Interest Rates and Bond Valuation

T1 Bond Features

 Bond - evidence of debt issued by a corporation or a

governmental body. A bond represents a loan made by investors to the issuer. In return for his/her money, the investor receives a legaI claim on future cash flows of the borrower. The issuer promises to:

 Make regular coupon payments every period until the

bond matures, and matures.

 Pay the face/par/maturity value of the bond when it  Default - since the abovementioned promises are

contractual obligations, an issuer who fails to keep them is subject to legal action on behalf of the lenders (bondholders).

T2 Bond Features (concluded)

 If a bond has five years to maturity, an $80 annual coupon,

and a $1000 face value, its cash flows would look like this: Time Coupons Face Value 0 1 $80 2 $80 3 $80 4 $80 5 $80

$ 1000 $______

 How much is this bond worth? It depends on the level of

current market interest rates. If the going rate on bonds like this one is 10%, then this bond is worth $924.18. Why? Stay tuned.

T3 Bond Rates and Yields

 Suppose a bond currently sells for $932.90. It pays an

annual coupon of $70, and it matures in 10 years. It has a face value of $1000. What are its coupon rate, current yield, and yield to maturity (YTM)?


1. The coupon rate (or just coupon) is the annual dollar coupon expressed as a percentage of the face value: Coupon rate = $70 /$_____ = ___%

2. The current yield is the annual coupon divided by the current market price of the bond: Current yield = $___ /_____ = 7.5%

Under what conditions will the coupon rate and current yield be the same? Stay tuned.

T4 Bond Rates and Yields (concluded)

 3.

The yield to maturity (or YTM) is the rate that makes the price of the bond just equal to the present value of its future cash flows. It is the unknown r in: $932.90 = $_______ [1 - 1/(1 + r)10]/r + $_______ /(1 + r)10

The only way to find the YTM is trial and error: a. Try 10%: $70 b. Try 9%: $70 c. Try 8%: $70 [(1 - 1/(1.10)10]/.10 + $1000/(1.10)10 = $816 [1 - 1/(1.09)10]/.09 + $1000/(1.09)10 = $872 [1 - 1/(1.08)10]/.08 + $1000/(1.08)10 = $933

( ) The yield to maturity is 8%

T5 Valuing a Bond

 Assume you have the following information.

Barnhart, Inc. bonds have a $1,000 face value The promised annual coupon is $100 The bonds mature in 20 years The markets required return on similar bonds is 10%

1. Calculate the present value of the face value = $1,000 [1/1.1020 ] = $1,000 .14864 = $148.64

2. Calculate the present value of the coupon payments = $100 [1 - (1/1.1020)]/.10 = $100 8.5136 = $851.36

3. The value of each bond = $148.64 + 851.36 = $1,000

T6 Example: A Discount Bond

 Assume you have the following information.

Barnhart, Inc. bonds have a $1,000 face value The promised annual coupon is $100 The bonds mature in 20 years The markets required return on similar bonds is 12%

1. Calculate the present value of the face value = $1,000 [1/1.1220 ] = $1,000 .10366 = $103.66

2. Calculate the present value of the coupon payments = $100 [1 - (1/1.1020)]/.10 = $100 7.4694 = $746.94

3. The value of each bond = $103.66 + 746.94 = $850.60

T7 Example: A Premium Bond

 Assume you have the following information.

Barnhart, Inc. bonds have a $1,000 face value The promised annual coupon is $100 The bonds mature in 20 years The markets required return on similar bonds is 8%


1. Calculate the present value of the face value = $1,000 [1/1.0820 ] = $1,000 .21455 = $214.55

2. Calculate the present value of the coupon payments = $100 [1 - (1/1.0820)]/.08 = $100 9.8181 = $981.81

3. The value of each bond = $214.55 + 981.81 = $1,196.36

 Why do the bonds in this and the preceding example have prices

that are different from par?

T8 Bond Price Sensitivity to YTM

Bond price

$1,800 $1,600 $1,400 $1,200 $1,000 $ 800 $ 600 4% 6%

Coupon = $100 20 years to maturity $1,000 face value Notice: bond prices and YTMs are inversely related.

Yields to maturity, YTM 8% 10% 12% 14% 16%

T9 Interest Rate Risk and Time to Maturity

Bond values ($)

2,000 $1,768.62 30-year bond 1,500 Interest rate 5% 1,000 $1,047.62 1-year bond $916.67 10 15 20 500 $502.11 Time to Maturity 1 year $1,047.62 1,000.00 956.52 916.67 30 years $1,768.62 1,000.00 671.70 502.11

Interest rates (%) 5 10 15 20 Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities

T10 Bond Pricing Theorems

 The following statements about bond pricing are always true.



1. Bond prices and market interest rates move in opposite directions. 2. When a bonds coupon rate is (greater than / equal to / less than) the markets required return, the bonds market value will be (greater than / equal to / less than) its par value. 3. Given two bonds identical but for maturity, the price of the longer-term bond will change more than that of the shorter-term bond, for a given change in market interest rates. 4. Given two bonds identical but for coupon, the price of the lower-coupon bond will change more than that of the higher-coupon bond, for a given change in market interest rates.

T11 Bond Ratings Low Quality, speculative, and/or Junk Low Grade BB Ba B B Very Low Grade CCC Caa CC C Ca C D C

Investment-Quality Bond Ratings High Grade Standard & Poors Moodys AAA Aaa AA Aa Medium Grade A A BBB Baa

T12 Sample Wall Street Journal Bond Quotation New York Exchange Bonds
Quotations as of 4 p.m. Eastern Time Thursday, January 30, 1997
CORPORATION BONDS Volume, $29,351,000 Cur Yld 8.1 4.8 4.6 6.1 5.4 7.0 6.8 7.2 8.0 8.0 8.1 8.2 Net Chg.
7/8 3/8

Bonds AMR 9s16 ATT 4 3/4 98 ATT 4 3/8 99 ATT 6s00 ATT 5 1/8 01 ATT 7 1/8 02 ATT 6 3/4 04 ATT 7 1/2 06 ATT 8 1/8 22 ATT 8 1/8 24 ATT 8.35s25 ATT 8 5/8 31

Vol 19 5 30 5 118 50 15 10 338 398 110 26

Close 110 1/2 + 98 1/8 96 98 1/4 95 1/2 + 102 1/4 + 99 3/4 104 + 102 1/8 + 101 3/4 + 103 1/4 105 7/8 +

...
5/8 3/4 1/8 1/4

1
... ...

1/4 ...

Source: Reprinted by permission of The Wall Street Journal, 1997 Dow Jones and Company, Inc., January 30, 1997. All Rights Reserved Worldwide.

T13 Sample Wall Street Journal U.S. Treasury Note and Bond Prices

GOVT. BONDS AND NOTES

Maturity Rate Mo/Yr 111/8Aug 03 117/8Nov 03 5 7/8 Feb 04n . . . 7 7/8 Feb 21 8 1/8 May 21 8 1/8 Aug 21 8 Nov 21 7 1/4 Aug 22 7 5/8 Nov 22 7 1/8 Feb 23 6 1/4 Aug 23 Bid 125:10 130:04 96:17 . . . 110:19 113:18 113:19 112:06 103:15 108:00 102:01 91:19 Asked 125:16 130:10 96:19 . . . 110:23 113:22 113:23 112:10 103:17 108:02 102:03 91:21 Chg. -6 -7 -6 . . . -13 -14 -14 -14 -14 -13 -13 -12 Ask Yld. 6.44 6.46 6.46 . . . 6.95 6.95 6.96 6.95 6.95 6.95 6.95 6.94

Source: Reprinted by permission of The Wall Street Journal, 1996 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

T14 Inflation and Returns

 Key issues:


What is the difference between a real and a nominal return? How can we convert from one to the other?

 Example:

Suppose we have $1,000, and Diet Coke costs $2.00 per six pack. We can buy 500 six packs. Now suppose the rate of inflation is 5%, so that the price rises to $2.10 in one year. We invest the $1,000 and it grows to $1,100 in one year. Whats our return in dollars? In six packs?

T15 Inflation and Returns (continued)

 A. Dollars. Our return is

($1100 - $1000)/$1000 = $100/$1000 = ________. ( ) The percentage increase in the amount of green stuff is 10%; our return is 10%.
 B. Six packs. We can buy $1100/$2.10 = ________

six packs, so our return is (523.81 - 500)/500 = 23.81/500 = 4.76% ( ) The percentage increase in the amount of brown stuff is 4.76%; our return is 4.76%.

T16 Inflation and Returns (continued)

 Real versus nominal returns:

Your nominal return is the percentage change in the amount of money you have. Your real return is the percentage change in the amount of stuff you can actually buy.

T17 Inflation and Returns (concluded)

 The relationship between real and nominal returns is described by

the Fisher Effect. Let: R r h = = = the nominal return the real return the inflation rate

 According to the Fisher Effect:

1 + R = (1 + r) x (1 + h)
 From the example, the real return is 4.76%; the nominal return is

10%, and the inflation rate is 5%: (1 + R) = 1.10 (1 + r) x (1 + h) = 1.0476 x 1.05 = 1.10

T18 Solution to Problem

 Reznik Corporation has bonds on the market with 10.5

years to maturity, a yield-to-maturity of 10 percent, and a current price of $860. Coupon payments are semiannual. What must the coupon rate be on the bonds? Total number of coupon payments = 10.5 Yield-to-maturity per period Maturity value = F 2 = 21

= 10% / 2 = 5% = $1,000

T19 Solution to Problem (concluded)

 Substituting the known values into the bond pricing

equation: Bond Value $860 $860 C = C = C = C [1 - 1/(1 + r)t] / r + F / (1 + r)t [1 - 1/(1 + .05)21] / .05 + $1,000/(1.05)21 12.8211 + $358.94

= $39.08 2 = $78.16

So the annual coupon must be $39.08

and the coupon rate is $78.16 / $1,000 = .07816 } .0782.

T20 Solution to Problem

 Bond J has a 4% coupon and Bond K a 10% coupon. Both

have 10 years to maturity, make semiannual payments, and have 9% YTMs. If market rates rise by 2%, what is the percentage price change of these bonds? If rates fall by 2%? What does this say about the risk of lower-coupon bonds? Current Prices: Bond J: PV = $20 [1 - 1/(1.045)20]/.045 + $1,000/(1.045)20 = $______ Bond K: PV = $50 [1 - 1/(1.045)20]/.045 + $1,000/(1.045)20 = $1065.04

T21 Solution to Problem (continued)

Prices if market rates rise by 2%: Bond J: PV = $20 [1 - 1/(1.055)20]/.055 + $1,000/(1.055)20 = $581.74 Bond K: PV = $50 [1 - 1/(1.055)20]/.055 + $1,000/(1.055)20 = $______

T22 Solution to Problem (continued)

Prices if market rates fall by 2%: Bond J: PV = = $20 [1 - 1/(1.035)20]/.035 + $1,000/(1.035)20 $786.82

Bond K: PV = = $50 [1 - 1/(1.035)20]/.035 + $1,000/(1.035)20 $1213.19

T23 Solution to Problem (concluded)

 Percentage Changes in Bond Prices

Bond Prices and Market Rates 7% 9% 11% _________________________________ Bond J % chg. Bond K % chg. $786.81 (+16.60%) $674.80 $581.74 (___%)

$1,213.19 $1,065.04 $940.25 (___%) (-11.72%) _________________________________

The results above demonstrate that, all else equal, the price of the lower-coupon bond changes more (in percentage terms) than the price of the higher-coupon bond when market rates change.