Chapter 8

Interest Rates and Bond Valuation

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Chapter
Outline
1. Bonds and Bond Valuation
2. Government and Corporate Bonds
3. Bond Markets
4. Inflation and Interest Rates
5. Determinants of Bond Yields

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8.1 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

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Bond
Example
• Consider a U.S. government bond with as 6 3/8%
coupon that expires in December 2013.
• The Par Value of the bond is $1,000.
• Coupon payments are made semiannually (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, 2009 the size and timing of cash flows
are:

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Bond
Example
• On January 1, 2009, the required yield is 5%.
• The current value is:

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Bond
Example
• Now assume that the required yield is 11%.
• How does this change the bond’s price?

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 YTM and Bond
Value When the YTM < coupon, the bond
trades at a premium.
1300

1200
Bond Value

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 8-8
Interest Rate
Risk
• Change in price due to changes in interest rates
• Long-term bonds have more interest rate risk than
short-term bonds
• Low coupon rate bonds have more interest rate risk
than high coupon rate bonds.

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Maturity and Bond Price
Consider two otherwise identical
Volatility bonds.
The long-maturity bond will have
much more volatility with respect to
changes in the discount rate.

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Coupon Rates and Bond
Prices 10 year semi-annual bonds
YTM 10%Coupon 20%Coupon
5% 139 217
10% 100 162
15% 75 125
20% 57 100
Consider two otherwise identical
250 bonds.
The low-coupon bond will have much
200
more volatility with respect to changes
150 in the discount rate.
10%Coupon

100
20%Coupon

50

0
5% 10% 15% 20%

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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 without

spreadsheet and is similar to the process for finding r with
an annuity.

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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
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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
using formula 8-14
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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 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)

Present value of a pure discount bond at time 0:

F
PV 
(1 r)T 8-17
Pure Discount Bonds:
Example
Find the value of a 15-year zero-coupon bond with a $1,000
par value and a YTM of 12%.

$1,000
$0 $0 $0 

…
0 1 2 29 30

F
PV  T 
$1,000
30 
(1 r) (1.06)
$174.11
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8.2 Government and Corporate 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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Corporate
Bonds
• Greater default risk relative to government bonds
• The promised yield (YTM) may be higher than the
expected return due to this added default risk

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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 speculative with respect to capacity to pay.
• Very Low Grade
• Moody’s C
• S&P C & D
• Highly uncertain repayment and, in many cases,
already in default, with principal and interest in
arrears.

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 8.3 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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 8.4 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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Real versus Nominal
Rates
• (1 + R) = (1 + r)(1 + i), where
• R = nominal rate
• r = real rate
• i = expected inflation rate
• Approximation
• R=r+i

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Inflation-Linked
Bonds
• Most government bonds face inflation risk

• TIPS (Treasury Inflation-Protected Securities), however,

eliminate this risk by providing promised payments

specified in real, rather than nominal, terms.

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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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8.5 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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Term structure

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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 (remember bid-ask

spreads)
• 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 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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