TI Interest Rates and Bond Valuation

Bond Features
– Bond - evidence of debt issued by a corporation or a governmental
body. A bond represents a loan made by investors to the issuer. In
return for his/her money, the investor receives a legaI claim on
future cash flows of the borrower. The issuer promises to:
– Make regular coupon payments every period until the bond matures,
and
– Pay the face/par/maturity value of the bond when it matures.
– Default - since the abovementioned promises are contractual
obligations, an issuer who fails to keep them is subject to legal action
on behalf of the lenders (bondholders).
 T2 Bond Features (concluded)
– If a bond has five years to maturity, an $80 annual coupon, and a $1000
face value, its cash flows would look like this:

Time 0 1 2 3 4 5
Coupons $80 $80 $80 $80 $80
Face Value $ 1000
$______

– How much is this bond worth? It depends on the level of current market
interest rates. If the going rate on bonds like this one is 10%, then this
bond is worth $924.18.
 T3 Bond Rates and Yields
– Suppose a bond currently sells for $932.90. It pays an annual coupon of
$70, and it matures in 10 years. It has a face value of $1000. What are its
coupon rate, current yield, and yield to maturity (YTM)?

– 1. The coupon rate (or just “coupon”) is the annual

dollar coupon expressed as a percentage of the face value:
Coupon rate = $70 /$_____ = ___%

– 2. The current yield is the annual coupon divided by

the current market price of the bond:
Current yield = $___ /_____ = 7.5%
Under what conditions will the coupon rate and current yield be the
same?
 T4 Bond Rates and Yields
– 3.
(concluded)
The yield to maturity (or “YTM”) is the rate that makes the price of the
bond just equal to the present value of its future cash flows. It is the
unknown r in:
$932.90 = $_______ [1 - 1/(1 + r)10]/r + $_______ /(1 + r)10

The only way to find the YTM is trial and error:

a. Try 10%: $70 [(1 - 1/(1.10)10]/.10 + $1000/(1.10)10 = $816
b. Try 9%: $70 [1 - 1/(1.09)10]/.09 + $1000/(1.09)10 = $872
c. Try 8%: $70 [1 - 1/(1.08)10]/.08 + $1000/(1.08)10 = $933
( ) The yield to maturity is 8%
 T5 Valuing a Bond
– Assume you have the following information.
Barnhart, Inc. bonds have a $1,000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The market’s required return on similar bonds is 10%

– 1. Calculate the present value of the face value

– 2. Calculate the present value of the coupon payments

= $100 [1 - (1/1.1020)]/.10 = $100 8.5136 = $851.36

– 3. The value of each bond = $148.64 + 851.36 = $1,000

 T6 Example: A Discount Bond
– Assume you have the following information.
Barnhart, Inc. bonds have a $1,000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The market’s required return on similar bonds is 12%

– 1. Calculate the present value of the face value

– 2. Calculate the present value of the coupon payments

= $100 [1 - (1/1.1020)]/.10 = $100 7.4694 = $746.94

– 3. The value of each bond = $103.66 + 746.94 = $850.60

 T7 Example: A Premium Bond
– Assume you have the following information.
Barnhart, Inc. bonds have a $1,000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The market’s required return on similar bonds is 8%

– 1. Calculate the present value of the face value

– 2. Calculate the present value of the coupon payments

= $100 [1 - (1/1.0820)]/.08 = $100 9.8181 = $981.81

– 3. The value of each bond = $214.55 + 981.81 = $1,196.36

– Why do the bonds in this and the preceding example have prices that are
different from par?
 T8 Bond Price Sensitivity to YTM
Bond price

$1,800
Coupon = $100
20 years to maturity
$1,600
$1,000 face value

$1,400 Notice: bond prices and YTMs are

inversely related.
$1,200

$1,000

$ 800

$ 600 Yields to maturity,

YTM
4% 6% 8% 10% 12% 14% 16%
 T9 Interest Rate Risk and Time to
Bond values ($) Maturity
2,000
$1,768.62
30-year bond
Time to Maturity
1,500 Interest rate 1 year 30 years
5% $1,047.62 $1,768.62
$1,047.62 1-year bond 10 1,000.00 1,000.00
1,000
$916.67 15 956.52 671.70
20 916.67 502.11

500 $502.11

Interest rates (%)

5 10 15 20

Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities
 T10 Bond Pricing Theorems
– The following statements about bond pricing are always true.

– 1. Bond prices and market interest rates move in opposite

directions.
– 2. When a bond’s coupon rate is (greater than / equal to / less
than) the market’s required return, the bond’s market value
will be (greater than / equal to / less than) its par value.
– 3. Given two bonds identical but for maturity, the price of the
longer-term bond will change more than that of the shorter-term
bond, for a given change in market interest rates.
– 4. Given two bonds identical but for coupon, the price of the
lower-coupon bond will change more than that of the higher-
coupon bond, for a given change in market interest rates.
 T11 Bond Ratings
Low Quality, speculative,
Investment-Quality Bond Ratings and/or “Junk”

High Grade Medium Grade Low Grade Very Low Grade

Standard & Poor’s AAA AA A BBB BB B CCC CC C D

Moody’s Aaa Aa A Baa Ba B Caa Ca C C
T12 Sample Wall Street Journal
Bond Quotation

NewCurYork Exchange BondsNet

BondsQuotations as of
Yld Vol Close Chg.
4 p.m. Eastern Time
Thursday, January 30, 1997

CORPORATION BONDS
Volume, $29,351,000

1
AMR 9s16 8.1 19 110 1/2 + 7/8
ATT 4 3/4 98 4.8 5 98 1/8 - 3/8
ATT 4 3/8 99 4.6 30 96 ...
ATT 6s00 6.1 5 98 1/4 - 5/8
ATT 5 1/8 01 5.4 118 95 1/2 + 3/4
ATT 7 1/8 02 7.0 50 102 1/4 + 1/8
ATT 6 3/4 04 6.8 15 99 3/4 - 1/4
ATT 7 1/2 06 7.2 10 104 +
ATT 8 1/8 22 8.0 338 102 1/8 + ...
ATT 8 1/8 24 8.0 398 101 3/4 + ...
ATT 8.35s25 8.1 110 103 1/4 - 1 1/4
ATT 8 5/8 31 8.2 26 105 7/8 + ...

Source: Reprinted by permission of The Wall Street Journal, © 1997 Dow Jones and
T13 Sample Wall Street Journal U.S.
Treasury Note and Bond Prices
Maturity Ask
Rate Mo/Yr Bid Asked Chg. Yld.

GOVT. BONDS AND NOTES

111/8 Aug 03125:10125:16 -6 6.44

117/8 Nov 03130:04130:10 -7 6.46
5 7/8 Feb 04n96:17 96:19 -6 6.46
. . . . .
. . . . .
. . . . .
7 7/8 Feb 21110:19110:23 -13 6.95
8 1/8 May 21113:18113:22 -14 6.95
8 1/8 Aug 21113:19113:23 -14 6.96
8 Nov 21 112:06112:10 -14 6.95
7 1/4 Aug 22103:15103:17 -14 6.95
7 5/8 Nov 22108:00108:02 -13 6.95
7 1/8 Feb 23102:01102:03 -13 6.95
6 1/4 Aug 2391:19 91:21 -12 6.94

Source: Reprinted by permission of The Wall Street Journal, © 1996 Dow Jones &
Company, Inc. All Rights Reserved Worldwide.
 T18 Solution to Problem

– Reznik Corporation has bonds on the market with 10.5 years to

maturity, a yield-to-maturity of 10 percent, and a current price of $860.
Coupon payments are semiannual. What must the coupon rate be on
the bonds?

Total number of coupon payments = 10.5 2 = 21

Yield-to-maturity per period = 10% / 2 = 5%
Maturity value = F = $1,000
 T19 Solution to Problem
(concluded)
– Substituting the known values into the bond pricing equation:
Bond
Value = C [1 - 1/(1 + r)t] / r + F / (1 + r)t
$860 = C [1 - 1/(1 + .05)21] / .05 + $1,000/(1.05)21
$860 = C 12.8211 + $358.94
C = $39.08

So the annual coupon must be $39.08 2 = $78.16

and the coupon rate is $78.16 / $1,000 = .07816  .0782.

 T20 Solution to Problem
– Bond J has a 4% coupon and Bond K a 10% coupon. Both have 10 years to
maturity, make semiannual payments, and have 9% YTMs. If market rates rise
by 2%, what is the percentage price change of these bonds? If rates fall by
2%? What does this say about the risk of lower-coupon bonds?
Current Prices:
Bond J:
PV = $20 [1 - 1/(1.045)20]/.045 + $1,000/(1.045)20
= $______
Bond K:
PV = $50 [1 - 1/(1.045)20]/.045 + $1,000/(1.045)20
= $1065.04
 T21 Solution to Problem
(continued)
Prices if market rates rise by 2%:
Bond J:
PV = $20 [1 - 1/(1.055)20]/.055 + $1,000/(1.055)20
= $581.74

Bond K:
PV = $50 [1 - 1/(1.055)20]/.055 + $1,000/(1.055)20
= $______
 T22 Solution to Problem
(continued)
Prices if market rates fall by 2%:
Bond J:
PV = $20 [1 - 1/(1.035)20]/.035 + $1,000/(1.035)20
= $786.82
Bond K:
PV = $50 [1 - 1/(1.035)20]/.035 + $1,000/(1.035)20
= $1213.19
T23 Solution to Problem
(concluded)

– Percentage Changes in Bond Prices

Bond Prices and Market Rates
7% 9% 11%
_________________________________
Bond J $786.81 $674.80 $581.74
% chg. (+16.60%) (___%)
Bond K $1,213.19 $1,065.04 $940.25
% chg. (___%) (-11.72%)
_________________________________
The results above demonstrate that, all else equal, the price of the
lower-coupon bond changes more (in percentage terms) than the price
of the higher-coupon bond when market rates change.