Fixed Income
Fixed-Income Bond Valuation:
Prices and Yields
Fixed-Income Bond Valuation: Prices and Yields
Calculating the Value of an Annual Coupon Bond
The value of a coupon bond is the sum of present values of the
promised cash flows discounted at the bond’s yield to maturity (YTM).
Example: Consider a 5-year, 10% coupon, annual-pay, $100 par value
bond. Assume that the yield is also 10%.
Calculate the value of this bond.
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Fixed-Income Bond Valuation: Prices and Yields
Calculating the Value of an Annual Coupon Bond
The bond value is the sum of the present value of the future cash flows:
10 10 10 10 110
PV 1
2
3
4
5
100
(1.1) (1.1) (1.1) (1.1) (1.1)
Using the calculator is faster:
N = 5, PMT = 10, FV = 100, I/Y = 10 CPT PV = –100
(If the coupon % = YTM, the bond trades at par) 2
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Fixed-Income Bond Valuation: Prices and Yields
Calculating the Value of an Annual Coupon Bond
Example: Consider a 5-year, 10% coupon, annual-pay, $100 par value
bond. Assume that the yield changes to 8%.
Calculate the value of this bond.
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Fixed-Income Bond Valuation: Prices and Yields
Calculating the Value of an Annual Coupon Bond
If the yield falls, the bond price rises (inverse price/yield relationship):
10 10 10 10 110
PV 107.99
1.08 1
1.08 2
1.08 3
1.08 4
1.08 5
Using the calculator:
N = 5, PMT = 10, FV = 100, I/Y = 8 CPT PV = –107.99
(If the coupon % > YTM, the bond trades above par)
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Fixed-Income Bond Valuation: Prices and Yields
Calculating the Value of an Annual Coupon Bond
Example: Consider a 5-year, 10% coupon, annual-pay, $100 par value
bond. Assume that the yield changes to 12%.
Calculate the value of this bond.
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Fixed-Income Bond Valuation: Prices and Yields
Calculating the Value of an Annual Coupon Bond
If the yield rises, the bond price falls (inverse price/yield relationship):
10 10 10 10 110
PV 92.79
1.12 1
1.12 2
1.12 3
1.12 4
1.12 5
Using the calculator:
N = 5, PMT = 10, FV = 100, I/Y = 12 CPT PV = –92.79
(If the coupon % < YTM, the bond trades below par)
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Fixed-Income Bond Valuation: Prices and Yields
Trading At, Above, or Below Par
When bonds are first issued, they usually trade at par as the coupon
equals the yield to maturity. The coupon is fixed, but yields can change
over time.
Coupon = yield: bond trades at par
Coupon > yield: bond trades above par (excessive coupon)
Coupon < yield: bond trades below par (deficient coupon)
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Fixed-Income Bond Valuation: Prices and Yields
Calculating the Value of a Semiannual Bond
The value of a semiannual coupon bond is the sum of present values
of the promised cash flows discounted at the bond’s yield to maturity.
We adjust N, PMT, and I/Y to semiannual periods.
Example: Consider a 5-year, 10% coupon, semiannual, $100 par value
bond. Assume that the annual yield is 8%.
Calculate the value of this bond.
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Fixed-Income Bond Valuation: Prices and Yields
Calculating the Value of a Semiannual Bond
The bond value is the sum of the present value of the future cash flows:
5 5 5 5 105
PV ... 108.11
1.04 1
1.04 2
1.04 3
1.04 9
1.04 10
Using the calculator:
N = 10, PMT = 5, FV = 100, I/Y = 4 CPT PV = –108.11
(Note that N, PMT, and I/Y are adjusted for semiannual periods)
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Fixed-Income Bond Valuation: Prices and Yields
Flat Price, Full Price, and Accrued Interest
Bonds accrue coupon interest between coupon payment dates, which
increases the value of the bond.
We calculate three prices (all different):
1. Bond price on its last coupon payment date
2. The flat price (clean price) = full price – accrued interest
3. The full price (dirty price) includes accrued interest
The buyer of the bond pays the full price, which includes any accrued
interest due.
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Fixed-Income Bond Valuation: Prices and Yields
Flat Price, Full Price, and Accrued Interest
Example: A 5%, semiannual coupon bond makes coupon payments on
June 15 and December 15 and is trading with a YTM of 4%. The bond is
purchased and will settle on August 21, when there are four coupons
remaining until maturity.
Calculate the full price of the bond using actual days.
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Fixed-Income Bond Valuation: Prices and Yields
Flat Price, Full Price, and Accrued Interest
Calculate the value of the bond on the last coupon date:
N = 4, PMT = 2.5, FV = 100, I/Y = 2 CPT PV = –101.904
Find the number of days since the last coupon payment:
June 15–Dec. 15: 15 + 31 + 31 + 30 + 31 + 30 + 15 = 183 days
June 15–Aug. 21 (settlement): 15 + 31+ 21 = 67 days
Full price = 101.904 × (1.02)67/183 = 102.646
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Fixed-Income Bond Valuation: Prices and Yields
Flat Price, Full Price, and Accrued Interest
Calculate the accrued interest:
The semiannual coupon is (5% × 100 par) / 2 = $2.50
67 / 183 days of accrued interest × $2.50 = $0.915
Calculate the flat price:
flat price = full price – accrued interest
= $102.646 – $0.915 = $101.73
Note that the flat price is not the price of the bond on its last coupon date.
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Fixed-Income Bond Valuation: Prices and Yields
Accrued Interest
Example: An investor buys a 4% annual-pay bond that pays its
coupons on May 15. The investor’s order settles on August 10.
Calculate the accrued interest that is owed to the bond seller, using
the 30/360 method and the actual/actual method.
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Fixed-Income Bond Valuation: Prices and Yields
Accrued Interest Solution (1)
30/360 method
Interest is accrued for:
30 – 15 = 15 days in May, 30 days in June and July, 10 days in August
= 15 + 30 + 30 + 10 = 85 days
Accrued interest 30/360 = 85 / 360 × $4 = $0.944
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Fixed-Income Bond Valuation: Prices and Yields
Accrued Interest Solution (2)
Actual/actual method
Interest is accrued for:
31 – 15 = 16 days May, 30 days June, 31 days July, 10 days August
= 16 + 30 + 31 + 10 = 87 days
Accrued interest actual/actual = 87 / 365 × $4 = $0.953
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Fixed-Income Bond Valuation: Prices and Yields
Bond Price/Yield Relationship
A decrease in a bond’s yield to maturity will increase its price. There is
an inverse relationship between yield and price.
Bond features affect this relationship:
Lower coupon rate: more sensitive to yield/price changes
Longer maturity: more sensitive to yield/price changes
Convexity: price/yield relationship is not linear
If yields rise or fall by 1%, the price rise is greater than the price fall
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Fixed-Income Bond Valuation: Prices and Yields
Market Yield vs. Bond Value
Bond value
Premium
to par
Par value
Discount to par
Market yield
6% 7% 8% 9% 10%
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Fixed-Income Bond Valuation: Prices and Yields
Convergence to Par Value
At maturity, bonds are redeemed at par value. As time passes,
bonds “pull to par” assuming no changes in yield.
Bonds trading at discount: rise in price toward par
Bonds trading at a premium: fall in price toward par
This convergence to par is known as the constant-yield price
trajectory and assumes time passes with no change in yield.
Capital gain/loss: typically relative to constant-yield price trajectory
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Fixed-Income Bond Valuation: Prices and Yields
Constant-Yield Price Trajectory
Bond value $
6% bond, trading above par, YTM 3%
108.546
100 Maturity
6% bond, trading at par, YTM 6%
85.248
6% bond, trading below par, YTM 12%
Time
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Fixed-Income Bond Valuation: Prices and Yields
Matrix Pricing
Matrix pricing is a method of estimating a price or YTM for bonds that
are currently not traded or infrequently traded (i.e., illiquid).
Match the bond features of traded bonds with those of the infrequently
traded bond, as closely as possible.
Bond features: credit quality, maturity, coupons
Estimate required YTM of the infrequently traded bond
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Fixed-Income Bond Valuation: Prices and Yields
Pricing an Illiquid Bond
Example: Rob Phelps is estimating the value of a nontraded 4%
annual-pay, A+ rated bond that has three years remaining until maturity.
He has obtained the following data on similar corporate bonds.
A+ rated, 2-year annual-pay, YTM = 4.3%
A+ rated, 5-year annual-pay, YTM = 5.1%
A+ rated, 5-year annual-pay, YTM = 5.3%
Estimate the value of the nontraded bond.
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Fixed-Income Bond Valuation: Prices and Yields
Pricing an Illiquid Bond: Solution (1)
Solution:
The average 5-year yield = (5.1% + 5.3%) / 2 = 5.2%
Interpolate between the 5-yr and the 2-yr YTM:
Average 5-yr YTM = 5.2%
2-year YTM = 4.3%
YTM difference = 0.9%
3-year YTM estimate = 2-year yield + 1/3 of yield difference
= 4.2% + (0.9 / 3) = 4.6% 23
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Fixed-Income Bond Valuation: Prices and Yields
Pricing an Illiquid Bond: Solution (2)
Solution:
Now, price the illiquid 3-year bond, with the estimated yield of 4.6%:
N =3
FV = 100
PMT = 4
I/Y = 4.6
CPT PV = $98.354 per $100 par value
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Fixed-Income Bond Valuation: Prices and Yields
Estimating a Credit Spread
Example: Estimate the spread for a new A rated bond issue.
Consider the following market yields:
4-year U.S. Treasury bond YTM = 1.48%
5-year A rated corporate bond YTM = 2.64%
6-year U.S. Treasury bond YTM = 2.15%
Estimate the required yield on a newly issued 6-year, A rated
corporate bond.
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Fixed-Income Bond Valuation: Prices and Yields
Estimating a Credit Spread: Solution (1)
Interpolate to create a 5-year Treasury bond yield using the 6-year
and 4-year Treasury bond yields:
5-year Treasury YTM = (2.15% + 1.48%) / 2 = 1.815%
Calculate the A rated spread over the 5-year Treasury bond:
5-year A rated spread = 5-yr corporate yield – 5-yr Treasury yield
= 2.64% – 1.815% = 0.825%
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Fixed-Income Bond Valuation: Prices and Yields
Estimating a Credit Spread: Solution (2)
Add the A rated spread to the 6-year Treasury bond yield:
6-year A rated YTM = 6-year Treasury yield + A rated spread
= 2.15% + 0.825%
= 2.975%
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