Financial Management

Lecture 4

Dr. Harshit Rajaiya

Telfer School of Management
University of Ottawa
 Readings
• Readings: Chapter 7

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 Overview
➢ Know the important bond features and bond types
➢ Understand bond values and why they fluctuate
➢ Understand bond ratings and what they mean
➢ Know how bond prices are quoted
➢ Understand the impact of inflation on interest rates
➢ Understand the term structure of interest rates and the
determinants of bond yields

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 What is a bond?
➢ A bond is any debt instrument that promises an income
stream to the holder and the repayment of the face value
(principal) at maturity
• Examples: Corporate bonds, Treasury bonds

➢ Most bonds (there are exceptions) have:

• A fixed maturity date
• A fixed face (or par) value paid to the holder at maturity
• A fixed coupon which defines the bond’s interest payments and are typically paid
either annually or semi-annually

➢ They are often classified according to maturity:

• Less than one year – Bills or Paper
• 1 year < Maturity < 10 years – Notes
• Maturity > 10 years – Bonds

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What is a bond?

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LO1
Bond: important parameters
➢ Par value (face value)
➢ Coupon rate
➢ Coupon payment
➢ Maturity date
➢ Yield or Yield to maturity

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 Zero Coupon Bonds
➢ A zero-coupon bond is a bond issued at a discount that
matures at par or face value

➢ To calculate the price of a zero-coupon bond, solve for

the PV(face value)
➢ Example: What is the market price of a $50,000 zero
coupon bond with 25 years to maturity that is currently
yielding 6%?

F F = Face Value (or “Par” Value) to

PZCB = be received at time “n” (i.e. “T”, or

(1 + r )n year) in the future

Note: For zero-coupon bonds assume annual compounding unless otherwise stated
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 Bond Valuation: Semi-Annual Coupons
➢ So far, we have assumed that all bonds pay annual
coupons
• This is true for many Eurobonds; not true for most
domestic bond issues which pay semi-annual
coupons
• The standard North American method of expressing
bond coupons & yields is as a stated rate per year,
compounded semi-annually
➢ We adjust the bond valuation formula for semi-annual
coupons
• Size of the coupon payment → Divide by 2
• Number of periods → Multiply by 2
• Yield-to-maturity → Divide by 2
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 Bond Yields
➢ Yield-to-maturity (YTM) – the discount rate used to
value bonds
• The yield earned by a bond investor who:
• Purchases the bond at the current market price
• Held the bond to maturity
• Reinvested all of the coupons at the YTM
• Represents the bond’s Expected Rate of Return

C  1  F
B =  1 − +
r  ( 1 + r)n  ( 1 + r)n

NOTE: YTM is that discount rate that causes the sum of the present value
of promised cash flows to equal the current bond price.
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 Example:
For example, suppose you want to value a
10-year, $1,000 Government of Canada bond
with a 5% coupon, paid twice a year, given a
YTM of 6%.

1 1  F F
B = C − n
+ = C  Ar +
n

 r r( 1 + r)  ( 1 + r)n
( 1 + r)n

With the financial calculator:

N=20; PMT=25 FV=1000; I/Y=3; COMP PV=925.6 (it sells at a discount)
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 Solving for YTM
Example: What is the YTM for a 20-year, $1,000 bond
with a 6% coupon, paid semi-annually, given a current
market price of $1,030?

➢ Problem: can’t
solve for YTM C  1  F
B=  1 − +
algebraically; r  ( 1 + r)n  ( 1 + r)n
therefore, must either 30  1  1000
1030 =  1 − 40 
+
use a financial r  ( 1 + r)  ( 1 + r)40
calculator or trial and
error.

NOTE: Do not confuse YTM and coupon rate

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 YTM Calculation Continued
➢ Solving for YTM on the Calculator
➢ Remember to clear the memory first (in the BAII Plus: 2ndFV Mode)
➢ (YTM and IRR are the same thing)
Solving for YTM
30 PMT
1000 FV
40 n
-1030 PV
Comp I/Y => 2.87%x 2 = 5.74% YTM

Note: When solving for YTM with a semi-annual pay coupon, the yield
obtained must be multiplied by two to obtain the annual YTM

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LO2 Valuing a Discount Bond with Annual
Coupons
➢ Consider a bond with a coupon rate of 10% and coupons
paid annually. The par value is $1000 and the bond has 5
years to maturity. The yield to maturity is 11%. What is
the value of the bond?

• Using the formula:

• B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.11)5] / .11 + 1000 / (1.11)5
• B = 369.59 + 593.45 = 963.04

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 Valuing a Premium Bond with Annual
Coupons
➢ Suppose you are looking at a bond that has a 10%
annual coupon and a face value of $1000. There are 20
years to maturity and the yield to maturity is 8%.
➢ What is the price of this bond?

• Using the formula:

• B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20
• B = 981.81 + 214.55 = 1196.36

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 Bond Prices:
Relationship Between Coupon & Yield
• If YTM = coupon rate, then par value = bond price
– Selling at a par

• If YTM > coupon rate, then par value > bond price
– Selling at a discount, called a discount bond

• If YTM < coupon rate, then par value < bond price
– Selling at a premium, called a premium bond

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 Factors Affecting Bond Prices
• Yield-to-maturity (interest rate risk)
• Bond prices decrease when the YTM increases
• Bond prices increase when the YTM decreases

Inverse relation between YTM and bond price 16

LO3
Differences Between Debt and Equity
➢ Debt
• Not an ownership interest
• Bondholders do not have voting rights
• Interest is considered a cost of doing business and is
tax deductible
• Bondholders have legal recourse if interest or
principal payments are missed
• Excess debt can lead to financial distress and
bankruptcy

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Differences Between Debt and Equity
➢ Equity
• Ownership interest
• Common shareholders vote for the board of
directors and other issues
• Dividends are not considered a cost of doing
business and are not tax deductible
• Dividends are not a liability of the firm and
shareholders have no legal recourse if dividends are
not paid
• An all equity firm can not go bankrupt

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LO1
The Bond Indenture

Contract between the company and the

bondholders; 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
• Details of protective covenants

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 Corporate Long-Term Debt: Corporate
Bonds
➢ Issuer: Corporation
➢ Default: If firm does not pay debt, firm defaults and
creditors take control. Default creates additional risk for
corporate bondholders versus government bondholders.
➢ Control Rights: Creditors do not usually have voting power
or other ownership rights.
➢ Loan contract: Since they don’t have control, creditors
protect themselves using loan contracts.
➢ Tax Treatment: Interest on debt is fully tax-deductible.

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Some Special Features of Corporate Bonds
• Covenants: Various clauses that protect bondholders by limiting
management actions when firm is near defaults.
• Senior vs Subordinated bond: Seniority gives bondholder “first
rights” in case of default.
• Security: Gives bondholder collateral in event of default.
• A debenture is an unsecured bond
• Call Provisions: Allows bond issuer to buy back bond at pre-
specified price (and sometimes time)
• Most callable bonds have a deferred call and a declining call premium.
• Sinking fund provision: Provision to pay off a loan over its life
rather than all at maturity. Implemented in two ways:
1. Call x% at par per year for sinking fund purposes (randomly chosen)
2. Buy bonds on the open market.

➢ Do they help or hurt investors?

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 Other Bond Features
➢ Convertible bonds: Bondholders have a right to convert the bond
into shares of common stock, at a fixed price.
➢ Income bonds: Pay interest only when the issuer can afford to do
so (when earnings are high enough).
➢ Real return bonds: Principal and interests are indexed and
protected against inflation.
➢ Floating-rate bonds: The coupon rate is adjusted based on a
short-term rate (e.g., LIBOR)
➢ Retractable bonds: Allows investors to sell back bond at pre-
specified price (and sometimes time)
• Protect investors from the rising interest rates or increase in the default risk

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LO3 Bond Characteristics and Required
Returns
➢ The coupon rate 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 bond with a sinking fund versus one without
• A callable bond versus a non-callable bond

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 Default Risk and Ratings

• Rating companies
– Moody’s Investor Service
– Standard & Poor’s
– DBRS
– Fitch
• Rating Categories
– Investment grade
– Speculative grade

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 Bond Ratings – Investment Quality
➢ High Grade
• DBRS’s AAA – capacity to pay is exceptionally
strong
• DBRS’s AA – capacity to pay is very strong

➢ Medium Grade
• DBRS’s A – capacity to pay is strong, but more
susceptible to changes in circumstances
• DBRS’s BBB – capacity to pay is adequate, adverse
conditions will have more impact on the firm’s ability
to pay

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 Bond Ratings - Speculative

➢ Low Grade
• DBRS’s BB, B, CCC, CC
• Considered speculative with respect to capacity to
pay.
➢ Very Low Grade
• DBRS’s C – bonds are in immediate danger of default
• DBRS’s D – in default, with principal and/or interest in
arrears

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Bond Ratings
LO1
Stripped or Zero-Coupon Bonds
𝐅
Bond Value =
(𝟏 + 𝐫)𝐭

➢ 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
➢ Bondholder must pay taxes on accrued interest every
year, even though no interest is received

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LO1
Floating Rate Bonds
➢ Coupon rate floats depending on some index
value
➢ 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
➢ Coupons may have a “collar” – the rate cannot
go above a specified “ceiling” or below a
specified “floor”

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LO1
Other Bond Types
➢ Catastrophe bonds
➢ Income bonds
➢ Convertible bonds
➢ Put bond (retractable bond)
➢ 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

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 Bond Market
➢ Bonds are mostly traded over the counter (OTC)
➢ Bonds ETFs
➢ Purchasing directly from treasury, e.g., TreasuryDirect in US
➢ Canada Saving Bonds:
https://www.csb.gc.ca/products/?page_moved=1
 Determinants of Market Interest Rates
rd  r* + IP + DRP + LP + MRP
where rd = Market interest rate
r* = Real risk-free rate
IP = Inflation premium
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium

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LO5
The Fisher Effect
➢ The Fisher Effect defines the relationship
between real rates, nominal rates and inflation
➢ Exact relationship is (1 + R) = (1 + r)(1 + h),
where:
• R = nominal rate
• r = real rate
• h = expected inflation rate
➢ Approximation of the above relationship is:
• R=r+h

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 The Inflation Premium (IP)
➢ Extra points over r* to compensate bondholders for losing
the purchasing power of money due to inflation
➢ IP = Average expected inflation rate over the life of the
security.
➢ Relation between nominal (rRF) and real rate (r*)
rRF = (1 + r*)(1 + IP) – 1
= r* + IP + (r* x IP)
≈ r* + IP (because r* x IP is small).
➢ rRF = rT-bill = Rate on short- or long-term government bonds

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LO5
Example – Fisher Effect

➢ If we require a 5% real return and we expect

inflation to be 2%, what is the nominal rate?
➢ R = (1.05)(1.02) – 1 = 0.071 = 7.1%
➢ Approximation: R = 5% + 2% = 7%

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 The Default Risk Premium (DRP)
➢ The component of the nominal interest rate that
compensates bondholders for taking the default risk
➢ Default risk = the chance that interest or principal will not
be paid on the due date and in the promised amount.
➢ The greater the default risk, the higher the bond's DRP.

Bond Provisions That Influence Default Risk:

• Secured vs. unsecured debt
• Senior vs. subordinated debt
• Debt maturity

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 Credit rating

• Credit Ratings convey the risk of a firm

defaulting.
• Investment grade vs. junk (high-yield) bonds
• Important for YTM and Price of Corporate Bonds
• The YTM includes a risk premium to
compensate investors
• Are they always accurate? Conflict of interest
because firms pay ratings agencies for ratings
See also https://www.youtube.com/watch?v=9xZx1lf2tvs

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 The Liquidity Premium (LP)

➢ The component of the nominal interest rate that

compensates investors for holding illiquid bonds
➢ Liquidity (also known as marketability) refers to the
ease with which an asset can be converted into cash
quickly and at a "fair" market value
➢ Often difficult to accurately measure

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 The Maturity Risk Premium (MRP)

➢ All bonds, including Government of Canada

bonds, are exposed to two extra risks:

➢ MRP is greater for long-duration bonds,

primarily driven by interest rate risks

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 Bankruptcy and Reorganization
➢ A business is declared insolvent when it cannot meet its financial
obligations.
➢ Two options to deal with insolvency:
• dissolve through liquidation (bankruptcy)
• reorganize and stay alive

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 Reorganization
➢ If a company can't meet its obligations, it files under
Canada Revenue Agency, which stops creditors from
foreclosing, taking assets, and shutting down the
business.

➢ Company has 120 days to file a reorganization plan.

• Court appoints a "trustee" to supervise reorganization.
• Management usually stays in control.

➢ If both the majority of the creditors and the judge

approve, the company "emerges" from bankruptcy with
reorganize debt and continue to be in business.

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LO6
Term Structure of Interest Rates
➢ Term structure is the relationship between time to
maturity and yields, all else equal

➢ Tells us the what nominal interest rates are on default-

free, pure discount bonds of all interest rates

➢ Yield curve – same as term structure except that yield

curve is based on coupon bond yields
• Normal – upward-sloping, long-term yields are
higher than short-term yields
• Inverted – downward-sloping, long-term yields are
lower than short-term yields
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LO6 Term structure of interest rates

1-43

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 Yield Curve Canada

Source: https://www.marketwatch.com/investing/bond/tmbmkca-05y?countrycode=bx

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 Summary
➢ You should know:
• How to price a bond or find the yield
• Bond prices move inversely with interest rates
• Bonds have a variety of features that are spelled out
in the indenture
• Bonds are rated based on their default risk
• Fisher effect links interest rates and inflation
• Term structure of interest rates shows the
relationship between interest rates and maturity

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