CHAPTER 7

I N T E R E S T R AT E S A N D B O N D V A L U AT I O N
 BOND FEATURES AND PRICES
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.

<Some terminology for Bond>

• Face value, or par value, is the principal amount of a bond that is paid off at the
end of the loan, the maturity.
• Maturity is the specified date on which the principal amount of a bond is paid.
• Coupon is the stated interest payment made on a bond’s face value.
• Coupon rate is the interest rate paid on a bond’s face value as coupon.
• Yield to maturity (YTM), or yield is the interest rate required or the discount rate
on a bond in the market.

7-2
 BOND VALUES AND YIELDS
Over time, interest rates change in the marketplace, but the cash flows from
a bond remain the same; as a result, the value of the bond will fluctuate.
• When interest rates rise, the present value of the bond’s remaining cash
flows declines, and the bond is worth less.
• When interest rates fall, the bond is worth more.
To find the value of a bond at a particular point in time, we need the following
pieces of information:
• Number of periods remaining until maturity.
• Face value.
• Coupon.
• Yield to maturity (YTM

7-3
 BOND VALUES AND YIELDS:
AN EXAMPLE (PAR VALUE BOND) 1

Suppose Xanth Co. were to issue a bond with 10 years to

maturity. The Xanth bond has an annual coupon of $80. Similar
bonds have a yield to maturity of 8 percent. In 10 years, Xanth
will pay $1,000 to the bond owner.
What would this bond sell for?

PV of the Face value = $1000/1.0810 = $1,000/2.1589

= $463.19.

© McGraw Hill 7-4

 BOND VALUES AND YIELDS:
AN EXAMPLE (PAR VALUE BOND) 2

• PV of the couponis:
Annuity present value = $80  (1 − 1 1.0810 ) .08
= $80  (1 − 1 2.1589 ) .08
= $80  6.7101
= $536.81.

• Total bond value = $463.19 + 536.81 = $1,000.

This bond sells for exactly the face value, so it is a par value
bond.

© McGraw Hill 7-5

 BOND VALUES AND YIELDS:
AN EXAMPLE (DISCOUNT BOND) 1

Suppose a year has gone by. The Xanth bond now has nine
years to maturity. If the interest rate in the market has risen to
10%, what will the bond be worth?
Present value of the $1,000 paid in nine years at 10 percent is:
• Pr esent value = $1,000 1.10 = $1,000 2.3579 = $424.10.
9

Bond now offers $80 per year for nine years; the present value
of this annuity stream at 10% is:
Annuity present value = $80  (1 − 1 1.109 ) .10
= $80  (1 − 1 2.3579 ) .10
= $80  5.7590
© McGraw Hill
= $460.70.
7-6
 BOND VALUES AND YIELDS:
AN EXAMPLE (DISCOUNT BOND) 2

Add the values for the two parts together to get the bond’s
value:
• Total bond value = $424.10 + 460.72 = $884.82.
This bond sells for less than face value, so it is a discount bond.

7-7
 BOND VALUES AND YIELDS:
AN EXAMPLE (PREMIUM BOND) 1

What would the Xanth bond sell for if interest rates had
dropped by 2% instead of rising by 2%? In other words, assume
the bond has a coupon rate of 8% when the market rate is now
only 6%.
The present value of the $1,000 face amount is:
• Present value = $1,000/1.069 = $1,000/1.6895 = $591.90.

• The present value of the coupon stream is:

Annuity present value = $80  (1 − 1 1.069 ) .06
= $80  (1 − 1 1.6895 ) .06
= $80  6.8017
= $544.14.
7-8
 BOND VALUES AND YIELDS:
AN EXAMPLE (PREMIUM BOND) 2

Add the values for the two parts together to get the bond’s
value:
• Total bond value = $591.90 + 544.14 = $1,136.03.
This bond sells for more than face value, so it is a premium
bond.

7-9
 GENERAL EXPRESSION FOR VALUE OF A
BOND
If a bond has the following:
• A face value of F paid at maturity;
• A coupon of C paid per period;
• t periods to maturity; and
• A yield of r per period.
• Its value is calculated as follows:

Bond value = C  1 − 1 (1 + r ) r + F (1 + r )
 
t t

 
Present value Present value
Bond value = +
of the coupons of the face amount
7-10
 SEMIANNUAL COUPONS 1

In practice, bonds issued in the United States usually make coupon payments
twice a year. So, 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. Suppose we are examining such a bond. The yield to
maturity is quoted at 16 percent.
Bond yields are quoted like APRs; the quoted rate is equal to the
actual rate per period multiplied by the number of periods. In this case, with
a 16 percent quoted yield and semiannual payments, the true yield is 8
percent per six months. The bond matures in seven years. What is the bond’s
price? What is the effective annual yield on this bond?
Based on our discussion, we know the bond will sell at a discount
because it has a coupon rate of 7 percent every six months when the market
requires 8 percent every six months. So, if our answer exceeds $1,000, we
know we have made a mistake.
© McGraw Hill 7-11
 SEMIANNUAL COUPONS 2

To get the exact price, we first calculate the present value of the
bond’s face value of $1,000 paid in seven years. This seven-year period has
14 periods of six months each. At 8 percent per period, the value is:
Present value = $1,000 1.0814 = $1,000 2.9372 = $340.46
The coupons can be viewed as a 14-period annuity of $70 per period. At an 8
percent discount rate, the present value of such an annuity is:
Annuity present value = $70  (1 − 1 1.0814 ) .08

= $70  (1 − .3405 ) .08

= $70  8.2442
= $577.10
The total present value gives us what the bond should sell for:
Total present value = $340.46 + 577.10 = $917.56
© McGraw Hill 7-12
 SEMIANNUAL COUPONS 3

To calculate the effective yield on this bond, note that 8 percent

every six months is equivalent to:
Effective annual rate = (1 + .08 ) − 1 = .1664, or 16.64%
2

The effective yield is 16.64 percent.

7-13
 INTEREST RATE RISK
• Interest rate risk arises from fluctuating interest rates, and the degree of interest
rate risk a bond has depends on two things:
1. Time to maturity.
2. Coupon rate.

• All other things being equal:

1. The longer the time to maturity, the greater the interest rate risk.
2. The lower the coupon rate, the greater the interest rate risk.

• Interest rate risk increases at a decreasing rate.

© McGraw Hill 7-14

 INTEREST RATE RISK AND TIME TO
MATURITY
Notice the slope of the line connecting
prices is much steeper for the 30-year bond
than for the 1-year bond.
• This tells us a relatively small change in
interest rates will lead to a substantial
change in the bond’s value.

The reason bonds with lower coupons

have greatest interest rate risk is
essentially the same.
• The bond with the higher coupon has a
larger cash flow early in its life, so its
value is less sensitive to changes in the
discount rate.

Access the text alternative for slide images.

7-15
 SUMMARY OF BOND VALUATION
I. Finding the Value of a Bond
Bond value = C  1 − 1 (1 + r )  r + F (1 + r )
t t
 
where:
C = Coupon paid each period
r = Rate per period
t = Number of periods
F = Bond’s face value
II. Finding the Yield on a Bond
Given a bond value, coupon, time to maturity, and face value, it is possible to
find the implicit discount rate, or yield to maturity, by trial and error only. To
do this, try different discount rates until the calculated bond value equals the
given value (or let a financial calculator do it for you). Remember that
increasing the rate decreases the bond value.
© McGraw Hill 7-16
 HOW TO CALCULATE BOND PRICES AND
YIELDS USING A FINANCIAL CALCULATOR
• Using Example 7.3 (on the previous slide), the first bond sells for $935.08 and has
a 10% annual coupon rate. What’s the yield?

• For the second bond, we now know the relevant yield is 11%. It has a 12% annual
coupon and 12 years to maturity, so what’s the price?

• Suppose we have a bond with a price of $902.29, 10 years to maturity, and a

coupon rate of 6%. Assuming this bond pays semiannual interest, what’s the bond’s
yield?

© McGraw Hill 7-17

 DIFFERENCES BETWEEN
DEBT AND EQUITY
• Debt • Equity
▪ Not an ownership interest ▪ Ownership interest
▪ Creditors do not have voting rights ▪ Common stockholders vote for the board
▪ Interest is considered a cost of doing of directors and other issues
business and is tax deductible ▪ Dividends are not considered a cost of
▪ Creditors have legal recourse if interest or doing business and are not tax deductible
principal payments are missed ▪ Dividends are not a liability of the firm,
▪ Excess debt can lead to financial distress and stockholders have no legal recourse if
and bankruptcy dividends are not paid
▪ An all equity firm can not go bankrupt
merely due to debt since it has no debt
 THE INDENTURE
The indenture (That is, deed of trust) is the written agreement between the
corporation (the borrower) and the lender detailing the terms of the debt issue.
Indenture generally includes the following provisions:
• Basic terms of the bonds.
• Total amount of bonds issued.
• Description of property used as security.
• Repayment arrangements.
• Call provisions.
• Details of the protective covenants.

Usually, a trustee (For Example, a bank) is appointed by the corporation to represent

the bondholders and the trustee must:
• Make sure the terms of the indenture are obeyed.
• Manage the sinking fund.
• Represent the bondholders in default.
7-19
 TERMS OF A BOND

Principal value is stated on bond certificate.

Par value of a bond is almost always the same as the face value, with
the terms used interchangeably in practice.
• Corporate bonds historically had a face value of $1,000.
• Municipal bonds often have par valued of $5,000.
• Treasury bonds with par values of $10,000 or $100,000 are common.

Corporate bonds are usually in registered form, meaning the registrar of

the company records ownership of each bond with payment being made
directly to the owner of record.
Bonds can also be in bearer form, in which case the bond is issued
without record of the owner’s name with payment being made to
whomever holds the bond.
• Difficult to recover if bonds are lost or stolen.
• Because the company does not know who owns its bonds, it cannot
notify bondholders of important events.

© McGraw Hill 7-20

 SECURITY
Debt securities are classified according to the collateral and mortgages
used to protect the bondholder .
Mortgage securities are secured by a mortgage on the real property of
the borrower, with the property involved typically being real estate (For
Example, land or buildings).
• Legal document that describes the mortgage is called a mortgage
trust indenture or trust deed.
• Sometimes mortgages are on specific property (For Example,
railroad car).
• Blanket mortgage pledges all real property owned by the company.

Bonds usually represent unsecured obligations of the company.

• A debenture is an unsecured debt, usually with a maturity of 10 years
or more.
• Most public bonds issued in the U.S. by industrial and financial
companies are typically debentures.
• A note is an unsecured debt, usually with a maturity under 10.

© McGraw Hill 7-21

 SENIORITY AND REPAYMENT

Seniority indicates preference in position over other lenders, with debts sometimes
labeled as senior or junior to indicate seniority.
• Some debt is subordinated (For example, subordinated debenture), and holders
of such debt must give preference to other specified creditors.
• Debt cannot be subordinated to equity.
Bonds can be repaid at maturity, at which time the bondholder will receive the stated,
or face, value of the bond; or they may be repaid in part or in entirety before
maturity.
• Early repayment is common and is often handled through a sinking fund, an
account managed by the bond trustee for early redemption.
• There are various types of sinking fund arrangements; for example:
• Some sinking funds start about 10 years after the initial issuance.
• Some sinking funds establish equal payments over the life of the bond.
• Some high-quality bond issues establish payments to the sinking fund that are not
sufficient to redeem the entire issue.

© McGraw Hill 7-22

 THE CALL PROVISION

Call provision is an agreement giving the corporation the

option to repurchase a bond at a specified price prior to
maturity.
• Corporate bonds are usually callable.

Call price is usually above the bond’s stated value (That is,
par value), with the difference between the call price and
the stated value being the call premium.
Deferred call provisions prohibit the company from
redeeming a bond prior to a certain date.
• During period of prohibition, the bond is said to be call-
protected.

© McGraw Hill 7-23

 PROTECTIVE COVENANTS
• A protective covenant limits certain actions that might
be taken during the loan’s term, usually to protect the
lender’s interest
1. Negative covenant is a “thou shalt not” type of
covenant that limits or prohibits actions the company
might take; examples include:
• Firm must limit amount of dividends paid, according to
some formula.
• Firm cannot pledge any assets to other lenders.
• Firm cannot merge with another firm.
• Firm cannot sell or lease any major assets without
lender’s approval.
• Firm cannot issue additional long-term debt.

© McGraw Hill 7-24

 PROTECTIVE COVENANTS

2. Positive covenant is a “thou shalt” type of covenant

that specified an action the company agrees to take or
a condition the company must abide by; examples
include:

• Company must maintain working capital at or above

some specified minimum level.
• Company must periodically furnish audited financials to
lender.
• Firm must maintain any collateral or security in good
condition.

© McGraw Hill 7-25

 BOND RATINGS 1

Firms often pay to have their debt rated, with ratings serving as an
assessment of the creditworthiness of the corporate issuer .
• Leading bond-rating firms are Moody’s and Standard & Poor’s (S&P).
• Definitions of creditworthiness used by Moody’s and S&P are based
on how likely the firm is to default and the protection creditors have
in the event of a default.

Ratings can change as the issuer’s financial strength changes.

• Highest rating a firm’s debt can have is AAA or Aaa, and such debt is
judged to be the best quality and to have the lowest degree of risk.
• AA or Aa ratings indicate very good quality debt and are much more
common
• Investment-grade bonds are rated at least BBB or Baa.
• Large part of corporate borrowing takes the form “junk” bonds, which
are rated below investment grade if rated at all.

Rating agencies don’t always agree (For Example, “crossover” bonds).

© McGraw Hill 7-26

 BOND RATINGS 2

© McGraw Hill 7-27

END OF CHAPTER
CHAPTER 7