Chapter 10 – Bond Prices and Yields
CHAPTER TEN
BOND PRICES AND YIELDS
CHAPTER OVERVIEW
This chapter presents various types of bonds, bond characteristics, bond safety and bond ratings, and
pricing and yield calculations. This edition also covers credit default swaps.
LEARNING OBJECTIVES
After studying this chapter, the student should be able to calculate bond prices including accrued interest,
promised yields and realized yields (called holding period yields or HPYs). Readers should also
understand how bond prices change as they approach maturity. The text discuses what bond ratings mean
and provides some of the major ratios that ratings agencies use. The reader should also have a basic
understanding of credit default swaps and yield spreads. They should be able to understand the effects of
common bond features such as the call feature, convertibility and sinking fund provisions on bond yields.
Finally students should understand what determines the shape of the yield curve.
CHAPTER OUTLINE
1. Bond Characteristics
PPT 10-2 through PPT 10-13
Data from 2008 on the size of the bond markets is provided at the beginning. Notice that the bond
markets in total are much larger than the equity markets. Basic characteristics of bonds follow in the
PPT. Stress that the most common denomination is $1,000 for corporate bonds and Treasury bonds.
Individual investors can buy $100 par T–notes and T-bonds but the standard is $1,000, and in many cases
the bonds are bundled and sold as a group in multiples of $1,000. Bonds issued by federal agencies and
municipalities may not have $1,000 par. Many will have substantially larger par amounts because of the
institutional nature of these markets. Note the main differences with the municipal bonds are the tax
Chapter 10 – Bond Prices and Yields
A list of major corporate bond provisions is presented in the PPT. Secured bonds are backed by assets of
the corporation which serve as collateral for the bond. Unsecured bonds, referred to as debentures, have
Foreign bonds are bonds issued by a borrower from a country other than the one in which the bond is
sold. The bonds are denominated in the currency of the country in which it is sold. They are often given
colorful names. For instance, Yankee bonds are bonds issued in the U.S. by foreign borrowers; they are
denominated in U.S. dollars. Likewise, Samurai bonds are issued in Japan by non-Japanese borrowers
and are denominated in yen. Bulldog bonds are issued in Great Britain by non-British borrowers and are
2. Bond Pricing
PPT 10-14 through PPT 10-20
The bond pricing equation is presented in the PPT along with an example.
Prices that are quoted in the financial pages do not contain accrued interest. Most pricing examples that
are used in finance also do not include accrued interest. Actual invoice prices to buy a bond will include
3. Bond Yields
PPT 10-21 through PPT 10-26
The relationship between bond prices and yields along with a graph of the relationship is presented. The
concept of yield to maturity can be related to prior work the students have done by equating it to the IRR.
The yield to maturity is simply the discount rate that equates the present value of the cash flows from the
bond to its current price. Finding the yield to maturity is a trial and error solution unless you have a
4. Bond Prices over Time
Chapter 10 – Bond Prices and Yields
PPT 10-27 through PPT 10-31
The behavior of discount and premium bonds over time is presented. Class discussion of the reasoning
behind the premium and discount, as it relates to current yields, helps students to understand pricing. A
premium bond is priced above par because the coupon rate is too high relative to what the bond is
5. Default Risk and Bond Pricing
PPT 10-32 through PPT 10-42
The rating systems contain major and sub-categories that allow for differentiation in the major categories.
The highest four major categories are labeled as investment grade. Bonds that have ratings in lower
major categories are referred to as speculative grade or junk bonds. The major factors that determine a
bond’s rating are provided The highest rated firms have high levels of profitability, high levels of cash
flow to debt, high levels of coverage and liquidity ratios and lower levels of financial leverage.
Some bond contracts have covenants that provide protection against default. Sinking funds can prevent a
cash crisis at maturity since they require the firm to systematically repay part of the principal. The larger
cash flow requirements of a sinking fund can substantially reduce coverage and cash flow ratios prior to
Defaults, Credit Default Swaps (CDSs) and the Financial Crisis
agencies, although others exist. Even now, participation in TALF funding requires the securities be rated
by one of the big three (Moody’s, S&P and Fitches). We have known for a long time that bond prices
move ahead of announced downgrades in ratings. This is probably not due to information leakage ahead
of the announced change, but rather due to the slowness of the agency to respond and the unwillingness to
downgrade. Extrapolation bias also exists in the current agency-based paradigm as explained below.
CDS there was no principal investment required; a low capital requirement (important if regulated); and
with a strong seller credit rating, little collateral was required. The result was excessive risk taking on
both sides. Buyers took on more risk because they were insured, even though insurer’s collateral was
woefully inadequate. The Seller did not plan on having to ever make the payment so there was
insufficient collateral or credit in place. This is also a good example of extrapolation bias discussed in the
6. The Yield Curve
Chapter 10 – Bond Prices and Yields
PPT 10-43 through PPT 10-48
The term structure of interest rates depicts the relationship between term to maturity and maturity for a
group of bonds that are identical in all aspects except maturity. In practice, identical means the same
rating, preferably the same coupon so that you don’t get into tax differences.
The Pure Expectations Theory of the Term Structure
Long-term rates are a function of expected future short-term rates. This is the case with some restrictive
assumptions. First, if transaction costs are zero, securities are perfectly divisible, and most importantly,
future interest rates can be perfectly predicted. With these assumptions, a simple arbitrage argument will
require that the long-term spot rate equal the (geometric) average of the expected future short-term rates.
Liquidity Preference
The liquidity preference idea deals with the reality that future interest rates cannot be forecast perfectly so
that the arbitrage argument used above is a risky arbitrage. More importantly it is riskier to invest for n
years all at once as opposed to investing a year at a time for n years. Investors must be offered a
Excel Applications
Two excel spreadsheets for this chapter are available on the website. The first spreadsheet provides a
template for students to calculate bond values and the second one calculates yield to maturity.