CHAPTER SIX

BOND CONCEPTS
 Bond Basics
A bond is a tradable instrument of
indebtedness issued by firms, governments,
and quasi-government institutions to raise
long-term funds from the investing public.
Bonds represent a contractual obligation by
the issuing entity to make scheduled payments
to bondholders.
A typical bond pays interest on the face value
of the bond either annually or semi-annually.
The face value is then paid as a single amount
upon maturity of the bond.
 Bond Basics
Failure to meet scheduled interest payments to
bondholders may result in bankruptcy (typically in the
case of corporates).
Interest on bonds is usually tax-deductible, i.e. taxable
corporate income is considered net of interest on debt.
Bonds that do not pay any periodic interest are called
zero-coupon bonds.
Zero coupon bonds are issued and traded at a discount
from par/face value.
Bonds are typically redeemable at a specified future date.
Bonds with no scheduled maturity date are called
irredeemable/perpetual bonds.
 Bond Basics
Bond Features
The conventional or straight bond has the following characteristics:
 Initial/Original Maturity- bonds are classified into ‘short-term’
(with lives up to five years); ‘medium-term’(from five to fifteen
years) ; ‘long-term’(over fifteen years).
 Residual maturity (or term to maturity)- as time passes, the
residual maturity of any bond shortens.
 Coupon- this is a fixed annual interest payment, normally made
in two instalments, at six-monthly intervals, each equal to half the
annual coupon.
 Coupon rate- is the annual coupon divided by the par value of the
bond.
 Par or redemption value- the amount ‘deemed’ to have been
‘borrowed’ from the investor and is therefore supposed to be
returned at maturity.
 Straight bonds are typically redeemed at par.
 Bond Basics
 Par value is commonly USD100 (or other currency). This is also the
price at which bonds are first issued.
 Market Price-the price at which the bond is currently trading in the
secondary market.
 The market price differs from the par value of the bond whenever
the bond’s required yield differs from the fixed coupon rate.
 Required yield (redemption yield or yield to maturity)- the
annual rate of return that investors demand on comparable coupon
bonds of the same risk and maturity, taking into account both
coupon cash flows and the capital gain or loss at redemption.
 The required yield changes in response to changing market
conditions and investor risk perception and appetite.
 When coupon rate< yield to maturity, bond trades at a discount from
par; when coupon rate> yield to maturity, bond trades at a premium
to par; when coupon rate=yield to maturity, bond trades at par.
 Bond Basics
Interest yield or running yield (also
called current yield)-the return on a
bond taking account only of the coupon
payments.
 Bond Basics
Special types of bonds:
 Callable bonds-callable bonds can be redeemed at
the issuer’s discretion prior to the specified
maturity (redemption) date.
 Putable bonds-putable bonds can be sold back to
the issuer on specified dates, prior to the
redemption date.
 Convertible bonds-these are usually corporate
bonds, issued with the option for holders to convert
into some other asset on specified terms at a future
date. Conversion is usually into equities in the firm.
 Bond Valuation
 The value of a bond is the discounted value of the expected
cash flows to an investor who buys the bond and holds it to
maturity (i.e. coupons and the maturity/redemption value).
 Generally,
Where:
;
;
;
;
 Bond Valuation
Example 1
A bond pays a coupon of USD4 every six months, and
USD100 will be repaid at maturity. There are ten years to
maturity and the next coupon is due in six months. The
redemption yield on similar bonds is 6% p.a. Estimate the fair
price of the bond.
Solution

;;;
 Bond Valuation
Example 2
Estimate the fair price of a zero coupon bond with a par value
of $100, a redemption yield of 6% p.a. and 10 years
remaining to maturity.
Solution

;;

NB: The redemption yield for a zero coupon bond is also the
effective annual rate of interest for valuation purposes.
 Bond Valuation
Important points regarding the redemption yield
 In the case of coupon bonds, quoted redemption yields are
not always effective annual rates of interest.
 For a coupon bond that pays coupons pthly, the redemption
yield must be interpreted as a quoted rate of interest
convertible pthly.
 In the special case of a zero coupon bond however, the
redemption yield must be interpreted as an effective annual
rate of interest for valuation purposes.
 Bond Yields
Redemption yield or yield to maturity (YTM).
 The redemption yield/yield to maturity of a bond is the
interest rate which equates the fair value of a bond to its
observed market price.
 The following formula is used to estimate redemption yields
for coupon bonds:

Where:; ;
;;
 NB: The YTM above is a quoted rate and is only a rough
estimate.
 Bond Yields
Example 3.
 Estimate the redemption yield of a coupon bond that pays
$4 every six months, has a face value of $100, sells at
$114.88, and has 10 years remaining to maturity.
Solution

 You will notice that the above estimate of 5.92% differs

from the 6% we used earlier to value the bond.
 Generally, the above formula understates redemption yields
for premium bonds and overstates redemption yields for
discount bonds.
 Bond Yields
Adjusting the YTM estimate:

 The following adjustment may be used to refine YTM

estimates:

 Thus, in the above case

 Therefore, our refined estimate for the redemption yield is
6.01%.
 Bond Yields
Example 4.
 Estimate the redemption yield of a coupon bond that pays
$2.50 every six months, has a face value of $100, sells at
$92.56, and has 10 years remaining to maturity.
Solution

 As said earlier, we can clearly see that the first estimation

overstates the redemption yield of the discount bond
(6.044%>6%).
 Bond Yields
 We apply the adjustment formula as follows:

 Thus, our final estimate of the redemption yield is 6%.

 Bond Yields
Holding Period Yield.
 The holding period yield (HPY) for a bond is determined as
follows:

Where:
; ; and .
 is equal to the accumulated value of coupons plus the
horizon date price (HDP).
 Bond Yields
Example 5:
An investor purchases a 10-year bond at $114.88. The bond
pays $4 every six months. The investor is able to reinvest
coupons at the bond’s YTM. The YTM is 6% p.a. for the first 2
years and 6.6% for the remainder of the term. After holding
the bond for 3 years, the investor sells the bond at $107.75.
Calculate the investor’s holding period yield.
Solution:

 Thus:
 Bond Yields
Points to note about YTM and HPY:
 It is important to note that the YTM and the HPY are not
directly comparable.
 The YTM is a quoted or nominal rate whereas the HPY is an
effective annual rate.
 For comparison, the YTM must be converted into an effective
rate first.
 For example, if the YTM had not risen to 6.6% in the previous
case, the investor’s HPY would have been approximately
6.09%. This cannot be compared against the YTM of 6%.
 Instead, we convert 6% into an effective rate thus: .
 We have shown that if the YTM remains constant during the
holding period, the investor earns a holding period yield equal
to the bond’s promised ‘effective’ yield to maturity.