INTEREST RATES AND BOND VALUATION

Chapter 6

Key Concepts and Skills

Know the important bond features and bond types

Understand bond values and why they fluctuate

Understand bond ratings and what they mean

Understand the impact of inflation on interest rates

Understand the term structure of interest rates and the

determinants of bond yields

Chapter Outline

Bonds and Bond Valuation

More on Bond Features
Bond Ratings
Some Different Types of Bonds
Bond Markets
Inflation and Interest Rates
Determinants of Bond Yields

Bond

A certificate showing that a borrower owes a

specified sum.
To repay the money, the borrower has agreed to
make interest and principal payments on
designated dates.

Fixed Income Securities - Bond

Definition of a Bond

A bond is a legally binding agreement between a borrower

and a lender that specifies the:
Definitions

Par / face value

$1,000 in most of the example in textbook

The principal amount of a bond that is repaid at the end of
the term.

Coupon rate

The annual coupon divided by the face value of a

bond

Coupon payment

The stated interest payment made on a bond

Maturity Date

Date on which the principal amount of a bond is

paid

Yield to maturity (YTM)

It is the required market interest rate on the bond.

Current Yield

A bonds annual coupon divided by its price

Key Features of a Bond

6-7

Par value:
Face amount
Re-paid at maturity
Assume $1,000 for corporate bonds

Coupon interest rate:

Stated interest rate
Usually = YTM at issue
Multiply by par value to get coupon payment

Key Features of a Bond

6-8

Maturity:
Years

until bond must be repaid

Yield to maturity (YTM):

The

market required rate of return for bonds of similar

risk and maturity
The discount rate used to value a bond
Return if bond held to maturity
Usually = coupon rate at issue
Quoted as an APR

Bond Characteristics
Coupon= coupon rate*face value

Issuer:
Cash inflow:
The price of
The bond

Cash outflow:
Coupon
(interest Payment)

Cash outflow:
Coupon
(interest Payment)

Cash outflow:
Face Value
(Par value)
And interest

Maturity
Date

Bond Holder:
Cash outflow:
The price of
The bond

Cash inflow:
Coupon
(interest Payment)

Cash inflow:
Coupon
(interest Payment)

Cash inflow:
Face Value
(Par value)
And last coupon

If there is no coupon payment in each period (i.e., coupon rate=0%)

the bond is call Zero-coupon Bond

Example - Bond

1.

2.

3.

Video Game company just issued 100,000 bonds for $1,000

each, where the bonds have a coupon rate of 5% and a
maturity of 2 years. Interest on the bonds is to be paid
yearly.
$100 million (=100,000$1,000) has been borrowed by the
firm
The firm must pay interest of $5 million (=5%$100
million) at the end of one year.
The firm must pay both $5 million of interest and $100
million of principal at the end of 2 years

Bond Pricing (Example)

8% coupon, $1000 face value, 30-year maturity, semiannual coupon payments ($40 each)
Suppose market interest rate r is 5% per 6-month period
1

FV
Bond Pr ice C 1 r
T
r

1 r

60

1000
Bond Pr ice 40 1.05
60
0.05 1.05

Bond Price = 810.71

How to Value Bonds

Primary Principle:
Value of financial securities
= PV of expected future cash flows

Bond value is, therefore, determined by the present

value of the coupon payments and par value/face
value.
Interest rates are inversely related to present (i.e.,
bond) values.

How to Value Bonds

Bond Value = Present value of the coupon
+ Present Value of the face value
1

1 t
(1

r)
Bond Value C

F
(1 r) t

PV(Annuity)
C = Coupon payment; F = Face value

PV(lump sum)

Types of Bonds
1. Premium bonds:

Bond price>face value

2. Discount bonds:

Bond price<face value

3. Par bonds:

Bond price=face value

Par Bond (Bond price = Face Value)

Example:
The (market) interest rate is 10%. A two-year bond with a
10% coupon pays interest of $100(=$1000*10%).

For simplicity we assume that the interest is paid annually. In this case, we see
that the bond is priced at its face value of $1000.
Bond Price =

100 1000 100

1.10
(1.10) 2
= $1,000
Bond Price = Face Value

Discount Bond (Bond Price < Face Value)

If the (market) interest rate is 12%, the face value is $1,000

Bond Price =

100 1000 100

1.12
(1.12) 2
= $966.20

Discount bond= Bond Price < Face Value

Since the interest rate is 12%, a newly issued bond with a 12%
coupon rate will see at $1,000. This newly issued bond will have
coupon payments of $120 (=12%*1000).
Because our bond has interest payments of only $100, investors
will pay less than $1,000 for it.

Premium Bond (Bond price > Face Value)

If (market) interest rates fell to 8%, the bond would sell at:

Bond Price =

100 1000 100

1.08
(1.08) 2

= $1,035.67
Premium Bond = Bond Price > Face Value
Because $1,035.67 is more than $1,000, the bond
said to sell at a premium.

Valuing a Discount Bond with Annual Coupons

Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 5 years
YTM = 11%

Valuing a Premium Bond with Annual Coupons

Coupon rate = 10%
Annual coupons
Par = $1,000
Maturity = 20 years
YTM = 8%

Graphical Relationship Between Price and YTM

1500
1400
1300
1200
1100
1000
900
800
700
600
0%

2%

4%

6%

Higher YTM, Lower Bond Price

8%

10%

12%

14%

Bond Prices: Relationship between Coupon and

Yield
1.

2.

3.

If YTM = coupon rate

then par value = bond price
If YTM > coupon rate
then par value > bond price
Why?
Selling at a discount, called a discount bond
If YTM < coupon rate,
then par value < bond price
Why?
Selling at a premium, called a premium bond

Bond Value ($) vs Years remaining to Maturity

Premium

CR>YTM

YTM = CR

1,000

CR<YTM
Discount
30

25

20

15

10

The Bond-Pricing Equation

Adjusted for Semi-annual Coupons
1

1
C
(1 YTM/2) 2t
Bond Value
2
YTM/2

C = Annual coupon payment

2t
(1

YTM/2)

C/2 = Semi-annual coupon

YTM = Annual YTM (as an APR) YTM/2 = Semi-annual YTM

t = Years to maturity

2t = Number of 6-month
periods to maturity

Semiannual Bonds

Coupon rate = 14% - Semiannual

YTM = 16% (APR)
Maturity = 7 years

Interest Rate Risk

Price Risk

Change in price due to changes in interest rates

Interest rates up, bond price down!

Long-term bonds have more interest rate risk than shortterm bonds

Lower coupon rate bonds have more interest rate risk

than higher coupon rate bonds

Interest Rate Risk

Reinvestment Risk

Uncertainty concerning rates at which cash flows can be

reinvested
Short-term bonds have more reinvestment rate risk than
long-term bonds
High coupon rate bonds have more reinvestment rate risk
than low coupon rate bonds

Figure 6.2

Computing YTM

Yield-to-maturity is the rate implied by the current bond

price

Finding the YTM requires trial and error if you do not have
a financial calculator and is similar to the process for
finding r with an annuity
If you have a financial calculator, enter N, PV, PMT and FV,
remembering the sign convention (PMT and FV need to
have the same sign; PV the opposite sign)

YTM with Annual Coupons

Consider a bond with a 10% annual coupon rate,

15 years to maturity and a par value of $1,000.
The current price is $928.09.

Will the yield be more or less than 10%?

= 15; PV = -928.09; FV = 1,000; PMT = 100

CPT I/Y = 11%
The YTM is more than the coupon since the price is less than par.

YTM with Semiannual Coupons

Suppose a bond with a 10% coupon rate and semiannual

coupons, has a face value of $1,000, 20 years to maturity
and is selling for $1,197.93.
Is the YTM more or less than 10%?

What is the semiannual coupon payment?

How many periods are there?

N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y = 4% (Is

this the YTM?)
YTM = 4%*2 = 8%

Table 6.1

Differences Between Debt and Equity

Debt

Not an ownership interest

Creditors do not have voting
rights
Interest is considered a cost of
doing business and is taxdeductible
Creditors have legal recourse if
interest or principal payments
are missed
Excess debt can lead to
financial distress and
bankruptcy

Equity
Ownership interest
Common stockholders vote to
elect the board of directors
and on other issues
Dividends are not considered
a cost of doing business and
are not tax deductible
Dividends are not a liability
of the firm until declared.
Stockholders have no legal
recourse if dividends are not
declared
An all-equity firm cannot go
bankrupt

The Bond Indenture

Contract between the company and the bondholders and

includes:

The basic terms of the bonds

The total amount of bonds issued
A description of property used as security, if applicable
Sinking fund provisions
Call provisions

Deferred call
Call premium

Details of protective covenants

Bond Classifications

Registered vs. Bearer Forms

Security

Collateral secured by financial securities

Mortgage secured by real property, normally land or buildings

Mortgage trust indenture or trust deed

A blanket mortgage pledges all the real property owned by the company

Debentures unsecured

An asset pledged on a debt

Often involve a pledge of common stock held by the corporation

No specific pledge

Notes unsecured debt with original maturity less than 10 years

Seniority
Senior or junior In the event of default, preference in position over
other lenders

Some debt is subordinated, a subordinated debenture

Repayment

Bonds can be repaid at maturity, at which time the

bondholder will received the state, or face, value of the
bond, or they may be repaid in part or in entirely before
maturity.
Sinking Fund Provision

An account managed by the bond trustee for early bond redemption

The company makes annual payments to the trustee, who then uses the
funds to retire a portion of the debt
Different types of sinking fund arrangements
1.
2.
3.

Some sinking funds start about 10 years after the initial issuance
Some sinking funds establish equal payments over the life of the bond.
Some high-quality bond issues establish payments to the sinking fund that are
sufficient to redeem the entire issue. As a consequence, there is the possibility of a
large balloon payment at maturity.

The Call Provision

The Call Provision

An agreement giving the corporation the option to repurchase the bond

at a specific price prior to maturity.
Corporate bonds are usually callable.

Call price: usually is above the bonds stated value (par value).
Call premium: The difference between the call price and the par value.

The amount of the call premium usually becomes smaller over time.

Deferred Call provision- company is prohibited from calling its bonds in

the bonds early years.
During this period of prohibition, the bond is said to be call
protected.

Make-whole call: bondholders receive exactly what the bonds

are worth if they are called.

Bond Classification

Protective Covenants

A part of the indentures limiting certain actions that might be takes

during the term of the loan, usually to protect the lender.
Negative covenants and positive covenants.

Negative Covenants
Limits

or prohibits certain actions

Positive Covenants
Requires

certain actions

Bond Characteristics and Required Returns (R)

The coupon rate is usually set close to the yield, which

depends on the risk characteristics of the bond when issued
Which bonds will have the higher coupon, all else equal?

Secured debt versus a debenture

Subordinated debenture versus senior debt
A callable bond versus a non-callable bond

Bond Ratings

Two leading bond-rating firms

1.
2.

Moodys
Standard & Poors (S&P)

It is important to recognize that the bond ratings are

concerned only with the possibility of default.

Why so important about bond ratings?

Coupon rate
Investors

Bond Ratings
Investment Quality Rating
(Investment Grade)

Very High
Quality

Low- Quality

High Quality

Speculative

Very Poor

S&P

AAA
AA

A
BBB

BB
B

CCC
D

Moodys

Aaa
Aa

A
Baa

Ba
B

Caa
C

Types of Bonds

Corporate Bonds
Government Bonds
Zero Coupon Bonds
Floating-Rate Bonds
Other types of Bonds

Income Bonds
Convertible Bonds
Put Bonds

Government Bonds
Treasury Securities

Federal government debt

T-bills pure discount bonds with original maturity of
one year or less
T-notes coupon debt with original maturity between
one and ten years
T-bonds coupon debt with original maturity greater
than ten years

Treasury Securities

T-bills

Risk-free
Always can come up with the money to make the payment

The coupons received from treasury notes and bonds are

only taxed at the federal level

Government Bonds
Municipal Securities

Debt of state and local governments

Varying degrees of default risk, rated similar to
corporate debt
Interest received is tax-exempt at the federal level

Example : Taxable versus Municipal Bonds

A taxable bond has a yield of 8% and a

municipal bond has a yield of 6%
If

you are in a 40% tax bracket, which bond do

you prefer?

At

what tax rate would you be indifferent between

the two bonds?

Zero Coupon Bonds

Make no periodic interest payments

(coupon rate = 0%)

The entire yield-to-maturity comes from the difference

between the purchase price and the par value

Cannot sell for more than par value

Sometimes called zeroes, or deep discount bonds

Treasury Bills and principal-only Treasury strips are good

examples of zeroes

Floating Rate Bonds

Coupon rate floats depending on some index value

Examples adjustable rate mortgages and inflation-linked
Treasuries (e.g. iBond in Hong Kong)
There is less price risk with floating rate bonds

The coupon floats, so it is less likely to differ substantially from the

yield-to-maturity

The holder has the right to redeem the note at par on the
coupon payment date after some specified amount of time.
This is called a put provision.
Coupons may have a collar the rate cannot go above a
specified ceiling or below a specified floor

Other Bond Types

Income bonds

Convertible bonds

Can be exchanged for a fixed number of shares

Relatively common

Put bond

Coupon payments are dependent on company income

Not too common

Allows the holder to force the issuer to buy the bond back at a stated
price.

There are many other types of provisions that can be added to a bond
and many bonds have several provisions

it is important to recognize how these provisions affect required returns

Who does the provision benefit?

Bond Markets

Primarily over-the-counter (OTC) transactions with dealers

connected electronically
Extremely large number of bond issues, but generally low
daily volume in single issues
Makes getting up-to-date prices difficult, particularly on
small company or municipal issues

OTC had little or no transparency

Treasury securities are an exception

Corporate Bond Quotations

ABC 8.375 Jul 15, 2033 100.641 8.316 362 30 763,528

What company are we looking at?

What is the coupon rate? If the bond has a $1000 face value, what
is the coupon payment each year?

When does the bond mature?

What was the trading volume on that day?

What is the current yield? What is the quoted price?

How does the bonds yield compare to a comparable Treasury

note/bond

Government -Treasury Quotations

2020 Feb 15 8.5 145.12 145.15 +64 3.4730

What is the coupon rate on the bond?

When does the bond mature?

What is the bid price? What does this mean?

What is the ask price? What does this mean?

What is the bid-ask spread? What does this mean?

How much did the price change from the previous day?

What is the yield based on the ask price?

Bond Price Quotes

Clean Price

The price of a bond net of accrued interest. This is the price

that is typically quoted

Dirty Price (full or invoice price)

The price of a bond including accrued interest. This is the
price that the buyer actually pays.
Dirty price = Clean price + accrued interest

Accrued Interest

Interest earned since last coupon payment is owed to bond

seller at time of sale

Inflation and Interest Rates

Real Rates

Interest rates that have been adjusted for inflation

Nominal rates

Interest rates that have not been adjusted for inflation

The Fisher Effect

Because investors are ultimately concerned with what

they can buy with their money, they required
compensation for inflation

The Fisher Effect defines the relationship between real

rates, nominal rates and inflation

(1 + R) = (1 + r)(1 + h), where

R = nominal rate
r = real rate
h = expected inflation rate

Approximation

R=r+h

Example 6.6

If we require a 10% real return and we expect

inflation to be 8%, what is the nominal rate?

R = (1.1)(1.08) 1 = .188 = 18.8%

Approximation: R = 10% + 8% = 18%

Because the real return and expected inflation are

relatively high, there is significant difference
between the actual Fisher Effect and the
approximation.

Term Structure of Interest Rates

The relationship between short- and long-term interest rate is

known as the term structure of interest rate.
Term structure of interest rates tells us what nominal interest
rates are on default-free, pure discount bonds of all maturities.
It is important to recognize that we pull out the effect of default
risk, different coupons, etc.
Yield curve graphical representation of the term structure

Normal upward-sloping, long-term yields are higher than short-term

yields
Inverted downward-sloping, long-term yields are lower than shortterm yields

What determines the shape of the term

structure?

Three Components:
1.

2.
3.

The real rate of interest

The rate of inflation
Interest rate risk premium

Figure 6.5 Upward-Sloping Yield Curve

Figure 6.5 B Downward-Sloping

Yield Curve

Treasury Yield Curve

http://www.bloomberg.com/markets/rates/index.html

Factors Affecting Required Return

1.

Default risk premium remember bond ratings

2.

Taxability premium remember municipal versus taxable

3.

Liquidity premium bonds that have more frequent trading

will generally have lower required returns
Anything else that affects the risk of the cash flows to the
bondholders, will affect the required returns