How to calculate the net present value of a bond's coupon

Published on the Financial Times website on 31 October 2008

www.ft.com/cms/s/0/103e69c6-a6ec-11dd-95be-000077b07658.html

From Mr James Lockyer

Sir, Hans Byström (Letters, October 29) says that the net present value of a bond’s coupon "most likely is close to the net present value of the cost of insuring against the bond defaulting". Surely not.

It is routine to disaggregate the yield to maturity (coupons plus capital gain) on a bond into five components: the real risk-free rate (government bond rate), the inflation premium, the liquidity premium (corporate bonds are less liquid than government bonds), a maturity premium (though this may be disputed by some), and a premium to cover the risk of default. So for coupon-paying bonds trading at or close to par, we may expect the net present value of the coupons to be much greater than the cost of credit insurance: say 5 per cent risk-free, plus 3 per cent inflation, 1 per cent liquidity and maturity, and ¼ per cent to 6 per cent for default risk – the latter being only 3 to 40 per cent of the coupon. Only this last element should be reflected in the cost of credit default swaps.

The unreliability of CDS prices as an indicator of credit risk and the limited number of CDS providers in the market are separate issues.

James Lockyer,
Director of Education,
Association of Corporate Treasurers,
London EC2, UK