CHAPTER 7

INTEREST RATES AND BOND VALUATION

Copyright © 2016 by McGraw-Hill Education. All rights reserved

BOND DEFINITIONS

• Bond

• Par value (face value)

• Coupon rate

• Coupon payment

• Maturity date

• Yield or Yield to maturity

7-2

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PRESENT VALUE OF CASH FLOWS
AS RATES CHANGE
• Bond Value = PV of coupons + PV of par
• Bond Value = PV of annuity + PV of lump
sum

• As interest rates increase, present values

decrease

• So, as interest rates increase, bond prices

decrease and vice versa

7-3

VALUING A DISCOUNT BOND

WITH ANNUAL COUPONS
• Consider a bond with a coupon rate of 10%
and annual coupons. The par value is $1,000,
and the bond has 5 years to maturity. The
yield to maturity is 11%. What is the value of
the bond?

 Using the formula:

• B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.11)5] / .11 + 1,000 / (1.11)5
• B = 369.59 + 593.45 = 963.04

 Using the calculator:

• N = 5; I/Y = 11; PMT = 100; FV = 1,000
• CPT PV = -963.04
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 VALUING A PREMIUM BOND
WITH ANNUAL COUPONS
• Suppose you are reviewing a bond that has a
10% annual coupon and a face value of
$1000. There are 20 years to maturity, and the
yield to maturity is 8%. What is the price of this
bond?

 Using the formula:

• B = PV of annuity + PV of lump sum
• B = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20
• B = 981.81 + 214.55 = 1196.36

 Using the calculator:

• N = 20; I/Y = 8; PMT = 100; FV = 1000
• CPT PV = -1,196.36
7-5

GRAPHICAL RELATIONSHIP BETWEEN

PRICE AND YIELD-TO-MATURITY (YTM)

1500
Bond Price, in dollars

1400
1300
1200
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
Yield-to-Maturity Yield-to-maturity
(YTM) (YTM)
Bond characteristics:
10 year maturity, 8% coupon rate, $1,000 par value
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 BOND PRICES: RELATIONSHIP
BETWEEN COUPON AND YIELD
• If YTM = coupon rate, then par value = bond
price

• If YTM > coupon rate, then par value > bond

price
 Why? The discount provides yield above coupon
rate
 Price below par value, called a discount bond

• If YTM < coupon rate, then par value < bond

price
 Why? Higher coupon rate causes value above par
 Price above par value, called a premium bond 7-7

THE BOND PRICING EQUATION

 1 
1 -
 (1  r) t  FV
Bond Value  C  
 (1  r)
t
 r
 

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4
 EXAMPLE 7.1

• If an ordinary bond has a coupon rate of

14 percent, then the owner will get a total
of $140 per year, but this $140 will come in
two payments of $70 each. The yield to
maturity is quoted at 16 percent. The bond
matures in seven years.

• Note: Bond yields are quoted like APRs;

the quoted rate is equal to the actual rate
per period multiplied by the number of
periods.

7-9

EXAMPLE 7.1
 How many coupon payments are there?

 What is the semiannual coupon payment?

 What is the semiannual yield?

 What is the bond price?

 B = 70[1 – 1/(1.08)14] / .08 + 1,000 / (1.08)14 =

917.56

 Or PMT = 70; N = 14; I/Y = 8; FV = 1,000; CPT

PV = -917.56

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5
 INTEREST RATE RISK
• 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 long-term bonds
 High coupon rate bonds have more reinvestment
rate risk than low coupon rate bonds

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FIGURE 7.2

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COMPUTING YIELD TO MATURITY
• Yield to Maturity (YTM) is the rate implied by
the current bond price

• Finding the YTM requires trial and error if you

do not have a financial calculator and is
similar to the process for finding r with an
annuity

• If you have a financial calculator, enter N,

PV, PMT, and FV, remembering the sign
convention (PMT and FV need to have the
same sign, PV the opposite sign)
7-13

YTM WITH ANNUAL COUPONS

• Consider a bond with a 10% annual coupon

rate, 15 years to maturity and a par value of
$1,000. The current price is $928.09.

 Will the yield be more or less than 10%?

 N = 15; PV = -928.09; FV = 1,000; PMT = 100; CPT I/Y

= 11%

7-14

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 YTM WITH SEMIANNUAL
COUPONS
• Suppose a bond with a 10% coupon rate
and semiannual coupons, has a face value
of $1,000, 20 years to maturity and is selling
for $1,197.93.
 Is the YTM more or less than 10%?
 What is the semiannual coupon payment?
 How many periods are there?
 N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y
= 4% (Is this the YTM?)
 YTM = 4%* 2 = 8%
7-15

TABLE 7.1

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 CURRENT YIELD VS. YIELD TO
MATURITY
• Current Yield = annual coupon / price
• Yield to maturity = current yield + capital gains yield
• Example: 10% coupon bond, with semiannual
coupons, face value of 1,000, 20 years to maturity,
$1,197.93 price
 Current yield = 100 / 1,197.93 = .0835 = 8.35%

 Price in one year, assuming no change in YTM = 1,193.68

 Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 = -.0035

= -.35%

 YTM = 8.35 - .35 = 8%, which is the same YTM computed

earlier
7-17

BOND PRICING THEOREMS

• 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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 BOND PRICES WITH A
SPREADSHEET
• There is a specific formula for finding
bond prices on a spreadsheet
 PRICE(Settlement,Maturity,Rate,Yld,Redemption,
Frequency,Basis)
 YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
 Settlement and maturity need to be actual dates
 The redemption and Pr need to be input as % of
par value

7-19

DIFFERENCES BETWEEN
DEBT AND EQUITY
• Debt • Equity
 Not an ownership interest  Ownership interest
 Creditors do not have  Common stockholders
voting rights vote for the board of
 Interest is considered a directors and other issues
cost of doing business  Dividends are not
and is tax deductible considered a cost of
 Creditors have legal doing business and are
recourse if interest or not tax deductible
principal payments are  Dividends are not a
missed liability of the firm, and
 Excess debt can lead to stockholders have no
financial distress and legal recourse if
bankruptcy dividends are not paid
 An all equity firm can not
go bankrupt merely due
to debt since it has no
debt
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 BOND CHARACTERISTICS AND
REQUIRED RETURNS
• The coupon rate depends on the risk
characteristics of the bond when issued

7-21

BOND RATINGS –
INVESTMENT QUALITY
• High Grade
 Moody’s Aaa, S&P and Fitch AAA – capacity to
pay is extremely strong
 Moody’s Aa, S&P and Fitch AA – capacity to
pay is very strong

• Medium Grade
 Moody’s A, S&P and Fitch A – capacity to pay
is strong, but more susceptible to changes in
circumstances
 Moody’s Baa, S&P and Fitch BBB – capacity to
pay is adequate, adverse conditions will have
more impact on the firm’s ability to pay
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 BOND RATINGS –
SPECULATIVE GRADE
• Low Grade
 Moody’s Ba and B
 S&P and Fitch BB and B
 Considered possible that the capacity to pay
will degenerate.

• Very Low Grade

 Moody’s C (and below) and S&P and Fitch C
(and below)
• income bonds with no interest being paid,
or
• in default with principal and interest in
arrears
7-23

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
 Varying degrees of default risk, rated similar to
corporate debt
 Interest received is tax-exempt at the federal level
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 EXAMPLE 7.4

• A taxable 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?
• 8%(1 - .4) = 4.8%
• The after-tax return on the corporate bond is 4.8%,
compared to a 6% return on the municipal

 At what tax rate would you be indifferent

between the two bonds?
• 8%(1 – T) = 6%
• T = 25%

7-25

ZERO COUPON BONDS

• 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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 FLOATING-RATE BONDS
• 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

7-27

BOND MARKETS
• 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 small company
or municipal issues

• Treasury securities are an exception

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 WORK THE WEB EXAMPLE

• Bond quotes are available online

• One good site is FINRA’s Market Data

Center

• Click on the web surfer to go to the site

 Choose a company, enter it in the Issuer Name
bar, choose Corporate, and see what you can
find!

7-29

INFLATION AND INTEREST RATES

• Real rate of interest – change in

purchasing power

• Nominal rate of interest – quoted rate

of interest, change in actual number of
dollars

• The ex ante nominal rate of interest

includes our desired real rate of return
plus an adjustment for expected
inflation
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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
7-31

EXAMPLE 7.5
• 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 significant
difference between the actual Fisher Effect
and the approximation.

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 TERM STRUCTURE OF
INTEREST RATES
• Term structure is the relationship between
time to maturity and yields, all else equal

• It is important to recognize that we pull out

the effect of default risk, different coupons,
etc.

• 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
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