Chapter 6 – Bond Valuation and Interest

Rates
INTRODUCTION TO
CORPORATE FINANCE
Second Edition

Laurence Booth • W. Sean Cleary
Prepared by
Ken Hartviksen
Lecture Agenda
1. Basic Structure of Bonds
2. Bond Valuation
3. Bond Yields
4. Interest Rate Determinants
5. Other Debt Instruments
Bond Basics Valuation Yields Determinants Other Debt
Learning Objectives
 The basic features of different types of bonds
 How to value bonds given an appropriate discount rate
 How to determine the discount rate or yield given the
market value of a bond
 How market interest rates or yields affect bond investors
 How bond prices change over time
 The factors (both domestic and global) that affect interest
rates
Bond Basics Valuation Yields Determinants Other Debt
Basic Structure of Bonds
The Basic Structure of Bonds
 What is a bond?
 In its broadest sense, a bond is any debt
instrument that promises a fixed income
stream to the holder
 Fixed income securities are often classified
according to maturity, as follows:
 Less than one year – Bills or “Paper”
 1 year < Maturity < 7 years – Notes
 < 7 years – Bonds
Bond Basics Valuation Yields Determinants Other Debt
The Basic Structure of Bonds
 A typical bond has the following characteristics:
 A fixed face or par value, paid to the holder of the
bond, at maturity
 A fixed coupon, which specifies the interest payable
over the life of the bond
 Coupons are usually paid either annually or semi-
annually
 A fixed maturity date
Bond Basics Valuation Yields Determinants Other Debt
 Bonds may be either:
 Bearer bonds
 Registered bonds
 Bond indenture - the contract between the
issuer of the bond and the investors who hold it
 The market price of a bond is equal to the
present value of the payments promised by the
bond

(See the basic pattern of cash flows from a traditional bond on the next
slide)
The Basic Structure of Bonds
Bond Basics Valuation Yields Determinants Other Debt
The Basic Structure of Bonds
Cash Flow Pattern for a Traditional Coupon-Paying Bond

0 1 2 3 … n

I I I I I
F



FIGURE 6-1
I = interest payments, and F = principal repayment
Bond Basics Valuation Yields Determinants Other Debt
Cash Flow Pattern of a Bond
The Purchase Price or Market Price of a bond is simply the present
value of the cash inflows, discounted at the bond’s yield-to-maturity
0 2
3
4 n 1
Coupon Coupon Coupon Coupon Coupon +
Face Value
Purchase
Price
Cash Inflows
to the Investor
Cash Outflows
to the Investor
Bond Basics Valuation Yields Determinants Other Debt
 Bond indenture is the contract between the
issuer and the holder. It specifies:
 Details regarding payment terms
 Collateral
 Positive and negative covenants
 Par or face value (usually increments of $1,000)
 Bond pricing – usually shown as the price per $100
of par value, which is equal to the percentage of the
bond’s face value
The Basic Structure of Bonds
Bond Basics Valuation Yields Determinants Other Debt
 Term-to-maturity – the time remaining to the
bond’s maturity date
 Coupon rate – the annual percentage interest
paid on the bond’s face value; to calculate the
dollar value of the annual coupon, multiply the
coupon rate by the face value
 If the coupon is paid twice a year, divide the annual
coupon by two
 Example: A $1,000 bond with an 8% coupon rate will
have an $80 coupon if paid annually or a $40 coupon if
paid semi-annually

The Basic Structure of Bonds
Bond Basics Valuation Yields Determinants Other Debt
Security and Protective Provisions
 Mortgage bonds – secured by real assets
 Debentures – either unsecured or secured with
a floating charge over the firm’s assets
 Collateral trust bonds – secured by a pledge of
financial assets, such as common stock, other
bonds or treasury bills
 Equipment trust certificates – secured by a
pledge of equipment, such as railway rolling
stock
Bond Basics Valuation Yields Determinants Other Debt
Security and Protective Provisions
 Covenants
 Positive covenants – things the firm agrees to do
 Supply periodic financial statements
 Maintain certain ratios
 Negative covenants – things the firm agrees not to do
 Restricts the amount of debt the firm can take on
 Prevents the firm from acquiring or disposing of
assets
Bond Basics Valuation Yields Determinants Other Debt
More Bond Features
 Call feature – allows the issuer to redeem or pay
off the bond prior to maturity, usually at a
premium
 Retractable bonds – allows the holder to sell the
bonds back to the issuer before maturity
 Extendible bonds – allows the holder to extend
the maturity of the bond
 Sinking funds – funds set aside by the issuer to
ensure the firm is able to redeem the bond at
maturity
 Convertible bonds – can be converted into
common stock at a pre-determined conversion
price
Bond Basics Valuation Yields Determinants Other Debt
Bond Valuation
Bond Valuation
 The value of a bond is a function of:
 Par value
 Term to maturity
 Coupon rate
 Investor’s required rate of return (discount rate is
also known as the bond’s yield to maturity)
Bond Basics Valuation Yields Determinants Other Debt
Bond Value
General Formula

) k (
F
k
) k (
I B
n
b b
n
b
+
× +
(
(
(
(
¸
(

¸

+
÷
× =
1
1 1
1
1
[ 6-1]
Where:
I = interest (or coupon ) payments
k
b
= the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond
Bond Basics Valuation Yields Determinants Other Debt
Bond Valuation: Example
 What is the market price of a ten-year, $1,000 bond
with a 5% coupon, if the bond’s yield-to-maturity is
6%?
( )
( )
( )
( )
10
10
1 1
1
1 1.06
1, 000
50
0.06
1.06
$926.40
n
b
n
b
b
k
F
B I
k
k
÷
÷
(
÷ +
= + (
+
(
¸ ¸
(
÷
= + (
(
¸ ¸
=
Calculator Approach:
1,000 FV
50 PMT
10 N
I/Y 6
CPT PV 926.40
Bond Basics Valuation Yields Determinants Other Debt
Example
Factors Affecting Bond Prices
Bond Price-Yield Curve
Market Yield (%)
FIGURE 6-2
Price
($)
When interest rates increase, bond prices fall
Bond Basics Valuation Yields Determinants Other Debt
 The relationship between the coupon rate and the bond’s
yield-to-maturity (YTM) determines if the bond will sell at
a premium, at a discount, or at par
If Then Bond Sells at a:
Coupon < YTM Market < Face Discount
Coupon = YTM Market = Face Par
Coupon > YTM Market > Face Premium
Factors Affecting Bond Prices
Bond Basics Valuation Yields Determinants Other Debt
Bond Valuation: Semi-Annual Coupons
 So far, we have assumed that all bonds have
annual pay coupons. While this is true for
many Eurobonds, it is not true for most
domestic bond issues, which have coupons
that are paid semi-annually
 To adjust for semi-annual coupons, we must
make three changes:
 Size of the coupon payment (divide by 2)
 Number of periods (multiply by 2)
 Yield-to-maturity (divide by 2)
Bond Basics Valuation Yields Determinants Other Debt
Bond Valuation: Semi-Annual Coupons
For example, suppose you want to value a five-year, $10,000
Government of Canada bond with a 4% coupon, paid twice a
year, given a YTM of 6%.
2
2
2 5
2 5
1 1
2
2
1
2
2
.06
1 1
400 10, 000
2
0.06
2
.06
1
2
2
$9,146.98
n
b
n
b
b
x
x
k
I F
B
k
k
÷
÷
(
| |
÷ +
(
|
\ .
(
= +
(
| |
+
(
|
(
\ .
¸ ¸
(
| |
÷ +
(
|
\ .
(
= +
(
| |
+
(
|
\ .
¸ ¸
=
Calculator Approach:
10,000 FV
400 ÷ 2 = PMT
5 x 2 = N
6 ÷ 2 = I/Y
CPT PV 926.40
Bond Basics Valuation Yields Determinants Other Debt
Factors Affecting Bond Prices
 There are three factors that affect the price
volatility of a bond
 Yield to maturity
 Time to maturity
 Size of coupon
Bond Basics Valuation Yields Determinants Other Debt
Factors Affecting Bond Prices
 Yield to maturity
 Bond prices go down when the YTM goes up
 Bond prices go up when the YTM goes down
 Look at the graph on the next slide. It shows
how the price of a 25 year, 10% coupon bond
changes as the bond’s YTM varies from 1% to
30%
 Note that the graph is not linear – instead it is
said to be convex to the origin
Bond Basics Valuation Yields Determinants Other Debt
Factors Affecting Bond Prices
Price and Yield: 25 Year Bond, 10% Coupon
Price/Yield Relationship
0
50
100
150
200
250
300
350
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Percent YTM
P
r
i
c
e

p
e
r

$
1
0
0

o
f

F
a
c
e

V
a
l
u
e
Bond Basics Valuation Yields Determinants Other Debt
 The convexity of the price/YTM graph reveals
two important insights:
 The price rise due to a fall in YTM is greater than the
price decline due to a rise in YTM, given an identical
change in the YTM
 For a given change in YTM, bond prices will change
more when interest rates are low than when they are
high
Factors Affecting Bond Prices
Bond Convexity
Bond Basics Valuation Yields Determinants Other Debt
Factors Affecting Bond Prices
 Time to maturity
 Long bonds have greater price volatility than
short bonds
 The longer the bond, the longer the period for
which the cash flows are fixed
 Size of coupon
 Low coupon bonds have greater price volatility
than high coupon bonds
 High coupons act like a stabilizing device, since a
greater proportion of the bond’s total cash flows
occur closer to today & are therefore less affected
by a change in YTM
Bond Basics Valuation Yields Determinants Other Debt
Interest Rate Risk & Duration
 The sensitivity of bond prices to changes in
interest rates is a measure of the bond’s
interest rate risk
 A bond’s interest rate risk is affected by:
 Yield to maturity
 Term to maturity
 Size of coupon
 These three factors are all captured in one
number called duration
Bond Basics Valuation Yields Determinants Other Debt
Duration
 Duration is a measure of interest rate risk
 The higher the duration, the more sensitive the
bond is to changes in interest rates
 A bond’s duration will be higher if its:
 YTM is lower
 Term to maturity is longer
 Coupon is lower
Bond Basics Valuation Yields Determinants Other Debt
Bond Quotations
Issuer Coupon Maturity Price Yield
Canada 5.500 2009-Jun-01 103.79 4.16
Bond Basics Valuation Yields Determinants Other Debt
Cash Versus Quoted Prices
 The quoted price is the price reported by the
media
 The cash price is the price paid by an investor
 The cash price includes both the quoted price
plus any interest that has accrued since the
last coupon payment date
Bond Basics Valuation Yields Determinants Other Debt
Cash Versus Quoted Price: Example
 Assume you want to purchase a $1,000 bond with a
5% coupon, paid semi-annually. Today is July 15
th
.
The last coupon was paid June 30
th
. If the quoted
price is $902, how much is the cash price?
 Solution: The cash price is equal to:
 Quoted price of $902
 Plus 15 days of interest
( )( )
15
902 1, 000 0.05
365
902 2.05
$904.05
Cash price=Quoted Price+Accrued Interest
| |
= +
|
\ .
= +
=
Bond Basics Valuation Yields Determinants Other Debt
Bond Yields
Bond Yields
 Yield-to-maturity (YTM) – the discount rate
used to evaluate bonds
 The yield earned by a bond investor who:
 Purchases the bond at the current market price
 Held the bond to maturity
 Reinvested all of the coupons at the YTM
 Is the bond’s Internal Rate of Return (IRR)
Bond Basics Valuation Yields Determinants Other Debt
Bond Yield to Maturity








 The yield to maturity is that discount rate that causes the
sum of the present value of promised cash flows to equal
the current bond price.

YTM) (
F
YTM
YTM) (
I B
n
n
+
× +
(
(
(
(
¸
(

¸

+
÷
× =
1
1 1
1
1
[ 6-2]
Bond Basics Valuation Yields Determinants Other Debt
Solving for YTM
 To solve for YTM, solve for YTM in the following formula:





 Problem: can’t solve for YTM algebraically; therefore, must
either use a financial calculator, spreadsheet, trial and error, or
approximation formula.
( )
( )
1 1
1
n
n
YTM
F
B I
YTM
YTM
÷
(
÷ +
= +
(
+
(
¸ ¸
Bond Basics Valuation Yields Determinants Other Debt
Solving for YTM
 Example: What is the YTM on a 10 year, 5% coupon
bond (annual pay coupons) that is selling for $980?
( )
( )
( )
( )
10
10
1 1
1
1 1
1, 000
980 50
1
5.26%
n
n
YTM
F
B I
YTM
YTM
YTM
YTM
YTM
YTM
÷
÷
(
÷ +
= + (
+
(
¸ ¸
(
÷ +
= + (
+
(
¸ ¸
=
Financial Calculator
1,000 FV
980 +/- PV
50 PMT
10 N
I/Y 5.26%
Bond Basics Valuation Yields Determinants Other Debt
Solving for YTM: Semi-annual Coupons
 When solving for YTM with a semi-annual pay
coupon, the yield obtained must be multiplied
by two to obtain the annual YTM
 Example: What is the YTM for a 20 year,
$1,000 bond with a 6% coupon, paid semi-
annually, given a current market price of
$1,030?
Bond Basics Valuation Yields Determinants Other Debt
Solving for YTM: Semi-annual Coupons
( )
( )
( )
( )
40
40
1 1
1
1 1
1, 000
1, 030 30
1
2.87 2 5.74%
n
n
YTM
F
B I
YTM
YTM
YTM
YTM
YTM
YTM x
÷
÷
(
÷ +
= + (
+
(
¸ ¸
(
÷ +
= + (
+
(
¸ ¸
= =
Financial Calculator
1,000 FV
1,030 +/- PV
30 PMT
40 N
I/Y 2.87 x 2
= 5.746%
Bond Basics Valuation Yields Determinants Other Debt
The Approximation Formula
Where
F = Face Value = Par Value = $1,000
B = Bond Price
I = the semi annual coupon interest
N = number of semi-annual periods left to maturity

1 YTM) annual - semi (1 YTM
YTM annual - semi 2 YTM
2
n
B - F
Maturity to Yield annual - Semi
2
÷ + =
× =
+
+
=
B F
I
Bond Basics Valuation Yields Determinants Other Debt
Example
 Find the yield-to-maturity of a 5 year 6%
coupon bond that is currently priced at $850.
(Always assume the coupon interest is paid
semi-annually.)
 Therefore there is coupon interest of $30 paid
semi-annually
 There are 10 semi-annual periods left until
maturity
Bond Basics Valuation Yields Determinants Other Debt
Solution
The actual answer is 9.87%...so of course, the
approximation approach only gives us an approximate
answer…but that is just fine for tests and exams.
% 97 . 9 1 ) 0486 . 1 ( 1 YTM) annual - semi (1 YTM
9.3% 0.09273 2 0.0486 YTM annual - semi 2 YTM
0486 . 0
925 $
30 $ 15 $
2
850 , 1 $
30 $
10
850 $ 000 , 1 $
2
n
B - F
Maturity to Yield annual - Semi
2 2
= ÷ = ÷ + =
= = × = × =
=
+
=
+
÷
=
+
+
=
B F
I
Bond Basics Valuation Yields Determinants Other Debt
The Logic of the Equation
Approximation Formula for YTM
 The numerator simply represents the average semi-annual
returns on the investment; it is made up of two
components:
 The first component is the average capital gain (if it is a
discount bond) or capital loss (if it is a premium priced bond)
per semi-annual period.
 The second component is the semi-annual coupon interest
received.
 The denominator represents the average price of the bond.
 Therefore the formula is basically, average semi-annual
return on average investment.
 Of course, we annualize the semi-annual return so that we
can compare this return to other returns on other
investments for comparison purposes.
Bond Basics Valuation Yields Determinants Other Debt
Yield to Call
 If a bond has a call feature, the issuer can call
the bond prior to its stated maturity
 To calculate the yield to call, replace the
maturity date with the first call date
Yield to Call
 The yield to call is that discount rate that causes the
present value of all promised cash flows including the call
price (CP) to equal the current bond price.

YTC) (
CP
YTC
YTC) (
I B
n
n
+
× +
(
(
(
(
¸
(

¸

+
÷
× =
1
1 1
1
1
[ 6-3]
Bond Basics Valuation Yields Determinants Other Debt
Solving for YTC: Semi-Annual Coupons
Financial Calculator
1,050 FV
1,030 +/- PV
30 PMT
10 N
I/Y 3.081 x 2
= 6.16%
YTC on a 20-year 6 percent bond that is callable in five years at a call price of
$1,050. The bond pays semi-annual coupons and is selling for $1,030.
% 16 . 6 2 % 081 . 3
% 081 . 3
1
050 , 1 $ 1
1
1
30 $ 030 , 1 $
1
1 1
1
1
10
10
= × =
÷ =
+
+
(
(
(
(
¸
(

¸

+
÷
=
+
× +
(
(
(
(
¸
(

¸

+
÷
× =
YTC
annually semi YTC
YTC) ( YTC
YTC) (

YTC) (
CP
YTC
YTC) (
I B
n
n
Bond Basics Valuation Yields Determinants Other Debt
Current Yield
 The current yield is the yield on the bond’s current
market price provided by the annual coupon
 It is not a true measure of the return to the bondholder
because it does not consider potential capital gain or
capital losses based on the relationship between the
purchase price of the bond and it’s par value.

B
interest Annual
CY = [ 6-4]
Bond Basics Valuation Yields Determinants Other Debt
Current Yield
Example
 The current yield is the yield on the bond’s current
market price provided by the annual coupon
 Example: If a bond has a 5.5% annual pay coupon and
the current market price of the bond is $1,050, the
current yield is:
55
1, 050
5.24%
Annual Coupon
Current Yield =
Current Market Price
=
=
Bond Basics Valuation Yields Determinants Other Debt
Interest Rate Determinants
Interest Rate Determinants
 Interest is the “price” of money
 Basis points – 1/100 of 1%
 Interest rates go:
 Up – when the demand for loanable funds rises
 Down – when the demand for loanable funds falls
Bond Basics Valuation Yields Determinants Other Debt
Risk-free Interest Rate
 Usually use the yield on short federal government
treasury bills as a proxy for the risk-free rate (RF)
 The risk-free rate is comprised of two components:
 Real rate – compensation for deferring consumption
 Expected inflation – compensation for the expected loss in
purchasing power

(See Figure 6-3 to see rates of inflation and yields on long Canada bonds since 1961)
Bond Basics Valuation Yields Determinants Other Debt
Inflation and Yields over Time
FIGURE 6-3
Bond Basics Valuation Yields Determinants Other Debt
Fisher Equation
 If we call the risk-free rate the nominal rate, then the
relationship between the real rate, the nominal rate and
expected inflation is usually referred to as the Fisher
Equation (after Irving Fisher)
inflation Expected rate Real RF + = [ 6-5]
Bond Basics Valuation Yields Determinants Other Debt
Fisher Equation
 When inflation is low, can safely use the approximation
formula:


 When inflation is high, use the exact form of the Fisher
Equation:
Nominal Real
R = R +Expected Inflation
( ) ( )( )
1 1 1
Nominal Real
R = R Expected Inflation + + +
Bond Basics Valuation Yields Determinants Other Debt
Fisher Equation
Example
 If the real rate is 3% and the nominal rate is 5.5%, what is the
approximate expected future inflation rate?
5.5 3
2.5%
Nominal Real
R = R +Expected Inflation
Expected Inflation
Expected Inflation
= +
=
Bond Basics Valuation Yields Determinants Other Debt
Global Influences on Interest Rates
 Canadian domestic interest rates are heavily
influenced by global interest rates
 Interest rate parity (IRP) theory states that FX
forward rates will be established that equalize
the yield an investor can earn, whether
investing domestically or in a foreign
jurisdiction
 A country with high inflation and high interest rates
will have a depreciating currency
Bond Basics Valuation Yields Determinants Other Debt
Term Structure of Interest Rates
 Is that set of rates (YTM) for a given risk-class
of debt securities (for example, Government of
Canada Bonds) at a given point in time.
 When plotted on a graph, the line is called a
Yield Curve

Bond Basics Valuation Yields Determinants Other Debt
Term Structure of Interest Rates
 The Yield Curve is the graph created by putting
term to maturity on the X axis, YTM on the Y
axis and then plotting the yield at each
maturity.
 The four typical shapes of yield curves:
 Upward sloping (the most common shape)
 Downward sloping
 Flat
 Humped

(See Figure 6-4 for Yield curves that existed at various times in Canada)
Bond Basics Valuation Yields Determinants Other Debt
Historical Yield Curves
1990, 1994, 1998, 2004
P
e
r
c
e
n
t

Term Left to Maturity
16








14

12








10







8







6








4







2

0
1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs
FIGURE 6-4
1990 1994 1998 2004
Bond Basics Valuation Yields Determinants Other Debt
Theories of the Term Structure
 Three theories are used to explain the shape of
the term structure
 Liquidity preference theory
 Investors must be paid a “liquidity premium” to hold
less liquid, long-term debt
 Expectations theory
 The long rate is the average of expected future short
interest rates
 Market segmentation theory
 Distinct markets exist for securities of different
maturities
Bond Basics Valuation Yields Determinants Other Debt
Term Structure of Interest Rates
Risk Premiums

 More risky bonds (i.e.. BBB rated Corporate Bonds) will
have their own yield curve and it will plot at higher YTM at
every term to maturity because of the default risk that BBBs
carry
 The difference between the YTM on a 10-year BBB
corporate bond and a 10-year Government of Canada bond
is called a yield spread and represents a default-risk
premium investors demand for investing in more risky
securities.
 Spreads will increase when pessimism increases in the
economy
 Spreads will narrow during times of economic expansion
(confidence)
Bond Basics Valuation Yields Determinants Other Debt
Yield Curves for Different Risk
Classes
Risk Premiums (Yield Spreads)
P
e
r
c
e
n
t

Term Left to Maturity
16








14

12








10







8







6








4







2

0
1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs
BBB Corporates Government of Canada Bonds
Yield
Spread
Bond Basics Valuation Yields Determinants Other Debt
Risk Premiums
 The YTM on a corporate bond is comprised of:








 The maturity yield differential is explained by the term
structure
 Spread is the additional yield due to default risk
Spread al differenti yield Maturity - / RF k
b
+ + = =YTM [ 6-6]
Bond Basics Valuation Yields Determinants Other Debt
Debt Ratings
 All publicly traded bonds are assigned a “risk
rating” by a rating agency, such as Dominion
Bond Rating Service (DBRS), Standard &
Poors (S&P), Moodys, Fitch, etc.
 Bonds are categorized as
 Investment grade – top four rating categories (AAA,
AA, A & BBB)
 Junk or high yield – everything below investment
grade (BB, B, CCC, CC, D, Suspended)

Bond Basics Valuation Yields Determinants Other Debt
Why Do Bonds Have Different
Yields?
 Default risk – the higher the default risk, the
higher the required YTM
 Liquidity – the less liquid the bond, the higher
the required YTM
 Call features – increase required YTM
 Extendible feature – reduce required YTM
 Retractable feature – reduce required YTM

Bond Basics Valuation Yields Determinants Other Debt
Other Types of Bonds/Debt Instruments
Treasury Bills
 Treasury bills are short-term obligations of government
with an initial term to maturity of one year or less
 Issued at a discount and mature at face value
 The difference between the issue price and the face
value is treated as interest income
 To calculate the price of a T-bill, use the following
formula
1
T Bill
F
P
n
BEY
B
=
| |
+
|
\ .
Where:
P = market price of the T Bill
F = face value of the T Bill
BEY = the bond equivalent yield
n = the number of days until maturity
B = the annual basis (365 days in Canada)
Bond Basics Valuation Yields Determinants Other Debt
Treasury Bills: Example
 What is the price of a $1,000,000 Canadian T bill with
80 days to maturity and a BEY of 4.5%?
1
1, 000, 000
80
1 .045
365
$990, 233.32
T Bill
F
P
n
BEY
B
=
| |
+
|
\ .
=
| |
+
|
\ .
=
Bond Basics Valuation Yields Determinants Other Debt
Solving for Yield on a T Bill
 To solve for the yield on a T bill, rearrange the previous
formula and solve for BEY.
 Example: What is the yield on a $100,000 T bill with 180
days to maturity and a market price of $98,200?
100, 000 98, 200 365
98, 200 180
3.72%
F P B
BEY
P n
÷
| |
=
|
\ .
÷
| |
=
|
\ .
=
Bond Basics Valuation Yields Determinants Other Debt
Zero Coupon Bonds
 A zero coupon bond is a bond issued at a
discount that matures at par or face value
 A zero coupon bond has no reinvestment rate
risk, since there are no coupons to be
reinvested
 To calculate the price of a zero coupon bond,
solve for the PV of the face amount
Bond Basics Valuation Yields Determinants Other Debt
Zero Coupon Bonds
 Example: What is the market price of a $50,000 zero
coupon bond with 25 years to maturity that is
currently yielding 6%?

( )
( )
25
F
1
50, 000
1.06
$11, 649.93
n
b
B
k
=
+
=
=
Bond Basics Valuation Yields Determinants Other Debt
Floating Rate & Real Return Bonds
 Floating rate bonds have a coupon that floats
with some reference rate, such as the yield on
T bills
 Because the coupon floats, the market price will
typically be close to the bond’s face value
 Real return bonds are issued by the
Government of Canada to protect investors
against unexpected inflation
 Each period, the face value of the bond is grossed
up by the inflation rate. The coupon is then paid on
the grossed up face value.
Bond Basics Valuation Yields Determinants Other Debt
Canada Savings Bonds
 A Canada Savings Bond (CSB) is a special
type of bond issued by the Government of
Canada
 It is issued in two forms:
 Regular interest – interest is paid annually
 Compound interest – interest compounds over the
life of the bond
 CSBs are redeemable at any chartered bank in
Canada at their face value
 There is no secondary market for CSBs
Bond Basics Valuation Yields Determinants Other Debt
Summary and Conclusions
In this chapter you have learned:
 About the nature of bonds as an investment
 How to value a bond using discounted cash flow
concepts
 About the determinants of interest rates and
theories used to explain the term structure of
interest rates
Bond Basics Valuation Yields Determinants Other Debt
Interesting Web Links
1. Bond Characteristics
2. Bond Valuation
3. Bond Yields
4. Bond Ratings and Agencies
Bond Basics Valuation Yields Determinants Other Debt
End of Chapter Problems
Chapter 6 – Bond Valuation and Interest
Rates
Question 6 - 1
Which of the following statements concerning bonds is
incorrect?
A. They involve blended payments of principal and interest.
B. They have a fixed maturity date at which time the issuer
repays the full principal amount.
C. Bondholders are paid a series of fixed periodic amounts
before the maturity date.
D. The bond indenture is a legal document, specifying
payment requirements and so on.
Solution: A

Mortgages have “blended” payments including interest and
principal payment, not bonds.
End-of-Chapter Problems
Question 6 - 2
Which of the following statements is incorrect?
A. Callable bonds give the bond issuer an option to call the
bond at a predetermined price.
B. All debentures are secured bonds.
C. Extendible bonds allow bondholders to extend the
maturity date.
D. Convertible bonds give the bondholders an option to
convert into common shares at a predetermined
conversion ratio.

Solution: B

Debentures are generally unsecured.
End-of-Chapter Problems
Question 6 - 3
Determine the price of a five-year 7 percent annual coupon bond
when the market rate is 8 percent. The face value is $100.
A. $100
B. $102.50
C. $96.01
D. $104.10

Solution: C



Or, by financial calculator:
N = 5; I/Y= 8; PMT = 7; FV = 100; CPT PV = –96.01
$96.01 68.0583 27.9490
) 08 . 1 (
1
100
08 .
) 08 . 1 (
1
1
7
5
5
= + =
+
× +
(
(
(
(
¸
(

¸

+
÷
× = B
End-of-Chapter Problems
Question 6 - 4
Which of the following bond prices is most sensitive to
market rate changes? The par value = $100 for all.
A. 5-year, 5 percent coupon rate, yield = 5.5 percent
B. 3-year, 8 percent coupon rate, yield = 5.6 percent
C. 7.5-year, 4.5 percent coupon rate, yield = 5.5 percent
D. 10-year, 4.5 percent coupon rate, yield = 5.5 percent

Solution: D
All else being equal, interest rate risk is positively related to term to
maturity, but negatively related to coupon rate and market yields.
The bond in choice D has the lowest yield, lowest coupon rate and
the longest term to maturity relative to other bonds. Therefore it has
the highest interest rate risk.
End-of-Chapter Problems
Question 6 - 5
Determine the yield to maturity on a six-year, 7 percent,
semi-annual-pay bond, which is now priced at $993. Use a
financial calculator.
A. 7.05 percent
B. 6.98 percent
C. 3.57 percent
D. 7.15 percent

Solution: D
Coupon = ($1,000)(7%)/2=$35, N=6×2=12, FV=1,000, PV= –993

Using a financial calculator,
N=12, PV= –993, PMT=35, FV=1,000 CPT I/Y=3.5727
Therefore, YTM=3.5727%×2=7.15%
End-of-Chapter Problems
Question 6 - 6
Which of the following statements is correct?
A. Current yield is the ratio of annual coupon payment divided by
the par value.
B. When the coupon rate is higher than the market rate, the bond is
priced at discount.
C. When the market rate is higher than the coupon rate, the bond is
priced at premium.
D. If a bond is at discount, the coupon rate < current yield < YTM.

Solution: D
Current yield is the ratio of annual coupon divided by the current
market price. When coupon rate is higher than the market rate, bond
is at premium and when the market rate is higher, bond is at discount.
End-of-Chapter Problems
Question 6 - 7
According to interest rate parity (IRP) theory,
A. differences in interest rates across countries cannot be totally offset by
expected changes in exchange rates.
B. forward exchange rates may be locked in today to eliminate foreign
exchange risk and ensure investors can profit from moving capital to
countries with higher interest rates.
C. the inflation differentials between countries affect both interest rates and
currency exchange rates.
D. the country with a higher inflation rate will see its currency appreciate
against another country with a lower inflation rate.

Solution: C
Difference in interest rates across countries can be offset by expected changes in
exchange rates. If a country has a higher expected inflation rate, its currency
will depreciate.

IRP states that forward exchange rates locked-in today to eliminate foreign
exchange risk ensure investors earn the same amount no matter where they
invest.
End-of-Chapter Problems
Question 6 - 8
Which statement is incorrect?
A. The liquidity preference theory states that investors prefer
short-term debt.
B. According to the expectations theory, a downward-sloping yield
curve implies that interest rates are expected to decline in the
future.
C. The risk premium in the bond yield reflects default risk, liquidity
risk, and issue-specific features.
D. A debt rating of AAA is a worse rating than BB for S&P.

Solution: D
AAA is rated higher than BB.
End-of-Chapter Problems
Question 6 - 9
Calculate the quoted price of a 182-day Canadian T-bill
that has a face value of $10,000 and a quoted yield of
5.5 percent.
A. $9,733.07
B. $9,478.67
C. $97.3307
D. $94.7867

Solution: C


Because it is quoted on a basis of $100, therefore quoted price is
$97.3307.
07 . 733 , 9 $
02742466 . 1
000 , 10
)
365
182
055 . 0 1 (
000 , 10
= =
× +
= P
End-of-Chapter Problems
Question 6 - 10
Which of the following statements is false?
A. Zero coupon bonds are deep-discount bonds.
B. Zero coupon bonds are often created when cash flows are
stripped from traditional bonds.
C. Floating rate bonds provide protection against decreasing
interest rates.
D. There are two forms of return available for Canadian Savings
Bond buyers.

Solution: C


Floating rate bonds provide protection against increasing interest
rates compared to fixed rate bonds.
End-of-Chapter Problems
Question 6 - 11
State the relationship between the market rates and bond
prices.

Solution:


When market interest rates increase, prices of bonds decrease.
When market interest rates decrease, prices of bonds increase.
End-of-Chapter Problems
Question 6 - 12
Find the price of a bond with FV = $1,000, a coupon rate
of 6 percent (paid semi-annually), and three years to
maturity when
A. kb = 7 percent.
B. kb = 6 percent.
C. kb = 5 percent.

Solution:

Using a financial calculator:
A. N = 6; I/Y= 3.5; PMT = 30; FV = 1,000; CPT PV = –973.36
B. N = 6; I/Y= 3; PMT = 30; FV = 1,000; CPT PV = –1,000
C. N = 6; I/Y= 2.5; PMT = 30; FV = 1,000; CPT PV = –1,027.54
Clearly, the price of bonds is inversely related to the market yield.
End-of-Chapter Problems
Question 6 - 13
At maturity, each of the following zero-coupon bonds (pure
discount bonds) will be worth $1,000. For each bond, find
the missing quantity in the table below.







Solution:

Using a financial calculator:
A. N = 30; PMT = 0; FV = 1,000; PV = - 400; CPT I/Y = 3.10%
B. I/Y = 8; PMT = 0; FV = 1,000; PV = - 400; CPT N = 11.9 years
C. N = 10; I/Y = 12; PMT = 0; FV = 1,000; CPT PV = $321.97
Price Maturity
(years)
Yield to
Maturity
A.
$400 30
B.
$400 8%
C.
10 12%
End-of-Chapter Problems
Question 6 - 14
Suppose that a government of Canada 9 percent annual-
pay bond that matures in two years has a yield to maturity
of 9.80 percent. If inflation is expected to be 3 percent per
year over the next two years, what coupon rate would you
expect to find on a Real Return Bond that is otherwise
identical?

Solution:

Using the approximate relationship:
9.80% = Real Rate + 3%, so the Real Rate = 6.8%.

Using the exact relationship:
Real Rate = (1+0.098)/(1+0.03) – 1 = 6.60%
End-of-Chapter Problems
Question 6 - 15
Suppose the inflation rate in Canada, as measured by the CPI,
has been averaging 2.5 percent in recent years. The most recent
Bank of Canada announcement indicates that it expects
4 percent inflation over the next year. If the real rate of return on
Canadian T-bills is 1.75 percent, what is the nominal risk-free
rate?

Solution:

The Fisher relationship uses expected inflation figures, not the actual rate of
inflation experienced in the past. Therefore:

RF = 1.75% + 4% = 5.75%

Using the exact relationship:

RF = (1+0.0175)(1.04)–1=5.82%
End-of-Chapter Problems
Question 6 - 16
The following values are the spread for corporate bond yields:








A. One-year T-bills are trading with a YTM of 6 percent. What yield would you
expect to find on A rated corporate bonds maturing in one year?
B. Five-year government bonds have a maturity yield differential of 50 basis
points. What yield would you expect to observe on non-investment grade (BB
rated) corporate bonds with a five-year maturity?

Solution:
A. We can assume that T-bills (short-term, federal government bonds) have the highest possible credit rating,
“AAA”, because they have virtually no default risk. We expect lower rated (riskier) bonds to have a higher yield.
For “A” rated bonds, we should expect kb = 6% + 0.45% = 6.45%
B. Adding the maturity yield and the “spread” for this bond rating, we find: kb = 6% + 0.50% + 1.10% = 7.60%

Bond Rating Spread over AAA
AA 30 basis points
A 45 basis points
BBB 70 basis points
BB 110 basis points
End-of-Chapter Problems
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Canada, Ltd. All rights reserved.
Reproduction or translation of this
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should be addressed to the
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caused by the use of these files or
programs or from the use of the
information contained herein.

Lecture Agenda

1. Basic Structure of Bonds 2. Bond Valuation 3. Bond Yields 4. Interest Rate Determinants 5. Other Debt Instruments

Bond Basics

Valuation

Yields

Determinants

Other Debt

Learning Objectives

 The basic features of different types of bonds  How to value bonds given an appropriate discount rate  How to determine the discount rate or yield given the market value of a bond  How market interest rates or yields affect bond investors  How bond prices change over time  The factors (both domestic and global) that affect interest rates

Bond Basics

Valuation

Yields

Determinants

Other Debt

Basic Structure of Bonds .

The Basic Structure of Bonds    What is a bond? In its broadest sense. as follows:    Less than one year – Bills or “Paper” 1 year < Maturity < 7 years – Notes < 7 years – Bonds Bond Basics Valuation Yields Determinants Other Debt . a bond is any debt instrument that promises a fixed income stream to the holder Fixed income securities are often classified according to maturity.

The Basic Structure of Bonds  A typical bond has the following characteristics:   A fixed face or par value. which specifies the interest payable over the life of the bond  Coupons are usually paid either annually or semiannually  A fixed maturity date Bond Basics Valuation Yields Determinants Other Debt . paid to the holder of the bond. at maturity A fixed coupon.

The Basic Structure of Bonds  Bonds may be either:   Bearer bonds Registered bonds   Bond indenture .the contract between the issuer of the bond and the investors who hold it The market price of a bond is equal to the present value of the payments promised by the bond (See the basic pattern of cash flows from a traditional bond on the next slide) Bond Basics Valuation Yields Determinants Other Debt .

The Basic Structure of Bonds
Cash Flow Pattern for a Traditional Coupon-Paying Bond

FIGURE 6-1

0

1

2

3

n

I

I

I

I

I F

I = interest payments, and F = principal repayment

Bond Basics

Valuation

Yields

Determinants

Other Debt

Cash Flow Pattern of a Bond

0

1

2 Coupon

3 Coupon

4 Coupon

n Coupon + Face Value

Purchase Coupon Price Cash Outflows to the Investor

Cash Inflows to the Investor

The Purchase Price or Market Price of a bond is simply the present value of the cash inflows, discounted at the bond’s yield-to-maturity
Bond Basics

Valuation

Yields

Determinants

Other Debt

The Basic Structure of Bonds
 Bond indenture is the contract between the issuer and the holder. It specifies:
    

Details regarding payment terms Collateral Positive and negative covenants Par or face value (usually increments of $1,000) Bond pricing – usually shown as the price per $100 of par value, which is equal to the percentage of the bond’s face value

Bond Basics

Valuation

Yields

Determinants

Other Debt

000 bond with an 8% coupon rate will have an $80 coupon if paid annually or a $40 coupon if paid semi-annually Bond Basics Valuation Yields Determinants Other Debt . divide the annual coupon by two Example: A $1.The Basic Structure of Bonds  Term-to-maturity – the time remaining to the bond’s maturity date  Coupon rate – the annual percentage interest paid on the bond’s face value. multiply the coupon rate by the face value   If the coupon is paid twice a year. to calculate the dollar value of the annual coupon.

other bonds or treasury bills Equipment trust certificates – secured by a pledge of equipment. such as common stock.Security and Protective Provisions    Mortgage bonds – secured by real assets Debentures – either unsecured or secured with a floating charge over the firm’s assets Collateral trust bonds – secured by a pledge of financial assets. such as railway rolling stock  Bond Basics Valuation Yields Determinants Other Debt .

Security and Protective Provisions  Covenants   Positive covenants – things the firm agrees to do  Supply periodic financial statements  Maintain certain ratios Negative covenants – things the firm agrees not to do  Restricts the amount of debt the firm can take on  Prevents the firm from acquiring or disposing of assets Bond Basics Valuation Yields Determinants Other Debt .

usually at a premium  Retractable bonds – allows the holder to sell the bonds back to the issuer before maturity  Extendible bonds – allows the holder to extend the maturity of the bond  Sinking funds – funds set aside by the issuer to ensure the firm is able to redeem the bond at maturity  Convertible bonds – can be converted into common stock at a pre-determined conversion price Bond Basics Valuation Yields Determinants Other Debt .More Bond Features  Call feature – allows the issuer to redeem or pay off the bond prior to maturity.

Bond Valuation .

Bond Valuation  The value of a bond is a function of:     Par value Term to maturity Coupon rate Investor’s required rate of return (discount rate is also known as the bond’s yield to maturity) Bond Basics Valuation Yields Determinants Other Debt .

Bond Value General Formula [ 6-1] 1  1  ( 1  k )n b B  I  kb    Where:   1 F ( 1  k b )n    I = interest (or coupon ) payments kb = the bond discount rate (or market rate) n = the term to maturity F = Face (or par) value of the bond Bond Basics Valuation Yields Determinants Other Debt .

40 FV PMT N 6 Bond Basics Valuation Yields Determinants Other Debt .Bond Valuation: Example  What is the market price of a ten-year.000  50   0.000 50 10 I/Y CPT PV 926. if the bond’s yield-to-maturity is 6%? 1  1  kb  n  F BI  n kb   1  kb    1  1.06 10     $926.06 10  1. $1.06  1.000 bond with a 5% coupon.40 Example Calculator Approach: 1.

bond prices fall FIGURE 6-2 Price ($) Market Yield (%) Bond Basics Valuation Yields Determinants Other Debt .Factors Affecting Bond Prices Bond Price-Yield Curve When interest rates increase.

or at par If Coupon < YTM Then Market < Face Bond Sells at a: Discount Coupon = YTM Coupon > YTM Market = Face Market > Face Par Premium Bond Basics Valuation Yields Determinants Other Debt . at a discount.Factors Affecting Bond Prices  The relationship between the coupon rate and the bond’s yield-to-maturity (YTM) determines if the bond will sell at a premium.

it is not true for most domestic bond issues. we must make three changes:     Size of the coupon payment (divide by 2) Number of periods (multiply by 2) Yield-to-maturity (divide by 2) Bond Basics Valuation Yields Determinants Other Debt . While this is true for many Eurobonds. which have coupons that are paid semi-annually To adjust for semi-annual coupons. we have assumed that all bonds have annual pay coupons.Bond Valuation: Semi-Annual Coupons  So far.

40 Valuation Yields Determinants Other Debt .000 FV 400 ÷ 2 = PMT 5x2= N 6 ÷ 2 = I/Y CPT PV 926.06 2 x 5  1   1    400   10. paid twice a year. suppose you want to value a five-year.06 2 x 5 2    1   2 2      $9. $10.000 2     0.Bond Valuation: Semi-Annual Coupons For example.06   .98 Bond Basics Calculator Approach: 10.   kb 2 n  1   1    I F 2  B    kb   kb  2 n 2   1   2    2     . given a YTM of 6%.000 Government of Canada bond with a 4% coupon.146.

Factors Affecting Bond Prices  There are three factors that affect the price volatility of a bond    Yield to maturity Time to maturity Size of coupon Bond Basics Valuation Yields Determinants Other Debt .

It shows how the price of a 25 year. 10% coupon bond changes as the bond’s YTM varies from 1% to 30% Note that the graph is not linear – instead it is said to be convex to the origin Bond Basics Valuation Yields Determinants Other Debt .Factors Affecting Bond Prices  Yield to maturity   Bond prices go down when the YTM goes up Bond prices go up when the YTM goes down   Look at the graph on the next slide.

10% Coupon Price/Yield Relationship 350 300 250 200 150 100 50 0 1 3 5 7 9 11 13 15 17 Percent YTM 19 21 23 25 27 29 Price per $100 of Face Value Bond Basics Valuation Yields Determinants Other Debt .Factors Affecting Bond Prices Price and Yield: 25 Year Bond.

given an identical change in the YTM For a given change in YTM. bond prices will change more when interest rates are low than when they are high Bond Basics Valuation Yields Determinants Other Debt .Factors Affecting Bond Prices Bond Convexity  The convexity of the price/YTM graph reveals two important insights:   The price rise due to a fall in YTM is greater than the price decline due to a rise in YTM.

since a greater proportion of the bond’s total cash flows occur closer to today & are therefore less affected by a change in YTM Bond Basics Valuation Yields Determinants Other Debt .Factors Affecting Bond Prices  Time to maturity  Long bonds have greater price volatility than short bonds  The longer the bond. the longer the period for which the cash flows are fixed  Size of coupon  Low coupon bonds have greater price volatility than high coupon bonds  High coupons act like a stabilizing device.

Interest Rate Risk & Duration  The sensitivity of bond prices to changes in interest rates is a measure of the bond’s interest rate risk A bond’s interest rate risk is affected by:     Yield to maturity Term to maturity Size of coupon  These three factors are all captured in one number called duration Bond Basics Valuation Yields Determinants Other Debt .

the more sensitive the bond is to changes in interest rates A bond’s duration will be higher if its:    YTM is lower Term to maturity is longer Coupon is lower Bond Basics Valuation Yields Determinants Other Debt .Duration    Duration is a measure of interest rate risk The higher the duration.

16 Bond Basics Valuation Yields Determinants Other Debt .79 Yield 4.Bond Quotations Issuer Canada Coupon 5.500 Maturity 2009-Jun-01 Price 103.

Cash Versus Quoted Prices    The quoted price is the price reported by the media The cash price is the price paid by an investor The cash price includes both the quoted price plus any interest that has accrued since the last coupon payment date Bond Basics Valuation Yields Determinants Other Debt .

how much is the cash price?  Solution: The cash price is equal to:   Quoted price of $902 Plus 15 days of interest Cash price = Quoted Price+ Accrued Interest  15   902  1.000  0.05    365    902  2. paid semi-annually. The last coupon was paid June 30th.05 Bond Basics Valuation Yields Determinants Other Debt . Today is July 15th.05  $904.000 bond with a 5% coupon.Cash Versus Quoted Price: Example  Assume you want to purchase a $1. If the quoted price is $902.

Bond Yields .

Bond Yields  Yield-to-maturity (YTM) – the discount rate used to evaluate bonds  The yield earned by a bond investor who:  Purchases the bond at the current market price  Held the bond to maturity  Reinvested all of the coupons at the YTM  Is the bond’s Internal Rate of Return (IRR) Bond Basics Valuation Yields Determinants Other Debt .

Bond Yield to Maturity [ 6-2] 1  1  ( 1  YTM)n B  I  YTM      1 F ( 1  YTM)n     The yield to maturity is that discount rate that causes the sum of the present value of promised cash flows to equal the current bond price. Bond Basics Valuation Yields Determinants Other Debt .

or approximation formula. Bond Basics Valuation Yields Determinants Other Debt . therefore.Solving for YTM  To solve for YTM. must either use a financial calculator. trial and error. spreadsheet. solve for YTM in the following formula: 1  1  YTM  n  F BI  n YTM   1  YTM     Problem: can’t solve for YTM algebraically.

5% coupon bond (annual pay coupons) that is selling for $980? 1  1  YTM  n  F BI  n YTM   1  YTM    1  1  YTM 10  1.Solving for YTM  Example: What is the YTM on a 10 year.PV 50 PMT 10 N I/Y 5.000 FV 980 +/.26% Financial Calculator 1.26% Bond Basics Valuation Yields Determinants Other Debt .000 980  50   10 YTM   1  YTM    YTM  5.

000 bond with a 6% coupon. given a current market price of $1. paid semiannually. $1.Solving for YTM: Semi-annual Coupons  When solving for YTM with a semi-annual pay coupon.030?  Bond Basics Valuation Yields Determinants Other Debt . the yield obtained must be multiplied by two to obtain the annual YTM Example: What is the YTM for a 20 year.

000 1.000 FV 1.87 x 2  5.746% Bond Basics Valuation Yields Determinants Other Debt .PV 30 PMT 40 N I/Y 2.87 x 2 = 5.74% Financial Calculator 1.030 +/.Solving for YTM: Semi-annual Coupons 1  1  YTM  n  F BI   n YTM   1  YTM    1  1  YTM 40  1.030  30    40 YTM   1  YTM    YTM  2.

annual YTM YTM  (1  semi .annual YTM) 2  1 Bond Basics Valuation Yields Determinants Other Debt .annual Yield to Maturity  n FB 2 YTM  2  semi .000 B = Bond Price I = the semi annual coupon interest N = number of semi-annual periods left to maturity F-B I Semi .The Approximation Formula Where F = Face Value = Par Value = $1.

Example
 Find the yield-to-maturity of a 5 year 6% coupon bond that is currently priced at $850. (Always assume the coupon interest is paid semi-annually.)
 Therefore there is coupon interest of $30 paid semi-annually  There are 10 semi-annual periods left until maturity

Bond Basics

Valuation

Yields

Determinants

Other Debt

Solution

$1,000  $850 F-B  $30 I $15  $30 10 Semi - annual Yield to Maturity  n    0.0486 FB $1,850 $925 2 2 YTM  2  semi - annual YTM  0.0486 2  0.09273  9.3% YTM  (1  semi - annual YTM) 2  1  (1.0486) 2  1  9.97%

The actual answer is 9.87%...so of course, the approximation approach only gives us an approximate answer…but that is just fine for tests and exams.

Bond Basics

Valuation

Yields

Determinants

Other Debt

The Logic of the Equation
Approximation Formula for YTM

 The numerator simply represents the average semi-annual returns on the investment; it is made up of two components:

The first component is the average capital gain (if it is a discount bond) or capital loss (if it is a premium priced bond) per semi-annual period. The second component is the semi-annual coupon interest received.

 The denominator represents the average price of the bond.  Therefore the formula is basically, average semi-annual return on average investment.  Of course, we annualize the semi-annual return so that we can compare this return to other returns on other investments for comparison purposes.

Bond Basics

Valuation

Yields

Determinants

Other Debt

Yield to Call   If a bond has a call feature. replace the maturity date with the first call date . the issuer can call the bond prior to its stated maturity To calculate the yield to call.

Yield to Call [ 6-3] 1  1  ( 1  YTC)n B  I  YTC      1   CP  ( 1  YTC)n     The yield to call is that discount rate that causes the present value of all promised cash flows including the call price (CP) to equal the current bond price. Bond Basics Valuation Yields Determinants Other Debt .

050.PV 30 PMT 10 N I/Y 3.081 x 2 = 6. The bond pays semi-annual coupons and is selling for $1. Financial Calculator 1.16% Bond Basics Valuation Yields Determinants Other Debt .16% 1   1  ( 1  YTC)n  1 B  I    CP  YTC ( 1  YTC)n       1   1  ( 1  YTC)10  $1.030.050 $1.030 +/.Solving for YTC: Semi-Annual Coupons YTC on a 20-year 6 percent bond that is callable in five years at a call price of $1.030  $30   10 YTC   ( 1  YTC)     YTC  3.081%  2  6.050 FV 1.081% semi  annually YTC  3.

Current Yield  The current yield is the yield on the bond’s current market price provided by the annual coupon  It is not a true measure of the return to the bondholder because it does not consider potential capital gain or capital losses based on the relationship between the purchase price of the bond and it’s par value. [ 6-4] Annual interest CY  B Bond Basics Valuation Yields Determinants Other Debt .

24% Bond Basics Valuation Yields Determinants Other Debt .050  5.050.5% annual pay coupon and the current market price of the bond is $1.Current Yield Example   The current yield is the yield on the bond’s current market price provided by the annual coupon Example: If a bond has a 5. the current yield is: Current Yield =  Annual Coupon Current Market Price 55 1.

Interest Rate Determinants .

Interest Rate Determinants    Interest is the “price” of money Basis points – 1/100 of 1% Interest rates go:   Up – when the demand for loanable funds rises Down – when the demand for loanable funds falls Bond Basics Valuation Yields Determinants Other Debt .

Risk-free Interest Rate   Usually use the yield on short federal government treasury bills as a proxy for the risk-free rate (RF) The risk-free rate is comprised of two components:   Real rate – compensation for deferring consumption Expected inflation – compensation for the expected loss in purchasing power (See Figure 6-3 to see rates of inflation and yields on long Canada bonds since 1961) Bond Basics Valuation Yields Determinants Other Debt .

Inflation and Yields over Time FIGURE 6-3 Bond Basics Valuation Yields Determinants Other Debt .

then the relationship between the real rate. the nominal rate and expected inflation is usually referred to as the Fisher Equation (after Irving Fisher) [ 6-5] RF  Real rate  Expected inflation Bond Basics Valuation Yields Determinants Other Debt .Fisher Equation  If we call the risk-free rate the nominal rate.

use the exact form of the Fisher Equation: 1 RNominal  = 1 RReal 1 Expected Inflation Bond Basics Valuation Yields Determinants Other Debt .Fisher Equation  When inflation is low. can safely use the approximation formula: RNominal = RReal + Expected Inflation  When inflation is high.

5%.5% Bond Basics Valuation Yields Determinants Other Debt .Fisher Equation Example  If the real rate is 3% and the nominal rate is 5.5  3  Expected Inflation Expected Inflation  2. what is the approximate expected future inflation rate? RNominal = RReal + Expected Inflation 5.

whether investing domestically or in a foreign jurisdiction  A country with high inflation and high interest rates will have a depreciating currency Bond Basics Valuation Yields Determinants Other Debt .Global Influences on Interest Rates   Canadian domestic interest rates are heavily influenced by global interest rates Interest rate parity (IRP) theory states that FX forward rates will be established that equalize the yield an investor can earn.

When plotted on a graph.Term Structure of Interest Rates   Is that set of rates (YTM) for a given risk-class of debt securities (for example. the line is called a Yield Curve Bond Basics Valuation Yields Determinants Other Debt . Government of Canada Bonds) at a given point in time.

The four typical shapes of yield curves:     Upward sloping (the most common shape) Downward sloping Flat Humped (See Figure 6-4 for Yield curves that existed at various times in Canada) Bond Basics Valuation Yields Determinants Other Debt .Term Structure of Interest Rates   The Yield Curve is the graph created by putting term to maturity on the X axis. YTM on the Y axis and then plotting the yield at each maturity.

Historical Yield Curves 1990. 1994. 1998. 2004 FIGURE 6-4 16 14 12 10 Percent 8 6 4 2 0 1 mth 3 mths 1990 6 mths 1 yr 1994 2yrs 5 yrs 1998 7 yrs 10 yrs 2004 30 yrs Term Left to Maturity Bond Basics Valuation Yields Determinants Other Debt .

long-term debt  Expectations theory  The long rate is the average of expected future short interest rates  Market segmentation theory  Distinct markets exist for securities of different maturities Bond Basics Valuation Yields Determinants Other Debt .Theories of the Term Structure  Three theories are used to explain the shape of the term structure  Liquidity preference theory  Investors must be paid a “liquidity premium” to hold less liquid.

.Term Structure of Interest Rates Risk Premiums  More risky bonds (i.  Spreads will increase when pessimism increases in the economy  Spreads will narrow during times of economic expansion (confidence) Bond Basics Valuation Yields Determinants Other Debt .e. BBB rated Corporate Bonds) will have their own yield curve and it will plot at higher YTM at every term to maturity because of the default risk that BBBs carry  The difference between the YTM on a 10-year BBB corporate bond and a 10-year Government of Canada bond is called a yield spread and represents a default-risk premium investors demand for investing in more risky securities.

Yield Curves for Different Risk Classes Risk Premiums (Yield Spreads) 16 14 12 10 Yield Spread Percent 8 6 4 2 0 1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs Term Left to Maturity BBB Corporates Government of Canada Bonds Bond Basics Valuation Yields Determinants Other Debt .

Risk Premiums  The YTM on a corporate bond is comprised of: [ 6-6] k b  YTM  RF  / .Maturity yield differential  Spread  The maturity yield differential is explained by the term structure  Spread is the additional yield due to default risk Bond Basics Valuation Yields Determinants Other Debt .

etc. D. A & BBB) Junk or high yield – everything below investment grade (BB. Standard & Poors (S&P).Debt Ratings  All publicly traded bonds are assigned a “risk rating” by a rating agency. Moodys. such as Dominion Bond Rating Service (DBRS). AA. CCC. CC. B. Fitch. Bonds are categorized as    Investment grade – top four rating categories (AAA. Suspended) Bond Basics Valuation Yields Determinants Other Debt .

the higher the required YTM Liquidity – the less liquid the bond. the higher the required YTM Call features – increase required YTM Extendible feature – reduce required YTM Retractable feature – reduce required YTM Bond Basics Valuation Yields Determinants Other Debt .Why Do Bonds Have Different Yields?      Default risk – the higher the default risk.

Other Types of Bonds/Debt Instruments .

use the following formula Where: F P = market price of the T Bill   n  F = face value of the T Bill 1  BEY   BEY = the bond equivalent yield  B  n = the number of days until maturity B = the annual basis (365 days in Canada) Yields Determinants    PT Bill Bond Basics Valuation Other Debt .Treasury Bills  Treasury bills are short-term obligations of government with an initial term to maturity of one year or less Issued at a discount and mature at face value The difference between the issue price and the face value is treated as interest income To calculate the price of a T-bill.

045   365    $990.000.5%? PT Bill  F n 1  BEY   B 1.000. 233.Treasury Bills: Example  What is the price of a $1.32 Bond Basics Valuation Yields Determinants Other Debt .000   80  1  .000 Canadian T bill with 80 days to maturity and a BEY of 4.

Solving for Yield on a T Bill  To solve for the yield on a T bill. 200 180    3. 200  365     98. rearrange the previous formula and solve for BEY. Example: What is the yield on a $100.000 T bill with 180 days to maturity and a market price of $98.000  98.200?  F PB BEY    P n 100.72% Bond Basics Valuation Yields Determinants Other Debt .

Zero Coupon Bonds   A zero coupon bond is a bond issued at a discount that matures at par or face value A zero coupon bond has no reinvestment rate risk. solve for the PV of the face amount  Bond Basics Valuation Yields Determinants Other Debt . since there are no coupons to be reinvested To calculate the price of a zero coupon bond.

649.000 25  $11.06  n 50.93 Bond Basics Valuation Yields Determinants Other Debt .Zero Coupon Bonds  Example: What is the market price of a $50.000 zero coupon bond with 25 years to maturity that is currently yielding 6%? B  F 1  kb  1.

Floating Rate & Real Return Bonds  Floating rate bonds have a coupon that floats with some reference rate. such as the yield on T bills  Because the coupon floats. The coupon is then paid on the grossed up face value. Bond Basics Valuation Yields Determinants Other Debt . the face value of the bond is grossed up by the inflation rate. the market price will typically be close to the bond’s face value  Real return bonds are issued by the Government of Canada to protect investors against unexpected inflation  Each period.

Canada Savings Bonds  A Canada Savings Bond (CSB) is a special type of bond issued by the Government of Canada It is issued in two forms:    Regular interest – interest is paid annually Compound interest – interest compounds over the life of the bond   CSBs are redeemable at any chartered bank in Canada at their face value There is no secondary market for CSBs Bond Basics Valuation Yields Determinants Other Debt .

Summary and Conclusions In this chapter you have learned:    About the nature of bonds as an investment How to value a bond using discounted cash flow concepts About the determinants of interest rates and theories used to explain the term structure of interest rates Bond Basics Valuation Yields Determinants Other Debt .

4. Bond Characteristics Bond Valuation Bond Yields Bond Ratings and Agencies Bond Basics Valuation Yields Determinants Other Debt .Interesting Web Links 1. 2. 3.

End of Chapter Problems Chapter 6 – Bond Valuation and Interest Rates .

C. Solution: A Mortgages have “blended” payments including interest and principal payment. They have a fixed maturity date at which time the issuer repays the full principal amount.1 Which of the following statements concerning bonds is incorrect? A. End-of-Chapter Problems . not bonds. specifying payment requirements and so on. B.Question 6 . They involve blended payments of principal and interest. D. Bondholders are paid a series of fixed periodic amounts before the maturity date. The bond indenture is a legal document.

Convertible bonds give the bondholders an option to convert into common shares at a predetermined conversion ratio.Question 6 . C. Callable bonds give the bond issuer an option to call the bond at a predetermined price. Solution: B Debentures are generally unsecured. All debentures are secured bonds. Extendible bonds allow bondholders to extend the maturity date. End-of-Chapter Problems . B.2 Which of the following statements is incorrect? A. D.

08)5  1 B  7    100  . FV = 100. PMT = 7. I/Y= 8.08 (1  . The face value is $100.9490  68. B.Question 6 .08)5        27. by financial calculator: N = 5. C.01 Or. CPT PV = –96.3 Determine the price of a five-year 7 percent annual coupon bond when the market rate is 8 percent. D.50 $96.0583  $96. A.01 $104.10 Solution: C 1   1  (1  .01 End-of-Chapter Problems . $100 $102.

End-of-Chapter Problems .6 percent 7. 4. yield = 5. Therefore it has the highest interest rate risk. yield = 5.5-year. B. The bond in choice D has the lowest yield. D. C.5 percent Solution: D All else being equal. 5-year. 4.5 percent coupon rate.Question 6 . yield = 5.4 Which of the following bond prices is most sensitive to market rate changes? The par value = $100 for all.5 percent coupon rate. lowest coupon rate and the longest term to maturity relative to other bonds. interest rate risk is positively related to term to maturity. 5 percent coupon rate. A.5 percent 3-year.5 percent 10-year. 8 percent coupon rate. but negatively related to coupon rate and market yields. yield = 5.

YTM=3.57 percent 7. D.Question 6 . PMT=35.5727 Therefore.000.05 percent 6. C. FV=1.15% End-of-Chapter Problems .5 Determine the yield to maturity on a six-year. N=12. PV= –993. PV= –993 Using a financial calculator. B. 7. 7 percent. Use a financial calculator.000 CPT I/Y=3. which is now priced at $993. FV=1.000)(7%)/2=$35. A.15 percent Solution: D Coupon = ($1. N=6×2=12. semi-annual-pay bond.98 percent 3.5727%×2=7.

the bond is priced at discount. B.6 Which of the following statements is correct? A.Question 6 . the bond is priced at premium. End-of-Chapter Problems . the coupon rate < current yield < YTM. When the coupon rate is higher than the market rate. When the market rate is higher than the coupon rate. bond is at discount. Solution: D Current yield is the ratio of annual coupon divided by the current market price. C. When coupon rate is higher than the market rate. Current yield is the ratio of annual coupon payment divided by the par value. D. bond is at premium and when the market rate is higher. If a bond is at discount.

its currency will depreciate. Solution: C Difference in interest rates across countries can be offset by expected changes in exchange rates. the inflation differentials between countries affect both interest rates and currency exchange rates. A. If a country has a higher expected inflation rate. C. D. differences in interest rates across countries cannot be totally offset by expected changes in exchange rates.Question 6 . IRP states that forward exchange rates locked-in today to eliminate foreign exchange risk ensure investors earn the same amount no matter where they invest. End-of-Chapter Problems .7 According to interest rate parity (IRP) theory. B. the country with a higher inflation rate will see its currency appreciate against another country with a lower inflation rate. forward exchange rates may be locked in today to eliminate foreign exchange risk and ensure investors can profit from moving capital to countries with higher interest rates.

The risk premium in the bond yield reflects default risk. a downward-sloping yield curve implies that interest rates are expected to decline in the future. A debt rating of AAA is a worse rating than BB for S&P.Question 6 .8 Which statement is incorrect? A. B. End-of-Chapter Problems . The liquidity preference theory states that investors prefer short-term debt. Solution: D AAA is rated higher than BB. liquidity risk. C. and issue-specific features. D. According to the expectations theory.

B.3307.07 182 1. D.478.000 and a quoted yield of 5.3307 $94.07 $9.7867 Solution: C 10.733. C. A.Question 6 .055  ) 365 Because it is quoted on a basis of $100.02742466 (1  0. $9.000 10.733.9 Calculate the quoted price of a 182-day Canadian T-bill that has a face value of $10.67 $97. End-of-Chapter Problems .000   $9.5 percent. therefore quoted price is P $97.

C.Question 6 . B. Floating rate bonds provide protection against decreasing interest rates. Solution: C Floating rate bonds provide protection against increasing interest rates compared to fixed rate bonds.10 Which of the following statements is false? A. Zero coupon bonds are often created when cash flows are stripped from traditional bonds. Zero coupon bonds are deep-discount bonds. End-of-Chapter Problems . There are two forms of return available for Canadian Savings Bond buyers. D.

11 State the relationship between the market rates and bond prices. End-of-Chapter Problems . Solution: When market interest rates increase. When market interest rates decrease. prices of bonds decrease.Question 6 . prices of bonds increase.

PMT = 30. N = 6. kb = 6 percent. FV = 1. End-of-Chapter Problems . I/Y= 3.000.000. FV = 1.000 C. kb = 7 percent. N = 6. PMT = 30. C. CPT PV = –1.12 Find the price of a bond with FV = $1. PMT = 30. FV = 1. N = 6.5. a coupon rate of 6 percent (paid semi-annually). I/Y= 2.36 B.000. B. Solution: Using a financial calculator: A.5.027.Question 6 . CPT PV = –1.54 Clearly. and three years to maturity when A. CPT PV = –973. I/Y= 3. the price of bonds is inversely related to the market yield.000. kb = 5 percent.

I/Y = 8.Question 6 .400. For each bond. PV = . I/Y = 12.000. PMT = 0. find the missing quantity in the table below.000. PMT = 0.10% B. each of the following zero-coupon bonds (pure discount bonds) will be worth $1. C. PMT = 0. CPT N = 11. B.400.000.000. N = 30. CPT PV = $321. FV = 1.9 years C. $400 $400 8% 12% Solution: Using a financial calculator: A. N = 10. Price Maturity (years) 30 10 Yield to Maturity A.13 At maturity. CPT I/Y = 3. PV = . FV = 1.97 End-of-Chapter Problems . FV = 1.

03) – 1 = 6. Using the exact relationship: Real Rate = (1+0.80 percent.Question 6 . If inflation is expected to be 3 percent per year over the next two years. so the Real Rate = 6.8%.60% End-of-Chapter Problems . what coupon rate would you expect to find on a Real Return Bond that is otherwise identical? Solution: Using the approximate relationship: 9.14 Suppose that a government of Canada 9 percent annualpay bond that matures in two years has a yield to maturity of 9.098)/(1+0.80% = Real Rate + 3%.

04)–1=5. what is the nominal risk-free rate? Solution: The Fisher relationship uses expected inflation figures.75 percent. as measured by the CPI.82% End-of-Chapter Problems . Therefore: RF = 1.Question 6 . The most recent Bank of Canada announcement indicates that it expects 4 percent inflation over the next year.15 Suppose the inflation rate in Canada. If the real rate of return on Canadian T-bills is 1.0175)(1.5 percent in recent years. not the actual rate of inflation experienced in the past.75% + 4% = 5. has been averaging 2.75% Using the exact relationship: RF = (1+0.

60% End-of-Chapter Problems . We can assume that T-bills (short-term. One-year T-bills are trading with a YTM of 6 percent. “AAA”. We expect lower rated (riskier) bonds to have a higher yield.Question 6 . For “A” rated bonds. What yield would you expect to observe on non-investment grade (BB rated) corporate bonds with a five-year maturity? Solution: A. federal government bonds) have the highest possible credit rating.10% = 7.45% = 6. What yield would you expect to find on A rated corporate bonds maturing in one year? Five-year government bonds have a maturity yield differential of 50 basis points. B.45% Adding the maturity yield and the “spread” for this bond rating. we should expect kb = 6% + 0.16 The following values are the spread for corporate bond yields: Bond Rating AA A BBB BB Spread over AAA 30 basis points 45 basis points 70 basis points 110 basis points A.50% + 1. we find: kb = 6% + 0. B. because they have virtually no default risk.

Ltd. The author and the publisher assume no responsibility for errors. Ltd. John Wiley & Sons Canada. . All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful.Copyright Copyright © 2010 John Wiley & Sons Canada. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. or damages caused by the use of these files or programs or from the use of the information contained herein. Requests for further information should be addressed to the Permissions Department. omissions.

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