Chapter 5

Interest Rates and Bond Valuation

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 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

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 Chapter Outline
5.1 Bonds and Bond Valuation
5.2 More on Bond Features
5.3 Bond Ratings
5.4 Some Different Types of Bonds
5.5 Bond Markets
5.6 Inflation and Interest Rates
5.7 Determinants of Bond Yields

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 5.1 Bonds and Bond Valuation
 A bond is a legally binding agreement between
a borrower and a lender that specifies the:
 Par (face) value
 Coupon rate
 Coupon payment
 Maturity Date

 The yield to maturity is the required market

interest rate on the bond.

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 Bond Valuation
 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.
 Interest rates are inversely related to present
(i.e., bond) values.

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 The Bond-Pricing Equation

 1 
1 -
 (1  r) T  F
Bond Value  C   T
 r  (1  r)
 

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 Bond Example
 Consider a U.S. government bond with as 6 3/8%
coupon that expires in December 2009.
 The Par Value of the bond is $1,000.
 Coupon payments are made semi-annually (June 30 and
December 31 for this particular bond).
 Since the coupon rate is 6 3/8%, the payment is $31.875.
 On January 1, 2005 the size and timing of cash flows are:
$31.875 $31.875 $31.875 $1,031.875

1 / 1 / 05 6 / 30 / 05 12 / 31 / 05 6 / 30 / 09 12 / 31 / 09
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 Bond Example
 On January 1, 2005, the required yield is 5%.
 The size and timing of the cash flows are:

$31.875 $31.875 $31.875 $1,031.875


1 / 1 / 05 6 / 30 / 05 12 / 31 / 05 6 / 30 / 09 12 / 31 / 09

$31.875  1  $1,000
PV  1 10 
 10
 $1,060.17
.05 2  (1.025)  (1.025)
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 Bond Example: Calculator
Find the present value (as of January 1, 2005), of a 6 3/8%
coupon bond with semi-annual payments, and a maturity date of
December 2009 if the YTM is 5%.
N 10

I/Y 2.5

PV – 1,060.17
1,000×0.06375
PMT 31.875 =
2
FV 1,000
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 Bond Example
 Now assume that the required yield is 11%.
 How does this change the bond’s price?

$31.875 $31.875 $31.875 $1,031.875


1 / 1 / 05 6 / 30 / 05 12 / 31 / 05 6 / 30 / 09 12 / 31 / 09

$31.875  1  $1,000
PV  1 10 
 10
 $825.69
.11 2  (1.055)  (1.055)
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 YTM and Bond Value
When the YTM < coupon, the bond
1300 trades at a premium.
Bond Value

1200

1100 When the YTM = coupon, the

bond trades at par.
1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8 Discount Rate
When the YTM > coupon, the bond trades at a discount.
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 Bond Concepts
 Bond prices and market interest rates move
in opposite directions.
 When coupon rate = YTM, price = par
value
 When coupon rate > YTM, price > par
value (premium bond)
 When coupon rate < YTM, price < par
value (discount bond)

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 Interest Rate Risk
 Price Risk
 Change in price due to changes in interest rates
 Long-term bonds have more price risk than short-term bonds
 Low coupon rate bonds have more price risk than high coupon
rate bonds.
 Reinvestment Rate 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.

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 Maturity and Bond Price Volatility
Bond Value

Consider two otherwise identical bonds.

The long-maturity bond will have much more
volatility with respect to changes in the
discount rate.

Par

Short Maturity Bond

C Long Maturity Discount Rate

Bond
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 Coupon Rates and Bond Prices
Bond Value

Consider two otherwise identical bonds.

The low-coupon bond will have much more
volatility with respect to changes in the
discount rate.

Par

High Coupon Bond

C Discount Rate
Low Coupon Bond
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 Computing Yield to Maturity
 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).

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 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%?
 N = 15; PV = -928.09; FV = 1,000; PMT = 100
 CPT I/Y = 11%

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 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 semi-annual 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%

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 Current Yield vs. Yield to Maturity
 Current Yield = annual coupon / price
 Yield to maturity = current yield + capital gains yield
 Example: 10% coupon bond, with semi-annual
coupons, face value of 1,000, 20 years to maturity,
$1,197.93 price
 Current yield = 100 / 1197.93 = .0835 = 8.35%
 Price in one year, assuming no change in YTM = 1,193.68
 Capital gain yield = (1193.68 – 1197.93) / 1197.93 =
-.0035 = -.35%
 YTM = 8.35 - .35 = 8%, which is the same YTM computed
earlier

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 Bond Pricing Theorems
 Bonds of similar risk (and maturity) will be
priced to yield about the same return,
regardless of the coupon rate.
 If you know the price of one bond, you can
estimate its YTM and use that to find the price
of the second bond.
 This is a useful concept that can be transferred
to valuing assets other than bonds.

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 Bond Pricing with a Spreadsheet
 There are specific formulas for finding bond
prices and yields on a spreadsheet.
 PRICE(Settlement,Maturity,Rate,Yld,Redemption,
Frequency,Basis)
 YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
 Settlement and maturity need to be actual dates
 The redemption and Pr need to given as % of par value
 Click on the Excel icon for an example.

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 Debt versus Equity
 Debt  Equity
 Not an ownership interest  Ownership interest
 Creditors do not have voting  Common stockholders vote
rights for the board of directors and
 Interest is considered a cost of other issues
doing business and is tax  Dividends are not considered
deductible a cost of doing business and
 Creditors have legal recourse are not tax deductible
if interest or principal  Dividends are not a liability of
payments are missed the firm, and stockholders
 Excess debt can lead to have no legal recourse if
financial distress and dividends are not paid
bankruptcy  An all equity firm can not go
bankrupt

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 The Bond Indenture
 Contract between the company and the
bondholders that 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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 Bond Classifications
 Registered vs. Bearer Forms
 Security
 Collateral – secured by financial securities
 Mortgage – secured by real property, normally land or
buildings
 Debentures – unsecured
 Notes – unsecured debt with original maturity less than
10 years
 Seniority

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 Required Yields
 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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 5.3 Bond Ratings – Investment Quality
 High Grade
 Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
 Moody’s Aa and S&P AA – capacity to pay is very
strong
 Medium Grade
 Moody’s A and S&P A – capacity to pay is strong, but
more susceptible to changes in circumstances
 Moody’s Baa and S&P 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
 Moody’s Ba and B
 S&P BB and B
 Considered speculative with respect to capacity to pay.
 Very Low Grade
 Moody’s C and S&P C – income bonds with no
interest being paid
 Moody’s D and S&P D – in default with principal and
interest in arrears

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 Government Bonds
 Treasury Securities
 Federal government debt
 T-bills – pure discount bonds with original maturity less
than one year
 T-notes – coupon debt with original maturity between one
and ten years
 T-bonds – coupon debt with original maturity greater than
ten years
 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
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 After-tax Yields
 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?
 8%(1 - .4) = 4.8%
 The after-tax return on the corporate bond is 4.8%, compared
to a 6% return on the municipal
 At what tax rate would you be indifferent between the
two bonds?
 8%(1 – T) = 6%
 T = 25%

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 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, deep discount bonds, or
original issue discount bonds (OIDs)
 Treasury Bills and principal-only Treasury strips are
good examples of zeroes

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 Pure Discount Bonds
Information needed for valuing pure discount bonds:
 Time to maturity (T) = Maturity date - today’s date
 Face value (F)
 Discount rate (r)

$0 $0 $0 $F

0 1 2 T 1 T

Present value of a pure discount bond at time 0:

F
PV 
(1  r )T
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 Pure Discount Bonds: Example
Find the value of a 30-year zero-coupon bond
with a $1,000 par value and a YTM of 6%.
$0 $0 $0 $1,000 0$ 0$0,1$

01 22930



0 1 2 29 30

F $1,000
PV  T
 30
 $174.11
(1  r ) (1.06)
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 Floating Rate Bonds
 Coupon rate floats depending on some index value
 Examples – adjustable rate mortgages and inflation-
linked Treasuries
 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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 Other Bond Types
 Income bonds
 Convertible bonds

 Put bonds

 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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 5.5 Bond Markets
 Primarily over-the-counter 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 a small company or municipal
issues
 Treasury securities are an exception

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 Treasury Quotations
8 Nov 21 132:23 132:24 -12 5.14
 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?

 How much did the price change from the previous

day?
 What is the yield based on the ask price?

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 Clean versus Dirty Prices
 Clean price: quoted price
 Dirty price: price actually paid = quoted price plus accrued
interest
 Example: Consider T-bond in previous slide, assume today is
July 15, 2005
 Number of days since last coupon = 61
 Number of days in the coupon period = 184
 Accrued interest = (61/184)(.04*1,000) = 13.26
 Prices (based on ask):
 Clean price = 1,327.50
 Dirty price = 1,327.50 + 13.26 = 1,340.76
 So, you would actually pay $1,340.76 for the bond.

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 5.6 Inflation and Interest Rates
 Real rate of interest – change in purchasing
power
 Nominal rate of interest – quoted rate of
interest, change in purchasing power and
inflation
 The ex ante nominal rate of interest includes
our desired real rate of return plus an
adjustment for expected inflation.

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 The Fisher Effect
 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

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 The Fisher Effect: Example
 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 a significant
difference between the actual Fisher Effect and
the approximation.
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 5.7 Determinants of Bond Yields
 Term structure is the relationship between time to
maturity and yields, all else equal.
 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 short-term yields

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 Factors Affecting Required Return
 Default risk premium – remember bond ratings
 Taxability premium – remember municipal
versus taxable
 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.
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 Quick Quiz
 How do you find the value of a bond, and why do
bond prices change?
 What is a bond indenture, and what are some of the
important features?
 What are bond ratings, and why are they important?
 How does inflation affect interest rates?
 What is the term structure of interest rates?
 What factors determine the required return on bonds?

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