Chapter 6

Interest Rates and Bond Valuation

Yacoub Sleibi, PhD, FHEA
Bethlehem University
1

Chapter Overview

LG1 Describe interest rate fundamentals, the term structure of

interest rates, and risk premiums.
LG2 Review the legal aspects of bond financing and bond cost.
LG3 Discuss the general features, yields, prices, popular types,
and international issues of corporate bonds.
LG4 Understand the key inputs and basic model used in the
valuation process.
LG5 Apply the basic valuation model to bonds and describe the
impact of required return and time to maturity on bond
values.
LG6 Explain yield to maturity (YTM), its calculation, and the
procedure used to value bonds that pay interest
semiannually/quarterly.

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 Part I: Interest rates,
theory and types of bonds

Bond: basic concepts

• Definitions:
• Bond: is a debt instruments (security) requiring (obligation) the issuer
(borrower) to repay the lender (bondholder/investor) the amount borrowed
plus interest over a specified period of time.
• Maturity date (due): the date on which the principal is required to be
repaid.
• Yield to maturity (YTM): the rate at which the present value of the future
payment equals the price of the bond (discount rate or required return)
quoted as APR.
• Coupon: the interest amount paid to bondholder.
• Coupon rate: the interest rate used to determine the coupon payment.
• Par value: the amount of money that bond issuers promise to repay to
investors at mature date. (aka: face value, principal, maturity value)
• Bond indenture: the contract between the issuer and bondholder that
specifies all bonds’ features.

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 Interest Rates and Required Returns

• The term interest rate is usually applied to debt

instruments such as bank loans or bonds; the
compensation paid by the borrower of funds to the
lender; from the borrowerbs point of view, the cost of
borrowing funds.

Interest Rates and Required Returns

Several factors can influence the equilibrium

interest rate:
1. Inflation, which is a rising trend in the prices of
most goods and services.
2. Risk, which leads investors to expect a higher
return on their investment
3. Liquidity preference, which refers to the general
tendency of investors to prefer short-term
securities

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 Interest Rates and Required Returns

• The real rate of interest (r*) is the rate that creates

equilibrium between the supply of savings and the
demand for investment funds in a perfect world,
without inflation, where suppliers and demanders of
funds have no liquidity preferences and there is no
risk.
• The real rate of interest changes with changing
economic conditions, tastes, and preferences.

Interest Rates and 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 and Required Returns:
Nominal or Actual Rate of Interest (Return)

• The nominal rate of interest for security 1, r1, is

given by the following equation:

• The nominal rate can be viewed as having two

basic components: a risk-free rate of return, RF,
and a risk premium, RP1:

Interest Rates and Required Returns:

Nominal or Actual Rate of Interest (cont.)

• For the moment, ignore the risk premium, RP1, and

focus exclusively on the risk-free rate. The risk-free
rate can be represented as:
RF = r* + IP
• The risk-free rate (as shown in the preceding equation)
embodies the real rate of interest plus the expected
inflation premium.
• The inflation premium is driven by investorsb
expectations about inflation—the more inflation they
expect, the higher will be the inflation premium and
the higher will be the nominal interest rate.
 Interest Rates and Required Returns:
Nominal or Actual Rate of Interest (cont.)

r* = nominal rate – inflation rate

• Real interest rate is the nominal interest rate after

removing the inflation expectations.
• Also called Fisher equation.

Term Structure of Interest Rates

• The term structure of interest rates is the
relationship between the maturity (time) and rate
of return (interest) for bonds with similar levels of
risk.
• A graphic depiction of the term structure of
interest rates is called the yield curve.
• The yield to maturity is the compound annual
rate of return earned on a debt security
purchased on a given day and held to maturity.
 Term Structure of Interest Rates: Yield Curves (cont.)

• A normal yield curve is an upward-sloping yield

curve indicates that long-term interest rates are
generally higher than short-term interest rates.
• An inverted yield curve is a downward-sloping
yield curve indicates that short-term interest
rates are generally higher than long-term interest
rates (happens when investors expect a recession
in the S/T).
• A flat yield curve is a yield curve that indicates
that interest rates do not vary much at different
maturities (it signals uncertainty in the market)

Figure 6.3
Treasury Yield Curves (page 279)
 Theories of Term Structure

Three theories are frequently cited to explain

the general shape of the yield curve:
1. Expectations theory
2. Liquidity preference theory
3. Market segmentation theory

Theories of Term Structure

1) Expectations Theory
Expectations theory is the theory that the yield
curve reflects investor expectations about future
interest rates (or inflation); an expectation of
rising interest rates results in an upward-sloping
yield curve (normal), and an expectation of
declining rates results in a downward-sloping yield
curve (inverted).
 Theories of Term Structure (cont.)

2) Liquidity Preference Theory

Liquidity preference theory suggests that long-term
rates are generally higher than short-term rates
(hence, the yield curve is upward sloping) because
investors perceive short-term investments to be more
liquid and less risky than long-term investments.
Borrowers must offer higher rates on long-term bonds
to compensate and attract investors.
Note: Based on the liquidity theory the curve must be
normal

Theories of Term Structure (cont.)

3) Market Segmentation Theory

Market segmentation theory suggests that the
market for loans (or bonds) is segmented on the
basis of maturity and that the supply of and
demand for loans within each segment determine
its prevailing interest rate; the slope of the yield
curve is determined by the general relationship
between the prevailing rates in each market
segment.
 Risk Premiums: Issue and Issuer Characteristics

• So far, we have considered only risk-free U.S.

Treasury securities.
• The nominal rate of interest for a security is equal
to the risk-free rate (consisting of the real rate of
interest plus the inflation expectation premium)
plus the risk premium RP.
r = r* + IP + RP
• The risk premium varies with specific issuer and
issue characteristics.

Risky versus riskless bonds

Remember:

Two types of bonds in terms of the issuer:

A) Government bonds(treasury) ex: T-bills (US),
GILTS (UK) these bonds are risk free.
B) Corporate bonds (risky) ex: a bond issues by
Apple.

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 Risk Premiums: Issue and Issuer Characteristics

The nominal rates on

a number of classes
of long-term
securities in May
2019 were:

Because the
Treasury bond
would represent
the risk-free, long-
term security, we
can calculate the
risk premium of
the other securities
by subtracting the
risk-free rate.

Table 6.1 Debt-Specific Risk Premium Components

In the Fisher equation, r = r* + IP + RP, the risk premium, RP, consists of the following:

Default risk: The possibility that the issuer will not pay the contractual interest or
principal as scheduled.
Maturity (interest rate) risk: The possibility that changes in the interest rates on
similar securities will cause the value of the security to change by a greater amount the
longer its maturity, and vice versa.
Liquidity risk: The ease with which securities can be converted to cash without a loss
in value.
Contractual provisions: Covenants included in a debt agreement defining the rights
and restrictions of the issuer and the purchaser. These can increase or reduce the risk
of a security. Ex: Call risk.
Tax risk: Certain securities issued by agencies of state and local governments are
exempt from federal, and in some cases state and local taxes, thereby reducing the
nominal rate of interest by an amount that brings the return into line with the after-tax
return on a taxable issue of similar risk.
 Credit rating and risk

• Credit rating is a way to measure the creditworthiness

of a bond.
• Creditworthiness: evaluation of bonds issuer, it refers
to the financial strength & capacity to repay back the
promised payments from the company to investors.
• How do we learn about credit rating?
• Three rating agencies (US based):
Moody, standard and Poor (S&P), and Fitch.

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Table 6.3 Moodybs and Standard & Poorbs Bond Ratings

 Credit rating and risk

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Credit rating and risk

• High rated bonds have better investments quality due

to their high grade. Ex: AAA or AA
• Low grade bonds are speculative. Ex: Ba, B, Caa.

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 Traditional Types of Bonds

Bonds can be secured or unsecured

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Table 6.4 Characteristics and Priority of Lenderbs Claim of

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

Definition and Example of Bonds

Other types of bonds

• Companies and governments may want to borrow internationally by issuing bonds:
• Eurobond: issued by international borrower, denominated in a currency other
than home currency and traded globally.
• Foreign bond: issued in a host country’s financial market, in a host country’s
currency by foreign borrower.
• Other types:
• zero coupon bond (sells at discount),
• junk bond (high risk),
• puttable bond
• floating rate bond (coupon floats depending on mortgage rate and inflation).
• extendible bonds or notes

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 Appendix for part I

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Term Structure of Interest Rates

• Term structure: the relationship between time

to maturity and yields, all else equal.

• Yield curve: Graphical representation of the term structure.

– Normal = upward-sloping ĺ L/T > S/T.
– Inverted = downward-sloping ĺ L/T < S/T.

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Figure A-18: Upward-Sloping Yield Curve

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Figure B-19: Downward-Sloping Yield Curve

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 Downward-Sloping Yield Curve

Note: An inverted yield curve (abnormal) can be an indicator for

an upcoming recession.
• If investors expect a recession in the S/T, then they go short
on S/T bonds, and instead, invest in L/T bonds.
• Investors, shift their money to L/T bonds by selling their
holdings on S/T bonds. This scenario creates a surge in the
demand for L/T bonds.
• As the demand for L/T bonds increase, the prices of these
instruments also increase.
• An increase in prices of L/T bonds pressure down the interest
on these bonds (negative relation between P and YTM)
• This results in inverted yield curve.

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Bonds vs a bank loan

Bonds Bank Loans

•Public • Private
•Principal not • Repayments
normally paid normally in the
form of annuity
until end of (loan amortization)
bond life

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 Part II: Bond valuation

37

Bond: basic concepts

• Definitions:
• Bond: is a debt instruments (security) requiring (obligation) the issuer
(borrower) to repay the lender (bondholder/investor) the amount borrowed
plus interest over a specified period of time.
• Maturity date (due): the date on which the principal is required to be
repaid.
• Yield to maturity (YTM): the rate at which the present value of the future
payment equals the price of the bond (discount rate also called required
return on a bond) quoted as APR.
• Coupon: the interest amount paid to bondholder.
• Coupon rate: the interest rate used to determine the coupon payment.
• Par value: the amount of money that bond issuers promise to repay to
investors at mature date. (aka: face value, principal, maturity value)
• Bond indenture: the contract between the issuer and bondholder that
specifies all bonds’ features.

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 Valuation overview

• Definitions:
• Valuation: is the process of findings/determining the
worth of an asset (intrinsic value) usually at time (t=0).
• Why valuation is important?
• Three inputs needed:
• cash flow (payments, returns)
• Timing
• A measure of risk (interest rate)

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How to Value Bonds?

To find PV of a bond, we must discount
all future cash flows: Coupon + par
 How to Value Bonds
Three Common Bond Types

Pure Discount (zero Coupon bond): No Coupon, Only Principal

Fixed Rate: Coupon and Principal

Consol: Coupon, No Principal

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How to Value Bonds

Three types (cases) in terms of valuation:
Assume each bond matures in 5 years except the
perpetual bond.
1 2 3 4 5 … For ever
Pure
Discount
(zero
coupon) Principal
Fixed Coupon +
Rate Coupon Coupon Coupon Coupon Principal
Consol Coupon Coupon Coupon Coupon Coupon Coupon

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 How to Value Bonds
1. Valuation: Pure Discount Bonds (zero coupon)

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How to Value Bonds

1. Valuation: Pure Discount Bonds

What is the price of a pure discount bond

that pays €1 million in 20 years? Interest
rates are 10 per cent.

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 How to Value Bonds
2. Valuation: Fixed Rate Bonds

Note: One can use Annuity formula to discount bonds as follows

(we merge annuity + single formulas):
ª 1 º
« 1  t »
1  YTM F
Bond Value C « »
« YTM » 1  YTM t

« »
¬ ¼
Bond value = PV or V0, C = Coupon payment; F = Face value, YTM = discount rate or required rate

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How to Value Bonds

Example on Valuation: Fixed Rate Bonds

What is the price of a 1.375 per cent coupon bond

that pays €10,000 in five years? Interest rates are
1.48 per cent. If payments are made annually.

Now, find the PV based on the annuity formula….

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 How to Value Bonds
What if the bond pays semiannual Coupons?
C = Annual coupon payment ĺ C ÷ 2 = Semiannual coupon
r = Annual yield ĺ r ÷ 2 = Semiannual yield
t = Years to maturity ĺ 2t = total number of coupon
payments

What if the bond pays quarterly Coupons?

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How to Value Bonds

3. Valuation: Consol Bonds (no maturity, C forever)

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 How to Value Bonds
Valuation: Consol Bonds

What is the price of a 5 per cent consol

bond with a face value of €1,000?
Interest rates are 10 per cent.

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How to Value Bonds

Example:

Three years ago, you purchased a bond with a coupon rate of 8%

and 9 years left until maturity. The bond pays coupons semi-
annually. Today, the market requires a return of 6% for a similar
investment to your bond. What is the current value of your bond?

Answer: $1,149.36

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 Interest rates, prices and yield to
maturity

Bond Concepts
Interest Rates and Prices
Interest Bond Price
Rate
Interest
Bond Price Rate
At the face value if the coupon rate is equal to the market-wide interest rate.

At a discount if the coupon rate is below the market-wide interest rate.

At a premium if the coupon rate is above the market-wide interest rate.

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Bond Prices: Relationship Between Coupon and Yield

Summary:
Coupon rate = YTM ĺPrice = Par (at face value).
Coupon rate < YTM ĺPrice < Par (at discount)
Coupon rate > YTM ĺPrice > Par (at premium).

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