CH APTER

Valuing Bonds
6
AFTER A FOUR-YEAR HIATUS, THE U.S. GOVERNMENT BEGAN NOTATION
issuing 30-year Treasury bonds again in August 2005. While the move was due in
CPN coupon payment on
part to the government’s need to borrow to fund record budget deficits, the deci- a bond
sion to issue 30-year bonds was also a response to investor demand for long-term,
n number of periods
risk-free securities backed by the U.S. government. These 30-year Treasury bonds
are part of a much larger market for publicly traded bonds. As of September 2017, y, YTM yield to maturity
the value of traded U.S. Treasury debt was approximately $14.2 trillion, $5.4 tril- P initial price of a bond
lion more than the value of all publicly traded U.S. corporate bonds. If we in- FV face value of a bond
clude bonds issued by municipalities, government agencies, and other issuers,
YTMn yield to maturity on
investors had over $40 trillion invested in U.S. bond markets, compared with just a zero-coupon bond
over $27 trillion in U.S. equity markets.1 with n periods to
In this chapter, we look at the basic types of bonds and consider their valu- maturity
ation. Understanding bonds and their pricing is useful for several reasons. First, rn interest rate or dis-
the prices of risk-free government bonds can be used to determine the risk-free count rate for a cash
interest rates that produce the yield curve discussed in Chapter 5. As we saw flow that arrives in
period n
there, the yield curve provides important information for valuing risk-free cash
flows and assessing expectations of inflation and economic growth. Second, firms PV present value
often issue bonds to fund their own investments, and the returns investors receive NPER annuity spreadsheet
on those bonds is one factor determining a firm’s cost of capital. Finally, bonds notation for the num-
provide an opportunity to begin our study of how securities are priced in a com- ber of periods or date
of the last cash flow
petitive market. The ideas we develop in this chapter will be helpful when we
turn to the topic of valuing stocks in Chapter 9. RATE annuity spreadsheet
notation for interest
We begin the chapter by evaluating the promised cash flows for different
rate
types of bonds. Given a bond’s cash flows, we can use the Law of One Price to di-
PMT annuity spreadsheet
rectly relate the bond’s return, or yield, and its price. We also describe how bond
notation for cash flow
prices change dynamically over time and examine the relationship between the
prices and yields of different bonds. Finally, we consider bonds for which there
APR annual percentage
rate
is a risk of default, so that their cash flows are not known with certainty. As an
important application, we look at the behavior of corporate and sovereign bonds
during the recent economic crisis.
1
Securities Industry and Financial Markets Association, www.sifma.org, and the World
Bank, data.worldbank.org.
207
208 Chapter 6 Valuing Bonds

6.1 Bond Cash Flows, Prices, and Yields

In this section, we look at how bonds are defined and then study the basic relationship
between bond prices and their yield to maturity.

Bond Terminology
Recall from Chapter 3 that a bond is a security sold by governments and corporations to
raise money from investors today in exchange for promised future payments. The terms
of the bond are described as part of the bond certificate, which indicates the amounts
and dates of all payments to be made. These payments are made until a final repayment
date, called the maturity date of the bond. The time remaining until the repayment date is
known as the term of the bond.
Bonds typically make two types of payments to their holders. The promised interest pay-
ments of a bond are called coupons. The bond certificate typically specifies that the coupons
will be paid periodically (e.g., semiannually) until the maturity date of the bond. The principal or
face value of a bond is the notional amount we use to compute the interest payments. Usually,
the face value is repaid at maturity. It is generally denominated in standard increments such as
$1000. A bond with a $1000 face value, for example, is often referred to as a “$1000 bond.”
The amount of each coupon payment is determined by the coupon rate of the bond.
This coupon rate is set by the issuer and stated on the bond certificate. By convention, the
coupon rate is expressed as an APR, so the amount of each coupon payment, CPN, is
Coupon Payment
Coupon Rate * Face Value
CPN = (6.1)
Number of Coupon Payments per Year
For example, a “$1000 bond with a 10% coupon rate and semiannual payments” will pay
coupon payments of $1000 * 10%>2 = $50 every six months.

Zero-Coupon Bonds
The simplest type of bond is a zero-coupon bond, which does not make coupon pay-
ments. The only cash payment the investor receives is the face value of the bond on the
maturity date. Treasury bills, which are U.S. government bonds with a maturity of up to
one year, are zero-coupon bonds. Recall from Chapter 4 that the present value of a future
cash flow is less than the cash flow itself. As a result, prior to its maturity date, the price
of a zero-coupon bond is less than its face value. That is, zero-coupon bonds trade at a
discount (a price lower than the face value), so they are also called pure discount bonds.
Suppose that a one-year, risk-free, zero-coupon bond with a $100,000 face value has an
initial price of $96,618.36. If you purchased this bond and held it to maturity, you would
have the following cash flows:
0 1

2$96,618.36 $100,000

Although the bond pays no “interest” directly, as an investor you are compensated for
the time value of your money by purchasing the bond at a discount to its face value.
Yield to Maturity. Recall that the IRR of an investment opportunity is the discount rate
at which the NPV of the cash flows of the investment opportunity is equal to zero. So, the
IRR of an investment in a zero-coupon bond is the rate of return that investors will earn on
 6.1 Bond Cash Flows, Prices, and Yields 209

their money if they buy the bond at its current price and hold it to maturity. The IRR of an
investment in a bond is given a special name, the yield to maturity (YTM) or just the yield:
The yield to maturity of a bond is the discount rate that sets the present value of the promised bond payments equal to
the current market price of the bond.
Intuitively, the yield to maturity for a zero-coupon bond is the return you will earn as an
investor from holding the bond to maturity and receiving the promised face value payment.
Let’s determine the yield to maturity of the one-year zero-coupon bond discussed ear-
lier. According to the definition, the yield to maturity of the one-year bond solves the
following equation:
100,000
96,618.36 =
1 + YTM1
In this case,
100,000
1 + YTM1 = = 1.035
96,618.36
That is, the yield to maturity for this bond is 3.5%. Because the bond is risk free, investing
in this bond and holding it to maturity is like earning 3.5% interest on your initial invest-
ment. Thus, by the Law of One Price, the competitive market risk-free interest rate is 3.5%,
meaning all one-year risk-free investments must earn 3.5%.
Similarly, the yield to maturity for a zero-coupon bond with n periods to maturity, cur-
rent price P, and face value FV solves2
FV
P = (6.2)
(1 + YTMn)n
Rearranging this expression, we get
Yield to Maturity of an n@Year Zero@Coupon Bond

FV 1>n
YTMn = a b - 1 (6.3)
P

The yield to maturity (YTMn) in Eq. 6.3 is the per-period rate of return for holding the
bond from today until maturity on date n.
Risk-Free Interest Rates. In earlier chapters, we discussed the competitive market interest
rate rn available from today until date n for risk-free cash flows; we used this interest rate as the
cost of capital for a risk-free cash flow that occurs on date n. Because a default-free zero-coupon
bond that matures on date n provides a risk-free return over the same period, the Law of One
Price guarantees that the risk-free interest rate equals the yield to maturity on such a bond.
Risk@Free Interest Rate with Maturity n
rn = YTMn (6.4)

Consequently, we will often refer to the yield to maturity of the appropriate maturity, zero-
coupon risk-free bond as the risk-free interest rate. Some financial professionals also use
the term spot interest rates to refer to these default-free, zero-coupon yields.

2
In Chapter 4, we used the notation FVn for the future value on date n of a cash flow. Conveniently, for a
zero-coupon bond, the future value is also its face value, so the abbreviation FV continues to apply.
210 Chapter 6 Valuing Bonds

In Chapter 5, we introduced the yield curve, which plots the risk-free interest rate for
different maturities. These risk-free interest rates correspond to the yields of risk-free
zero-coupon bonds. Thus, the yield curve we introduced in Chapter 5 is also referred to as
the zero-coupon yield curve.

EXAMPLE 6.1 Yields for Different Maturities

Problem
Suppose the following zero-coupon bonds are trading at the prices shown below per $100 face
value. Determine the corresponding spot interest rates that determine the zero coupon yield curve.
Maturity 1 Year 2 Years 3 Years 4 Years
Price $96.62 $92.45 $87.63 $83.06

Solution
Using Eq. 6.3, we have
r1 = YTM1 = (100/96 .62) - 1 = 3 .50%
1>2
r2 = YTM2 = (100/92 .45) - 1 = 4 .00%
1>3
r3 = YTM3 = (100/87 .63) - 1 = 4 .50%
r4 = YTM4 = (100/83 .63)1>4 - 1 = 4 .75%

GLOBAL FINANCIAL CRISIS Negative Bond Yields

On December 9, 2008, in the midst of one of the worst finan- can view the $25.56 as the price investors were willing to pay
cial crises in history, the unthinkable happened: For the first to have the U.S. Treasury hold their money safely for them at
time since the Great Depression, U.S. Treasury Bills traded at a time when no other investments seemed truly safe.
a negative yield. That is, these risk-free pure discount bonds This phenomenon repeated itself in Europe starting in
traded at premium. As Bloomberg.com reported: “If you in- mid-2012. In this case, negative yields emerged due to a con-
vested $1 million in three-month bills at today’s negative dis- cern about both the safety of European banks as well as the
count rate of 0.01%, for a price of 100.002556, at maturity stability of the euro as a currency. As investors in Greece
you would receive the par value for a loss of $25.56.” or other countries began to worry their economies might
A negative yield on a Treasury bill implies that investors depart from the euro, they were willing to hold German and
have an arbitrage opportunity: By selling the bill, and holding Swiss government bonds even at negative yields as a way
the proceeds in cash, they would have a risk-free profit of to protect themselves against the Eurozone unraveling. By
$25.56. Why did investors not rush to take advantage of the mid-2015, some Swiss bonds had yields close to −1% and in
arbitrage opportunity and thereby eliminate it? 2016 Japanese government bond yields also dropped below
Well, first, the negative yields did not last very long, sug- zero. Although yields have increased since then, at the be-
gesting that, in fact, investors did rush to take advantage of ginning of 2018 the amount invested in bonds with negative
this opportunity. But second, after closer consideration, the yields still exceeded $7 trillion.
opportunity might not have been a sure risk-free arbitrage. The persistence of such large negative yields are challeng-
When selling a Treasury security, the investor must choose ing to explain. Most of the holders of these bonds are institu-
where to invest, or at least hold, the proceeds. In normal tions and pension funds who are restricted to hold very safe
times investors would be happy to deposit the proceeds with assets. And while they could hold currency instead, obtain-
a bank, and consider this deposit to be risk free. But these ing, storing, and securing large quantities of cash would also
were not normal times—many investors had great concerns be very costly. (Indeed, Swiss banks have reportedly refused
about the financial stability of banks and other financial in- large currency withdrawals by hedge funds attempting to ex-
termediaries. Perhaps investors shied away from this “arbi- ploit the arbitrage opportunity.) Bonds are also much easier to
trage” opportunity because they were worried that the cash trade, and use as collateral, than giant vaults of cash. Together,
they would receive could not be held safely anywhere (even the safety and convenience of these bonds must be worth the
putting it “under the mattress” has a risk of theft!). Thus, we nearly 1% per year these investors are willing to sacrifice.
 6.1 Bond Cash Flows, Prices, and Yields 211

Coupon Bonds
Like zero-coupon bonds, coupon bonds pay investors their face value at maturity. In ad-
dition, these bonds make regular coupon interest payments. Two types of U.S. Treasury
coupon securities are currently traded in financial markets: Treasury notes, which have
original maturities from one to 10 years, and Treasury bonds, which have original maturi-
ties of more than 10 years.

EXAMPLE 6.2 The Cash Flows of a Coupon Bond

Problem
The U.S. Treasury has just issued a five-year, $1000 bond with a 5% coupon rate and semiannual
coupons. What cash flows will you receive if you hold this bond until maturity?

Solution
The face value of this bond is $1000. Because this bond pays coupons semiannually, from Eq. 6.1,
you will receive a coupon payment every six months of CPN = $1000 * 5%>2 = $25. Here
is the timeline, based on a six-month period:
0 1 2 3 10
...
$25 $25 $25 $25 1 $1000

Note that the last payment occurs five years (10 six-month periods) from now and is composed of
both a coupon payment of $25 and the face value payment of $1000.

We can also compute the yield to maturity of a coupon bond. Recall that the yield to
maturity for a bond is the IRR of investing in the bond and holding it to maturity; it is the
single discount rate that equates the present value of the bond’s remaining cash flows to its
current price, shown in the following timeline:
0 1 2 3 N
...
2P CPN CPN CPN CPN 1 FV

Because the coupon payments represent an annuity, the yield to maturity is the interest rate
y that solves the following equation:3
Yield to Maturity of a Coupon Bond
1 1 FV
P = CPN * a1 - b + (6.5)
y (1 + y)N (1 + y)N

Unfortunately, unlike in the case of zero-coupon bonds, there is no simple formula to

solve for the yield to maturity directly. Instead, we need to use either trial-and-error or the
annuity spreadsheet we introduced in Chapter 4 (or Excel’s IRR function).

3
In Eq. 6.5, we have assumed that the first cash coupon will be paid one period from now. If the first coupon
is less than one period away, the cash price of the bond can be found by adjusting the price in Eq. 6.5 by mul-
tiplying by (1 + y) f, where f is the fraction of the coupon interval that has already elapsed. (Also, bond prices
are often quoted in terms of the clean price, which is calculated by deducting from the cash price P an amount,
called accrued interest, equal to f * CPN. See the box on “Clean and Dirty” bond prices on page 217.)
212 Chapter 6 Valuing Bonds

When we calculate a bond’s yield to maturity by solving Eq. 6.5, the yield we compute
will be a rate per coupon interval. This yield is typically stated as an annual rate by multiplying
it by the number of coupons per year, thereby converting it to an APR with the same com-
pounding interval as the coupon rate.

EXAMPLE 6.3 Computing the Yield to Maturity of a Coupon Bond

Problem
Consider the five-year, $1000 bond with a 5% coupon rate and semiannual coupons described
in Example 6.2. If this bond is currently trading for a price of $957.35, what is the bond’s yield
to maturity?

Solution
Because the bond has 10 remaining coupon payments, we compute its yield y by solving:
1 1 1000
957.35 = 25 * a1 - b +
y (1 + y)10 (1 + y)10

We can solve it by trial-and-error or by using the annuity spreadsheet:

NPER RATE PV PMT FV Excel Formula
Given 10 ]957.35 25 1,000
Solve for Rate 3.00% 5RATE(10,25,]957.35,1000)

Therefore, y = 3%. Because the bond pays coupons semiannually, this yield is for a six-month
period. We convert it to an APR by multiplying by the number of coupon payments per year.
Thus the bond has a yield to maturity equal to a 6% APR with semiannual compounding.

We can also use Eq. 6.5 to compute a bond’s price based on its yield to maturity. We
simply discount the cash flows using the yield, as shown in Example 6.4.

EXAMPLE 6.4 Computing a Bond Price from Its Yield to Maturity

Problem
Consider again the five-year, $1000 bond with a 5% coupon rate and semiannual coupons pre-
sented in Example 6.3. Suppose you are told that its yield to maturity has increased to 6.30%
(expressed as an APR with semiannual compounding). What price is the bond trading for now?

Solution
Given the yield, we can compute the price using Eq. 6.5. First, note that a 6.30% APR is equiva-
lent to a semiannual rate of 3.15%. Therefore, the bond price is

1 1 1000
P = 25 * a1 - 10 b + = $944.98
0.0315 1.0315 1.031510
We can also use the annuity spreadsheet:

NPER RATE PV PMT FV Excel Formula

Given 10 3.15% 25 1,000
Solve for PV 2944.98 5PV(0.0315,10,25,1000)
 6.2 Dynamic Behavior of Bond Prices 213

Because we can convert any price into a yield, and vice versa, prices and yields are often used
interchangeably. For example, the bond in Example 6.4 could be quoted as having a yield of
6.30% or a price of $944.98 per $1000 face value. Indeed, bond traders generally quote bond
yields rather than bond prices. One advantage of quoting the yield to maturity rather than the
price is that the yield is independent of the face value of the bond. When prices are quoted in
the bond market, they are conventionally quoted as a percentage of their face value. Thus, the
bond in Example 6.4 would be quoted as having a price of 94.498, which would imply an actual
price of $944.98 given the $1000 face value of the bond.

CONCEPT CHECK 1. What is the relationship between a bond’s price and its yield to maturity?
2. The risk-free interest rate for a maturity of n-years can be determined from the yield of
what type of bond?

6.2 Dynamic Behavior of Bond Prices

As we mentioned earlier, zero-coupon bonds trade at a discount—that is, prior to maturity,
their price is less than their face value. Coupon bonds may trade at a discount, at a premium
(a price greater than their face value), or at par (a price equal to their face value). In this sec-
tion, we identify when a bond will trade at a discount or premium as well as how the bond’s
price will change due to the passage of time and fluctuations in interest rates.

Discounts and Premiums

If the bond trades at a discount, an investor who buys the bond will earn a return both
from receiving the coupons and from receiving a face value that exceeds the price paid
for the bond. As a result, if a bond trades at a discount, its yield to maturity will exceed its
coupon rate. Given the relationship between bond prices and yields, the reverse is clearly
also true: If a coupon bond’s yield to maturity exceeds its coupon rate, the present value of
its cash flows at the yield to maturity will be less than its face value, and the bond will trade
at a discount.
A bond that pays a coupon can also trade at a premium to its face value. In this case,
an investor’s return from the coupons is diminished by receiving a face value less than the
price paid for the bond. Thus, a bond trades at a premium whenever its yield to maturity is
less than its coupon rate.
When a bond trades at a price equal to its face value, it is said to trade at par. A bond
trades at par when its coupon rate is equal to its yield to maturity. A bond that trades at a
discount is also said to trade below par, and a bond that trades at a premium is said to trade
above par.
Table 6.1 summarizes these properties of coupon bond prices.

TABLE 6.1 Bond Prices Immediately After a Coupon Payment

When the bond price is We say the bond trades This occurs when
greater than the face value “above par” or “at a premium” Coupon Rate 7 Yield to Maturity
equal to the face value “at par” Coupon Rate = Yield to Maturity
less than the face value “below par” or “at a discount” Coupon Rate 6 Yield to Maturity
214 Chapter 6 Valuing Bonds

EXAMPLE 6.5 Determining the Discount or Premium of a Coupon Bond

Problem
Consider three 30-year bonds with annual coupon payments. One bond has a 10% coupon rate,
one has a 5% coupon rate, and one has a 3% coupon rate. If the yield to maturity of each bond is
5%, what is the price of each bond per $100 face value? Which bond trades at a premium, which
trades at a discount, and which trades at par?

Solution
We can compute the price of each bond using Eq. 6.5. Therefore, the bond prices are
1 1 100
P (10% coupon) = 10 * a1 - b + = $176.86 (trades at a premium)
0 .05 1 .0530 1 .0530

1 1 100
P (5% coupon) = 5 * a1 - 30 b + = $100.00 (trades at par)
0 .05 1 .05 1 .0530

1 1 100
P (3% coupon) = 3 * a1 - 30 b + = $69.26 (trades at a discount)
0 .05 1 .05 1 .0530

Most issuers of coupon bonds choose a coupon rate so that the bonds will initially trade
at, or very close to, par (i.e., at face value). For example, the U.S. Treasury sets the coupon
rates on its notes and bonds in this way. After the issue date, the market price of a bond
generally changes over time for two reasons. First, as time passes, the bond gets closer to
its maturity date. Holding fixed the bond’s yield to maturity, the present value of the bond’s
remaining cash flows changes as the time to maturity decreases. Second, at any point in
time, changes in market interest rates affect the bond’s yield to maturity and its price (the
present value of the remaining cash flows). We explore these two effects in the remainder
of this section.

Time and Bond Prices

Let’s consider the effect of time on the price of a bond. Suppose you purchase a 30-year,
zero-coupon bond with a yield to maturity of 5%. For a face value of $100, the bond will
initially trade for
100
P (30 years to maturity) = = $23.14
1.0530
Now let’s consider the price of this bond five years later, when it has 25 years remaining
until maturity. If the bond’s yield to maturity remains at 5%, the bond price in five years will be
100
P (25 years to maturity) = = $29.53
1.0525
Note that the bond price is higher, and hence the discount from its face value is smaller,
when there is less time to maturity. The discount shrinks because the yield has not changed,
but there is less time until the face value will be received. If you purchased the bond for
$23.14 and then sold it after five years for $29.53, the IRR of your investment would be

29.53 1>5
a b - 1 = 5.0%
23.14
 6.2 Dynamic Behavior of Bond Prices 215

That is, your return is the same as the yield to maturity of the bond. This example illustrates
a more general property for bonds: If a bond’s yield to maturity has not changed, then the IRR of an
investment in the bond equals its yield to maturity even if you sell the bond early.
These results also hold for coupon bonds. The pattern of price changes over time is a
bit more complicated for coupon bonds, however, because as time passes, most of the cash
flows get closer but some of the cash flows disappear as the coupons get paid. Example 6.6
illustrates these effects.

EXAMPLE 6.6 The Effect of Time on the Price of a Coupon Bond

Problem
Consider a 30-year bond with a 10% coupon rate (annual payments) and a $100 face value.
What is the initial price of this bond if it has a 5% yield to maturity? If the yield to maturity is
unchanged, what will the price be immediately before and after the first coupon is paid?

Solution
We computed the price of this bond with 30 years to maturity in Example 6.5:
1 1 100
P = 10 * a1 - b + = $176.86
0.05 1.0530 1.0530

Now consider the cash flows of this bond in one year, immediately before the first coupon is
paid. The bond now has 29 years until it matures, and the timeline is as follows:
0 1 2 29
...
$10 $10 $10 $10 1 $100
Again, we compute the price by discounting the cash flows by the yield to maturity. Note that
there is a cash flow of $10 at date zero, the coupon that is about to be paid. In this case, we can
treat the first coupon separately and value the remaining cash flows as in Eq. 6.5:
1 1 100
P ( just before first coupon) = 10 + 10 * a1 - b + = $185.71
0.05 1.0529 1.0529

Note that the bond price is higher than it was initially. It will make the same total number of
coupon payments, but an investor does not need to wait as long to receive the first one. We could
also compute the price by noting that because the yield to maturity remains at 5% for the bond,
investors in the bond should earn a return of 5% over the year: $176.86 * 1.05 = $185.71.
What happens to the price of the bond just after the first coupon is paid? The timeline is the
same as that given earlier, except the new owner of the bond will not receive the coupon at date
zero. Thus, just after the coupon is paid, the price of the bond (given the same yield to maturity)
will be
1 1 100
P ( just after first coupon) = 10 * a1 - b + = $175.71
0.05 1.0529 1.0529

The price of the bond will drop by the amount of the coupon ($10) immediately after the coupon
is paid, reflecting the fact that the owner will no longer receive the coupon. In this case, the price
is lower than the initial price of the bond. Because there are fewer coupon payments remaining,
the premium investors will pay for the bond declines. Still, an investor who buys the bond initially,
receives the first coupon, and then sells it earns a 5% return if the bond’s yield does not change:
(10 + 175.71)>176.86 = 1.05.
216 Chapter 6 Valuing Bonds

Figure 6.1 illustrates the effect of time on bond prices, assuming the yield to maturity re-
mains constant. Between coupon payments, the prices of all bonds rise at a rate equal to the
yield to maturity as the remaining cash flows of the bond become closer. But as each coupon
is paid, the price of a bond drops by the amount of the coupon. When the bond is trading at a
premium, the price drop when a coupon is paid will be larger than the price increase between
coupons, so the bond’s premium will tend to decline as time passes. If the bond is trading at a
discount, the price increase between coupons will exceed the drop when a coupon is paid, so
the bond’s price will rise and its discount will decline as time passes. Ultimately, the prices of
all bonds approach the bonds’ face value when the bonds mature and their last coupon is paid.
For each of the bonds illustrated in Figure 6.1, if the yield to maturity remains at 5%,
investors will earn a 5% return on their investment. For the zero-coupon bond, this return
is earned solely due to the price appreciation of the bond. For the 10% coupon bond, this
return comes from the combination of coupon payments and price depreciation over time.

Interest Rate Changes and Bond Prices

As interest rates in the economy fluctuate, the yields that investors demand to invest in
bonds will also change. Let’s evaluate the effect of fluctuations in a bond’s yield to maturity
on its price.
Consider again a 30-year, zero-coupon bond with a yield to maturity of 5%. For a face
value of $100, the bond will initially trade for
100
P (5% yield to maturity) = = $23.14
1.0530
But suppose interest rates suddenly rise so that investors now demand a 6% yield to maturity
before they will invest in this bond. This change in yield implies that the bond price will fall to
100
P (6% yield to maturity) = = $17.41
1.0630

FIGURE 6.1
200
The Effect of Time on 180
Bond Prices
The graph illustrates the effects 160 10% Coupon Rate
Bond Price (% of Face Value)

of the passage of time on bond 140

prices when the yield remains
constant. The price of a zero- 120
5% Coupon Rate
coupon bond rises smoothly.
100
The price of a coupon bond
also rises between coupon 80
payments, but tumbles on the
coupon date, reflecting the 60 3% Coupon Rate
amount of the coupon pay-
40
ment. For each coupon bond,
the gray line shows the trend of 20 Zero Coupon
the bond price just after each
coupon is paid. 0
0 5 10 15 20 25 30
Year
 6.2 Dynamic Behavior of Bond Prices 217

Clean and Dirty Prices for Coupon Bonds

As Figure 6.1 illustrates, coupon bond prices fluctuate Note that immediately before a coupon payment is made,
around the time of each coupon payment in a sawtooth pat- the accrued interest will equal the full amount of the cou-
tern: The value of the coupon bond rises as the next coupon pon, whereas immediately after the coupon payment is
payment gets closer and then drops after it has been paid. made, the accrued interest will be zero. Thus, accrued inter-
This fluctuation occurs even if there is no change in the est will rise and fall in a sawtooth pattern as each coupon
bond’s yield to maturity. payment passes:
Because bond traders are more concerned about changes
in the bond’s price that arise due to changes in the bond’s CPN

Accrued Interest
yield, rather than these predictable patterns around coupon
payments, they often do not quote the price of a bond in
terms of its actual cash price, which is also called the dirty
price or invoice price of the bond. Instead, bonds are often
quoted in terms of a clean price, which is the bond’s cash 0 1 2 3
price less an adjustment for accrued interest, the amount of Time (Coupon Periods)
the next coupon payment that has already accrued:
As Figure 6.1 demonstrates, the bonds cash price also
Clean price = Cash (dirty) price - Accrued interest has a sawtooth pattern. So if we subtract accrued interest
Accrued interest = Coupon amount * from the bond’s cash price and compute the clean price,
the sawtooth pattern of the cash price is eliminated. Thus,
Days since last coupon payment absent changes in the bond’s yield to maturity, its clean price
¢ ≤ converges smoothly over time to the bond’s face value, as
Days in current coupon period
shown in the gray lines in Figure 6.1.

Relative to the initial price, the bond price changes by (17.41 - 23.14)>23.14 = - 24.8%,
a substantial price drop.
This example illustrates a general phenomenon. A higher yield to maturity implies a higher
discount rate for a bond’s remaining cash flows, reducing their present value and hence the
bond’s price. Therefore, as interest rates and bond yields rise, bond prices will fall, and vice versa.
The sensitivity of a bond’s price to changes in interest rates depends on the timing of its
cash flows. Because it is discounted over a shorter period, the present value of a cash flow
that will be received in the near future is less dramatically affected by interest rates than a
cash flow in the distant future. Thus, shorter-maturity zero-coupon bonds are less sensitive
to changes in interest rates than are longer-term zero-coupon bonds. Similarly, bonds with
higher coupon rates—because they pay higher cash flows upfront—are less sensitive to in-
terest rate changes than otherwise identical bonds with lower coupon rates. The sensitivity
of a bond’s price to changes in interest rates is measured by the bond’s duration.4 Bonds
with high durations are highly sensitive to interest rate changes.

EXAMPLE 6.7 The Interest Rate Sensitivity of Bonds

Problem
Consider a 15-year zero-coupon bond and a 30-year coupon bond with 10% annual coupons. By
what percentage will the price of each bond change if its yield to maturity increases from 5% to 6%?

4
We define duration formally and discuss this concept more thoroughly in Chapter 30.
218 Chapter 6 Valuing Bonds

Solution
First, we compute the price of each bond for each yield to maturity:

Yield to
Maturity 15-Year, Zero-Coupon Bond 30-Year, 10% Annual Coupon Bond
100 1 1 100
5% = $48.10 10 * a1 - 30 b + = $176.86
1.0515 0.05 1.05 1.0530
100 1 1 100
6% = $41.73 10 * a1 - 30 b + = $155.06
1.0615 0.06 1.06 1.0630
The price of the 15-year zero-coupon bond changes by (41.73 - 48.10)>48.10 = - 13.2% if
its yield to maturity increases from 5% to 6%. For the 30-year bond with 10% annual coupons,
the price change is (155.06 - 176.86)>176.86 = -12.3%. Even though the 30-year bond has a
longer maturity, because of its high coupon rate, its sensitivity to a change in yield is actually less
than that of the 15-year zero coupon bond.

In actuality, bond prices are subject to the effects of both the passage of time and changes
in interest rates. Bond prices converge to the bond’s face value due to the time effect, but simul-
taneously move up and down due to unpredictable changes in bond yields. Figure 6.2 illustrates

FIGURE 6.2
6.5
Yield to Maturity (%)

6.0
Yield to Maturity and Bond
5.5
Price Fluctuations over
5.0
Time
4.5
The graphs illustrate changes
in price and yield for a 4.0
30-year zero-coupon bond 3.5
over its life. The top graph 3.0
illustrates the changes in 0 5 10 15 20 25 30
the bond’s yield to maturity Year
over its life. In the bottom
graph, the actual bond price 100
is shown in blue. Because Actual Bond Price
90 Price with 5% Yield
the yield to maturity does Price with 4% Yield
Bond Price (% of Face Value)

not remain constant over the 80 Price with 6% Yield

bond’s life, the bond’s price 70
fluctuates as it converges to
60
the face value over time. Also
shown is the price if the yield 50
to maturity remained fixed at 40
4%, 5%, or 6%.
30
20
10
0
0 5 10 15 20 25 30
Year
 6.3 The Yield Curve and Bond Arbitrage 219

this behavior by demonstrating how the price of the 30-year, zero-coupon bond might change
over its life. Note that the bond price tends to converge to the face value as the bond approaches
the maturity date, but also moves higher when its yield falls and lower when its yield rises.
As Figure 6.2 demonstrates, prior to maturity the bond is exposed to interest rate risk. If
an investor chooses to sell and the bond’s yield to maturity has decreased, then the investor
will receive a high price and earn a high return. If the yield to maturity has increased, the
bond price is low at the time of sale and the investor will earn a low return. In the appendix
to this chapter, we discuss one way corporations manage this type of risk.

CONCEPT CHECK 1. If a bond’s yield to maturity does not change, how does its cash price change between
coupon payments?
2. What risk does an investor in a default-free bond face if he or she plans to sell the bond
prior to maturity?
3. How does a bond’s coupon rate affect its duration—the bond price’s sensitivity to interest
rate changes?

6.3 The Yield Curve and Bond Arbitrage

Thus far, we have focused on the relationship between the price of an individual bond and
its yield to maturity. In this section, we explore the relationship between the prices and
yields of different bonds. Using the Law of One Price, we show that given the spot interest
rates, which are the yields of default-free zero-coupon bonds, we can determine the price
and yield of any other default-free bond. As a result, the yield curve provides sufficient
information to evaluate all such bonds.

Replicating a Coupon Bond

Because it is possible to replicate the cash flows of a coupon bond using zero-coupon
bonds, we can use the Law of One Price to compute the price of a coupon bond from the
prices of zero-coupon bonds. For example, we can replicate a three-year, $1000 bond that
pays 10% annual coupons using three zero-coupon bonds as follows:

0 1 2 3

Coupon bond: $100 $100 $1100

1-year zero: $100

2-year zero: $100
3-year zero: $1100
Zero-coupon
bond portfolio: $100 $100 $1100

We match each coupon payment to a zero-coupon bond with a face value equal to the
coupon payment and a term equal to the time remaining to the coupon date. Similarly, we
match the final bond payment (final coupon plus return of face value) in three years to a
three-year, zero-coupon bond with a corresponding face value of $1100. Because the cou-
pon bond cash flows are identical to the cash flows of the portfolio of zero-coupon bonds,
the Law of One Price states that the price of the portfolio of zero-coupon bonds must be
the same as the price of the coupon bond.
220 Chapter 6 Valuing Bonds

TABLE 6.2 Yields and Prices (per $100 Face Value)

for Zero-Coupon Bonds

Maturity 1 year 2 years 3 years 4 years

YTM 3.50% 4.00% 4.50% 4.75%
Price $96.62 $92.45 $87.63 $83.06

To illustrate, assume that current zero-coupon bond yields and prices are as shown in
Table 6.2 (they are the same as in Example 6.1). We can calculate the cost of the zero-
coupon bond portfolio that replicates the three-year coupon bond as follows:

Zero-Coupon Bond Face Value Required Cost

1 year 100 96.62
2 years 100 92.45
3 years 1100 11 * 87.63 = 963.93
Total Cost: $1153.00
By the Law of One Price, the three-year coupon bond must trade for a price of $1153. If
the price of the coupon bond were higher, you could earn an arbitrage profit by selling the
coupon bond and buying the zero-coupon bond portfolio. If the price of the coupon bond
were lower, you could earn an arbitrage profit by buying the coupon bond and short selling
the zero-coupon bonds.

Valuing a Coupon Bond Using Zero-Coupon Yields

To this point, we have used the zero-coupon bond prices to derive the price of the coupon
bond. Alternatively, we can use the zero-coupon bond yields. Recall that the yield to matu-
rity of a zero-coupon bond is the competitive market interest rate for a risk-free investment
with a term equal to the term of the zero-coupon bond. Therefore, the price of a coupon
bond must equal the present value of its coupon payments and face value discounted at the
competitive market interest rates (see Eq. 5.7 in Chapter 5):
Price of a Coupon Bond
P = PV (Bond Cash Flows)
CPN CPN CPN + FV
= + 2 + g + (6.6)
1 + YTM1 (1 + YTM 2 ) (1 + YTM n )n

where CPN is the bond coupon payment, YTMn is the yield to maturity of a zero-coupon
bond that matures at the same time as the nth coupon payment, and FV is the face value of
the bond. For the three-year, $1000 bond with 10% annual coupons considered earlier, we
can use Eq. 6.6 to calculate its price using the zero-coupon yields in Table 6.2:
100 100 100 + 1000
P = + 2 + = $1153
1.035 1.04 1.0453
This price is identical to the price we computed earlier by replicating the bond. Thus, we
can determine the no-arbitrage price of a coupon bond by discounting its cash flows using
the zero-coupon yields. In other words, the information in the zero-coupon yield curve is
sufficient to price all other risk-free bonds.
 6.3 The Yield Curve and Bond Arbitrage 221

Coupon Bond Yields

Given the yields for zero-coupon bonds, we can use Eq. 6.6 to price a coupon bond. In
Section 6.1, we saw how to compute the yield to maturity of a coupon bond from its price.
Combining these results, we can determine the relationship between the yields of zero-
coupon bonds and coupon-paying bonds.
Consider again the three-year, $1000 bond with 10% annual coupons. Given the zero-
coupon yields in Table 6.2, we calculate a price for this bond of $1153. From Eq. 6.5, the
yield to maturity of this bond is the rate y that satisfies
100 100 100 + 1000
P = 1153 = + 2 +
(1 + y) (1 + y) (1 + y)3

We can solve for the yield by using the annuity spreadsheet:

NPER RATE PV PMT FV Excel Formula
Given 3 21,153 100 1,000
Solve for Rate 4.44% 5RATE(3,100,21153,1000)

Therefore, the yield to maturity of the bond is 4.44%. We can check this result directly as
follows:
100 100 100 + 1000
P = + 2 + = $1153
1.0444 1.0444 1.04443
Because the coupon bond provides cash flows at different points in time, the yield to
maturity of a coupon bond is a weighted average of the yields of the zero-coupon bonds
of equal and shorter maturities. The weights depend (in a complex way) on the magnitude
of the cash flows each period. In this example, the zero-coupon bonds’ yields were 3.5%,
4.0%, and 4.5%. For this coupon bond, most of the value in the present value calculation
comes from the present value of the third cash flow because it includes the principal, so
the yield is closest to the three-year, zero-coupon yield of 4.5%.

EXAMPLE 6.8 Yields on Bonds with the Same Maturity

Problem
Given the following zero-coupon yields, compare the yield to maturity for a three-year, zero-
coupon bond; a three-year coupon bond with 4% annual coupons; and a three-year coupon bond
with 10% annual coupons. All of these bonds are default free.

Maturity 1 year 2 years 3 years 4 years

Zero-coupon YTM 3.50% 4.00% 4.50% 4.75%

Solution
From the information provided, the yield to maturity of the three-year, zero-coupon bond is
4.50%. Also, because the yields match those in Table 6.2, we already calculated the yield to matu-
rity for the 10% coupon bond as 4.44%. To compute the yield for the 4% coupon bond, we first
need to calculate its price. Using Eq. 6.6, we have
40 40 40 + 1000
P = + + = $986.98
1.035 1.042 1.0453
222 Chapter 6 Valuing Bonds

The price of the bond with a 4% coupon is $986.98. From Eq. 6.5, its yield to maturity solves
the following equation:
40 40 40 + 1000
$986.98 = + +
(1 + y) (1 + y)2 (1 + y)3

We can calculate the yield to maturity using the annuity spreadsheet:

NPER RATE PV PMT FV Excel Formula
Given 3 2986.98 40 1,000
Solve for Rate 4.47% 5RATE(3,40,2986.98,1000)

To summarize, for the three-year bonds considered

Coupon rate 0% 4% 10%
YTM 4.50% 4.47% 4.44%

Example 6.8 shows that coupon bonds with the same maturity can have different yields
depending on their coupon rates. As the coupon increases, earlier cash flows become rela-
tively more important than later cash flows in the calculation of the present value. If the
yield curve is upward sloping (as it is for the yields in Example 6.8), the resulting yield to
maturity decreases with the coupon rate of the bond. Alternatively, when the zero-coupon
yield curve is downward sloping, the yield to maturity will increase with the coupon rate.
When the yield curve is flat, all zero-coupon and coupon-paying bonds will have the same
yield, independent of their maturities and coupon rates.

Treasury Yield Curves

As we have shown in this section, we can use the zero-coupon yield curve to determine
the price and yield to maturity of other risk-free bonds. The plot of the yields of coupon
bonds of different maturities is called the coupon-paying yield curve. When U.S. bond
traders refer to “the yield curve,” they are often referring to the coupon-paying Treasury
yield curve. As we showed in Example 6.8, two coupon-paying bonds with the same ma-
turity may have different yields. By convention, practitioners always plot the yield of the
most recently issued bonds, termed the on-the-run bonds. Using similar methods to those
employed in this section, we can apply the Law of One Price to determine the zero-coupon
bond yields using the coupon-paying yield curve (see Problem 25). Thus, either type of
yield curve provides enough information to value all other risk-free bonds.

CONCEPT CHECK 1. How do you calculate the price of a coupon bond from the prices of zero-coupon bonds?
2. How do you calculate the price of a coupon bond from the yields of zero-coupon bonds?
3. Explain why two coupon bonds with the same maturity may each have a different yield
to maturity.

6.4 Corporate Bonds

So far in this chapter, we have focused on default-free bonds such as U.S. Treasury securi-
ties, for which the cash flows are known with certainty. For other bonds such as corporate
bonds (bonds issued by corporations), the issuer may default—that is, it might not pay back
 6.4 Corporate Bonds 223

the full amount promised in the bond prospectus. This risk of default, which is known as
the credit risk of the bond, means that the bond’s cash flows are not known with certainty.

Corporate Bond Yields

How does credit risk affect bond prices and yields? Because the cash flows promised by the
bond are the most that bondholders can hope to receive, the cash flows that a purchaser of a
bond with credit risk expects to receive may be less than that amount. As a result, investors pay
less for bonds with credit risk than they would for an otherwise identical default-free bond.
Because the yield to maturity for a bond is calculated using the promised cash flows, the yield of
bonds with credit risk will be higher than that of otherwise identical default-free bonds. Let’s il-
lustrate the effect of credit risk on bond yields and investor returns by comparing different cases.
No Default. Suppose that the one-year, zero-coupon Treasury bill has a yield to maturity of 4%.
What are the price and yield of a one-year, $1000, zero-coupon bond issued by Avant Corporation?
First, suppose that all investors agree that there is no possibility that Avant will default within the
next year. In that case, investors will receive $1000 in one year for certain, as promised by the
bond. Because this bond is risk free, the Law of One Price guarantees that it must have the same
yield as the one-year, zero-coupon Treasury bill. The price of the bond will therefore be
1000 1000
P = = = $961.54
1 + YTM1 1.04
Certain Default. Now suppose that investors believe that Avant will default with certainty
at the end of one year and will be able to pay only 90% of its outstanding obligations. Then,
even though the bond promises $1000 at year-end, bondholders know they will receive only
$900. Investors can predict this shortfall perfectly, so the $900 payment is risk free, and the
bond is still a one-year risk-free investment. Therefore, we compute the price of the bond by
discounting this cash flow using the risk-free interest rate as the cost of capital:
900 900
P = = = $865.38
1 + YTM1 1.04
The prospect of default lowers the cash flow investors expect to receive and hence the
price they are willing to pay.

Are Treasuries Really Default-Free Securities?

Most investors treat U.S. Treasury securities as risk free, mean- President Franklin Roosevelt suspended bondholders’ right
ing that they believe there is no chance of default (a conven- to be paid in gold rather than currency.
tion we follow in this book). But are Treasuries really risk free? A new risk emerged in mid-2011 when a series of large
The answer depends on what you mean by “risk free.” budget deficits brought the United States up against the
No one can be certain that the U.S. government will debt ceiling, a constraint imposed by Congress limiting the
never default on its bonds—but most people believe the overall amount of debt the government can incur. An act of
probability of such an event is very small. More importantly, Congress was required by August 2011 for the Treasury to
the default probability is smaller than for any other bond. meet its obligations and avoid a default. In response to the
So saying that the yield on a U.S. Treasury security is risk political uncertainty about whether Congress would raise
free really means that the Treasury security is the lowest-risk the ceiling in time, Standard & Poor’s downgraded its rat-
investment denominated in U.S. dollars in the world. ing of U.S. Government bonds. Congress ultimately raised
That said, there have been occasions in the past where the debt ceiling and no default occurred. Given persistent
Treasury holders did not receive exactly what they were budget deficits, similar debt ceiling debates recurred in 2013,
promised: In 1790, Treasury Secretary Alexander Hamilton 2015, and 2017. These incidents serve as a reminder that
lowered the interest rate on outstanding debt and in 1933 perhaps no investment is truly “risk free.”
224 Chapter 6 Valuing Bonds

Given the bond’s price, we can compute the bond’s yield to maturity. When computing
this yield, we use the promised rather than the actual cash flows. Thus,
FV 1000
YTM = - 1 = - 1 = 15.56%
P 865.38
The 15.56% yield to maturity of Avant’s bond is much higher than the yield to maturity
of the default-free Treasury bill. But this result does not mean that investors who buy the
bond will earn a 15.56% return. Because Avant will default, the expected return of the
bond equals its 4% cost of capital:
900
= 1.04
865.38
Note that the yield to maturity of a defaultable bond exceeds the expected return of investing in the
bond. Because we calculate the yield to maturity using the promised cash flows rather than
the expected cash flows, the yield will always be higher than the expected return of invest-
ing in the bond.
Risk of Default. The two Avant examples were extreme cases, of course. In the first case,
we assumed the probability of default was zero; in the second case, we assumed Avant
would definitely default. In reality, the chance that Avant will default lies somewhere in
between these two extremes (and for most firms, is probably much closer to zero).
To illustrate, again consider the one-year, $1000, zero-coupon bond issued by Avant.
This time, assume that the bond payoffs are uncertain. In particular, there is a 50% chance
that the bond will repay its face value in full and a 50% chance that the bond will default
and you will receive $900. Thus, on average, you will receive $950.
To determine the price of this bond, we must discount this expected cash flow using a
cost of capital equal to the expected return of other securities with equivalent risk. If, like
most firms, Avant is more likely to default if the economy is weak than if the economy is
strong, then—as we demonstrated in Chapter 3—investors will demand a risk premium
to invest in this bond. That is, Avant’s debt cost of capital, which is the expected return
Avant’s debt holders will require to compensate them for the risk of the bond’s cash flows,
will be higher than the 4% risk-free interest rate.
Let’s suppose investors demand a risk premium of 1.1% for this bond, so that the
appropriate cost of capital is 5.1%.5 Then the present value of the bond’s cash flow is
950
P = = $903.90
1.051
Consequently, in this case the bond’s yield to maturity is 10.63%:
FV 1000
YTM = - 1 = - 1 = 10.63%
P 903.90
Of course, the 10.63% promised yield is the most investors will receive. If Avant defaults,
they will receive only $900, for a return of 900>903.90 - 1 = -0.43%. The average re-
turn is 0.50(10.63%) + 0.50(-0.43%) = 5.1%, the bond’s cost of capital.
Table 6.3 summarizes the prices, expected return, and yield to maturity of the Avant
bond under the various default assumptions. Note that the bond’s price decreases, and
its yield to maturity increases, with a greater likelihood of default. Conversely, the bond’s
expected return, which is equal to the firm’s debt cost of capital, is less than the yield to maturity if there

5
We will develop methods for estimating the appropriate risk premium for risky bonds in Chapter 12.
 6.4 Corporate Bonds 225

TABLE 6.3 Bond Price, Yield, and Return with Different

Likelihoods of Default
Avant Bond (1-year, zero-coupon) Bond Price Yield to Maturity Expected Return
Default Free $961.54 4.00% 4%
50% Chance of Default $903.90 10.63% 5.1%
Certain Default $865.38 15.56% 4%

is a risk of default. Moreover, a higher yield to maturity does not necessarily imply that a bond’s expected
return is higher.

Bond Ratings
It would be both difficult and inefficient for every investor to privately investigate the default
risk of every bond. Consequently, several companies rate the creditworthiness of bonds and
make this information available to investors. The two best-known bond-rating companies
are Standard & Poor’s and Moody’s. Table 6.4 summarizes the rating classes each company
uses. Bonds with the highest rating are judged to be least likely to default. By consulting

TABLE 6.4 Bond Ratings

Rating* Description (Moody’s)
Investment Grade Debt
Aaa/AAA Judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred
to as “gilt edged.” Interest payments are protected by a large or an exceptionally stable margin and principal is
secure. While the various protective elements are likely to change, such changes as can be visualized are most
unlikely to impair the fundamentally strong position of such issues.
Aa/AA Judged to be of high quality by all standards. Together with the Aaa group, they constitute what are generally
known as high-grade bonds. They are rated lower than the best bonds because margins of protection may
not be as large as in Aaa securities or fluctuation of protective elements may be of greater amplitude or there
may be other elements present that make the long-term risk appear somewhat larger than the Aaa securities.
A/A Possess many favorable investment attributes and are considered as upper-medium-grade obligations. Factors
giving security to principal and interest are considered adequate, but elements may be present that suggest a
susceptibility to impairment some time in the future.
Baa/BBB Are considered as medium-grade obligations (i.e., they are neither highly protected nor poorly secured).
Interest payments and principal security appear adequate for the present but certain protective elements may
be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding
investment characteristics and, in fact, have speculative characteristics as well.
Speculative Bonds
Ba/BB Judged to have speculative elements; their future cannot be considered as well assured. Often the protection
of interest and principal payments may be very moderate, and thereby not well safeguarded during both good
and bad times over the future. Uncertainty of position characterizes bonds in this class.
B/B Generally lack characteristics of the desirable investment. Assurance of interest and principal payments of
maintenance of other terms of the contract over any long period of time may be small.
Caa/CCC Are of poor standing. Such issues may be in default or there may be present elements of danger with respect
to principal or interest.
Ca/CC Are speculative in a high degree. Such issues are often in default or have other marked shortcomings.
C/C, D Lowest-rated class of bonds, and issues so rated can be regarded as having extremely poor prospects of ever
attaining any real investment standing.
* Ratings: Moody’s/Standard & Poor’s
Source: www.moodys.com
226 Chapter 6 Valuing Bonds

FIGURE 6.3
4.5

4.0
Corporate Yield Curves for
Various Ratings, February 3.5

Yield to Maturity (%)

2018 3.0
This figure shows the yield 2.5
curve for U.S. Treasury securi-
2.0
ties and yield curves for cor- US Treasury Yield
porate securities with different 1.5 Curve
ratings. Note how the yield to 1.0
US Industrials (AAA)
maturity is higher for lower US Industrials (A)
rated bonds, which have a 0.5
higher probability of default. 0.0
5 10 15 20 25 30
Source: Bloomberg
Time to Maturity (Years)

these ratings, investors can assess the creditworthiness of a particular bond issue. The ratings
therefore encourage widespread investor participation and relatively liquid markets.
Bonds in the top four categories are often referred to as investment-grade bonds because
of their low default risk. Bonds in the bottom five categories are often called speculative
bonds, junk bonds, or high-yield bonds because their likelihood of default is high. The
rating depends on the risk of bankruptcy as well as the bondholders’ ability to lay claim to
the firm’s assets in the event of such a bankruptcy. Thus, debt issues with a low-priority claim
in bankruptcy will have a lower rating than issues from the same company that have a high-
priority claim in bankruptcy or that are backed by a specific asset such as a building or a plant.

Corporate Yield Curves

Just as we can construct a yield curve from risk-free Treasury securities, we can plot a simi-
lar yield curve for corporate bonds. Figure 6.3 shows the average yields of U.S. corporate
coupon bonds rated AAA or A, as well as the U.S. (coupon-paying) Treasury yield curve.
We refer to the difference between the yields of the corporate bonds and the Treasury
yields as the default spread or credit spread. Credit spreads fluctuate as perceptions re-
garding the probability of default change. Note that the credit spread is high for bonds with
low ratings and therefore a greater likelihood of default.

CONCEPT CHECK 1. There are two reasons the yield of a defaultable bond exceeds the yield of an otherwise
identical default-free bond. What are they?
2. What is a bond rating?

6.5 Sovereign Bonds

Sovereign bonds are bonds issued by national governments. We have, of course, already
encountered an example of a sovereign bond—U.S. Treasury securities. But while U.S.
Treasuries are generally considered to be default free, the same cannot be said for bonds
issued by many other countries. Until recently, sovereign bond default was considered
 6.5 Sovereign Bonds 227

GLOBAL FINANCIAL CRISIS The Credit Crisis and Bond Yields

The financial crisis that engulfed the world’s economies in we can see that spreads of even the highest-rated Aaa bonds
2008 originated as a credit crisis that first emerged in August increased dramatically, from a typical level of 0.5% to over 2%
2007. At that time, problems in the mortgage market had led by the fall of 2008. Panel B shows a similar pattern for the
to the bankruptcy of several large mortgage lenders. The rate banks had to pay on short-term loans compared to the
default of these firms, and the downgrading of many of yields of short-term Treasury bills. This increase in borrowing
the bonds backed by mortgages these firms had originated, costs made it more costly for firms to raise the capital needed
caused investors to reassess the risk of other bonds in their for new investment, slowing economic growth. The decline in
portfolios. As perceptions of risk increased and investors at- these spreads in early 2009 was viewed by many as an impor-
tempted to move into safer U.S. Treasury securities, the prices tant first step in mitigating the ongoing impact of the financial
of corporate bonds fell and so their credit spreads rose relative crisis on the rest of the economy. Note, however, the 2012
to Treasuries, as shown in Figure 6.4. Panel A of the figure increase in spreads in the wake of the European debt crisis
shows the yield spreads for long-term corporate bonds, where and consequent economic uncertainty.

FIGURE 6.4
Panel A: Yield Spread of Long-Term Corporate
Bonds Versus U.S. Treasury Bonds
Yield Spreads and the 7
Financial Crisis Aaa A Baa
Panel A shows the yield 6
spread between long-term
(30-year) U.S. corporate 5
and Treasury bonds. Panel
Spread (%)

4
B shows the yield spread of
short-term loans to major
3
international banks (LIBOR)
and U.S. Treasury bills (also
2
referred to as the Treasury-
Eurodollar or “TED” spread).
1
Note the dramatic increase
in these spreads beginning
0
in August 2007 and again in 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
September 2008, before
beginning to decline in
Panel B: Yield Spread of Short-Term Loans to Major
early 2009. While spreads International Banks (LIBOR) Versus U.S. Treasury Bonds
returned to pre-crisis levels 5
by the end of 2010, they
increased sharply in the
4
second half of 2011 in
response to the European
Spread (%)

3
debt crisis. Spreads rose
again in 2016, partly in
response to concerns about 2
global economic growth.
Source: www.Bloomberg.com 1

0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
228 Chapter 6 Valuing Bonds

an emerging market phenomenon. The experience with Greek government bonds served
as a wake-up call to investors that governments in the developed world can also default. In
2012, Greece defaulted and wrote off over $100 billion, or about 50%, of its outstanding
debt, in the largest sovereign debt restructuring in world history (analyzed in the data case
at the end of this chapter). Unfortunately, the restructuring did not solve the problem.
Three years later, in 2015, Greece became the first developed country to default on an
IMF loan when it failed to make a $1.7 billion payment. Later that year, Greece narrowly
averted another default (this time to the European Central Bank) when its Eurozone part-
ners put together an €86 billion bailout package that provided the funds to make the re-
quired bond payments. And Greece is far from unique—as Figure 6.5 shows, there have
been periods when more than one-third of all debtor nations were either in default or
restructuring their debt.
Because most sovereign debt is risky, the prices and yields of sovereign debt behave
much like corporate debt: The bonds issued by countries with high probabilities of default
have high yields and low prices. That said, there is a key difference between sovereign de-
fault and corporate default.
Unlike a corporation, a country facing difficulty meeting its financial obligations typi-
cally has the option to print additional currency to pay its debts. Of course, doing so is
likely to lead to high inflation and a sharp devaluation of the currency. Consequently, debt
holders carefully consider inflation expectations when determining the yield they are will-
ing to accept because they understand that they may be repaid in money that is worth less
than it was when the bonds were issued.
For most countries, the option to “inflate away” the debt is politically preferable to an out-
right default. That said, defaults do occur, either because the necessary inflation or currency

FIGURE 6.5 Percent of Debtor Countries in Default or Restructuring Debt, 1800–2006

45

40

35
Countries in Default (%)

30

25

20

15

10

0
1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
Year

The chart shows, for each 5-year period, the average percentage of debtor countries per year that were either in
default or in the process of restructuring their debt. Recent peaks occurred around the time of World War II and
the Latin American, Asian, and Russian debt crises in the 1980s and 1990s.
Source: Data from This Time Is Different, Carmen Reinhart and Kenneth Rogoff, Princeton University Press, 2009.
 6.5 Sovereign Bonds 229

GLOBAL FINANCIAL CRISIS European Sovereign Debt Yields: A Puzzle

Before the EMU created the euro as a single European countries would be fiscally responsible and manage their
currency, the yields of sovereign debt issued by European debt obligations to avoid default at all costs. But as illus-
countries varied widely. These variations primarily reflected trated by Figure 6.6, once the 2008 financial crisis revealed
differences in inflation expectations and currency risk (see the folly of this assumption, debt yields once again diverged
Figure 6.6). However, after the monetary union was put in as investors acknowledged the likelihood that some coun-
place at the end of 1998, the yields all essentially converged to tries (particularly Portugal and Ireland) might be unable to
the yield on German government bonds. Investors seemed to repay their debt and would be forced to default.
conclude that there was little distinction between the debt of In retrospect, rather than bringing fiscal responsibility,
the European countries in the union––they seemed to feel that the monetary union allowed the weaker member countries
all countries in the union were essentially exposed to the same to borrow at dramatically lower rates. In response, these
default, inflation and currency risk and thus equally “safe.” countries reacted by increasing their borrowing––and at
Presumably, investors believed that an outright default least in Greece’s case, borrowed to the point that default be-
was unthinkable: They apparently believed that member came inevitable.

FIGURE 6.6 European Government Bond Yields, 1976–2018

20
Germany
Ireland
18
Spain
16 France
Government Bond Yield (%)

Portugal
14 Italy

12

10

0
1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016

The plot shows the yield on government debt issued by six countries in the European Currency Union. Prior to the
euro’s introduction in 1999, yields varied in accordance with differing inflation expectations and currency risk. Yields
converged once the euro was introduced, but diverged again after the 2008 financial crisis as investors recognized the
possibility of default.
Source: Federal Reserve Economic Data, research.stlouisfed.org/fred2

devaluation would be too extreme, or sometimes because of a change in political regime

(for example, Russian Tsarist debt became worthless paper after the 1917 revolution).
European sovereign debt is an interesting special case. Member states of the European
Economic and Monetary Union (EMU) all share a common currency, the euro, and so have ceded
control of their money supply to the European Central Bank (ECB). As a result, no individual
230 Chapter 6 Valuing Bonds

Carmen M. Reinhart is the Minos INTERVIEW WITH crisis. In Ireland and Spain in the late
A. Zombanakis Professor of the
International Financial System
CARMEN 2000s, public debt was under control, but
private sector debt, which carried an im-
at the John F. Kennedy School of M. REINHART plicit guarantee, was skyrocketing.
Government, Harvard University. She
is co-author of the award-winning QUESTION: Since the financial crisis these
book This Time Is Different: Eight yields have diverged. What has changed and
Centuries of Financial Folly, which why?
documents the striking similarities of
the recurring booms and busts charac- ANSWER: People found out that the
terizing financial history. world was not different; that is, the coun-
tries in Europe were not equally risky.
QUESTION: Is Europe’s sovereign debt crisis Financial crises adversely affect public
an anomaly in the developed world? finances—what starts as a financial crisis
morphs into banking and sovereign debt
ANSWER: There is a long history of
crises. Financial crises related to reces-
sovereign debt crises in the developed
sions are deeper and more protracted
world. Each time prior to the crisis
than normal recessions, creating enor-
people justified their actions with “this
mous problems because, even after fiscal
time is different.” Two years ago no one thought Greece
stimulus, revenues collapse. In addition, governments take
could default because it was in Europe. In fact, Greece has
on private debt to circumvent a financial meltdown. In
been in default 48% of the time since 1830. Before World
the U.S., FNMA and Freddie Mac moved from the private
War II, defaults, restructurings, and forced conversions
sector balance sheet before the crisis to the public sector
among advanced economies were not rare. Post-World
balance sheet afterwards. In Ireland and Spain, public debt
War II, sovereign debt defaults and restructurings have
became bloated as the governments took on the debts of
been largely confined to emerging markets such as Chile,
banks. In the aftermath of the 2007–2008 crisis, the slew
Argentina, Peru, Nigeria, and Indonesia, leading people
of simultaneous crises in advanced economies limited op-
to the false assumption that debt crises were a developing
portunities to grow out of crisis (for example, by increasing
market phenomena.
exports).
QUESTION: Prior to the 2008/2009 financial crisis, the yield QUESTION: What’s next for Europe? Could the same thing hap-
spreads on sovereign debt issued by Eurozone countries were very pen in the United States?
narrow, seeming to indicate that investors believed that the debt was
equally safe. Why would investors come to this conclusion? ANSWER: I think Europe’s prospects will remain
fairly dismal for a while. Europe has been moving
ANSWER: Economic and financial indicators in both very slowly, if at all, to address the implications of its
advanced economies and emerging markets indicate that huge debt—deleveraging takes a very long time and
interest rate spreads are not good predictors of future debt is painful.
rates. My earlier work with Graciela Kaminsky of early The United States has many of the same issues. While
warnings supported this conclusion. Often public and pri- a U.S. Treasury default is unlikely, I do not believe that the
vate debt builds up but the spreads do not reflect the added currently low Treasury debt yields imply that the U.S. fun-
risk. During the boom period, Eurozone countries had very damentals are good. Treasury debt yields are low because
low spreads and very strong credit ratings. Yet the underly- of massive official intervention—the Fed and other central
ing domestic fundamentals did not support these signals banks are buying Treasuries to prevent their currencies
of financial health. People convinced themselves that the from appreciating and to keep their borrowing rates low.
world was different. This kind of government intervention following a crisis
Also, looking exclusively at rising sovereign debt levels is common. It is why recovery takes so long. Historically,
can be deceptive. History has shown that private debts be- lackluster GDP growth lasts 23 years on average follow-
fore a crisis become public afterwards. In the early 1980s, ing a financial crisis, and is a dark cloud over U.S. growth
Chile had a fiscal surplus and still it had a massive debt prospects.
 MyLab Finance 231

country can simply print money to make debt payments. Furthermore, when the ECB does print
money to help pay one country’s debt, the subsequent inflation affects all citizens in the union, ef-
fectively forcing citizens in one country to shoulder the debt burden of another country. Because
individual countries do not have discretion to inflate away their debt, default is a real possibility
within the EMU. This risk became tangible in 2012 and again in 2015 with Greece’s multiple
defaults.

CONCEPT CHECK 1. Why do sovereign debt yields differ across countries?

2. What options does a country have if it decides it cannot meet its debt obligations?

Here is what you should know after reading this chapter. MyLab Finance will
MyLab Finance help you identify what you know and where to go when you need to practice.

6.1 Bond Cash Flows, Prices, and Yields

■■ Bonds pay both coupon and principal or face value payments to investors. By convention,
the coupon rate of a bond is expressed as an APR, so the amount of each coupon payment,
CPN, is
Coupon Rate * Face Value
CPN = (6.1)
Number of Coupon Payments per Year

■■ Zero-coupon bonds make no coupon payments, so investors receive only the bond’s face value.
■■ The internal rate of return of a bond is called its yield to maturity (or yield). The yield to matu-
rity of a bond is the discount rate that sets the present value of the promised bond payments
equal to the current market price of the bond.
■■ The yield to maturity for a zero-coupon bond is given by

FV 1>n
YTMn = a b - 1 (6.3)
P
■■ The risk-free interest rate for an investment until date n equals the yield to maturity of a risk-
free zero-coupon bond that matures on date n. A plot of these rates against maturity is called
the zero-coupon yield curve.
■■ The yield to maturity for a coupon bond is the discount rate, y, that equates the present value of
the bond’s future cash flows with its price:
1 1 FV
P = CPN * a1 - Nb + (6.5)
y (1 + y) (1 + y)N

6.2 Dynamic Behavior of Bond Prices

■■ A bond will trade at a premium if its coupon rate exceeds its yield to maturity. It will trade at
a discount if its coupon rate is less than its yield to maturity. If a bond’s coupon rate equals its
yield to maturity, it trades at par.
■■ As a bond approaches maturity, the price of the bond approaches its face value.
■■ If the bond’s yield to maturity has not changed, then the IRR of an investment in a bond equals
its yield to maturity even if you sell the bond early.
232 Chapter 6 Valuing Bonds

■■ Bond prices change as interest rates change. When interest rates rise, bond prices fall, and vice
versa.
■■ Long-term zero-coupon bonds are more sensitive to changes in interest rates than are short-

term zero-coupon bonds.

■■ Bonds with low coupon rates are more sensitive to changes in interest rates than similar

maturity bonds with high coupon rates.

■■ The duration of a bond measures the sensitivity of its price to changes in interest rates.

6.3 The Yield Curve and Bond Arbitrage

■■ Because we can replicate a coupon-paying bond using a portfolio of zero-coupon bonds, the
price of a coupon-paying bond can be determined based on the zero-coupon yield curve using
the Law of One Price:
P = PV( Bond Cash Flows)
CPN CPN CPN + FV
= + + g + (6.6)
1 + YTM1 (1 + YTM2 )2 (1 + YTMn )n

■■ When the yield curve is not flat, bonds with the same maturity but different coupon rates will
have different yields to maturity.

6.4 Corporate Bonds

■■ When a bond issuer does not make a bond payment in full, the issuer has defaulted.
■■ The risk that default can occur is called default or credit risk.
■■ U.S. Treasury securities are generally considered free of default risk.
■■ The expected return of a corporate bond, which is the firm’s debt cost of capital, equals the
risk-free rate of interest plus a risk premium. The expected return is less than the bond’s yield
to maturity because the yield to maturity of a bond is calculated using the promised cash flows,
not the expected cash flows.
■■ Bond ratings summarize the creditworthiness of bonds for investors.
■■ The difference between yields on Treasury securities and yields on corporate bonds is called
the credit spread or default spread. The credit spread compensates investors for the difference
between promised and expected cash flows and for the risk of default.

6.5 Sovereign Bonds

■■ Sovereign bonds are issued by national governments.
■■ Sovereign bond yields reflect investor expectations of inflation, currency, and default risk.
■■ Countries may repay their debt by printing additional currency, which generally leads to a rise in
inflation and a sharp currency devaluation.
■■ When “inflating away” the debt is infeasible or politically unattractive, countries may choose to
default on their debt.

Key Terms bond certificate p. 208 default (credit) spread p. 226

clean price p. 217 dirty price p. 217
corporate bonds p. 222 discount p. 208
coupon bonds p. 211 duration p. 217
coupon-paying yield curve p. 222 face value p. 208
coupon rate p. 208 high-yield bonds p. 226
coupons p. 208 investment-grade bonds p. 226
credit risk p. 223 invoice price p. 217
debt ceiling p. 223 junk bonds p. 226
 Problems 233

maturity date p. 208 term p. 208

on-the-run bonds p. 222 Treasury bills p. 208
par p. 213 Treasury bonds p. 211
premium p. 213 Treasury notes p. 211
pure discount bonds p. 208 yield to maturity (YTM) p. 209
sovereign bonds p. 226 zero-coupon bonds p. 208
speculative bonds p. 226 zero-coupon yield curve p. 210
spot interest rates p. 209

Further For readers interested in more details about the bond market, the following texts will prove use-
ful: Z. Bodie, A. Kane, and A. Marcus, Investments (McGraw-Hill, 2013); F. Fabozzi, The Handbook
Reading of Fixed Income Securities (McGraw-Hill, 2012); W. Sharpe, G. Alexander, and J. Bailey, Investments
(Prentice-Hall, 1998); and B. Tuckman, Fixed Income Securities: Tools for Today’s Markets ( Wiley, 2011).
C. Reinhart and K. Rogoff, This Time Is Different (Princeton University Press, 2010), provides a his-
torical perspective and an excellent discussion of the risk of sovereign debt. For details related to the
2012 Greek default, see “The Greek Debt Restructuring: An Autopsy,” J. Zettelmeyer, C. Trebesch,
and M. Gulati, Economic Policy 28 (2013): 513–563.

Problems All problems are available in MyLab Finance. The icon indicates Excel Projects problems available in
MyLab Finance.

Bond Cash Flows, Prices, and Yields

1. A 15-year bond with a face value of $1000 has a coupon rate of 4.5%, with semiannual
payments.
a. What is the coupon payment for this bond?
b. Draw the cash flows for the bond on a timeline.
2. Assume that a bond will make payments every six months as shown on the following timeline
(using six-month periods):
0 1 2 3 20
...
$30 $30 $30 $30 1 $1000

a. What is the maturity of the bond (in years)?

b. What is the coupon rate (in percent)?
c. What is the face value?
3. The following table summarizes prices of various default-free, zero-coupon bonds (expressed
as a percentage of face value):

Maturity (years) 1 2 3 4 5
Price (per $100 face value) $96.21 $91.83 $87.16 $82.51 $77.38
a. Compute the yield to maturity for each bond.
b. Plot the zero-coupon yield curve (for the first five years).
c. Is the yield curve upward sloping, downward sloping, or flat?
4. Suppose the current zero-coupon yield curve for risk-free bonds is as follows:

Maturity (years) 1 2 3 4 5
YTM 4.28% 4.75% 4.89% 5.20% 5.45%
234 Chapter 6 Valuing Bonds

a. What is the price per $100 face value of a three-year, zero-coupon, risk-free bond?
b. What is the price per $100 face value of a four-year, zero-coupon, risk-free bond?
c. What is the risk-free interest rate for a three-year maturity?
5. In the Global Financial Crisis box in Section 6.1, www.Bloomberg.com reported that the three-
month Treasury bill sold for a price of $100.002556 per $100 face value. What is the yield to
maturity of this bond, expressed as an EAR?
6. Suppose a 10-year, $1000 bond with a 7% coupon rate and semiannual coupons is trading for
a price of $1181.64.
a. What is the bond’s yield to maturity (expressed as an APR with semiannual compounding)?
b. If the bond’s yield to maturity changes to 9% APR, what will the bond’s price be?
7. Suppose a five-year, $1000 bond with annual coupons has a price of $1050 and a yield to matu-
rity of 6%. What is the bond’s coupon rate?

Dynamic Behavior of Bond Prices

8. The prices of several bonds with face values of $1000 are summarized in the following table:

Bond A B C D
Price $936.57 $1095.48 $1170.97 $1000.00
For each bond, state whether it trades at a discount, at par, or at a premium.
9. Explain why the yield of a bond that trades at a discount exceeds the bond’s coupon rate.
10. Suppose a seven-year, $1000 bond with a 9.08% coupon rate and semiannual coupons is trading
with a yield to maturity of 7.30%.
a. Is this bond currently trading at a discount, at par, or at a premium? Explain.
b. If the yield to maturity of the bond rises to 8.25% (APR with semiannual compounding),
what price will the bond trade for?

11. Suppose that Ally Financial Inc. issued a bond with 10 years until maturity, a face value of
$1000, and a coupon rate of 6% (annual payments). The yield to maturity on this bond when it
was issued was 10%.
a. What was the price of this bond when it was issued?
b. Assuming the yield to maturity remains constant, what is the price of the bond immediately
before it makes its first coupon payment?
c. Assuming the yield to maturity remains constant, what is the price of the bond immediately
after it makes its first coupon payment?

12. Suppose you purchase a 10-year bond with 4% annual coupons. You hold the bond for four
years, and sell it immediately after receiving the fourth coupon. If the bond’s yield to maturity
was 3.75% when you purchased and sold the bond,
a. What cash flows will you pay and receive from your investment in the bond per $100 face value?
b. What is the internal rate of return of your investment?
13. Consider the following bonds:

Bond Coupon Rate (annual payments) Maturity (years)

A 0% 16
B 0% 8
C 4% 16
D 7% 8
a. What is the percentage change in the price of each bond if its yield to maturity falls from 6% to 5%?
b. Which of the bonds A–D is most sensitive to a 1% drop in interest rates from 6% to 5% and
why? Which bond is least sensitive? Provide an intuitive explanation for your answer.
 Problems 235

14. Suppose you purchase a 30-year, zero-coupon bond with a yield to maturity of 6%. You hold
the bond for five years before selling it.
a. If the bond’s yield to maturity is 6% when you sell it, what is the internal rate of return of
your investment?
b. If the bond’s yield to maturity is 7% when you sell it, what is the internal rate of return of
your investment?
c. If the bond’s yield to maturity is 5% when you sell it, what is the internal rate of return of
your investment?
d. Even if a bond has no chance of default, is your investment risk free if you plan to sell it
before it matures? Explain.
15. Suppose you purchase a 30-year Treasury bond with a 7% annual coupon, initially trading at par.
In 10 years’ time, the bond’s yield to maturity has risen to 6% (EAR).
a. If you sell the bond now, what internal rate of return will you have earned on your invest-
ment in the bond?
b. If instead you hold the bond to maturity, what internal rate of return will you earn on your
investment in the bond?
c. Is comparing the IRRs in (a) versus (b) a useful way to evaluate the decision to sell the bond?
Explain.
16. Suppose the current yield on a one-year, zero coupon bond is 3%, while the yield on a five-year,
zero coupon bond is 4%. Neither bond has any risk of default. Suppose you plan to invest for
one year. You will earn more over the year by investing in the five-year bond as long as its yield
does not rise above what level?

The Yield Curve and Bond Arbitrage

For Problems 17–22, assume zero-coupon yields on default-free securities are as summarized in the following table:

Maturity (years) 1 2 3 4 5
Zero-coupon YTM 4.00% 4.30% 4.50% 4.70% 4.80%

17. What is the price today of a two-year, default-free security with a face value of $1000 and an
annual coupon rate of 6%? Does this bond trade at a discount, at par, or at a premium?
18. What is the price of a five-year, zero-coupon, default-free security with a face value of $1000?
19. What is the price of a three-year, default-free security with a face value of $1000 and an annual
coupon rate of 4%? What is the yield to maturity for this bond?
20. What is the maturity of a default-free security with annual coupon payments and a yield to
maturity of 4%? Why?
21. Consider a four-year, default-free security with annual coupon payments and a face value of
$1000 that is issued at par. What is the coupon rate of this bond?
22. Consider a five-year, default-free bond with annual coupons of 5% and a face value of $1000.
a. Without doing any calculations, determine whether this bond is trading at a premium or at a
discount. Explain.
b. What is the yield to maturity on this bond?
c. If the yield to maturity on this bond increased to 5.2%, what would the new price be?
23. Prices of zero-coupon, default-free securities with face values of $1000 are summarized in the
following table:
Maturity (years) 1 2 3
Price (per $1000 face value) $970.51 $936.89 $903.92
236 Chapter 6 Valuing Bonds

Suppose you observe that a three-year, default-free security with an annual coupon rate of 10%
and a face value of $1000 has a price today of $1180.79. Is there an arbitrage opportunity? If so,
show specifically how you would take advantage of this opportunity. If not, why not?
24. Assume there are four default-free bonds with the following prices and future cash flows:

Cash Flows
Bond Price Today Year 1 Year 2 Year 3
A $934.15 1000 0 0
B 879.84 0 1000 0
C 1130.84 100 100 1100
D 830.72 0 0 1000

Do these bonds present an arbitrage opportunity? If so, how would you take advantage of this
opportunity? If not, why not?
25. Suppose you are given the following information about the default-free, coupon-paying yield curve:

Maturity (years) 1 2 3 4
Coupon rate (annual payments) 0.00% 9.00% 4.00% 13.00%
YTM 1.234% 3.914% 5.693% 6.618%
a. Use arbitrage to determine the yield to maturity of a two-year, zero-coupon bond.
b. What is the zero-coupon yield curve for years 1 through 4?

Corporate Bonds
26. Explain why the expected return of a corporate bond does not equal its yield to maturity.
27. In the Data Case in Chapter 5, we suggested using the yield on Florida Sate bonds to estimate
the State of Florida’s cost of capital. Why might this estimate overstate the actual cost of capital?
28. Grummon Corporation has issued zero-coupon corporate bonds with a five-year matu-
rity. Investors believe there is a 25% chance that Grummon will default on these bonds. If
Grummon does default, investors expect to receive only 65 cents per dollar they are owed. If
investors require a 6% expected return on their investment in these bonds, what will be the
price and yield to maturity on these bonds?
29. The following table summarizes the yields to maturity on several one-year, zero-coupon securities:

Security Yield (%)

Treasury 2.940
AAA corporate 3.633
BBB corporate 4.259
B corporate 5.061

a. What is the price (expressed as a percentage of the face value) of a one-year, zero-coupon
corporate bond with a AAA rating?
b. What is the credit spread on AAA-rated corporate bonds?
c. What is the credit spread on B-rated corporate bonds?
d. How does the credit spread change with the bond rating? Why?
30. Andrew Industries is contemplating issuing a 30-year bond with a coupon rate of 9.69% (an-
nual coupon payments) and a face value of $1000. Andrew believes it can get a rating of A from
Standard and Poor’s. However, due to recent financial difficulties at the company, Standard and
Poor’s is warning that it may downgrade Andrew Industries bonds to BBB. Yields on A-rated,
long-term bonds are currently 9.19%, and yields on BBB-rated bonds are 9.59%.
a. What is the price of the bond if Andrew maintains the A rating for the bond issue?
b. What will the price of the bond be if it is downgraded?
 Data Case 237

31. HMK Enterprises would like to raise $14 million to invest in capital expenditures. The company
plans to issue five-year bonds with a face value of $1000 and a coupon rate of 4% (annual pay-
ments). The following table summarizes the yield to maturity for five-year (annual-pay) coupon
corporate bonds of various ratings:

Rating AAA AA A BBB BB

YTM 3.7% 3.9% 4% 4.7% 5.1%

a. Assuming the bonds will be rated AA, what will the price of the bonds be?
b. How much total principal amount of these bonds must HMK issue to raise $14 million
today, assuming the bonds are AA rated? (Because HMK cannot issue a fraction of a bond,
assume that all fractions are rounded to the nearest whole number.)
c. What must the rating of the bonds be for them to sell at par?
d. Suppose that when the bonds are issued, the price of each bond is $952.51. What is the likely
rating of the bonds? Are they junk bonds?

32. A BBB-rated corporate bond has a yield to maturity of 13.7%. A U.S. Treasury security has a
yield to maturity of 11.7%. These yields are quoted as APRs with semiannual compounding.
Both bonds pay semiannual coupons at a rate of 11.9% and have five years to maturity.
a. What is the price (expressed as a percentage of the face value) of the Treasury bond?
b. What is the price (expressed as a percentage of the face value) of the BBB-rated corporate bond?
c. What is the credit spread on the BBB bonds?
33. The Isabelle Corporation rents prom dresses in its stores across the southern United States. It
has just issued a five-year, zero-coupon corporate bond at a price of $77. You have purchased
this bond and intend to hold it until maturity.
a. What is the yield to maturity of the bond?
b. What is the expected return on your investment (expressed as an EAR) if there is no chance
of default?
c. What is the expected return (expressed as an EAR) if there is a 100% probability of default
and you will recover 90% of the face value?
d. What is the expected return (expressed as an EAR) if the probability of default is 50%, the
likelihood of default is higher in bad times than good times, and, in the case of default, you
will recover 90% of the face value?
e. For parts (b–d), what can you say about the five-year, risk-free interest rate in each case?

Sovereign Bonds
34. What does it mean for a country to “inflate away” its debt? Why might this be costly for inves-
tors even if the country does not default?
35. Suppose the yield on German government bonds is 1.2%, while the yield on Spanish govern-
ment bonds is 7%. Both bonds are denominated in euros. Which country do investors believe is
more likely to default? How can you tell?

Data Case Corporate Yield Curves

You are an intern with Enel Generacion Chile, the largest electric utility company in Chile, in their
corporate finance division. The firm is planning to issue $100 million of 7.875% annual coupon
bonds with a 10-year maturity in the United States. The firm anticipates an increase in its bond rating.
Your immediate superior wants you to determine the gain in the proceeds of the new issue if the issue
is rated above the firm’s current bond rating. To prepare the necessary information, you will need to
determine Enel Generacion Chile’s current debt rating and the yield curve of their particular rating.
1. You begin by finding the current U.S. Treasury yield curve. At the Treasury Web site (www.treas
.gov), search using the term “yield curve” and select “Daily Treasury Yield Curve Rates.” Choose
238 Chapter 6 Valuing Bonds

“Daily Treasury Yield Curve Rates” as the type of interest rate and “Current Month” as the
time period. Highlight the entire data table including the headers, copy and paste it into Excel.
Remember to use “Match Destination Formatting (M)” as the paste option.
2. The current yield spreads for the various bond ratings are shown below.

1 2 3 4 5 6 7 8 9 10 12 15 20 25 30
Rating
year years years years years years years years years years years years years years years
Aaa/AAA 21 26 38 45 53 55 61 65 70 76 84 99 122 127 121
Aa2/AA 30 32 42 53 65 72 83 95 108 121 137 149 153 146 114
A2/A 43 58 71 79 88 92 102 115 131 147 165 175 175 162 141
Baa1/BBB+ 96 111 132 144 153 160 178 204 230 253 277 269 269 240 200
Ba2/BB 172 272 331 346 343 335 336 341 349 361 - 364 364 304 -

Copy the table above and paste it to the same file as the Treasury yields from previous step.

3. Find the current bond rating for Enel Generacion Chile. Go to Standard & Poor’s Web site (www.
standardandpoors.com), select “Find a Rating” from the list at the left of the page, then select
“Credit Ratings Search.” At this point, you will have to register (it’s free) or enter a username and
password provided by your instructor. Next, you will be able to search by organization name –
enter Enel Generacion Chile and select accordingly. Use the credit rating of the organization, not
the specific issue ratings.
4. Return to Excel and create a time with the cash flows and discount rates you will need to value
the new bond issue.
a. To create the required spot rates for the Enel Generacion Chile issue, add the appropriate
spread to the Treasury yield of the same maturity.
b. The yield curve and spread rates you have found do not cover every year that you will need
for the new bonds. Fill in these by linearly interpolating the given yields and spreads. For ex-
ample, the four-year spot rate and spread will be the average of the three- and five-year rates.
c. To compute the spot rates for Enel Generacion Chile’s current debt rating, add the yield
spread to the Treasury rate for each maturity. However, note that the spread is in basis points,
which are 1/100th of a percentage point.
d. Compute the cash flows that would be paid to bondholders each year and add them to the
timeline.
5. Use the spot rates to calculate the present value of each cash flow paid to the bondholders.
6. Compare the issue price of the bond and its initial yield to maturity.
7. Repeat Steps 4–6 based on the assumption that Enel Generacion Chile is able to raise its bond
rating by one level. Compute the new yield based on the higher rating and the new bond price
that would result.
8. Compute the additional cash proceeds that could be raised from the issue if the rating were
improved.

Case Study The 2012 Greek Default and Subsequent Debt Restructuring6
In March and April 2012 Greece defaulted on its debt by swapping its outstanding obligations for
new obligations of much lesser face value. For each euro of face value outstanding, a holder of
Greek debt was given the following securities with an issue date of 12 March 2012.

6
This case is based on information and analysis published in “The Greek Debt Restructuring: An
Autopsy,” J. Zettelmeyer, C. Trebesch, and M. Gulati, Economic Policy ( July 2013) 513–563. For pedagogical
reasons, some details of the bond issues were changed marginally to simplify the calculations.
 Case Study 239

■■ Two European Financial Stability Fund (EFSF) notes. Each note had a face value of 7.5 ¢. The
first note paid an annual coupon (on the anniversary of the issue date) of 0.4% and matured on
12 March 2013. The second note paid an annual coupon of 1% and matured on 12 March 2014.
■■ A series of bonds issued by the Greek government with a combined face value of 31.5 ¢. The sim-
plest way to characterize these bonds is as a single bond paying an annual coupon (on December
12 of each year) of 2% for years 2012–2015, 3% for years 2016–2020, 3.65% for 2021, and 4.3%
thereafter. Principal is repaid in 20 equal installments (that is, 5% of face value) in December in
the years 2023–2042.
■■ Other securities that were worth little.
An important feature of this swap is that the same deal was offered to all investors, regardless of
which bonds they were holding. That meant that the loss to different investors was not the same.
To understand why, begin by calculating the present value of what every investor received. For sim-
plicity, assume that the coupons on the EFSF notes were issued at market rates so they traded at par.
Next, put all the promised payments of the bond series on a timeline. Figure 6.7 shows the imputed
yields on Greek debt that prevailed after the debt swap was announced. Assume the yields in Figure 6.7
are yields on zero coupon bonds maturing in the 23 years following the debt swap, and use them to
calculate the present value of all promised payments on March 12, 2012.
Next, consider 2 different bonds that were outstanding before the default (there were a total of 117
different securities).
■■ A Greek government bond maturing on March 12, 2012
■■ A Greek government 4.7% annual coupon bond maturing on March 12, 2024.
Using the yields in Figure 6.7, calculate the value of each existing bond as a fraction of face value.
Bondholders of both existing bonds received the same package of new bonds in exchange for their
existing bonds. In each case calculate the haircut, that is, the amount of the loss (as a fraction of the
original bonds’ face value) that was sustained when the existing bonds were replaced with the new
bonds. Which investors took a larger haircut, long-term or short-term bondholders?
Assume that participation in the swap was voluntary (as was claimed at the time), so that on the an-
nouncement the price of the existing bonds equaled the value of the new bonds. Using this equiva-
lence, calculate the yield to maturity of the existing bond that matured in 2024. What might explain
the difference between this yield and the yields in Figure 6.7?

FIGURE 6.7 Imputed Greek Government Yield Curve on March 12, 2012

50

40

30
%/annum

20

10

0
0 2 4 6 8 10 12 14 16 18 20 22 24
Maturity (years)

Source: “The Greek Debt Restructuring: An Autopsy,” J. Zettelmeyer, C. Trebesch, and M. Gulati.
240 Chapter 6 Valuing Bonds

Forward Interest Rates

CHAPTER 6
APPENDIX

NOTATION Given the risk associated with interest rate changes, corporate managers require tools to
fn one-year help manage this risk. One of the most important is the interest rate forward contract,
forward rate which is a type of swap contract. An interest rate forward contract (also called a forward
for year n rate agreement) is a contract today that fixes the interest rate for a loan or investment in
the future. In this appendix, we explain how to derive forward interest rates from zero-
coupon yields.

Computing Forward Rates

A forward interest rate (or forward rate) is an interest rate that we can guarantee today
for a loan or investment that will occur in the future. Throughout this section, we will
consider interest rate forward contracts for one-year investments; thus, when we refer to
the forward rate for year 5, we mean the rate available today on a one-year investment that
begins four years from today and is repaid five years from today.
We can use the Law of One Price to calculate the forward rate from the zero-coupon
yield curve. The forward rate for year 1 is the rate on an investment that starts today and
is repaid in one year; it is equivalent to an investment in a one-year, zero-coupon bond.
Therefore, by the Law of One Price, these rates must coincide:
f1 = YTM1 (6A.1)
Now consider the two-year forward rate. Suppose the one-year, zero-coupon yield is
5.5% and the two-year, zero-coupon yield is 7%. There are two ways to invest money risk
free for two years. First, we can invest in the two-year, zero-coupon bond at rate of 7%
and earn $(1.07)2 after two years per dollar invested. Second, we can invest in the one-year
bond at a rate of 5.5%, which will pay $1.055 at the end of one year, and simultaneously
guarantee the interest rate we will earn by reinvesting the $1.055 for the second year by
entering into an interest rate forward contract for year 2 at rate f2. In that case, we will earn
$(1.055)(1 + f2 ) at the end of two years. Because both strategies are risk free, by the Law
of One Price, they must have the same return:
(1.07)2 = (1.055)(1 + f 2 )
Rearranging, we have
1.072
(1 + f 2 ) = = 1.0852
1.055

Therefore, in this case the forward rate for year 2 is f2 = 8.52%.

In general, we can compute the forward rate for year n by comparing an investment
in an n-year, zero-coupon bond to an investment in an (n - 1) year, zero-coupon bond,
with the interest rate earned in the nth year being guaranteed through an interest rate
forward contract. Because both strategies are risk free, they must have the same payoff or
else an arbitrage opportunity would be available. Comparing the payoffs of these strate-
gies, we have
(1 + YTMn )n = (1 + YTM n - 1)n - 1(1 + f n )
 Chapter 6 Appendix: Forward Interest Rates 241

We can rearrange this equation to find the general formula for the forward interest rate:
(1 + YTM n )n
fn = - 1 (6A.2)
(1 + YTM n - 1 ) n - 1

EXAMPLE 6A.1 Computing Forward Rates

Problem
Calculate the forward rates for years 1 through 5 from the following zero-coupon yields:

Maturity 1 2 3 4
YTM 5.00% 6.00% 6.00% 5.75%

Solution
Using Eqs. 6A.1 and 6A.2:

f1 = YTM1 = 5 .00%

11 + YTM222 1.062
f2 = - 1 = - 1 = 7 .01%
11 + YTM12 1.05

11 + YTM323 1.063
f3 = - 1 = - 1 = 6 .00%
11 + YTM222 1.062

11 + YTM424 1.05754
f4 = 3 - 1 = - 1 = 5 .00%
11 + YTM32 1.063

Note that when the yield curve is increasing in year n (that is, when YTMn 7 YTMn - 1),
the forward rate is higher than the zero-coupon yield, fn 7 YTMn. Similarly, when the yield
curve is decreasing, the forward rate is less than the zero-coupon yield. When the yield
curve is flat, the forward rate equals the zero-coupon yield.

Computing Bond Yields from Forward Rates

Eq. 6A.2 computes the forward interest rate using the zero-coupon yields. It is also possible
to compute the zero-coupon yields from the forward interest rates. To see this, note that if
we use interest rate forward contracts to lock in an interest rate for an investment in year 1,
year 2, and so on through year n, we can create an n-year, risk-free investment. The return
from this strategy must match the return from an n-year, zero-coupon bond. Therefore,
(1 + f1 ) * (1 + f2 ) * g * (1 + fn ) = (1 + YTM n )n (6A.3)
For example, using the forward rates from Example 6A.1, we can compute the four-year
zero-coupon yield:
1 + YTM4 = 3 (1 + f 1 )(1 + f 2 )(1 + f 3)(1 + f 4 ) 4 1>4

= 3 (1.05)(1.0701)(1.06)(1.05) 4 1>4
= 1.0575
242 Chapter 6 Valuing Bonds

Forward Rates and Future Interest Rates

A forward rate is the rate that you contract for today for an investment in the future. How
does this rate compare to the interest rate that will actually prevail in the future? It is tempt-
ing to believe that the forward interest rate should be a good predictor of future interest
rates. In reality, this will generally not be the case. Instead, it is a good predictor only when
investors do not care about risk.

EXAMPLE 6A.2 Forward Rates and Future Spot Rates

Problem
JoAnne Wilford is corporate treasurer for Wafer Thin Semiconductor. She must invest some of
the cash on hand for two years in risk-free bonds. The current one-year, zero-coupon yield is 5%.
The one-year forward rate is 6%. She is trying to decide between three possible strategies: (1) buy
a two-year bond, (2) buy a one-year bond and enter into an interest rate forward contract to
guarantee the rate in the second year, or (3) buy a one-year bond and forgo the forward contract,
reinvesting at whatever rate prevails next year. Under what scenarios would she be better off fol-
lowing the risky strategy?

Solution
From Eq. 6A.3, both strategies (1) and (2) lead to the same risk-free return of
(1 + YTM2 )2 = (1 + YTM1)(1 + f 2 ) = (1.05)(1.06). The third strategy returns (1.05)(1 + r ),
where r is the one-year interest rate next year. If the future interest rate turns out to be 6%, then
the two strategies will offer the same return. Otherwise Wafer Thin Semiconductor is better off
with strategy (3) if the interest rate next year is greater than the forward rate—6%—and worse
off if the interest rate is lower than 6%.

As Example 6A.2 makes clear, we can think of the forward rate as a break-even rate. If
this rate actually prevails in the future, investors will be indifferent between investing in a
two-year bond and investing in a one-year bond and rolling over the money in one year. If
investors did not care about risk, then they would be indifferent between the two strate-
gies whenever the expected one-year spot rate equals the current forward rate. However,
investors do generally care about risk. If the expected returns of both strategies were the
same, investors would prefer one strategy or the other depending on whether they want
to be exposed to future interest rate risk fluctuations. In general, the expected future spot
interest rate will reflect investors’ preferences toward the risk of future interest rate fluc-
tuations. Thus,
Expected Future Spot Interest Rate = Forward Interest Rate + Risk Premium (6A.4)
This risk premium can be either positive or negative depending on investors’ preferences.7
As a result, forward rates tend not to be ideal predictors of future spot rates.

7
Empirical research suggests that the risk premium tends to be negative when the yield curve is upward slop-
ing, and positive when it is downward sloping. See E. Fama and R. Bliss, “The Information in Long-Maturity
Forward Rates,” American Economic Review 77(4) (1987): 680–692; and J. Campbell and R. Shiller, “Yield
Spreads and Interest Rate Movements: A Bird’s Eye View,” Review of Economic Studies 58(3) (1991): 495–514.
 Chapter 6 Appendix: Forward Interest Rates 243

Key Terms forward interest rate (forward rate) p. 240

forward rate agreement p. 240
interest rate forward contract p. 240

Problems All problems are available in MyLab Finance. Problems A.1–A.4 refer to the following table:

Maturity (years) 1 2 3 4 5
Zero-coupon YTM 4.0% 5.5% 5.5% 5.0% 4.5%

A.1. What is the forward rate for year 2 (the forward rate quoted today for an investment that
begins in one year and matures in two years)?
A.2. What is the forward rate for year 3 (the forward rate quoted today for an investment that
begins in two years and matures in three years)? What can you conclude about forward rates
when the yield curve is flat?
A.3. What is the forward rate for year 5 (the forward rate quoted today for an investment that
begins in four years and matures in five years)?
A.4. Suppose you wanted to lock in an interest rate for an investment that begins in one year and
matures in five years. What rate would you obtain if there are no arbitrage opportunities?
A.5. Suppose the yield on a one-year, zero-coupon bond is 5.24%. The forward rate for year 2 is
3.83%, and the forward rate for year 3 is 2.98%. What is the yield to maturity of a zero-coupon
bond that matures in three years?
This page is intentionally left blank
 PA RT

Valuing Projects
and Firms 3
THE LAW OF ONE PRICE CONNECTION. Now that the basic tools for finan-
cial decision making are in place, we can begin to apply them. One of the most
CHAPTER 7
important decisions facing a financial manager is the choice of which investments Investment
the corporation should make. In Chapter 7, we compare the net present value rule Decision Rules
to other investment rules that firms sometimes use and explain why the net present
value rule is superior. The process of allocating the firm’s capital for investment is CHAPTER 8
known as capital budgeting, and in Chapter 8, we outline the discounted cash flow
Fundamentals
method for making such decisions. Both chapters provide a practical demonstra-
of Capital
tion of the power of the tools that were introduced in Part 2.
Budgeting
Many firms raise the capital they need to make investments by issuing stock to in-
vestors. How do investors determine the price they are willing to pay for this stock? CHAPTER 9
And how do managers’ investment decisions affect this value? In Chapter 9, Valuing
Valuing Stocks
Stocks, we show how the Law of One Price leads to several alternative methods for
valuing a firm’s equity by considering its future dividends, its free cash flows, or how
it compares to similar, publicly traded companies.

245
 CHAP TER

7 Investment
Decision Rules

NOTATION IN 2017, AMAZON PURCHASED WHOLE FOODS FOR $13.7 BILLION,

r discount rate by far the largest single investment decision the firm has ever made. Besides the
upfront cost of the purchase, Amazon planned to spend significant resources in-
NPV net present value
tegrating Whole Foods’ bricks and mortar business into its online retail business.
IRR internal rate of return Presumably, Amazon executives believed that the acquisition would generate
PV present value large synergies that would translate into greater future revenues. How did they

NPER annuity spreadsheet know that these added revenues would exceed the significant investment cost or
notation for the number more generally, how do firm managers make decisions they believe will maxi-
of periods or dates of the mize the value of their firms?
last cash flow As we will see in this chapter, the NPV investment rule is the decision rule
RATE annuity spreadsheet that managers should use to maximize firm value. Nevertheless, some firms use
notation for interest rate other techniques to evaluate investments and decide which projects to pursue. In
PMT annuity spreadsheet this chapter, we explain several commonly used techniques—namely, the pay-
notation for cash flow back rule and the internal rate of return rule. We then compare decisions based
on these rules to decisions based on the NPV rule and illustrate the circumstances
in which the alternative rules are likely to lead to bad investment decisions. After
establishing these rules in the context of a single, stand-alone project, we broaden
our perspective to include deciding among alternative investment opportunities.
We conclude with a look at project selection when the firm faces capital or other
resource constraints.

246
 7.1 NPV and Stand-Alone Projects 247

7.1 NPV and Stand-Alone Projects

We begin our discussion of investment decision rules by considering a take-it-or-leave-it
decision involving a single, stand-alone project. By undertaking this project, the firm does
not constrain its ability to take other projects. To analyze such a decision, recall the NPV
rule:
NPV Investment Rule: When making an investment decision, take the alternative with the highest NPV.
Choosing this alternative is equivalent to receiving its NPV in cash today.
In the case of a stand-alone project, we must choose between accepting or rejecting the
project. The NPV rule then says we should compare the project’s NPV to zero (the NPV
of doing nothing) and accept the project if its NPV is positive.

Applying the NPV Rule

Researchers at Fredrick’s Feed and Farm have made a breakthrough. They believe that they
can produce a new, environmentally friendly fertilizer at a substantial cost savings over the
company’s existing line of fertilizer. The fertilizer will require a new plant that can be built
immediately at a cost of $250 million. Financial managers estimate that the benefits of the
new fertilizer will be $35 million per year, starting at the end of the first year and lasting
forever, as shown by the following timeline:

0 1 2 3
...
2$250 $35 $35 $35

As we explained in Chapter 4, the NPV of this perpetual cash flow stream, given a dis-
count rate r, is
35
NPV = - 250 + (7.1)
r

The financial managers responsible for this project estimate a cost of capital of 10% per
year. Using this cost of capital in Eq. 7.1, the NPV is $100 million, which is positive. The
NPV investment rule indicates that by making the investment, the value of the firm will
increase by $100 million today, so Fredrick’s should undertake this project.

The NPV Profile and IRR

The NPV of the project depends on the appropriate cost of capital. Often, there may be
some uncertainty regarding the project’s cost of capital. In that case, it is helpful to compute
an NPV profile: a graph of the project’s NPV over a range of discount rates. Figure 7.1
plots the NPV of the fertilizer project as a function of the discount rate, r.
Notice that the NPV is positive only for discount rates that are less than 14%. When
r = 14%, the NPV is zero. Recall from Chapter 4 that the internal rate of return (IRR) of
an investment is the discount rate that sets the NPV of the project’s cash flows equal to
zero. Thus, the fertilizer project has an IRR of 14%.
The IRR of a project provides useful information regarding the sensitivity of the proj-
ect’s NPV to errors in the estimate of its cost of capital. For the fertilizer project, if the
cost of capital estimate is more than the 14% IRR, the NPV will be negative, as shown in