Interest Rates

and Bond Valuation

Chapter 6

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Bonds
 A bond is a debt instrument requiring the issuer to repay to
the investors the amount borrowed plus interest over a
specified period of time.
 Involved Parties:
 Issuers / Debtors / Borrowers :
 The parties (government or corporations) that borrow money
and issue debt securities
 Investors / Creditors / Lenders / Bondholders :
 The parties (person, government or corporations that lend
money to issuers. (they buy the debt securities).
 Other parties:
 Underwriters: Investment banking firms that act as agents to
distribute bonds to investors. They will charge a fee for the
service.
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Bond – Face value

 Face Value (Par Value) - F

 The total principal amount that will be repaid at the
end of the loan.
 It is often different from market value
 Bond’s market value is the fair value a bond can be
bought/sold in the market.

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Bond - Coupons
 Stated annual interest payment make on a bond.
 It is determined upon issuance. Normally, it is
expressed as a percentage of par value.
 Coupon Payment = Coupon Rate (i) x Par Value.

 Coupon rate is NOT the discount rate for discounting!!!

Instead, it is only the interest rate that issuer promises
to pay periodically.
 If coupon rate is zero, bonds are called Zero-Coupon
Bonds (Zeros)
 Current Yield = the (annual) coupon / the market price

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Bond - Maturity

 The number of years left until the face value is

paid.
 The maturity date of a bond refers to the date that the debt
will cease to exist.
 A calendar year can correspond to many compounding
periods.

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 Issuer

Coupon rate Maturity date

Face Value

Face value, coupon rate and maturity

are stated in the bond and fixed.
Market value (price), however, varies
from time to time Coupon

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Summer 2008 Yunling Chen
The Bond Indenture
 Indenture – Written agreement between the company (the
borrower) and the bondholders (the lenders/creditors) and
includes:
 The rights of the bondholders and the duties of the issuing
corporation
 The basic terms of the bonds
 Face value, coupon rate, maturity, etc
 The total amount of bonds issued
 A description of property used as security, if applicable
 Describes collateral (bonds, stocks, etc) and/or mortgage (real
property, i.e., land, buildings, etc) used as pledge.
The repayment arrangements – schedule of repayments
 Call provisions: giving the issuer the option to repurchase the
bond at a specific price prior to maturity
 Details of protective covenants – positive (should) and
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Summernegative
2008 (should Yunling
not) Chen
Bond Indenture
 Standard provision
 Specify certain record keeping and general
business practices that the bond issue must follow.
 The borrower commonly must
 Maintain satisfactory accounting records in accordance
with generally accepted accounting principles (GAAP)
 Periodically supply audited financial statements
 Pay taxes and other ;liabilities when due
 Maintain all facilities in good working order

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Bond Indenture
 Restrictive provisions
 Which place operating and financial constraints on the
borrower
 Theses provisions help protect the bondholder against
increase in borrower risk
 Require a minimum level of liquidity
 Prohibit the sale of accounts receivables to generate cash
 Impose fixed asset restrictions (maintain a specific level of
fixed assets)
 Constrain subsequent borrowing (subordination)
 Limit the firm’s annual cash dividend payments to a specified
percentage or amount

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Bond Indenture
 Sinking Fund Requirements
 Objective is to provide for the systematic retirement of
bonds prior to their maturity
 Security Interest
 The bond indenture identifies any collateral pledged
against the bond specifies how it is to be maintained
 Trustee
 A trustee is a third party to a bond indenture
 The trustee can be one individual, a corporation, or a
commercial bank trust department
Cost of the bond to the Issuer
 Impact of bond maturity on bond cost
 Long term debt pay higher interest rates than
short term debt
 High risk of interest rate and price fluctuations
 Impact of offering size on bond cost
 Bond floatation and administration costs per
rupee borrowed are likely to decrease with
increasing offering size
 Large offerings result in greater risk of default
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Cost of the bond to the Issuer
 Impact of issuer’s risk
 The greater the issuer’s default risk, the higher the
interest rate
 Restrictive provisions can reduce some of the risk
 Bondholder may be compensated with higher
returns
 Bond ratings help to determine the issuer’s risk
 Impact of the cost of money
 Basic rate is added a risk premium that reflects the
factors (maturity, offering size and issuer’s risk)
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General features of a bond
issue
 Convertible feature
 Allow bond holders to change each bond into
stated number of shares of common stock
 Call feature
 Gives the issuer the opportunity to repurchase
bonds at stated call price prior to maturity
 Call price
 Call premium

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Types of bonds
 Unsecured bonds
 Debentures
 Subordinated debentures
 Income bonds
 Secured bonds
 Mortgage bonds
 Collateral trust bonds
 Equipment trust certificate

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Debentures
 Unsecured bonds that only credit worthy
firms can issue
 Convertible bonds are normally debentures
 Claims are the same as those of any general
creditors
 May have other unsecured bonds
subordinated to them

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 Types of bonds
 Subordinated debentures
 Claims are not satisfied until those of the creditors holdings
certain (senior) debts have been fully satisfied
 Claims is that of a general creditor but not as good as a senior
debt claim
 Income bonds
 Payment of interest is required only when earnings are
available
 Claims is that of a general creditor
 Are not default when interest payments are missed, because
they are contingent only on earnings being available.

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 Types of bonds
 Mortgage bonds
 Secured by real estate or buildings.
 Claims is on proceeds from sale of mortgaged assets; if
not fully satisfied, the lender becomes general creditors
 A number of mortgages can be issued against the same
collateral
 Collateral trust bonds
 Secured by stocks or bonds that are owned by the issuer
 Collateral value is generally 25% to 35% greater than
bond value

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Types of bonds
 Equipment trust certificate
 Used to finance rolling stock – airplanes, trucks,
boats, railroad cars
 Claim is on proceeds from the sale of the asset; if
proceeds do not satisfy outstanding debt, trust
certificate lenders become general creditors

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Contemporary types of bonds
 Zero coupon bonds
 is a bond that pays no interest but sells at a deep
discount from its face value
 it provides compensation to investors in the form
of price appreciation
Generally callable at par value

Treasury Bills are good examples of zeroes

 Junk bonds
Highrisk bonds high yields – often yielding 2% to
3% more than the best quality corporate debt.
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Contemporary types of bonds
 Floating rate bonds
 Stated interest rate is adjusted periodically within
stated limits in response to changes in specified
money market and capital market rates.
 Tend to sell at close to par because of the
automatic adjustment to changing markets
conditions
 Some issues provide for annual redemption at par
at the option of the bondholder

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Contemporary types of bonds
 Extendible notes
 Short maturities, typically 1 to 5 years, that can be
renewed for a similar period at the option of
holders
 An issue might be a series of 3 year renewable
notes over a period of 15 years; every 3 years ;
the notes could be extended for another 3 years,
at a new rate competitive with market interest
rates at the time of renewal.

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Contemporary types of bonds
 Putable bonds
 Bonds that can be redeemed at par at the option
of their holder either at specified dates after the
date of issue and every 1 to 5 years thereafter or
when and if the firm takes specified actions, such
as being acquired, acquiring another company, or
issuing a large amount of additional debt
 The bond’s yield is lower than that of a non
putable bond

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Bond Classifications
(priority to get paid when bankrupt)

Financial
Securities
Real (i.e., Bonds, Bondholders A
Properties A stocks,
(i.e., Land) etc)
bankrupt

Real
Properties B Bondholders B
(i.e., buildings,
Machines, etc)

Firm A 23
Bond Classifications (cont’d)
(priority to get paid when bankrupt)
 Secured Vs. Unsecured
Mortgage Collateral

Financial
Securities
Real (i.e., Bonds, Bondholders A
Properties A stocks,
(i.e., Land) Etc)
bankrupt security

Real
Properties B Bondholders B
(i.e., buildings,
Machines, etc)

Firm A 24
Bond Classifications (cont’d)
(priority to get paid when
bankrupt)
 Seniority – Order of priority in case of liquidation

Financial
Securities
Real (i.e., Bonds, Bondholders A
Properties A stocks, 1 (senior)
(i.e., Land) Etc)
bankrupt

Real
Properties B 2 Bondholders B
(i.e., buildings, (junior / subordinated)
Machines, etc)

Firm A 25
Bond Valuation
 If bond is correctly priced by the market, we should
have

Bond Price  PV (Coupons) + PV (Face value)

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Bond Valuation (cont’d)
$C $C $C $C+F
……. $C Time
0 1 2 3 T (years)

…….
C C C F
Bond Price    ...  
1  r (1  r ) 2 (1  r )T (1  r )T
T
C F C 1 1
   * (1  )  F *
t 1 (1  r ) (1  r )T r (1  r )T (1  r )T
t

 F: Face value Bond price: market value

 c: Coupon rate C: Coupon = c * F
 T: Maturity r: YTM, or required discount rate
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Bond - Yield to Maturity (YTM)
 Since the bond’s price is agreed by most investors
in the market, YTM reflects the underlying fair level
of required return in the market.
 It is also called “Market Interest Rate”
 It implies the current rate of interest or time value of money
agreed in the market.
 This is the appropriate discount rate for the bond valuation.
 The yield is changing over time, which depends on the
investors’ risk attitudes and investment opportunities.

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Bond Valuation Example -
Perpetuity
 Face value = 1000; Coupon rate = 8%; Time to maturity = .
Assume that investors require 10% yield to maturity on the
bond, what would be the price of the bond?

Bond Purchased $80 $80 $80

t=0 t=1 t=2 t=3

What is the appropriate rate for bond valuation, 10% or 8%?

– 10%
Since it is a perpetual bond, only coupon will be paid. Face
value is just used to calculate annual coupon.
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Valuation of Perpetuity
Bond price at t = 0
$80 $80 $80
P= + + +
(1+0.1) (1+0.1)2 (1+0.1)3

Recall price of perpetuity = I/k

$80 = $800
= 0.1
What would be the price of the bond if YTM = 8 %?
P = $80/8% = $1,000
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Relationship Between The Bond
Value & YTM
 Face value = 1000; Coupon rate = 8%,
paid annually; Time to maturity = 5 years.
What would be the price of the bond if
 YTM is 8% = coupon rate
 YTM is 10% > coupon rate
 YTM is 6% < coupon rate

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 Relationship Between The Bond Value &
YTM (cont’d)

Maturity
MaturityDate
Date
Bond Price?

$80 $80 $80 $80 $80+1,000

Time
0 1 2 3 4 (years)
5

Coupon
CouponPayment
Payment Face
Facevalue
value(Par
(Par
value)
value)

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If YTM = Coupon Rate = 8%
Price = C * [1 – 1/(1+r)T]/r + F * [1/(1+r)T]
=$80*[1-1/1.085]/0.08 + $1,000/1.085
=319.42 + 680.58
=1,000 = Face Value
Is this a coincidence?
If c = r,
Price = F *c* [1 – 1/(1+r)T]/r + F * [1/(1+r)T]
=Face Value
 Intuition?
 If the issuer promises to pay you the same interest as
investors required, the maximum amount investors are
willing to lend is just the face value of the bond.
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If YTM = 10% > Coupon Rate
Price = C * [1 – 1/(1+r)T]/r + F * [1/(1+r)T]
=$80*[1-1/1.15]/0.1 + $1,000/1.15
=$303.26 + $620.92
=$924.18 (discounted by $75.82)
Bond sells for less than its face value – a
Discount Bond
If c<r,
Price = F *(c/r)* [1 – 1/(1+r)T] + F * [1/(1+r)T]
< F [1- 1/(1+r)T] +F * [1/(1+r)T] = F

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If YTM = 6% < Coupon Rate
Price = C * [1 – 1/(1+r)T]/r + F * [1/(1+r)T]
=$80*[1-1/1.065]/0.06 + $1,000/1.065
=$336.99 + $747.26
=$1084.25
Bond sells at a premium of $84.25 – a Premium
Bond
If c>r,
Price = F *c* [1 – 1/(1+r)T]/r + F * [1/(1+r)T]
> F [1- 1/(1+r)T] +F * [1/(1+r)T] = F

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Relationship Between Coupon and Yield
– Summary

 If YTM = coupon rate, then bond price = par value

 If YTM > coupon rate, then bond price < par value
 Selling at a discount, called a discount bond
 If YTM < coupon rate, then bond price > par value
 Selling at a premium, called a premium bond

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