Chapter 6

Interest Rates and

Bond Valuation

1
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 1-2 6-2

Chapter Outline

• Bonds and Bond Valuation

• More on Bond Features
• Some Different Types of Bonds
• Inflation and Interest Rates

2
 1-3 6-3

Bond Definitions
• Bond: debt securities, interest-only loan
• Par value (face value): loan principal, eg: $1000
• Coupon rate: periodic interest rate
• Coupon payment (c): periodic interest payments
= coupon rate * par
• Time to maturity (t): no. of coupon payment till
maturity date
• Yield to maturity (r) : market required rate of return
on bond. IOW, the discount rate that equals the PV
of cash flows to bond price.

3
 1-4 6-4

Bond Definitions: Example

Consider a 5-year corporate bond with a 10%
coupon rate paid annually. The principal amount is
$1000 and the market interest rate is 10% .

•Coupon=10% * $1000=$100
•year to maturity= 5
•Yield to maturity=10%
•Cash Flows: year 1 - 4 = $100
year 5 = 100 + 1000 = $1100

4
 1-5 6-5

Bond Valuation
Asset value = Present value of all future cash flows
Bond value = PV of all payments discounted at YTM
= PV of coupon + PV of par
= PV of annuity + PV of par

 1 
1 - (1 + r) t  F
Bond Value = C  +
 r  (1 + r) t


 

Where c = coupon payment
r = YTM
t = numbers of period
F = face value (eg:1000)
5
 1-6 6-6

Bond valuation-Example
Consider a 5-year corporate bond with a 10%
coupon rate paid annually. The principal amount is
$1000 and the market interest rate is 10%

6
 1-7 6-7

PV of Cash Flows as Rates

Change
 1 
1 - (1 + r) t  F
Bond Value = C  +
 r  (1 + r) t
 
 
• Remember, as interest rates increase the
PV’s decrease
• So, as interest rates increase, bond prices
decrease and vice versa
7
 1-8 6-8
Valuing a Discount Bond with
Annual Coupons
• Consider a bond with a coupon rate of 10% and
coupons paid annually. The par value is $1000
and the bond has 5 years to maturity. The yield
to maturity is 12%. What is the value of the
bond?

8
 1-9 6-9

Valuing a Premium Bond with

Annual Coupons
• Suppose you are looking at a bond that has a
10% annual coupon and a face value of $1000.
There are 5 years to maturity and the yield to
maturity is 8%. What is the price of this bond?

9
 6-10
1-10

Bond Prices: Relationship

Between Coupon and Yield
• If YTM = coupon rate,
– bond price = par value = $1000
– selling at par, called a par bond
• If YTM > coupon rate,
– bond price < $1000
– Selling at a discount, called a discount bond
• If YTM < coupon rate,
– bond price > $1000
– Selling at a premium, called a premium bond
10
 6-11
1-11

Semiannual coupons
• Suppose you are looking at a bond that has a
10% coupon paid semiannually and a face value
of $1000. There are 5 years to maturity and the
yield to maturity is 12%. What is the price of this
bond?

11
 6-12
1-12

Interest Rate Risk

• How sensitive its price to the interest

rate changes
– Long-term bonds have more interest rate risk
than short-term bonds (+ve relationship with
time to maturity)
– The lower the coupon rate, the greater the
interest rate risk (-ve relationship with coupon
rate)

12
 6-13
1-13

Computing YTM
• Yield-to-maturity is the rate implied by the
current bond price, i.e., the rate that equals
the PV of bond’s cash flows with bond
price.
• Finding the YTM requires trial and error if
you do not have a financial calculator.

13
 6-14
1-14

YTM with Annual Coupons

• Consider a bond with a 10% annual
coupon rate, 15 years to maturity and a
par value of $1000. The current price is
$928.09.

14
 6-15
1-15

YTM with Semiannual Coupons

• Suppose a bond with a 10% coupon rate and
semiannual coupons, has a face value of
$1000, 20 years to maturity and is selling for
$1197.93.

15
 6-16
1-16

Bond Yield

– Yield to maturity: market required rate of return

on bond.
– Current yield = Annual coupon / price
• Par bond: CY = YTM
• Premium bond: CY > YTM
• Discount bond: CY < YTM

16
 6-17
1-17

Differences Betw. Debt & Equity

• Debt • Equity
– Not an ownership – Ownership interest
interest – Common stockholders vote
– Creditors do not have for the board of directors
voting rights and other issues
– Interest is considered a – Dividends are not
cost of doing business considered a cost of doing
and is tax deductible business and are not tax
deductible
– Creditors have legal
recourse if interest or – Dividends are not a liability
principal payments are of the firm and stockholders
missed have no legal recourse if
dividends are not paid
– Excess debt can lead to
financial distress and – An all equity firm can not go
bankruptcy bankrupt
17
 6-18
1-18

The Bond Indenture

• Contract between the company and the
bondholders and includes:
– The basic terms of the bonds: par, registered Vs
bearer
– The total amount of bonds issued
– A description of property used as security, if
applicable - collateral
– Sinking fund provisions
– Call provisions: rights to buyback at specific price
– Details of protective covenants: +ve Vs -ve

18
 6-19
1-19

Bond Classifications
• Registered vs. Bearer Forms
• Security: backed by asset
– 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
– preference in position over other lenders
19
 6-20
1-20

Bond Characteristics and

Required Returns
• 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

20
 6-21
1-21
Types of bonds-
Government Bonds
• Treasury Securities
– Federal government debt
– T-bills – pure discount bonds with original maturity of
one year or less
– 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
– Interest received is tax-exempt at the federal level

21
 6-22
1-22

Taxable Vs Municipal Bonds

• A taxable corporate bond has a yield of 8%
and a municipal bond has a yield of 6%
– If you are in a 40% tax bracket, which bond do
you prefer?

– At what tax rate would you be indifferent

between the two bonds?

22
 6-23
1-23

Zero Coupon Bonds

• Make no periodic interest payments (coupon rate
= 0%)
• Sometimes called zeroes, or deep discount
bonds
• The entire yield-to-maturity comes from the
difference between the purchase price and the
par value
• Treasury Bills and principal only Treasury strips
are good examples of zeroes

23
 6-24
1-24

Floating Rate Bonds

• Coupon rate floats depending on some index
value, eg: T-bill interest rate
• 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

24
 6-25
1-25

Other Bond Types

• Income bonds
– coupon depends on company’s income
• Convertible bonds
– can be converted/swapped to a fixed no. of
shares
• Put bond
– Holder can sell back to issuer at a stated price

25
 6-26
1-26

Inflation and Interest Rates

• Nominal rate of interest – quoted rate of
interest, includes our desired real rate of
return plus an adjustment for expected
inflation
• Rate on Treasury Bill
• Real rate of interest – change in
purchasing power

26
 6-27
1-27

The Fisher Effect

• 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
27
 6-28
1-28

Example
• If we require a 10% real return and we
expect inflation to be 3%, what is the
nominal rate?

28
 6-29
1-29

Tutorial
• Problem 6, 10, 17 and 18 from page 196

• Problem 18:
“…sell for 93% of par…” change to
“…sell for 91.167% of par…”

29