2

The Bond Indenture

Contract between the company and the
bondholders that includes
The basic terms of the bonds
The total amount of bonds issued
A description of property used as security, if
applicable
Sinking fund provisions
Call provisions
Details of protective covenants
8-3
Types and terms of bonds
Callable bond: the issuer has right to retire the bond
before maturity, at a predetermined price that is
always specified in the bond contract.
Almost all corporate bonds are callable. If interest rates
then fall in the future, firms can retire these existing bonds
and replace them with new lower rate bonds.
Callable bonds will command a higher interest rate or yield
(lower price) than a comparable risk non-callable bond.
Mortgage bond: bond is secured or collateralized by
some physical asset in case the issuer defaults.
Commonly used in the transportation industry.
8-4
Types and terms of bonds, continued
Convertible bond: bond can be converted into a
predetermined number of shares of common stock.
Investors are willing to accept a lower yield on such
bonds. The right to convert may become very
valuable.
A convertible bond thus has the opportunity to become an
exciting investment if the firm does unexpectedly well.
Debenture bond: bond is backed by the issuers
ability to generate future cash flow to make the
promised payments. There is no collateral.
8-5
Types and terms of bonds, continued
Subordinated bonds: the bonds claim on the issuer
is junior to one or more senior bond issues. The
more senior bonds have the higher priority in
bankruptcy and/or liquidation.
Sinking fund provision: issuer may be required to
retire a certain amount of an issue each year. For
example, having to retire 10% of a 20 year bond issue
each year from year 11 to year 20.
6
Bond Characteristics and Required
Returns
The coupon rate depends on the risk characteristics
of the bond when issued
Which bonds will have the higher coupon, all else
equal?
Secured debt versus a debenture
Subordinated debenture versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond
8-7
Evaluating default risk:
Bond ratings
Bond ratings are designed to reflect the probability of a
bond issue going into default. The lower the rating (the
higher the default risk), the higher the required yield.
AAA or Aaa bonds have the highest rating.
Depository institutions, e.g., commercial banks and Savings &
Loans may only own Investment Grade bonds.
Investment Grade Junk Bonds
Moodys Aaa Aa A Baa Ba B Caa C
S & P AAA AA A BBB BB B CCC D
8
Interest Rate Risk
Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-term bonds
Low coupon rate bonds have more price risk than high coupon rate
bonds
Reinvestment Rate Risk
Uncertainty concerning rates at which cash flows can be reinvested
Short-term bonds have more reinvestment rate risk than long-term
bonds
High coupon rate bonds have more reinvestment rate risk than low
coupon rate bonds
9
Term Structure and the Interest Rate Risk
10
Upward-Sloping Yield Curve
11
Downward-Sloping Yield Curve
12
Bond Pricing Theorems
Bonds of similar risk (and maturity) will be priced to
yield about the same return, regardless of the
coupon rate
If you know the price of one bond, you can estimate
its YTM and use that to find the price of the second
bond
This is a useful concept that can be transferred to
valuing assets other than bonds

13
The Bond Pricing Equation
t
t
r) (1
F
r
r) (1
1
- 1
C Value Bond
+
+
(
(
(
(

+
=
14
Clean vs. Dirty Prices
Clean price: quoted price
Dirty price: price actually paid = quoted price plus accrued
interest
Example: Consider a bond with 8% coupon and mature at
November 15, 2021, Face Value $100,000.
Assume today is July 15, 2007
Number of days since last coupon = 61 (from May 16 till July 15)
Number of days in the coupon period = 184
Accrued interest = (61/184)(.04*100,000) = 1,326.09
Prices (based on ask):
Clean price = 128,250
Dirty price = 128,250 + 1,326.09 = 129,576.09
So, you would actually pay $129,576.09 for the bond
15
Inflation and Interest Rates
Real rate of interest change in purchasing power
Nominal rate of interest quoted rate of interest,
change in purchasing power, and inflation
The ex ante nominal rate of interest includes our
desired real rate of return plus an adjustment for
expected inflation
16
The Fisher Effect
The Fisher Effect defines the relationship between
real rates, nominal rates, and inflation
(1 + R) = (1 + r)(1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate
Approximation
R = r + h
17
Factors Affecting Bond Yields
Default risk premium remember bond ratings
Taxability premium remember municipal versus
taxable
Liquidity premium bonds that have more frequent
trading will generally have lower required returns
Anything else that affects the risk of the cash flows
to the bondholders will affect the required returns
Elements of a Bond Valuation Model
The potential benchmark interest rates that can be
used in bond valuation are those in the Treasury
market, a specific bond sector with a given credit
rating, or a specific issuer.

Benchmark interest rates can be based on either an
estimated yield curve or an estimated spot rate
curve.
Relative Valuation Measures
Yield spread measures are used in assessing the
relative value of securities.

Relative value analysis is used to identify securities as
being overpriced (rich), underpriced (cheap), or
fairly priced relative to benchmark interest rates.

Traditional Yield Measures
Nominal spread
Static (z) spread
These measures do not consider the effect of
embedded options (reinvestment or call
features).
Yield to worst, i.e., smallest of:
Yield to maturity
All yields to calls and puts

Traditional Yield Measures
The interpretation of a spread measure
depends on the benchmark used.
Nominal Yield Spread
The nominal spread is the difference between a non-
Treasury bonds yield and the YTM for a benchmark
Treasury coupon security.

The nominal yield spread measures the compensation for
the additional credit risk, option risk, and liquidity risk an
investor is exposed to by investing in a non-Treasury
security with the same maturity.

Zero-Volatility Spread
The zero-volatility or Z- spread is a measure of the spread the
investor would realize over the entire Treasury spot rate curve if
the bond is held to maturity.
It is not the spread off of one point on the Treasury yield curve (nominal
spread), it is an average over all spot rates.

The Z-spread is also called a static spread and is calculated as
the spread which will make the present value of the cash flows
from the non-Treasury bond, when discounted at the Treasury
spot rate plus the spread, equal to the non-Treasury bonds
price.
Trial and error is used to determine the Z-spread.
Calculation of Price of a 25-Year 8.8% Coupon Bond
Using Treasury Spot Rates
Period Cash Flow
Treasury Spot
Rate (%)
Present Value
1 4.4 7.00000 4.2512
2 4.4 7.04999 4.1055
3 4.4 7.09998 3.9628
4 4.4 7.12498 3.8251
5 4.4 7.13998 3.6922
6 4.4 7.16665 3.5622
. . . .
46 4.4 10.10000 0.4563
47 4.4 10.30000 0.4154
48 4.4 10.50000 0.3774
49 4.4 10.60000 0.3503
50 104.4 10.80000 7.5278
Theoretical price 96.6134
Calculation of the Static Spread for a 25-Year 8.8% Coupon
Corporate Bond
Present Value if Spread Used Is:
Period Cash Flow
Treasury Spot
Rate (%)
100 BP 110 BP 120 BP
1 4.4 7.00000 4.2308 4.2287 4.2267
2 4.4 7.04999 4.0661 4.0622 4.0583
3 4.4 7.09998 3.9059 3.9003 3.8947
4 4.4 7.12498 3.7521 3.7449 3.7377
5 4.4 7.13998 3.6043 3.5957 3.5871
. . . . . .
46 4.4 10.10000 0.3668 0.3588 0.3511
47 4.4 10.30000 0.3323 0.3250 0.3179
48 4.4 10.50000 0.3006 0.2939 0.2873
49 4.4 10.60000 0.2778 0.2714 0.2652
50 104.4 10.80000 5.9416 5.8030 5.6677
Total present value 88.5474 87.8029 87.0796
Comparison of Traditional Yield Spread and Static Spread for
Various Bonds
a
Spread (basis points)
Bond Price
Yield to
Maturity (%)
Traditional Static Difference
25-year 8.8% Coupon Bond
Treasury 96.6133 9.15
A 88.5473 10.06 91 100 9
B 87.8031 10.15 100 110 10
C 87.0798 10.24 109 120 11
. . . . . .
5-year 8.8% Coupon Bond
Treasury 105.9555 7.36
J 101.7919 8.35 99 100 1
K 101.3867 8.45 109 110 1
L 100.9836 8.55 119 120 1
a
Assuming the same Treasury spot rate curve given in the previous example
Static Spread Vs Yield Spread
The magnitude of the difference between the traditional yield spread and
the static spread also depends on the shape of the yield curve.
The steeper the yield curve, the more the difference for a given coupon and maturity.

We also find that the shorter the maturity of the bond, the less the static
spread will differ from the traditional yield spread.

Differences are lower when the corporate bond makes a bullet payment at
maturity.

Similarly, the difference will be considerably greater for sinking fund
bonds and mortgage-backed securities in a steep yield curve environment.
What is the best spread?
Option Adjusted Spread (OAS)
The Z-spread, which looks at measuring the spread over a spot
rate curve, has a problem in that it fails to take future interest
rate volatility into consideration which could change the cash
flows for bonds with embedded options.

The option-adjusted spread (OAS) was developed to take the
dollar difference between the fair valuation and the market
price and convert it to a yield spread measure.
The OAS is used to reconcile the fair price (value) and the market price
by finding a return (spread) that will equate the two.
The spread is measured in basis points.
Option Adjusted Spread (OAS)
The option-adjusted spread is a measure of option risk.

Depending on the benchmark interest rates used to generate
the interest rate tree, the option-adjusted spread may or may
not capture credit risk.

The option-adjusted spread is not a spread off of one maturity
of the benchmark interest rates; rather, it is a spread over the
forward rates in the interest rate tree that were constructed
from the benchmark interest rates.
Callable Bonds and Their Investment
Characteristics
The presence of a call option results in two disadvantages
to the bondholder:
i. callable bonds expose bondholders to reinvestment risk
ii. price appreciation potential for a callable bond in a declining
interest-rate environment is limited
o This phenomenon for a callable bond is referred to as price
compression.
If the investor receives sufficient potential compensation
in the form of a higher potential yield, an investor would
be willing to accept call risk.

Callable Bonds and Their Investment
Characteristics (continued)
Traditional Valuation Methodology for Callable Bonds
o When a bond is callable, the practice has been to calculate a
yield to worst, which is the smallest of the yield to maturity
and the yield to call for all possible call dates.
o The yield to call (like the yield to maturity) assumes that all
cash flows can be reinvested at the computed yieldin this
case the yield to calluntil the assumed call date.
o Moreover, the yield to call assumes that
i. the investor will hold the bond to the assumed call date
ii. the issuer will call the bond on that date.
o Often, these underlying assumptions about the yield to call are
unrealistic because they do not take into account how an
investor will reinvest the proceeds if the issue is called.
Callable Bonds and Their Investment
Characteristics (continued)
Price-Yield Relationship for a Callable Bond
o The priceyield relationship for an option-free bond is convex.
o The figure on the next slide shows the priceyield relationship for both
a noncallable bond and the same bond if it is callable.
o The convex curve aa' is the priceyield relationship for the
noncallable (option-free) bond.
o The unusual shaped curve denoted by ab is the priceyield
relationship for the callable bond.
o The reason for the shape of the priceyield relationship for the callable
bond is as follows.
When the prevailing market yield for comparable bonds is higher than the
coupon interest, it is unlikely that the issuer will call the bond.
o If a callable bond is unlikely to be called, it will have the same convex
priceyield relationship as a noncallable bond when yields are greater
than y*.
Price-Yield Relationship for a Noncallable and Callable Bond
Price
Yield y*
b
Noncallable Bond
a- a
a
a
Callable
Bond
a - b
Callable Bonds and Their Investment
Characteristics (continued)
Price-Yield Relationship for a Callable Bond
o As yields in the market decline, the likelihood that yields will decline
further so that the issuer will benefit from calling the bond increases.
o The exact yield level at which investors begin to view the issue likely
to be called may not be known, but we do know that there is some
level, say y*.
o At yield levels below y*, the price-yield relationship for the callable
bond departs from the price-yield relationship for the noncallable
bond.
o For a range of yields below y*, there is price compressionthat is,
there is limited price appreciation as yields decline.
o The portion of the callable bond price-yield relationship below y* is
said to be negatively convex.
Callable Bonds and Their Investment
Characteristics (continued)
Price-Yield Relationship for a Callable Bond
o Negative convexity means that the price appreciation will be
less than the price depreciation for change in yield of a
given number of basis points.
For a bond that is option-free and displays positive convexity,
the price appreciation will be greater than the price
depreciation for a change in yield of a given number of basis
points.
o It is important to understand that a bond can still trade
above its call price even if it is highly likely to be called,
because of administrative costs of calling the bond.

Price Volatility Implications of Positive and
Negative Convexity

Absolute Value of Percentage Price Change
Change in Interest Rates Positive Convexity Negative Convexity
-100 basis points greater than X% Less than Y%
+100 basis points X% Y%



Components of a Bond with an Embedded
Option
To develop a framework for analyzing a bond with an embedded option, it
is necessary to decompose a bond into its component parts.
i. buys a noncallable bond from the issuer for which she pays some price
ii. sells the issuer a call option for which she receives the option price

A callable bond is equal to the price of the two components parts; that is,
callable bond price = noncallable bond price call option price
The call option price is subtracted from the price of the noncallable bond
because when the bondholder sells a call option, she receives the option
price.
The difference between the price of the noncallable bond and the callable
bond at any given yield is the price of the embedded call option.


Decomposition of a Price of a Callable Bond
Price
Yield
y**
b
Noncallable Bond
a- a
a
a
Callable
Bond
a - b
y*
P
NCB
P
CB
Note: At y** yield level: P
NCB
= noncallable bond price
P
CB
= callable bond price
P
NCB
- P
CB
= call option price
Components of a Bond with an Embedded
Option (continued)
The logic applied to callable bonds can be similarly applied
to putable bonds.
In the case of a putable bond, the bondholder has the right to
sell the bond to the issuer at a designated price and time.
A putable bond can be broken into two separate transactions.
i. The investor buys a noncallable bond.
ii. The investor buys an option from the issuer that allows the
investor to sell the bond to the issuer.
The price of a putable bond is then
putable bond price = non-putable bond price + put option price
Valuation of Bond with Embedded Option
The bond valuation process requires
that we use the theoretical spot rate to
discount cash flows.
For an embedded option the valuation
process also requires that we take into
consideration how interest-rate
volatility affects the value of a bond
through its effects on the embedded
options.

Binomial Model
A single factor interest rate model that, given an
assumed level of volatility, suggests that interest
rates have an equal probability of taking on one of
two possible values in the next period.
The set of possible interest rate paths that are
used to value bonds with a binomial model is
called a binomial interest rate tree
The relationship among the set of rates is a
function of the interest rate volatility assumption
of the model being employed to generate the tree
(e.g. )
For this tree, it is assumed that the interest rate
tree should generate arbitrage-free values for on-
the-run issues of the benchmark security (i.e. the
value of these on-the-run issues produced by the
interest rate tree must equal their market prices)
Construction of Arbitrage-Free Interest
Rate Tree
Step 1: Use the yield on the current 1-year on-the-run Treasury security
issue for i
0
. Suppose, for example, that i
0
= 4.5749%.
Step 2: Make an assumption about the volatility of interest rates. Suppose,
for example, we assume = 15%.
Step 3: Given the coupon rate and market value of the 2-year on-the-run
issue, provide a guess of i
1,L
, compute i
1,U
= i
1,L
e
2
, and use the resulting
interest rate tree to compute the value of the on-the-run issue. Suppose,
for example, that the coupon rate and market price of the 2-year on-the-
run treasury security issue are 7% and $102.999, respectively.
Step 4: If the value from the model is higher than the market price,
increase the guess of i
1,L
, recompute i
1,U
, and compute the new value of
the on-the-run issue. If the model value is too low, decrease the interest
rates in the tree.
Step 5: Repeat this iterative process until the value generated by the
model is equal to the market price. Suppose, for example, we determine
that if i
1,L
= 5.321%, and i
1,U
= 5.321% e
2(0.15)
= 7.1826%, then the value
from the model is equal to the market price of $102.999. Then the
interest rate tree (as shown in the next example) is arbitrage-free.
Assuming that the probabilities of an up move and
a down move are both 50%
Valuation of a Callable Bond
Valuation of callable bond is similar to non-
callable bond, however, the value used at any
node corresponding to the call date and beyond
must be either the price at which the issuer will
call the bond at that date or the computed value
if the bond is not called, whichever is less.
Assuming that the 2-year bond can be called in
one year at 100. The issuer will call the bond if the
computed bond price exceeds 100 one year from
today
V
call
= V
noncallable
V
callable V
call
= $102.999 $102.238 = $0.761
V
putable
= V
nonputable
+V
put
Incorporating Default Risk
o The basic binomial model explained above can be
extended to incorporate default risk.
o The extension involves adjusting the expected cash
flows for the probability of a payment default and the
expected amount of cash that will be recovered when a
default occurs.
Modeling Risk
o The user of any valuation model is exposed to
modeling risk.
o This is the risk that the output of the model is incorrect
because the assumptions upon which it is based are
incorrect.

Option-Adjusted Spread
Translating OAS to Theoretical Value
o Although the product of a valuation model is the OAS, the
process can be worked in reverse.
o For a specified OAS, the valuation model can determine the
theoretical value of the security that is consistent with that
OAS.
o As with the theoretical value, the OAS is affected by the
assumed interest rate volatility.
o The higher (lower) the expected interest rate volatility, the
lower (higher) the OAS.
Determining the Option Value in Spread Terms
o The option value in spread terms is determined as follows:
option value (in basis points) = static spread OAS
Effective Duration and Convexity
There is a duration measure that is more appropriate
for bonds with embedded options than the modified
duration measure.
In general, the duration for any bond can be
approximated as follows:


P_ = price if yield is decreased by x basis points
P+ = price if yield is increased by x basis points
P
0
= initial price (per $100 of par value)
y (or dy) = change in rate used to calculate price (x basis
points in decimal form)
( )( )
+
=
0
P_ P
duration
2 P dy
Effective Duration and Convexity (continued)
When the approximate duration formula is applied to a
bond with an embedded option, the new prices at the
higher and lower yield levels should reflect the value from
the valuation model.
Duration calculated in this way is called effective duration
or option-adjusted duration.
The standard convexity measure may be inappropriate for
a bond with embedded options because it does not
consider the effect of a change in interest rates on the
bonds cash flow.
Modified Duration Versus Effective Duration
Modified Duration
Duration measure in which it is assumed
that yield changes do not change
the expected cash flow
Effective Duration
Duration measure in which recognition
is given to the fact that yield changes may
change the expected cash flow
Duration
Interpretation: Generic description of the sensitivity of a bonds price
(as a percent of initial price) to a parallel shift in the yield curve
Valuing a Floating-Rate Note
To value a floating-rate note that has a cap, the coupon at
each node of the tree is adjusted by determining whether or
not the cap is reached at a node; if the rate at a node does
exceed the cap, the rate at the node is the capped rate rather
than the rate determined by the floaters coupon formula.

For a floating-rate note, the binomial method must be
adjusted to account for the fact that a floater pays in arrears;
that is, the coupon payment is determined in a period but not
paid until the next period.
Convertible Securities
Convertible and exchangeable securities can be
converted into shares of common stock.

The conversion ratio is the number of common stock
shares for which a convertible security may be
converted.

Almost all convertible securities are callable and
some are putable.
Convertible Securities
The conversion value is the value of the convertible bond if it is
immediately converted into the common stock.

The market conversion price is the price that an investor effectively pays
for the common stock if the convertible security is purchased and then
converted into the common stock.

The premium paid for the common stock is measured by the market
conversion premium per share and market conversion premium ratio.

The straight value or investment value of a convertible security is its value
if there was no conversion feature.

The minimum value of a convertible security is the greater of the
conversion value and the straight value.
Convertible Securities
A fixed income equivalent (or a busted convertible) refers to
the situation where the straight value is considerably higher
than the conversion value so that the security will trade much
like a straight security.

A common stock equivalent refers to the situation where the
conversion value is considerably higher than the straight value
so that the convertible security trades as if it were an equity
instrument.

A hybrid equivalent refers to the situation where the
convertible security trades with characteristics of both a fixed
income security and a common stock instrument.
Convertible Securities
While the downside risk of a convertible security usually is
estimated by calculating the premium over straight value, the
limitation of this measure is that the straight value (the floor)
changes as interest rates change.

An advantage of buying the convertible rather than the
common stock is the reduction in downside risk.

The disadvantage of a convertible relative to the straight
purchase of the common stock is the upside potential give-up
because a premium per share must be paid.
Convertible Securities
An option-based valuation model is a more
appropriate approach to value convertible securities
than the traditional approach because it can handle
multiple embedded options.

There are various option-based valuation models:
one-factor and multiple-factor models.

The most common convertible bond valuation model
is the one-factor model in which the one factor is the
stock price movement.