Bonds

Marcela Valenzuela

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Bonds
Investment in physical capital requires money. Sometimes rms can retain and accumulate earnings to cover the costs of investment, but often they need to raise extra cash from investors.
Equity Capital Banks (Short-term loans) Debt Capital (Bonds)

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Bonds
A bond is a certicate showing that a borrower owes a specied sum. The borrower agrees to make interest and principal payments on specic dates. A bond is a Fixed Income security since it is an investment that provides a return in the form of xed periodic payments and the eventual return of principal at maturity.

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Who Issues Bonds?

Corporations (Endesa). Governments (Governement of Chile). Municipalities or States (State of California). International organizations (World Bank).

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Corporate Bonds versus Government Bonds

Usually, corporate bonds are more complex securities than government bonds:
A corporation may not be able to come up with the money to

pay its debts, so investors have to worry about default risk.

Corporate bonds are also less liquid than government bonds:

they are not as easy to buy or sell, particularly in large quantities or on short notice.
Some corporate bonds can be exchanged for the companys

common stock.

All of these complications aect the spread of corporate bond rates over interest rates on government bonds of similar maturities.

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Bonds and the Risk of Default

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Standard and Poors Credit Ratings

Governments Argentina (CCC+) Chile (AA-) Spain (BBB-) Domestic Corporations
Banco de Chile (A+) Banco del Estado de Chile (AA-)

International Corporations Walmart (AA) Supranational Corporations Inter-American Development Bank (AAA)
Standard and Poor s web page: http://www.standardandpoors.com

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Features of a Bond
A bond is an investment that provides a return in the form of xed periodic payments (Coupons) and the eventual return of principal at maturity (T ). Features of a Bond:
Maturity T Face value (par, principal) F : Nominal amount used to

compute interest payments. Coupon rate: Determines the amount of each coupon payment, expressed as an Annual Percentage Rate (APR)

The coupon payment C is given by:

C = coupon rate x Face value number of coupon payments per year
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Example
Consider an issue of 100,000 bonds. The par value is $1000 per bond. The bonds have a coupon rate of 5% and a maturity of two years. Interest on bonds has to be paid yearly:
Maturity T =2 years. Face value F =$100 million: 100,000 x $1000. Coupon rate 5%.

Coupon payment C =$5 million. At the end of one year the million issuer must pay $5 million (C = 5%x$100 ). 1 Maturity T =2 years. At the end of two years, the rm must pay both $5 million of interest and $100 million of principal.
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Valuing Bonds
Zero-coupon bond Level-coupon bond Consols

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Zero-Coupon Bonds
A zero-coupon bond is perhaps the simplest kind of bond. It promises a single payment of F (face value) in T years, where the interest rate is r in each year. The holder receives no cash payments until maturity. Then the present value V0 is:

V0 =

F (1 + r )T

V0 : Market price of the bond at time 0. F : Face value T : Maturity r : Discount rate.

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Example
Suppose the following zero-coupon bonds are trading at the prices shown below per $100 face value. Determine the corresponding discount rates yi for each bond.

Maturity Price

1 year $96.62

2 years $92.45

3 years $87.63

4 years $83.06

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Example
1 T

F V0 = y = (1 + y )T 100 96.62 100 92.45 100 87.63 100 83.06

F V0

y1 = y2 = y3 = y4 =

1 = 3.5%
1/2

1 = 4%
1/3

1 = 4.5%
1/4

1 = 4.75%
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Level-Coupon Bonds
Typically, corporations and governments oer cash payment not only at maturity. Value of a Level-Coupon Bond: present value of its cash ows:

V0 =

t =1

(1 + r )t + (1 + r )T ,

where V0 : Market price of the bond at time 0. F : Face value T : Maturity C : Coupon payment. r : Discount rate.

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Example
A bond is issued with a face value $10,000. It pays an annual coupon rate of 8% with maturity of 10 years. The interest rate is 10%. What is the value of the bond?

V0 : ?? F : $10,000 T : 10 years
x 8% C : 10,000 = 800 1

r : 10%

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Example

V0 =

800 800 800 800 + 10, 000 + + ++ 1.1 (1.1)2 (1.1)3 (1.1)10 = $8771.09

Important
Coupon rate and interest rate: The coupon rate is specic to

the bond. The interest rate is not.

The coupon rate is used to determine the coupon payment. It

only indicates what cash ow should appear in the numerator. NOT in the denominator.

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Level-Coupon Bonds
Similar to an annuity:
V0 = PV (perpetuity) 1 F PV (perpetuity) + T (1 + r ) (1 + r )T

C F C + T r r (1 + r ) (1 + r )T 1 C 1 r (1 + r )T F (1 + r )T

V0 =

Previous example:
V0 = 1 800 10, 000 1 + = $8771.09 10 0.1 (1 + 0.1) (1 + 0.1)10
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Example
Suppose it is November 2003 and we are considering a government bond. The face value is $1,000, and the annual coupon rate is 13%. The interest is paid semi-annually. The maturity is 4 years. The annual interest rate is 10%. What is the present value of the bond?
Yearly coupon: $130 (13% x $1000)
$1000 Semi-annually coupon: $65 ( 13%x2 )

Semi-annual rate: 5% ( 10% 2 ) The holder has claims to the following cash ows:

5/04 $65

11/04 $65

5/05 $65

11/05 $65

5/06 $65

11/06 $65

5/07 $65

11/07 $65 +$1,000

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Example
$65 $65 $65 $1000 + ++ + 2 8 1 + 0.05 (1 + 0.05) (1 + 0.05) (1 + 0.05)8 1 $65 1000 1 = + 8 0.05 (1 + 0.05) (1 + 0.05)8 = $1, 097

PV

If r is the annual interest rate and m is the number of compounding intervals. The eective annual interest rate is:
r m
m

r = 1 +

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Consols
Consols are bonds that never stop paying a coupon. A consol is a perpetuity. Example English consols: These were bonds that the Bank of England guaranteed would pay the holder a cash ow forever. Then, the present value of such a bond is:
C r

V0 =

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Yield to Maturity
Now let us consider the problem in reverse: Suppose now you know the price of the bond. We can obtain r by solving the valuation equation:
T

V0 =

t =1

(1 + r )t + (1 + r )T .

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Yield to Maturity

The value of r that satises the equation when V0 , F , T and C are all known is called Yield to maturity

The yield to maturity (y ) is the one discount rate that sets the present value of the promised bond payments equal to the current market price of the bond.

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Yield to Maturity
Maturity is 2 years. Coupon rate is 10%. The interest is paid annually. Face value of $1000. What is the return that a bondholder is receiving if the bond price is $966.2?

$966.2 =

$100 $1, 000 $100 + + 2 1+y (1 + y ) (1 + y )2

y = 12% the bond has a yield to maturity of 12%

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How Bond Prices Vary with Interest Rates?

Changes in the interest rate lead to changes in the bond price. If interest rate is 10%. The price of the bond is:
$100 $100 $1000 + + 1 + 0.1 (1 + 0.1)2 (1 + 0.1)2 = $1, 000

V0 =

The interest rate rises to 12%, then the price of the bond is:
$100 $100 $1, 000 + + 1 + 0.12 (1 + 0.12)2 (1 + 0.12)2 = $966.2 ...we knew that from the previous example!
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V0 =

How Bond Prices Vary with Interest Rates?

The interest rate falls to 8%, then the price of the bond is:
$100 $100 $1000 + + 2 1 + 0.08 (1 + 0.08) (1 + 0.08)2 = $1, 035.7

V0 =

y V0 If V0 < F : The bond is said to sell at a discount If V0 = F : The bond is said to sell at a par If V0 > F : The bond is said to sell at a premium

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How Bond Prices Vary with Interest Rates?

Bond prices and interest rates must move in opposite directions. The yield to maturity is dened as the discount rate that explains the bond price. When bond prices fall, interest rates (that is, yields to maturity) must rise. When interest rates rise, bond prices must fall.

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How Bond Prices Vary with Interest Rates?

To sum up: If Coupon rate < y Coupon rate = y Coupon rate > y Then V0 < F V0 = F V0 > F Bond sells at a Discount Par Premium

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Exercise
A 6-year government bond makes annual coupon payments of 5 percent and oers a yield of 3 percent annually compounded. Suppose that one year later the bond still yields 3 percent. What return has the bondholder earned over the 12-month period? Now suppose instead that the bond yield is 2 percent at the end of the year. What return would the bondholder earn in this case?

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How Bond Prices Vary with Interest Rates?

Consider three bonds which pay $100 at expiration and expire in 1, 5, and 20 years. What is their percent price change if all yields suddenly change from 10% to 11%? Answer: 1-year: -0.9%; 5-year: -4.4%; 20 year: -16.6% Thus the price of long-term bonds is aected more by changing interest rates than the price of short-term bonds. Compare two bonds with same F = 1000 and same annual coupon rate of 4.875%. The maturity of one bond is 3 years, whereas the maturity of the second bond is 30 years.

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How Bond Prices Vary with Interest Rates?

The 30-year bond has much higher interest-rate sensitivity than the 3-year bond.

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Duration
Consider the following three bonds with same face value of $1,000, maturity of 4 years and interest rate of 5%: Cash ows:
Year 1 2 3 4 Price V0 zero-coupon 0 0 0 1,000 822.7 coupon rate 6% 60 60 60 1,060 1,035.46 coupon rate 10% 100 100 100 1,100 1,177.30

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Duration
Macaulay Duration is the weighted average payment date. Sum of the payment dates, weighted by the proportion of bond value received on each payment date. This weighted average payment date is called duration and measures the interest rate sensitivity of the bond.

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Duration
T

MacD = If zero-coupon bond:

t =1

PVt V0

Year 1 2 3 4

Ct 0 0 0 1,000

PV @ 5% 0 0 0 822.7 V0 =822.7

% of Total PV 0 0 0 1 1

% per year 0 0 0 4 Duration=4

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Duration
If coupon rate = 6%: Year 1 2 3 4 Ct 60 60 60 1,060 PV @ 5% 57.14 54.42 51.83 872.06 V0 =1,035.46 % of Total PV 0.055 0.053 0.050 0.842 1 % per year 0.055 0.105 0.150 3.369 Duration=3.679

If coupon rate = 10%: Year 1 2 3 4 Ct 100 100 100 1,100 PV @ 5% 95.24 90.70 86.38 904.97 V0 =1,177.30 % of Total PV 0.081 0.077 0.073 0.769 1 % per year 0.081 0.154 0.220 3.075 Duration=3.530
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Duration
For a standard bond the Macaulay duration will be between 0 and the maturity of the bond. It is equal to the maturity if and only if the bond is a zero-coupon bond. Duration measures how bond prices change when interest rates change better to use modied duration or volatility. Modied duration is a price sensitivity measure, dened as the percentage derivative of price with respect to yield.
1 V V y

ModD (y ) =

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Modied Duration

ModD (y ) =

MacD 1+y

Consider the following bonds with face value of $100.

Maturity 1 year 2 years 3 years 5 years 10 years 30 years Coupon 0 4.693% 4.666% 4.507% 4.625% 5.08% Yield 4.91% 4.67% 4.55% 4.49% 4.50% 4.58% Price 95.32 100.04 100.32 100.07 100.99 108.07 MacD 1.00 1.96 2.87 4.59 8.24 16.50 ModD 0.95 1.87 2.74 4.39 7.89 15.76

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Modied Duration
What happens if there is 100 basis point jump in market yields? 100 basis point = 1%

Maturity 1 year 2 years 3 years 5 years 10 years 30 years

Coupon 0 4.693% 4.666% 4.507% 4.625% 5.08%

Old Yield 4.91% 4.67% 4.55% 4.49% 4.50% 4.58%

New Yield 5.91% 5.67% 5.55% 5.49% 5.50% 5.58%

New Price 94.42 98.20 97.62 95.80 93.40 92.80

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Modied Duration
Maturity 1 year 2 years 3 years 5 years 10 years 30 years Old Price 95.32 100.04 100.32 100.07 100.99 108.07 New Price 94.42 98.20 97.62 95.80 93.40 92.80 Change % -0.94 -1.84 -2.69 -4.27 -7.51 -14.13 ModD 0.95 1.87 2.74 4.39 7.89 15.76

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Term Structure
So far we have employed one interest rate to discount cash ows. In reality, interest rates vary through time. A spot rate is the interest rate on a T -year loan that is to be made today. It is the rate of interest earned on an investment that provides payo only at time T .
r1 =5% indicates that the current rate for a one-year loan

today is 5%.
r2 =6% indicates that the current rate for a two-year loan

today is 6%.

The spot rate is equal to the yield to maturity on zero coupon bonds.
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Term Structure
Consider two zero-coupon bonds. Bond A is a one-year bond and bond B is a two-year bond. Both have face values of $1000. The one-year interest rate is r1 =8% . The two-year interest rate is r2 = 10%. These are examples of the spot rates. The prices are:
PVA = $925.93 = PVB 1000 1.08 1000 = $826.45 = 1.102

Given the spot rates, what should a 5% coupon, two year bond cost?
PV = 50 1050 + = $914.06 1.08 1.102

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Term Structure
Now we want to calculate a single rate, the yield to maturity, for the bond:
914.06 = 1050 50 + = $914.06 1+y (1 + y )2

y = 9.95 The Term Structure escribes the relationship of spot rates, r1 ,r2 ,r3 , ..., with dierent maturities. The yield curve is the plot of the term structure: interest rates against maturity.

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Term Structure of Risk-Free U.S. Interest Rates

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But the Slope is Not Always Positive

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Forward rates
Consider the following spot rates r1 =8% and r2 = 10%. Here, an individual investing $1 in a two-year zero-coupon bond would have $1x(1.10)2 Let as see the above equation as:
$1x(1.10)2 = $1x1.08x(1 + f2 ) = $1x1.08x1.1204

When an individual invests in a two-year zero-coupon bond yielding 10%, his wealth at the end of two years is the same as if he received an 8-percent return over the rst year, 12.04% return over the second year. This hypothetical rate over the second year, 12.04% , is called the forward rate Forward rates are entirely determined by spot rates (and vice-versa):

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Forward rates
In general: (1 + rn )n = (1 + r1 )(1 + f2 )(1 + f3 ) (1 + fn ) Forward rates can be calculated over later years as well. The general formula is: (1 + rn )n 1 (1 + rn1 )n1

fn =

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Exercise
You have estimated spot rates as follows: r1 =5%, r2 =5.4%, r3 =5.7%, r4 =5.9%, r5 =6%.
1

What are the discount factors for each date (that is, the present value of $1 paid in year t )? What are the forward rates for each period? Calculate the PV of the following bonds assuming annual coupons: i) 5%, two year bond; ii) 5%, ve year bond; and iii) 10%, ve year bond. Explain intuitively why the yield to maturity on the 10% bond is less than that on the 5% bond. What should be the yield to maturity on a ve year zero coupon bond? If the six-year spot rate was 4.8%. How can you make money?

2 3

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Exercise
Consider a bond with face value $1000. 8% and 10% two-year bond both with YTM=9.43%. What is the forward rate?

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Explaining the Term Structure

In September 1992 the term structure was upward-sloping, long-term rates were more than 7%; short term rates were around 4% or less. Why are there investors that put their money into the short end of the term structure? Reasons why you might decide to hold a portfolio of one-year Treasuries, despite their low rate of return:
1

Expectations Theory of the Term Structure. Liquidty-Preference.

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Explaining the Term Structure

Estimating the price of a bond at a future date: Consider two zero-coupon bonds A and B with prices $1000 each, and maturity one and two years, respectively. The spot rates are r1 = 8% and r2 = 10%. The payments at maturity are $1080 and $1210 for the oneand two-year zero-coupon bonds, A and B , respectively:
1210 1080 , $1000 = 1.08 1.12

$1000 =

What is the value of each bond at date 1?

The value of bond A is $1080 (maturity is one year). The value of bond B :
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Explaining the Term Structure

Price of Bond B at date 1 $1141.51= 1210 1.06 $1130.84= 1210 1.07 $1061.4= 1210 1.14 If Spot Rate from date 1 to date 2 6% 7% 14%

The one-year spot rate (future spot rate) beginning at date 1 is unknown ahead of time. Thus, the price of bond B is unknown ahead of time. The amount that bond B is expected to sell for on Date 1: $1210 1 + spot rate expected over year 2
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Explaining the Term Structure

What is the spot rate expected over year 2 ? Dierent for each individual. Hence, the expected value of bond B diers across individuals. Given a forecast of bond B s price, an investor can choose one of two strategies at date zero:
1 2

Buy one-year bond. Proceeds at date 1: $1080 Buy two-year bond but sell at date 1. Expected proceeds at date 1: Expected proceeds = $1210 1 + spot rate expected over year 2 1000x1.08x(1 + f2 ) 1 + spot rate expected over year 2
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where f2 was found to be equal to 12.04%

The Expectations Hypothesis

Under what condition will the return from strategy I equal the expected return from strategy II? The Expectation Theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today. Expectations Hypothesis: Investors will set interest rates such that the forward rate over the second year is equal to the one-year spot rate expected over the second year.

f2 = Spot rate expected over year 2

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Liquidity-Preference Hypothesis
What does the expectation theory leave out? The most obvious answer is risk. Consider the previous two strategies. Strategy (II) is riskier, because the nal return is dependent on what happens to future interest rates. Both strategies have the same expected returns, however if you are risk averse you will not choose strategy (II). Risk averse investors can have no preference for one strategy over the other only when the expected return on strategy (II) is above the return on strategy (I). That is, in order to induce investors to hold the riskier two-year bonds, f2 > Spot rate expected over year 2.
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Ination and Term Structure

Which of the following strategies is riskier? Invest in a succession of one-year Treasuries, rolled over annually, or invest one in 20-year strips? The answer depends on how condent you are about future ination. If you buy the 20-year strips, you know exactly how much money you will have at year 20, but you do not know what that money will buy. On the other hand you do not know future short-term interest rates, but you do know that future interest rates will adapt to ination. If ination is an important source of risk, borrowers must oer some extra incentive if they want investors to lend long.
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Real and Nominal Interest Rate

Let us say that the nominal cash ow from your one-year bond is $1100. If the ination rate is 6%, then each dollar will buy you 6% less next year than it does today. So at the end of the year $1100 will have the same purchasing power as $1100/1.06=$ 1037.74.
Nominal cash ow at date t (1 + ination rate)t

Real cash ow at date t =

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Real and Nominal Interest Rate

Going from nominal to real interest rates. Assume someone buys a $1 bond in period t while the interest rate is rnominal . If redeemed in period, t + 1, the buyer will receive (1+rnominal ) dollars. But if the price level has changed between period t and t + 1 by , then the real value of the proceeds from the bond is: (1 + rnominal ) , 1+

1 + rreal = where is the ination rate.

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