Chapter 6

Interest Rates and Bond Valuation

Describe interest rate fundamentals, term

structure of interest rates, and risk
premium.
Know the important bond features and
bond types
Apply the basic valuation model to bonds
Understand bond values and why they
fluctuate
Understand bond ratings and what they
mean

Interest Rate

apply to debt instruments

Required Rate of Return

apply to equity instruments

Inflation

a rising trend in the prices

Deflation

a general trend of falling prices

Liquidity preference

a general tendency for investors to prefer shortterm (more liquid) securities.

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Real Rate of Interest

the equilibrium rate between supply of savings

and the demand for investment funds in a
perfect world.
change in purchasing power

Nominal Rate of Interest

Actual rate of interest charged by supplier of

funds
r = r* + IP +RP
RF
quoted rate of interest, change in purchasing
power and inflation
4

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

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 a
significant difference between the actual
Fisher Effect and the approximation.

The relationship between the maturity and rate

of return for bonds with similar levels of risk

Normal upward-sloping, long-term yields are higher than

short-term yields
Inverted downward-sloping, long-term yields are lower than
short-term yields
Flat Yield Curve

Theories of Term Structure

Expectation Theory
Yield curve reflects investor expectations about future
interest rates

Market Segmentation Theory

Market for loans is segmented on the basis of maturity
the supply and demand within each segment determine
its prevailing interest rates
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A bond is a legally binding agreement

between a borrower and a lender that
specifies the:

Par (face) value

Coupon rate
Coupon payment
Maturity Date

The yield to maturity is the required market

interest rate on the bond.

Contract/legal document that specifies both the

rights of the bondholders and the duties of the
issuing corporation.
Standard debt provisions that include:
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
Etc..
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Primary Principle:
VALUE OF FINANCIAL SECURITIES = PV OF
EXPECTED FUTURE CASH FLOWS

Bond value is, therefore, determined by the

present value of the coupon payments and
par value.
Interest rates are inversely related to
present (i.e., bond) values.

10

1
1
T

(1 r)
Bond Value C
r

F

T
(1 r)

11

Consider bond with as 6 3/8% coupon that expires in

December 2015.
The Par Value of the bond is RM1,000.
Coupon payments are made semi-annually (June 30
and December 31 for this particular bond).
Since the coupon rate is 6 3/8%, the payment is
RM31.875.
On January 1, 2011 the size and timing of cash flows
are:

31.875

31.875

31.875

1,031.875

6 / 30 / 15

12 / 31 / 15

1 / 1 / 11

6 / 30 / 11

12 / 31 / 11

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On January 1, 2011, the required yield is

5%.
The size and timing of the cash flows are:

31.875
1
1,000
PV
1

1,060.17

10
10
0.025
(1.025) (1.025)

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Now assume that the required yield is 11%.

How does this change the bonds price?

31.875
1
1,000
PV
1

825.69

10
10
0.055
(1.055) (1.055)

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When the YTM < coupon, the

Bond Value

1300

bond trades at a premium.

1200

1100

When the YTM = coupon, the bond trades at par.

1000

When the YTM > coupon, the bond trades

at a discount.

800
0

0.01

0.02

0.03

0.04

0.05

0.06
0.07
6 3/8

0.08

0.09

0.1

Discount Rate
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Bond prices and market interest rates

move in opposite directions.
When coupon rate = YTM, price = par
value
When coupon rate > YTM, price > par
value (premium bond)
When coupon rate < YTM, price < par
value (discount bond)

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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 longterm bonds.
High coupon rate bonds have more reinvestment rate risk than
low coupon rate bonds.

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Bond Value

Consider two otherwise identical bonds.

The long-maturity bond will have much more
volatility with respect to changes in the
discount rate.

Par
Short Maturity Bond

Discount Rate
Long Maturity
Bond

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Bond Value

Consider two otherwise identical bonds.

The low-coupon bond will have much
more volatility with respect to changes in
the discount rate.

Par
High Coupon Bond

Low Coupon Bond Discount Rate

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Current Yield (CY)

= annual coupon / price

Yield to Maturity (YTM)

the rate implied by the current bond price.

The expected rate of return if an investor were
to purchase the bond at current market price
and hold the bond until maturity

Yield to call (YTC)

The rate implied when the bond is called at the

call price.
20

Consider a bond with a 10% annual coupon

rate, 15 years to maturity, and a par value
of RM1,000. The current price is RM928.09.
Will the yield be more or less than 10%?

21

Suppose a bond with a 10% coupon rate

and semiannual coupons has a face value of
RM1,000, 20 years to maturity, and is
selling for RM1,197.93.
Is the YTM more or less than 10%?

What is the semi-annual coupon payment?

How many periods are there?

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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.

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Registered vs. Bearer Forms

Security
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

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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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High Grade
AAA capacity to pay is extremely strong
AA capacity to pay is very strong

Medium Grade
A capacity to pay is strong, but more
susceptible to changes in circumstances
BBB capacity to pay is adequate, adverse
conditions will have more impact on the
firms ability to pay
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Low Grade

BB
B
Considered speculative with respect to
capacity to pay.

Very Low Grade

C&D
Highly uncertain repayment and, in many
cases, already in default, with principal and
interest in arrears.
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Treasury Securities

Federal government debt

T-bills pure discount bonds with original maturity less
than one year
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

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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

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Information needed for valuing pure discount bonds:

Time to maturity (T) = Maturity date - todays date
Face value (F)
Discount rate (r)

T 1

Present value of a pure discount bond at time 0:

F
PV
T
(1 r )

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Find the value of a 30-year zero-coupon

bond with a RM1,000 par value and a YTM
of 6%.
0
0
0
1,000

29

0$ 0$0,1$

01 22930

30

F
1,000
PV

174.11
T
30
(1 r )
(1.06)
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Coupon rate floats depending on some index

value
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.

Coupons may have a collar the rate cannot

go above a specified ceiling or below a
specified floor.

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Income bonds
Convertible bonds
Put bonds
There are many other types of provisions
that can be added to a bond, and many
bonds have several provisions it is
important to recognize how these provisions
affect required returns.

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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 a small company or
municipal issues
Treasury securities are an exception

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Default risk premium remember bond

ratings
Taxability premium remember municipal
versus taxable
Liquidity premium bonds that have more
frequent trading will generally have lower
required returns (remember bid-ask
spreads)
Anything else that affects the risk of the
cash flows to the bondholders will affect the
required returns.
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Debt

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

Equity
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 cannot
go bankrupt
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