • tax status
• periodicity • varying time-to
maturity
The term structure of interest rates is the factor that explains the
differences between yields. It involves the analysis of yield curves, which
are relationships between yields-to-maturity and times-to-maturity.

Examples of yield curves

The (government bond) spot The yield curve on coupon
curve is a sequence of yields- bonds is a sequence of
to-maturity on zero-coupon yields-to-maturity on coupon
(government) bonds. paying (government) bonds.
37
 A par curve is a sequence of yields-to-maturity
such that each bond is priced at par value.

The par curve is obtained from a spot curve using

the following formula and solving for PMT (z is the
spot rate for the period):

• A forward curve is a series of forward rates, each

having the same time frame. These forward rates
might be observed on transactions in the derivatives
market.

38
 • is the interest rate on a bond or
money market instrument traded
A forward rate in a forward market (future
delivery).
• is calculated from spot rates and
is a break-even reinvestment rate
An implied • links the return on an investment
forward rate in a shorter-term zero-coupon
(also known as a bond to the return on an
forward yield) investment in a longer-term zero-
coupon bond.

• Although finance textbook authors use varying notation, the

most common market practice is to name forward rates as in
this example: “2y5y” — pronounced “the two-year into five-year
rate.” The first number (two) refers to the length of the forward
period in years from today, and the second number (five) refers
to the tenor (time-to-maturity) of the underlying bond.

39
• A general formula for the relationship between the
two spot rates and the implied forward rate is

where A is the years from today when the security

starts and B – A is the tenor.

Example. Calculate the 2y4y if the two-year spot

rate is 4.5% and the four-year spot rate is 5%,
assuming annual compounding:

40
EXAMPLE 11

41
 Application of Forward Rates
Impliedspot rates can be calculated as geometric averages of forward rates.
Bonds can then be priced using implied spot rates.

42
5. YIELD SPREADS

The spread is the difference between the

yield-to-maturity and the benchmark.

The benchmark is often called the “risk-free

rate of return.” Fixed-rate bonds often use a
government benchmark (on-the-run) security
with the same time-to-maturity as, or the
closest time-to-maturity to, the specified bond.

A frequently used benchmark for floating-rate

notes is Libor. As a composite interbank rate,
it is not a risk-free rate.

43
 Yield-to-Maturity Building Blocks

Taxation

Risk
Spread Liquidity
Premium

Credit Risk

Expected
Inflation
“Risk-Free” Rate
Benchmark Rate of
Return
Expected
Real Rate

44
 • The yield spread in basis points over
G-spread an actual or interpolated government
bond

I-spread or • The yield spread of a specific bond

interpolated over the standard swap rate in that
spread to the currency of the same tenor
swap curve
• Calculated as a constant yield spread
over a government (or interest rate
swap) spot curve — as opposed to the
A zero G-spread and I-spread, which use the
volatility same discount rate for each cash flow
spread (Z-
spread) of a
bond • The Z-spread is also used to calculate
the option-adjusted spread (OAS)
on a callable bond.

45
 6. SUMMARY
Bond’s price given a market discount rate
• The market discount rate is the rate of return
required by investors given the risk of the investment
in the bond.
• A bond is priced at a premium above par value when
the coupon rate is greater than the market discount
rate.
• A bond is priced at a discount below par value when
Relationships among a bond’s price, coupon
the coupon
rate, rateand
maturity, is less than the
market marketrate
discount discount rate.
• A bond price moves inversely with its market
discount rate.
• The price of a lower-coupon bond is more volatile
than the price of a higher-coupon bond, other things
being equal.
• Generally, the price of a longer-term bond is more
volatile than the price of a shorter-term bond, other
things being equal.
46
 SUMMARY
Spot rate
• A spot rate is the yield-to-maturity on a zero-coupon
bond.
Flat price, accrued interest, and the full bond
price
• Between coupon dates, the full (or invoice, or “dirty”)
price of a bond is split between the flat (or quoted, or
“clean”) price and the accrued interest.
• Accrued interest is calculated as a proportional share
of the next coupon payment using either the
actual/actual or 30/360 method to count days.

Matrix pricing
• Matrix pricing is used to value illiquid bonds by using
prices and yields on comparable securities having the
same or similar credit risk, coupon rate, and maturity.

47
 SUMMARY
Yield measures for fixed-rate bonds, floating-rate
notes, and money market instruments
• A yield quoted on a semiannual bond basis is an
annual rate for a periodicity of two. It is the yield per
semiannual period times two.
• The current yield is the annual coupon payment
divided by the flat price.
• The simple yield is like the current yield but includes
the straight-line amortization of the discount or
premium.
• The quoted margin on a floater is typically the
specified yield spread over or under the reference
rate, which often is LIBOR.
• Money market instruments, having one year or less
time-to-maturity, are quoted on a discount rate or
add-on rate basis.
48
 SUMMARY
Spot curve, yield curve on coupon bonds, par curve,
and forward curve
• A spot curve is a series of yields-to-maturity on zero-
coupon bonds.
• A frequently used yield curve is a series of yields-to-
maturity on coupon bonds.
• A par curve is a series of yields-to-maturity assuming
the bonds are priced at par value.
• An implied forward curve can be calculated from the
spot curve.

Forward rates and spot rates

• A forward rate is the interest rate on a bond or money
market instrument traded in a forward market.

49
 SUMMARY
Forward rates and spot rates (continued)

• An implied forward rate is the breakeven

reinvestment rate linking the return on an investment
in a shorter-term zero-coupon bond to the return on
an investment in a longer-term zero-coupon bond.
• A fixed-income bond can be valued using a market
discount rate, a series of spot rates, or a series of
forward
Yield rates.
spread measures

• A bond yield-to-maturity can be separated into a

benchmark and a spread.
• Changes in spreads typically capture microeconomic
factors that affect the particular bond—credit risk,
liquidity, and tax effects.
• Benchmark rates are usually yields-to-maturity on
government bonds or fixed rates on interest rate
swaps.

50
Thank You