CHAPTER FOUR
BOND FUNDAMENTALS
1
© 2001 South-Western College Publishing
Outline

Bond Principles
 Identification
of Bonds
 Classification of Bonds
 Terms of Repayment
 Bond Cash Flows
 Convertible and Exchangeable Bonds
 Registration

The Financial Page Listing
 Basic
Information
 Footnotes
 Government Bonds
2
Outline

Bond Pricing and Returns
 Valuation
Equations
 Yield to Maturity
 Spot Rates
 Realized Compound Yield
 Current Yield
 Accrued Interest

Bond Risks
 Price
Risks
 Convenience Risks
3
Bond Principles: Identification of Bonds

Bonds are identified by issuer, coupon rate,
and maturity.

The face value of a bond is called its par
value.

e.g. 5 of “Hertz sevens of 03” (Hertz 7s03)

A legal document called the indenture
contains the details of the bond issue.
4
Bond Principles: Classification of Bonds
Method 1: By issuer
a. government e.g. US Treasury, federal agency,
state, local
b. corporation e.g. industrial, utility, financial,
transportation
c. others e.g. foreign government, foreign
corporation, World Bank
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Bond Principles: Classification of Bonds
Method 2: By security
a. unsecured debt - backed by faith in the taxing
power of the government, or the good name of
the company (debenture)
b. secured debt e.g. revenue bond, assessment
bond, mortgage, collateral trust bond,
equipment trust certificate
Bond security sometimes comes from non-traditional
sources. Some rock stars floated bonds using
their future earnings as backing.
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Bond Principles: Classification of Bonds
Method 3: By term
a. short-term ( a year) e.g. US Treasury bills
b. intermediate-term e.g. US Treasury notes
(2 to 10 years )
c. long-term e.g. US Treasury bonds ( 10 years)
d. open-ended e.g. corporate line of credit
e. serial bond - a portfolio of bonds with
staggered terms
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Bond Principles: Terms of Repayment
interest only - the periodic payments are
entirely interest
 sinking fund - periodically, a portion of the
debt principal is set aside or a
certain number of the bonds is
retired
 balloon loan - the debt may be partially
amortized with each payment
 income bond- interest is payable only if it is
earned

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Bond Principles: Bond Cash Flows
annuities - most bonds are annuities plus an
ultimate repayment of principal
 zero coupon - only the par value is returned
at maturity
 variable (adjustable) rate - the rate fluctuates
in accordance with some market
index or predetermined schedule
 consols - a level rate of interest is paid
perpetually
 inflation-indexed Treasury bonds - the
principal value is adjusted based
on the consumer price index

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Bond Principles: Options

convertible bond - may be exchanged for
common stock in the
company that issued the
bond

exchangeable bond - may be exchanged for
shares in another firm
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Bond Principles: Registration

bearer (coupon) bonds - belong to whomever
legally hold them; no longer
issued in the United States
because of tax considerations

registered bonds - the bonds show the
bondholder’s name

book entry bonds - bond ownership is
reflected only in the
accounting records
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The Financial Page Listing
Basic
Information
Footnotes
Government
Bonds
Bonds
AMR 9s16
Cur
Yld
8.4
cv - convertible
vj - bankruptcy
f - trading flat
Net
Vol Close
Chg.
23 107 + ¾
zr - zero coupon
dc - deep discount
Maturity
Ask
Rate Mo/Yr Bid Asked Chg. Yld.
6 Feb 26 86:09 86:11 - 9 7.11
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Bond Pricing & Returns: Valuation Equations
1. Annuities
The bond pricing relationship is customarily
expressed in terms of semiannual periods.
current bond price  PV(interest)  PV(princip al)
n

interest par value

t
r
r n
1

1

t 1
2
2
where n  term of the bond in semiannual periods
r  discount rate
t  time in semiannual periods from the present




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Bond Pricing & Returns: Valuation Equations
2. Zero Coupon Bonds
current bond price  PV(princip al) 
par value
1 r  n
3. Variable Rate Bonds
n

cash flow at time t
current bond price 
1  r t  t
t 1


2


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Bond Pricing & Returns: Valuation Equations
4. Consols

current bond price 

t 1
cash flow at time t
1  r  t
cash flow at time t

r
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Bond Pricing & Returns: Yield to Maturity
The yield to maturity is the single interest rate
that, when applied to the stream of cash flows
associated with a bond, causes the present
value of those cash flows to equal the bond’s
market price.
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Bond Pricing & Returns: Yield to Maturity
A heuristic:

market price - par value
annual interest YTM approx 

years until maturity
0.6(market price)  0.4(par value)
The yield to maturity calculation carries an
assumption that coupon proceeds are
reinvested at the yield to maturity.
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Bond Pricing & Returns: Yield to Maturity

If a bond pays periodic interest, it is not
possible to lock in a prescribed yield to
maturity.

A plot of interest rates against time to
maturity is known as a yield curve.
yield
time
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Bond Pricing & Returns: Spot Rates

A spot rate is the yield to maturity of
a zero coupon security of the
chosen maturity.

A treasury strip is a government bond or note
that has been decomposed into two parts, one
for the stream of interest payments and one
for the return of principal at maturity.

The yield to maturity is a derived statistic after
the bond price is known.
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Bond Pricing & Returns: Spot Rates

The yield to maturity can be thought of as an
“average” of the spot rates, or as a flat yield
curve at some constant interest rate.

This single interest rate makes the present
value of the future cash flows equal to the
bond’s market price.
%
Spot Rate Curve
Yield to Maturity
Term
20
Bond Pricing & Returns
How can two investments paying
interest on two different time
schedules be compared?
Realized Compound Yield:
x
r 

effective annual rate   1    1
x

where r  yield to maturity
x  number of payments per year
21
Bond Pricing & Returns: Current Yield

The current yield only measures the return
associated with the bond’s interest
payments.

A bond whose market price is less than its
par value is selling at a discount. The price
of such bonds rise as maturity
approaches.

If the market price is more than the par
value, the bond sells at a premium.
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Bond Pricing & Returns: Accrued Interest

Interest is earned for each day that a bond
is held, although interest payments are
generally made twice a year only.

A bond buyer must pay the accrued interest
to the seller of the bond.

dirty price = bond price + accrued interest
clean price = bond price

By convention, accrued interest is
calculated using a 360-day year.
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Bond Risks: Price Risks

default risk - the possibility that the issuer
of the bond is unable to pay
- rated by agencies like Moody’s
and Standard & Poor’s

interest rate risk - the chance of loss due to
changing interest rates
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Bond Risks: Convenience Risks

call risk - the possibility that the company
will exercise a bond’s call feature

reinvestment rate risk - the chance that the
interest received cannot be
reinvested to earn as much as the
bond’s original yield to maturity
- the higher the coupon on a bond,
the higher its reinvestment rate risk

marketability risk - the difficulty of selling a
bond in the secondary
market
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Review

Bond Principles
 Identification
of Bonds
 Classification of Bonds
 Terms of Repayment
 Bond Cash Flows
 Convertible and Exchangeable Bonds
 Registration

The Financial Page Listing
 Basic
Information
 Footnotes
 Government Bonds
26
Review

Bond Pricing and Returns
 Valuation
Equations
 Yield to Maturity
 Spot Rates
 Realized Compound Yield
 Current Yield
 Accrued Interest

Bond Risks
 Price
Risks
 Convenience Risks
27