Chapter 5

Interest rate and bond valuation

Chapter 5

Dr.Nassima DEBAB

Learning Goals
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2.

3.

4.

Describe interest rate fundamentals, the term structure of interest rates, and risk premiums. Review the legal aspects of bond financing and bond cost. Discuss the general features, yields, prices, popular types, and international issues of corporate bonds. Understand the key inputs and basic model used in the valuation process.
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Learning Goals (cont.)

5. Apply the basic valuation model to bonds and describe the impact of required return and time to maturity on bond values. 6. Explain the yield to maturity (YTM), its calculation, and the procedure used to value bonds that pay interest semiannually.

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Interest Rates & Required Returns

The interest rate or required return represents the price of money. Interest rates act as a regulating device that controls the flow of money between suppliers and demanders of funds. The Board of Governors of the Federal Reserve System regularly asses economic conditions and, when necessary, initiate actions to change interest rates to control inflation and economic growth.

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Interest Rates & Required Returns: Interest Rate Fundamentals

Interest rates represent the compensation that a demander of funds must pay a supplier. When funds are lent, the cost of borrowing is the interest rate. When funds are raised by issuing stocks or bonds, the cost the company must pay is called the required return, which reflects the suppliers expected level of return.
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Interest Rates & Required Returns: The Real Rate of Interest

The real interest rate is the rate that creates an equilibrium between the supply of savings and the demand for investment funds in a perfect world. In this context, a perfect world is one in which there is no inflation, where suppliers and demanders have no liquidity preference, and where all outcomes are certain. It is the supply-demand for funds relationship that determines the real rate of interest/

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Interest Rates & Required Returns: The Real Rate of Interest (cont.)
Figure 6.1 SupplyDemand Relationship

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Interest Rates & Required Returns: Nominal or Actual Rate of Interest (Return)
The nominal rate of interest is the actual rate of interest charged by the supplier of funds and paid by the demander. The nominal rate differs from the real rate of interest, r* as a result of two factors: Inflationary expectations reflected in an inflation premium (IP), and Issuer and issue characteristics such as default risks and contractual provisions as reflected in a risk premium (RP).

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Interest Rates & Required Returns: Nominal or Actual Rate of Interest (Return)(cont.)

K= k* + IP + RP
The equation indicate, the nominal rate K, can be viewed as having two basic components: a risk free rate, Rf and a risk premium Rp: K= Rf + RP Where Rf = K* + IP

K: nominal interest rate K*: real interest rate. RP: risk premium Rf: risk free rate.
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Interest Rates & Required Returns: Nominal or Actual Rate of Interest (Return)(cont.)

RP = DRP + LP+MRP
DRP : default risk premium, which reflects the chance that borrower ( that is, the issuer of the security) will not pay the debts interest or principal on time. ( the greater the default risk, the higher the interest rate lenders charge( demand) LP: liquidity, or marketability, premium, which reflects the fact that some investments are more easily converted into cash on a short notice at a reasonable price than other securities. MRP: Maturity risk premium, which accounts for the fact that longer term bonds experience greater price reactions to interest rate changes than do short term bonds.

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Term Structure of Interest Rates

The term structure of interest rates relates the interest rate to the time to maturity for securities with a common default risk profile. Typically, treasury securities are used to construct yield curves since all have zero risk of default. However, yield curves could also be constructed with AAA or BBB corporate bonds or other types of similar risk securities.

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Term Structure of Interest Rates (cont.)

Figure 6.3 Treasury Yield Curves

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Term Structure of Interest Rates (cont.)

Note that both the position and the shape of the yield curves change over time. The yield curve of May 22,1981, indicates that short term interest rates at that time were above longer-term rates. This curve is described as downward-sloping, reflecting long term borrowing cost generally cheaper than short term borrowing costs. Historically, the downward- sloping yield curve, which often called an inverted yield curve, has been the exception.
More frequently, yield curves similar to that of May 17,2004, have existed. These upward-sloping or normal yield curves indicate that short term borrowing costs are below long term borrowing costs.
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Term Structure of Interest Rates (cont.)

Sometimes, a flat yield curve, similar to that of September 29 1989, exists. It reflects relatively similar borrowing costs for both short term and longer-term loans. The shape of the yield curve may affect the firms financing decisions. A financial manager who faces a downward-sloping yield curve is likely to rely more heavily on cheaper, long term financing; when the yield curve is upward sloping, the manager is more likely to use cheaper, short term financing. Although a variety of other factors influence the choice of loan maturity, the shape of the yield curve provides useful insight into future interest rate expectations.
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Corporate Bonds

A bond is a long-term debt instrument that pays the bondholder a specified amount of periodic interest rate over a specified period of time. The bonds principal is the amount borrowed by the company and the amount owed to the bond holder on the maturity date. The bonds maturity date is the time at which a bond becomes due and the principal must be repaid. The bonds coupon rate is the specified interest rate (or $ amount) that must be periodically paid.

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Corporate Bonds (cont.)

The bonds current yield is the annual interest (income) divided by the current price of the security. The bonds yield-to-maturity is the yield (expressed as a compound rate of return) earned on a bond from the time it is acquired until the maturity date of the bond. A yield curve graphically shows the relationship between the time to maturity and yields for debt in a given risk class.
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Corporate Bonds: Cost of Bonds to the Issuer

In general, the longer the bonds maturity, the higher the interest rate (or cost) to the firm. In addition, the larger the size of the offering, the lower will be the cost (in % terms) of the bond. Also, the greater the risk of the issuing firm, the higher the cost of the issue. Finally, the cost of money in the capital market is the basis form determining a bonds coupon interest rate.
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Corporate Bonds: General Features

The conversion feature of convertible bonds allows bondholders to exchange their bonds for a specified number of shares of common stock. Bondholders will exercise this option only when the market price of the stock is greater than the conversion price. A call feature, which is included in most corporate issues, gives the issuer the opportunity to repurchase the bond prior to maturity at the call price.

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Corporate Bonds: General Features (cont.)

In general, the call premium is equal to one year of coupon interest and compensates the holder for having it called prior to maturity.

Furthermore, issuers will exercise the call feature when interest rates fall and the issuer can refund the issue at a lower cost. Issuers typically must pay a higher rate to investors for the call feature compared to issues without the feature.
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Corporate Bonds: General Features (cont.)

Bonds also are occasionally issued with stock purchase warrants attached to them to make them more attractive to investors.

Warrants give the bondholder the right to purchase a certain number of shares of the same firms common stock at a specified price during a specified period of time. Including warrants typically allows the firm to raise debt capital at a lower cost than would be possible in their absence.
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Corporate Bonds: Bond Prices

Because most corporate bonds are purchased and held by institutional investors, bond trading and price data is not readily available to individuals.

Although most corporate bonds are issued with a par or face value of $1,000, all bonds are quoted as a percentage of par. See Table 6.2

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Corporate Bonds: Bond Prices

Table 6.2 Data on Selected Bonds

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Corporate Bonds: Bond Ratings

Table 6.3 Moodys and Standard & Poors Bond Ratingsa

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Table 6.4 Characteristics and Priority of Lenders Claim of Traditional Types of Bonds

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Table 6.5 Characteristics of Contemporary Types of Bonds

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Corporate Bonds: International Bond Issues

Companies and governments borrow internationally by issuing bonds in the Eurobond market and the foreign bond market. A Eurobond is issued by an international borrower and sold to investors in countries with currencies other than the currency in which the bond is denominated. In contrast, a foreign bond is issued in a host countrys financial market, in the host countrys currency, by a foreign borrower.

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Valuation Fundamentals

The (market) value of any investment asset is simply the present value of expected cash flows. The interest rate that these cash flows are discounted at is called the assets required return. The required return is a function of the expected rate of inflation and the perceived risk of the asset. Higher perceived risk results in a higher required return and lower asset market values.

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Basic Valuation Model

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Bond Valuation: Bond Fundamentals

A noted earlier, bonds are long-term debt instruments used by businesses and government to raise large sums of money, typically from a diverse group of lenders. Most bonds pay interest semiannually at a stated coupon interest rate, have an initial maturity of 10 to 30 years, and have a par value of $1,000 that must be repaid at maturity.

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Bond Valuation: Basic Bond Valuation

Equation 1: B0 = I * (1- (1/(1-kd)n) kd + M * ( 1/ (1+Kd)n)

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Bond Valuation: Bond Fundamentals

Example: Mills Company, a large defense contractor, on January 1, 2007, issued a 10% coupon interest rate, 10-year bond with a $1,000 par value that pays interest semiannually.

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Bond Valuation: Bond Fundamentals (cont.)

Table 6.7 Bond Values for Various Required Returns (Mills Companys 10% Coupon Interest Rate, 10-Year Maturity, $1,000 Par, January 1, 2010, Issue Paying Annual Interest)

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Bond Value Behavior

In practice, the value of a bond in the marketplace is rarely equal to its par value. in bond quotations, the last prices of bonds often differ from their par values of 100 ( 10% of par). Some bonds are valued below par (quoted below 100), and others are valued above par (quoted above 100).

A variety of forces in the economy, as well as the passage of time, tends to affect value. Although these external forces are in no way controlled by bond issuers or investors, it is useful to understand the impact that required return and time to maturity have on bond value.

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Required return and Bond values

Whenever the required return on a bond differs from the bonds coupon interest rate the bonds value will differ from its par value. The required return is likely to differ from the coupon interest rate because either: Economic conditions have changed, causing a shift in the basic cost of long-term funds, The firms risk has changed. Increases in the basic cost of long term funds or in risk will raise the required return; decreases in the cost of funds or in risk will lower the required return. Regardless of the exact cause, what is important is the relationship between the required return and the coupon interest rate; When the required return is greater than the coupon interest rate, the bond value, B0 will be less than its par value, M. In this case, the bond is said to sell at a discount, which will equal M-B0. When the required return falls below the coupon interest rate, the bond value will be greater than par. In this situation, the bond is said to sell at a premium which will equal B0-M

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Bond Valuation: Bond Fundamentals (cont.)

Figure 6.4 Bond Values and Required Returns

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Bond

value and required return

Time to maturity and bond values Whenever the required return is different from the coupon interest rate, the amount of time to maturity affects bond value. An additional factor is whether required returns are constant or change over the life of the bond. Constant Required Returns - when the required return is different from the coupon interest rate and is assumed to be constant until maturity, the value of the bond will approach its par value as the passage of time moves the bonds value closer to maturity.( of course, when the required return equals the coupon interest rate, the bonds value closer to maturity. ( of course, when the required return equals the coupon interest rate, the bonds value will remain at par until it matures.) Example: Figure 6.5 depicts the behavior of the bond values calculated earlier and presented in table 6.7 for Mills Companys 10% coupon interest rate bond paying annual interest and having 10 years to maturity. Each of the three required returns (12%, 10%, 8%) is assumes to remain constant over the 10 years to the bonds maturity. The bonds value at both 12% and 8% approaches and ultimately equals the bonds $1,000 par value at its
maturity, as the discount (at 12%) or premium ( at 8%) declines with the passage of time.

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Bond Valuation: Bond Fundamentals (cont.)

Figure 6.5 Time to Maturity and Bond Values

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Bond value and required return (cont.)

Changing Required Returns - the chance that interest rate will changes and thereby change the required return and bond value is called interest rate risk . Bond holders are typically more concerned with rising interest rates because a rise in interest rates, and therefore in the required return, causes a decrease in bond value. The shorter the amount of time until a bonds maturity, the less responsive its market value to a given change in the required return. In other words, short maturities have less interest rate risk than long maturities when all other features (coupon interest rate, par value, and interest payment frequency) are the same. This is because of the mathematics of time value; the present values of short term cash flows change far less than the present values of longer term cash flows in response to a given change in the discount rate (required return). Example The effect of changing required returns on bonds with differing maturities can be illustrated by using Mills Companys bond and Figure 6.5. If the required return rises from 10% to 12% when the bond has 8 years to maturity ( see the dashed line at 8 years), the bonds value decreases from $1,000 to $901 a 9.9% decrease . if the same change in required return had occurred with only 3 years to maturity ( see the dashed line at 3 years), the bonds value would have dropped to just $ 952 only a 408% decrease . Similar types of responses can be seen for the change in bond value associated with decrease in required returns. The shorter the time to maturity, the less the impact on bond value caused by a given change in the required return.

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Coupon Effects on Price Volatility

The amount of bond price volatility depends on three basic factors: length of time to maturity risk amount of coupon interest paid by the bond First, we already have seen that the longer the term to maturity, the greater is a bonds volatility Second, the riskier a bond, the more variable the required return will be, resulting in greater price volatility.

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Coupon Effects on Price Volatility (cont.)

Finally, the amount of coupon interest also impacts a bonds price volatility. Specifically, the lower the coupon, the greater will be the bonds volatility, because it will be longer before the investor receives a significant portion of the cash flow from his or her investment.

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Semiannual Interest and Bond Values

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Semiannual Interest and Bond Values (cont.)

Assuming that the Mills Company bond pays interest semiannually and that the required stated annual return, rd is 12% for similar risk bonds that also pay semiannual interest, substituting these values into Equation 6.8a yields

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Yield
The word yield is frequently used with regard to investing in bonds. There are 3 important types of yields with which the investor must be familiar: the current yield, the yield to maturity, the yield to call. The Current Yield The current yield is the percentage that the investor earns annually. It is simply
Current = Annual Coupon Interest Current Market Price Yield

For example, a 10% coupon bond which is currently selling at $1,150 would have a current yield of: Current = $100 = 8.7% Yield $1,150

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Yield to Maturity (YTM)

When investors evaluate bonds, they commonly consider yield to maturity (YTM). This is the rate of return that investors earn if they buy the bond at a specific price and hold it until maturity. ( The measure assumes, of course, that the issuer makes all scheduled interest and principal payments as promised). The yield to maturity measures the compound annual return to an investor and considers all bond cash flows. It is essentially the bonds IRR based on the current price. Note that the yield to maturity will only be equal if the bond is selling for its face value ($1,000). And that rate will be the same as the bonds coupon rate. For premium bonds, the current yield > YTM. For discount bonds, the current yield < YTM.
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Yield to Maturity (YTM) ( Cont.)

- Assuming that interest rate is paid annually, the yield to maturity on a bond can be found by solving Equation 1 for kd. In other words, the current value, the annual interest, the par value and the years to maturity are known and the required return must be found. The required return is the bonds yield to maturity. The YTM can be found by trial and error or by using a financial calculator.

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Summary

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