Chapter 6

Interest Rates and

Bond Valuation

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline

• Bonds and Bond Valuation

• More on Bond Features
• Some Different Types of Bonds
• Inflation and Interest Rates

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Bond Definitions
• Bond: debt securities, interest-only loan
• Par value (face value): loan principal, eg: $1000
• Coupon rate: periodic interest rate
• Coupon payment (c): periodic interest payments
= coupon rate * par
• Time to maturity (t): no. of coupon payment till
maturity date
• Yield to maturity (r) : market required rate of return
on bond. IOW, the discount rate that equals the PV
of cash flows to bond price.

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Bond Definitions: Example

Consider a 5-year corporate bond with a 10%
coupon rate paid annually. The principal amount is
$1000 and the market interest rate is 10% .

•Coupon=10% * $1000=$100
•year to maturity= 5
•Yield to maturity=10%
•Cash Flows: year 1 - 4 = $100
year 5 = 100 + 1000 = $1100

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Bond Valuation
Asset value = Present value of all future cash flows
Bond value = PV of all payments discounted at YTM
= PV of coupon + PV of par
= PV of annuity + PV of par

 1 
1 - (1 + r) t  F
Bond Value = C  +
 r  (1 + r) t


 

Where c = coupon payment
r = YTM
t = numbers of period
F = face value (eg:1000)
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Bond valuation-Example
Consider a 5-year corporate bond with a 10%
coupon rate paid annually. The principal amount is
$1000 and the market interest rate is 10%

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PV of Cash Flows as Rates

Change
 1 
1 - (1 + r) t  F
Bond Value = C  +
 r  (1 + r) t
 
 
• Remember, as interest rates increase the
PV’s decrease
• So, as interest rates increase, bond prices
decrease and vice versa
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Valuing a Discount Bond with
Annual Coupons
• Consider a bond with a coupon rate of 10% and
coupons paid annually. The par value is $1000
and the bond has 5 years to maturity. The yield
to maturity is 12%. What is the value of the
bond?

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Valuing a Premium Bond with

Annual Coupons
• Suppose you are looking at a bond that has a
10% annual coupon and a face value of $1000.
There are 5 years to maturity and the yield to
maturity is 8%. What is the price of this bond?

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Bond Prices: Relationship

Between Coupon and Yield
• If YTM = coupon rate,
– bond price = par value = $1000
– selling at par, called a par bond
• If YTM > coupon rate,
– bond price < $1000
– Selling at a discount, called a discount bond
• If YTM < coupon rate,
– bond price > $1000
– Selling at a premium, called a premium bond
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Semiannual coupons
• Suppose you are looking at a bond that has a
10% coupon paid semiannually and a face value
of $1000. There are 5 years to maturity and the
yield to maturity is 12%. What is the price of this
bond?

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Interest Rate Risk

• How sensitive its price to the interest

rate changes
– Long-term bonds have more interest rate risk
than short-term bonds (+ve relationship with
time to maturity)
– The lower the coupon rate, the greater the
interest rate risk (-ve relationship with coupon
rate)

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Computing YTM
• Yield-to-maturity is the rate implied by the
current bond price, i.e., the rate that equals
the PV of bond’s cash flows with bond
price.
• Finding the YTM requires trial and error if
you do not have a financial calculator.

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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 $1000. The current price is
$928.09.

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YTM with Semiannual Coupons

• Suppose a bond with a 10% coupon rate and
semiannual coupons, has a face value of
$1000, 20 years to maturity and is selling for
$1197.93.

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Bond Yield

– Yield to maturity: market required rate of return

on bond.
– Current yield = Annual coupon / price
• Par bond: CY = YTM
• Premium bond: CY > YTM
• Discount bond: CY < YTM

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Differences Betw. Debt & Equity
• Debt • Equity
– Not an ownership
interest
– Creditors do not have
voting rights
– Interest is considered a
cost of doing business
and is tax deductible
– Creditors have legal
recourse if interest or
principal payments are
missed
– Excess debt can lead to
financial distress and
bankruptcy
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– Ownership interest
– Common stockholders vote
for the board of directors
and other issues
– Dividends are not
considered a cost of doing
business and are not tax
deductible
– Dividends are not a liability
of the firm and stockholders
have no legal recourse if
dividends are not paid
– An all equity firm can not go
bankrupt
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The Bond Indenture

• Contract between the company and the
bondholders and includes:
– The basic terms of the bonds: par, registered Vs
bearer
– The total amount of bonds issued
– A description of property used as security, if
applicable - collateral
– Sinking fund provisions
– Call provisions: rights to buyback at specific price
– Details of protective covenants: +ve Vs -ve

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Bond Classifications
• Registered vs. Bearer Forms
• Security: backed by asset
– Collateral – secured by financial securities
– Mortgage – secured by real property, normally
land or buildings
– Debentures – unsecured
– Notes – unsecured debt with original maturity
less than 10 years
• Seniority
– preference in position over other lenders
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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

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Types of bonds-
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
– Interest received is tax-exempt at the federal level

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Taxable Vs Municipal Bonds

• A taxable corporate 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?

– At what tax rate would you be indifferent

between the two bonds?

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Zero Coupon Bonds

• Make no periodic interest payments (coupon rate
= 0%)
• Sometimes called zeroes, or deep discount
bonds
• The entire yield-to-maturity comes from the
difference between the purchase price and the
par value
• Treasury Bills and principal only Treasury strips
are good examples of zeroes

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Floating Rate Bonds

• Coupon rate floats depending on some index
value, eg: T-bill interest rate
• Examples – adjustable rate mortgages and
inflation-linked Treasuries
• There is less price risk with floating rate bonds
– The coupon floats, so it is less likely to differ
substantially from the yield-to-maturity

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Other Bond Types

• Income bonds
– coupon depends on company’s income
• Convertible bonds
– can be converted/swapped to a fixed no. of
shares
• Put bond
– Holder can sell back to issuer at a stated price

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Inflation and Interest Rates

• Nominal rate of interest – quoted rate of
interest, includes our desired real rate of
return plus an adjustment for expected
inflation
• Rate on Treasury Bill
• Real rate of interest – change in
purchasing power

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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
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Example
• If we require a 10% real return and we
expect inflation to be 3%, what is the
nominal rate?

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Tutorial
• Problem 6, 10, 17 and 18 from page 196

• Problem 18:
“…sell for 93% of par…” change to
“…sell for 91.167% of par…”

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