Interest Rates and Bond Valuation

T1 Bond Features

Bond - evidence of debt issued by a corporation or a

governmental body. A bond represents a loan made by

investors to the issuer. In return for his/her money, the
investor receives a legaI claim on future cash flows of
the borrower. The issuer promises to:
Make regular coupon payments every period until the

bond matures, and

Pay the face/par/maturity value of the bond when it

matures.
Default - since the abovementioned promises are

contractual obligations, an issuer who fails to keep

them is subject to legal action on behalf of the lenders
(bondholders).

T2 Bond Features (concluded)

If a bond has five years to maturity, an $80 annual coupon,

and a $1000 face value, its cash flows would look like this:
Time
Coupons
Face Value

$80

$80

$80

$80

$80
$ 1000
$______

How much is this bond worth? It depends on the level of

current market interest rates. If the going rate on bonds

like this one is 10%, then this bond is worth $924.18. Why?
Stay tuned.

T3 Bond Rates and Yields

Suppose a bond currently sells for $932.90. It pays an

annual coupon of $70, and it matures in 10 years. It has a

face value of $1000. What are its coupon rate, current yield,
and yield to maturity (YTM)?

1. The coupon rate (or just coupon) is the annual

dollar coupon expressed as a percentage of the face
value:
Coupon rate = $70 /$_____ = ___%

2. The current yield is the annual coupon divided by

the current market price of the bond:
Current yield = $___ /_____ = 7.5%

Under what conditions will the coupon rate and current

yield be the same? Stay tuned.

T4 Bond Rates and Yields (concluded)

The yield to maturity (or YTM) is the rate that makes the
price of the bond just equal to the present value of its future
cash flows. It is the unknown r in:

3.

$932.90 = $_______

[1 - 1/(1 + r)10]/r + $_______ /(1 + r)10

The only way to find the YTM is trial and error:

a. Try 10%: $70

[(1 - 1/(1.10)10]/.10 + $1000/(1.10)10 = $816

b. Try 9%: $70

[1 - 1/(1.09)10]/.09 + $1000/(1.09)10 = $872

c. Try 8%: $70

[1 - 1/(1.08)10]/.08 + $1000/(1.08)10 = $933

( ) The yield to maturity is 8%

T5 Valuing a Bond

Assume you have the following information.

Barnhart, Inc. bonds have a $1,000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The markets required return on similar bonds is 10%

1. Calculate the present value of the face value

= $1,000

.14864 = $148.64

2. Calculate the present value of the coupon payments

= $100

[1/1.1020 ] = $1,000

[1 - (1/1.1020)]/.10 = $100

8.5136 = $851.36

3. The value of each bond = $148.64 + 851.36 = $1,000

T6 Example: A Discount Bond

Assume you have the following information.

Barnhart, Inc. bonds have a $1,000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The markets required return on similar bonds is 12%

1. Calculate the present value of the face value

= $1,000

.10366 = $103.66

2. Calculate the present value of the coupon payments

= $100

[1/1.1220 ] = $1,000

[1 - (1/1.1020)]/.10 = $100

7.4694 = $746.94

3. The value of each bond = $103.66 + 746.94 = $850.60

T7 Example: A Premium Bond

Assume you have the following information.

Barnhart, Inc. bonds have a $1,000 face value
The promised annual coupon is $100
The bonds mature in 20 years
The markets required return on similar bonds is 8%

1. Calculate the present value of the face value

= $1,000

.21455 = $214.55

2. Calculate the present value of the coupon payments

= $100

[1/1.0820 ] = $1,000

[1 - (1/1.0820)]/.08 = $100

9.8181 = $981.81

3. The value of each bond = $214.55 + 981.81 = $1,196.36

Why do the bonds in this and the preceding example have prices

that are different from par?

T8 Bond Price Sensitivity to YTM

Bond price

$1,800

Coupon = $100
20 years to maturity
$1,000 face value

$1,600

Notice: bond prices and YTMs are

inversely related.

$1,400
$1,200
$1,000
$ 800
$ 600

Yields to maturity, YTM

4%

6%

8%

10%

12%

14%

16%

T9 Interest Rate Risk and Time to Maturity

Bond values ($)

2,000
$1,768.62
30-year bond

Time to Maturity

1,500

Interest rate
5%

1,000

$1,047.62

1-year bond
$916.67

500

1 year
$1,047.62

$1,768.62

10

1,000.00

1,000.00

15

956.52

671.70

20

916.67

502.11

$502.11

Interest rates (%)

5

10

15

30 years

20

Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities

T10 Bond Pricing Theorems

The following statements about bond pricing are always true.

1. Bond prices and market interest rates move in opposite

directions.

2. When a bonds coupon rate is (greater than / equal to /

less than) the markets required return, the bonds
market value will be (greater than / equal to / less than)
its par value.

3. Given two bonds identical but for maturity, the price of

the longer-term bond will change more than that of the
shorter-term bond, for a given change in market
interest rates.

4. Given two bonds identical but for coupon, the price of

the lower-coupon bond will change more than that of
the higher-coupon bond, for a given change in market
interest rates.

T11 Bond Ratings

Investment-Quality Bond Ratings

Standard & Poors

Moodys

Low Quality, speculative,

and/or Junk

High Grade

Medium Grade

Low Grade

Very Low Grade

AAA
Aaa

A
A

BB
Ba

CCC
Caa

AA
Aa

BBB
Baa

B
B

CC C
Ca C

D
C

T12 Sample Wall Street Journal Bond Quotation

New York Exchange Bonds
Quotations as of 4 p.m. Eastern Time
Thursday, January 30, 1997
CORPORATION BONDS
Volume, $29,351,000

Bonds
AMR 9s16
ATT 4 3/4 98
ATT 4 3/8 99
ATT 6s00
ATT 5 1/8 01
ATT 7 1/8 02
ATT 6 3/4 04
ATT 7 1/2 06
ATT 8 1/8 22
ATT 8 1/8 24
ATT 8.35s25
ATT 8 5/8 31

Cur
Yld

Vol

Close

8.1
4.8
4.6
6.1
5.4
7.0
6.8
7.2
8.0
8.0
8.1
8.2

19
5
30
5
118
50
15
10
338
398
110
26

110 1/2 +
98 1/8 96
98 1/4 95 1/2 +
102 1/4 +
99 3/4 104
+
102 1/8 +
101 3/4 +
103 1/4 105 7/8 +

Net
Chg.
7/8
3/8

...
5/8
3/4
1/8
1/4

...
...
1/4
...

Source: Reprinted by permission of The Wall Street Journal, 1997 Dow Jones
and Company, Inc., January 30, 1997. All Rights Reserved Worldwide.

T13 Sample Wall Street Journal U.S. Treasury Note and Bond Prices

GOVT. BONDS AND NOTES

Maturity
Rate Mo/Yr
111/8 Aug 03
117/8 Nov 03
5 7/8 Feb 04n
.
.
.
7 7/8 Feb 21
8 1/8 May 21
8 1/8 Aug 21
8
Nov 21
7 1/4 Aug 22
7 5/8 Nov 22
7 1/8 Feb 23
6 1/4 Aug 23

Bid
125:10
130:04
96:17
.
.
.
110:19
113:18
113:19
112:06
103:15
108:00
102:01
91:19

Asked
125:16
130:10
96:19
.
.
.
110:23
113:22
113:23
112:10
103:17
108:02
102:03
91:21

Chg.
-6
-7
-6
.
.
.
-13
-14
-14
-14
-14
-13
-13
-12

Ask
Yld.
6.44
6.46
6.46
.
.
.
6.95
6.95
6.96
6.95
6.95
6.95
6.95
6.94

Source: Reprinted by permission of The Wall Street Journal, 1996 Dow Jones
& Company, Inc. All Rights Reserved Worldwide.

T14 Inflation and Returns

Key issues:

What is the difference between a real and a

nominal return?

How can we convert from one to the other?

Example:

Suppose we have $1,000, and Diet Coke costs $2.00 per six
pack. We can buy 500 six packs. Now suppose the rate of
inflation is 5%, so that the price rises to $2.10 in one year.
We invest the $1,000 and it grows to $1,100 in one year.
Whats our return in dollars? In six packs?

T15 Inflation and Returns (continued)

A. Dollars. Our return is

($1100 - $1000)/$1000 = $100/$1000 = ________.

( ) The percentage increase in the amount of green

stuff is 10%; our return is 10%.
B. Six packs. We can buy $1100/$2.10 = ________

six packs, so our return is

(523.81 - 500)/500 = 23.81/500 = 4.76%
( ) The percentage increase in the amount of brown
stuff is 4.76%; our return is 4.76%.

T16 Inflation and Returns (continued)

Real versus nominal returns:

Your nominal return is the percentage change in

the amount of money you have.

Your real return is the percentage change in the

amount of stuff you can actually buy.

T17 Inflation and Returns (concluded)

The relationship between real and nominal returns is described by

the Fisher Effect. Let:

R

the nominal return

the real return

the inflation rate

According to the Fisher Effect:

1 + R = (1 + r) x (1 + h)
From the example, the real return is 4.76%; the nominal return is

10%, and the inflation rate is 5%:

(1 + R) = 1.10
(1 + r) x (1 + h) = 1.0476 x 1.05 = 1.10

T18 Solution to Problem

Reznik Corporation has bonds on the market with 10.5

years to maturity, a yield-to-maturity of 10 percent, and a

current price of $860. Coupon payments are semiannual.
What must the coupon rate be on the bonds?

Total number of coupon payments = 10.5

Yield-to-maturity per period
=
10% / 2 = 5%

Maturity value

=
F
$1,000

2 = 21

T19 Solution to Problem (concluded)

Substituting the known values into the bond pricing

equation:
Bond
Value

= C

[1 - 1/(1 + r)t] / r + F / (1 + r)t

$860

= C

[1 - 1/(1 + .05)21] / .05 + $1,000/(1.05)21

$860

= C

12.8211 + $358.94

= $39.08

So the annual coupon must be $39.08

2 = $78.16

and the coupon rate is $78.16 / $1,000 = .07816 .0782.

T20 Solution to Problem

Bond J has a 4% coupon and Bond K a 10% coupon. Both

have 10 years to maturity, make semiannual payments, and

have 9% YTMs. If market rates rise by 2%, what is the
percentage price change of these bonds? If rates fall by 2%?
What does this say about the risk of lower-coupon bonds?
Current Prices:
Bond J:
PV = $20 [1 - 1/(1.045)20]/.045 + $1,000/(1.045)20
= $______
Bond K:
PV = $50 [1 - 1/(1.045)20]/.045 + $1,000/(1.045)20
= $1065.04

T21 Solution to Problem (continued)

Prices if market rates rise by 2%:

Bond J:
PV
= $20 [1 - 1/(1.055)20]/.055 + $1,000/(1.055)20
= $581.74
Bond K:
PV
= $50 [1 - 1/(1.055)20]/.055 + $1,000/(1.055)20
= $______

T22 Solution to Problem (continued)

Prices if market rates fall by 2%:

Bond J:
PV

=
=

$20 [1 - 1/(1.035)20]/.035 + $1,000/(1.035)20

$786.82

Bond K:
PV

=
=

$50 [1 - 1/(1.035)20]/.035 + $1,000/(1.035)20

$1213.19

T23 Solution to Problem (concluded)

Percentage Changes in Bond Prices

Bond Prices and Market Rates

7%
9%
11%
_________________________________
Bond J
% chg.

$786.81
(+16.60%)

$674.80

$581.74
(___%)

Bond K
% chg.

$1,213.19
$1,065.04
$940.25
(___%)
(-11.72%)
_________________________________

The results above demonstrate that, all else equal, the

price of the lower-coupon bond changes more (in
percentage terms) than the price of the higher-coupon
bond when market rates change.