Finance

Lecture 2: Bond Market and Interest Rates

Leon Zolotoy

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Synopsis of the Previous Lecture

How do …rms select their investment projects?

the left-hand side of market-value based balance sheet
NPV method
IRR rule
payback methods

Question
how do the …rms …nance their projects?
the right-hand side of market-value based balance sheet

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The Financing "Landscape" of Australian Firms

Most of Australian business funding comes from equity, followed by bank loans and bonds

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From Project Selection to the Project Financing

Firms can …nance their operations using

debt (bonds, bank loans)
equity (shares, retained earnings)
The costs of …nancing for the …rm will, thus, depend on
the cost of debt
the cost of equity
Topics to be covered
bond markets and interest rates (Week 2)
public equity (stock) markets (Week 3)

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Outline of the Lecture

Bonds and Bond Features

Issuing and Trading Bonds
Bond Valuation
Price-Yield Relation
Default Risk and Credit Ratings
Interest Rate Risk and Term Structure of Interest Rates
Bonds with Embedded Options

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Bond Features

Bond - evidence of debt issued by a corporation or a governmental

body.
A bond essentially represents a publicly traded loan made by investors
to the issuer.
In return for his/her money, the investor receives a legal claim on
future cash ‡ows of the issuer
The issuer promises to:
Make regular coupon (interest) payments every period until the bond
matures.
Pay the face value of the bond when it matures (principal of the loan)

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Bonds vs Bank Loans

Why issue bonds instead of taking a loan from the bank?

the required return on bonds is, typically, lower than the interest rate
paid on comparable bank loans
though, for large …rms costs of …nancing using bonds and loans are
(broadly) comparable
the tenure of bank loans is, typically, shorter than the tenure of bonds
bank loans have debt covenants (restrictions imposed on the borrowing
companies)
In Australia …rms historically relied more on bank debt
with rapid development of Australia bond market this trend starts to
revert
large Australian …rms also issue bonds overseas on the US and
European bond markets

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Australian Bond Market
Government vs Non-Government Bonds

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Australian Bond Market
Major Issuers of the Non-Government Bonds

Australian banks access bond market to support growth in lending (a dramatically increasing trend in the Financial blue line)

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Issuing Bonds

Bonds are issued on so-called "primary market"

company sells bonds to investors
The most common process of issuing corporate bonds is underwriting
typically, underwriters are investment banks who assist the issuing …rm
with
valuing the bonds
selling the bonds to investors

The underwriters charge a certain percentage of proceeds-the gross

spread
average gross spread for a typical bond issue is about 0.8%-1.2%.

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Issuing Bonds
an Example

On June 14 2013 Rio Tinto Plc announced an issue of US$ 2.25 bln
bonds
Bond issue comprised of
US$1 billion of 3-year bonds with a 1.375% coupon rate maturing in
June 2016
US$1.25 billion of 5.5-year bonds with a 2.250% coupon rate maturing
in December 2018
The 3-year bond was priced at 100 basis points (1%) margin above
the relevant U.S. Treasury yields.
The 5.5-year bond was priced at 140 basis points (1.4%) margin
above the relevant U.S. Treasury yields.
BNP Paribas Securities Corp., J.P. Morgan Securities, Morgan
Stanley & Co., and Credit Suisse acted as underwriters.

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Issuing Bonds
Terminology-From "Finance English" to Plain English

Rio Tinto raised US$ 2.25 bln worth of debt on the US bond market
Rio Tinto promises to pay the following interest rates (the coupon
rates)
1.375% for the bondholders of the 3-year bond
2.250% for the bondholders of the 5.5-year bond
The discount rates used by the market to value the bonds (the yields)
were
for the 3-year bond: the yield on the 3-year US Treasury bond on June
14 2013+1%
for the 5-year bond: the yield on the 5-year US treasury bond on June
14 2013+1.4%
The margins of 1% and 1.4% re‡ect risk premiums required by the
market (will be discussed later today)

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Trading Bonds
After the bond has been issued, it is traded on so-called "secondary
market"
on secondary market investors trade between themselves
Corporate bonds are, typically, traded on the "over the counter"
(OTC) market (also called "dealers market")
in Australia, some corporate bonds are traded on exchange (ASX)
The dealers are usually investment banks or other …nancial institutions
Dealers provide market liquidity by buying bonds from/selling bonds
to investors at quoted prices
Quoted purchase price=bid, quoted selling price=ask
ask minus bid=dealers’pro…ts
The gap between bid and ask prices=measure of asset liquidity
the larger is the gap, the more investor loses in transaction costs when
trading the asset
more costly to trade=less trading=less liquidity
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Valuing a Bond
Terminology

Consider a following bond. It sells for $924.18, pays an annual coupon

of $80, and it matures in 5 years. It has a face value of $1000.
Market price=$924.18
Time to maturity=5 years
Face value is the value of principal=$1000
$80
Coupon rate = 1000 = 8% is the annual dollar coupon as a percentage
of the face value
Yield to maturity=required return on bond by the market (the discount
rate used by investors to value the bond)

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Valuing a Bond
The Bond Pricing Equation

Think of the bond as a "cash-generating box"

The "box" generates (1) a stream of coupon payments, and (2) the
face value
Therefore, market price of the bond=PV(coupons)+PV(face value)

C C C F
B= + 2
+ .. + T
+
1+r (1 + r ) (1 + r ) (1 + r )T
pv of coupons pv of face value
| {z } | {z }

C coupon paid each period

r discount rate or yield to maturity (YTM)
T number of periods
F bonds face value

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Valuing a Bond
Relation Between Coupon Rate and Yield to Maturity

Barnhart, Inc. bonds have a $1000 face value.

The coupon rate is 10%
The bond matures in 20 years.
What is the market price of the bond if
the yield to maturity is 10%.
the yield to maturity is 8%
the yield to maturity is 12%.

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Valuing a Bond
Relation Between Coupon Rate and Yield to Maturity

Coupon rate 10% 10% 10%

Yield to maturity 10% 8% 12%
Face value $1000 $1000 $1000
Market price $1000 $1171.6 $850.61
Traded at par premium discount

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Valuing a Bond
The Relation Between Yield to Maturity and Coupon Rate

Yield to maturity=coupon rate! the bond is selling at par

Yield to maturity<coupon rate! the bond is selling at premium
Yield to maturity>coupon rate! the bond is selling at discount
Intuition
coupon rate=promised rate of return (determined by the contract)
yield to maturity=required rate return (determined by the market)
the relation between these two components determines whether the
bond will be traded above/below its face value

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Valuing a Bond
The Bond With Semi-Annual Coupon Payments

Some bonds (e.g. in US) make coupon payments on a semi-annual

basis
Consider a 20-year bond with the face value of $1000
It pays annual coupon rate of 12% on a semi-annual basis. It has
annual yield to maturity of 10%.
Semi-annual coupon payment= 12%
2 $1000 = $60,number of
payments=20 2 = 40
Semi-annual yield to maturity= 10%
2 = 5%
Market price of the bond

$60 $60 $1000

B= + ..... + 40
+ = $1171.59
1 + 0.05 (1 + 0.05) (1 + 0.05)40

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Valuing a Bond
Calculating Yield to Maturity From Bond Prices

Market price of the bond is $850.61

Coupon rate=10%, face value=$1000, time to maturity=20 years
Calculate the yield to maturity (r =?)

$100 $100 $1000

+ ..... + 20
+ = $850.61
1+r (1 + r ) (1 + r )20

Use the IRR function in Excel to …nd YTM

=IRR(-850.61,100,100.....1100)=12%
for the semi-annual bond use IRR and then multiply by 2

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What Determines the Yield to Maturity?

YTM re‡ects the discount rate used by the market to value the bond
market "penalizes" future cash ‡ows of the bond based on the risk
pro…le of the bond and/or the issuer
thus, YTM re‡ects the cost of …rm’s …nancing using bonds (publicly
traded debt)
One can view YTM as the sum of four major components
risk-free rate=yield on the short-term government debt (time value of
money)
default risk premium
interest-rate risk premium
risk premium/discount for embedded options
Each of the three premiums captures a di¤erent aspect of
compensation required by the market for investing in the bond.

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Default Risk Premium
The Default Risk Structure of Interest Rates

Default means that the …rm cannot pay the interest and/or principal
on time.
Clearly, the yield (required return) on speci…c bond depends on the
probability of issuer’s default.
Bond ratings by the credit rating agencies (CRA’s), such as S&P and
Moody’s assign credit ratings to company’s debt
Lower probability of default!higher rating
Highest rating is AAA.
Bonds above BBB are considered investment grade bonds.
Bonds below BBB are considered speculative grade (or "junk") bonds

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Default Risk Premium
The Default Risk Structure of Interest Rates-an Example

The yield to maturity on corporate bond goes up as the ratings go down=investors require extra premium for default risk

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Default Risk Premium
Criticism of CRA’s

Potential con‡icts of interest

charging issuers for credit ratings
provide ancillary advisory services to their clients
customized credit risk management services
other quantitative tool services

Global Financial Crisis

CRA’s have downgraded the ratings on nearly $1.9 trillion of securities
over the period of June 2007-June 2008
CRAs ratings should be treated with some degree of caution

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Default Risk Premium
The Impact of COVID-19

Corporate bond yields spiked relative to a risk-free bechmark at the peak of COVID-19 market turbulence

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Interest Rate Risk Premium
The Term Structure of Interest Rates

The term structure of interest rates,(or the yield curve), is the

relationship between interest rates on government bonds of di¤erent
maturities.
Short term interest rates are, typically, di¤erent from long term
interest rates.
More speci…cally, long term rates are, typically, higher than short term
rates
Yield curve is constructed from the YTM’s of zero-coupon bonds
(Strips) with di¤erent maturities
these bonds pay no coupons, just the face value at maturity date
Note, that the government debt (in domestic currency) is, essentially,
default risk free
long-term bonds are more sensitive to changes in interest rate
compared to the short-term bonds
higher yield to maturity on the long-term bonds re‡ects an interest rate
risk premium
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Interest Rate Risk Premium
The Term Structure of Interest Rates-an Example

Yields are increasing as the time to maturity increases-premium for the interest-rate risk

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Interest Rate Risk Premium
Sensitivity to Interest Rate Risk-Duration

Duration measures price sensitivity of the bond to 1 percentage

change in interest rate
In Excel-function "Duration"
Long-term bonds are more sensitive to changes in interest rates than
the short-term bonds.
long-term bonds have higher duration!hence, are more risky
Suppose, on January 1, 2008 you purchased a 5-year bond with 5%
coupon rate and semi-annual payments. YTM is 7%
Using duration(1/01/2008,1/01/2013,5%,7%,2)=4.46
If interest rates go up by 1% the market value of the bond is expected
to decline by, approximately, 4.46%
in Excel use DATE (year, month, day) function to write input dates

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Term Structure and Future Interest Rates
Forward Rates

Consider two alternative investments

a. Investing $1000 in 2-years zero-coupon bond today and hold for two
years
b. Investing $1000 in 1-year zero-coupon bond today and then re-invest
the proceedings in 1-year zero coupon bond one year from now.
The yields on 1-and 2-years zero coupon bonds are 2% and 3%,
respectively
The payo¤ from project a.=$1000 (1.03)2
The payo¤ from project b.=$1000 (1.02) (1 + x ) where x is the
unknown yield on 1-year zero coupon bond one year from now.

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Term Structure and Future Interest Rates
Forward Rates

Question: what should be x to make investor indi¤erent between the

two investments?
Need to …nd x such that

(1.02) (1 + x ) = (1.03)2

Solving for x

(1 + 0.03)2
x= 1 = 0.0401 = 4.01%
(1 + 0.02)

The two-year forward rate is 4.01%

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Term Structure and Future Interest Rates
Forward Rates

A general formula for n year forward rate is

(1 + rn )n
n-year forward rate = 1
(1 + rn 1 )n 1

rn yield for a zero-coupon bond with a maturity of n

rn 1 yield for a zero-coupon bond with a maturity of n 1
Forward rates are often used as forecasts of future interest rates
This measure should be treated with caution!
forward rates are estimated from the yield curve
apart from re‡ecting market expectations yield curve also includes
interest rate risk premium!

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Risk Premium/Discount for Embedded Options
Bonds with Embedded Options

These bonds include, among others

callable bonds. A bond which the issuer has the right to redeem (buy
back) prior to its maturity date at face value
this option is favorable to the issuer
convertible bonds. A bond which the holder has the right to convert to
shares of issuing company at an agreed-upon price.
this option is favorable to the bond holder

These embedded options will be re‡ected in the YTM.

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Risk Premium/Discount for Embedded Options
Bonds with Embedded Options

Callable bond.
option to call the bond back is favorable to the issuer
will be traded at discount relative to a similar straight bond
YTM on callable bond >YTM on a similar straight bond
Convertible bond.
option to convert the bond into company shares is favorable to the
bond holder
will be traded at premium relative to a similar straight bond
YTM on convertible bond <YTM on a similar straight bond

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Other Factors That Can A¤ect Bond Yield

Bond liquidity
corporate bonds vary substantially in terms of how liquid they are
all else equal, bonds with low liquidity will have higher yields
Tax considerations
di¤erences of income vs capital gains tax treatment
may a¤ect market demand for the bonds with high vs low coupon rates
in turn, market demand may a¤ect bond prices and yields

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