Chapter 7

Interest Rates and Bond Valuation

Bond and Bond Valuation

Bond Features and Prices
 Bond is an interest – only loan : pay interest every period, none of the principal will be repaid until the
end
 Coupun : The stated interest payment made on a bond
o Level coupon bond  constant & paid every year bond
 Face value / par value : The principal amount of a bond that is repaid at the end of the term
o Par value bond  bond that sells for its par value
 Coupon rate : the annual coupon divided by the face value of a bond
 Maturity : the specific date on which the principal amount of bond is paid

Bond Values and Yields

 As times pases, interest rates change, cashflow from bonds stay the same  value of bond changes
[interest rates increasing while PV of bons decreasing ; worth less] [interest rate decreasing while PV of
bonds increasing ; Worth more ]
 To determine value of bond :
o Number of period remaining until maturity
o The face value
o The coupon
o The rate required in the market on bond (Yield To Maturity  YTM)
 Example :
10 years to maturity
Annual Coupon = $80
YTM = 8%
Face Value = 1.000
1. Present Value of $1.000 in 10 years at the rate 8%
PV = 1.000 / 1.08^10
PV = $463,19
 2. PV of annuity stream from bonds
Annuity PV = 80 x (1 – 1/1.08^10)/0.10
Annuity PV = $536,81
3. Total Bond Value
$463,19 + $536,81 = $1.000
Suppose 1 year passed YTM increase to 10%
1. PV of Face Value
1.000 / 1,10^9 = $424,10
2. Annuity PV of YTM
80 x (1 – 1/1,10^9)/0,10 = $460,72
3. Total Bond Value
$424,10 + 460,72 = $884,82 (Bond sells less than face value)
Discount Bond : Bond sells for less than face value
Par Value Bond : Bond sells for face value
Premium Bond : Bond sells for more than face value

Interest Rate Risk

Risk that arises for bond owners from fluctuating interest rates
Depends on how sensitive its price to interest rate changes ( time to maturity ; coupon rate )
Assumption :
1. All other things being equal, the longer the time to maturity, the greater the interest rate risk
2. All other things being equal, the lower the coupon rate, the greater the interest rate risk.
Point 1  longer term bonds have greater interest rate sensitivity because a large portion of a
bonds value comes from face value (small change in interest rate have a significant effect on PV)
Point 2  bonds with lower coupon is proportionally more dependent on the face amount to be
received at maturity  value fluctuate more as interest change
Finding The Yield To Maturity
Current Yield = annual coupon / price
Discount Bond  CY < YTM  it considers only the coupon portion of return. Doesn’t consider the built – in
gain from price discount
Premium Bond  CY > YTM  it ignores the built-in loss

Main difference between debt and equity :

1. Debt is not an ownership interest in the term
2. The firm’s payment of interest on debt is a cost of doing business & fully tax deductible
3. Unpaid debt is a liability of the firm  possibility of financial failure (liquidation / reorganization)
IS IT DEBT / EQUITY ?
Sometimes it is not clear
Eg. A perpetual bond with interest payable solely from corporate indome if and only if earned
Exotic and Hybrid securities of Equity but treated as debt
Tax benefit of debt and bankruptcy benefits of equity
General Rule  Equity represents an ownership interest. Equity is a residual cllaim means equity
holder are paid after debt holders
Long term Debt : The Basics
Long term debt securities : prmoises made by issuing firm to pay principal when due and to make timely
interest payment on the unpaid balance
Maturity of long-term debt instruments : the length of time the debt remains outstandiing with some unpaid
balance

The Indenture / Deed of Trust

Legal written agreement between the corporation (borrower) and its creditors
The Role of The Trust Company :
1. Make sure the terms of the indenture are obeyed
2. Manage the sinking funds
3. Represent the bondholders in default  If the company defaults on its payments to bondholders

I. Terms of a bond
Registered Form : The form of bond issue in which the registar (the paying agent) of the company
records ownership of each bond, payment is made directly to the owner of record
 Bearer Form : The form of bond issue in which the bond is issued without record of the owners’ name
payment is made to whoever holds the bond
Drawbacks :
1. Difficult to recover if stolen / lost
2. Company cannot notify bondholders of important events
II. Security
 Collateral  securities / assets that are pledged as security for payment of debt
 Mortgage Securities  Securities that are secured by a mortgage on the real
property of borrower
o Mortgage Trust Indenture  the legal document that describes the
mortgage
o Blanket Mortgage  Pledges all the real property owned by the company
 Debenture : an unsecured bond, no specific pledge of property is made (maturity
up to 10 years)
o Note  Instruments with maturity of unsecured. Bonds is less than 10 years
III. Seniority
Preference in position over other lenders
Subordinate Debt  In the event of default, this holders must give preference to other
specified creditord. Subordinate lenders will be paid off only after specified creditors
have been compensated
Debt cannot be subordinate to equity
IV. Repayment
Sinking Fund : An account managed by the bond trustee for the purpose of repaying the
bonds
 The Company makes annual payments to the trustee
 The Trusttee use the funds to retire a portion of the debt
Either by : buying up some of the bonds in the market or calling in a fraction of the
outstanding bonds
V. The Call Provision
 An agreement giving the corporation the option to repurchase a bond prior to maturity at
a sprcific price
Call Premium : The amount by which the call price exceeds the par
value of a bond
Deferred Call Provision : A call provision prohibitting the company from
redeeming a bond prior to certain date
Call – Protected Date : A bond that during a certain period cannot be
rededemed by the issuer
Make While Call : Call Provision in which the bondholders receive
approximately what the bonds are worth if they are called
VI. Protective Covenants
A part of indenture limiting certain actions that might be taken during the term of the
loan, usually to protect the lenders’ interest
Negative Covenants  Limits / Prohibit actions (thou shalt not)
Positie / Affirmative Convenants  specifies actions the company agrees to take / a
condition the company must be abid by (thou shalt)

BOND RATINGS
The debt ratings : an assesment of the creditwhorthiness of the corporate issuer
Bond ratings are concerned only with the possibility of default, doesn’t address the interest
rate risk issue.
Bond Ratings are constructed from information supplied by the corporation
Bond’s rating can change as the issuers’ financial strength improves / deteriorates
Fallen angels : Bonds that drop into junk terrtory

DIFFERENT TYPES OF BONDS

Government Bonds
The Us Treasury Issues :
  Have no default risk
 Are exempt from state income taxes
Municipal Notes & Bonds (MUNIS)
 Way of borrowing money by state & local government
 Have varying default risk
 Rated much like corporate issues
 Coupons are exempt from federal income taxes

Zero Coupon Bonds / ZEROES

Bons that pays no coupons at all must be offered at a price that is much lower than state value.
Original-issue Discount Bond : A bond issued at a very low coupon rate
For Tax Purpose :
 Deducts interest every year even though no interest is actually paid  owner must pay
taxes on interest accrued every year
 The implicit interest is determined by amortizing the loan  changes the bonds value
Floating – Rate Bonds
The coupon Payments are adjustable where the adjusments are tied to an interest rate index
The value of floaters bonds depend on exactly how the coupon payment adjusment are defined
Features of Floaters :
1. Put Provision
The holder has the right to redeem the note at par on the coupon payment date after some
specified amount of time
2. The coupon rate has a floor and a celling (collar), the coupon is subject to a minimum &
a maximum (capped)
Inflation – linked Bond : The coupons are adjusted according to the rate of inflation
Other Types of Bonds
1. Income bonds
Coupons payment depend on company income, only paid if sufficient
2. Convertible Bonds
Can be swapped for a fixed number of stock anytime before maturity
 3. Put Bonds
Allows the holder to force the issuer to buy back the bond at a stated price

SUKUK
Islamic bonds that accommodate the restriction on interest payments

BONDS MARKETS
How Bonds are Brought and Sold
 Over The Counter (OTC)
No Particular place where buying and selling occur
Why Bond Market is Big ?
Number bond issued more than number of stock issues

 Little / No Transparency
Transparent Financial Market  it is possible to easily observe its price and trading
volume in bond markets, transactions are privately negotiated & there is no centralized
reporting of transaction
 Only a small fraction of the total bond issues that exxist actually trade on a given day

Bond Price Reporting

Trace  Trade Report and Compliance engine
Bid Price : The price a dealer is willing to pay for a security
Asker Price : The price a dealer is willing to take for a security
Bid-Ask Spread : The difference vetween the bid price & the asked price (the dealer’s
profit)
Bond Price Quotes
Clean Price (quoted) : The Price of a bond net of accrued interest
Dirty Price (Full/invoice price) : The Price of a bond including accrued interest the price
buyer actually pays
INFLATION AND INTEREST RATES
Real and Nominal Rates
Real Rates : Interest rates / Rates of return that have been adjusted for inflation
Nominal Rates : interest rates / rates of return that have not been adjusted for inflation
Real Rate on an Investment  percentage change in how much dollars can be bought (buying power)
Nominal Rate on an Investment  percentage change in the number of dollars acquired

THE FISHER EFFECT

Shows relationship between nominal returns/ R, real returns/r , and inflation/ h
1 + R = (1 + r) (1 + h) or R = r + h + rh

DETERMINANTS OF BONDS YIELD

The relationship between nominal interest rates on default – free, pure discount securities, and time to maturity
tells the pure time value of money for different lengths of time

Long term rates > short term rates  upward sloping

Long term rates < short term rates  downward sloping

Components that determine the shape of term structure :

1. The real rate of interest
The compensation investors demand for forgoing the use of their money
2. The rate of Inflation
Inflation premium  The portion of a normal interest rate that represents compensation for expected
future inflation
3. Interest Rate Risk
Interest Rate Risk Premium  the compensation investors demand for bearing interest rate risk

Bonds Yield and the Yield Curve

Treasury Yield Curve : a plot of yields on treasury notes and bonds relative to maturity
Determined by :
1. The real rate
2. Expected future inflation
 3. Interest rate risk premium

Default Risk Premium

The portion of nominal rate / bond yield that represents compensation for the possibility of default
Taxability Premium
The portion of nominal interest rate / bond yield that represents compensation for unfavorable tax status
Liquidity Premium
The Portion of nominal interest rate / bond yield that represents compensation for lack of liquidity