Bonds, Bond Valuation, and Interest Rates

Topics in Chapter
 Key features of bonds
 Bond valuation
 Measuring yields
 Assessing risk
 The term structure of interest rates and yield curves
 The pure expectations hypothesis

2
Bonds – An Introduction:
 A long-term debt instrument in which a borrower
agrees to make payments of principal and interest,
on specific dates, to the holders of the bond.
 It may be a nicely engraved piece of paper, or
simply an electronic entry stored in a secure
computer.
 Based on issuer classification, there are 4 types of
bonds: (1) Treasury, (2) Corporate, (3) Municipal,
and (4) Foreign.

3
Contractual Features of a Bond
 Par value – face amount paid at maturity (assume
$1,000).
 Coupon interest rate – stated interest rate (usually
fixed, but can be floating or even zero!) on par
value paid by the issuer.
 Maturity date – years until repayment is required.
 Issue date – when the bond was issued.
 Yield to maturity – the average rate of return
earned on a bond which is held until maturity.

4
Cont… call provision
 Call Provision – Most corporate and municipal
(but not treasury) bonds have provisions in the
indenture that allows the issuer to pay off the
bond early (happens when rates decline, helps the
issuer, hurts the investor).
 are not usually callable until several years after the
issue – this call protection is known as Deferred
Call.
 issuer must pay a call premium (declining) over
par value (often equal to 1-year coupon).

5
Cont… collateral
 Collateral – Some bonds are backed by specific
assets that must be turned over to the
bondholders if the issuer defaults on payment,
while other bonds have no such collateral backup
(often referred to as debentures).

6
What’s a sinking fund?
 Provision to pay off a loan over its life rather than all at
maturity.
 Similar to amortization on a term loan.
 Reduces risk to investor, shortens average maturity.
 But not good for investors if rates decline after
issuance.

7
Sinking funds are generally handled in 2 ways

 1. Call x% at par per year for sinking

fund purposes.
 2. Buy bonds on open market.
 Company would call if rd is below the coupon rate and
bond sells at a premium. Use open market purchase if
rd is above coupon rate and bond sells at a discount.

8
The Value of Financial Assets
0 r% 1 2 n
...
Value CF1 CF2 CFn
CF1 CF2 CFN
Bond's Value (VB ) = + + ... + [CFn =Interest (INT)+Maturity Value (M)]
(1+rd )1 (1+rd )2 (1+rd )N
N
INT M
= 
t=1 (1 + rd )
t
+
(1 + rd )N
 1-(1+rd )-N  M
=INT   + N
 rd  (1 + rd )
= INT(PVA rd ,N ) + M(PVrd ,N )

9
What is the opportunity cost of debt capital?

 The discount rate (rd) is the opportunity cost of

capital, and is the rate that could be earned on
alternative investments of equal risk.

10
 What is the value of a 10-year, 10% annual
coupon bond, if rd = 10%?
0 1 2 n
r% ...

VB = ? 100 100 100 + 1,000

$100 $100 $1,000

VB  1
 ...  10

(1.10) (1.10) (1.10)10
 $90.91  ...  $38.55  $385.54
 $1,000
11
What would happen if expected inflation rose by
3%, causing r = 13%?

VB = $837.21

When coupon rate < rd, the bond’s value

falls below par, so it sells at a discount.

12
What would happen if inflation fell, and rd
declined to 7%?

VB = $1,210.71

If coupon rate > rd, price rises above par,

and bond sells at a premium.

13
Bond Value ($) vs Years remaining to
Maturity
 Suppose the bond was issued 20 years ago and now has
10 years to maturity. What would happen to its value
over time if the required rate of return remained at
10%, or at 13%, or at 7%?

14
Bond Value ($) vs Years remaining to
Maturity
1,372 rd = 7%.
1,211

1,000 M
rd = 10%.
837
rd = 13%.
775

30 25 20 15 10 5 0

15
Bond Value ($) vs Years remaining to
Maturity
 At maturity, the value of any bond must equal its par
value.
 The value of a premium bond would decrease to
$1,000.
 The value of a discount bond would increase to $1,000.
 A par bond stays at $1,000 if rd remains constant.

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Yield To Maturity (YTM)
YTM is the average rate of return you can earn by
buying the bond today and holding it until its
maturity. Also called “promised yield.”
n I M
P0 = S (1 + kd )t
+
(1 + kd )n
t=1

= I (PVA k , n) + M (PV k , n)
d d
kd = YTM
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Yield To Maturity (YTM)
Julie Miller wants to determine the YTM for an issue of
outstanding bonds at Basket Wonders (BW). BW has an
issue of 10% annual coupon bonds with 15 years left to
maturity. The bonds have a current market value of
$1,250.
What is the YTM?

18
YTM – try different rates
V = $100(PVIFA9%,15) + $1,000(PVIF9%, 15)
= $100(8.061) + $1,000(0.275)
= $806.10 + $275.00 = $1,081.10 [Rate is too high!]

V = $100(PVIFA7%,15) + $1,000(PVIF7%, 15)

= $100(9.108) + $1,000(0.362)
= $910.80 + $362.00 = $1,272.80 [Rate is too low!]

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YTM – Interpolation (Linear Approximation)

.07 $1273
X $23
.02 YTM $1250 $192
.09 $1081
X $23
= X = .0024
.02 $192

YTM = .07 + .0024 = .0724 or 7.24%

20
YTM – Crude Approximation
F = Face Value = Par Value
P = Bond Price
C = Annual coupon interest
N = Number of periods (years) left to maturity
F-P $1000 - $1250
+C + $100
N 15
Approx. YTM = =
F+P $1000 + $1250
2 2
$83.33
= =0.0741=7.41%
$1125
21
What is the YTM on a 10-year, 9% annual coupon,
$1,000 par value bond, selling for $887?

 The problem can be set up as follows

INT INT M
VB  1
 ...  N

(1  rd ) (1  rd ) (1  rd )N
90 90 1,000
$887  1
 ...  10

(1  rd ) (1  rd ) (1  rd )10

 YTM  10.91%.
 YTM > coupon rate, confirming that this bond
sells at a discount.
22
Find YTM If the Bond Price is $1,134.20

 YTM  7.08%
 YTM < coupon rate, confirming that this bond sells at
a premium

23
YTM = Current Yield + Capital Grains Yields

Current yield (CY) = Annual coupon pmt

Current price

Capital gains yield (GY) = Change in price

Beginning price

Exp total return = YTM = Exp CY + Exp GY

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9% coupon, 10-year bond, P = $887, and
YTM = 10.91%
Current yield = $90 = 0.1015 = 10.15%
$887
Cap gains yield = YTM - Current yield
= 10.91% - 10.15%
= 0.76%
Could also find values in Years 1 and 2,
get difference, and divide by value in
Year 1. Same answer.

25
Semiannual Coupon Bonds
1. Multiply years by 2: Number of periods = 2N
2. Divide nominal rate by 2: Periodic rate (I/YR) = rd/2
3. Divide annual coupon by 2: PMT = Annual coupon/2

What is the value of a 10-year, 10% semiannual coupon

bond, if rd = 13%?
1. Multiply years by 2: N = 2 x 10 = 20.
2. Divide nominal rate by 2: I/YR = 13/2 = 6.5.
3. Divide annual coupon by 2: PMT = 100/2 = 50.

26
Semiannual Coupon Bonds
Annual coupon paying bonds:
 1-(1+rd )-N  M
Value = INT   + N
 rd  (1 + rd )
= INT(PVA rd ,N ) + M(PVrd ,N )
Semiannual coupon paying bonds:
 rd -(2×N) 
1-(1+ )
INT  2  M
Value =   +
2  rd r
 (1 + d )(2×N)
 2  2
INT
= (PVA rd ,2×N ) + M(PVrd ,2×N )
2 2 2

27
Value of 10-year, 10% coupon, semiannual
bond if rd = 13%

VB = $834.72

28
Yield To Call (YTC)
 A 10-year, 10% semiannual coupon bond selling
for $1,135.90 can be called in 4 years for $1,050,
what is its yield to call (YTC)?
 The bond’s YTM can be determined to be 8%.
Solving for the YTC (3.568% per semiannual
period) is identical to solving for YTM, except
 The time to call is used for N, and
 The call premium (call price) is FV.

29
Yield to Call (YTC)
 3.568% represents the periodic semiannual yield
to call.
 YTCNOM = rNOM = 3.568% x 2 = 7.137% is the rate
that a broker would quote.
 The effective yield to call can be calculated.
YTCEFF = (1.03568)2 – 1 = 7.26%

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 If you bought these callable bonds, would you be
more likely to earn the YTM or YTC?

 The coupon rate = 10% compared to YTC = 7.137%.

The firm could raise money by selling new bonds
which pay 7.137%.
 Could replace bonds paying $100 per year with
bonds paying only $71.37 per year.
 Investors should expect a call, and to earn the YTC
of 7.137%, rather than the YTM of 8%.

31
When is a call more likely to occur?

 In general, if a bond sells at a premium, then a call is

more likely.
 This implies: Current coupon rate > rd

 So, expect to earn:

 YTC on premium bonds.
 YTM on par and discount bonds.

32
Interest Rate (rd)
 Price (pre-tax) that lenders receive and borrowers pay
for debt capital.
 Why are there so many interest rates? Because not all
debts are the same in terms of borrower’s risk, the
length of time the money is tied up, the type of
collateral (security) to back up the loan.
 rd comprises a real risk-free rate and several premiums
that reflect inflation, risk of the security, maturity
period, and marketability of the security (liquidity).

33
rd = r* + IP + DRP + LP + MRP
Here,
rd = Required rate of return on a debt security.
r* = Real risk-free rate (rate on short term TIPS is a
good proxy).
IP = Inflation premium (average expected inflation
over the term of maturity)
DRP = Default (interest and principal) risk premium.
LP = Liquidity premium.
MRP = Maturity risk premium (longer term bonds are
exposed to significant risk of price declines).

34
What is the nominal risk-free rate?
 rRF = (1+r*)(1+IP)-1
= r*+ IP + (r*xIP)
≈ r*+ IP. (Because r*xIP is small)
 rRF = Rate on Treasury securities.

35
Estimating IP
 The price of Treasury Inflation-Protected
Securities (TIPS) are indexed to inflation.
 The IP for a particular length maturity can be
approximated as the difference between the
yield on a non-indexed Treasury security of that
maturity minus the yield on a TIPS of that
maturity.
 Alternative proxy: avg expected infl rate over
N
years 1 to N:  INFL t
t 1
IPN 
N

36
Bond Spreads - the DRP, and the LP
 A bond spread (DRP) is often calculated as the
difference between a corporate bond’s yield and a
Treasury security’s yield of the same maturity.
 The most liquid and the least liquid financial
assets of similar default risk and maturity often LP
as high as 2%. Bond’s of large (small), strong
(weaker) companies often have very small (large)
LPs.

37
Bond Ratings Provide One Measure of
Default Risk

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D

38
Bond Ratings and Bond Spreads
(YahooFinance, 2006)
Long-term Bonds Yield Spread
U.S. Treasury 5.25%

AAA 6.26 1.01%

AA 6.42 1.17
A 6.54 1.29
BBB 6.60 1.35
BB 7.80 2.55
B 8.42 3.17
CCC 10.53 5.28
39
What factors affect default risk and bond
ratings?
 Financial performance
 Debt ratio
 Coverage ratios, such as interest coverage ratio or
EBITDA coverage ratio
 Current ratios
 Provisions in the bond contract
 Secured versus unsecured debt
 Senior versus subordinated debt
 Guarantee provisions
 Sinking fund provisions
 Debt maturity
(More…)
40
What factors affect default risk and bond
ratings? (cont.)
 Other factors
 Earnings stability
 Regulatory environment
 Potential product liability
 Accounting policies

41
Maturity Risk Premium
 All bonds are exposed to two additional sources of
risk – interest rate risk and reinvestment risk. The
net effect of these two sources of risk upon a
bond’s yield is called maturity risk premium
(MRP).

42
What is interest rate (or price) risk? Does a 1-year
or 10-year bond have more interest rate risk?
 Interest rate risk is the concern that rising rd will
cause the value of a bond to fall.
rd 1-year Change 10-year Change
5% $1,048 $1,386
+ 4.8% +38.6%
10% 1,000 1,000
– 4.4% –25.1%
15% 956 749

 The 10-year bond is more sensitive to interest rate

changes, and hence has more interest rate risk.

43
Value
1,500 10-year

1,000 1-year

500

0 rd
0% 5% 10% 15%

44
What is reinvestment rate risk?
 The risk that CFs will have to be reinvested in the
future at lower rates, reducing income.

 Illustration: Suppose you just won $500,000

playing the lottery. You’ll invest the money and live
off the interest. You buy a 1-year bond with a YTM
of 10%.

45
Reinvestment rate risk (cont.)
 Year 1 income = $50,000. At year-end get back
$500,000 to reinvest.

 If rates fall to 3%, income will drop from $50,000 to

$15,000. Had you bought 30-year bonds, income would
have remained constant.

46
Maturity Risk Premium
 Long-term bonds: High interest rate risk, low
reinvestment rate risk.
 Short-term bonds: Low interest rate risk, high
reinvestment rate risk.
 Nothing is riskless!
 Yields on longer term bonds usually are greater
than on shorter term bonds, so the MRP is more
affected by interest rate risk than by
reinvestment rate risk.

47
Maturity Risk Premium
 The following equation is often popularly used to
find a security’s maturity risk premium (MRP).
MRPt = 0.1% (t – 1)

48
Premiums Added to r* for Different
Types of Debt
IP MRP DRP LP
S-T Treasury 

L-T Treasury  

S-T Corporate   

L-T Corporate    

49
Yield Curve and the Term Structure of
Interest Rates Interest

 Term structure – 14%

March 1980

relationship between 12%

interest rates (or yields) 10%

and maturities. 8%
February 2000

6%
 The yield curve is a graph
4%
of the term structure. October 2008
2%
 The October 2008 Treasury
0%
yield curve is shown at the 0 10 20 30

Years to Maturity
right.

50
Hypothetical Yield Curve
Interest  An upward sloping
Rate (%)
15 Maturity risk premium yield curve.
 Upward slope due
10 Inflation premium to an increase in
expected inflation
5 and increasing
Real risk-free rate
Years to
maturity risk
0 Maturity premium.
1 10 20

51
Relationship Between Treasury Yield Curve and
Yield Curves for Corporate Issues
 rCorporate, t = r* + IPt + MRPt + DRPt + LPt
Both DRP and LP are increasing functions of time to maturity.

Default probability for Apple bond in 1 year Vs that in 100 years.

It is easier to find a buyer for a shorter-term bond because it has less default
risk and it will not require much credit analysis for a buy decision.
 Corporate yield curves are higher than that of
Treasury securities, though not necessarily
parallel to the Treasury curve.
 The spread between corporate and Treasury yield
curves widens as the corporate bond rating
decreases.

52
Hypothetical Treasury and
Corporate Yield Curves
12.0%
10.0%
Interest Rate

8.0%
BB Bond
6.0% AAA Bond
5.2% 5.9% 6.0% Treasury Bond
4.0%

2.0%
0.0%
1 10 20
Years to Maturity

53
Explaining the shape of the Yield Curve: Pure
Expectations Hypothesis

 Although we saw that the shape of the yield curve

(treasury) depends primarily on two factors: (1)
expectations about future inflation and (2) the
relative risk of securities with different maturities.
 The PEH contends that the shape of the yield
curve depends only on investor’s expectations
about future periodic (1-year) interest rates.

54
Pure Expectations Hypothesis (cont.)
 The PEH implies that the bond yields are
simply weighted average of expected future 1-
year interest rates.
 If periodic (1-year) interest rates are expected to
increase, L-T rates will be higher than S-T rates,
and vice-versa. Thus, the yield curve can slope
up, down, or even bow.

55
Critical assumption of the PEH
 Assumes that the maturity risk premium for Treasury
securities is zero.
Some academics and practitioners argue that the assumption is
reasonable, at least as an approximation. Bond markets are dominated
by large-scale traders who are primarily interested in making short-
term profits by buying and selling bonds with different maturities
everyday, and do not care about maturity risk. According to this view,
such traders are just as willing to buy a 10-year bond to pick up a short-
term profit as she is to buy a 3-month bond. Therefore, yield curve is
determined by market expectations about future short-term (1-year)
interest rates.

56
An Example:
Observed Treasury Rates and the PEH
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%
If PEH holds, what does the market expect will be
the interest rate on one-year securities, one year
from now? Three-year securities, two years from
now?
57
1-Year Forward Rate
6.0% x%

0 1
2
6.2%
(1.062)2 = (1.060) (1 + X)
1.12784/1.060 = (1 + X)
6.4004% = X
 PEH says that one-year securities will yield
6.4004%, one year from now.
Notice, if an arithmetic average is used, the answer is still very close.
Solve: 6.2% = (6.0% + X)/2, and the result will be 6.4%.

58
3-Year Security, 2 years from now?
6.2% x%

0 1 2 3 4
5
6.5%

(1.065)5 = (1.062)2 (1 + X)3

1.37009/1.12784 = (1 + X)3
6.7005% = X

 PEH says that three-year securities will yield

6.7005%, two years from now.

59
Conclusions about PEH
 Some would argue that the MRP ≠ 0, and hence the
PEH is incorrect.
 Most evidence supports the general view that
lenders prefer S-T securities, and view L-T securities
as riskier.
 Thus, investors demand a premium to persuade them
to hold L-T securities (i.e., MRP > 0).

60
An example where MRP ≠ 0
 Suppose the interest rate on a 1-year T-bond is 7.00%
and that on a 2-year T-bond is 9%. Assume that the
pure expectations theory is NOT valid, and the MRP is
zero for a 1-year T-bond but 0.5% for a 2-year bond.
What is the yield on a 1-year T-bond expected to be one
year from now?

2-year rate net of MRP = 9% - 0.5% = 8.5%

(1.085)2 = (1.07) (1 + X) => X = 10.02%

61