Unit 3, lesson 17

Bond cash flows and yield mathematics

How a coupon bond is valued from its dated payments, how accrued interest links the clean price to the full price, and when the yield to maturity, an internal rate of return, is unique and a realized return.

  • Video 17
  • Bonds, discount curves and rate sensitivities

A two-year bond with a 5 percent annual coupon promises 5 after one year and 105 after two years per 100 of principal. A dealer can quote it at one number while the buyer pays another, and the bond can be priced to yield 6 percent even though its coupon is 5 percent. Which number is the price, and does the yield tell an investor what the bond will actually return? This lesson values a bond from its dated payments, separates accrued interest from the quoted price, proves that the yield is unique when every payment is positive, and states the extra assumptions under which the yield is a realized compound return.

Key terms

Coupon bond

Definition A fixed-rate coupon bond with principal NN (its face value) and annual coupon rate cc promises coupons on the dates t1<t2<⋯<tn=Tt_1 < t_2 < \dots < t_n = T and the principal at maturity TT. With mm regular coupon periods per year each coupon is cN/mcN/m, but in general the bond’s contract fixes the exact amounts and dates through its payment frequency, accrual rule, business-day adjustment and calendar. Write ckc_k for the coupon due at tkt_k and CkC_k for the whole promised payment at tkt_k, so Ck=ckC_k = c_k for k<nk < n and Cn=cn+NC_n = c_n + N, with times in years from the valuation date. Assume no default, no embedded option, no taxes and no settlement frictions. Then the payments are deterministic, and the value of the bond at time 00 is

V0=∑k=1nCk P(0,tk),V_0 = \sum_{k=1}^{n} C_k \, P(0, t_k),

where the discount factor P(0,t)>0P(0, t) > 0 is today’s price of a default-free zero-coupon bond paying 1 currency unit at tt, in the bond’s currency and under its funding convention. As a function of tt it is today’s discount curve, which is known now and so is a deterministic function of the maturity. A callable bond or a bond that can default has payments that depend on future events, so it is not described by a fixed list of amounts CkC_k, and this formula does not value it.

In plain words A bond is a list of dates and amounts. The coupon rate decides how large the amounts are, and the discount curve decides what each dated amount is worth today. The coupon rate is not the rate at which the payments are discounted.

Example The two-year bond above has N=100N = 100, c=0.05c = 0.05 and one coupon a year, so it pays C1=5C_1 = 5 at t1=1t_1 = 1 and C2=105C_2 = 105 at t2=2t_2 = 2, because the last date carries both the final coupon and the principal. With the constructed discount factors P(0,1)=0.96P(0, 1) = 0.96 and P(0,2)=0.90P(0, 2) = 0.90 of Time value of money and discount functions, its value is

V0=5(0.96)+105(0.90)=4.8+94.5=99.3.\begin{aligned} V_0 &= 5(0.96) + 105(0.90) \\[0.4em] &= 4.8 + 94.5 = 99.3 . \end{aligned}

A bond with the same 5 percent coupon rate paid semiannually pays 2.52.5 at each of the times 0.50.5, 11 and 1.51.5 and 102.5102.5 at time 22. It has a different schedule, so it is a different bond, valued from its own payments and dates.

Accrued interest

Definition Let settlement take place at a date ss inside a regular coupon period, tk−1≤s<tkt_{k-1} \le s < t_k, whose coupon is ckc_k. Under linear accrual the accrued interest is

AI⁡(s)=ck α(tk−1,s)α(tk−1,tk),\operatorname{AI}(s) = c_k \, \frac{\alpha(t_{k-1}, s)}{\alpha(t_{k-1}, t_k)},

where α(a,b)\alpha(a, b) is the day count from date aa to date bb under the bond’s day-count convention, for example the actual number of days under Actual/Actual or a count with 30-day months under 30/360. The fraction is 00 at the start of the period and approaches 11 at its end. The accrued interest is the part of the coming coupon that the convention assigns to the seller, who held the bond during the elapsed part of the period, while the buyer receives the whole coupon at tkt_k. Some bonds have an ex-coupon period just before tkt_k. A buyer who settles in it does not receive the coming coupon, and under such a rule the accrued interest is negative.

In plain words The buyer pays the seller for the share of the current coupon earned while the seller still owned the bond. How much of the period has passed is decided by the day-count convention, and two conventions can give different answers for the same dates.

Example A constructed bond with principal 100100 and a 5 percent coupon paid semiannually has a coupon period from 15 January 2025 to 15 July 2025 with coupon 2.52.5. For settlement on 15 March 2025, Actual/Actual counts 5959 of the 181181 days in the period, so

AI⁡=2.5⋅59181≈0.8149.\operatorname{AI} = 2.5 \cdot \frac{59}{181} \approx 0.8149 .

Under 30/360 the same dates count 6060 of 180180 days, and AI⁡=2.5/3≈0.8333\operatorname{AI} = 2.5/3 \approx 0.8333. The two conventions differ by about 0.01840.0184 per 100 of principal, so a stated accrued interest is meaningful only together with its convention.

Clean price and full price

Definition The full price, also called the dirty or invoice price, at settlement ss is the amount the buyer actually pays. In the default-free model it equals the value at ss of all payments after ss that the buyer will receive. The clean price is the quoted number, and at settlement ss the two are linked by

Vfull=Vclean+AI⁡(s).V^{\text{full}} = V^{\text{clean}} + \operatorname{AI}(s).

Right after a coupon has been paid the accrued interest is 00 and the two prices agree. With an unchanged deterministic curve and no ex-coupon period, the full price falls by ckc_k at the moment the coupon ckc_k is paid, while the accrued interest, which has grown toward ckc_k, falls to 00 at the same moment, so the clean price has no such drop. Present values and yields are computed from the full price, because it is the amount exchanged.

In plain words The full price is what changes hands. The clean price is the full price with the accrued interest taken out, which keeps the quoted number from dropping by a whole coupon every time a coupon is paid.

Example Suppose the full price is 99.399.3 and, by the bond’s day count, 40 percent of a coupon period with coupon 55 has elapsed. The accrued interest is 5⋅0.4=25 \cdot 0.4 = 2, so the clean price is 99.3−2=97.399.3 - 2 = 97.3, and adding the 22 back restores the 99.399.3 the buyer pays. A buyer who compared the clean price 97.397.3 with the value of the remaining payments would understate the cost by 22.

Yield to maturity

Definition Consider a bond at a settlement date with remaining payments C1,…,CnC_1, \dots, C_n at times 0<t1<⋯<tn0 < t_1 < \dots < t_n in years and full price V0V_0. Under annual compounding its price-yield function is

V(y)=∑k=1nCk(1+y)tkV(y) = \sum_{k=1}^{n} \frac{C_k}{(1+y)^{t_k}}

for y>−1y > -1, and a yield to maturity is a number y>−1y > -1 with V(y)=V0V(y) = V_0. With mm compounding periods per year the factor (1+y)−tk(1+y)^{-t_k} is replaced by (1+y/m)−mtk(1 + y/m)^{-m t_k} with y>−my > -m, so a yield is incomplete without its compounding convention. Between coupon dates the exponents are fractional, and the instrument’s convention specifies them.

Uniqueness holds for nonnegative payments. Suppose every Ck≥0C_k \ge 0 and at least one Ck>0C_k > 0. The function VV is continuous on (−1,∞)(-1, \infty), and

V′(y)=−∑k=1ntkCk(1+y)tk+1<0,\begin{aligned} V'(y) &= -\sum_{k=1}^{n} \frac{t_k C_k}{(1+y)^{t_k + 1}} \\[0.4em] &< 0, \end{aligned}

so VV is strictly decreasing. As yy decreases to −1-1 every positive term grows without bound, and as y→∞y \to \infty every term tends to 00. By the intermediate value theorem, each full price V0>0V_0 > 0 has exactly one yield, and a price V0≤0V_0 \le 0 has none. Since V(0)=∑kCkV(0) = \sum_k C_k, the yield is positive exactly when the price is below the undiscounted sum of the payments, zero when it equals that sum and negative when it exceeds it.

At a coupon date, a bond with regular annual periods and coupon rate c>0c > 0 is priced at par at the yield y=cy = c under annual compounding, because the geometric sum gives

V(c)=∑k=1ncN(1+c)k+N(1+c)n=N(1−(1+c)−n)+N(1+c)−n=N.\begin{aligned} V(c) &= \sum_{k=1}^{n} \frac{cN}{(1+c)^{k}} \\[0.4em] &\quad + \frac{N}{(1+c)^{n}} \\[0.4em] &= N\bigl(1 - (1+c)^{-n}\bigr) \\[0.4em] &\quad + N(1+c)^{-n} = N . \end{aligned}

With strict monotonicity, such a bond is priced below par exactly when y>cy > c and above par exactly when y<cy < c. The same holds with mm coupons a year and a yield compounded mm times a year. Irregular periods, amortizing principal or settlement between coupon dates break this cancellation.

In plain words The yield is the one flat rate that reproduces this bond’s full price. It summarizes one schedule at one price, so bonds valued with the same discount curve usually have different yields, and the yield of one bond is not a discount rate for another.

Example At a coupon date the bond paying 55 and 105105 has, at y=0.06y = 0.06, the price

V(0.06)=51.06+1051.062≈4.716981+93.449626≈98.166607.\begin{aligned} &V(0.06) = \frac{5}{1.06} + \frac{105}{1.06^2} \\[0.4em] &\approx 4.716981 + 93.449626 \\[0.4em] &\approx 98.166607 . \end{aligned}

This is below par because the yield exceeds the coupon rate, and indeed V(0.05)=100V(0.05) = 100. Going backwards, V(0)=110V(0) = 110 and V(0.2)≈77.083V(0.2) \approx 77.083 lie on opposite sides of 98.16660798.166607, so the yield lies between 00 and 0.20.2, and because VV is continuous and decreasing, repeatedly halving this bracket converges to 0.060.06. Under the curve with P(0,1)=0.96P(0, 1) = 0.96 and P(0,2)=0.90P(0, 2) = 0.90 from the first card, the one-year zero-coupon bond yields about 4.1667 percent, the two-year zero-coupon bond about 5.4093 percent and the coupon bond priced at 99.399.3 about 5.3785 percent, three yields from one curve.

Internal rate of return

Definition Let an investment have cash flows X0,X1,…,XnX_0, X_1, \dots, X_n at times 0=t0<t1<⋯<tn0 = t_0 < t_1 < \dots < t_n, positive when the investor receives money and negative when the investor pays. An internal rate of return is a rate r>−1r > -1 with zero net present value under annual compounding,

∑k=0nXk(1+r)tk=0.\sum_{k=0}^{n} \frac{X_k}{(1+r)^{t_k}} = 0 .

The yield to maturity is the internal rate of return of buying the bond at its full price and receiving every promised payment, the sequence (−V0,C1,…,Cn)(-V_0, C_1, \dots, C_n). When X0<0X_0 < 0 and all later cash flows are nonnegative with at least one positive, the argument of the previous card shows that exactly one internal rate of return exists. When the signs change more than once, there can be several or none. For cash flows at whole years, the substitution x=1/(1+r)x = 1/(1+r) turns the net present value into a polynomial in x>0x > 0, and Descartes’s rule of signs then says that the number of internal rates of return in (−1,∞)(-1, \infty), counted with multiplicity, is at most the number of sign changes in the sequence of nonzero cash flows and differs from it by an even number.

In plain words An internal rate of return is a constant rate at which the discounted inflows and outflows of a deal cancel. If money goes out only at the start and only comes back afterwards, there is exactly one such rate. Once money has to go out again later, the equation can have two answers or none, and a single quoted rate hides that.

Example A constructed contract costs 100100 now, pays 230230 after one year and requires the holder to pay 132132 after two years. Its net present value

NPV⁡(r)=−100+2301+r−132(1+r)2\begin{aligned} \operatorname{NPV}(r) &= -100 + \frac{230}{1+r} \\[0.4em] &\quad - \frac{132}{(1+r)^2} \end{aligned}

is zero at r=0.10r = 0.10 and at r=0.20r = 0.20, two internal rates of return, matching the two sign changes in (−100,230,−132)(-100, 230, -132). If the contract instead paid 150150 after one year and required 100100 after two, the net present value would be −100+150x−100x2-100 + 150x - 100x^2 with x=1/(1+r)x = 1/(1+r). Its largest value over x>0x > 0 is −43.75-43.75, at x=0.75x = 0.75, so that contract has no internal rate of return at all.

Reinvestment assumption

Definition The yield is defined by the price equation alone, and no assumption about reinvestment is needed to define it. It becomes a realized return only under further assumptions. Suppose the bond is bought at the full price V0V_0 at time 00 and held to maturity T=tnT = t_n, every promised payment is received on its date, each payment received before TT is reinvested until TT at the constant annual rate yy, the bond’s own yield, and there are no costs or taxes. Then the wealth at TT is

WT=∑k=1nCk(1+y)T−tk=(1+y)T V(y)=(1+y)T V0,\begin{aligned} W_T &= \sum_{k=1}^{n} C_k (1+y)^{T - t_k} \\[0.4em] &= (1+y)^{T} \, V(y) \\[0.4em] &= (1+y)^{T} \, V_0 , \end{aligned}

so the realized annual compound return (WT/V0)1/T−1(W_T / V_0)^{1/T} - 1 equals yy. For nonnegative payments reinvested instead at a constant rate ρ>−1\rho > -1, the wealth WTW_T is strictly increasing in ρ\rho as long as some positive payment arrives before TT. The realized return is then above yy when ρ>y\rho > y and below yy when ρ<y\rho < y. A sale before maturity at a market price, a late or missed payment, or a default also changes the realized return.

In plain words A yield is a property of a price, not a forecast of what an investor will earn. The investor earns it by holding to maturity, being paid in full and reinvesting every coupon at that same yield. A zero-coupon bond held to maturity has nothing to reinvest, so without default its yield is exactly its realized return.

Example Bought at 98.16660798.166607 at a coupon date, the bond paying 55 and 105105 yields 6 percent. Reinvesting the first coupon for one year at 6 percent gives W2=5(1.06)+105=110.3W_2 = 5(1.06) + 105 = 110.3, which equals 98.166607⋅1.06298.166607 \cdot 1.06^2, a realized return of exactly 6 percent a year. Reinvesting at 2 percent gives W2=110.1W_2 = 110.1 and a realized return of about 5.904 percent a year, while reinvesting at 10 percent gives W2=110.5W_2 = 110.5 and about 6.096 percent. The price, and so the yield, is the same in all three cases.

Check yourself

  1. A bond pays an annual coupon of 66 per 100 of principal. Settlement falls 7373 days into a coupon period of 365365 days, the day count is Actual/Actual with linear accrual, and the buyer pays a full price of 101.5101.5. Find the accrued interest and the clean price.
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The elapsed fraction of the period is 73/365=0.273/365 = 0.2, so the accrued interest is

AI⁡=6⋅73365=1.2.\operatorname{AI} = 6 \cdot \frac{73}{365} = 1.2 .

The clean price is the full price minus the accrued interest, 101.5−1.2=100.3101.5 - 1.2 = 100.3. The full price 101.5101.5 is what the buyer pays, and it is the number a yield calculation must reproduce.

  1. A three-year bond with principal 100100 pays a 4 percent annual coupon. At a coupon date it is priced to yield 5 percent with annual compounding. Find its price and explain without further computation why it is below par. An investor buys it, holds it to maturity, is paid in full and reinvests both coupons at 3 percent. What annual return does the investor realize?
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The price is

V(0.05)=41.05+41.052+1041.053≈3.809524+3.628118+89.839110≈97.276752.\begin{aligned} &V(0.05) = \frac{4}{1.05} + \frac{4}{1.05^2} \\[0.4em] &\quad + \frac{104}{1.05^3} \\[0.4em] &\approx 3.809524 + 3.628118 \\[0.4em] &\quad + 89.839110 \\[0.4em] &\approx 97.276752 . \end{aligned}

At the yield 0.040.04, equal to the coupon rate, the bond would be priced at par, and the price is strictly decreasing in the yield because all payments are positive, so the yield 0.050.05 gives a price below 100100. With reinvestment at 3 percent the wealth at year 3 is

W3=4(1.03)2+4(1.03)+104=4.2436+4.12+104=112.3636.\begin{aligned} W_3 &= 4(1.03)^2 + 4(1.03) \\[0.4em] &\quad + 104 \\[0.4em] &= 4.2436 + 4.12 + 104 \\[0.4em] &= 112.3636 . \end{aligned}

The realized return is (112.3636/97.276752)1/3−1≈0.049234(112.3636/97.276752)^{1/3} - 1 \approx 0.049234, about 4.923 percent a year, below the 5 percent yield. Reinvestment at 5 percent would give W3=112.61=97.276752⋅1.053W_3 = 112.61 = 97.276752 \cdot 1.05^3 and exactly 5 percent.

  1. A contract costs 100100, pays 230230 after one year, and requires the holder to pay 132132 after two years. A colleague writes its price-yield function V(y)=230/(1+y)−132/(1+y)2V(y) = 230/(1+y) - 132/(1+y)^2, notes that V(0)=98V(0) = 98 and V(0.15)≈100.189V(0.15) \approx 100.189 lie on opposite sides of 100100, bisects on the interval from 00 to 0.150.15 and reports the yield as 10 percent. The colleague adds that, as for any bond, a higher yield means a lower price. What is wrong?
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The root at 10 percent is genuine, since V(0.1)=209.0909−109.0909=100V(0.1) = 209.0909 - 109.0909 = 100. The error is to call it the yield. The uniqueness theorem needs every payment to be nonnegative, and here the holder must pay 132132 at year 2. In fact V(0.2)=191.6667−91.6667=100V(0.2) = 191.6667 - 91.6667 = 100 as well, so the contract has two internal rates of return, as the two sign changes in (−100,230,−132)(-100, 230, -132) allow. The derivative

V′(y)=264−230(1+y)(1+y)3V'(y) = \frac{264 - 230(1+y)}{(1+y)^{3}}

is positive for y<264/230−1≈0.1478y < 264/230 - 1 \approx 0.1478 and negative above it. The price rises with the yield up to a maximum of about 100.189100.189 and then falls, so the statement that a higher yield means a lower price is false here, and the bisection merely found the root inside the bracket it was given. The contract should be described by both roots or, better, valued with a discount curve.

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