CHAPTER 8

Interest Rates and Bond Valuation

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.

8-2
 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.
8-3
THE BOND-PRICING EQUATION

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

8-4
 BOND EXAMPLE

• Consider a U.S. government bond with as 6

3/8% coupon that expires in December 2016.
• 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, 2012 the size and timing of cash
flows are:
$ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 1,0 3 1 .8 7 5

1 /1 /12 6 / 30 /12 12 / 31 /12 6 / 30 /16 12 / 31 /16

8-5
 BOND EXAMPLE
• On January 1, 2012, the required yield is 5%.
• The current value is:

$ 31 . 875  1  $ 1, 000
PV   1  (1 . 025 ) 1 0   (1 . 025 ) 1 0  $ 1, 060 . 17
. 05 2  

8-6
 BOND EXAMPLE: CALCULATOR
Find the present value (as of January 1, 2012), of a 6
3/8% coupon bond with semi-annual payments, and a
maturity date of December 2016 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
8-7
 BOND EXAMPLE
• Now assume that the required yield is 11%.
• How does this change the bond’s price?

$ 31 . 875  1  $ 1, 000
PV   1  (1 . 055 ) 1 0   (1 . 055 ) 1 0  $ 825 . 69
. 11 2  

8-8
 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. 8-9
 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)

8-10
 INTEREST RATE RISK
• Price Risk
• Price risk is simply the risk that the price of a
security will fall.
• 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.

8-11
 REINVESTMENT RATE RISK
• The risk that future coupons from a bond will not
be reinvested at the prevailing interest rate when
the bond was initially purchased.
• Reinvestment risk is more likely when interest
rates are declining.
• Reinvestment risk affects the yield-to-maturity of a
bond, which is calculated on the idea that all
future coupon payments will be reinvested at the
interest rate when the bond was first purchased.

8-12
 REINVESTMENT RATE RISK
• Two factors that have a bearing on the degree of
reinvestment risk are:

Maturity of the bond - The longer the maturity of the

bond, the higher the likelihood that interest rates will be
lower than they were at the time of the bond purchase.

Interest rate on the bond - The higher the interest rate,

the bigger the coupon payments that have to be
reinvested, and consequently the reinvestment risk.

8-13
 INTEREST RATE RISK
• Reinvestment Rate Risk
• 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.

8-14
 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 Discount Rate
Long Maturity
Bond 8-15
 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
Low Coupon Bond

C Discount Rate

8-16
 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 it 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).

8-17
 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%

8-18
 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%

8-19
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 8-20
 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

8-21
 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 2 T  1 T

Present value of a pure discount bond at time 0:

F
PV  T
(1  r ) 8-22
 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%.

$0 $0 $0 $ 1,0 0 0 $0 $0 $1,0

022930

0 2 29 30

F $ 1,000
PV  T
 30
 $ 174 .11
(1  i ) (1 .06 )
8-23
 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

8-24
 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
8-25
 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%

8-26
 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

8-27
 CORPORATE BONDS
•• Default
Default Risk
Risk Premium
Premium ((DRP
DRP))
DRP
DRPj j=
=ijtijt––iTt
iTt

iijtjt =
= interest
interest rate
rate on
on security
security jj at
at time
time tt
iiTtTt =
= interest
interest rate
rate on
on similar
similar maturity
maturity
U.S.
U.S. Treasury
Treasury security
security at
at time
time tt

8-28
 BOND CREDIT RATINGS
Bond Credit Ratings (Source: Text Table 6-10)
Explanation Moody’s S&P
Best quality; smallest degree of risk Aaa AAA
Aa1 AA+
High quality; slightly more long-term risk than top rating Aa2 AA
Aa3 AA-
A1 A+
Upper medium grade; possible impairment in the future A2 A
A3 A-
Baa1 BBB+
Medium grade; lacks outstanding investment characteristics Baa2 BBB
Baa3 BBB-
Ba1 BB+
Speculative issues; protection may be very moderate Ba2 BB
Ba3 BB-
B1 B+
Very speculative; may have small assurance of interest and
B2 B
principal payments
B3 B-
Issues in poor standing; may be in default Caa CCC
Speculative in a high degree; with marked shortcomings Ca CC
Lowest quality; poor prospects of attaining real investment C C
standing D
8-29
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

8-30
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.

8-31
 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

8-32
 TREASURY QUOTATIONS

8 Nov 28 132:23 132:24 -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?

8-33
 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, 2012
• 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.

8-34
 ACCRUED INTEREST AND
PRICES
•• Accrued
Accrued interest
interest mustmust bebe paid
paid byby the
the buyer
buyer
of
of aa bond
bond to
to the
the seller
seller of
of aa bond
bond ifif the
the bond
bond is
is
purchased
purchased between
between interest
interest payment
payment dates.
dates.

•• The
The price
price of
of the
the bond
bond with
with accrued
accrued interest
interest is
is
called
called the
the full
full price
price or
or the
the dirty
dirty price
price,, the
the
price
price without
without accounting
accounting forfor accrued
accrued interest
interest
is
is the
the clean
clean price
price..

8-35
 ACCRUED INTEREST ON BONDS

•• Accrued
Accrued interest
interest on
on T-notes
T-notes and
and T-bonds
T-bonds is
is
calculated
calculated as:
as:
INT Actual number of days since last coupon payment
Accrued interest  
2 Actual number of days in coupon period

•• The
The full
full (or
(or dirty)
dirty) price
price of
of aa T-note
T-note or or T-bond
T-bond is
is
the
the sum
sum of of the
the clean
clean price
price ((VVbb)) and
and the
the
accrued
accrued interest
interest

8-36
 ACCRUED INTEREST EXAMPLE
•• You
Youbuy
buyaa6%
6%coupon
coupon$1,000
$1,000par
parT-bond
T-bond59 59days
daysafter
afterthe
thelast
last
coupon
couponpayment.
payment. Settlement
Settlementoccurs
occursinintwo
twodays.
days. YouYoubecome
become
the
theowner
owner6161days
daysafter
afterthe
thelast
lastcoupon
couponpayment
payment(59+2),
(59+2),andand
there
thereare
are121
121days
daysremaining
remaininguntil
untilthe
thenext
nextcoupon
couponpayment.
payment.
The
Thebond’s
bond’sclean
cleanprice
pricequote
quoteisis120:19.
120:19. What
Whatisisthe
thefull
fullor
ordirty
dirty
price
price(sometimes
(sometimescalled
calledthe
theinvoice
invoiceprice)?
price)?
$60 61
Accrued Interest   $10.05
2 (121  61)

•• The
Theclean
cleanprice
priceisis120:19
120:19oror120
12019/32%
19/32%of
of$1,000
$1,000or
or
$1,205.9375.
$1,205.9375.
•• Thus,
Thus,the
thedirty
dirtyprice
priceisis$1,205.9375
$1,205.9375++$10.05
$10.05==$1,215.9875.
$1,215.9875.

8-37
 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.

8-38
 REAL VERSUS NOMINAL RATES
• (1 + R) = (1 + r)(1 + h), where
• R = nominal rate
• r = real rate
• h = expected inflation rate

• Approximation
• R=r+h

8-39
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.

8-40
 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.

8-41
 PRACTICE QUESTIONS
1. If Treasury bills are currently paying 4.5 percent and the inflation
rate is 2.1 percent, what is the approximate real rate of interest?
The exact real rate?

2. Laurel, Inc., and Hardy Corp. both have 7 percent coupon bonds
outstanding, with semiannual interest payments, and both are
priced at par value. The Laurel, Inc., bond has 2 years to maturity,
whereas the Hardy Corp. bond has 15 years to maturity. If interest
rates suddenly rise by 2 percent, what is the percentage change in
the price of these bonds? If interest rates were to suddenly fall by 2
percent instead, what would the percentage change in the price of
these bonds be then? Illustrate your answers by graphing bond
prices versus YTM. What does this problem tell you about the
interest rate risk of longer-term bonds?

8-42
 PRACTICE QUESTIONS
3. Tesla Corporation needs to raise funds to finance a plant
expansion, and it has decided to issue 25-year zero coupon bonds
to raise the money. The required return on the bonds will be 7
percent.
a. What will these bonds sell for at issuance?
b. Using the IRS amortization rule, what interest deduction can
the company take on these bonds in the first year? In the last
year?
c. Repeat part (b) using the straight-line method for the interest
deduction.
d. Based on your answers in (b) and (c), which interest deduction
method would Tesla Corporation prefer? Why?

8-43