Chapter 12

Bond Prices and Yields

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 Chapter Summary

Objective: To review the principles of

bond pricing and to examine the
determinants of credit risk.
Bond Characteristics
Bond Pricing and YTM
Taxation Issues
Default Risk and Ratings

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 Bond Characteristics

Face or par value

Coupon rate
Zero coupon bond
Compounding and payments
Accrued Interest and dirty price
Indenture

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 Different Issuers of Bonds

Canada bonds
Provincial government bonds
Corporations
Municipalities
International Governments and Corporations
Innovative Bonds
Indexed Bonds
Floaters and Reverse Floaters
Asset-Backed
Catastrophe

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 Provisions of Bonds

Secured or unsecured
Registered or bearer bonds (Canada)
Call provision
Convertible provision
Retractable and extendible (putable)
bonds
Floating rate bond
Sinking funds

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 Table 12.1 Principal and Interest
Payments for a Real Return Bond

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 Summary Reminder

Objective: To review the principles of

bond pricing and to examine the
determinants of credit risk.
Bond Characteristics
Bond Pricing and YTM
Taxation Issues
Default Risk and Ratings

2015 McGraw-Hill Ryerson Limited

12-7

C
P

(
1 P
a
r
V
l
u
e

r)(
1
) T

Bt

t1 T
PB =price of the bond
Bond Pricing

Ct = interest or coupon payments

T = number of periods to maturity
r = the appropriate semi-annual discount
rate

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P4
0 1
(0
6 .5
0 1
,
0
)(.5
Bt1t 6
0)
Solving for Price: 30-yr,
8% Coupon Bond, FV =

Ct
P
T
r
$1,000
=
=
=
=

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40 (SA)
1000
60 periods
5% (SA)

PB = $810.71

12-9
 Bond Prices and Interest
Rates

Prices and yields (required rates of

return) have an inverse relationship
When yields get very high the value
of the bond will be very low
When yields approach zero, the value
of the bond approaches the sum of
the cash flows

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 Figure 12.2 The Inverse
Relationship Between Prices
and Yields

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 Table 12.2 Bond Prices at Different
Interest Rates (8% Coupon Bond,
Coupons Paid Semiannually)

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PC
P
ar
V
l
u
e

r)(1
(1 )
BT
t
t
1
to its price

T
T
Yield to Maturity

Interest rate that makes the present

value of the bonds payments equal

Solve the bond price formula for r

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12-13
 1.
,2
7
6 r)(

4
0
(1 10
r)
30 yr Maturity
8%
Price = $1,276.76


T6
0
t1
t
Solve for r r==semiannual
3.0%

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T
Yield to Maturity
Example

Coupon Rate =

rate

12-14
 Yield Measures

Bond Equivalent Yield

3.0% x 2 = 6%
Effective Annual Yield
(1.03)2 - 1 = 6.09%
Current Yield (Annual Interest/Market Price)
$80 / $1,276.76 = 6.27 %
Yield to Call

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 Bond Yields: YTM vs. Current
Yield
Yield to Maturity
Bonds internal rate of return
The interest rate that makes the PV of a bonds
payments equal to its price; assumes that all
bond coupons can be reinvested at the YTM
Current Yield
Bonds annual coupon payment divided by the
bond price
For premium bonds
Coupon rate > Current yield > YTM
For discount bonds, relationships are reversed
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12-16
 Figure 12.3 The Inverse Relationship
between Bond Prices and Yields for a
Callable Bond

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 Bond Yields: Yield to Call

If interest rates fall, price of straight

bond can rise considerably
The price of the callable bond is flat over
a range of low interest rates because the
risk of repurchase or call is high
When interest rates are high, the risk of
call is negligible and the values of the
straight and the callable bond converge

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 Realized Yield versus YTM

Reinvestment Assumptions
Holding Period Return
Changes in rates affects returns
Reinvestment of coupon payments
Change in price of the bond

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 Figure 12.4
Growth of Invested Funds

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 Figure 12.5
Price Paths of Coupon
Bonds

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 where



IH
(P
RP
)
1
0
Holding-Period Return:
Single Period

I = interest payment
P1 = price in one period
P0 = purchase price

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 CR = 8% ;

P
R

8
0
(H
1
5
0
10
)
Holding-Period Example

YTM = 8%;
Annual Coupons P0 = $1000
In 6M the rate falls;
N=30 years

P 1 =$1050

HPR = 13% (annual)

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 Summary Reminder

Objective:To review the principles of

bond pricing and to examine the
determinants of credit risk.
Bond Characteristics
Bond Pricing and YTM

Taxation Issues
Default Risk and Ratings

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 Figure 12.6 The Price of a
30-Year Zero-Coupon Bond
Over Time

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

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12-26


In
co
m
e
ta
x
(4
5
3
.0
6
5
4
9
.
6
)
0
.
3
6
1
8
3 Example
30-year bond with 4% coupon rate, issued at
an 8% YTM; if sold one year later, when
YTM=7%, for a 36% income tax and a 20%
capital gains tax:
P0=549.69;
P1(8%)=553.66;
P1(7%)=631.67

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 C
G
tR
a
x
(a
.teT
oA 6 3
1
lfeurt
a 7
8
x490 5
in.53
.6
)
e/4
1
com
2015 McGraw-Hill Ryerson Limited
0
.
2
3

4
915.
6
.61.5%
Example (cont)

12-28
 Summary Reminder

Objective:To review the principles of

bond pricing and to examine the
determinants of credit risk.
Bond Characteristics
Bond Pricing and YTM
Taxation Issues

Default Risk and Ratings

2015 McGraw-Hill Ryerson Limited

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 Default Risk and Ratings

Rating companies
Moodys Investor
Service
Standard & Poors
DBRS
Rating Categories
Investment grade
Speculative grade

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 Figure 12.7 Definitions of
Each Bond Rating Class

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 Factors Used by Rating
Companies

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

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 Table 12.3 Financial Ratios and
Default Risk by Rating Class,
Long-Term Debt

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 Figure 12.8 Discriminant
Analysis

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 The Altman
Discriminant Analysis
Method
Observe a sample of bankrupt firms one
year prior to default
Observe a sample of similar solvent
firms
Find a function of ROE and coverage
ratios that separates the bankrupt from
the solvent firms
Use the function to predict
default/solvency for any off-sample firm
(high/low values)
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Z
10.6C
0
.234T o S
a
l
e
t12ur(E
A s
tnqL
ib
Example of the

syG
Altman Method (Canada)
Predicting equation:

0
.
9

row
7
2
5
3
hAN
T
1et
E
o
setGa
r
n
i
l
D
e
A
rw
g
s
b
t
h)
Firms with Z>1.626 were safe, and
firms with Z<1.626 were in risk of
default
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 Default Risk and Bond
Pricing:
Bond Indentures
Sinking funds: A way to call bonds early
Subordination of future debt: Restrict
additional borrowing
Dividend restrictions: Force firm to
retain assets rather than paying them
out to shareholders
Collateral: A particular asset
bondholders receive if the firm defaults

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 Default Risk and Yield

Risk structure of interest rates

Default premiums
Yields compared to ratings
Yield spreads over business
cycles
Flight to quality

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 Figure 12.10
Yields on Long-Term Bonds

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 Default Risk and Bond Pricing

Credit Default Swaps (CDS)

Acts like an insurance policy on the
default risk of a corporate bond or loan
Buyer pays annual premiums
Issuer agrees to buy the bond in a
default or pay the difference between
par and market values to the CDS buyer

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 Default Risk and Bond Pricing

Credit Default Swaps

Institutional bondholders, e.g. banks, used
CDS to enhance creditworthiness of their
loan portfolios, to manufacture AAA debt
Can also be used to speculate that bond
prices will fall
This means there can be more CDS
outstanding than there are bonds to insure

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 Figure 12.11
Prices of Credit Default
Swaps

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 Default Risk and Bond
Pricing
Credit Risk and Collateralized Debt
Obligations (CDOs)
Major mechanism to reallocate credit risk in
the fixed-income markets
Structured Investment Vehicle (SIV) often
used to create the CDO
Loans are pooled together and split into
tranches with different levels of default risk
Mortgage-backed CDOs were an
investment disaster in 2007-2009
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 Figure 12.12
Collateralized Debt
Obligations

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