7-1

Interest Rates and Bond

Valuation
Chapter
7
Copyright 2013 by The McGraw-Hill Companies, I nc. All rights reserved. McGraw-Hill/I rwin
7-2
Chapter Outline
Bond Definition
Bond Features
Valuation of a Bond
Bond Relationships
Inflation and Interest Rates
Determinants of Bond Yields
Bond Ratings
Bond Markets

7-3
A bond is a
between two parties: one
is the (you)
and the other is a
or a
government agency (like
a municipal bond)
7-4
You are the
investor
The company
(or
government)
is borrowing
the money
7-5
A bond contains three
key items:

1. The par value
(usually $1,000)

2. The length of time (often
10 or 20 years)

3. A coupon interest rate
7-6
You lend money to the
borrower and you will get
back your original
investment plus interest.

The interest is
determined by the coupon
interest rate.
7-7
For example:
A 6% coupon interest rate yields:

(the coupon interest rate) x ( the par
value)

(6%) x ($1,000) = $60 per year for each
year of the bond.
7-8
Lets look at this visually using
the time line:
1 2 3 4 5
$60 $60 $60 $60 $60
7-9
Lets look at this visually using
the time line:

Now lets add the maturity
value
1 2 3 4 5
$60 $60 $60 $60 $60
$1,000
7-10
So the investor receives the
principle ($1,000) and earned
interest ($60 per year) as payment
for loaning the company money.
7-11
Types of Bonds
1. Government Bonds
2. Zero Coupon Bonds
3. Floating-Rate Bonds
4. Catastrophe (Cat) Bonds
5. Income Bonds
6. Convertible Bond
7. Put Bond
8. Sukuk
9. James Bond
7-12
From the previous chapters on
the time value of money you
know how to bring back a
single payment (lump sum) and
an annuity.
To value a bond, just put both
pieces together!
7-13
Lets look at this visually
using the time line:
1. The annuity
2. The single payment (lump
sum)
$60 $60 $60 $60 $60
$1,000
1 2 3 4 5 0
7-14
Now bring each back into
present value terms:
First the annuity
Secondly, the lump sum
$60 $60 $60 $60 $60
$1,000
1 2 3 4 5 0
7-15
The Bond Pricing
Equation
t
t
r) (1
FV
r
r) (1
1
- 1
C Value Bond

Notice that r = the discount rate used to bring back

the future dollars.
This discount rate has a name in bonds:
The Yield to Maturity (YTM).
7-16
Your finance
calculator can
compute both
parts (the annuity
and the lump
sum)
simultaneously
7-17
A bond valuation example:

5 year bond
14% as the discount rate
(YTM)
6% coupon interest rate
$1,000 maturity value

5 years = N
14% = Discount rate (YTM)
$60 = Payment (PMT)
$1,000 = FV
PV = ?
-725.35
1st
2nd
TI BA II Plus
7-18
7-19
Student alert!
Keep it simple:

Once you have computed the
annuity amount, you can throw
away the coupon interest
rate. You need the dollar
amount of the annuity, not the
coupon interest rate itself.
7-20
Bond
Relationships
Key concept:

If the YTM is greater (>)than the coupon
interest rate, then the value of the bond will
be less than < $1,000.

Conversely, if the YTM is < the coupon
interest rate, then the value of the bond will
be > $1,000.
7-21
Bond Relationships
(using the previous
numerical example)
Discount
Rate
(YTM)
Coupon
Interest
Rate
Present
Value of
the Bond
6% 6% $1,000
4% 6% >$1,000

9% 6% <$1,000
7-22
Graphical Relationship
Between Price and Yield-to-
maturity (YTM)
B
o
n
d

P
r
i
c
e

Yield-to-maturity (YTM)
7-23
Bond Valuation
7-24
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
7-25
Fisher Effect Example
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%
An 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.
7-26
Term Structure of Interest
Rates
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
7-27
Upward-Sloping Yield Curve
7-28
Downward-Sloping Yield
Curve

7-29
Bond Ratings Investment
Quality
High Grade
Moodys Aaa and S&P AAA
capacity to pay is extremely strong
Moodys Aa and S&P AA capacity
to pay is very strong
Medium Grade
Moodys A and S&P A capacity to
pay is strong, but more susceptible
to changes in circumstances
Moodys Baa and S&P BBB
capacity to pay is adequate,
adverse conditions will have more
impact on the firms ability to pay
7-30
Bond Ratings -
Speculative
Low Grade
Moodys Ba and B
S&P BB and B
Considered possible that
the capacity to pay will
degenerate.
Very Low Grade
Moodys 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
7-31
1. A bonds value is the present value of
all expected future earnings.

2. As the risk of a bond goes up, the
price or value goes down.

3. The closer the bond is to maturity,
the more likely the value will
approach the par value.



What are the most
important topics of this
chapter?
7-32
7-33
Terminology
Bond
Par value (face value)
Coupon rate
Coupon payment
Maturity date
Yield or Yield to Maturity (YTM)


7-34
Formulas


t
t
r) (1
FV
r
r) (1
1
- 1
C Value Bond

Fisher Effect: (1 + R) = (1 + r)(1 + h)

Fisher Effect (approximation): R = r + h
7-35
Key Concepts and Skills
Bond definition
Computation of bonds value
Inverse relationship between YTM
and bond value
Impact of inflation on bonds
Term structure of interest rates