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chapter 6
Bonds, Bond Valuation,
and Interest Rates
 Topics in Chapter
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• Key features of bonds

• Bond valuation
• Measuring yield
• Determining interest rate
• Term structure
• Assessing risk

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 Bond Issuers
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• Bond is a promissory note issued by a

business, a government unit or a foreign party.
• Each type differs in risk and expected return.
• Although Government bonds have no default
risk, they are not riskless.
• Depending on the business, corporate bonds
are exposed to default risk.
• Foreign bonds have additional exchange rate
risk.

5-3
 Key Features of a Bond
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• Par value: Face amount; paid at

maturity. Assume $1,000.

• Coupon interest rate: Stated

interest rate. Multiply by par value
to get dollars of interest. Generally
fixed, but can vary.

5-4
 Key Features of a Bond (cont’d)
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• Maturity: Years until bond must be

repaid. Declines.

• Issue date: Date when bond was

issued.

• Default risk: Risk that issuer will

not make interest or principal
payments.
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 Call Provision
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• Issuer can refund if interest rates

decline. That helps the issuer but hurts
the investor.
• Therefore, borrowers are willing to pay
more, and lenders require more, on
callable bonds.
• Most bonds have a deferred call and a
declining call premium.

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 Retractable Bonds
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• Investors have the right to sell the

bonds back before maturity to the
issuing company at a pre-set price.
• Protect investors from the rising
interest rates or the event risk.

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 What’s a sinking fund?
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• Provision to pay off a loan over its

life rather than all at maturity.
• Similar to amortization on a term
loan.
• Reduces risk to investor, shortens
average maturity.
• But not good for investors if rates
decline after issuance.
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 Sinking funds are generally
handled in 2 ways
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• 1. Call x% at par per year for

sinking fund purposes.
• 2. Buy bonds on open market.
• Company would call if the going
market rate of interest (rd) is below
the coupon rate and bond sells at a
premium. Use open market
purchase if rd is above coupon rate
and bond sells at a discount.
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 Other Bond Features
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• Convertible bonds: convert into

shares of common stock, at a fixed
price, at the bondholder’s discretion
• Income bonds: pay interest only
when the issuer can afford.
• Real return bonds: principal and
interests are indexed and protected
against inflation.
5-10
 Bond Valuation
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0 1 2 n
%
Rd
...

Value INT INT INT +M

INT INT (INT+M)

PV = + + ... +
1+ rd 1
1 + rd2
1+ rd
n

5-11
 Value of a 15-year, 10%
coupon bond if rd = 10%
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0 1 2 15
Rd=10% ...
V=? 100 100 100 + 1,000

$100 $100 $1,000

VB  + . . . + +
1+ 0.10 1 + 0.10
1 15 15
1 + 0.10
= $90.91 + . . . + $23.94 + $239.39
= $1,000
5-12
 Bond Valuation
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Another Equation:

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 6-13

 What’s the value of a 15-year,
10% coupon bond if rd = 10%?
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0 1 2 15
10%
...
V=? 100 100 100 + 1,000

M 1
1-
VB  (1  r d)
N

1 + r d
N + INT
rd
1
1-
$1,000 (1  0.10)15
VB  15 + 100
1+ .10 0.10

= $239.39 + 760.61 = $1,000

 The bond consists of a 15-year, 10% annuity
of $100/year plus a $1,000 lump sum at t = 15:
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PV annuity $ = 760.61
PV maturity value = 239.39
Value of bond $1,000.00
=

INPUTS
15 10 100 1000
N I/YR PV PMT FV
OUTPUT -1,000

5-15
 Zero-coupon Bond Prices
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• With no intern interest payments,

the price of a zero is the present
value of the principal payment at
maturity.
M
Vzero 
(1  rd ) N

5-16
 What would happen if going market
rate of interest rd = 15%?
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INPUTS
15 15 100 1000
N I/YR PV PMT FV
OUTPUT -707.63

When rd rises, above the coupon

rate, the bond’s value falls below
par, so it sells at a discount.

5-17
 What would happen if rd
declined to 5%?
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INPUTS
15 5 100 1000
N I/YR PV PMT FV
OUTPUT -1,518.98

If coupon rate > rd, price rises

above par, and bond sells at a
premium.

5-18
 What’s “yield-to-maturity”?
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• YTM is the expected rate of total return

earned on a bond held to maturity. Also
called “promised yield.”
• YTM = expected current (interest) yield +
expected capital gains yield.
• It assumes the bond will not default and
cannot be called.
• YTM changes whenever market interest
rates change.

5-19
 YTM on a 14-year, 10% annual coupon,
$1,000 par value bond selling for $1,494.93
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0 1 13 14
rd=?
...
100 100 100
PV1 1,000
.
.
.
PV10
PVM
1,494.93 Find rd that “works”!

5-20
 Find rd
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INT INT M
VB  + ... + +
1 + r d  1 + r d  1 + r d 
1 N N

1,000
1494.93  100 1 + ... + 100
14 +
1 + r d  1+ r d  1 + r d 
14

Solving for the unknown rd is tedious.

Need a financial calculator.
5-21
 Find YTM with financial
calculator
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INPUTS
14 -1494.93 100 1000
N I/YR PV PMT FV
OUTPUT5 = YTM

Sells at a premium. Because

coupon = 10% > rd = 5% (YTM),
bond’s value > par.

5-22
 Callable Bonds and Yield to Call
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• A 10-year, 10% annual coupon,

$1,000 par value bond is selling for
$1,494.93 with an 5% yield-to-
maturity.
It can be called after 1 year at
$1,100
N
INT callprice
VCALL  
t 1 (1  rd ) t
(1  rd ) N

5-23
 Yield to Call (YTC)
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INPUTS
9 -1494.93 100 1100
N I/YR PV PMT FV
OUTPUT4.21=YTC

5-24
 If you bought bonds, would you be
more likely to earn YTM or YTC?
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• Coupon rate = 10% vs. YTC = rd =

4.21%. Firm could raise money by
selling new bonds which pay 4.21%
• Could thus replace bonds which
pay $100/year with bonds that pay
only $42.1/year.
• Investors should expect a call,
hence YTC = 4.21%, not YTM = 5%

5-25
 If you bought bonds, would you be more
likely to earn YTM or YTC? (cont’d)
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• In general, if a bond sells at a

premium, then (1) coupon > rd, so
(2) a call is likely.
• So, expect to earn:
– YTC on premium bonds.
– YTM on par & discount bonds.

5-26
 Current yield
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10% coupon, 14-year bond, P =

$1,494.93, and YTM = 5.0%

Annual coupon pmt

Current yield =
Current price

Current yield = $100

$1,494.93
= 0.0669 = 6.69%

5-27
 Capital gains yield
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Capital gains yield = YTM - Current

yield
= 5.00% - 6.69%
= - 1.69%
Capital gains yield
= Change in price/beginning price
= -25.25/1494.93 = - 1.69%

5-28
 Changes in Bond Values ($)
Over Time
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1,495 Premium bond

rd = 10% (par bond)

1,000 M

Discount bond
714
0 1 2 3 14 15
5-29
 Changes in Bond Values ($)
Over Time (cont’d)
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• At maturity, the value of any bond

must equal its par value.
• The value of a premium bond would
decrease to $1,000
• The value of a discount bond would
increase to $1,000
• A par bond stays at $1,000 if rd
remains constant.

5-30
 Changes in Bond Values ($)
Over Time (cont’d)
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• If coupon rate < rd, bond sells at a

discount.
• If coupon rate = rd, bond sells at its
par value.
• If coupon rate > rd, bond sells at a
premium.
• If rd rises, price falls.
• Price = par at maturity.
5-31
 Semiannual Bonds
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1. Multiply years by 2 to get periods = 2n.

2. Divide nominal rate by 2 to get periodic
rate = rd/2.
3. Divide annual INT by 2 to get PMT =
INT/2.

INPUTS
2n rd/2 OK INT/2 OK
N I/YR PV PMT FV
OUTPUT

5-32
 Value of 15-year, 10% coupon,
semiannual bond if rd = 5%
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2(15) 5/2 100/2

INPUTS
30 2.5 50 1000
N I/YR PV PMT FV
OUTPUT -1523.26

5-33
 Market Interest Rate
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rd = r* + IP + DRP + LP + MRP
where rd = Required rate of return on a
debt security.
r* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.
LP= Liquidity premium.
MRP = Maturity risk premium.
5-34
 Real Risk-free Rate of
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Interest (r*)
• R* = rate of return on a riskless
security if no inflation is expected
• The best estimate is the short-term
government T-bills in an inflation-
free world
• R* is not static, changing over time

5-35
 Inflation Premium (IP)
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• Inflation erodes the purchasing power

of money.
• The IP for a particular length maturity
can be approximated as the
difference between the yield on a
non-indexed security of that maturity
minus the yield on a default-free
government bond of that maturity.

5-36
 What is the nominal risk-free rate?
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• rRF= (1+r*)(1+IP)-1
= r*+ IP + (r*x IP)
≈ r*+ IP. (Because r*x IP is small)
• rRF = Rate on short- or long-term
government bonds.

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 Default Risk Premium (DRP)
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• Investors want to be compensated for the

chance that interest or principal will not be
paid on the due date and in the promised
amount
• The greater the default risk, the higher the
bond’s DRP
• While Governmental bonds is default free,
default risk can be substantial for
corporate bonds
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 Bond Provisions that
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Influence Default Risk
• Provisions in the bond contract
– Secured versus unsecured debt:
mortgage bonds vs. debentures
– Senior versus subordinated debt
– Guarantee provisions: agency bonds
– Sinking fund provisions
– Debt maturity

5-39
 Bond Ratings Provide
One Measure of Default Risk
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Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

DBRS AAA AA A BBB BB B CCC D

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 What factors affect default
risk and bond ratings?
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• Financial performance
– Debt ratio
– Coverage ratios, such as interest coverage ratio
or EBITDA coverage ratio
– Current ratios
• Other factors
– Earnings stability
– Regulatory environment
– Potential product liability
– Accounting policies

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 Liquidity Premium (LP)
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• A “liquid” asset can be converted into

cash quickly and at a “fair” market
price.
• Liquidity is also known as marketability
• Financial assets are generally more
liquid than real assets
• Often difficult to accurately measure

5-42
 Bond Spreads, the DRP, and
the LP
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• A “bond spread” is often calculated as the

difference between a corporate bond’s yield
and a Government bond’s yield of the same
maturity. Therefore:
Spread = DRP + LP.
• Bond’s of large, strong companies often
have very small LPs. Bond’s of small
companies often have LPs as high as 2%.

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 Maturity Risk Premium
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(MRP)
• All bonds, including Governmental
bonds, are exposed to two extra
risks: interest rate (price) risk and
reinvestment risk.
• MRP is the net effect of these two
sources of risk on a bond’s yield

5-44
 Interest rate (or price) risk for 1-
year and 10-year 10% bonds
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Interest rate risk: Rising rd causes

bond’s price to fall.
rd 1-year Change 10-year Change
5% $1,048 $1,386
10% 1,000 4.8% 1,000 38.6%

15% 956 4.4% 749 25.1%

5-45
 What is reinvestment rate risk?
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• The risk that CFs will have to be reinvested

in the future at lower rates, reducing
income.

• Illustration: Suppose you just won $500,000

playing the lottery. You’ll invest the money
and live off the interest. You buy a 1-year
bond with a YTM of 10%.

5-46
 What is reinvestment rate
risk? (cont’d)
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• Year 1 income = $50,000. At year-

end get back $500,000 to reinvest.

• If rates fall to 3%, income will drop

from $50,000 to $15,000. Had you
bought 30-year bonds, income
would have remained constant.

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 Remarks of MRP
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• Long-term bonds: High interest rate risk,

low reinvestment rate risk.
• Short-term bonds: Low interest rate risk,
high reinvestment rate risk.
• Nothing is riskless!
• Yields on longer term bonds usually are
greater than on shorter term bonds, so
the MRP is more affected by interest rate
risk than by reinvestment rate risk.

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