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Treasury Finance and Development Banking: A Guide to Credit, Debt, and Risk, + Website by Biagio Mazzi

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CHAPTER 5

Bond Pricing

We have built all the tools needed to approach the topic that is at the center of any discussion of credit and the activity of a treasury: debt. We have seen how to generate and discount future cash flows, we have seen how a choice of discounting is highly sensitive to the credit environment, and we have explicitly discussed credit. It is now time to use this knowledge to observe and price debt instruments.

In order to build a self-contained narrative we shall begin with an introduction to the basic concepts surrounding a bond. We shall then move on to the very important issue of trying to isolate the credit component of a bond in a more or less explicit way; we shall present the concepts of benchmarks, asset swaps (introduced here and revisited in the following chapters); and an analysis of the relationship between bonds and credit default swaps. We shall conclude with a section on how to price distressed and/or highly illiquid bonds and one where this final topic is presented through a numerical example.

5.1 WHAT IS A BOND?

We have defined a bond as a way for an entity to raise capital without relinquishing control. Bonds are among the oldest financial instruments and among the first types of securitization,1 a way of turning the scattered revenues of a government or a corporation into a well-defined and tradable instrument. An entity forecasts a fairly regular set of revenues (from sales for a company or from taxes and investments for a government) but ...

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