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Principles of

Chapter 3 Corporate Finance


Tenth Edition

Valuing Bonds

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
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Topics Covered
Using The Present Value Formula to Value
Bonds
How Bond Prices Vary With Interest Rates
The Term Structure of Interest Rates
Explaining the Term Structure
Real and Nominal Rates of Interest
Corporate Bonds and the Risk of Default
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Valuing a Bond

C1 C2 1,000  C N
PV    ... 
(1  r ) 1
(1  r ) 2
(1  r ) N
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Valuing a Bond

Example
 If today is October 1, 2010, what is the value of the
following bond? An IBM Bond pays $115 every
September 30 for 5 years. In September 2015 it pays an
additional $1000 and retires the bond. The bond is rated
AAA (WSJ AAA YTM is 7.5%)

Cash Flows
Sept 11 12 13 14 15
115 115 115 115 1115
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Valuing a Bond

Example continued
 If today is October 1, 2010, what is the value of the following bond? An
IBM Bond pays $115 every September 30 for 5 years. In September
2015 it pays an additional $1000 and retires the bond. The bond is rated
AAA (WSJ AAA YTM is 7.5%)

115 115 115 115 1,115


PV     
1.075 1.075 1.075 1.075 1.0755
2 3 4

 $1,161.84
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Valuing a Bond

Example - France
 In December 2008 you purchase 100 Euros of bonds in France which
pay a 8.5% coupon every year. If the bond matures in 2012 and the
YTM is 3.0%, what is the value of the bond?
8.5 8 .5 8 .5 108.5
PV    
1.03 1.03 1.03 1.034
2 3

 120.44 Euros
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Valuing a Bond

Another Example - Japan


 In July 2010 you purchase 200 Yen of bonds in Japan which pay a 8%
coupon every year. If the bond matures in 2015 and the YTM is 4.5%,
what is the value of the bond?

16 16 16 16 216
PV     
1.045 1.045 1.045 1.045 1.0455
2 3 4

 243.57 Yen
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Valuing a Bond

Example - USA
 In February 2009 you purchase a 3 year US Government bond. The
bond has an annual coupon rate of 4.875%, paid semi-annually. If
investors demand a 0.6003% semiannual return, what is the price of the
bond?

24.375 24.375 24.375 24.375 24.375 1024.375


PV      
1.006003 1.0060032 1.0060033 1.0060034 1.0060035 1.0060036

 $1,107.95
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Valuing a Bond

Example continued - USA


 Take the same 3 year US Government bond. If investors demand a 4.0%
semiannual return, what is the new price of the bond?

24.375 24.375 24.375 24.375 24.375 1024.375


PV      
1.04 1.04 1.04 1.04 1.04 1.046
2 3 4 5

 $918.09
Yield , %

10
12
14
16

0
2
4
6
8
1900

1906

1912

1918

1924

1930

1936

1942

Year
1948

1954

1960

1966

1972

1978

1984

1990

1996

2002

2008
Interest Rate on 10yr Treasuries
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Bond Prices and Yields


115.00

110.00

105.00
Bond Price, %

100.00

95.00

90.00

85.00

80.00
0

10
Interest Rates, %
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Maturity and Prices

3,000

2,500

30 yr bond
Bond Price, ($)

2,000 When the interest rate


equals the 5% coupon,
both bonds sell for
1,500 face value

1,000
3 yr bond

500

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Interest Rates, %
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Duration Formula

1  PV (C1 ) 2  PV (C 2 ) 3  PV (C3 ) T  PV (CT )


Duration     ... 
PV PV PV PV

duration
Modified Duration  volatility (%) 
1  yield
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Duration Calculation

Proportion of Total Value Proportion of Total


Year Ct PV(Ct) at 5.0% [PV(Ct)/V] Value Time
1 100 95.24 0.084 0.084
2 100 90.7 0.08 0.16
3 1100 950.22 0.836 2.509
V = 1136.16 1 Duration= 2.753 years
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Duration
Example (Bond 1)
Calculate the duration of our 6.875 % bond @ 4.9 % YTM

Year CF PV@YTM % of Total PV % x Year


1 68.75 65.54 .060 0.060
2 68.75 62.48 .058 0.115
3 68.75 59.56 .055 0.165
4 68.75 56.78 .052 0.209
5 1068.75 841.39 ` .775 3.875
1085.74 1.00 Duration 4.424
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Duration
Example (Bond 2)
Given a 5 year, 9.0%, $1000 bond, with a 8.5% YTM, what is
this bond’s duration?

Year CF PV@YTM % of Total PV % x Year


1 90 82.95 .081 0.081
2 90 76.45 .075 0.150
3 90 70.46 .069 0.207
4 90 64.94 .064 0.256
5 1090 724.90 .711 3.555
1019.70 1.00 Duration= 4.249
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Duration & Bond Prices


Bond Price, percent

Interest rate, percent


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Interest Rates
 Short- and long-term interest rates do not always move in parallel.
Between September 1992 and April 2000 U.S. short-term rates rose
sharply while long term rates declined.
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Term Structure of Interest Rates


YTM (r)

1981
1987 & Normal

1976
Year
1 5 10 20 30
Spot Rate - The actual interest rate today (t=0)
Forward Rate - The interest rate, fixed today, on a loan made
in the future at a fixed time.
Future Rate - The spot rate that is expected in the future
Yield To Maturity (YTM) - The IRR on an interest bearing
instrument
Spot rates (%)

0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
2009 Aug 15

2011 Aug 15

2013 Aug 15

2015 Aug 15

2017 Aug 15

2019 Aug 15

2021 Aug 15

2023 Aug 15

Maturity
2025 Aug 15

2027 Aug 15

2029 Aug 15
Yield Curve

2031 Aug 15

2033 Aug 15

2035 Aug 15

2037 Aug 15
U.S. Treasury Strip Spot Rates as of February 2009
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Law of One Price


All interest bearing instruments are priced
to fit the term structure
This is accomplished by modifying the asset
price
The modified price creates a New Yield,
which fits the Term Structure
The new yield is called the Yield To
Maturity (YTM)
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Yield to Maturity
Example
A $1000 treasury bond expires in 5 years.
It pays a coupon rate of 10.5%. If the
market price of this bond is 107.88, what is
the YTM?
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Yield to Maturity
Example
A $1000 treasury bond expires in 5 years. It pays
a coupon rate of 10.5%. If the market price of this
bond is 107.88, what is the YTM?

C0 C1 C2 C3 C4 C5
-1078.80 105 105 105 105 1105

Calculate IRR = 8.5%


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Term Structure
What Determines the Shape of the Term Structure?

Expectations Theory

Term Structure & Capital Budgeting


 CF should be discounted using Term Structure info
 Since the spot rate incorporates all forward rates, then you
should use the spot rate that equals the term of your project.
 If you believe in other theories take advantage of the
arbitrage.
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Debt & Interest Rates


Classical Theory of Interest Rates (Economics)
 developed by Irving Fisher

Nominal Interest Rate = The rate you actually pay when


you borrow money

Real Interest Rate = The theoretical rate you pay when you
borrow money, as determined by supply and demand
r
Supply

Real r

Demand

$ Qty
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Inflation Rates
Annual rates of inflation in the United States from 1900–2008.

25

20
Annual Inflation (%)

15

10

0
1900

1906

1912

1918

1924

1930

1936

1942

1948

1954

1960

1966

1972

1978

1984

1990

1996

2002

2008
-5

-10

-15
Average Inflation, %

Sw
it
Ne zer

0.00
2.00
4.00
6.00
8.00
10.00
12.00

th lan
er d
la
nd
s
US
Ca A
na
Sw da
ed
No en
r
Au wa
st y
De ra lia
nm
ar
k
UK
So Ire
G ut lan
er
m h d
an Af
ric
y A
(e ve a
x r
19 age
22
/
Be 2 3)
lg
iu
m
Averages from 1900-2006

Sp
a
Fr in
an
Global Inflation Rates

ce
Ja
pa
n
Ita
ly
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Debt & Interest Rates


Nominal r = Real r + expected inflation (approximation)

Real r is theoretically somewhat stable

Inflation is a large variable

Q: Why do we care?
A: This theory allows us to understand the Term Structure of
Interest Rates.

Q: So What?
A: The Term Structure tells us the cost of debt.
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Debt & Interest Rates


Actual formula

1  rnominal  (1  rreal )  (1  i)
Interest rate (%)

0
2
4
6
8
14
16
18
20

10
12
1-Jan-84
1-Apr-85
1-Jul-86
1-Oct-87
1-Jan-89
1-Apr-90
1-Jul-91
1-Oct-92
10 year real interest rate

1-Jan-94
1-Apr-95
1-Jul-96
1-Oct-97
1-Jan-99
10 year nominal interest rate

1-Apr-00
UK Bond Yields

1-Jul-01
1-Oct-02
1-Jan-04
1-Apr-05
1-Jul-06
1-Oct-07
1-Jan-09
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Govt. Bills vs. Inflation (’53-’08)
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United Kingdom
30.00

25.00 Inflation

20.00

15.00
%

T-Bill Returns
10.00

5.00

0.00
Govt. Bills vs. Inflation (’53-’08)
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United States
16.00

14.00

12.00
Inflation

10.00

8.00

T-Bill Returns
6.00
%

4.00

2.00

0.00

-2.00
Govt. Bills vs. Inflation (’53-’08)
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Germany
12.00

10.00

T-Bill Returns
8.00

6.00

4.00
%

2.00 Inflation

0.00

-2.00

-4.00
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Bond Ratings
 Key to bond ratings. The highest-quality bonds are rated triple A.
Bonds rated triple B or above are investment grade. Lower-rated bonds
are called high-yield, or junk, bonds.
Yield spread between corporate
and government bonds, %

0
1
2
4
5
6
7

-1
3
0.4
0.24
0.22
0.5
0.22
0.42
0.44
0.58
0.79
0.25

Years
-0.05
-0.01
0.83
Spread on Baa bonds
Yield Spread

0.75
Treasury bonds.

1.21
1.08
1.18
1.9
Spread on Aaa bonds

1.38
0.67
Yield spreads between corporate and 10-year
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Prices and Yields


 Prices and yields of a sample of corporate bonds,
December 2008.

Source: Bond transactions reported on FINRA’s TRACE service:


http://cxa.marketwatch.com/finra/BondCenter
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Web Resources
Click to access web sites
Internet connection required

http://cxa.marketwatch.com/finra/BondCenter
www.ft.com
www.smartmoney.com
www.wsj.com
www.finpipe.com
www.investinginbonds.com
www.investorguide.com
http://money.cnn.com/markets/bondcenter
www.federalreserve.gov
www.stls.frb.org
www.ustreas.gov