TOPIC 2

Interest Rates and Bond Valuation

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 Interest Rate
◦ apply to debt instruments
 Required Rate of Return
◦ apply to equity instruments
 Inflation
◦ a rising trend in the prices
 Deflation
◦ a general trend of falling prices
 Liquidity preference
◦ a general tendency for investors to prefer short-
term (more liquid) securities.
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 Describe interest rate fundamentals, term
structure of interest rates, and risk
premium.
 Know the important bond features and
bond types
 Apply the basic valuation model to bonds
 Understand bond values and why they
fluctuate
 Understand bond ratings and what they
mean

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 Real Rate of Interest
◦ the equilibrium rate between supply of savings
and the demand for investment funds in a perfect
world.
◦ change in purchasing power

 Nominal Rate of Interest

◦ Actual rate of interest charged by supplier of
funds
r = r* + IP +RP

RF
◦ quoted rate of interest, change in purchasing
power and inflation

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 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

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 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.

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 The relationship between the maturity and rate
of return for bonds with similar levels of risk
◦ Normal – upward-sloping, long-term yields are higher than
short-term yields
◦ Inverted – downward-sloping, long-term yields are lower
than short-term yields
◦ Flat Yield Curve
 Theories of Term Structure
◦ Expectation Theory
 Yield curve reflects investor expectations about future
interest rates
◦ Market Segmentation Theory
 Market for loans is segmented on the basis of maturity
 the supply and demand within each segment determine
its prevailing interest rates
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 A bond is a legally binding agreement
between a borrower and a lender that
specifies the:
◦ Par (face) value
◦ Coupon rate
◦ Coupon payment
◦ Maturity Date

 The yield to maturity is the required market

interest rate on the bond.

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 Contract/legal document that specifies both
the rights of the bondholders and the duties
of the issuing corporation.
 Standard debt provisions that include:
◦ 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
◦ Etc..
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 Primary Principle:
◦ VALUE OF FINANCIAL SECURITIES = PV OF
EXPECTED FUTURE CASH FLOWS

 Bond value is, therefore, determined by the

present value of the coupon payments and
par value.
 Interest rates are inversely related to present
(i.e., bond) values.

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  1 
1 -
 (1 + r)T  F
Bond Value = C +
 (1 + r)
T
 r
 

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 Consider bond with as 6 3/8% coupon that expires in
December 2015.
◦ The Par Value of the bond is RM1,000.
◦ Coupon payments are made semi-annually (June 30 and
December 31 for this particular bond).
◦ Since the coupon rate is 6 3/8%, the payment is
RM31.875.
◦ On January 1, 2011 the size and timing of cash flows
are:

31.875 31.875 31.875 1,031.875


1 / 1 / 11 6 / 30 / 11 12 / 31 / 11 6 / 30 / 15 12 / 31 / 15
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 On January 1, 2011, the required yield is 5%.
 The size and timing of the cash flows are:

31.875  1  1,000
PV = 1− 10 
+ 10
= 1,060.17
0.025  (1.025)  (1.025)

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 Now assume that the required yield is 11%.
 How does this change the bond’s price?

31.875  1  1,000
PV = 1− 10 
+ 10
= 825.69
0.055  (1.055)  (1.055)

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 When the YTM < coupon, the
1300 bond trades at a premium.
Bond Value

1200

1100

When the YTM = coupon, the bond trades at par.

1000
When the YTM > coupon, the bond trades
at a discount.
800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8 Discount Rate
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❑ Bond prices and market interest rates
move in opposite directions.
❑ When coupon rate = YTM, price = par
value
❑ When coupon rate > YTM, price > par
value (premium bond)
❑ When coupon rate < YTM, price < par
value (discount bond)

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 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. 16
 Bond Value

Consider two otherwise identical bonds.

The long-maturity bond will have much more
volatility with respect to changes in the
discount rate.

Par

Short Maturity Bond

C Discount Rate
Long Maturity
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Bond
 Bond Value

Consider two otherwise identical bonds.

The low-coupon bond will have much
more volatility with respect to changes in
the discount rate.

Par

High Coupon Bond

C Low Coupon Bond Discount Rate

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 Current Yield (CY)
◦ = annual coupon / price

 Yield to Maturity (YTM)

◦ the rate implied by the current bond price.
◦ The expected rate of return if an investor were to
purchase the bond at current market price and
hold the bond until maturity

 Yield to call (YTC)

◦ The rate implied when the bond is called at the
call price.

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 Consider a bond with a 10% annual coupon
rate, 15 years to maturity, and a par value of
RM1,000. The current price is RM928.09.

◦ Will the yield be more or less than 10%?

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 Suppose a bond with a 10% coupon rate and
semiannual coupons has a face value of
RM1,000, 20 years to maturity, and is selling
for RM1,197.93.
◦ Is the YTM more or less than 10%?

◦ What is the semi-annual coupon payment?

◦ How many periods are there?

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 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.

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 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

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 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

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 High Grade
◦ AAA – capacity to pay is extremely strong
◦ AA – capacity to pay is very strong

 Medium Grade
◦ A – capacity to pay is strong, but more
susceptible to changes in circumstances
◦ BBB – capacity to pay is adequate, adverse
conditions will have more impact on the
firm’s ability to pay

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 Low Grade
◦ BB
◦ B
◦ Considered speculative with respect to
capacity to pay.

 Very Low Grade

◦ C&D
◦ Highly uncertain repayment and, in many
cases, already in default, with principal and
interest in arrears.

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 Treasury Securities
◦ Federal government debt
◦ T-bills – pure discount bonds with original maturity less
than one year
◦ 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

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 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
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Information needed for valuing pure discount
bonds:
◦ Time to maturity (T) = Maturity date - today’s
date
◦ Face value (F)
◦ Discount rate (r)

0 0 0 F

0 1 2 T −1 T

Present value of a pure discount bond at time 0:

F
PV =
(1 + r )T 29
Find the value of a 30-year zero-coupon
bond with a RM1,000 par value and a YTM of
6%.
0 0 0 1,000 $0$1,0

102 3029


0 1 2 29 30

F 1,000
PV = = = 174.11
(1 + r ) T
(1.06) 30

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 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.”
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 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.

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 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 a small company or municipal
issues
 Treasury securities are an exception

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 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 (remember bid-ask spreads)
 Anything else that affects the risk of the cash
flows to the bondholders will affect the
required returns.

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 Debt  Equity
◦ Not an ownership
interest
◦ Creditors do not have
voting rights
◦ Interest is considered a
cost of doing business
and is tax deductible
◦ Creditors have legal
recourse if interest or
principal payments are
missed
◦ Excess debt can lead to
financial distress and
bankruptcy
◦ Ownership interest
◦ Common stockholders vote
for the board of directors
and other issues
◦ Dividends are not
considered a cost of doing
business and are not tax
deductible
◦ Dividends are not a liability
of the firm, and
stockholders have no legal
recourse if dividends are
not paid
◦ An all-equity firm cannot
go bankrupt
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