Learning Objectives • Bonds & Bond Valuation. • Inflation & Interest Rates. • Determinants of Bond Yields.
Introduction • Corporations and governments frequently borrow money by issuing or selling debt securities called bonds.
• These bonds can be valued using the cashflows associated with these bonds. – By discounting these cashflows. – Hence, bond values depend, in large part, on interest rates.
Bonds & Bond Valuation
Bond Features & Prices
• A bond is normally an interest-only loan.
– Borrower pay interest every period. – The principal is repaid only at the end of the loan.
• Example: Beck Corporation wants to borrow $1,000 for 30 years.
• The interest rate on similar debt issued by similar corporations is 12%.
• Beck will thus pay .12 × $1,000 = $120 in interest every year for 30 years. – $120 regular interest payments are called the bond’s coupons. – Coupon is constant and paid every year: Level coupon bond.
• At the end of 30 years, Beck will repay the $1,000.
– The amount repaid at the end of the loan is called the bond’s face value, or par value. – However, the price of a bond can be equal, less or greater than the Face/Par value. – Annual coupon divided by the face value is called the coupon rate on the bond (12%).
• The number of years until the face value is paid is called the bond’s time to maturity. – Once the bond has been issued, the number of years to maturity declines as time passes. ∗ Reference: Corporate Finance, Ross, Westerfield, Jaffe & Jordan, Chapter 8 † [email protected]
1 Bonds & Bond Valuation Bond Values & Yields
• With time, interest rates change in the market, however the cash flows from a bond stay same. – When interest rates rise, PV of the bond’s cash flows declines, and the bond is worth less. – When interest rates fall, the bond is worth more.
• To determine the value of a bond at a particular point in time, we need to know
– The number of periods remaining until maturity. – The face value, the coupon, and the market interest rate for bonds with similar features. – The interest rate required in the market on a bond is called the bond’s yield to maturity (YTM).
Bonds & Bond Valuation
Bond Values & Yields: Example
• Xanth Co. were to issue a bond with 10 years to maturity.
• Annual coupon is $80: Bond will pay $80 per year for the next 10 years in coupon interest.
• In addition, Xanth will pay $1,000 to the bondholder in 10 years.
• Assuming similar bonds have a yield of 8%, what will this bond sell for?
Bonds & Bond Valuation
Bond Values & Yields: Example
• Total bond value = PV of Annuity + PV of Face value.
• This bond sells for exactly its face value. This is not a coincidence.
• The going interest rate in the market is 8%.
• With an $80 coupon, this bond pays exactly 8% interest only when it sells for $1,000.
2 Bonds & Bond Valuation
Bond Values & Yields: Example
• Suppose that a year has gone by. 9 years to maturity.
• Interest rate in the market has risen to 10%. Bond Price?
• PV of Annuity + PV of Face value = 460.72 + 424.10 = 884.82.
– Therefore, the bond should sell for about $885. – pv.annuity(r = .1, n = 9, pmt = -80) + 1000/1.1ˆ9 – In other words, this bond, with its 8% coupon, is priced to yield 10% at $885.
• Why the bond is selling for less than its face value? – Because market interest rate is 10% & coupon is only 8%. – To compensate, the price is less than the face value: Discount Bond.
Bonds & Bond Valuation
Bond Values & Yields: Example
• Why the bond is discounted by $115?
– Current coupon is $80. – The bond would be worth $1,000 only if it had a coupon of $100 per year. – In a sense, an investor who buys and keeps the bond gives up $20 per year for nine years. – At 10%, this annuity stream is worth: $115.18 (the discount). – pv.annuity(r = .1, n = 9, pmt = -20)
• What would be the bond price if interest rates had dropped by 2%? – The bond would sell for more than $1,000. – Such a bond is said to sell at a premium and is called a premium bond.
Bonds & Bond Valuation
Bond Values & Yields: Semiannual Coupons
• In practice, bonds usually make coupon payments twice a year.
– So, if coupon rate of 14%, the owner will receive $140 per year, but in two payments of $70 each.
• Bond yields are quoted like annual percentage rates (APRs).
– With a 16% quoted yield and semiannual payments, the true yield is 8% per six months.
3 Bonds & Bond Valuation
Bond Values & Yields: Semiannual Coupons
• If this bond matures in 7 years, what is the bond’s price?
– Total value = PV of annuity + PV of face value – 917.56 = 577.10 + 340.46 – pv.annuity(r = .08, n = 14, pmt = -70) + 1000/1.08ˆ14
• What is the effective annual yield on this bond?
• Overall, the bond prices and interest rates always move in opposite directions.
• When interest rates rise, a bond’s value, like any other present value, declines.
• Similarly, when interest rates fall, bond values rise.
Bonds & Bond Valuation
Interest Rate Risk
• The risk that arises for bond owners from fluctuating interest rates is called interest rate risk.
• How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes.
• This sensitivity directly depends on two things: the time to maturity and the coupon rate.
• All other things equal:
– The longer the time to maturity, the greater the interest rate risk. – The lower the coupon rate, the greater the interest rate risk.
4 Bonds & Bond Valuation
Interest Rate Risk
Bonds & Bond Valuation
Interest Rate Risk
• Intuitively, short-term bonds are less sensitivity because cashflows are received quickly.
• The reason that bonds with lower coupons have greater interest rate risk is essentially the same.
• Bond with the higher coupon has a larger cash flow early in its life, so its less sensitive to changes in the discount rate.
Bonds & Bond Valuation
Finding the Yield to Maturity (YTM)
• Suppose we are interested in a 6-year, 8% coupon bond.
– A broker quotes a price of $955.14. – What is the yield on this bond? – By trial and error or by other tools. – irr(cf = c(-955.14, 80,80,80,80,80,1080)) OR – a <- rep(80, 5) – irr(cf = c(-955.14, a, 1080)) – A bond’s YTM should not be confused with its current yield. – Current yield is simply a bond’s annual coupon divided by its price.
5 Bonds & Bond Valuation
Finding the Yield to Maturity (YTM)
• Example 8.2 – A bond has a price of $1,080.42, face value of $1,000, a semiannual coupon of $30, and a maturity of 5 years. – What is its current yield? What is its yield to maturity? – Current yield: 60/1080.42 = 5.55%. – YTM: 4.2%. – irr(cf = c(-1080.42, 30,30,30,30,30,30,30,30,30,1030)) * 2 OR – b <- rep(30, 9) – irr(cf = c(-1080.42, b ,1030)) * 2
Bonds & Bond Valuation
Zero Coupon Bonds
• A bond that pays no coupons at all must be offered at a price much lower than its face value.
• Such bonds are called zero coupon bonds, or just zeroes.
• Example 8.4: – Suppose that the Geneva Electronics Co. issues a $1,000 face value, 8-year zero coupon bond. – What is the yield to maturity on the bond if the bond is offered at $627? Assume annual compounding. – 627 = 1000/(1 + r)8 – YTM: 6%. – discount.rate(n = 8, pv = -627, fv = 1000, pmt = 0)
Inflation & Interest Rates
Real vs Nominal Rates
• Suppose the one-year interest rate is 15.5%.
– Anyone depositing $100 in a bank today will end up with $115.50 next year.
• Further imagine a pizza costs $5 today, implying that $100 can buy 20 pizzas.
• Finally, assume that the inflation rate is 5%, leading to the price of pizza being $5.25 next year.
• How many pizzas can you buy next year if you deposit $100 today?
• You can buy $115.50/$5.25 = 22 pizzas.
– This is up from 20 pizzas, implying a 10% increase in purchasing power.
• Overall, the nominal rate of interest is 15.5%, the real rate of interest is only 10%.
6 • Nominal Rate: Percentage change in the number of dollars.
• Real Rate: Percentage change in how much you can buy with your dollars. – Percentage change in buying power.
Inflation & Interest Rates
Relation between nominal rates, real rates, and inflation.
• 1 + R = (1 + r) × (1 + h).
• R is the nominal rate, r is the real rate, h is the inflation rate.
• Approximate Relationship: R = r + h
• Also known as Fisher equation.
• Fisher Effect: A rise in the rate of inflation causes the nominal rate to rise just enough so that the real rate of interest is unaffected.
• In other words, the real rate is invariant to the rate of inflation
Determinants of Bond Yields
The Term Structure of Interest Rates
• At any point in time, short-term and long-term interest rates generally differ.
• Sometimes short-term rates are higher, sometimes lower.
• The relationship between short- and long-term interest rates is known as the term structure of interest rates.
• The term structure tells us the nominal interest rates on default-free, pure discount bonds of all maturities.
• These rates are, in essence, “pure” interest rates because they contain no risk of default and involve just a single, lump-sum future payment.
• In other words, the term structure tells us the pure time value of money for different lengths of time.
7 Determinants of Bond Yields
Shape of Term Structure
• When long-term rates are higher than short-term rates, we say that the term structure is upward sloping.
• When short-term rates are higher, we say it is downward sloping.
• The term structure can also be “humped.” When this occurs, it is usually because rates increase at first, but then decline at longer-term maturities.
• The most common shape of the term structure, particularly in modern times, is upward sloping, but the degree of steepness has varied quite a bit.
Determinants of Bond Yields
What determines the shape of the term structure?
• Real interest rate.
• Prospect of future inflation: Inflation premium.
• Interest rate risk: Interest rate risk premium.
Determinants of Bond Yields
Yield Curve: A plot of Treasury yields relative to maturity
• This plot is called the Treasury yield curve (or just the yield curve).
8 Determinants of Bond Yields
Yield Curve
• The shape of the yield curve is a reflection of the term structure of interest rates.
• In fact, the Treasury yield curve and the term structure of interest rates are almost the same thing.
• The only difference is that the term structure is based on pure discount bonds, whereas the yield curve is based on coupon bond yields.
• As a result, Treasury yields depend on the three components that underlie the term struc- ture.
