Chapter 6

Interest Rates and

Bond Valuation
 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
 Chapter Outline
Bonds and Bond Valuation
More on Bond Features
Bond Ratings
Some Different Types of Bonds
Bond Markets
Inflation and Interest Rates
Determinants of Bond Yields
 Bond Definitions
Bond
Par value (face value)
Coupon rate
Coupon payment
Maturity date
Yield or Yield to maturity
 PV of Cash Flows as Rates
Change
Bond Value = PV of coupons + PV of par
Bond Value = PV annuity + PV of lump
sum
Remember, as interest rates increase, the
PVs decrease
So, as interest rates increase, bond prices
decrease, and vice versa
Valuing a Discount Bond with
Annual Coupons
Consider a bond with a coupon rate of 10%
and coupons paid annually. 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
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 $1,000. 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 + $1,000 /
(1.08)20
B = $981.81 + 214.55 = $1,196.36
Graphical Relationship Between
Price and YTM
1500
1400
1300
1200
Price

1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
YTM
 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?
Price below par = discount bond
If YTM < coupon rate, then par value <
bond price
Why?
Price above par = premium bond
The Bond-Pricing Equation

1
1- t
(1 + r) F
Bond Value = C + t
r (1 + r)
 Example 6.1
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
 Interest Rate Risk
Change in price due to changes in interest
rates
Interest rates up, bond price down!
Long-term bonds have more interest rate risk
than short-term bonds
More-distant cash flows are more adversely
affected by an increase in interest rates
Lower coupon rate bonds have more interest
rate risk than higher coupon rate bonds
More of the bonds value is deferred to maturity
(thus, for a longer time) if the coupons are small
Figure 6.2
 Computing YTM
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
or spreadsheet, 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)
 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%?
CPT YTM = 11%
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?
Solve for r by trial-and-error, starting with a
semiannual rate below 5%. Will this r be the
YTM?
YTM = 4%*2 = 8%
Table 6.1
Differences Between Debt and
Equity
Debt Equity
Not an ownership interest Ownership interest
Creditors do not have voting Common stockholders vote
rights to elect the board of
Interest is considered a cost directors and on other
of doing business and is tax- issues
deductible Dividends are not
Creditors have legal considered a cost of doing
recourse if interest or business and are not tax
principal payments are deductible
missed Dividends are not a liability
Excess debt can lead to of the firm until declared.
financial distress and Stockholders have no legal
bankruptcy recourse if dividends are not
declared
An all-equity firm cannot go
bankrupt
 The Bond Indenture
Contract between the company and the
bondholders and 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
 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
 Bond Characteristics and
Required Returns
The coupon rate is usually set close to
the yield, which depends on the risk
characteristics of the bond when issued
Which bonds will have the higher yield, 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
 Bond Ratings Investment
High Grade
Quality
Moodys Aaa and S&P AAA capacity to pay is
extremely strong
Moodys Aa and S&P AA capacity to pay is
very strong
Medium Grade
Moodys A and S&P A capacity to pay is
strong, but more susceptible to changes in
circumstances
Moodys Baa and S&P BBB capacity to pay is
adequate; adverse conditions will have more
impact on the firms ability to pay
 Bond Ratings - Speculative
Low Grade
Moodys Ba, B, Caa, and Ca
S&P BB, B, CCC, CC
Considered speculative with respect to
capacity to pay. The B ratings are the lowest
degree of speculation.
Very Low Grade
Moodys C and S&P C income bonds with no
interest being paid
Moodys D and S&P D in default with
principal and interest in arrears
 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
 Example 6.3
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%
 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, or deep discount
bonds
Treasury Bills and principal-only Treasury
strips are good examples of zeroes
 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
 Other Bond Types
Disaster bonds
Income bonds
Convertible bonds
Put 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
 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
 Bond Quotations
Consider the following bond quotation:
GM 8.375 Jul 15, 2033 100.641 8.316
362 30 763,528
Interpret the information above
Consider the last Treasury quotation
in Figure 6.3:
4 Feb 36 92:21 92:22 -8 4.98
What was the previous days asked
price?
 Inflation and Interest Rates
Real rate of interest change in
purchasing power
Nominal rate of interest - quoted rate of
interest; Reflects 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
 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
 Example 6.6
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.
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
Figure 6.5 Upward-Sloping
Yield Curve
Figure 6.5 Downward-Sloping
Yield Curve
Figure 6.6 Treasury Yield
Curve
 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
 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?
 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% YTM, 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%?