Professional Documents
Culture Documents
CORPORATE FINANCE
Laurence Booth W. Sean Cleary
Prepared by
Ken Hartviksen and Robert Ironside
CHAPTER 6
Bond Valuation and Interest
Rates
Lecture Agenda
Learning Objectives
Important Terms
Basic Structure of Bonds
Valuing Bonds
Bond Yields
Interest Rate Determinants
Other Types of Bonds/Debt Instruments
Summary and Conclusions
6-3
Learning Objectives
6-4
Balloon payment
Bills
Bond indenture
Bullet payment
Call prices
Callable bonds
Canada Savings Bonds
Collateral trust bonds
Coupons
Current yield
Debentures
Debt ratings
Default free
Default risk
Discount (premium)
Duration
Equipment trust certificates
Expectations theory
Extendible bonds
Face value
Floating rate bonds
Interest payments
Interest rate parity (IRP)
theory
Interest rate risk
Issue-specific premiums
Liquidity preference theory
Maturity value
6-5
Mortgage bonds
Nominal interest rates
Notes
Paper
Par value
Protective covenants
Purchase fund provisions
Real return bonds
Retractable bonds
Risk-free rate
Sinking fund provisions
Spread
Term structure of
interest rates
Term to maturity
Yield curve
Yield to maturity
Zero coupon bond
6-6
What is a Bond?
In its broadest sense, a bond is any debt
instrument that promises a fixed income
stream to the holder
Fixed income securities are often classified
according to maturity, as follows:
6-8
6-9
6 - 10
6 - 11
00
11
II
22
II
33
II
II
nn
II
FF
6 - 12
Purchase Coupon
Price
Cash Outflows
to the Investor
Coupon
Coupon
Coupon
Coupon +
Face Value
Cash Inflows
to the Investor
6 - 13
Bond Indenture
The bond indenture is the contract between
the issuer and the holder. It specifies:
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6 - 19
6 - 20
Bond Valuation
Annual Coupon Payments
Bond Valuation and Interest Rates
Bond Valuation
The value of a bond is a function of:
6 - 22
Bond Value
General Formula
[ 6-1]
1
1 ( 1 k )n
b
B I
kb
1
F
n
(
1
k
)
Where:
I = interest (or coupon ) payments
kb = the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond
6 - 23
1 1 kb n
F
BI
n
k
1
b
b
1 1.06 10
1, 000
50
10
0.06
1.06
Calculator Approach:
1,000
50
10
I/Y
CPT PV 926.40
FV
PMT
N
6
$926.40
CHAPTER 6 Bond Valuation and
Interest Rates
6 - 24
Bond Valuation
Semi-Annual Coupon Payments
Bond Valuation and Interest Rates
6 - 26
kb
1
I
2
B
kb
2
400
2 n
$9,146.98
kb
1
.06
1
2
0.06
2
Calculator Approach:
10,000
FV
400 2 =
PMT
5x2=
N
6 2 = I/Y
CPT PV 926.40
2n
2 x 5
10, 000
.06
1
2 x5
6 - 27
Yield to maturity
Time to maturity
Size of coupon
6 - 29
6 - 30
Price ($)
6 - 31
Bond Convexity
The convexity of the price/YTM graph reveals
two important insights:
The price rise due to a fall in YTM is greater than the
price decline due to a rise in YTM, given an identical
change in the YTM
For a given change in YTM, bond prices will change
more when interest rates are low than when they are
high
6 - 32
Then
Bond Sells at a:
Discount
Coupon = YTM
Market = Face
Par
Premium
6 - 33
6 - 34
6 - 35
6 - 36
Time to maturity
Long bonds have greater price volatility than short
bonds
The longer the bond, the longer the period for which the
cash flows are fixed
More distant cash flows are affected more in the
discounting process (remember the exponential nature of
compoundingand that discounting is the inverse of
compounding)
The most distant cash flow from a bond investment is the
most important (it is the face value of the bond) and this
cash flow is affected the greatest in the discounting
process.
CHAPTER 6 Bond Valuation and
Interest Rates
6 - 37
Size of coupon
Low coupon bonds have greater price volatility
than high coupon bonds
High coupons act like a stabilizing device, since a
greater proportion of the bonds total cash flows occur
closer to today & are therefore less affected by a change
in YTM
The greatest price volatility is found with stripped bonds
(no coupon payments)
6 - 38
Yield to maturity
Term to maturity
Size of coupon
6 - 39
Duration
Duration is a measure of interest rate risk
The higher the duration, the more sensitive
the bond is to changes in interest rates
A bonds duration will be higher if its:
YTM is lower
Term to maturity is longer
Coupon is lower
(See the Appendix to this slide set for a complete discussion of duration)
6 - 40
Bond Quotations
Bond Valuation and Interest Rates
Bond Prices
Discount and Premium Priced Bonds
6 - 42
Bond Quotations
Issuer
Coupon
Maturity
Price
Yield
Canada
5.500
2009-Jun-01
103.79
4.16
6 - 43
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6 - 45
365
6 - 46
Bond Yields
Bond Valuation and Interest Rates
Bond Yields
The Yield to Maturity = Investors Required Rate of Return
6 - 48
[ 6-2]
1
1
( 1 YTM)n
B I
YTM
1
F
n
(
1
YTM)
6 - 49
1 1 YTM n
F
BI
n
YTM
1 YTM
There is a Problem:
You cant solve for YTM algebraically; therefore, must either
use a financial calculator, Excel, trial & error or approximation
formula.
6 - 50
1 1 YTM 10
1, 000
980 50
10
YTM
1 YTM
Financial Calculator
1,000 FV
980 +/- PV
50
PMT
51
N
I/Y
5.26%
YTM 5.26%
6 - 51
6 - 52
1 1 YTM n
F
BI
n
YTM
1
YTM
1 1 YTM 40
1, 000
1, 030 30
40
YTM
1 YTM
Financial Calculator
1,000
FV
1,030 +/- PV
30
PMT
40
N
I/Y
2.87 x 2
= 5.746%
6 - 53
NO
Remember a YTM is an ex ante calculation as a
forecast, it is based on assumptions which may or
may not hold in this case, therefore as a forecast or
estimate, the approximation approach should be fine.
CHAPTER 6 Bond Valuation and
Interest Rates
6 - 55
F-B
I
Semi - annual Yield to Maturity n
FB
2
YTM 2 semi - annual YTM
YTM (1 semi - annual YTM) 2 1
6 - 56
Example
Find the yield-to-maturity of a 5 year 6%
coupon bond that is currently priced at $850.
(Always assume the coupon interest is paid
semi-annually.)
Therefore there is coupon interest of $30 paid semi-annually
There are 10 semi-annual periods left until maturity
6 - 57
0.0486
FB
$1,850
$925
2
2
YTM 2 semi - annual YTM 0.0486 2 0.09273 9.3%
YTM (1 semi - annual YTM) 2 1 (1.0486) 2 1 9.97%
The
Theactual
actualanswer
answerisis9.87%...so
9.87%...soofofcourse,
course,the
the
approximation
approximationapproach
approachonly
onlygives
givesus
usan
anapproximate
approximate
answerbut
answerbutthat
thatisisjust
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fortests
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exams.
CHAPTER 6 Bond Valuation and
Interest Rates
6 - 58
6 - 59
Yield To Call
Bond Valuation and Interest Rates
Yield to Call
If a bond has a call feature, the issuer can call
the bond prior to its stated maturity
To calculate the yield to call, simply replace
the maturity date with the first call date
6 - 61
Yield to Call
[ 6-3]
1
1
( 1 YTC)n
B I
YTC
1
CP
n
(
1
YTC)
6 - 62
Financial Calculator
1,050
FV
1,030 +/- PV
30
PMT
10
N
I/Y
3.081 x 2
= 6.16%
1
( 1 YTC)n
B I
CP
YTC
( 1 YTC)n
$1,050
( 1 YTC)10
$1,030 $30
10
YTC
( 1 YTC)
6 - 63
Current Yield
Bond Valuation and Interest Rates
Current Yield
The current yield is the yield on the bonds current
market price provided by the annual coupon
It is not a true measure of the return to the bondholder because
it does not consider potential capital gain or capital losses based
on the relationship between the purchase price of the bond and
its par value.
[ 6-4]
Annual interest
CY
B
6 - 65
Current Yield
Example
Annual Coupon
Current Market Price
55
1, 050
5.24%
Current Yield =
6 - 66
6 - 68
6 - 69
6 - 70
Fisher Equation
If we call the risk-free rate the nominal rate, then
the relationship between the real rate, the
nominal rate and expected inflation is usually
referred to as the Fisher Equation (after Irving
Fisher)
[ 6-5]
6 - 71
Fisher Equation
When inflation is low, can safely use the
approximation formula:
Inflation
6 - 72
Fisher Equation
Example
6 - 73
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Percent
10
8
6
4
2
0
1 mth
3 mths
6 mths
1 yr
2yrs
5 yrs
7 yrs
10 yrs
30 yrs
1994
1998
2004
6 - 78
Expectations theory
The long rate is the average of expected future short interest
rates
6 - 79
6 - 80
16
14
12
Yield
Spread
Percent
10
8
6
4
2
0
1 mth
3 mths
6 mths
1 yr
2yrs
5 yrs
7 yrs
10 yrs
30 yrs
6 - 81
Risk Premiums
The YTM on a corporate bond is comprised of:
[ 6-6]
6 - 82
Debt Ratings
All publicly traded bonds are assigned a risk
rating by a rating agency, such as Dominion
Bond Rating Service (DBRS), Standard &
Poors (S&P), Moodys, Fitch, etc.
Bonds are categorized as:
Investment grade top four rating categories (AAA,
AA, A & BBB)
Junk or high yield everything below investment
grade (BB, B, CCC, CC, D, Suspended)
6 - 83
6 - 84
Treasury Bills
Short-term obligations of government with an initial
term to maturity of one year or less
Issued at a discount & mature at face value
The difference between the issue price and the face
value is treated as interest income
To calculate the price of a T bill, use the following
formula:
PT Bill
F
n
1 BEY
B
Where:
P = market price of the T Bill
F = face value of the T Bill
BEY = the bond equivalent yield
n = the number of days until maturity
B = the annual basis (365 days in Canada)
6 - 86
PT Bill
B
1, 000, 000
80
1 .045
365
$990, 233.32
1 BEY
6 - 87
F P B
P n
100, 000 98, 200 365
98, 200
180
3.72%
BEY
6 - 88
6 - 89
1 kb
50, 000
1.06
25
$11, 649.93
CHAPTER 6 Bond Valuation and
Interest Rates
6 - 90
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6 - 95
Duration
An alternative measure of bond price sensitivity is the bonds
duration.
Duration measures the life of the bond on a present value
basis.
Duration can also be thought of as the average time to receipt
of the bonds cash flows.
The longer the bonds duration, the greater is its sensitivity to
interest rate changes.
6 - 97
Duration Rules-of-Thumb
Duration of zero-coupon bond (strip bond) = the term left until
maturity.
Duration of a consol bond (ie. a perpetual bond) = 1 + (1/k)
where: k = required yield to maturity
6 - 98
The higher the coupon or promised interest payment on the security, the lower
its duration.
6 - 99
= - D [ dk/(1+k)]
Where:
P=
C = Coupon (annual)
k = YTM
N = Number of periods
F = Face value of bond
Price of bond
6 - 100
(The following slide illustrates how bond price sensitivity can be graphed
against changing discount rates)
6 - 101
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= $20,000(PVIFn=30, k = 12%)
= $20,000 (.0334)
= $668.00
Assume now that interest rates fall by 16.7% from 12% to 10%.
What is the percentage change in price of the bond?
P0
= $20,000(PVIFn=30, k = 10%)
= $20,000 (.0573)
= $1,146.00
6 - 103
6 - 104
Duration
The numerator of the duration formula represents the present value of
future payments, weighted by the time interval until the payments
occur. The longer the intervals until payments are made, the larger will
be the numerator, and the larger will be the duration. The
denominator represents the discounted future cash flows resulting
from the bond, which is the bonds present value.
n
Ct (t )
t
t 1 (1 k )
DUR n
Ct
t
t 1 (1 k )
where : Ct the coupon or principal payment generated by the bond
t the time at which the payments are provided
k the bond ' s yield to maturity
6 - 105
Duration Example
$70
$70(2) $1070(3)
1
2
(1.09) (1.09)
(1.09) 3
DUR
$70
$70
$1070
1
2
(1.09) (1.09) (1.09) 3
2.80 years
6 - 106
Duration Example
A Formula-based Duration Calculation for a Zero Coupon Bond
As an example, the duration of a zero-coupon bond with $1,000 par
value and three years remaining to maturity, and a 9 percent yield to
maturity is:
$1000(3)
(1.09) 3
DUR
$1000
(1.09) 3
3.0 years
6 - 107
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Duration of a Portfolio
6 - 109
Duration of a Portfolio
Insurance Company Example
A life insurance company knows that they need $100 million 30 years from
now cover actuarially-determined claims against a group of life insurance
policies just no sold to a group of 30 year olds.
The insurance company has invested the premiums into 30-year government
bonds. Therefore there is no default risk to worry about. The company
expects that if the realized rate of return on this bond portfolio equals the
yield-to-maturity of the bond portfolio, there wont be a problem growing that
portfolio to $100 million. The problem is, that the coupon interest payments
must be reinvested and there is a chance that rates will fall over the life of the
portfolio.
If this happens the portfolios terminal value will be less than the liability the
insurance company needs to finance. This shortfall in investment returns will
have to be borne at the expense of the Insurance companys shareholders.
6 - 110
6 - 111
Duration of a Portfolio
Immunization
6 - 112
Copyright
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this
work beyond that permitted by
Access Copyright (the Canadian
copyright licensing agency) is
unlawful. Requests for further
information should be addressed to
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or damages caused by the use of
these files or programs or from the
use of the information contained
herein.
6 - 113