Economics 122

FINANCIAL ECONOMI CS (DE BT S ECURITIES 3)

M. DE BUQUE - G ONZ ALES
AY2014 -201 5

SOURCE: BODIE ET AL. (2009), ROSS ET AL., LO (2008)

Yield-to-maturity (YTM)
 Recall: Yield-to-maturity or 𝑦𝑡𝑚 is the interest rate that makes the present
value  of  the  bond’s  payments  equal  to  its  price.
𝐶 𝐶 𝐶+𝐹
𝑃 = + + ⋯+
(1 + 𝑟) (1 + 𝑟) 1+𝑟
𝐶 𝐹
= + r=y

1+𝑟 1+𝑟
𝐹
= 𝐶 × 𝐴𝐷𝐹(𝑟, 𝑇) +
1+𝑟
 An important by-the-way: Note how the coupon rate = market rate, if the
bond is issued at par (sold at face value)
Yield-to-maturity (YTM)
 The 𝑦𝑡𝑚 is  the  bond’s  internal  rate  of  return.
 𝑦𝑡𝑚 is  the  interest  rate  that  makes  the  present  value  of  a  bond’s  
payments equal to its price.
 𝑦𝑡𝑚 assumes that all bond coupons can be reinvested at the 𝑦𝑡𝑚
rate.
 The Price over Time of a 30-Year Zero-Coupon Bond

14-4
 Prices over Time of 30-Year Maturity, 6.5% Coupon Bonds
Premium bond:
Coupon rate > Market interest rate
o Interest income greater than
available elsewhere.
o Investors will bid up the price of the
bond above their par value.

Discount bond:
Coupon rate < Market interest rate
o Interest income less than available
elsewhere.
o Investor will need to earn from price
appreciation to receive a fair return,
and bonds would therefore sell at
below their par value.

14-5
 Bond Prices at Different Interest Rates

14-6
YTM vs. current yield NOTE: Default Face =
$1000

 Current yield is  the  bond’s  annual  coupon  payment  divided  by  the  bond  price.
 Suppose an 8% coupon (semiannual), 30 year bond is selling for $1,276.76 (i.e., selling at
greater  than  par  value  or  “at  a  premium”).  
$ $ ,
$1,276.76 = ∑ +

𝑟 = 3% 𝑝𝑒𝑟 ℎ𝑎𝑙𝑓 𝑦𝑒𝑎𝑟; 𝑏𝑜𝑛𝑑 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 = 6%

𝑦𝑡𝑚 = 𝐸𝐴𝑅 = 1.03 − 1 = 6.09%
$
 Current yield: = 6.3%
$ , .
$
 Coupon rate: = 8%
$ ,

 Coupon rate > Current yield > 𝑦𝑡𝑚 (accounts for built-in capital loss in the bond)
YTM vs. Current Yield
YTM CURRENT YIELD
The 𝑦𝑡𝑚 is  the  bond’s  internal  rate   The  current  yield  is  the  bond’s  
of return. annual coupon payment divided by
the bond price.
𝑦𝑡𝑚 is the interest rate that makes
the  present  value  of  a  bond’s   For bonds selling at a premium
payments equal to its price. (above par or face value),
coupon rate > current yield > 𝑦𝑡𝑚.
𝑦𝑡𝑚 assumes that all bond coupons
can be reinvested at the 𝑦𝑡𝑚 rate. For discount bonds (selling below
par or face value), relationships are
reversed:
coupon rate < current yield < 𝑦𝑡𝑚.
14-8
YTM vs. realized yield
 Reinvestment assumptions
o Yield-to-maturity will equal the rate of return realized over the
life of a bond if all coupons are reinvested at an interest rate
equal  to  the  bond’s  𝑦𝑡𝑚.
 If reinvestment rate = 𝑦𝑡𝑚, realized compound return = 𝑦𝑡𝑚.
o However, this is not necessarily so if the reinvestment rate is not
equal to 𝑦𝑡𝑚.
 Growth of Invested Funds
Example: 2-year bond selling at par, coupon
rate = 𝑦𝑡𝑚 = 10%

Realized compound return 𝑟:

* Case 1: reinvestment rate = 𝑦𝑡𝑚 = 10%
𝑉 1+𝑟 =𝑉
$1,000 1 + 𝑟 = $1,210
𝑟 = 0.10 𝑜𝑟 10% (= 𝑦𝑡𝑚)

* Case 2: reinvestment rate = 8%

𝑉 1+𝑟 =𝑉
$1,000 1 + 𝑟 = $1,208
𝑟 = 0. 099 𝑜𝑟 9.9% < 𝑦𝑡𝑚

* Case 3: reinvestment rate of 12%?

14-10
Holding period return
 Forecast of total return over various holding periods would
differ, and would depend on your forecast of both:
o Price of the bond when you sell it at the end of the investment
horizon (which in turn depends on the 𝑦𝑡𝑚 at the horizon date)
o Rate at which you are able to reinvest the coupon payments
Holding period return
 Example: 30-year bond with 7.5% annual coupon rate which you
buy at $980 (𝑦𝑡𝑚 of 7.67%) and plan to hold for 20 years.
 Your forecast:
o 𝑦𝑡𝑚 will be 8% when you sell the bond.
o Reinvestment rate will be 6%.
 At end of investment horizon (20 years), the bond will still have 10
years remaining: at 8% 𝑦𝑡𝑚, forecast sales price is $966.45.
$ ,
o Bond price at year 20: $75 × 𝐴𝐷𝐹 8%, 10 + =
%
$966.45 (< $980)
Holding period return
 Example: 30-year bond with 7.5% annual coupon rate which you
buy at $980 (𝑦𝑡𝑚 was 7.67%) and plan to hold for 20 years.
Forecast 𝑦𝑡𝑚 = 8%. Forecast reinvestment rate = 6%.
 The 20 coupon payments will grow with compound interest rate of
6% to $2,758.92 .
o FV of 20-yr $75 annuity:
$75
𝐶 × 𝐹𝑉𝐹 6%, 20 − 1 = (1 + 6%) −1 = $2,758.92
.6%
 Therefore, $980 investment would in 20 years grow to $3,725.37
(= $966.45 + $2,758.92).
Holding period return
 This corresponds to an annualized compound return of 6.9%
𝑉 1+𝑟 =𝑉
$980 1 + 𝑟 = $3,725.37
𝑟 = 0. 069 𝑜𝑟 6.9%
 The holding period return includes capital loss (from a fall in
price due to higher 𝑦𝑡𝑚) and compounded income from
coupon payments (at 6%).
Holding period return
 In general, as interest rates change, bond investors are subject
to 2 sources of offsetting risk:
o Price risk – when rates rise, bond prices fall, reducing portfolio
value. (And vice-versa.)
o Reinvestment risk – when rates rise, reinvested coupon income
will compound more rapidly at the higher rate, offsetting the
impact of price risk. (And vice-versa.)
 Knowing this, one can tailor bond portfolios by balancing risk!
YTM and HPR
When 𝑦𝑡𝑚 is unchanged over the investment period, the HPR will
equal 𝑦𝑡𝑚.
 Example: Bond issued when interest rate was 7% and annual
coupon rate set at 7%. Suppose you now have 3 years left in the
bond’s  life  and  the  interest  rate  is  8%.
$ ,
o Bond price today: 𝑃 = $70 × 𝐴𝐷𝐹 8%, 3 + =
%
$974.23 < 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒
$ ,
o Bond price next year: 𝑃 = $70 × 𝐴𝐷𝐹 8%, 2 + =
%
$982.17
o This  yields  “capital  gain”  of    $7.94 = $982.17 − $974.23
YTM and HPR
o If an investor had purchased the bond at $974.23, the total
return over the year would be:
$70 + $7.94 = $77.94
o This represents an 𝑅𝑂𝑅 = $77.94/$974.23 = 8% (exactly the
current ROR available elsewhere in the market!
o This should not be surprising. The bond must offer an ROR
competitive with those available on other securities!
YTM and HPR
However,  when  yields  fluctuate,  so  will  the  bond’s  HPR.
o Rise  in  bond’s  yield  acts  to  reduce  its  price,  HPR  would  be  less  than  
the initial 𝑦𝑡𝑚.
o Decline  in  bond’s  yield  acts  to  increase  its  price,  HPR  would  be  
greater than the initial 𝑦𝑡𝑚.
YTM and HPR
 Example: 30-yr bond with annual coupon of $80 (8% coupon rate) and
selling at par value of $1,000. Bond’s  𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑦𝑡𝑚 = 8%.
o We already know that if yield remains at 8% over the year, the bond price
will remain at par, so HPR will also be 8%.
o But what if yield rises above 8%?
• If 𝑦𝑡𝑚 rises to 8.5%:
$ ,
𝑃 = $80 × 𝐴𝐷𝐹 8.5%, 29 + = $946.7
. %
• We know that the bond initially sold at $1,000 when issued at the start of
the year, hence HPR is:
$ ($ . $ , )
𝐻𝑃𝑅 = = .0267 𝑜𝑟 2.67% < 8% 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑦𝑡𝑚
$ ,
• At higher yield, price and return would be lower.
YTM and HPR
 Example: 30-yr bond with annual coupon of $80 (8% coupon rate) and
selling at par value of $1,000. Bond’s  𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑦𝑡𝑚 = 8%.
o We already know that if yield remains at 8% over the year, the bond price
will remain at par, so HPR will also be 8%.
o But what if yield falls below 8%?
• If 𝑦𝑡𝑚 falls to around 7.57%:
$ ,
𝑃 = $80 × 𝐴𝐷𝐹 7.57%, 29 + = $1050
. %
• The bond initially sold at $1,000 when issued at the start of the year,
hence HPR is:
$ ($ , $ , )
𝐻𝑃𝑅 = = .13 𝑜𝑟 13% > 8% 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑦𝑡𝑚
$ ,
• At lower yield, price and return would be higher.
YTM vs. HPR
YTM
 𝑦𝑡𝑚 is the average return if the
bond is held to maturity.
 𝑦𝑡𝑚 depends on coupon rate,
maturity, and par value.
 All of these are readily observable.
HPR
 HPR is the rate of return over a
particular investment period.
 HPR  depends  on  the  bond’s  price
at the end of the holding period,
an unknown future value.
 HPR can only be forecasted.
Yield to Call
 𝑦𝑡𝑚 is calculated on the assumption that the bond will be held until
maturity.
 What if the bond is callable and may be retired prior to maturity date?
 Example: 30-year bond with par value of $1,000 and 8% coupon rate
callable at 110% of par value (or $1,100, known as the call price).
 When  interest  rates  fall,  the  present  value  of  the  bond’s  scheduled  
payment rises, but the call provision allows the issuer to repurchase the
bond at the call price.

14-22
Yield to Call
 If PV > call price, the issuer may call the bond back from the
bondholder.
 Therefore, analysts might be more interested in the yield-to-call
(𝑦𝑡𝑐).
 𝑦𝑡𝑐 is calculated just like 𝑦𝑡𝑚 except that the time until call
replaces time until maturity and the call price replaces par value.
 Premium bonds are more likely to be called than discount bonds
(which have an implicit form of call protection if deeply
discounted). Why?

14-23
Bond Prices: Callable and Straight Debt

14-24
Yield to Call
 If interest rates fall, the price of a straight bond can rise
considerably.
 The price of the callable bond is flat over a range of low interest
rates because the risk of repurchase or call is high.
 When interest rates are high, the risk of call is negligible and the
values of the straight and the callable bond converge.

14-25
Other Derivatives
 Note: Mortgage-backed securities and callable bonds can also be considered as
derivative instruments
 MBS
o This instrument behaves like a regular bond with predetermined coupons but
with risk of prepayment (at any time before the end of the mortgage term, the
house buyer can pay off the mortgage, which usually happens when interest rates
are falling)
o Hence, for a buyer of MBS, equivalent to buying a standard bond with fixed
coupon and writing an American call option on the bond with a strike price equal
to the principal
 Callable bonds
o With fixed interest rate and maturity, but debtor has the possibility to repay the
principal after some date prior to the scheduled maturity
o As in MBS, a callable bond behaves like a standard bond minus a call on the bond