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BOND VALUATION AND BOND YIELDS

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Bondsandtheirvariantssuchasloannotes,debenturesandloanstock,areIOUsissuedbygovernments
andcorporationsasameansofraisingfinance.Theyareoftenreferredtoasfixedincomeorfixed
interestsecurities,todistinguishthemfromequities,inthattheyoften(butnotalways)makeknown
returnsfortheinvestors(thebondholders)atregularintervals.Theseinterestpayments,paidasbond
coupons,arefixed,unlikedividendspaidonequities,whichcanbevariable.Mostcorporatebondsare
redeemableafteraspecifiedperiodoftime.Thus,aplainvanillabondwillmakeregularinterest
paymentstotheinvestorsandpaythecapitaltobuybackthebondontheredemptiondatewhenit
reachesmaturity.

Thisarticle,thefirstoftworelatedarticles,willconsiderhowbondsarevaluedandtherelationship
betweenthebondvalueorprice,theyieldtomaturityandthespotyieldcurve.Itaddresses,inpart,the
learningrequiredinSectionsC3aandC3dofthePaperP4SyllabusandStudyGuide.

Bondvalueorprice

Example1

Howmuchwouldaninvestorpaytopurchaseabondtoday,whichisredeemableinfouryearsforitspar
valueorfacevalueof$100andpaysanannualcouponof5%ontheparvalue?Therequiredrateof
return(oryield)forabondinthisriskclassis4%.

Aswithanyassetvaluation,theinvestorwouldbewillingtopay,atthemost,thepresentvalueofthe
futureincomestreamdiscountedattherequiredrateofreturn(oryield).Thus,thevalueofthebondcan
bedeterminedasfollows:

Iftherequiredrateofreturn(oryield)was6%,thenusingthesamecalculationmethod,thepriceofthe
bondwouldbe$96.53.Andwheretherequiredrateofreturn(oryield)isequaltothecoupon5%inthis
casethecurrentpriceofthebondwillbeequaltotheparvalueof$100.

Thus,thereisaninverserelationshipbetweentheyieldofabondanditspriceorvalue.Thehigherrate
ofreturn(oryield)required,thelowerthepriceofthebond,andviceversa.However,itshouldbenoted
thatthisrelationshipisnotlinear,butconvextotheorigin.

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Theplainvanillabondwithannualcouponpaymentsintheaboveexampleisthesimplertypeofbond.In
additiontotheplainvanillabond,candidatesaspartoftheirPaperP4studiesandexamarerequired
tohaveknowledgeof,andbeabletodealwith,morecomplicatedbondssuchas:bondswithcoupon
paymentsoccurringmorefrequentlythanonceayearconvertiblebondsandbondswithwarrantswhich
containoptionfeaturesandmorecomplicatedpaymentfeaturessuchasrepaymentmortgageorannuity
typepaymentstructures.

Yieldtomaturity(YTM)(alsoknownasthe[Gross]RedemptionYield(GRY))
Ifthecurrentpriceofabondisgiven,togetherwithdetailsofcouponsandredemptiondate,thenthis
informationcanbeusedtocomputetherequiredrateofreturnoryieldtomaturityofthebond.

Example2

Abondpayingacouponof7%isredeemableinfiveyearsatpar($100)andiscurrentlytradingat
$106.62.Estimateitsyield(requiredrateofreturn).

Theinternalrateofreturnapproachcanbeusedtoobtainr.Sincethecurrentpriceishigherthan$100,r
mustbelowerthan7%.

Initially,try5%asr:

$7x4.3295[5%,fiveyearannuity]+$100x0.7835[PV5%,fiveyear]=$30.31+$78.35=$108.66

Try6%asr:
$7x4.2124[6%,fiveyearannuity]+$100x0.7473[PV6%,fiveyear]=
$29.49+$74.73=$104.22

Yield=5%+(108.66106.62/108.66104.22)x1%=5.46%

The5.46%istheyieldtomaturity(YTM)(orredemptionyield)ofthebond.TheYTMistherateofreturn
atwhichthesumofthepresentvaluesofallfutureincomestreamsofthebond(interestcouponsand
redemptionamount)isequaltothecurrentbondprice.Itistheaverageannualrateofreturnthebond
investorsexpecttoreceivefromthebondtillitsredemption.YTMsforbondsarenormallyquotedinthe
financialpress,basedontheclosingpriceofthebond.Forexample,ayieldoftenquotedinthefinancial
pressisthebidyield.ThebidyieldistheYTMforthecurrentbidprice(thepriceatwhichbondscanbe
purchased)ofabond.

Termstructureofinterestratesandtheyieldcurve
Theyieldtomaturityiscalculatedimplicitlybasedonthecurrentmarketprice,thetermtomaturityofthe
bondandamount(andfrequency)ofcouponpayments.However,ifacorporatebondisbeingissuedfor
thefirsttime,itspriceand/orcouponpaymentsneedtobedeterminedbasedontherequiredyield.The
requiredyieldisbasedonthetermstructureofinterestratesandthisneedstobediscussedbefore
consideringhowthepriceofabondmaybedetermined.

Itisincorrecttoassumethatbondsofthesameriskclass,whichareredeemedondifferentdates,would
havethesamerequiredrateofreturnoryield.Infact,itisevidentthatthemarketsdemanddifferent
annualreturnsoryieldsonbondswithdifferinglengthsoftimebeforetheirredemption(ormaturity),even
wherethebondsareofthesameriskclass.Thisisknownasthetermstructureofinterestratesandis
representedbythespotyieldcurveorsimplytheyieldcurve.

Forexample,acompanymayfindthatifitwantstoissueaoneyearbond,itmayneedtopayinterestat
3%fortheyear,ifitwantstoissueatwoyearbond,themarketsmaydemandanannualinterestrateof
3.5%,andforathreeyearbondtheannualyieldrequiredmaybe4.2%.Hence,thecompanywould
needtopayinterestat3%foroneyear3.5%eachyear,fortwoyears,ifitwantstoborrowfundsfortwo
yearsand4.2%eachyear,forthreeyears,ifitwantstoborrowfundsforthreeyears.Inthiscase,the
termstructureofinterestratesisrepresentedbyanupwardslopingyieldcurve.

Thenormalexpectationwouldbeofanupwardslopingyieldcurveonthebasisthatbondswithalonger
periodofmaturitywouldrequireahigherinterestrateascompensationforrisk.Noteherethatthebonds
consideredmaybeofthesameriskclassbutthelongertimeperiodtomaturitystilladdstohigher
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uncertainty.

However,itisentirelynormalforyieldcurvestobeofmanydifferentshapesdependentonthe
perceptionsofthemarketsonhowinterestratesmaychangeinthefuture.Threemaintheorieshave
beenadvancedtoexplainthetermstructureofinterestratesortheyieldcurve:expectationshypothesis,
liquiditypreferencehypothesisandmarketsegmentationhypothesis.Althoughitisbeyondtheremitof
thisarticletoexplainthesetheories,manytextbooksoninvestmentsandfinancialmanagementcover
theseindetail.

Valuingbondsbasedontheyieldcurve
Annualspotyieldcurvesareoftenpublishedbythefinancialpressorbycentralbanks(forexample,the
BankofEnglandregularlypublishesUKgovernmentbondyieldcurvesonitswebsite).Thespotyield
curvecanbeusedtoestimatethepriceorvalueofabond.

Example3
Acompanywantstoissueabondthatisredeemableinfouryearsforitsparvalueorfacevalueof$100,
andwantstopayanannualcouponof5%ontheparvalue.Estimatethepriceatwhichthebondshould
beissued.

Theannualspotyieldcurveforabondofthisriskclassisasfollows:
Oneyear3.5%
Twoyear4.0%
Threeyear4.7%
Fouryear5.5%

Thefouryearbondpaysthefollowingstreamofincome:

Year1234
Payments$5$5$5$105

Thiscanbesimplifiedintofourseparatebondswiththefollowingpaymentstructure:

Year1234
Bond1$5
Bond2$5
Bond3$5
Bond4$105

Eachannualpaymentisasinglepaymentinthatparticularyear,muchlikeazerocouponbond,andits
presentvaluecanbedeterminedbydiscountingeachcashflowbytherelevantyieldcurverate,as
follows:

Thesumoftheseflowsisthepriceatwhichthebondcanbeissued,$98.57.

Theyieldtomaturityofthebondisestimatedat5.41%usingthesamemethodologyasexample2.

Someimportantpointscanbenotedfromtheabovecalculationfirstly,the5.41%islowerthan5.5%
becausesomeofthereturnsfromthebondcomeinearlieryears,whentheinterestratesontheyield
curvearelower,butthelargestproportioncomesinYear4.Secondly,theyieldtomaturityisaweighted
averageofthetermstructureofinterestrates.Thirdly,theyieldtomaturityiscalculatedafterthepriceof
thebondhasbeencalculatedorobservedinthemarkets,buttheoreticallyitistermstructureofinterest
ratesthatdeterminesthepriceorvalueofthebond.

Mathematically:

Inthisarticleitisassumedthatcouponsarepaidannually,butitiscommonpracticetopaycouponsmore
frequentlythanonceayear.Inthesecircumstances,thecouponpaymentsneedtobereducedandthe
timeperiodfrequencyneedstobeincreased.

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Estimatingtheyieldcurve
Therearedifferentmethodsusedtoestimateaspotyieldcurve,andtheiterativeprocessbasedon
bootstrappingcouponpayingbondsisperhapsthesimplesttounderstand.Thefollowingexample
demonstrateshowtheprocessworks.

Example4
Agovernmenthasthreebondsinissuethatallhaveafaceorparvalueof$100andareredeemablein
oneyear,twoyearsandthreeyearsrespectively.Sincethebondsareallgovernmentbonds,letsassume
thattheyareofthesameriskclass.Letsalsoassumethatcouponsarepayableonanannualbasis.
BondA,whichisredeemableinayearstime,hasacouponrateof7%andistradingat$103.BondB,
whichisredeemableintwoyears,hasacouponrateof6%andistradingat$102.BondC,whichis
redeemableinthreeyears,hasacouponrateof5%andistradingat$98.

Todeterminetheyieldcurve,eachbondscashflowsarediscountedinturntodeterminetheannualspot
ratesforthethreeyears,asfollows:

Theannualspotyieldcurveistherefore:

Year
13.88%
24.96%
35.80%

Discussionofothermethodsofestimatingthespotyieldcurve,suchasusingmultipleregression
techniquesandobservationofspotratesofzerocouponbonds,isbeyondthescopeofthePaperP4
syllabus.

Asstatedintheprevioussection,oftenthefinancialpressandcentralbankswillpublishestimatedspot
yieldcurvesbasedongovernmentissuedbonds.Yieldcurvesforindividualcorporatebondscanbe
estimatedfromthesebyaddingtherelevantspreadtothebonds.Forexample,thefollowingtableof
spreads(inbasispoints)isgivenfortheretailsector.

Rating1year2year3year
AAA142538
AA294155
A466076

Example5
MasonRetailCohasacreditratingofAA,thenitsindividualyieldcurvebasedonthegovernmentbond
yieldcurveandthespreadtableabovemaybeestimatedas:

Year1Year2Year3
4.17%5.37%6.35%

ThesewouldbetheratesofreturnaninvestorbuyingbondsissuedbyMasonRetailCowouldexpect,
andthereforeMasonRetailCowouldusetheseratesasdiscountratestoestimatethepriceorvalueof
couponswhenitissuesnewbonds.AndMasonRetailCosexistingbondsmarketpricewouldreflectits
individualyieldcurve.

Conclusion
Thisarticleconsideredtherelationshipbetweenbondprices,theyieldcurveandtheyieldtomaturity.It
demonstratedhowbondscanbevaluedandhowayieldcurvemaybederivedusingbondsofthesame
riskclassbutofdifferentmaturities.Finallyitshowedhowindividualcompanyyieldcurvesmaybe
estimated.

Afollowingarticlewilldiscusshowforwardinterestratesaredeterminedfromthespotyieldcurveand
howtheymaybeusefulindeterminingthevalueofaninterestrateswap.Itwilladdressthelearning
requiredinSectionsF1andF3ofthePaperP4SyllabusandStudyGuide.

WrittenbythePaperP4examiningteam

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Lastupdated:18Aug2015

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