Chapter 7

Interest Rates and

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 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
• Bonds and Bond Valuation
• More about Bond Features
• Bond Ratings
• Some Different Types of Bonds
• Bond Markets
• Inflation and Interest Rates
• Determinants of Bond Yields

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 Bond Definitions
• Bond
• Par value (face value)
• Coupon rate
• Coupon payment
• Maturity date
• Yield or Yield to maturity

7-4
Present Value of Cash Flows as
Rates Change
• Bond Value = PV of coupons + PV of par
• Bond Value = PV of annuity + PV of lump
sum
• As interest rates increase, present values
decrease
• So, as interest rates increase, bond prices
decrease and vice versa

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Valuing a Discount Bond with
Annual Coupons
• Consider a bond with a coupon rate of 10% and
annual coupons. The par value is $1,000, 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 + 1,000 / (1.11)5
• B = 369.59 + 593.45 = 963.04
– Using the calculator:
• N = 5; I/Y = 11; PMT = 100; FV = 1,000
• CPT PV = -963.04

7-6
Valuing a Premium Bond with
Annual Coupons
• Suppose you are reviewing 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
– Using the calculator:
• N = 20; I/Y = 8; PMT = 100; FV = 1000
• CPT PV = -1,196.36

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Graphical Relationship Between
Price and Yield-to-maturity (YTM)
1500
1400
1300
Bond Price

1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%

Yield-to-maturity (YTM)

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Bond Prices: Relationship
Between Coupon and Yield
• If YTM = coupon rate, then par value = bond price
• If YTM > coupon rate, then par value > bond price
– Why? The discount provides yield above coupon rate
– Price below par value, called a discount bond
• If YTM < coupon rate, then par value < bond price
– Why? Higher coupon rate causes value above par
– Price above par value, called a premium bond

7-9
 The Bond Pricing Equation

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

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 Example 7.1
• Find present values based on the payment
period
– How many coupon payments are there?
– What is the semiannual coupon payment?
– What is the semiannual yield?
– B = 70[1 – 1/(1.08)14] / .08 + 1,000 / (1.08)14 =
917.56
– Or PMT = 70; N = 14; I/Y = 8; FV = 1,000;
CPT PV = -917.56

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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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Figure 7.2

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Computing Yield to Maturity
• Yield to Maturity (YTM) 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)

7-14
 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 semiannual 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%

7-16
Table 7.1

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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 semiannual
coupons, face value of 1,000, 20 years to
maturity, $1,197.93 price
– Current yield = 100 / 1,197.93 = .0835 = 8.35%
– Price in one year, assuming no change in YTM =
1,193.68
– Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 =
-.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

7-19
 Bond Prices with a
Spreadsheet
• There is a specific formula for finding
bond prices 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 be input as % of par
value
• Click on the Excel icon for an example

7-20
 Differences Between
Debt and Equity
• Debt • Equity
– Not an ownership interest – Ownership interest
– Creditors do not have – Common stockholders
voting rights vote for the board of
– Interest is considered a directors and other issues
cost of doing business and – Dividends are not
is tax deductible considered a cost of doing
– Creditors have legal business and are not tax
recourse if interest or deductible
principal payments are – Dividends are not a liability
missed of the firm, and
– Excess debt can lead to stockholders have no legal
financial distress and recourse if dividends are
bankruptcy not paid
– An all equity firm can not
go bankrupt merely due to
debt since it has no debt
7-21
 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

7-22
 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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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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 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 possible that the capacity
to pay will degenerate.
• Very Low Grade
– Moody’s C (and below) and S&P C
(and below)
• income bonds with no interest being paid, or
• 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 of
one year or less
– 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

7-27
 Example 7.4
• 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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 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
• Disaster bonds
• 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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 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 small company or municipal
issues
• Treasury securities are an exception

7-32
 Work the Web Example
• Bond quotes are available online
• One good site is Bonds Online
• Click on the web surfer to go to the site
– Follow the bond search, corporate links
– Choose a company, enter it under Express
Search Issue and see what you can find!

7-33
Treasury Quotations
• Highlighted quote in Figure 7.4
– 8 Nov 21 136.29 136.30 5 4.36
– 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?

7-34
 Clean vs. Dirty Prices
• Clean price: quoted price
• Dirty price: price actually paid = quoted price plus
accrued interest
• Example: Consider a T-bond with a 4%
semiannual yield and a clean price of $1,282.50:
– Number of days since last coupon = 61
– Number of days in the coupon period = 184
– Accrued interest = (61/184)(.04*1000) = $13.26
– Dirty price = $1,282.50 + $13.26 = $1,295.76
• So, you would actually pay $ 1,295.76 for the
bond

7-35
Inflation and Interest Rates
• Real rate of interest – change in
purchasing power
• Nominal rate of interest – quoted rate of
interest, change in actual number of
dollars
• The ex ante nominal rate of interest
includes our desired real rate of return plus
an adjustment for expected inflation

7-36
 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

7-37
 Example 7.5
• 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
significant difference between the actual
Fisher Effect and the approximation.

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 Term Structure of Interest
Rates
• 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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Figure 7.6 – Upward-Sloping
Yield Curve

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Figure 7.6 – Downward-
Sloping Yield Curve

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 Figure 7.7

Insert new Figure 7.7 here

7-42
 Factors Affecting Bond
Yields
• 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

7-43
 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?

7-44
 Ethics Issues
• In 1996, allegations were made against Moody’s
that it was issuing ratings on bonds it had not
been hired to rate, in order to pressure issuers to
pay for their service. The government conducted
an inquiry, but charges of antitrust violations were
dropped. Even though no legal action was taken,
does an ethical issue exist?

7-45
 Comprehensive Problem
• What is the price of a $1,000 par value
bond with a 6% coupon rate paid
semiannually, if the bond is priced to yield
5% and it has 9 years to maturity?
• What would be the price of the bond if the
yield rose to 7%.
• What is the current yield on the bond if the
YTM is 7%?

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End of Chapter

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