Chapter 7

CHAPTER 7: Interest Rates and Bond
Valuation
You lend a company $1,000. The company pays you interest regularly, and it repays the original loan
amount of $1,000 at some point in the future. When a corporation or government wishes to borrow money
from the public on a long-term basis, it usually does so by issuing or selling debt securities that are
generically called bonds.
Bond market tells you about the future. It is much bigger than the stock market
Bond: a long-term debt instrument indicating that a corporation has borrowed a certain amount of money
and promises to repay it in the future under clearly defined terms.
Mortgage-backed security: a bond that is backed by a pool of home mortgages. The
bondholders receive payments derived from payments on the underlying mortgages, and these payments
can be divided up in various ways to create different classes of bonds.
Bond values depend, in large part, on interest rates.
Coupon (level coupon bond): the stated interest payment made on a bond; the percentage of a bond’s par
value that will be paid annually, typically in 2 equal semiannual payments, as interest.
Face value (par value): the principal amount of a bond that is repaid at the end of the term; loan amount;
the amount borrowed by the company and the amount owed to the bond holder on the maturity date.
Par value bond: a bond that sells for its par value
Coupon rate: the annual coupon divided by the face value of a bond
Maturity: the specified date on which the principal amount of a bond is a paid; the time at which a bond
becomes due and the principal must be repaid
Main differences between debt and equity:

 Debt is not an ownership interest in the firm. Creditors generally don’t have voting power
 The corporation’s payment of interest on debt is considered a cost of doing business and is fully
tax deductible. Dividends paid to stockholders are not tax deductible
 Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of
the firm. This action can result in liquidation or reorganization, two of the possible consequences
of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This
possibility does not arise when equity is issued.
So, one reason that corporations try to create a debt security that is really equity is to obtain the tax
benefits of debt and the bankruptcy benefits of equity.
As a general rule, equity represents an ownership interest, and it is a residual claim. This means that
equity holders are paid after debt holders. As a result of this, the risks and benefits associated with
owning debt and equity are different
Determinants of interest rates
The discount rate (r): the opportunity cost of capital, i.e., the rate that could be earned on alternative
investments of equal
r d =r ¿ + IP+ MRP+ DRP+ LP
r d : required return on a debt security

¿
r : real rate of interest
IP: inflation premium (always affect everyone)
MRP: maturity risk premium
DRP: default risk premium
LP: liquidity premium
Risk premiums added to r* for different types of debt
IP MRP DRP LP
S-T Treasury x
L-T Treasury x x
S-T Corporate x x x
L-T Corporate x x x x
Long-term corporate has highest interest rate
Short-term treasury has lowest interest rate
Basic Bond Valuation

1
1− t
(1+ r) F
V B=C × + t
=Present value of the coupons+ Present value of the face amount
r (1+r )
V B: value of the bond at present time

C: coupon interest paid each period
T: number of years to maturity
F: face or par value in dollars
r: required return on a bond
Bond values and Yields

r =r d , par bond
r <r d ⇒V B < F : When r d rises, above the coupon rate, the bond’s value falls below par, so it sells at a
discount
r >r d ⇒V B > F : Price rises above par, and bond sells at a premium, if coupon > r d
r d rises  Price falls
Price = Par at maturity
Yield to maturity (YTM) (promised yield): the rate required in the market on a bond; rate of return
earned on a bond held to maturity
Price goes up: investors lose benefit, the companies gain benefit
Price goes down: investors gain benefit, the companies lose benefit
Price goes up more than price comes down
Interest Rate Risk

Interest rate risk: the risk that arises for bond owners from fluctuating interest rates  depends on how
sensitive its price is to interest rate changes  Sensitivity directly depends on 2 things: the time to
maturity and the coupon rate
- All other things being equal, the longer the time to maturity, the greater the interest rate risk
- All other things being equal, the lower the coupon rate, the greater the 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
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
Bond Ratings
2 leading bond-rating firms: Moody’s and Standard & Poor’s (S&P)
Debt ratings: an assessment of the creditworthiness of the corporate issuer
Based on how likely the firm is to default and the protection creditors have in the event of a default
Bond ratings are concerned only with the possibility of default

Bond ratings are designed to reflect the probability of a bond issue going into default
Crossover/5B bonds: bonds that are rated triple-B (or Baa) by 1 rating agency and double-B (or Ba) by
another, a “split rating”.
Fallen angels: Bonds that drop into junk territory (from investment grade to junk bond status)
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; that is, the pure time value of money
Tells us what nominal interest rates are on default-free, pure discount bonds of all maturities
Term structure: the relationship between time to maturity and yields, all else equal
Yield curve: graphical representation of the term structure

 Long-term rates > short-term rates  term structure is upward sloping (most common shape,
particularly in modern times) Normal  belief that rate of inflation will be higher
 Long-term rates < short-term rates  term structure is downward sloping Inverted  belief
that inflation will be falling in the future
 Rates increase at first, but then begin to decline as we look at long- and longer-term rates 
term structure is humped
Treasury yield curve: a plot of the yields on Treasury notes and bonds relative to maturity
Kinds of treasury securities:
 Default-free
 Treasury bills: shortest range of maturities (4,8,13,26,52 weeks)
 Taxable
 Treasury notes: middle range of maturities (2,3,5,7,10 years)
 Highly liquid
 Treasury bonds: long bonds (30 years)
Difference between term structure and Treasury yield curve: term structure is based on pure discount
bonds, whereas the yield curve is based on coupon bond yields.
Additional factors when looking at bonds issued:

 Credit risk: possibility of default.
o Default risk premium: the portion of a nominal interest rate or bond yield that
represents compensation for the possibility of default
o A bond’s yield is that it is calculated assuming that all the promised payments will be
made. As a result, it is really a promised yield, and it may or may not be what you will
earn. In particular, if the issuer defaults, your actual yield will be lower—probably much
lower. This fact is particularly important when it comes to junk bonds. Thanks to a clever
bit of marketing, such bonds are now commonly called high-yield bonds, which has a
much nicer ring to it; but now you recognize that these are really high promised yield
bonds
 Taxability premium: the portion of a nominal interest rate or bond yield that represents
compensation for unfavorable tax status
 Liquidity premium: the portion of a nominal interest rate or bond yield that represents
compensation for lack of liquidity
o Less liquid bonds have higher yields than more liquid bonds
What determines the shape of the term structure?

1. Real rate of interest: compensation investors demand for forgoing the use if their money; pure
value of money after adjusting for the effects of inflation
 Basic component
 Real rate is high  all interest rates will tend to be higher, and vice versa
 Doesn’t really determine the shape, instead, it mostly influences the overall level of interest rates
2. Rate of inflation
 Inflation premium: the portion of nominal interest rate that represent compensation for expected
future inflation
3. Interest rate risk
 Interest rate risk premium: the compensation investors demand for bearing interest rate risk
 The longer is the term to maturity, the greater is the interest rate risk, so the interest rate risk
premium increases with maturity
 Increases at a decreasing rate
Pure Expectations Hypothesis

PEH: contends that the shape of the yield curve depends on investor’s expectations about future interest
rates
1.B 2. D 3. E 4. C 5. A 6. D 7. C 8. D 9. E 10. B 11. E 12. A 13. C 14. C 15. A 16. D 17. E 18. D 19. B 20. C 21.
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37. B 38. E 39. C 40. B 41. B 42. C 43. A 44. B 45. C 46. A 47. E 48. D 49. C 50. C 51. A 52. B 53. D 54. D 55.
D 56. B 57. A 58. E 59. A 60. D 61. C 62. B 63. A 64. A 65. E 66. A 67. E 68. A 69. B 70. C 71. C 72. B 73. E
74. D
75. D 76. B 77. C 78. E 79. C 80. C 81. E 82. D 83. D 84. C 85. D 86. B 87. E 88. E 89. C 90. E 91. C 92. A 93.
B 94. B
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CHAPTER 7: Interest Rates and Bond

Bond values depend, in large part, on interest rates.

Main differences between debt and equity:

r d =r ¿ + IP+ MRP+ DRP+ LP

r d : required return on a debt security

Risk premiums added to r* for different types of debt

Basic Bond Valuation

V B: value of the bond at present time

Bond values and Yields

Interest Rate Risk

Reinvestment Rate Risk

Debt ratings: an assessment of the creditworthiness of the corporate issuer

Bond ratings are concerned only with the possibility of default

Determinants of Bond Yields

Yield curve: graphical representation of the term structure

Additional factors when looking at bonds issued:

What determines the shape of the term structure?

Pure Expectations Hypothesis

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