1 1

2
A bond is simply a negotiable IOU, or a loan.
Bonds are a form of ______
Bonds are often referred to as fixed-income
investments.

Bond Basics
3
Key Features of a Bond
Debt instrument issued by a corp. or government.
4
Key Features of a Bond
Par value = face amount of the bond, which is paid at
maturity (assume $1,000).

=
5
Key Features of a Bond
Coupon rate stated interest rate (generally fixed)
paid by the issuer. Multiply by par to get dollar
payment of interest.
6
Key Features of a Bond
Maturity date when the bond must be repaid.
Yield to maturity - rate of return earned on a bond
held until maturity.

7
What is interest rate risk?
Interest rate risk is the concern that interest rates will
change, and therefore, a reduction in the value/price
of a security.
8
Suppose you just inherited $500,000. You intend to
invest the money and live off the interest.

Interest rate risk example
9
Interest rate risk example
You may invest in either a:
10-year bond
series of ten 1-year bonds
Both bonds currently yield 5%.
10
If you choose the 1-year bond strategy:
After year 1, you receive $25,000 in
income and have $500,000 to reinvest.
But, if 1-year rates fall to 3%, your
annual income would fall to $15,000.

If you choose the 10-year bond strategy:
You can lock in a 5% interest rate, and
$25,000 annual income.

11
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
12
13
Bond Value
Bond Value = PV(coupons) + PV(par)
Bond Value = PV(annuity) + PV(lump sum)
Remember:
As interest rates increase present values decrease ( r
PV )
As interest rates increase, bond prices decrease
and vice versa
14 14
Bond Valuation

Compute the value for an IBM Bond with a
6.375% coupon that will mature in 5 years
given that you require an 8% return on your
investment.

What are the annual interest payments ($)?
15 15
0 1 2 3 4 5
2009 2010 2011 2012 2013
63.75 63.75 63.75 63.75
63.75
1,000.00
IBM Bond Timeline:
16 16
$63.75 Annuity for 5 years $1000 Lump Sum in 5 years
0 1 2 3 4 5
2009 2010 2011 2012 2013
63.75 63.75 63.75 63.75
63.75
1000.00
IBM Bond Timeline:
17 17
= 63.75 PMT 1000 FV 8% I 5 N
= PV = 935.12
$63.75 Annuity for 5 years $1000 Lump Sum in 5 years
0 1 2 3 4 5
2009 2010 2011 2012 2013
63.75 63.75 63.75 63.75
63.75
1000.00
IBM Bond Timeline:
18
Valuing a Discount Bond
with Annual Coupons
Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 5 years
YTM = 11%
5
5
) 11 . 1 (
1000
11 . 0
) 11 . 1 (
1
1
100 B +
(
(
(
(

=
Using the formula:
B = PV(annuity) + PV(lump sum)
B = 369.59 + 593.45 = 963.04

Using the calculator:
5 N
11 I/Y
100 PMT
1000 FV
CPT PV = -963.04
Note: When YTM > Coupon rate Price < Par = Discount Bond
Using Excel: =PV(0.11, 5, 100, 1000, 0)
19
Valuing a Premium Bond
with Annual Coupons
Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 20 years
YTM = 8%
20
20
) 08 . 1 (
1000
08 . 0
) 08 . 1 (
1
1
100 +
(
(
(
(

= B
Using the formula:
B = PV(annuity) + PV(lump sum)
B = 981.81 + 214.55 = 1196.36

Note: When YTM < Coupon rate Price > Par = Premium Bond
Using the calculator:
20 N
8 I/Y
100 PMT
1000 FV
CPT PV = -1196.36
Using Excel: =PV(0.08, 20, 100, 1000, 0)
20 20
Most Bonds Pay Interest Semi-Annually:
What is the value of a bond with a semi-annual
coupon with 5 years to maturity, 9% (nominal)
coupon rate if an investor desires a 10% (nominal)
return?

21 21
Most Bonds Pay Interest Semi-Annually:
e.g. semiannual coupon bond with 5 years
to maturity, 9% annual coupon rate.

Instead of 5 annual payments of $90, the bondholder
receives 10 semiannual payments of $45.
0 1 2 3 4 5
2013 2014 2015 2016 2017
45
45.00
1000.00
45 45 45 45 45 45
45 45
22 22
Compute the value of the bond given that you
require a 10% s-a. return on your investment.
Since interest is received every 6 months, we need to use
semiannual compounding
V
B
=
45 - PMT
1000 - FV
5% - I
10 - N
Most Bonds Pay Interest Semi-Annually:
0 1 2 3 4 5
2013 2014 2015 2016 2017

45
45.00
1000.00
45 45 45 45 45 45
45 45
23 23
Most Bonds Pay Interest Semi-Annually:
= PV = 961.39
Compute the value of the bond given that you
require a 10% s-a. return on your investment.
Since interest is received every 6 months, we need to use
semiannual compounding
0 1 2 3 4 5
2013 2014 2015 2016 2017
45
45
1,000
45 45 45 45 45 45
45 45
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Semiannual Bonds

Coupon rate = 14% - Semiannual
YTM = 16% (APR)
Maturity = 7 years
Number of coupon payments? (2t or N)
14 = 2 x 7 years
Semiannual coupon payment? (C/2 or PMT)
$70 = (14% x Face Value)/2
Semiannual yield? (YTM/2 or I/Y)
8% = 16%/2
25
Semiannual Bonds
Semiannual coupon = $70
Semiannual yield = 8%
Periods to maturity = 14

Bond value =
70[1 1/(1.08)
14
] / .08 + 1000
/ (1.08)
14
= 917.56

( )
( )
2t
2t
2
YTM
1
F
2
YTM
2
YTM
1
1
- 1
2
C
Value Bond
+
+
(
(
(
(
(

+
=
14
14
) 08 . 1 (
1000
08 . 0
) 08 . 1 (
1
1
70 B +
(
(
(
(

=
Using the calculator:
14 N
8 I/Y
70 PMT
1000 FV
CPT PV = -917.56
Using Excel: =PV(0.08, 14, 70, 1000, 0)
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If bond Sells at a DISCOUNT (less than
$1,000) then YTM > Coupon Rate
If bond Sells at a PREMIUM (more than
$1,000) then YTM < Coupon Rate
Yield to Maturity
-1,000
0 1 2 3 4 5
2013 2014 2015 2016 2017
80 80 80 80
80
1,000
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Yield to Maturity
If an investor purchases a 6.375% annual
coupon bond today for $900 and holds it until
maturity (5 years), what is the expected annual
rate of return (YTM)?
-900
??
0 1 2 3 4 5
2013 2014 2015 2016 2017

63.75 63.75 63.75 63.75 63.75
1000.00
+ ??
900
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Yield to Maturity
YTM
B
= 63.75 PMT 1000 FV
5 N -900 PV
I = ?
If an investor purchases a 6.375% annual coupon
bond today for $900 and holds it until maturity (5
years), what is the expected annual rate of return ?
Will it be >< than 6.375%?
-900
??
0 1 2 3 4 5
2013 2014 2015 2016 2017

63.75 63.75 63.75 63.75 63.75
1000.00
+ ??
900
29
Whats the YTM on a 10-year, 9% annual
coupon, $1,000 par value bond that sells for
$887?
90 90 90
0 1 9 10
r
d
=?
1,000
PV
1

.
.
.
PV
10

PV
M
887 Find r
d
that works!
...
30
10 -887 90 1000
N I/YR PV PMT FV
10.91
INPUTS
OUTPUT
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Types of Bonds
Vanilla fixed coupons, repaid at maturity
Convertible can be converted into to stock
Zero Coupon pay no explicit interest but instead, sell
at a deep discount

32
Types of Bonds
Junk Bonds below investment grade

33
Government Bonds
Treasury Securities = Federal government debt
Treasury Bills (T-bills)
Pure discount bonds
Original maturity of one year or less
Treasury notes
Coupon debt
Original maturity between one and ten years
Treasury bonds
Coupon debt
Original maturity greater than ten years
34
Tax Consequences
A taxable bond has a yield of 8% and a
municipal bond has a yield of 6%
If you are in a 40% tax bracket, which bond do
you prefer?
8%(1 - .4) = 4.8%
The after-tax return on the corporate bond is 4.8%,
compared to a 6% return on the municipal
At what tax rate would you be indifferent
between the two bonds?
8%(1 T) = 6%
T = 25%
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Bond Ratings
Moodys and Standard & Poors regularly
monitor issuers financial condition and assign a
rating to the debt
Investment
Grade
Below
Investment
Grade
(Junk)
AAA Best Quality
AA High Quality
A Upper Medium Grade
BBB Medium Grade
BB Speculative
B Very Speculative
CCC Very Very Speculative
CC
C No Interest Being Paid
D Currently in Default
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Bond Ratings
Investment Quality
High Grade
Moodys Aaa and S&P AAA capacity to pay is extremely
strong
Moodys Aa and S&P AA capacity to pay is very strong
Medium Grade
Moodys A and S&P A capacity to pay is strong, but
more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is adequate,
adverse conditions will have more impact on the firms
ability to pay
37
Bond Ratings - Speculative
Low Grade
Moodys Ba, B, Caa and Ca
S&P BB, B, CCC, CC
Considered speculative with respect to capacity
to pay. The B ratings are the lowest degree
of speculation.
Very Low Grade
Moodys C and S&P C income bonds with no
interest being paid
Moodys D and S&P D in default with principal
and interest in arrears
38
What affects Bond prices?
Risk
Interest rates

39
What is the term structure of interest rates?
What is a yield curve?
Term structure: the relationship between
interest rates (or yields) and maturities.
A graph of the term structure is called the yield
curve.
40
Draw a normal yield curve

41
Hypothetical Treasury Yield Curve
0
5
10
15
1
10
20
Years to Maturity
Interest
Rate (%)
1 yr 8.0%
10 yr 11.4%
20 yr 12.65%
Real risk-free rate
Inflation premium
Maturity risk premium
42
What factors can explain the shape of this
yield curve?
This constructed yield curve is upward
sloping.
This is due to increasing expected inflation
and an increasing maturity risk premium.
43
Current Yield Curve
Bloomberg
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Default risk
If an issuer defaults, investors receive less than
the promised return.
Influenced by the issuers financial strength and
the terms of the bond contract.
45
Real versus Nominal Rates
Real rates adjust for inflation, nominal does not.
Assume inflation is 5%
An investment costs $100 and returns $115.50 in 1 year.
Rate of return is ____ (nominal rate)
If a pizza cost $5 you could buy 20
In 1 year, pizza will cost ____?

46
Real versus Nominal Rates
How many pizzas can we buy with our investment?
$115.50/5.25 = 22 pizzas
20 to 22 pizzas is a 10% return
Therefore, buying power only increased 10%

47
Calculating Real Rates
h = inflation rate
R = nominal rate of return
r = real rate

Real rate = ((1 + R)/(1 + h))-1
(1.155/1.05) 1 = .10

48
Yahoo Bond Center Exercise
Find a bond that meets the following criteria:
Minimum AA rating
Minimum 5% YTM
Not callable
Utilize Yahoo Bond Screener
How many did you find?
Which would you choose?