15 Bond Valuation

Chapter Contents
Overview 456
15.1 Basic Bond Terminology  457
15.2 Computing the Yield to Maturity (YTM) of a Bond  462
15.3 U.S. Treasury Bills  470
15.4 U.S. Treasury Bonds and Notes  472
15.5 A Corporate Bond Example: Caterpillar Inc.  475
15.6 Callable Bonds  480
15.7 Preferred Stock  483
15.8 Deriving the Yield Curve from Zero-​Coupon Bonds  486
15.9 Inflation: Real and Nominal Interest Rates and Cash Flows  490
15.10 Understanding TIPS  495
15.11 Using TIPS to Predict Inflation  500
Summary 501
Exercises 501

 Overview
When businesses, governments, or municipalities borrow money, they issue
bonds. The fundamental characteristic that distinguishes a bond from other kinds
of securities such as stocks, preferred stock, and options is that the borrower
is very specific about the promised payments on the bond. All bonds specify
the precise dates and the amounts that the issuer/​borrower promises to repay the
bond’s purchaser/​lender.
In this chapter, we apply the discounting techniques discussed in Chapters 1–​6
to value bonds.You will learn to analyze a bond based on its yield to maturity
(YTM). The YTM is a concept much like the internal rate of return discussed
first in Chapter 3. You will learn to analyze the different kinds of bonds: Treasury

­­­­456
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CHAPTER 15 Bond Valuation  

bills, Treasury bonds, corporate bonds, and callable bonds. We also include a
brief discussion of preferred stock, a security that—​despite its name—​is very
much like a bond.

Finance concepts discussed Excel functions used

• Basic definitions, example of bond value and YTM • IRR
• U.S. Treasury markets: Discussion of the types of bonds • XIRR
and yield conventions • Yield
o Discussion of T-​bills • NPV
o Treasury bonds • Ln
o Strips • Exp
• The U.S. Treasury yield curve • Sum
• Corporate bond markets: Example of Caterpillar Inc. • Average
• Callable bonds • Min and Max
• Preferred stock

15.1  Basic Bond Terminology

We start out the chapter with some basic bond terminology and examples of
various kinds of bonds.

The XYZ Corporation Bond

To get the bond terminology straight, Figure 15.1 gives some details for an imag-
inary bond offering by XYZ Corporation, a highly ​reliable borrower.

FIGURE 15.1:  On 15 December 2014, XYZ Corporation sold $10 million of bonds paying a 7%

coupon. The italicized terms are explained in the text.
458  PART 3  Valuing Securities

The terminology (bolded) is as follows:

• The XYZ bond has a face value and a coupon rate. The $10 million of
bonds issued by XYZ Corporation are issued as individual bonds of $1,000
face value; each such bond pays a coupon rate of 7%. The periodic interest
payments are based on the product of the coupon rate and the face value.
The XYZ bonds pay interest only once a year; since the coupon rate is 7%
and the face value is $1,000, this means that the coupon payments are
$70 annually. (As you will see in Section 15.2, most corporate bonds pay
interest semi-annually; if this were true for the XYZ bonds, they would pay
$35 on 15 December and 15 June of each year until the redemption year
(2021).)
• The XYZ bond has a principal repayment on the last day of the bond’s
maturity (the bond’s maturity date). On this day, 15 December 2016, a
$1,000 face-​value XYZ bond will pay its holder a final repayment of princi-
pal of $1,000 in addition to the interest payment of $70 due for 2021.
• The bond’s offer price is the initial price at which it is sold to the public.
The XYZ bonds are offered at par value, meaning that the initial sale price
is equal to the bond’s face value.
Tricky details, covenants, and other conditions: XYZ promises to make
•
a set of contractual payments in exchange for the loan of $1,000 made to it
by the purchaser. Often the bond-​issuing company agrees to abide by certain
restrictions on its behavior; these restrictions, termed bond covenants, might
specify that XYZ will pay no dividends until the bond issue is redeemed, or
perhaps that it will refrain from certain other actions.1 The “boilerplate” in
which all these conditions are specified also specifies what happens if XYZ
defaults—that is, if it fails to keep its promises. The boilerplate also specifies
what constitutes default.2

Some Other Corporate Bonds

Figure 15.2 shows you some of the corporate bonds traded in September 2014.
By looking at the table, you can learn the following facts about bonds:

Not all the bonds are traded at par. The AT&T bonds, for example, are
•
traded at $110.17 for every $100 of face value. In Section 15.2, we discuss
the effect of issuance not at par on the analysis of the bond.

1
 A detailed example of covenants is given in Section 15.4, where we discuss the Caterpillar Inc.
bonds.
2
 This is not as trivial as it might sound. If a coupon payment is late by 2 days, does this violation
of the contract automatically mean bankruptcy? Suppose one of the bond covenants is violated? Do
bondholders have recourse (can they do something if the covenants are violated)?
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CHAPTER 15 Bond Valuation  

FIGURE 15.2:  Partial list of corporate bonds traded in September 2014.

(Source: https://​screener.finance.yahoo.com/​bonds.html)
460  PART 3  Valuing Securities

Bonds differ in their ratings. Bonds are rated according the credit worthi-
•
ness of their issuers. Figure 15.3 shows you the ratings used by the two pri-
mary bond rating agencies, Standard and Poor’s (S&P), Fitch, and Moody’s.
The ratings are based on the agency’s estimation of the issuing company’s
ability to pay off the bonds and play an important role in determining the
interest rate that the company pays on its bonds. The “Investment Grade”
bonds on the left side of Figure 15.2 are issued by companies whose ability
to repay the funds borrowed is highly regarded by the rating agencies. The
“Speculative Grade” bonds (often called “junk bonds”) in the bottom half of
the figure are issued by companies whose credit ratings are lower.
Some bonds are callable. A bond is callable if the issuer has the right to
•
refund the bond’s principal before maturity. For example:  The Alcoa Inc.
bonds in Figure 15.2 promise to pay 5.4% interest annually until 15 April
2021. However, these bonds are callable, and Alcoa Inc. can refund the
bonds by forcing bondholders to return their bonds to the company for their
face value. We discuss callable bonds in Section 15.6.
• The price, coupon, and maturity of the bond affect the internal rate of return
(IRR) of the bond holder. In bond markets the jargon for IRR is yield to
maturity (YTM). If the bond is callable, we can also calculate a yield to call
(YTC). These concepts are discussed in Sections 15.2 and 15.6.

FIGURE 15.3:  Compilation of Standard and Poor’s (S&P), Fitch, and Moody’s bond rating classifications.
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CHAPTER 15 Bond Valuation  

U.S. Government Debt

The market for U.S. government debt is without question the largest and most
important bond market in the world. In August 2014, the U.S. Treasury had
$17.6 trillion of bonds outstanding (see Figure  15.4). Almost every week the
Treasury sells stupendous amounts of debt to the public (see Figure 15.5 for a
fairly standard weekly announcement, in which the government sells $24 billion
of short-​term debt).
The U.S. Treasury classifies its debt into three main categories: bills, notes,
and bonds:

•
Treasury bills are short-​term bonds sold by the government. Treasury bills
are zero-​coupon bonds; they are sold at a discount. For example, a 1-​year
Treasury bill with a $100 face value might be sold for $90. The Treasury bill
has no explicit interest rate: The purchaser of this bill pays $90 today and
gets back $100 in 1 year. We discuss the pricing of T-​bills in Section 15.3.
• The U.S. Treasury uses the word notes to describe coupon bonds that have
maturities up to 10 years. It uses the word bonds to describe coupon bonds
that have greater maturities. Since there is no analytical difference between
U.S. Treasury notes and bonds—​ both refer to bonds that have coupon
payments—​we will analyze them together in Section 15.4.

UNITED STATES FEDERAL DEBT

Debt Held by the Intragovernmental Total Public Debt
Date Public Holdings Outstanding
(millions $) (millions $) (millions $)
31-Dec-00 3,413,541 2,248,675 5,662,216
31-Dec-01 3,393,758 2,549,681 5,943,439
31-Dec-02 3,647,385 2,758,322 6,405,707
31-Dec-03 4,044,054 2,953,910 6,997,964
31-Dec-04 4,406,352 3,189,791 7,596,143
31-Dec-05 4,714,607 3,455,806 8,170,413
31-Dec-06 4,901,208 3,779,016 8,680,224
31-Dec-07 5,136,288 4,092,884 9,229,172
31-Dec-08 6,372,651 4,327,154 10,699,805
31-Dec-09 7,814,359 4,496,990 12,311,349
31-Dec-10 9,395,411 4,629,804 14,025,215
31-Dec-11 10,452,503 4,770,437 15,222,940
31-Dec-12 11,586,560 4,846,169 16,432,729
31-Dec-13 12,355,194 4,996,776 17,351,970
30-Aug-14 12,572,021 5,060,585 17,632,606

FIGURE 15.4:  Debt of the United States government. On 30 August 2014, the U.S. government had $12.6 trillion of debt
outstanding in the form of bonds owned by the public. A further $5 trillion of debt consists of debts of one government
agency to another. The total government debt was $17.6 trillion.
(Source: http://​w ww.treasurydirect.gov/​NP/​BPDLogin?application=np.)
462  PART 3  Valuing Securities

FIGURE 15.5:  On September 25, 2014, the U.S. Treasury announced the sale of $24 billion dollars of Treasury bills. Similar
sales are generally held weekly. Note that $23 billion of the proceeds will go toward refunding existing debt.
(Source: http://​www.treasurydirect.gov/​instit/​annceresult/​press/​press_​secannpr.htm.)

15.2  Computing the Yield to Maturity (YTM) of a Bond

The most common tool for the analysis of bonds is the yield to maturity (YTM).
YTM of the bond is the internal rate of return of the bond’s cash flows. Suppose
we observe the bond’s market price P and we know its stream of future promised
payments (coupons and principal) C1, C2, ...., CN. Then the YTM is defined as the
internal rate of return of the bond price and its future payments, which is the rate
of return that sets the present value of the bond’s future promised payments equal
to its current price:

C1 C2 C3 CN
P= + + ++
(1+YTM ) (1+YTM )2 (1+YTM )3 (1+YTM )N
In this section, we illustrate how to compute the YTM. In addition to the IRR
function that you already know, the Excel XIRR and Yield functions enable you
to compute the YTM in more complicated cases. We use the XYZ Corporation
bond from the previous section as our example.
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CHAPTER 15 Bond Valuation  

Back to the XYZ bond

Suppose that it’s the morning of 15 December 2014 and that you have been
asked to value the XYZ bond illustrated earlier in this chapter (page 457). Using
Excel’s IRR function, you determine that the yield to maturity (YTM) of the
bond is 7.00%:

A B C
1 YIELD TO MATURITY OF XYZ BOND
2 Market price of bond 1,000.00
3
4 Date Bond cash flow
5 15-Dec-14 –1,000.00
6 15-Dec-15 70.00
7 15-Dec-16 70.00
8 15-Dec-17 70.00
9 15-Dec-18 70.00
10 15-Dec-19 70.00
11 15-Dec-20 70.00
12 15-Dec-21 1,070.00
13
14 YTM of bond 7.00% <-- =IRR(B5:B12)

Are the XYZ bonds a good buy? This depends on whether the market inter-
est rate on equivalently risky bonds is bigger or smaller than 7%. If the market
is paying more than 7% for bonds of companies that—​in terms of risk—​are like
XYZ Corporation, then the XYZ bonds are not a good buy. On the other hand, if
the market is paying less than 7%, they are a good buy.3
Just for the sake of argument, suppose that on 15 December 2009, the market
interest rate for bonds like the XYZ Corporation is 6.5%. You can use the NPV
of the future payments on the bond to determine how much you should be willing
to pay for them:

 Having read Chapter 14 on efficient markets, you naturally suspect that the market price pretty
3

much reflects the risk-​adjusted return on the XYZ bonds.

464  PART 3  Valuing Securities

A B C D E F G
1 VALUING THE XYZ CORPORATION BONDS
2 Market interest rate 6.50%
3
Bond Market Bond
4 Year cash flow interest rate value
5 15-Dec-14 70.00 0.00% 1,560.00 <-- =NPV(E5,$B$5:$B$12)
6 15-Dec-15 70.00 1.00% 1,459.10 <-- =NPV(E6,$B$5:$B$12)
7 15-Dec-16 70.00 2.00% 1,366.27 <-- =NPV(E7,$B$5:$B$12)
8 15-Dec-17 70.00 3.00% 1,280.79 <-- =NPV(E8,$B$5:$B$12)
9 15-Dec-18 70.00 4.00% 1,201.98
10 15-Dec-19 70.00 5.00% 1,129.26
11 15-Dec-20 70.00 6.00% 1,062.10
12 15-Dec-21 1,070.00 7.00% 1,000.00
13 Value of the bond 1,030.44 <-- =NPV(B2,B5:B12) 8.00% 942.53
14 9.00% 889.30
15 10.00% 839.95
16 11.00% 794.16
17 12.00% 751.62
18 13.00% 712.07
19 14.00% 675.28
20
21
22
23
24
25
26
27
28
29

If the market values the bond using the 6.5% interest rate, then it would be
worth $1,030.44. If you could buy the bond for $1,000, you should do so. Making
a table (cells E5:F19) in Excel shows that the bond is worth more than $1,000 if
the market interest rate is less than 7% and vice versa.
As you can see, the basics of bond analysis using the YTM are very similar
to standard IRR analysis and quite simple. However, for bonds there are three fac-
tors that sometimes complicate the pricing calculations. In the rest of this section
we discuss these factors.

Complicating Factor 1: Uneven Spacing of Bond Payments

The calculation of both the present value of the bond’s future payments and the
YTM can be complicated by the fact that the payments are not evenly spaced.
Suppose, for example, that you buy the XYZ bond on 15 May 2015 and that its
market price on that date is $1,050. In order to compute the YTM of the bond, we
have to compute the IRR of its payments. But the problem is that the payments
are not evenly spaced. As you can see in Figure 15.6, the time between the pur-
chase date of the bond and the first coupon payment is 214 days, whereas all the
other payments are 365 or 366 days:
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CHAPTER 15 Bond Valuation  

Payment pattern of XYZ bond purchased on 15 May 2015 and held to maturity

15-May-15 15-Dec-15 15-Dec-16 15-Dec-17 15-Dec-18 15-Dec-19 15-Dec-20 15-Dec-21

–1,050 70 70 70 70 70 70 1,070

214 days 366 days 365 days 365 days 365 days 366 days 365 days
leap year leap year

FIGURE 15.6:  If you buy the XYZ bond on 15 May 2015, the first coupon payment will be received in 214 days. Subsequent
coupon payments will be received with spacing of 1 year. Excel’s XIRR function computes the YTM for the bond.

Excel’s IRR function will not correctly compute the YTM of this bond—​
IRR assumes that all the payments are spaced at equal intervals, whereas in our
example the first interval (214 days) is very different from the subsequent pay-
ment intervals. Fortunately, Excel has a function called XIRR that correctly com-
putes the internal rate of return for uneven spacing of payments. The use of this
function is discussed in the Excel note on page 466.4 Here is its implementation
for our problem:

A B C
YIELD TO MATURITY
1 For uneven date spacing for XYZ bond
2 Market price of bond 1,050.00
3
4 Date Bond cash flow
5 15-May-15 –1,050.00
6 15-Dec-15 70.00
7 15-Dec-16 70.00
8 15-Dec-17 70.00
9 15-Dec-18 70.00
10 15-Dec-19 70.00
11 15-Dec-20 70.00
12 15-Dec-21 1,070.00
13
14 YTM of bond 6.58% <-- =XIRR(B5:B12,A5:A12)

As you can see, when you buy the bond on 15 May 2015, the YTM is 6.58%
annually.

4
 For more information on dates and date functions in Excel, see Chapter 26.
466  PART 3  Valuing Securities

EXCEL NOTE
The XIRR Function

To use XIRR, you have to put in the dates on which the payments are received.
In the previous example, the cells A5:A12 contain these dates. Once you’ve got
the dates in, you can use XIRR as illustrated below (that the XIRR function
computes the effective annual YTM).

You may not see XIRR in your list of Excel functions. In this case:

• Go to the Excel 2016 “FILE” and click

options and then Add-​Ins.
• In the drop-​down box at the bottom of the
Add-​Ins page indicate and click Go.
• Click on the Analysis ToolPak box.
• Click the OK button and you are good to go.
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CHAPTER 15 Bond Valuation  

Complicating Factor 2: Semi-Annual Interest

Corporate and government bonds often pay interest twice a year and not annually.
We are thus faced with a problem of annualizing the interest rate on the bond.
This corresponds to the concept of effective annual interest rate (EAIR) discussed
in Chapter 5.
Here is an example. Suppose that the ABC Corporation issues a bond at the
same time as XYZ Corporation. Like the XYZ bond, ABC’s bond pays a 7%
coupon on its face value of $1,000, is issued on 15 December 2014, and matures
on 15 December 2021. The only difference between the two bonds is that ABC’s
interest payment is semi-annual:  Instead of paying $70 once a year, the ABC
bond pays $35 twice a year, on 15 June and 15 December.
We can use either IRR or XIRR to compute the yield to maturity of the
ABC bond:

A B C
1 YTM WITH SEMI-ANNUAL COUPON PAYMENTS
2 Market price of bond 1,000.00
3
4 Date ABC bond cash flow
5 15-Dec-14 –1,000.00 <-- =–B2
6 15-Jun-15 35.00
7 15-Dec-15 35.00
8 15-Jun-16 35.00
9 15-Dec-16 35.00
10 15-Jun-17 35.00
11 15-Dec-17 35.00
12 15-Jun-18 35.00
13 15-Dec-18 35.00
14 15-Jun-19 35.00
15 15-Dec-19 35.00
16 15-Jun-20 35.00
17 15-Dec-20 35.00
18 15-Jun-21 35.00
19 15-Dec-21 1,035.00
20
21 Semi-annual IRR 3.50% <-- =IRR(B5:B19)
22 Annualized IRR—this is the YTM! 7.12% <-- =(1+B21)^2–1
23
24 YTM using XIRR 7.12% <-- =XIRR(B5:B19,A5:A19)

In cell B21, we use IRR to calculate the internal rate of return of the bond
price and its payments. Because the basic period is a half-​year, the annualized
IRR is (1 + 3.50%) − 1 = 7.12% (cell B22). In cell B24, we use the XIRR func-
2

tion to compute the annualized YTM directly.

468  PART 3  Valuing Securities

Complicating Factor 3: Accrued Interest

In U.S. bond markets, the “price” quoted for a bond is usually not the amount you
will be asked to pay for the bond because it doesn’t include the interest that has
accrued on the bond. Sound confusing? Here’s an example.
Suppose you’re going to buy the XYZ bond on 3 April 2015. You call a bond
dealer, who quotes you a price of $1,050 for the bond. To this quoted price is
added the bond’s accrued interest, the proportional part of the bond’s annual cou-
pon payment (see Figure 15.7).

A B C D E
1 ACCRUED INTEREST AND YTM COMPUTATIONS
2 Bond purchase date 3-Apr-15
3 Previous coupon date 15-Dec-14 Number of days since last coupon 109 <-- =B2–B3
4 Next coupon date 15-Dec-15 Number of days between coupons 365 <-- =B4–B3
5 Coupon payment over the period 70.00
6
7 Quoted bond price 1,050.00
8 Accrued interest 20.90 <-- =B5*D3/D4
9 Actual bond price paid 1,070.90 <-- =B7+B8
10
Bond
11 Year cash flow
12 3-Apr-15 –1,070.90
13 15-Dec-15 70.00
14 15-Dec-16 70.00
15 15-Dec-17 70.00
16 15-Dec-18 70.00
17 15-Dec-19 70.00
18 15-Dec-20 70.00
19 15-Dec-21 1,070.00
20
21 YTM of bond, using XIRR 6.06% <-- =XIRR(B12:B19,A12:A19)
22 YTM of bond, using Yield 6.06% <-- =YIELD(A12,A19,7%,105,100,1,3)

In the spreadsheet above, the accrued interest is $20.90 (cell B8). This is
computed as 109/​365 times the annual bond coupon of $70. The actual price paid
for the bond is $1,070.90 (cell B9), and using XIRR we can compute the bond’s
YTM as 6.06% (cell B21).
In cell B22, we illustrate Yield, yet another Excel function that computes the
yield to maturity. This function is explained in the Excel note on page 469. Yield
is somewhat more complicated to use than XIRR, but its advantage is that it does
the accrued interest calculation automatically.
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CHAPTER 15 Bond Valuation  

FIGURE 15.7:  Computing the accrued interest. The accrued interest is jargon for the unpaid part of the bond coupon since
the last interest payment. In U.S. bond markets, the accrued interest is added to the quoted bond price to compute the amount
actually paid for the bond. In most European bond markets, there is no separate accrued interest calculation, and the quoted
bond price is the actual price paid for the bond.

EXCEL NOTE
The Yield Function

The Yield function contains seven cells to fill (Settlement, Maturity, Rate, Pr,
Redemption, Frequency, Basis). Excel’s dialogue box for this function can’t accom-
modate all the arguments on one screen, so it includes a “slider” that allows you to nav-
igate between the arguments. The two screens above show all the arguments.
470  PART 3  Valuing Securities

The yield function used in cell B22 of the spreadsheet above involves the following:

• The Settlement is the date that the bond is purchased (cell A12). Notice that Excel
translates this date to 42097; to understand this translation, refer to Chapter 26.
• Maturity is the maturity date of the bond.
• Rate is the annual coupon rate on the bond.
• Pr is the price per $100 face value. In our example, a $1,000 face-​value ABC
bond is selling for $1,050; this is $105 for each $100 of face value.
• Redemption is the redemption value per $100 face value.
• Frequency is the number of coupon payments per year.
• Basis is the number of days in a year (sounds stupid, but there are different
conventions). The answer of “3” used here tells Excel to use the actual number
of days.

15.3  U.S. Treasury Bills

U.S. government bonds are variously defined as Treasury bills, Treasury notes,
and Treasury bonds. In this section, we analyze U.S. Treasury bills, and in the
next section, we examine U.S. Treasury bonds and notes.5
Treasury bills (“T-​bills”) are short-​term securities sold by the U.S. Treasury.
T-​bills mature in 1 year or less from their issue date. They have no coupon pay-
ments. Instead, you pay less than the face value, and you get the face value at
maturity. Here’s an example: Suppose you purchase a 26-​week T-​bill with face
value $10,000 for $9,750. In 26 weeks (182  days), you will get $10,000. The
spreadsheet below illustrates two methods for computing the yield to maturity
of the T-​bill. (The discussion of these two methods follows the spreadsheet.)
Remember that the YTM is nothing more than the annualized internal rate of
return; thus these calculations are very reminiscent of our discussion of the effec-
tive annual interest rate (EAIR) in Chapter 5.

5
 There’s a very good website operated by the U.S. government that explains more about Treasury
securities: http://​www.treasurydirect.gov/​instit/​research/​faqs/​faqs_​basics.htm.
 471
CHAPTER 15 Bond Valuation  

A B C
COMPUTING THE YIELD TO MATURITY (YTM)
1 ON TREASURY BILLS
2 Purchase price 9,750.00
3 Face value 10,000.00
4 Time to maturity (days) 182 <-- =26*7
5 Time to maturity (years) 0.49863 <-- =B4/365
6
7 Method 1: Compound the daily return
8 Daily interest rate 0.0139% <-- =(B3/B2)^(1/B4)–1
9 YTM—the annualized rate 5.2086% <-- =(1+B8)^365–1
10
11 Method 2: Calculate the continuously compounded return
12 Continuously compounded 5.0775% <-- =LN(B3/B2)*(1/B5)
13
14 Future value in 1 year using each method
15 Method 1 10,257.84 <-- =B2*(1+B9)
16 Method 2 10,257.84 <-- =B2*EXP(B12)

Method 1: YTM of the Treasury Bill Is the Compounded Daily

Return
One way to calculate the T-​bill YTM is to compound the daily interest rate paid
by the T-​bill. To do this, we first find the daily interest rate paid by the T-​bill: 
1/182
 10, 000 
( )
182
10, 000 = 9, 750 * 1 + rdaily . Solving this equation gives 1 + rdaily =  ,
 9, 750 
which solves to give rdaily = 0.0139%. Compounding this rate to give an annual rate
shows that the T-​bill pays 5.2086% annually: (1 + 0.0139%) − 1 = 5.2086%.
365

Method 2: YTM of the Treasury Bill is the Continuously

Compounded Return
This is the method preferred by most finance academics and by many finance
professionals.6 We assume that the purchase price grows at continuously com-
pound rate r:

 Continuous compounding and discounting was explained in Section 5.7. If you’re not comfortable
6

with continuous discounting and compounding, just skip Method 2.

472  PART 3  Valuing Securities

10, 000 = 9, 750 * e(182 / 365)r = 9, 750 * e0.49863r

10, 000
⇒ e0.49863r =
9, 750
 10, 000 
ln 
 9, 750 
⇒r = = 5.0775%
0.49863

Which Method Is Correct?

Both methods are correct! We know this is confusing, but then so are many other
things in life. The principle is: Any method that gives the same future value using
the annualized interest is a valid periodic interest rate. In the spreadsheet above, in
cells B15:B16, you can see that both methods indeed give the same future value.

15.4  U.S. Treasury Bonds and Notes

Treasury bonds and notes have a coupon rate and a fixed maturity date at which
the bond’s principal is repaid.7 Here’s an example: On 15 August 2013, the U.S.
Treasury issued a 10-​year, 2.5% Treasury note. The notes were sold at a price
of $100.45, so that if you bought $1,000 face value of this security at issue you
would have paid $1,004.5. You would expect to be paid a $12.5 coupon (2.5%/​
2*1,000 = $12.5) every half-​year (15 February 2014, 15 August 2015, 15 February
2015, ....) until, on the bond’s maturity date of 15 August 2023, you would be paid
$1,012.5 (the repayment of the bond’s principal plus the last half-​year’s coupon
payment).
If you bought the bond at issue and intended to hold it until maturity, your
anticipated cash flows would be:

7
 The nomenclature for interest-​paying Treasury securities distinguishes between “Treasury Notes”
and “Treasury Bonds.” Notes have an initial maturity of 10 years or less, whereas Bonds have an
initial maturity longer than 10 years. Since there is no analytical difference between the two, we
shall refer to them both with as “bonds” (with a lower-​case “b”).
 473
CHAPTER 15 Bond Valuation  

A B C
UNITED STATES TREASURY BOND, 2.5%
MATURING 15 AUGUST 2023
1 Bought at issue date
2 Face value of bonds bought 1,000.00
3 Price 101.99
4 Coupon rate 2.500%
5 Issue date 15-Aug-13
6 Maturity date 15-Aug-23
7
8 Cash flows to purchaser at bond issue
9 Date Cash flow
10 15-Aug-13 –1,019.92 <-- =–B3*B2/100
11 15-Feb-14 12.50 <-- =$B$4*$B$2/2
12 15-Aug-14 12.50 <-- =$B$4*$B$2/2
13 15-Feb-15 12.50
14 15-Aug-15 12.50
15 15-Feb-16 12.50
16 15-Aug-16 12.50
17 15-Feb-17 12.50
18 15-Aug-17 12.50
19 15-Feb-18 12.50
20 15-Aug-18 12.50
21 15-Feb-19 12.50
22 15-Aug-19 12.50
23 15-Feb-20 12.50
24 15-Aug-20 12.50
25 15-Feb-21 12.50
26 15-Aug-21 12.50
27 15-Feb-22 12.50
28 15-Aug-22 12.50
29 15-Feb-23 12.50
30 15-Aug-23 1,012.50 <-- =$B$4*$B$2/2+B2
31
32 IRR (semi-annual interest) 1.1381% <-- =IRR(B10:B30)
33 Annualizing the semi-annual IRR 2.2891% <-- =(1+B32)^2–1
34 YTM using XIRR 2.2877% <-- =XIRR(B10:B30,A10:A30)

Cell B32 gives the semiannual IRR for the bond, 1.1381%. When we annualize
this semiannual IRR, we find the yield to maturity (cell B33):

YTM of T -bond = (1 + semi-annual IRR ) − 1 = (1 + 1.1381%) − 1 = 2.2891%

2 2

We can also compute the YTM on the T-​bond directly by using XIRR
(cell B34).8

8
 XIRR gives a slightly different answer than the calculation in cell B33 because it takes account of
the actual days between each payment. See Chapter 26 for more details.
474  PART 3  Valuing Securities

Time Moves on: Purchasing the 2.5% T-​note on 29 September 2014

Suppose you purchased $1,000 face value of the same bond on 29 September
2014. In this case, you would have paid $1,010.32 for the bond (this price, as
shown on the spreadsheet below, includes the accrued interest). Had you intended
to hold the bond to maturity, you would anticipate getting:

• $12.5 on 15 February 2015, 15 August 2015, 15 February 2016, . . . , 15

February 2023.
• $1012.5 on 15 August 2023.

In the spreadsheet that follows we calculate the YTM of the bond using three
calculations (cells B31:B33):

A B C D E F
UNITED STATES TREASURY BOND, 2.5%, MATURING 15 AUGUST 2023
1 Bought on 29 September 2014
2 Face value of bonds bought 1,000.00
3 Coupon rate 2.50%
4 Today's date 29-Sep-14
5 Market price 1,007.27 Last coupon date 15-Aug-14
6 Accrued interest 3.06 <-- =E12 Next coupon date 15-Feb-15
7
8 Actual price paid 1,010.32 <-- =B5+B6 Days since last coupon 45 <-- =E4–E5
9 Days between coupons 184 <-- =E6–E5
10 Date Cash flow
11 29-Sep-14 –1,010.32 <-- =–B8 Semi-annual coupon 12.5 <-- =B3/2*B2
12 15-Feb-15 12.50 <-- =$B$3*$B$2/2 Accrued interest 3.06 <-- =E8/E9*E11
13 15-Aug-15 12.50
14 15-Feb-16 12.50
15 15-Aug-16 12.50
16 15-Feb-17 12.50
17 15-Aug-17 12.50
18 15-Feb-18 12.50
19 15-Aug-18 12.50
20 15-Feb-19 12.50
21 15-Aug-19 12.50
22 15-Feb-20 12.50
23 15-Aug-20 12.50
24 15-Feb-21 12.50
25 15-Aug-21 12.50
26 15-Feb-22 12.50
27 15-Aug-22 12.50
28 15-Feb-23 12.50
29 15-Aug-23 1,012.50
30
31 XIRR (annualized IRR) 2.422% <-- =XIRR(B11:B29,A11:A29)
32 Excel's Yield function 2.408% <-- =YIELD(A11,A29,B3,B5/10,100,2,3)
33 Excel's Yield annualized 2.423% <-- =(1+B32/2)^2–1

Cell B31 shows that the YTM computed with the XIRR function is 2.422%.
Cell B32 shows that Excel’s Yield function computes the YTM as 2.408%. This
is different from cell B31, because Yield follows the practical conventions of the
 475
CHAPTER 15 Bond Valuation  

FIGURE 15.8:  Much information about bonds is available on http://​bonds.yahoo.com/​. The Treasury note reported above
pays $12.5 (2.5%/​2*1,000 = $12.5) interest on 15 August and 15 February until the 15 August 2023 maturity date. The price of
the bond of $100.79 does not include accrued interest. The current yield is the annual bond coupon divided by the bond price: 
2.5 / 100.79 = 2.480% .

U.S. bond markets in computing the semi-annual yield doubled. Cell B33 trans-
lates the Yield result to a true annualized interest rate:
2 2
 Excel ’s Yield from cell B32   2.408% 
Cell B33:  1 +  − 1 =  1 +  − 1 = 2.423%
 2 2 

The small difference between cells B33 and B31 is attributable to the fact that
XIRR is based on the daily interest rate. The reader can compare our calculation
to the that presented in “finance.yahoo.com” as shown in ­Figure 15.8.

15.5  A Corporate Bond Example: Caterpillar Inc.

In this section, we present a case example of a corporate bond. Caterpillar Inc.
(stock symbol CAT) manufactures and sells construction and mining equipment,
diesel and natural gas engines, industrial gas turbines, and diesel–​electric loco-
motives worldwide. The firm’s shares are listed on the New York Stock Exchange.
Figure 15.9 presents a quick overview on the capital structure of the firm.
Let’s focus on one of the bonds. Figure 15.10 presents “Caterpillar Inc Del
3.803%,” maturing on 2042. Summarizing:

• The face value of the bonds is $1,000. The bonds were issued on 15 August
2012. The bonds mature on 15 August 2042.
• The coupon rate on the bonds is 3.803%. This interest is paid semi-annually.
Thus the purchaser of $1,000 face value of bonds would get two payments
per year of  3.803% * 1, 000 = $19.015.
2
476  PART 3  Valuing Securities

FIGURE 15.9:  Caterpillar’s capital structure and debt maturity date. Much information about
corporate bonds for specific firms is available on http://​www.morningstar.com/​.
 477
CHAPTER 15 Bond Valuation  

FIGURE 15.10:  Caterpillar’s 3.803% bond details. The bond has semi-annual payments of
3.803%/​2 and matures on 15 August 2042. The yield to maturity of the bond is 4.03%.
478  PART 3  Valuing Securities

What Did the Bonds Cost the Company?

We start by considering the effective annual interest rate of the bond issue to CAT.
We do this by setting up a table of CAT cash flows at the issuance date (15 August
2012). (Note that the Excel clip hides rows 17–​59.)

A B C
CATERPILLAR INC. 3.803% BONDS
ISSUER PERSPECTIVE
1 15 August 2012 (issue date)
2 Principal amount ($ thousands) 1,700,000
3 Coupon rate 3.80%
4 Maturity date 15-Aug-42
5 Issue date 15-Aug-12
6
7 Date Cash flow to CAT
8 15-Aug-12 1,700,000 <-- =B2
9 15-Feb-13 –32,325.50 <-- =–$B$3*$B$2/2
10 15-Aug-13 –32,325.50 <-- =–$B$3*$B$2/2
11 15-Feb-14 –32,325.50
12 15-Aug-14 –32,325.50
13 15-Feb-15 –32,325.50
14 15-Aug-15 –32,325.50
15 15-Feb-16 –32,325.50
16 15-Aug-16 –32,325.50
60 15-Aug-38 –32,325.50
61 15-Feb-39 –32,325.50
62 15-Aug-39 –32,325.50
63 15-Feb-40 –32,325.50
64 15-Aug-40 –32,325.50
65 15-Feb-41 –32,325.50
66 15-Aug-41 –32,325.50
67 15-Feb-42 –32,325.50
68 15-Aug-42 –1,732,325.50 <-- =–$B$3*$B$2/2–B2
69
70 Semiannual IRR of payments 1.90% <-- =IRR(B8:B68)
71 YTM—annualized semiannual IRR 3.84% <-- =(1+B70)^2–1
72 YTM computed with XIRR 3.84% <-- =XIRR(B8:B68,A8:A68)

We’ve written down the semi-annual cash flows for the whole bond issue.
Excel’s IRR function shows that the internal rate of return (we could also call
this the semi-annual yield to maturity) of the bonds is 1.90% (cell B70). The com-
pounded effective annual cost of the bonds to CAT is given in cell B71: 3.84%.
The yield to maturity as computed by Excel’s XIRR function (cell B72) is
the same.
 479
CHAPTER 15 Bond Valuation  

Buying the Bonds on the Open Market After Issue

Thus far we have only considered the purchase of the bonds at issue. We now sup-
pose that the date is 10 October 2014 and that you purchase $1,000 (face value)
of the bonds on the open market. Looking on a website that reports bond prices,
you see that the price of the bonds on this date was $96.25 per $100 face value;
to this price, we have to add the accrued interest:

96.25
Actual price paid = * 1, 000 + Accrued interest
100
Days between 15 August 2014 and 10 October 2014
= 962.50 + * Semi -annual bond coupon
Days between 15 August 20144 and 15 February 2015
56
= 932.50 + * 19.02 = 932.50 + 5.79 = 968.29
184

Because the time between the bond payments is unevenly spaced, the
computation of the YTM requires the use of XIRR. Using this function shows
that the YTM is 4.07% (in cell B68 below). (Note that the Excel clip hides
rows 15–​57.)

A B C
CATERPILLAR INC. 3.803% BONDS
BUYER PERSPECTIVE
1 10 October 2014
2 Face value of bonds bought 1,000.00
3 Coupon rate 3.80%
4
5 Quoted price 962.50 <-- =96.25/100*1000
6 Accrued interest 5.79 <-- =E12
7 Actual price paid 968.29 <-- =B5+B6
8
9 Date Cash flow
10 10/10/2014 –968.29 <-- =–B7
11 15/02/2015 19.02 <-- =$B$3*$B$2/2
12 15/08/2015 19.02
13 15/02/2016 19.02
14 15/08/2016 19.02
58 15/08/2038 19.02
59 15/02/2039 19.02
60 15/08/2039 19.02
61 15/02/2040 19.02
62 15/08/2040 19.02
63 15/02/2041 19.02
64 15/08/2041 19.02
65 15/02/2042 19.02
66 15/08/2042 1,019.02 <-- =$B$3*$B$2/2+B2
67
68 YTM using XIRR 4.07% <-- =XIRR(B10:B66,A10:A66)
69 YTM using Excel's Yield function 4.03% <-- =YIELD(A10,A66,B3,B5/10,100,2,3)
70 Excel's Yield annualized 4.07% <-- =(1+B69/2)^2–1
480  PART 3  Valuing Securities

Note that Excel’s Yield function in cell B69 gives the doubled semiannual yield
as it is often reported in U.S. bond markets (also reported at Morningstar’s website
as 4.03%). As in the Treasury bond example in Section 15.4, annualizing this yield
(cell B70) gives the same answer as the YTM reported by XIRR (cell B68).

15.6  Callable Bonds
Many bonds are callable. This means that the bond issuer has the right to refund
the bonds after a given date. As an example of a callable bond, we consider the
notes (remember that “notes” is just another word for “bond”) issued by General
Electric that are described in Figure 15.11.
The GE notes pay interest of 4.7%. This interest is paid quarterly, so that
per $25 of par value, the bonds pay annual interest of $1.175 (= 4.7%*$25); this
works out to $0.29375 quarterly (= 4.7%/​4*$25). The notes are callable at par on
or after 16 May 2018. The notes mature on 16 May 2053.
Below we compute the internal rate of return on these bonds, assuming that
they are sold on 10 October 2014 for $23.21 and held until maturity. (Note that
the Excel clip hides rows 18–​160.)

A B C
GENERAL ELECTRIC BONDS
1 Computing the yield to maturity
2 Face value 25.00
3 Coupon rate 4.700%
4 Maturity date 16-May-53
5 Current date 10-Oct-14 <-- The date the bonds are sold
6 First call 16-May-18
7 Bond price on current date 23.21
8
9 Computing the Yield to Maturity
10 Date Cash flow
11 10-Oct-14 –23.2100 <-- =–B7
12 16-Nov-14 0.2938 <-- =$B$3*$B$2/4
13 16-Feb-15 0.2938 <-- =$B$3*$B$2/4
14 16-May-15 0.2938
15 16-Aug-15 0.2938
16 16-Nov-15 0.2938
17 16-Feb-16 0.2938
161 16-Feb-52 0.2938
162 16-May-52 0.2938
163 16-Aug-52 0.2938
164 16-Nov-52 0.2938
165 16-Feb-53 0.2938
166 16-May-53 25.2938 <-- =$B$3*$B$2/4+B2
167
168 Using XIRR 5.27% <-- =XIRR(B11:B166,A11:A166)
169 Quarterly IRR 1.28% <-- =IRR(B11:B166,3%)
170 Annualizing the quarterly IRR 5.23% <-- =(1+B169)^4–1
171
172 Using Yield 5.13% <-- =YIELD(B5,B4,B3,B7*4,B2*4,4,3)
173 4 times the YTM 5.13% <-- =4*B169
 481
CHAPTER 15 Bond Valuation  

FIGURE 15.11:  Description of a callable bond issued by General Electric.

(Source: http://​w ww.quantumonline.com)
482  PART 3  Valuing Securities

The spreadsheet shows several ways of computing the notes’ yield to matu-
rity. Using the XIRR function (cell B168) gives a yield of 5.27%. Using the Yield
function, the notes’ yield is 5.13% (cell B172).
Each of these numbers can be derived using Excel’s IRR function. Since
the bond payments are quarterly, IRR computes the quarterly interest rate on
the bonds (cell B169). Cell B170 annualizes this quarterly rate by calculating
(1 + quarterly IRR )4 − 1; this is equivalent to the yield computed by XIRR in cell
B168 (minor difference is due to actual days vs. 365 days base). Cell B173 multi-
plies the quarterly IRR by 4 to get the same number as computed by Yield.
Here are two comments on this spreadsheet:

1. The effective annual interest rate paid by the GE notes is the number com-
puted by XIRR and not the number computed by Yield. So why do we use
Yield? Because the convention in American bond markets is the computed
annual rates of return by multiplying the periodic rates as is done in cell
B173. If you’re going to understand how bond rates are quoted in the United
States, you have to understand the difference between the rates computed by
XIRR and those computed by Yield.
2. The minor difference between cells B168 and B170 is a result of the exact days
calculation performed using the XIRR function vs. the 365 days assumptions
and 365/​4 days per quarter underlying assumption in the IRR calculation. In
this case, XIRR always gives the correct effective annual interest rate. The
IRR also assumes that between the first cash flow (10 October 2014) and the
second one (16 November 2014) there is a full period of one-​quarter. This is
why we should be careful when using the IRR in real-​life scenarios.

Calculating Yield to First Call on GE’s Bond

To see the effect of the call provision of the bond, we calculate the yield to first
call. This is the yield to maturity, assuming that the bond is actually called by GE
at the first call date. The spreadsheet below shows the calculations.
 483
CHAPTER 15 Bond Valuation  

A B C
1 GENERAL ELECTRIC BONDS
2 Face value 25.00
3 Coupon rate 4.70%
4 Maturity date 16-May-53
5 Current date 10-Oct-14 <-- The date the bonds are sold
6 First call 16-May-18
7 Bond price on current date 23.21
8
9 Computing the Yield to First Call (YTC)
10 Date Cash flow
11 10-Oct-14 –23.210 <-- =–B7
12 16-Nov-14 0.2938 <-- =$B$3*$B$2/4
13 16-Feb-15 0.2938 <-- =$B$3*$B$2/4
14 16-May-15 0.2938
15 16-Aug-15 0.2938
16 16-Nov-15 0.2938
17 16-Feb-16 0.2938
18 16-May-16 0.2938
19 16-Aug-16 0.2938
20 16-Nov-16 0.2938
21 16-Feb-17 0.2938
22 16-May-17 0.2938
23 16-Aug-17 0.2938
24 16-Nov-17 0.2938
25 16-Feb-18 0.2938
26 16-May-18 25.2938 <-- =$B$3*$B$2/4+B2
27
28 Using XIRR 7.39% <-- =XIRR(B11:B26,A11:A26)
29 Using Yield 6.97% <-- =YIELD(B5,B6,B3,B7*4,B2*4,4,3)

15.7  Preferred Stock
In addition to shares and bonds, companies sometimes issue preferred stock.
Preferred stock is a security that promises a fixed payment to the shareholders.
Although called “stock,” preferred has many of the properties of a bond—​the
dividend is fixed and resembles the coupon payments on bonds. In addition, pre-
ferred stock can be callable. It shall be noted that preferred stocks also have many
properties of stocks, and usually liquidation of a firm cannot be forced in cases
where payments are not paid (the firm accumulates the unpaid coupons plus some
interest).
In this section, we analyze the preferred stock issued by General Electric
(Figure 15.12). The 6.25% preferred stock issued by the GE has the following
features:
484  PART 3  Valuing Securities

FIGURE 15.12:  A description of General Electric Capital Corp’s 6.25% preferred stock.

(Source: http://​www.quantumonline.com)

• The par value of the stock is $100,000.

• The preferred stock’s dividend is 6.25% of its par value, which is
6.25%*100,000  =  $6,250 annually. A  6-​month period of this annual divi-
dend, $3,125, is paid twice a year, on 15 June and 12 December.
• The preferred stock is listed on the TRACE platform (a platform of profes-
sional trade securities that are not traded on a stock exchange). The price
varies with market interest rates and the market’s estimation of GE’s credit
worthiness—​its ability to make good its promise to pay the dividends on the
preferred stock. The market price of the preferred stock on 10 October 2014
was $110,445.00.

Computing the Yield Assuming No Call

An investor who buys the General Electric preferred stock on 10 October 2014
pays the market price of $110,445.00 and gets a semi-annual dividend of $3,125.
If the investor assumes that the stock will never be called—​that is, that the divi-
dend will be paid forever—​then the annualized yield on the stock is 5.74%:
 485
CHAPTER 15 Bond Valuation  

A B C
GENERAL ELECTRIC CO. PREFERRED STOCK
1 Annualized yield assuming no call
2 Par value $100,000.00
3 Annual dividend 6.25%
4 Annual dividend 6,250.00 <-- =B3*B2
5 Semi-annual dividend 3,125.00 <-- =B4/2
6 Market price, 10 October 2014 110,445.00
7
8 Semi-annual yield 2.83% <-- =B5/B6
9 Annualized yield 5.74% <-- =(1+B8)^2–1

Cell B8 computes the semi-annual yield of 2.83%. In cell B9, we annualize

this yield as explained in Chapter 5.

Computing the Yield to First Call

Although in principle the preferred stock will pay its dividends indefinitely,
General Electric can call the stock at any time starting 15 December 2022. If the
stock is called, the company is obliged to pay the preferred stock holders the par
value of $100,000 plus the accrued preferred dividend. This concept is very much
like the concept of the accrued interest discussed in Section 15.2 (page 468). For
example, if General Electric calls the preferred on 19 August 2023, it has to pay
the preferred holders $103,125.00:

Days between 15 December 2022 and 15 June 20022

$
100  + Days between 15 December 2022 and 15 June 2022 * $
, 000
 3  =
,125
↑   ↑
Par ↑ Semi-annual
value Percentage of th
he quarter between dividend
call date and last dividend date
65
$100, 000 + * $3,125 = $103,125.00
183

Suppose that the investor believes that General Electric will call the preferred
stock at the first legal call date. Then his anticipated yield is 5.04%, as shown
below in cell B34.
486  PART 3  Valuing Securities

A B C
GENERAL ELECTRIC 6.25% PREFERRED STOCK
1 Computing the yield to first call
2 Call date 15/12/2022
3 Last dividend date 15/06/2022
4 Next dividend date 15/12/2022
5 Par value 100,000.00
6 Semi-annual dividend 3,125.00 <-- =(6.25%*B5)/2
7 Current market price 110,445.00 <-- As of 10/10/2014
8
9 Days since last dividend 183 <-- =B2–B3
10 Days between last dividend and next dividend 183 <-- =B4–B3
11 Accrued dividend on call date 3,125.00 <-- =B9/B10*B6
12 Paid by company to shareholders at call 103,125.00 <-- =B5+B11
13
14 Date Cash flow
15 10/10/2014 –110,445.00 <-- =–B7
16 15/12/2014 3,125.00 <-- =$B$11
17 15/06/2015 3,125.00 <-- =$B$11
18 15/12/2015 3,125.00
19 15/06/2016 3,125.00
20 15/12/2016 3,125.00
21 15/06/2017 3,125.00
22 15/12/2017 3,125.00
23 15/06/2018 3,125.00
24 15/12/2018 3,125.00
25 15/06/2019 3,125.00
26 15/12/2019 3,125.00
27 15/06/2020 3,125.00
28 15/12/2020 3,125.00
29 15/06/2021 3,125.00
30 15/12/2021 3,125.00
31 15/06/2022 3,125.00
32 15/12/2022 103,125.00 <-- =B12
33
34 Yield to first call 5.04% <-- =XIRR(B15:B32,A15:A32)

15.8  Deriving the Yield Curve from Zero-​Coupon Bonds

A zero-​coupon bond is a bond that makes no coupon payments between the time
of the bond’s issue and the bond’s maturity. For example, the Treasury bills dis-
cussed in Section 15.3 are zero-coupon bonds. Zero coupons have the pleasant
property that they allow us to identify the time-​specific discount for each pay-
ment. Here’s an example.
 487
CHAPTER 15 Bond Valuation  

A B C D
USING ZERO COUPONS TO DETERMINE
1 BOND DISCOUNT RATES
2 Zero-coupon bond A: maturity in 1 year
3 Price today 95
4 Payoff in 1 year 100
5 IRR 5.26% <-- =B4/B3–1
6
7 Zero-coupon bond B: maturity in 2 years
8 Price today 99
9 Payoff in 2 years 110
10 IRR 5.41% <-- =(B9/B8)^(1/2)–1
11
12 Zero-coupon bond C: maturity in 3 years
13 Price today 101
14 Payoff in 3 years 122
15 IRR 6.50% <-- =(B14/B13)^(1/3)–1

Bonds A, B, and C have no intermediate payments. The IRR of each bond

is thus the discount rate for a specific payment at time t. For example: $200 paid
out in 2 years would be discounted by 5.41%, the rate determined by Bond B.
Now look at bond D in the spreadsheet below. This bond is a regular coupon
bond—​it pays $50 at dates 1 and 2, and at date 3 it pays $1,050 (the face value
plus the interest). In cells A19:C22, we use the zero-​coupon yield curve to deter-
mine the price of the bond as $961.88.

A B C D
USING ZERO COUPONS TO DETERMINE
1 BOND DISCOUNT RATES
2 Zero-coupon bond A: maturity in 1 year
3 Price today 95
4 Payoff in 1 year 100
5 IRR 5.26% <-- =B4/B3–1
6
7 Zero-coupon bond B: maturity in 2 years
8 Price today 99
9 Payoff in 2 years 110
10 IRR 5.41% <-- =(B9/B8)^(1/2)–1
11
12 Zero-coupon bond C: maturity in 3 years
13 Price today 101
14 Payoff in 3 years 122
15 IRR 6.50% <-- =(B14/B13)^(1/3)–1
16
17 Coupon bond D: A bond with payments at end of years 1, 2, 3
Present value of
18 Year Payment payment
19 1 50 47.50 <-- =B19/(1+B5)
20 2 50 45.00 <-- =B20/(1+B10)^2
21 3 1,050 869.26 <-- =B21/(1+B15)^3
22 Bond price 961.76 <-- =SUM(C19:C21)
488  PART 3  Valuing Securities

Suppose $961.76 is indeed the market price of bond D. Note that the bond’s
yield to maturity will be different from each of the pure-​discount yields deter-
mined above:

A B C
24 Determining the yield to maturity (YTM) of bond D
25 Year Payment
26 0 –961.76
27 1 50.00
28 2 50.00
29 3 1,050.00
30 YTM 6.44% <-- =IRR(B26:B29)

U.S. Treasury Strips
In the United States, brokers often split up the payments on U.S. Treasury bonds
and sell them off separately. The bonds created in this way are zero-coupon bonds
and are referred to as “ ‘separate trading of registered interest and principal secu-
rities” or, for short, strips. As an example: Suppose a broker bought bond D from
the previous example. She could sell off the year 1 coupon of $50 as a separate
security, the year 2 coupon of $50 as a separate security, and the year 3 payment
of $1,050 as a separate security. Each of these zero-​coupon “strip securities”
would have a separate price.
Zero-​coupon strips allow customers with specialized payment needs to buy
a security that makes a payment on a specific date. For example, if you know
that you have to make a payment in 2 years, then you could buy 2-​year Treasury
strips. This eliminates all intermediate interest rate risks.
We can use strip prices to identify a yield curve. This is a graph that
shows the zero-​coupon interest rate on bonds for each date. Using Treasury
strip data from 14 October 2014, here’s an example of zero-​coupon Treasury
yield curve:
 489
CHAPTER 15 Bond Valuation  

A B C D E F G H I J K
1 PRICES AND YIELDS OF U.S. TREASURY STRIPS
2 Current date 14-Oct-14
3
Days till Annual
4 Maturity Price maturity yield
5 15-Nov-14 99.9985 32 <-- =A5–$B$2 0.0171% <-- =(100/B5)^(365/C5)–1
6 15-Dec-14 99.9935 62 <-- =A6–$B$2 0.0383%
7 31-Dec-14 99.9890 78 0.0515%
8 15-Jan-15 99.9940 93 0.0236%
9 15-Feb-15 99.9915 124 0.0250%
10 15-Mar-15 99.9755 152 0.0589%
11 15-Apr-15 99.9655 183 0.0688% <-- =(100/B11)^(365/C11)–1
12 15-May-15 99.9710 213 0.0497%
13 31-May-15 99.9660 229 0.0542% TREASURY STRIP YIELD CURVE
14 15-Jun-15 99.9470 244 0.0793%
15 30-Jun-15 99.9435 259 0.0797%
16 15-Jul-15 99.9230 274 0.1027%
17 31-Jul-15 99.9510 290 0.0617%
18 15-Aug-15 99.9327 305 0.0806%
19 31-Aug-15 99.9350 321 0.0740%
20 15-Sep-15 99.9085 336 0.0995%
21 30-Sep-15 99.9170 351 0.0864%
22 15-Oct-15 99.8975 366 0.1023%
23 31-Oct-15 99.8890 382 0.1062%
24 15-Nov-15 99.8677 397 0.1218%
25 30-Nov-15 99.8520 412 0.1313%
26 15-Dec-15 99.8340 427 0.1421%
27 31-Dec-15 99.8125 443 0.1548%
28 15-Jan-16 99.7885 458 0.1689%
29 31-Jan-16 99.7700 474 0.1775%
30 15-Feb-16 99.7537 489 0.1843%
31 15-Mar-16 99.6855 518 0.2222%

The graph gives actual prices and maturities for Treasury strips on 14
October 2014. The maturities (column C) are calculated in days. (There are many
rows of data that we haven’t shown but which may be found on the companion web-
site at http://oup.com/​us/​benninga.) Here’s a sample calculation (cells A11:D11):
On 14 October 2014, a zero-​coupon Treasury strip with maturity 15 April 2015
sells for $99.9655. This bond promises $100 on maturity. There are 183  days
between 14 October 2014 and 15 April 2015. To compute the annualized yield
1/183
 100 
for the bond, we find one plus the daily interest rate, 1 + rdaily rate =  .
 99.9655 
Raising this number to the power 365 (the number of days per year) and subtract-
ing 1 gives the annualized yield in cell E11:
365 /183
 100 
( )
365
Yield to maturity = 1 + rdaily −1 =  − 1 = 0.0688%
 99.9655 
490  PART 3  Valuing Securities

15.9  Inflation: Real and Nominal Interest Rates and

Cash Flows
This section discusses the terminology of inflation. Prices tend to rise, and because
they do, money loses its value over time. When you finish the section, you should
understand the difference between real and nominal interest rates and real and
nominal cash flows. We’ll illustrate these concepts with several “real-world”
examples so that hopefully you’ll have a better idea of the impact of inflation.
First some facts. The spreadsheet below shows the purchasing power of $1
from 1947 through 2014. The index has been normalized so that 1980 prices
are set at 100. As the spreadsheet shows, the goods you could buy with one U.S.
dollar in 1947 would cost you $10.599 in 2014. Adjusting for inflation, $1 in
1963 would be worth $7.727 in 2014. To arrive at these numbers, we’ve adjusted
the $1 in year t to its relative value in 2014 by multiplying by the quotient of the
Consumer Price Index (CPI). Here’s the calculation for 1963:

CPI 2014 236.687

Value of $1 in 1963 in 2014 dollars = $1 * = $1 * = 7.727
CPI1963 30.633

Simply put—​prices between 1963 and 2014 went up by a factor of 7.727.

A B C D E F G H I J K
WHAT’S A DOLLAR WORTH?
1 How much would it cost in 2014 to buy $1 of goods?
2
Purchasing
power of $1
in 2014 Purchasing power of $1 in 2014 terms
3 Date CPI terms
4 01-Jan-47 22.332 10.599 <-- =1*($B$71/B4)
5 01-Jan-48 24.045 9.844 <-- =1*($B$71/B5)
6 01-Jan-49 23.809 9.941 <-- =1*($B$71/B6)
7 01-Jan-50 24.063 9.836 <-- =1*($B$71/B7)
8 01-Jan-51 25.973 9.113
9 01-Jan-52 26.567 8.909
10 01-Jan-53 26.768 8.842
11 01-Jan-54 26.865 8.810
12 01-Jan-55 26.796 8.833
13 01-Jan-56 27.191 8.705
14 01-Jan-57 28.113 8.419
15 01-Jan-58 28.881 8.195
16 01-Jan-59 29.150 8.120
17 01-Jan-60 29.585 8.000
18 01-Jan-61 29.902 7.915
19 01-Jan-62 30.253 7.824
20 01-Jan-63 30.633 7.727 <-- =1*($B$71/B20)
66 01-Jan-09 214.565 1.103
67 01-Jan-10 218.080 1.085
68 01-Jan-11 224.932 1.052
69 01-Jan-12 229.599 1.031
70 01-Jan-13 232.960 1.016
71 01-Jan-14 236.687 1.000
 491
CHAPTER 15 Bond Valuation  

In column C of the next spreadsheet, we’ve used Excel to compute the annual
inflation rates from this data:

CPI t
Inflation rate in year t = −1
CPI t −1

As you can see from the following graph, the inflation rate in the United States at
the beginning of the 1980s was considerably higher than in the 1990s. Nevertheless,
even throughout the relatively low-inflation decade of the 1990s, the inflation rate
in the United States has generally been between 2% and 4% per year. Through the
period surveyed, the average inflation rate was 3.62%.

A B C D E F G H I J
1 ANNUAL INFLATION RATE IN THE UNITED STATES, 1948–2014
Annual
2 Date CPI inflation
3 01-Jan-47 22.332 Average annual inflation 3.62% <-- =AVERAGE(C:C)
4 01-Jan-48 24.045 7.67% <-- =B4/B3–1 Minimum inflation –0.98% <-- =MIN(C:C)
5 01-Jan-49 23.809 –0.98% <-- =B5/B4–1 Maximum inflation 13.50% <-- =MAX(C:C)
6 01-Jan-50 24.063 1.07% <-- =B6/B5–1
7 01-Jan-51 25.973 7.94% Annual inflation
8 01-Jan-52 26.567 2.29%
9 01-Jan-53 26.768 0.76%
10 01-Jan-54 26.865 0.36%
11 01-Jan-55 26.796 –0.26%
12 01-Jan-56 27.191 1.47%
13 01-Jan-57 28.113 3.39%
14 01-Jan-58 28.881 2.73%
15 01-Jan-59 29.150 0.93%
16 01-Jan-60 29.585 1.49%
17 01-Jan-61 29.902 1.07%
18 01-Jan-62 30.253 1.17%
19 01-Jan-63 30.633 1.26% <-- =B19/B18–1
20 01-Jan-64 31.038 1.32%
21 01-Jan-65 31.528 1.58%
22 01-Jan-66 32.471 2.99%
23 01-Jan-67 33.375 2.78%
24 01-Jan-68 34.792 4.25%
25 01-Jan-69 36.683 5.44%
26 01-Jan-70 38.842 5.89%
27 01-Jan-71 40.483 4.22%
28 01-Jan-72 41.808 3.27%
29 01-Jan-73 44.425 6.26%
30 01-Jan-74 49.317 11.01%

Inflation of 3.62% per year may not seem like much, but it adds up. Suppose,
for example, that we had 3% inflation per year for 10 years. As the Excel spread-
sheet below shows, this means that the cumulative inflation over the decade
would have been (1 + 3.62%) − 1 = 42.70%. Another way to think about this is
10

that an end-​of-​the-​decade dollar is worth only 1 (1 + 3.62%) = 0.7008 in terms

10

of a beginning-​of-​the-​decade dollar. In other words: Every 10 years, a dollar loses

30% of its value.
492  PART 3  Valuing Securities

A B C
ANNUAL INFLATION RATES AND
1 CUMULATIVE INFLATION
2 Annual inflation rate 3.62%
Cumulative inflation over
3 10 years 42.70% <-- =(1+B2)^10–1
End-decade $ in terms of
4 beginning of decade $ 70.08% <-- =1/(1+B2)^10

Nominal and Real Interest Rates

Inflation affects not only the prices of goods but also interest rates. Financial
economists distinguish between nominal interest rates and real interest rates. The
nominal interest rate is the rate quoted on a loan or a bank deposit in dollar terms,
and the real interest rate is the loan or bank deposit rate in purchasing-​power
terms (that is, after adjusting for inflation). In this section, we explore and define
these concepts.
Suppose you lend your friend Martha $100 with the agreement that she’ll
repay you next year. How much interest should you ask for? Martha suggests a
4% interest rate, but thinking about it, you realize that you anticipate 5% inflation
over the year, meaning that goods worth $100 today will cost $100*(1.05) = $105
next year when the money is repaid. So if Martha repays you $100*(1.04) = $104,
she’s not even repaying you the purchasing power of the loan. In this case,

Next year ’s
Amount repaid 100 * (1+interest ) 104
repayment in = = = = 99.048
1 + Inflation 1 + Inflation 1.05
terms of this
year ’s dollars

In the jargon of finance, the 4% interest rate is called the nominal interest
rate; the word “nominal” indicates that the interest paid has not been adjusted for
the effects of inflation. This is another way of saying that Martha will repay you
$104 regardless of how much prices increase over the year. Quoted interest rates
(whether on mortgages, credit cards, or government bonds) are almost always
nominal interest rates (“lend me $100 today and I’ll pay you back next year with
10% interest”).
The real interest rate is defined as the interest rate in terms of purchasing
power of money. In our example, you can see that you loan Martha $100 but get
back (in purchasing power terms) $99.048. Thus the real interest paid by Martha
is –​0.952%:

Real interest Purchasing power repaid 99.048

= −1 = − 1 = −0.952%
on 1-year loan Purchasing power lent 100

From the above formula, you can see that

 493
CHAPTER 15 Bond Valuation  

1 + Nominal interest 1 + 4%
Real interest = −1 = − 1 = −0.9952%
1 + Inflation 1 + 5%

An equivalent and easier way to define the real interest rate is

1+ Nominal interest = (1+ Real interest ) * (1+ Inflation rate)

This equation is often called “the Fisher equation,” after the famous American
economist Irving Fisher (1867–​1947).

Terminology Review
Inflation: We almost always associate “inflation” with a decrease in the purchasing
power of money (and an increase in the price level). Historically there have also been
periods of deflation—​that is, increases in the purchasing power of money caused by
decreases in the price level.9
Nominal interest rate or nominal cash flow: An interest rate or cash flow that
has not been adjusted for the effects of inflation. Example: You borrow $100 today
and agree to repay $120 at the end of the year. The nominal interest rate is 20%, and
the $120 repayment (which will be in next year’s dollars, irrespective of the inflation
over the next year) is a payment in nominal dollars.
Real interest rate or real cash flow: An interest rate or cash flow adjusted for
inflation. To calculate the real cash flow, decide on a base year and compute all the
cash flows in units of that base year. The cash flows so computed are real cash flows
(cash flows in constant dollars), and the interest rates resulting from them are real
interest rates.

Nominal and Real Cash Flows

In the previous subsection, we showed the relation between the real and nominal
interest rates. The nominal interest rate is the quoted interest rate, unadjusted for
inflation, and the real interest rate is the interest rate adjusted for the change in the
purchasing power of money.
In this section, we show the relation between real and nominal cash flows.
We start with a 1-year example:  You make an investment $100 in year 0 and
get back $120 at the end of year 1; over this period, the CPI increases from 131
to 138:

9
 During the 1990s, Japan had prolonged periods of declining prices.
494  PART 3  Valuing Securities

A B C D
1 REAL AND NOMINAL CASH FLOWS
2 Year 0 Year 1
3 Nominal cash flow –100 120
4 Consumer price index (CPI) 131 138
5
6 Inflation 5.34% <-- =C4/B4–1
7
Real cash flow
8 in year 0 dollars –100 113.913 <-- =C3*B4/C4
9
10 Nominal return 20.00% <-- =C3/–B3–1
11 Real return 13.91% <-- =C8/–B8–1

The real year 1 cash flow (defined in this case as the year 1 cash flow in year
0 dollars) is computed as

Year 1 cash flow

Year 1 real cash flow =
1+ Inflation rate over period
Year 1 cash flow 120
= = = 113.913
CPI end -period ( / 131)
138
CPI beginning -period

To compute the real return on the investment:

Year 1 real cash flow

1+ Real investment return = −1
Year 0 real cash flow
113.913
= − 1 = 13.91%
100

Equivalently we can calculate the real return by using the nominal rate of return
and deflating it by the inflation rate:

End -period nominal cash flow

1+ Nominal return Beginning-period nominal cash flow
1 + Real return = −1 =
1+ Inflation rate CPI end -period
CPI beginning -period
120
1 + 20%
= 100 − 1 = = 1 + 13.91%
138 1 + 5.34%
131
 495
CHAPTER 15 Bond Valuation  

Investment Analysis: How Much Did You Really Earn?

Suppose that at the end of 2000 you invested $1,000 in a security that subse-
quently paid you $150 at the end of each year from 2001 to 2012. At the end of
2013, you sold the security for $1,150. Looking back you realize that the CPI
went from 172.2 in 2000 to 232.96 in 2013. What was your real rate of return? To
do this calculation, we translate each of the investment’s nominal cash flows into
real cash flows, using the cumulative inflation rate:

A B C D E F G
1 HOW MUCH DID YOU REALLY EARN?
Cumulative <-- This is the
Nominal inflation Real cash flow in 2000
2 Year cash flow CPI rate cash flow dollars
3 2000 –1,000 172.192 –1,000.00
4 2001 150 177.042 2.82% <-- =C4/$C$3–1 145.89 <-- =B4/(1+D4)
5 2002 150 179.867 4.46% <-- =C5/$C$3–1 143.60 <-- =B5/(1+D5)
6 2003 150 184.000 6.86% <-- =C6/$C$3–1 140.37
7 2004 150 188.908 9.71% 136.73
8 2005 150 195.267 13.40% 132.27
9 2006 150 201.558 17.05% 128.15
10 2007 150 207.344 20.41% 124.57
11 2008 150 215.254 25.01% 119.99
12 2009 150 214.565 24.61% 120.38
13 2010 150 218.080 26.65% 118.44
14 2011 150 224.932 30.63% 114.83
15 2012 150 229.599 33.34% 112.50
16 2013 1,150 232.960 35.29% <-- =C16/$C$3–1 850.02 <-- =B16/(1+D16)
17
18 Nominal IRR 15.00% <-- =IRR(B3:B16) Real IRR 12.25% <-- =IRR(F3:F16)

As you can see, your 15% nominal rate of return was reduced by inflation to
a 12.25% real rate of return (the rate of return adjusted for changes in the purchas-
ing power of money).

15.10  Understanding TIPS
The U.S. Treasury department issues securities called Treasury Inflation Protected
Security (TIPS).10 These securities promise a real rate of interest on your initial
investment adjusted for increases in the CPI. Here’s an example to show how
this works:

• You invest $1,000 today in a 1-year TIPS which has a real interest rate of 4%.
The CPI today is 120.
CPI 1 year
* (1 + 4%)
from now
• In 1 year, the Treasury will pay you $1, 000 *
CPI today

 The U.S. Treasury website offers good explanations of these securities and current prices: http://​
10

www.treasurydirect.gov/​instit/​annceresult/​tipscpi/​tipscpi.htm.
496  PART 3  Valuing Securities

Your investment in TIPS is fully inflation-​protected. To see this, break up the

TIPS repayment into two factors:

CPI 1 year from now

$1, 000 * * 1 + 4% )
(
CPI today   
  ↑
↑ Return of initial investment
Maintains the purchasing adjusted for inflation
poweer of $1,000 today PLUS
Interest on the inflatioon-adjusted
investment

To analyze TIPS, suppose you think that the CPI will rise from 120 today to
126 in 1 year. As the spreadsheet below shows, you’ll anticipate a repayment of
$1,092.00.

A B C
ANALYZING A 1-YEAR TREASURY INFLATION PROTECTED
1 SECURITY (TIPS)
2 Initial investment 1,000.00
3 TIPS real interest rate 4.00%
4 Current CPI 120
5 Anticipated CPI in 1 year 126
6
7 TIPS repayment in 1 year 1,092.00 <-- =B2*(B5/B4)*(1+B3)
8
9 Further analysis
10 Anticipated inflation rate 5.00% <-- =B5/B4–1
11 TIPS repayment of inflation-adjusted investment 1,050.00 <-- =B2*(1+B10)
12 TIPS interest on inflation-adjusted investment 42.00 <-- =B3*B11
13 Total TIPS repayment in 1 year 1,092.00 <-- =B12+B11
14
TIPS interest on inflation-adjusted investment
15 (this is the real interest rate paid by the TIPS) 4.00% <-- =B12/B11

In rows 11–​16, we show an alternative analysis of the 1-​year TIPS repayment

of $1,092.00:

CPI 1 year from now 126

• Your anticipated inflation rate is  −1 = − 1 = 5%
CPI today 120

• The TIPS always repays you the initial investment, adjusted for the inflation. In
this case, this is $1, 000 * (1 + Anticipated inflation ) = $1, 000 * (1.05) = $1, 050.
• In addition, the TIPS pays you the real interest rate (4% in this case) on the
inflation-​adjusted initial investment. As you can see in cell B12, this is $42.

The result is that the TIPS maintains the purchasing power of your investment
($1,000*(1.05) = $1,050) and pays you interest on the inflation-​adjusted invest-
ment (4% * $1,050 = $42).
 497
CHAPTER 15 Bond Valuation  

Understanding a 10-​Year TIPS
Suppose you’ve got $1,000 to save, and you’re considering buying a 10-​year
TIPS with the same conditions as above. What will be the nominal payment on
the TIPS you can expect in 10 years? In the spreadsheet below, we assume an
annual inflation rate of 3%; this brings the total anticipated TIPS repayment to
$1,989.32. A little analysis (rows 10–​16) shows the breakdown of this payment
into return of inflation-​adjusted investment ($1,343.92) and interest ($645.41).

A B C
ANALYZING A 10-YEAR TREASURY INFLATION PROTECTED
1 SECURITY (TIPS)
2
3 Initial investment 1,000.00
4 TIPS real interest rate 4.00%
5 Anticipated annual inflation rate 3.00%
6
7 TIPS repayment in 10 years 1,989.32 <-- =B3*(1+B5)^10*(1+B4)^10
8
9 Further analysis
10 Anticipated cumulative inflation rate over 10 years 34.39% <-- =(1+B5)^10–1
11 TIPS repayment of inflation-adjusted investment 1,343.92 <-- =B3*(1+B10)
12 TIPS interest on inflation-adjusted investment 645.41 <-- =B11*((1+B4)^10–1)
13 Total TIPS repayment in 10 years 1,989.32 <-- =B12+B11
14
TIPS interest on inflation-adjusted investment
15 (this is the real interest rate paid by the TIPS) 48.02% <-- =B12/B11
Annualized TIPS interest on inflation-adjusted
16 investment 4.00% <-- =(1+B15)^(1/10)–1
17
18 Anticipated nominal return on TIPS 7.12% <-- =(B7/B3)^(1/10)–1
Another way of computing the nominal return:
19 (1+TIPS real rate)*(1+inflation rate)–1 7.12% <-- =(1+B4)*(1+B5)–1

In cells B18:B19, we calculate the TIPS anticipated nominal return. As sug-

gested in the previous section:

1+ Nominal interest = (1+ Real interest ) * (1+ Inflation rate )

= (1+ 4% ) * (1+ 3% ) = 1.0712

Comparing TIPS and a Bank Certificate of Deposit

You have $1,000 extra cash which you don’t think you’ll need for the next 5 years.
You’re considering two alternatives:

• You can put the money in a bank certificate of deposit. This is a security you
buy from the bank (in this case for $1,000). The bank has agreed to pay you
8% per year, so that you anticipate receiving $1, 000 * (1 + 8%) = $1, 469.33
5

in 5 years.
498  PART 3  Valuing Securities

• On the other hand you’re considering buying a 5-year U.S. Treasury Inflation-​
Protected Security (TIPS). This security costs $1,000 and promises you 3.5%
annual interest on your initial $1,000 investment, adjusted for the CPI.

How should you make your decision? The spreadsheet below shows the
nominal payment made by the TIPS in 5 years. The graph compares these pay-
ments to the $1,469.33 you will get from the CD. As you can see from cells
A11:C19, if the anticipated inflation rate is more than 4.3478%, the TIPS will
pay off more than the CD.

A B C D
COMPARING A 5-YEAR TIPS
1 VERSUS A 5-YEAR BANK CERTIFICATE OF DEPOSIT (CD)
2 Initial investment 1,000.00
3 TIPS real interest rate 3.50%
4 Anticipated annual inflation rate 3.00%
5 Bank CD nominal interest rate 8.00%
6
7 TIPS repayment in 5 years 1,376.85 <-- =B2*(1+B4)^5*(1+B3)^5
8 Bank CD repayment in 5 years 1,469.33 <-- =B2*(1+B5)^5
9
CD
Anticipated annual payment
10 inflation rate in 5 years TIPS payment in 5 years
11 0% 1,469.33 1,187.69 <-- =$B$2*(1+$B$3)^5*(1+A11)^5
12 1% 1,469.33 1,248.27
13 2% 1,469.33 1,311.30
14 3% 1,469.33 1,376.85
15 4.3478% 1,469.33 1,469.33 <-- Break-even inflation rate
16 5% 1,469.33 1,515.82
17 6% 1,469.33 1,589.39
18 7% 1,469.33 1,665.79
19 8% 1,469.33 1,745.10
20
21 1,800
TIPS versus bank CD
22 1,700
Payment in 5 years

23 1,600
24 1,500
25 1,400 CD payment in
26 1,300 5 years
TIPS payment in
27 1,200
5 years
28 1,100
0% 2% 4% 6% 8%
29
Anticipated inflation rate
30
31
32
 499
CHAPTER 15 Bond Valuation  

Nominal Return Certainty Versus Real Return Certainty

The comparison of the CD and TIPS in the above spreadsheet shows you that
whereas the TIPS nominal return depends on the inflation rate, the CD nominal
return is fixed. In some ways, this might make it look as if the CD is preferred
to the TIPS. But wait! In the spreadsheet below, we compute the CD and TIPS
real rate of return. This time the tables are turned: The TIPS always returns 3.5%
in real terms, whereas the CD’s real rate of return depends on the inflation rate.
500  PART 3  Valuing Securities

TIPS or CD? What’s the Answer?

Like all good finance questions, the answer depends on your assumptions. If you
believe that the inflation rate will be higher than 4.3478% per year, then the TIPS
is preferred; otherwise, you should choose the CD.

15.11  Using TIPS to Predict Inflation

We can use the interest data from TIPS and from Treasury bills to derive the
market’s prediction of future inflation. Here’s an example: On 21 August 2009, a
5-​year nominal Treasury security sold in the market to yield an annual interest
rate of 2.58%. On the same date, a 5-​year TIPS was yielding 1.22% annually.
Since the TIPS yield is in real interest, we can surmise that the market is predict-
ing an inflation rate of 1.36% annually (=2.58% –​1.22%) over the 5-​year horizon.
Using available data for all maturities, here are the market’s predicted infla-
tion rates on the same date:

A B C D E F G H I J K L
1 NOMINAL AND REAL INTEREST RATES ON 21 AUGUST 2009
2 Treasury interest 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 10 yr 30 yr
3 Nominal interest 0.10% 0.10% 0.26% 0.45% 1.10% 1.65% 2.58% 3.21% 3.56% 4.32% 4.36%
4
5 TIPS data 5 yr 7 yr 10 yr 10 yr
6 Real interest 1.22% 1.41% 1.69% 2.10%
7
8 Implied inflation –1.12% –1.12% –0.96% –0.77% –0.12% 0.43% 1.36% 1.80% 1.87% 2.22% 2.26%
9
10
11
12
Implied inflation, 21 Aug 2009
13 2.50%
14
2.00%
15
16 1.50%
17 1.00%
18
0.50%
19
20 0.00%
21 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 10 yr 30 yr
–0.50%
22
23 –1.00%

24 –1.50%
25
 501
CHAPTER 15 Bond Valuation  

The data predict negative inflation over the 2-​year horizon and positive infla-
tion afterwards. On the date of this data, the world was in a financial crisis, and
the negative inflation rates are indicative that there is an expectation that this
crisis will continue for the next few years.11

 Summary
Bonds are basic to the financing of a business. This chapter discusses the basic
bond concepts: bond payment patterns over time, the yield to maturity (the inter-
nal return of the bond cash flows), and inflation-​adjusted bonds (TIPS). All the
computations can be done with the judicious use of a few Excel functions! Pricing
a bond is largely an exercise in applying the present value concepts discussed in
Chapters 2–​5. The yield on a bond is the annualized internal rate of return of its
payments.
Bond pricing and yield computations are also applicable to callable bonds
and to preferred stock. We have given examples of each of these securities.
Finally, the chapter discussed zero-coupon securities, inflation, and TIPS.

 Exercises
Note:  The data for these exercises can be found on the Benninga, Principles
of Finance with Excel, Third Edition companion website (www.oup.com/​us/​
Benninga).

1. (Bond price) Consider the following two bonds:

Bond A Bond B
• Term to maturity: 10 years from today • Term to maturity: 20 years from today
• Face value: $1,000 • Face value: $1,000
• Coupon: 5%, interest payments to be made in • Coupon: 5%, interest payments to be made
1 year from today, 2 years from today, . . . , 10 years in 1 year from today, 2 years from today, . . . ,
from today 20 years from today
• Repayment of bond: On last coupon date • Repayment of bond: On last coupon date

 We’ve had to make some compromises to derive the inflation curve. See the spreadsheet on the
11

companion website for this chapter for details on the computations and the data sources.
502  PART 3  Valuing Securities

a. Assume the market interest rate is 6%. What is the price of each
bond?
b. Make a table comparing the bond prices when the market interest rate
varies from 0%, 1%, . . ., 5%, 6%, . . ., 20%. Use the template below,
which may be found on the companion website. Make sure that when
the market interest rate is 5%, both bonds are valued at $1,000.
c. Can you conclude that “the longer-​term bond’s price is more sensi-
tive to changes in the market interest rate?” Explain using a graph.

A B C D E F G
1 COMPARING TWO BONDS
2 Bond A Bond B Section a.
3 Coupon rate 5% 5% Market interest rate 6%
4 Maturity 10 20 Price of Bond A
5 Face value 1,000.00 1,000.00 Price of Bond B
6
7 Year Bond A Bond B Section b.
8 1 50.00 50.00 Effect of market interest rate on bond prices
9 2 50.00 50.00 Interest rate Bond A price Bond B price
10 3 50.00 50.00 0%
11 4 50.00 50.00 1%
12 5 50.00 50.00 2%
13 6 50.00 50.00 3%
14 7 50.00 50.00 4%
15 8 50.00 50.00 5%
16 9 50.00 50.00 6%
17 10 1,050.00 50.00 7%
18 11 50.00 8%
19 12 50.00 9%
20 13 50.00 10%
21 14 50.00 11%
22 15 50.00 12%
23 16 50.00 14%
24 17 50.00 16%
25 18 50.00 18%
26 19 50.00 20%
27 20 1,050.00

2. (YTM) On 1 August 2015, you are offered the following bond:

• Face value: $1,000.00
• Coupon rate: 6%
• Coupon payments: Once a year on 1 August 2002, 2003, . . ., 2012
• Bond price: $1,252.00
• Bond’s face value repaid on last coupon date
 503
CHAPTER 15 Bond Valuation  

a. Use Excel’s IRR function to compute the bond’s yield to

maturity (YTM).
b. Use Excel’s XIRR function to compute the bond’s yield to
maturity (YTM).
3. (YTM, continuous vs. discrete) You have been offered a U.S. Treasury bill.
The face value of the bill is $10,000, and the price is $9,925. The bill matures
in 6 months. Compute the YTM of the bill using both discrete and continu-
ously compounded interest.
4. (YTM, continuous) You have been offered a U.S. Treasury bill. The bill has
face value of $10,000 and a price of $9,756. It matures in 210 days. Compute:
a. The daily interest rate and the corresponding annualized interest rate.
b. The continuously compounded interest rate.
5. (Accrued interest, YTM) On 20 February 2015, you are offered a U.S.
Treasury note. Here are the terms of the note:
• The note has face value of $100,000 and a 6.5% coupon rate. The note
matures on 15 October 2020.
6.5%* 100, 000
• The semi-annual interest on the note (i.e., = $3, 250) is
2
paid on 15 April and 15 October of each year. The last interest payment
was 15 October 2014, and the next interest payment is on 15 April 2015.
• Other interest payments are on 15 October 2015, 15 April 2016, . . ., 15
October 2020. On this last date, the bond’s principal of $100,000 is also
returned.
• On 20 February 2015, the bond was priced at $109,477.71. This price was
computed as follows:
$107,152.00
  + $2,285.71
  = $109,477.71

↑ ↑ ↑
In the jargon of Accrued Interest In the jargon of
bond markets, this is bond markets, this is
called the “ bond price ” called the “ invoice price ”

a. Confirm the calculation of the accrued interest.

b. Use XIRR calculate the annualized yield to maturity (IRR).
6. (Accrued interest, YTM) On 26 February 2015, a UtilityCorp 8.2% bond
maturing 15 January 2021 is priced at 103.790 per $100 of face value (this
price does not include the accrued interest). The bond was originally issued
in 1992. The bond pays interest semi-annually, on 15 January and 15 July of
each year.
504  PART 3  Valuing Securities

a. Compute the accrued interest of the bond.

b. Compute the yield to maturity of the bond.
7. (YTM, semiannual payments) On 15 August 1990, the U.S. Treasury issued
a bond maturing on 15 February 2020. The bond has a coupon rate of 8.75%,
payable semi-annually on 15 February and 15 August. If on 22 June 2015
a $100 face value bond is selling for $138.89, what is the bond’s yield to
maturity?
8. (YTM on zeros) The file below may be found on the book’s companion web-
site at http://​oup.us.benninga.

A B C D E F
1 U.S. TREASURY STRIP DATA
2 Current date 22-Jun-2015
Yahoo Days to Years to Continuous
3 Price Maturity yield maturity maturity yield
4 99.996 15-Aug-2015 0.020%
5 99.964 15-Nov-2015 0.090%
6 99.874 15-Feb-2016 0.190%
7 99.7095 15-May-2016 0.320%
8 99.551 15-Aug-2016 0.390%
9 99.333 15-Nov-2016 0.480%
10 98.7775 15-May-2017 0.640%
11 98.787 15-May-2017 0.640%
12 98.4465 15-Aug-2017 0.730%
13 97.2295 15-May-2018 0.970%
14 96.0995 15-Nov-2018 1.170%
15 95.4985 15-Feb-2019 1.260%
16 94.09 15-Aug-2019 1.470%
17 92.7465 15-Feb-2020 1.620%
18 92.6395 29-Feb-2020 1.630%

a. Complete the file to derive the continuous yields of the zero-coupon

Treasury strips. Graph the yields to derive the yield curve on 22
June 2015.
b. Why do you think that the yields of very short-​term zero strips (the
first two) are so low?
c. Be ambitious! Go to Yahoo, download the zero-coupon data for a
recent date, and repeat the previous exercise.
9. (Coupon stripping, arbitrage) You are given the following information on
three traded bonds making annual coupon payments:
 505
CHAPTER 15 Bond Valuation  

A B C D E
Face Coupon Yield to
1 Bond value rate Maturity maturity
2 A $1,000 0.00% 1 5.00%
3 B $1,000 5.00% 2 5.85%
4 C $1,000 10.00% 2 6.00%

a. What are the prices of the above three bonds?

b. What is the zero-​coupon bond yield for a 1-​year bond?
c. What is the zero-​coupon bond yield for a 2-​year bond based on the
price of bond B?
d. What is the zero-​coupon bond yield for a 2-​year bond based on the
price of bond C?
e. Challenge question: Create an arbitrage strategy from buying and/​
or selling a combination of the three bonds.

10. (Annual yield and financing expenses) On 15 August 2016, Corporate Junk
issues $100  million of 10-​year bonds. The bonds have a coupon of 10%,
payable semiannually on 15 February and 15 August of each year. They are
issued at par. Corporate Junk’s financing expenses related to the bond issue
are $4 million.
a. Compute the annualized yield to the bond investors and the annual-
ized cost to the company.
b. On 18 October 2016, the Corporate Junk bond issue is selling for
$103. Use XIRR to compute the investor’s yield to maturity (YTM)
of the bonds.

11. (YTM and yield to first call semi-annual payments) On 15 May 1985, the
U.S. Treasury issued a bond maturing on 15 November 2014. The bond had a
coupon rate of 11.75%, payable semi-annually on 15 November and 15 May.
On 23 January 2005, a $1,000 face-​value bond was selling for $1,356.20.
This price does not include the accrued interest. The bond is callable at par
starting 15 November 2009. Compute:
a. The bond’s yield to maturity.
b. The bond’s yield to first call.
506  PART 3  Valuing Securities

12. (Preferred stock yield) Consolidated Edison’s 4.65% Series C cumulative

preferred stock trades on the New York Stock Exchange. The stock has face
value $100 and pays its dividend four times per year, on the first of February,
May, July, and November. The stock is not redeemable.

a. If the share price on 2 February 2005 is $85, what is the preferred

stock’s yield?
b. Suppose that the stock trades for $87.50 on 3 January 2005. What
is its yield? (Don’t forget that the price does not include the accrued
dividend.)
 507
CHAPTER 15 Bond Valuation  

13. (Preferred stock yield to first call) Genworth Financial’s 5.25% Series
A  cumulative preferred stock has a par value of $50 and interest rate of
5.25% payable quarterly on the first day of March, June, September, and
December. The stock is callable at par from 1 June 2011. If the stock trades
at $45.50 on 2 June 2005, what is its yield to first call?