CHAPTER 7
INTEREST RATES AND BOND VALUATION
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KEY CONCEPTS AND SKILLS
• Know the important bond features and bond types
• Understand bond values and why they fluctuate
• Understand bond ratings and what they mean
• Understand the impact of inflation on interest rates
• Understand the term structure of interest rates and the
determinants of bond yields
7-2
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
CHAPTER OUTLINE
• Bonds and Bond Valuation
• More about Bond Features
• Bond Ratings
• Some Different Types of Bonds
• Bond Markets
• Inflation and Interest Rates
• Determinants of Bond Yields
7-3
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DIFFERENCES BETWEEN
DEBT AND EQUITY
• Debt • Equity
Not an ownership interest Ownership interest
Creditors do not have voting Common stockholders vote
rights for the board of directors and
Interest is considered a cost of other issues
doing business and is tax Dividends are not considered
deductible a cost of doing business and
Creditors have legal recourse are not tax deductible
if interest or principal Dividends are not a liability of
payments are missed the firm, and stockholders
Excess debt can lead to have no legal recourse if
financial distress and dividends are not paid
bankruptcy An all equity firm can not go
bankrupt merely due to debt
since it has no debt
7-4
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BOND DEFINITIONS
• Bond
• Par value (face value)
• Coupon rate
• Coupon payment
• Maturity date
• Yield or Yield to maturity
7-5
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PRESENT VALUE OF CASH FLOWS
AS RATES CHANGE
• Bond Value = PV of coupons + PV of par
• Bond Value = PV of annuity + PV of lump sum
• As interest rates increase, present values decrease
• So, as interest rates increase, bond prices decrease
and vice versa
7-6
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VALUING A DISCOUNT BOND
WITH ANNUAL COUPONS
• Consider a bond with a coupon rate of 10% and annual
coupons. The par value is $1,000, and the bond has 5
years to maturity. The yield to maturity is 11%. What is
the value of the bond?
Using the formula:
• B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.11)5] / .11 + 1,000 / (1.11)5
• B = 369.59 + 593.45 = 963.04
Using the calculator:
• N = 5; I/Y = 11; PMT = 100; FV = 1,000
• CPT PV = -963.04
7-7
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VALUING A PREMIUM BOND
WITH ANNUAL COUPONS
• Suppose you are reviewing a bond that has a 10% annual
coupon and a face value of $1000. There are 20 years to
maturity, and the yield to maturity is 8%. What is the
price of this bond?
Using the formula:
• B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20
• B = 981.81 + 214.55 = 1196.36
Using the calculator:
• N = 20; I/Y = 8; PMT = 100; FV = 1000
• CPT PV = -1,196.36
7-8
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GRAPHICAL RELATIONSHIP BETWEEN
PRICE AND YIELD-TO-MATURITY
(YTM)
1500
1400
1300
Bond Price
1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
Yield-to-Maturity Yield-to-maturity
(YTM) (YTM)
Bond characteristics:
10 year maturity, 8% coupon rate, $1,000 par value
7-9
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BOND PRICES: RELATIONSHIP
BETWEEN COUPON AND YIELD
• If YTM = coupon rate, then par value = bond price
• If YTM > coupon rate, then par value > bond price
Why? The discount provides yield above coupon rate
Price below par value, called a discount bond
• If YTM < coupon rate, then par value < bond price
Why? Higher coupon rate causes value above par
Price above par value, called a premium bond
7-10
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THE BOND PRICING EQUATION
1
1 -
(1 r) t FV
Bond Value C
(1 r)
t
r
7-11
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EXAMPLE 7.1
• If an ordinary bond has a coupon rate of
14 percent, then the owner will get a total
of $140 per year, but this $140 will come in
two payments of $70 each. The yield to
maturity is quoted at 16 percent. The bond
matures in seven years.
• Note: Bond yields are quoted like APRs;
the quoted rate is equal to the actual rate
per period multiplied by the number of
periods.
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EXAMPLE 7.1
How many coupon payments are there?
What is the semiannual coupon payment?
What is the semiannual yield?
What is the bond price?
B = 70[1 – 1/(1.08)14] / .08 + 1,000 / (1.08)14 =
917.56
Or PMT = 70; N = 14; I/Y = 8; FV = 1,000; CPT
PV = -917.56
7-13
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INTEREST RATE RISK
• Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-term bonds
Low coupon rate bonds have more price risk than high
coupon rate bonds
• Reinvestment Rate Risk
Uncertainty concerning rates at which cash flows can be
reinvested
Short-term bonds have more reinvestment rate risk than long-
term bonds
High coupon rate bonds have more reinvestment rate risk
than low coupon rate bonds
7-14
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FIGURE 7.2
7-15
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COMPUTING YIELD TO MATURITY
• Yield to Maturity (YTM) is the rate implied by the
current bond price
• Finding the YTM requires trial and error if you do
not have a financial calculator and is similar to the
process for finding r with an annuity
• If you have a financial calculator, enter N, PV, PMT,
and FV, remembering the sign convention (PMT and
FV need to have the same sign, PV the opposite sign)
7-16
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YTM WITH ANNUAL COUPONS
• Consider a bond with a 10% annual coupon rate, 15
years to maturity and a par value of $1,000. The
current price is $928.09.
Will the yield be more or less than 10%?
N = 15; PV = -928.09; FV = 1,000; PMT = 100; CPT I/Y =
11%
7-17
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YTM WITH SEMIANNUAL
COUPONS
• Suppose a bond with a 10% coupon rate and
semiannual coupons, has a face value of $1,000, 20
years to maturity and is selling for $1,197.93.
Is the YTM more or less than 10%?
What is the semiannual coupon payment?
How many periods are there?
N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y =
4% (Is this the YTM?)
YTM = 4%* 2 = 8%
7-18
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BOND PRICING THEOREMS
• Bonds of similar risk (and maturity) will be priced to
yield about the same return, regardless of the coupon
rate
• If you know the price of one bond, you can estimate
its YTM and use that to find the price of the second
bond
• This is a useful concept that can be transferred to
valuing assets other than bonds
7-19
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
DIFFERENCES BETWEEN
DEBT AND EQUITY
• Debt • Equity
Not an ownership interest Ownership interest
Creditors do not have voting Common stockholders vote
rights for the board of directors and
Interest is considered a cost of other issues
doing business and is tax Dividends are not considered
deductible a cost of doing business and
Creditors have legal recourse are not tax deductible
if interest or principal Dividends are not a liability of
payments are missed the firm, and stockholders
Excess debt can lead to have no legal recourse if
financial distress and dividends are not paid
bankruptcy An all equity firm can not go
bankrupt merely due to debt
since it has no debt
7-20
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.
THE BOND INDENTURE
• Contract between the company and the bondholders
that includes
The basic terms of the bonds
The total amount of bonds issued
A description of property used as security, if applicable
Sinking fund provisions
Call provisions
Details of protective covenants
7-21
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BOND CHARACTERISTICS AND
REQUIRED RETURNS
• The coupon rate depends on the risk characteristics of
the bond when issued
• Which bonds will have the higher coupon, all else
equal?
Secured debt versus a debenture
Subordinated debenture versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond
7-22
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GOVERNMENT BONDS
• Treasury Securities
Federal government debt
T-bills – pure discount bonds with original maturity of one
year or less
T-notes – coupon debt with original maturity between one and
ten years
T-bonds – coupon debt with original maturity greater than ten
years
• Municipal Securities
Debt of state and local governments
Varying degrees of default risk, rated similar to corporate debt
Interest received is tax-exempt at the federal level
7-23
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EXAMPLE 7.4
• A taxable bond has a yield of 8%, and a municipal
bond has a yield of 6%.
If you are in a 40% tax bracket, which bond do you prefer?
• 8%(1 - .4) = 4.8%
• The after-tax return on the corporate bond is 4.8%, compared to a 6%
return on the municipal
At what tax rate would you be indifferent between the two
bonds?
• 8%(1 – T) = 6%
• T = 25%
7-24
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ZERO COUPON BONDS
• Make no periodic interest payments (coupon rate = 0%)
• The entire yield-to-maturity comes from the difference between
the purchase price and the par value
• Cannot sell for more than par value
• Sometimes called zeroes, deep discount bonds, or original issue
discount bonds (OIDs)
• Treasury Bills and principal-only Treasury strips are good
examples of zeroes
7-25
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BOND MARKETS
• Primarily over-the-counter transactions with
dealers connected electronically
• Extremely large number of bond issues, but
generally low daily volume in single issues
• Makes getting up-to-date prices difficult,
particularly on small company or municipal
issues
• Treasury securities are an exception
7-26
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BOND RATINGS –
INVESTMENT QUALITY
• High Grade
Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
Moody’s Aa and S&P AA – capacity to pay is very
strong
• Medium Grade
Moody’s A and S&P A – capacity to pay is strong, but
more susceptible to changes in circumstances
Moody’s Baa and S&P BBB – capacity to pay is
adequate, adverse conditions will have more impact on
the firm’s ability to pay
7-27
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BOND RATINGS –
SPECULATIVE GRADE
• Low Grade
Moody’s Ba and B
S&P BB and B
Considered possible that the capacity to pay will
degenerate.
• Very Low Grade
Moody’s C (and below) and S&P C (and below)
• income bonds with no interest being paid, or
• in default with principal and interest in arrears
7-28
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INFLATION AND INTEREST RATES
• Real rate of interest – change in purchasing
power
• Nominal rate of interest – quoted rate of
interest, change in actual number of dollars
• The ex ante nominal rate of interest includes
our desired real rate of return plus an
adjustment for expected inflation
7-29
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THE FISHER EFFECT
• The Fisher Effect defines the relationship between
real rates, nominal rates, and inflation
• (1 + R) = (1 + r)(1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate
• Approximation
R=r+h
7-30
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EXAMPLE 7.5
• If we require a 10% real return and we expect inflation
to be 8%, what is the nominal rate?
• R = (1.1)(1.08) – 1 = .188 = 18.8%
• Approximation: R = 10% + 8% = 18%
• Because the real return and expected inflation are
relatively high, there is significant difference between
the actual Fisher Effect and the approximation.
7-31
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TERM STRUCTURE OF
INTEREST RATES
• Term structure is the relationship between time to
maturity and yields, all else equal
• It is important to recognize that we pull out the effect
of default risk, different coupons, etc.
• Yield curve – graphical representation of the term
structure
Normal – upward-sloping; long-term yields are higher than
short-term yields
Inverted – downward-sloping; long-term yields are lower than
short-term yields
7-32
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FIGURE 7.6 – UPWARD-SLOPING
YIELD CURVE
7-33
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FIGURE 7.6 – DOWNWARD-
SLOPING YIELD CURVE
7-34
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• https://markets.on.nytimes.com/research/markets/bonds/
bonds.asp
FIGURE 7.7
7-36
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FACTORS AFFECTING
BOND YIELDS
• Real rate of interest
• Expected future inflation premium
• Interest rate risk premium
• Default risk premium
• Taxability premium
• Liquidity premium
7-37
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