CHAPTER 7

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 about 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
 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
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
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
 Graphical Relationship Between Price and
Yield-to-maturity (YTM)
1500
Bond Price, in dollars

1400
1300
1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%

Yield-to-Maturity Yield-to-maturity
(YTM) (YTM)

Bond characteristics:
10 year maturity, 8% coupon rate, $1,000 par value
 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
The Bond Pricing Equation

 1 
1 -
 (1 + r) t  FV
Bond Value = C  +
 (1 + r)
t
 r
 
Example 7.1

• If an ordinary bond has a coupon rate of

14 percent, then the owner will get a total
of $140 per year, but this $140 will come in
two payments of $70 each. The yield to
maturity is quoted at 16 percent. The bond
matures in seven years.

• Note: Bond yields are quoted like APRs;

the quoted rate is equal to the actual rate
per period multiplied by the number of
periods.
Example 7.1

▪ How many coupon payments are there?

▪ What is the semiannual coupon payment?

▪ What is the semiannual yield?

▪ What is the bond price?

▪ 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
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
Figure 7.2
 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)
 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%
 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%
Table 7.1
 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
 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
 Differences Between
Debt and Equity
◼ Debt ◼ Equity
▪ Not an ownership interest ▪ Ownership interest
▪ Creditors do not have ▪ Common stockholders vote
voting rights for the board of directors
▪ Interest is considered a 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
missed liability 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
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
 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 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
 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
Bond Ratings –
Speculative Grade

◼ 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
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 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%
 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
 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 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
 Sukuk

◼ Sukuk are bonds have been created to

meet a demand for assets that comply
with Shariah, or Islamic law

◼ Shariah does not permit the charging or

paying of interest

◼ Sukuk are typically bought and held to

maturity, and are extremely illiquid
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

Treasury Quotations

◼ Highlighted quote in Figure 7.4

Maturity Coupon Bid Asked Chg Asked yield
5/15/2030 6.250 136.8359 136.9141 -0.7813 3.289

▪ 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?

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

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
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 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.
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 7.6 – Upward-Sloping Yield Curve
Figure 7.6 – Downward-Sloping
Yield Curve
Figure 7.7
Factors Affecting
Bond Yields

◼ Real rate of interest

◼ Expected future inflation premium

◼ Interest rate risk premium

◼ Default risk premium

◼ Taxability premium

◼ Liquidity premium
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%?
Chapter 7
End of Chapter