CHAPTER 8: BONDS AND

SINKING FUNDS

2
OVERVIEW

8.1 Bond Terminology

8.2 Calculating Purchase Price and Yield Rate of Bonds
8.3 Quotation of Bonds
8.4 Constructing a Bond Schedule
8.5 Sinking Funds

3
INTRODUCTION

• When a government agency or a corporation borrows money from people

for a long term, they issue a printed contract or certificate to the lender,
promising to repay the loan with periodic interest payments, with the
principal to be repaid upon maturity. This certificate or contract is called a
bond
• Bonds are similar to term loans, except that in term loans, each payment has
an interest portion that pays for the interest on the previous balance and a
principal portion that reduces the outstanding balance (debt)
• However, a bond requires only periodic payments for the interest. The
issuer of the bond agrees to repay the principal amount of the loan when
the bond reaches maturity and to pay only the interest periodically, as
specified in the contract

4
8.1 BOND TERMINOLOGY

• Face value is the value that is assigned to the bond by the issuer. It is
the principal amount that is owed to the bond holder at the end of the
debt period. Interest payments made to the holder are calculated on
the face value of the bond.
• Redemption value (also called maturity value) is the amount to be
repaid by the issuer of the bond to the holder when the bond is
redeemed or surrendered
• Coupon rate is the interest rate of the bond
• Maturity is the length of time before the principal is returned on a
bond

5
8.1 BOND TERMINOLOGY

• Maturity date (also called redemption date) is the date on which the
bond expires
• Balloon payment is the final payment on the maturity date
encompassing the redemption value and the final interest payment
• Purchase price is the price that the holder pays to purchase a bond
• Yield rate is the market rate of return that the purchaser of the bond
will earn if the bond is purchased at its current market price and held
until maturity

6
8.1 BOND TERMINOLOGY

• The price of the bond in the market depends on the yield rate:
• If the yield rate of the bond is the same as its coupon rate, it signifies that the bond is
providing the same rate of return as an investment in the market that has similar risk.
Such a bond is said to be selling at par
• If the yield rate of the bond is higher than its coupon rate, it signifies that the bond is
providing a lower rate of return than an investment in the market that has similar risk.
The bond will not be in demand and be traded at a price that is lower than its face
value. Such a bond is said to be selling below par or at a discount. The amount of
discount on the bond is the difference between its face value and purchase price
• If the yield rate of the bond is lower than its coupon rate, it signifies that the bond is
providing a higher rate of return than an investment in the market that has similar risk.
Bond will be in demand in the market and will be traded at a price that is higher than
its face value. Such a bond is said to be selling above par or at a premium. The amount
of premium on the bond is the difference between its purchase price and face value.

7
EXAMPLE

The Bank of Canada issues a $10,000 bond on January 01, 2017 that is
redeemable at par in ten years. The bond has a coupon rate of 5%. What
is the face value, redemption value, and maturity date of the bond? Will
the bond be sold at par, discount, or premium if its yield rate is:
a. 5% compounded semi-annually
b. 7% compounded semi-annually
c. 4% compounded semi-annually

8
8.2 CALCULATING PURCHASE PRICE AND YIELD RATE OF BONDS

• Bonds can be purchased and sold on any date prior to the maturity
date
• It can be sold either on an interest payment date (i.e. a date when
interest on the bond is to be paid or a date between interest payments
• The procedure for determining the purchase price of a bond differs
depending on whether it is purchased on an interest payment date or
between interest payment dates.

9
PURCHASE PRICE ON AN INTEREST PAYMENT DATE

• Assume that interest on the bond is paid semi-annually and that it is

sold on an interest payment date
• The purchase price of the bond on the interest payment date is the
sum of the present value of all the remaining interest payments on the
bond (PVPMT) on this date and the present value of the redemption
value of the bond (PVRedemption Value) on this date, discounted at
the bond's yield rate, i

10
PURCHASE PRICE ON AN INTEREST PAYMENT DATE

𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 = 𝑃𝑉!"# + 𝑃𝑉$%&%'()*+, -./0%

𝑃𝑀𝑇 = 𝐹𝑉×𝑏

b: periodic coupon rate (b = coupon rate/number of coupons per year)

i: periodic yield rate (i = j/m)
FV: redemption value
PMT: periodic interest payment

11
EXAMPLES

1. A bond has a face value of $1000, coupon rate of 10%, and will mature in
six years.
a. Calculate the purchase price when the yield rate is 10% compounded
semi-annually
b. Calculate the purchase price and the amount of discount when the yield
rate is 12% compounded semi-annually
c. Calculate the purchase price and the amount of premium when the yield
rate is 8% compounded semi-annually
2. A $25,000 bond that carries a 4.6% coupon rate is purchased five years
before maturity when the yield rate was 5% compounded annually. Calculate
the purchase price and amount of discount on the bond

12
EXAMPLES

3. A $20,000 bond has a 6% coupon rate and matures on June 01, 2024.
Suzanne purchased it on June 01, 2014 when the interest rate in the
market was 7% compounded semi-annually. On June 01, 2018, she sold
the bond when the interest rate in the market was 5% compounded
semi-annually
a. What was the purchase price of the bond?
b. What was the selling price of the bond?
c. How much did she gain or lose on this investment?
d. What is the percent gain or loss on this investment?

13
PURCHASE PRICE BETWEEN INTEREST PAYMENT DATES

• When a bond is purchased between interest payment dates, the buyer

and the seller split the interest payment (coupon) at the time of the
purchase based on the fractional part of the interest period during
which each of them holds ownership of the bond
• The interest part received by the seller (called accrued interest is the
interest that has accumulated on a bond since the last interest
payment up to, but not including, the settlement date
• This accrued interest is included in the purchase price

14
PURCHASE PRICE BETWEEN INTEREST PAYMENT DATES

• 3 steps to calculate the purchase price of the bond

• Step 1: Identifying the Interest Payment Dates
• Step 2: Calculating the Purchase Price on the Previous Interest Payment Date
The purchase price on the previous interest payment date is the sum of the
present value of all the remaining interest payments on the bond (PVPMT) on this
date and the present value of the redemption value of the bond (PVRedemption Value)
on this date discounted at the yield rate i
• Step 3: Calculating the Purchase Price on the Purchase Date
The purchase price of the bond is the future value of the price calculated in Step
2, on the purchase date

15
PURCHASE PRICE BETWEEN INTEREST PAYMENT DATES

𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒!1%2*+03 4,)%1%3) !.5'%,) 6.)% = 𝑃𝑉!"# + 𝑃𝑉$%&%'()*+, -./0%

𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒!"#$%&'( )&*( = 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒!#(+,-"' ./*(#('* !&01(/* )&*( ∗ (1 + 𝑖)/

𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑓𝑟𝑜𝑚 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑑𝑎𝑡𝑒 𝑡𝑜 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑑𝑎𝑡𝑒

𝑛=
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑓𝑟𝑜𝑚 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑑𝑎𝑡𝑒 𝑡𝑜 𝑛𝑒𝑥𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑑𝑎𝑡𝑒

16
EXAMPLES

1. A company issued a $1000 bond with a coupon rate of 10% and

redeemable on January 01, 2023. If Henry wanted to purchase this bond
on April 16, 2016 when the yield rate was 7% compounded semi-
annually, calculate the purchase price of the bond
2. Debra purchased a $1000 bond with a coupon rate of 5.40%
compounded semi-annually that was redeemable on July 14, 2026. If
she purchased the bond on April 4, 2019, when the yield rate was 3.95%
compounded semi-annually, what was the purchase price of the bond?

17
CALCULATING THE YIELD RATE

• The yield rate is the market rate of return that the purchaser of the
bond will earn if the bond is purchased at its current market price and
held until maturity
• It represents the discount rate, which equates the discounted value of
a bond's future cash flow to its current market price

For example: A $10,000 bond has a coupon rate of 12% and is

redeemable in five years. What is the yield rate of the bond if it was
purchased for $9640?

18
8.3 QUOTATION OF BONDS

• The price that the buyer of the bond would actually pay when the
bond is purchased is called the full price
• Bond prices fluctuate in the market for the following reasons:
• Change in market interest rate
• Decrease in the life of the bond
• Between interest payment dates
• To be able to compare the price of bonds easily, the bond price is not
quoted as its full price
• Instead, it is quoted as a price excluding the accrued interest. This price
is called the quoted price

19
8.3 QUOTATION OF BONDS

𝐹𝑢𝑙𝑙 𝑃𝑟𝑖𝑐𝑒 = 𝑄𝑢𝑜𝑡𝑒𝑑 𝑃𝑟𝑖𝑐𝑒 + 𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

𝑄𝑢𝑜𝑡𝑒𝑑 𝑃𝑟𝑖𝑐𝑒 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑄𝑢𝑜𝑡𝑎𝑡𝑖𝑜𝑛 × 𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒

• Daily bond prices in the market are quoted as a percent of their face
value; this is called the market quotation of a bond
• For example, if a bond has a market quotation of 108.5 (or $108.5 or
108.5%), it means that the bond has a quoted price of 108.5% of its
redemption value. So if the redemption value of the bond is $1000,
then the quoted price of the bond is 1.085 × 1000 = $1085

20
EXAMPLES

1. A $10,000 bond with a coupon rate of 6% was redeemable on March

01, 2017. If it was purchased on December 18, 2010 when the quote
was 102.5, calculate the full price (purchase price) of the bond
2. A $5000 corporation bond with a coupon rate of 6.5% matures on
June 11, 2033. An investor desiring a 3.84% compounded semi-annually
yield rate purchased the bond on February 9, 2017.
a. What is the full price (purchase price) of the bond?
b. What is the accrued interest?
c. What was the quoted price of the bond?
d. What was the market quotation of the bond?

21
8.4 CONSTRUCTING A BOND SCHEDULE

• Bond interest payments (coupons) are considered a taxable income for

an investor
• Bond schedules are created to show how the interest payments are
recorded using accepted accounting practices
• When a bond is purchased at par, there are no difficulties in recording
the payments as the entire interest is recorded as interest revenue
earned

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AMORTIZATION OF PREMIUM
• When a bond is purchased at a premium, the premium amount is not recovered
when the bond is redeemed at maturity
• On the redemption date, the investor will have a capital loss equal to the amount
of premium (the difference between the amount paid for the bond and the amount
received on the redemption date)
• This loss can be applied to the investors income on the redemption date, which
results in a lower tax amount being owed at the time of redemption
• An investor can choose to distribute this tax saving that occurs on the redemption
date over each interest payment period, thereby paying a lower tax amount for
each period rather than having a lump-sum tax saving (tax break) on the
redemption date
• In this way, the book value of the bond is gradually reduced until it reaches the
redemption value on the redemption date. This process of a gradual decrease in
the book value of the bond is called the amortization of premium

23
CONSTRUCT A BOND SCHEDULE FOR THE AMORTIZATION OF PREMIUM

• Book Value Period 0 = Purchase Price of the bond

• Premium to be Amortized Period 0 = Purchase Price - Redemption Value
• Interest Received = FV x b
• Interest on BV = BV Previous Period x i
• Amortized Premium= Interest Received - Interest on BV
• Book value = Book Value Previous Period - Amortized Premium
• Premium to be Amortized = Premium to be Amortized Previous Period -
Amortized Premium

24
CONSTRUCT A BOND SCHEDULE FOR THE AMORTIZATION OF PREMIUM

Period Interest Received Interest on BV Amortized Book Value (BV) Premium to be

(FV x b) (BV x i) Premium Amortized
0
1
2
3
4
5
6
7
8
Total

25
EXAMPLES

A$1000 bond with a coupon rate of 10% is redeemable in two years. It

was purchased when the yield rate was 8% compounded semi-annually.
Construct the bond schedule showing the amortization of premium

26
ACCUMULATION OF DISCOUNT

• When a bond is purchased at a discount, the investor will have a capital gain equal
to the amount of discount on the redemption date
• This gain can be applied to the investor's income on the redemption date, which
results in a higher tax amount being owed at the time of redemption
• Alternatively, an investor can choose to distribute this tax expense (that occurs on
the redemption date) over each interest payment period thereby paying a higher
tax amount for each period rather than having a lump-sum tax expense on the
redemption date
• In this way, the book value of the bond is gradually increased until it reaches the
redemption value on the redemption date
• This process of a gradual increase in the book value of the bond is called the
accumulation of discount

27
CONSTRUCT A BOND SCHEDULE FOR THE ACCUMULATION OF DISCOUNT

• Book Value Period 0 = Purchase Price of the bond

• Discount to be Accumulated Period 0 = Redemption Value - Purchase
Price
• Interest Received = FV x b
• Interest on BV= BV Previous Period x i
• Accumulated Discount = Interest on BV - Interest Received
• Book Value = Book Value Previous Period + Accumulated Discount
• Discount to be Accumulated = Discount to be Accumulated Previous Period
- Accumulated Discount

28
CONSTRUCT A BOND SCHEDULE FOR THE AMORTIZATION OF DISCOUNT

Period Interest Received Interest on BV Accumulated Book Value (BV) Discount to be

(FV x b) (BV x i) Discount Accumulated
0
1
2
3
4
5
6
7
8
Total

29
EXAMPLES

A $1000 bond carries an 8% coupon rate and is redeemable in two

years. It was purchased when the yield-to-maturity was 10%
compounded semi-annually. Construct the bond schedule showing the
accumulation of discount

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8.5 SINKING FUNDS

• A sinking fund is an interest earning fund that is set up by a

corporation or government to periodically deposit money into, so that
the accumulated funds will be available at a future date to repay the
principal of a large debt at the time of its maturity
• For example, if a business receives $1 million by issuing ten-year bonds
to the public, on the date of maturity of the bonds, it would have to
repay the entire principal to the holders of the bonds
• As the principal amount is very large, the business may establish a
sinking fund to deposit money into periodically, until it accumulates $1
million by the maturity date of the bonds. This amount can then be
used to repay the principal amount to the bond holders.

31
SINKING FUND CALCULATIONS

• As a sinking fund is generally a series of equal deposits made at regular

intervals for a fixed period of time, it is treated as an annuity
• Payments into the fund can be made at the end of the period (ordinary
annuity) or at the beginning of the period (annuity due)
• A sinking fund schedule provides details of the payment number,
periodic payment into the fund, interest earned during the period,
increase in the fund, the fund balance, and the book value of the fund.

32
STEPS TO CONSTRUCT A SINKING FUND SCHEDULE

• Fund Balance Period 0 = $0.00

• Book Value Period 0 = Principal
• Interest Earned = Fund Balance Previous Period x i
• Increase in the Fund = PMT + Interest Earned
• Fund Balance = Fund Balance Previous Period + Increase in the Fund
• Book Value = Principal - Fund Balance
• Total Increase in the Fund = Fund Balance Final Period
• Total Payment = Sum of the Payments = n × PMT
• Total Interest Earned = Total Increase in the Fund - Total Payment

33
CONSTRUCT A SINKING FUND SCHEDULE

Payment Payment Interest Earned Increase in the Fund Balance Book Value
Period (PMT) Fund
0
1
2
3
4
5
6
7
8
Total

34
EXAMPLES

Acapac Industries established a sinking fund in order to accumulate at

least $10,000 by depositing equal amounts of money at the end of every
six months for two years. If the fund was earning interest at 4%
compounded semi-annually, calculate the following and construct a
sinking fund schedule to illustrate details of the fund:
a. Size of the periodic sinking fund deposit
b. Sinking fund balance at the end of the 2nd payment period
c. Interest earned in the 3rd payment period
d. Amount by which the sinking fund increased in the 3rd payment
period

35
EXAMPLES

A social networking company wanted to raise $100,000 and issued

twenty, $5000 bonds paying a 10% coupon rate payable semi-annually
for five years. It set up a sinking fund to repay the debt at the end of five
years and made deposits at the end of every six months into the fund.
The sinking fund was earning 6.5% compounded semi-annually.
a. Calculate the periodic cost of the debt.
b. Calculate the book value of the debt after three years.
c. Construct a partial sinking fund schedule showing details of the first
two and last two payments and the totals of the schedule.

36
 CALCULATING THE PERIODIC COST AND CONSTRUCTING A PARTIAL SINKING FUND SCHEDULE

• When a company issues a bond and sets up a sinking fund, it makes the
following two periodic payments until the maturity of the bond:
• Periodic interest payments to the bond holder
• Periodic deposits made into the sinking fund
• The periodic cost of this debt for any period is the sum of the above two
payments for that period

𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑏𝑡 = 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 + 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝐷𝑒𝑝𝑜𝑠𝑖𝑡 𝑖𝑛𝑡𝑜 𝑡ℎ𝑒 𝑆𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑

𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑏𝑡 𝑎𝑓𝑡𝑒𝑟 𝑥 𝑦𝑒𝑎𝑟 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑏𝑡 − 𝑆𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑥 𝑦𝑒𝑎𝑟

37
EXAMPLES

A social networking company wanted to raise $100,000 and issued

twenty, $5000 bonds paying a 10% coupon rate payable semi-annually
for five years. It set up a sinking fund to repay the debt at the end of five
years and made deposits at the end of every six months into the fund.
The sinking fund was earning 6.5% compounded semi-annually.
a. Calculate the periodic cost of the debt.
b. Calculate the book value of the debt after three years.
c. Construct a partial sinking fund schedule showing details of the first
two and last two payments and the totals of the schedule.

38
THANK YOU !

39