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Chapter 6: Interest Rates and Bond Valuation





Overview
This chapter begins with a thorough discussion of interest rates, yield curves, and their
relationship to required returns. Features of the major types of bond issues are presented along
with their legal issues, risk characteristics, and indenture convents. The chapter then introduces
students to the important concept of valuation and demonstrates the impact of cash flows, timing,
and risk on value. It explains models for valuing bonds and the calculation of yield-to-maturity
using either the trial-and-error approach or the approximate yield formula. Students learn how
interest rates may affect their ability to borrow and expand business operations or assets under
personal control.


Bonds and Bond Valuation

Bonds are long-term IOUs, usually interest-only loans (interest is paid by the borrower every
period with the principal repaid at the end of the loan). Bonds pay coupons which are the regular
interest payments (if fixed amount level coupon). The face or par value principal, amount
repaid at the end of the loan is generally $1,000 per bond. Coupon rate is the interest rate per
year quoted as a percent of face value.

The cash flows from a bond are the coupons and the face value. The value of a bond (market
price) is the present value of the expected cash flows discounted at the market rate of interest.

Yield to maturity (YTM) the required market rate or rate that makes the discounted cash flows
from a bond equal to the bonds market price.

Most corporate bonds are issued in denominations of $1,000 with maturities of 10 to 30 years.
The stated interest rate on a bond represents the percentage of the bonds par value that will be
paid out annually, although the actual payments may be divided up and made quarterly or
semiannually.

Both bond indentures and trustees are means of protecting the bondholders. The bond indenture
is a complex and lengthy legal document stating the conditions under which a bond is issued.
The trustee may be a paid individual, corporation, or commercial bank trust department that acts
as a third-party watch dog on behalf of the bondholders to ensure that the issuer does not
default on its contractual commitment to the bondholders.



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Example 1: Suppose Wilhite, Co. issues $1,000 par bonds with 20 years to maturity. The annual
coupon is 11 percent. Similar bonds have a yield to maturity of 11%.

Bond value = PV of coupons + PV of face value
Coupon Amount which is also known as PMT = coupon rate * face value = .11 * 1000 = $110

Remember coupons are identical amounts paid at constant interval therefore they are nothing but
Annuities.
From the previous chapter you know how to calculate PV of ordinary annuity. You can use
mathematical equation or financial calculator to estimate PV of an ordinary annuity.

General Expression for the value of a bond:

Bond value = present value of coupons + present value of par
Bond value (P
0
) = C[1 1/(1+i)
n
] / r + FV / (1+i)
n


C is the dollar amount of interest = coupon rate * face value = .11 * 1000 = $110
Bond value = 110[1 1/ (1.11)
20
] / .11 + 1000 / (1.11)
20

Bond value = 875.97 + 124.03 = $1000

or

20 press N
11 press I/Y
110 press +|- then press PMT
1000 press +|- then press FV
CPT PV and the answer is 1000.

A word of Caution: Remember calculator is a machine. If input(s) is (are) positive then it will
give output as negative. Also to make sure if amounts are occurring in the future then all the
future amounts should have same sign. For example, in the previous example, we are expecting
to receive $110 per year for 20 years in the future and also we are expecting to receive $1000
face value in the future. Both these amounts are going to occur in the future and thats why I
used +|- sign after I typed in the amounts.

IMPORTANT: Bonds Par Value also knows as Face Vale or Maturity Value is $1,000 unless
otherwise stated something else.

There can be three types of Bonds in terms of their market values:
1) Par Bond 2) Premium Bond 3) Discount Bond.

Condition Effect Classification
If YTM > Coupon Rate Price < Face Value Discount Bond
If YTM = Coupon Rate Price = Face Value Par Bond
If YTM < Coupon Rate Price > Face Value Premium Bond
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Since in the above example (Example 1) the coupon rate and the yield are the same, the price
should equal face value.

Discount bond is a bond that sells for less than its par value. This is the case when the YTM is
greater than the coupon rate.

Example 2: Suppose the YTM on bonds similar to that of Wilhite Co. (see the previous
example) is 13% instead of 11%. What is the bond price?

Bond price = 110[1 1/ (1.13)
20
] / .13 + 1000/(1.13)
20

Bond price = 772.72 + 86.78 = 859.50

Or

20 press N
13 press I/Y
110 press +|- then press PMT
1000 press +|- then press FV
CPT PV and the answer is 859.50.

Points to understand:

1. As you may notice, as YTM is increased the PV is decreased. Recall form the previous
chapter, Price (PV) is indirectly related to the interest rate (i)).

2. YTM which is 13% is more than the coupon rate of 11%. In other words, based on risk,
this bond should give investors 13% (also known as required rate of return by investors),
but this bond is only giving 11% coupon rate. In other words, investors will not be happy
and they will buy this type of bond only if the issuing firm gives them some discount. If
we go by the classification (mentions above in the table), YTM > Coupon rate => Bond
must be a discount bond.


The coupon rate and the face value are fixed by the bond indenture when the bond is issued
(except for floating-rate bonds). Therefore, the expected cash flows dont change during the life
of the bond. However, the bond price will change as interest rates (required rate of return)
change and as the bond approaches maturity.

Premium bond is a bond that sells for more than its par value. This is the case when the YTM is
less than the coupon rate.



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Example 3: Consider the Wilhite bond in the previous examples. Suppose that the yield on
bonds of similar risk and maturity is 9% instead of 11%. What will the bonds sell for?

Bond value = 110[1 1/ (1.09)
20
] / .09 + 1000/(1.09)
20

Bond value = 1004.14 + 178.43 = $1,182.57

Semiannual coupons coupons are paid twice a year. Everything is quoted on an annual basis
so you divide the annual coupon and the yield by two and multiply the number of years by 2.

Example 4: A $1000 bond with an 8% coupon rate, with coupons paid every 6 months, is
maturing in 10 years. If the quoted YTM is 10%, what is the bond price?

C = (.08/2) * (1000) = $40 every six months; i = .10/2 = .05 or 5% every six months; n = 10*2 =
20 periods.

Bond value = 40* [1 1/(1.05)
20
] / .05 + 1000 / (1.05)
20

Bond value = 498.49 + 376.89 = $875.38

20 press N
5 press I/Y
40 press +|- then press PMT
1000 press +|- then press FV
CPT PV and the answer is 875.38.

Interest Rate Risk

Interest rate risk changes in bond prices due to fluctuating interest rates.

All else equal, the longer the time to maturity, the greater the interest rate risk. It takes longer to
receive the large cash flow at the end and we know from previous chapters that the present value
decreases as time increases.

All else equal, the lower the coupon rate, the greater the interest rate risk. The par value makes
up a larger portion of the bonds cash flows and it comes at the end.

Finding the Yield to Maturity: More Trial and Error

It is a trial and error process to find the YTM via the general formula mentioned below.

Bond value (P
0
) = C*[1 1/ (1+i)
n
] / r + FV / (1+i)
n


Knowing if a bond sells at a discount (YTM > coupon rate) or premium (YTM < coupon rate) is
a help, but using a financial calculator is by far the quickest, easiest and most accurate method.

Students should understand that finding the yield to maturity by using trial and error is a
tedious process.
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Example 5: A 10-year, 10% coupon bond sells for $1,100. What is the required rate of return
(yield to maturity) of this bond?

Use the financial calculator to solve this problem:

PV -1100
FV 1000
N 10
PMT 100
CPT I/Y the answer is 8.48%.

b) What if interest (coupon) is paid semi-annually?

Dont forget that we modify YTM (i), Coupon rate (c), and time period (n) when bond pays
coupon non-annually.
In other words, YTM and Coupon rate are divided by that frequency and N is multiplied by that
frequency.

Since it is a semi-annual bond therefore frequency of payments will be 2 (twice a year).

N = 10*2; coupon rate = 10% /2 = 5%.

PV -1100
FV 1000
N 20
PMT 50
CPT I/Y the answer is 4.25%, but it is semi-annual YTM therefore to get annual YTM we
multiply 4.25% by 2 and the answer is 8.50%.


c) What if interest (coupon) is paid quarterly?


PV -1100
FV 1000
N 40
PMT 25
CPT I/Y the answer is 2.13%, but it is quarterly YTM therefore to get annual YTM we
multiply 2.13% by 4 and the answer is 8.51%.

YTM must be estimated on annual basis.

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Example 6: A 10-year, 8% YTM bond sells for $1,050. What is the coupon rate of this bond?

10 press N
8 press I/Y
1050 +|- press PV
1000 press FV
CPT PMT and the answer is 87.45
But the question is asking you to estimate the coupon rate.

Coupon Amount = Coupon Rate * Face Value

Coupon Rate = PMT / FV = 87.45 / 1000 = 0.08745 or 8.75%.

b) What if coupons are paid semi-annually?


20 press N
4 press I/Y
1050 +|- press PV
1000 press FV

CPT PMT and the answer is 43.68

Coupon Amount = Coupon Rate * Face Value

Coupon Rate = PMT / FV = 43.67 / 1000 = 0.04368 or 4.368%. But this is semi-annual coupon
rate therefore annual coupon rate is 0.04368 * 2 = 0.08736 or 8.74%.

Bond Features

Bond strictly speaking, secured debt; but used to describe all long-term debt.

Indenture written agreement between issuer and creditors detailing terms of borrowing. (Also
deed of trust.) The indenture includes the following provisions:

-Bond terms
-The total face amount of bonds issued
-A description of any property used as security
-The repayment arrangements
-Any call provisions
-Any protective covenants

Registered form ownership is recorded, payment made directly to owner
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Bearer form payment is made to holder (bearer) of bond

Security debt classified by collateral and mortgage

Collateral strictly speaking, pledged securities

Mortgage securities secured by mortgage on real property

Debenture an unsecured debt with 10 or more years to maturity

Note a debenture with 10 years or less maturity

Seniority order of precedence of claims

Subordinated debenture of lower priority than senior debt

Repayment early repayment in some form is typical

Sinking fund an account managed by the bond trustee for early redemption

Call provision allows company to call or repurchase part or all of issue

Call premium amount by which the call price exceeds the par value

Deferred call firm cannot call bonds for a designated period

Call protected the description of a bond during the period it cant be called

Long-term lenders include restrictive covenants in loan agreements in order to place certain
operating and/or financial constraints on the borrower. These constraints are intended to assure
the lender that the borrowing firm will maintain a specified financial condition and managerial
structure during the term of the loan. Since the lender is committing funds for a long period of
time, he seeks to protect himself against adverse financial developments that may affect the
borrower. The restrictive provisions (also called negative covenants) differ from the so-called
standard debt provisions in that they place certain constraints on the firms operations, whereas
the standard provisions (also called affirmative covenants) require the firm to operate in a
respectable and businesslike manner. Standard provisions include such requirements as
providing audited financial statements on a regular schedule, paying taxes and liabilities when
due, maintaining all facilities in good working order, and keeping accounting records in
accordance with generally accepted accounting procedures (GAAP). Violation of any of the
standard or restrictive loan provisions gives the lender the right to demand immediate repayment
of both accrued interest and principal of the loan. However, the lender does not normally demand
immediate repayment but instead evaluates the situation in order to determine if the violation is
serious enough to jeopardize the loan. The lenders options are: Waive the violation, waive the
violation and renegotiate terms of the original agreement, or demand repayment.
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Protective covenants indenture conditions that limit the actions of firms
Negative covenant thou shalt not sell major assets, etc.
Positive covenant thou shalt keep working capital at or above $X, etc.



Government Bonds

Long-term debt instruments issued by a governmental entity. Treasury bonds are bonds issued by
a federal government; a state or local government issues municipal bonds. In the US, Treasuries
are exempt from state taxation and munis are exempt from federal taxation.

Zero coupon bonds are bonds that are offered at deep discounts because there are no periodic
coupon payments. Although, no cash interest is paid, firms deduct the implicit interest while
holders report it as income. Interest expense equals the periodic change in the amortized value of
the bond.

Floating-Rate Bonds

Floating-rate bonds coupon payments adjust periodically according to an index. Also,

-put provision holder can sell back to issuer at par
-collar - coupon rate has a floor and a ceiling

Other Types of Bonds

Income bonds coupon is paid if income is sufficient
Convertible bonds can be traded for a fixed number of shares of stock
Put bonds shareholders can redeem for par at their discretion

Inflation and Interest Rates

Real versus Nominal Rates

Nominal rates rates that have not been adjusted for inflation
Real rates rates that have been adjusted for inflation

The Fisher Effect

The Fisher Effect is a theoretical relationship between nominal returns,
real returns and the expected inflation rate. Let R be the nominal rate, r the
real rate and h the expected inflation rate; then,

(1 + R) = (1 + r) * (1 + h)
R is the nominal rate, r is the real rate and h is inflation.
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A reasonable approximation, when expected inflation is relatively low, is
R = r + h.

A definition whereby the real rate can be found by deflating the nominal
rate by the inflation rate: r = [(1 + R) / (1 + h)] 1.

Example 6: The real rate in the economy is 4% and expected inflation rate is 3%. What would
be the nominal interest rate based on the information provided above?

Nominal rate (R) ?

(1 + R) = (1+.04) * (1+.03)

R = [(1+.04) * (1+.03)] -1 = 1.0712 1 = 0.0712 or 7.12%.

Example 7: The real rate in the economy is 4% and government rate is 6.5%. What will be
expected inflation rate based on the information provided above?

1.065 = 1.04 * (1+h) => 1+ h = 1.065 / 1.04

1+ h = 1.024 => h = 0.024 or 2.4%.

Example 8: The inflation rate in the economy is 3% and government rate is 8%. What will be
expected real rate of return based on the information provided above?

1.08 = (1+r) * (1+.03) => 1+ r = 1.08 / 1.03

1+ r = 1.0485 => r = 0.0485 or 4.85%.

Determinants of Bond Yields

The Term Structure of Interest Rates

Term structure of interest rates the relationship between nominal interest
rates on default-free, pure discount securities and time to maturity
Inflation premium portion of the nominal rate that is compensation for
expected inflation
Interest rate risk premium compensation for bearing interest rate risk

Short-term borrowing is normally less expensive than long-term borrowing due to the greater
uncertainty associated with longer maturity loans. The major factors affecting the cost of long-
term debt (or the interest rate), in addition to loan maturity, are loan size, borrower risk, and the
basic cost of money.

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If a bond has a conversion feature, the bondholders have the option of converting the bond into a
certain number of shares of stock within a certain period of time. A call feature gives the issuer
the opportunity to repurchase, or call, bonds at a stated price prior to maturity. It provides extra
compensation to bondholders for the potential opportunity losses that would result if the bond
were called due to declining interest rates. This feature allows the issuer to retire outstanding
debt prior to maturity and, in the case of convertibles, to force conversion. Stock purchase
warrants, which are sometimes included as part of a bond issue, give the holder the right to
purchase a certain number of shares of common stock at a specified price.

Bonds are rated by independent rating agencies such as Moodys and Standard & Poors with
respect to their overall quality, as measured by the safety of repayment of principal and interest.
Ratings are the result of detailed financial ratio and cash flow analyses of the issuing firm. The
bond rating affects the rate of return on the bond. The higher the rating, the less risk and the
lower the rate.

Current yields are calculated by dividing the annual interest payment by the current price. Bonds
are quoted in percentage of par terms, to the thousandths place. Hence, corporate bond prices are
effectively quoted in dollars and cents. A quote of 98.621 means the bond is priced at 98.621%
of par, or $986.21.
Bonds are rated by independent rating agencies such as Moodys and Standard & Poors with
respect to their overall quality, as measured by the safety of repayment of principal and interest.
Ratings are the result of detailed financial ratio and cash flow analyses of the issuing firm. The
bond rating affects the rate of return on the bond. The higher the rating, the less risk and the
lower the yield.

Eurobonds are bonds issued by an international borrower and sold to investors in countries with
currencies other than that in which the bond is denominated. For example, a dollar-denominated
Eurobond issued by an American corporation can be sold to French, German, Swiss, or Japanese
investors. A foreign bond, on the other hand, is issued by a foreign borrower in a host countrys
capital market and denominated in the host currency. An example is a French-franc denominated
bond issued in France by an English company.

Review of Bond Pricing and YTM Calculation

The value of any asset is the PV of future cash flows expected from the asset over the relevant
time period. The three key inputs in the valuation process are cash flows, the required rate of
return, and the timing of cash flows. The equation for value is:

P
0
=

()
+

()
+

()


(IMPORTANT: In the above equation, individual terms are CF
1
/ (1+i)
1
, CF
2
/ (1+i)
2
, CF
n
/
(1+i)
n
. In other words, 1, 2, and n in the denominator terms are the exponential terms. Somehow,
in the equation they look like a multiplicative terms.)

where:
P
0
= value of the asset at time zero
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CF
n
= cash flow expected at the end of year t
i = appropriate required return (discount rate)
n = relevant time period

The basic bond valuation equation for a bond that pays annual interest is:

P
0
= C*[1 1/(1 + i)
n
] / i +

()


(IMPORTANT: In the above equation, the last term is FV / (1+i)
n
. In other words, n is the
exponential term. Somehow, n in the equation n seems like a multiplicative term.)

where:

P
0
= value of a bond that pays annual interest
C = interest payment = coupon rate * face value
n = years to maturity
i = required return on the bond

To find the value of bonds paying interest semiannually, the basic bond valuation equation is
adjusted as follows to account for the more frequent payment of interest:
a. The annual interest must be converted to semiannual interest by dividing by two.
b. The number of years to maturity must be multiplied by two.
c. The required return must be converted to a semiannual rate by dividing it by two.

A bond sells at a discount when the required return exceeds the coupon rate. A bond sells at a
premium when the required return is less than the coupon rate. A bond sells at par value when
the required return equals the coupon rate. The coupon rate is generally a fixed rate of interest,
whereas the required return fluctuates with shifts in the cost of long-term funds due to economic
conditions and/or risk of the issuing firm. The disparity between the required rate and the coupon
rate will cause the bond to be sold at a discount or premium.

The yield-to-maturity (YTM) on a bond is the rate investors earn if they buy the bond at a specific
price and hold it until maturity. The YTM can be found precisely by using a hand-held financial
calculator and using the time value functions. Enter the B0 as the PV, and the i as the annual
payment, and the n as the number of periods until maturity. Have the calculator solve for the
interest rate. This interest value is the YTM. Many calculators are already programmed to solve
for the internal rate of return (IRR). Using this feature will also obtain the YTM since the YTM
and IRR are determined the same way. Spreadsheets include formula for computing the yield to
maturity.

The trial-and-error approach to calculating the YTM requires finding the value of the bond at
various rates to determine the rate causing the calculated bond value to equal its current value.