Ch 7.

Interest Rate and Bond

Valuation
 1. Goals
• To discuss the types of bonds
• To understand the terms of bonds
• To understand the types of risks to issuers
and investors
• To understand the changes of value
 I. Bonds
• A bond: a long term contract under which a
borrower agrees to make payments of interest
and principal, on specific dates, to the holders of
the bond.
• E.g) 3 year corporate bond with 6% coupon rate.

1. Characteristics of Bonds

(1)Face value or Par value: the stated face value

of the bond. Ex) $1000 or multiples of $1000
(2)Coupon rate: coupon payment / par value.
(usually coupon is paid semiannually)
• (3) Maturity: a specific date on which the
par value of the bond must be paid.
• (4) Yield to Maturity (YTM): the rate
required in the market on a bond.
2. Bond valuation:
• It is based on the cash flows to investors.
• Two types of cash flows: Coupon
payment & Par value
• Bond value = discounted coupon
payments (PV of annuity) + discounted
par value
Formula:

PV  C  [1  1 /(1  rd ) ] / rd  1000 /(1  rd )

t t

Yield To Maturity (YTM):

• The discount rate (rd) that will match current
market bond price with the above formula.
• Promised rate of return that investors will receive
if all promised payments are made.
• E.g) 5 year bond with 6% coupon rate.
Coupon is paid annually. If yield to
maturity is 10%, what is the bond price?
• 60*(1-1/(1.1^5))/0.1+1000/(1.1^5)

• E.g) 5 year bond with 6% coupon rate.

Coupon is paid semi-annually. If yield to
maturity is 10%, what is the bond price?
• 30*(1-1/(1.05^10))/0.05+1000/(1.05^10)
• E.g) 6 year bond with 5% coupon rate.
Currently, it is priced at $1100 in the
market. Coupon is paid annually. What is
yield to maturity of the bond?
Coupon rate and Bond price:
• (1) if the coupon rate equals to discount
(interest) rates, a bond price is par value
• (2) if the coupon rate > discount (interest)
rates, premium bond
• (3) if the coupon rate < discount (interest)
rates, discount bond
• (4) As maturities approach, the
premium/discount bonds’ prices approach
to par value
• Yield to Call: The rate of return earned on a
bond if it is called before its maturity date. (in
the formula, par value is replaced with call
price).
• Current Yield = annual coupon payment/
current bond price
• Bond valuation with semi-annual coupon rate.

3. Riskiness of Bonds

1) Interest rate risk:

• The risk of a decline in a bond’s price due to an
increase in interest rates.
• The longer the maturity of the bond, the greater
the interest rate risk.
• The lower coupon rate, the greater the interest
rate risk.

2) Reinvestment Rate Risk:

• The risk that a decline in interest rates will lead
to a decline in income from a bond portfolio.
• The shorter maturity, the higher the reinvestment
rate risk.
• 4.The indenture: written agreement
between the corporation and the lender
detailing terms of debt issue.
• Basic terms of bonds.
• Total amounts of bonds issued.
• Description of property used as security.
• Repayment arrangements.
• Call provisions.
• Protective covenants.
• 1) form of bond issue
• Registered form: the form of bond issue in
which the registrar of the company records
ownership of each bond; payment is made
directly to the owner of record.
• Bearer form: the form of bond issue in
which the bond is issued without record of
the owner’s name; payment is made to
whomever holds the bond.
• (2) Security: collateral (e.g. stocks) and
mortgages (e.g. real property) used to protect
the bondholder.
• - debenture: an unsecured debt, usually with a
maturity of 10 years or more.
• - note: an unsecured debt, usually with a
maturity under 10 years.
• - blank mortgage pledges all property owned by
the company.

• (3) Seniority: senior debt holders have priority to

receive money back.
• (4) Repayment: Bond may be repaid in part or in
entirety before maturity.
• - sinking fund: an account managed by the bond
trustee for early bond redemption – buying
bonds from market or call back bonds.
• (5) Call provision: A provision that gives the
issuer the right to redeem the bonds prior to the
maturity date. In this case, call premium
(difference between call price and par value) is
offered. But a bond is often not callable until
several years after issues (deferred call
provision). This bond are said to be “ call
protected bond.”
• “Make-whole” call: bond holders receive
approximately what the bond is worth if it is
called.
• (6) Protective covenant: a part of the indenture
limiting certain actions that might be taken
during the term of the loan, usually to protect the
lender’s interest.
• -negative covenant (thou shalt not): limiting or
prohibiting actions a company may take.
• -positive covenant (thou shalt): specifying
actions that a company agrees.
• 5. Bond rating
• Two leading bond-rating firms: Moody’s
and Standard &Poor’s.
• Bond rating only concerns the possibility of
default.
• Investment-graded rating is BBB. Bonds
below BBB is called junk bonds.
• 5B or split rating: one agency gives BBB
and another one gives BB.
• Fallen angels: bonds down-graded to junk
bonds.
4. Other types of bonds, depending on characters
• (1) Government bonds: No default and highly
liquid.
• - Treasury notes, bills and bonds – state tax
exemption.
• - Municipal bonds (state or local) – federal tax
exemption.
• (2) Zero Coupon Bonds: A bond that pays no
annual interest but is sold at a discount below
par. Any bond originally offered at a price
significantly below its par value is called an
original issue discount (OID) bond.
• - For tax purpose, the issuer would deduct
interest every year – implicit interest is
determined by amortizing the loan. Table 7.2.
• E.g) $1000 face value zero coupon bond.
5 year maturity is assumed. Semi-annual
coupon payment is assumed. YTM is 14%.
Initial price is $508.35. After one year,
bond value is $582.01 (=1000/(1.07^8)).
Implicit interest at the first year is $73.66
(=582.01-508.35). At the second year,
interest is 84.33 = 666.34 -582.01. here
(666.34=1000/(1.07^6)).
• (3) Floating rate bond: bonds whose coupon
payment will vary with market rates such as T-
Bill or Bond rates or inflation. e.g) Treasury
Inflation-Protected Securities (TIPS)-coupon
payment is adjusted with inflation.
• (4) Convertible bond: A bond that is
exchangeable for common stocks of issuing firm
at a fixed price.
• (5) Income bond: A bond that pays interest only
if the interest is earned.
• (6) Putable bond: a bond with provisions that
allow its investor to sell it back to the company
prior to maturity at a pre-arranged price.
• 7) warrant: the right to purchase shares of stock
in the company at a fixed price.
• 8) CoCo (coupon payment) or NoNo bonds (no
coupon payment)– contingent convertible,
putable, callable, subordinated bonds.
• 9) Sukuk – Islamic law does not permit charging
or paying riba or interests. Islamic bond (sukuk)
having partial ownership in a debt or asset has
been created. E.g) there is a binding promise to
repurchase a certain asset by the issuer at
maturity.
6. Bond market
• Bonds are traded in OTC (over the
counter) market.
• Trading information of corporate bonds is
reported to TRACE (trade report and
compliance engine).
www.finra.org/marketdata.
• Treasury price is quoted at the percentage
of face value or 32nd (Treasury)
• - bid price: a dealer is willing to pay for a
security.
• - asked price: a dealer is willing to take (sell) a
security.
• - bid-ask spread: difference between the bid
price and the asked price.
• - clean price: the price of bond net of accrued
interest. It is the price typically quoted.
• - dirty price: the price of a bond including
accrued interest, also known as the full or
invoice price. This is the price the buyer actually
pays.
• E.g) Suppose you buy a bond with a 12%
annual coupon rate. You actually pay
$1,080. Coupon is paid semiannually.
When you buy this bond, next coupon
payment is due in 4 months.
• Dirty price = $1,080.
• Clean price = 1,080 – 20 (=60*2/6)
•
• 7. Inflation and interest rate
• Inflation reduces the purchasing power of
currency. Quoted rate is nominal rate.

• 1) Fisher effect
• (1+R)=(1+r)*(1+h)
• R: nominal interest rate not adjusted for
inflation
• r: real interest rate adjusted for inflation
• H: inflation rate
• E.g) if nominal rate is 15.50%. Inflation
rate is 5%. What is the real rate?
• 1+0.1550=(1+r)*(1+0.05)
• r=10%

• 2) Present Value Calculation

• Discount nominal cash flows at a nominal
rate or discount real cash flows at a real
rate.
• E.g) You want to withdraw $25000 (purchasing
power) each year for next three years. Currently
inflation rate is 4%. What is the present value of
this withdrawal plan if a nominal rate is 10%?

- Discount nominal cash flows by a nominal rate.

• Considering a 4% inflation,
• C1 = 25000*1.04
• C2=25000*1.04^2 and C3=25000*1.04^3
• Using a 10% nominal rate, PV= C1/1.1 + C2/(1.1^2) +
C3/(1.1^3) = 67,111.65

• - Discounting real cash flows by a real discount rate.

Estimating a real interest rate.
• (1+0.1) =(1+r)*(1+0.04)
• r=0.0577

• PV = 25000/1.0577 +
25000/(1.0577^2)+25000/(1.0577^3)
• =25000*(1-1/(1+0.0577)^3)/0.0577
• =67111.65
• Using a growing annuity,
• PV = 26000*[1-(1.04/1.1)^3]/(0.1-0.04)
• = 67,111.65
 8. Determinants of bond yield
• Term structure of interest rates: relationship
between nominal interest rates on default-free,
pure discount securities and time to maturity.

• 1) Treasury yield curve

• = real interest rate + inflation premium + interest
rate risk premium
• (inflation premium: compensation for expected
future inflation. Interest rate risk premium:
compensation for bearing interest rate risk)
• 2) Corporate bond yield curve
• = real interest rate + inflation premium +
interest rate risk premium + default risk
premium + taxability premium + liquidity
premium
• (Default risk premium: compensation for
the possibility of default. Taxability
premium: compensation for unfavorable
tax status. Liquidity premium:
compensation for lack of liquidity)