Lecture 2

 Determinants of Interest Rates

 Bond Duration
o Macaulay Duration
o Modified Duration (Negative Volatility )
 Bond Refunding

1. Imagine (IAC)
 You are bond traders attending a t-bill auction, bidding for 1-year t-bills with face value of $1,000
 How much will you bid for t-bill?

2. Relationship Between Price and Yield to Maturity

 Assume a 10 year 10% coupon bond with a face value of $1,000


 1. When bond is at par, yield equals coupon rate
 2. Price and yield are negatively related
 3. Yield greater than coupon rate when bond price is below par value
The Bond-Pricing Equation
3. Interest Rate Risk
 Interest rate risk arises from fluctuating interest rates
 Two things determine how sensitive a bond will be to interest rate risk:
o Time to Maturity – All other things being equal, the longer the time to maturity, the greater the
interest rate risk.
o Coupon rate – All other things being equal, the lower the coupon rate, the greater the interest
rate risk.
Interest Rate Risk & Time to Maturity

4. Semiannual coupons
 In practice bonds issued in Canada usually make coupon payments twice a year.
 Example:
o Coupon rate 8%- 2 payments of $40. The yield to maturity is quoted at 10%.
o Bond yields are quoted as APRs.
o Bond matures in 7 years
o What is the bond price and the effective annual yield on this bond?
o True yield is 5% per 6 months.
o We know it should be sold at discount.
o Present value of bond face value (14 periods at 5%)
o Present value = $1,000/1.0514= $505.08
o Coupons can be viewed as a 14 period annuity of $40 per period
o Annuity present value= $40 x(1-1/1.0514)/.05= $395.92
o Total present value = $505.08+ $395.92= $901
o To calculate the effective yield
o Effective annual rate = (1+.05)2- 1 =10.25%
5. The Bond Indenture
 Usually, a trustee (a trust company) is appointed by the corporation to represent the bondholders.
 The trust company must
1) make sure the terms of the indenture are obeyed,
2) manage the sinking fund (described later), and
3) represent the bondholders in default; that is, if the company defaults on its payments to them.
 Contract between the company and the bondholders; includes:
o The basic terms of the bonds
o The total amount of bonds issued
o A description of property used as security, if applicable
o Sinking fund provisions (managed by trustee)
o Call provisions
• Agreement giving the corporation the option to repurchase the bond at a specified price
before maturity.
o Details of protective covenants
• Negative (limit the amount of dividends, cannot pledge an asset, cannot merge……)
• Positive (must maintain w/c at a level, collateral or security in good condition, …)
6. Bond Classifications
 Registered vs. Bearer Forms
 Security
o Collateral trust bonds – secured by financial securities (e.g. common stock)
o Mortgage securities – secured by real property, normally land or buildings
o Debentures – unsecured debt with original maturity of 10 years or more
o Notes – unsecured debt with original maturity less than 10 years
 Seniority
o Sinking Fund – Account managed by the bond trustee for early bond redemption
 Call Provision
o Call premium
o Deferred call
o Call protected
o Canada plus call
 Protective Covenants
o Negative covenants
o Positive covenants
7. Bond Characteristics and Required Returns (IAC)
 The coupon rate depends on the risk characteristics of the bond when issued
 Which bonds will have the higher coupon, all else equal?
o Secured debt versus a debenture
o Subordinated debenture versus senior debt
o A bond with a sinking fund versus one without
o A callable bond versus a non-callable bond
7.3 Bond Ratings – Investment Quality
 Standard & Poor’s, Moody’s, and Fitch
o The strength of the issuer’s balance sheet; specifically, its total debt and the strength of its cash
position
o Its ability to service its debt via the cash left over after expenses are subtracted from revenue
o Its current business conditions – including earnings growth, profit margins, etc. as well as its
future outlook, including the potential impact of industry trends, the regulatory environment, its
tax burden, its ability to withstand economic adversity, etc.
 In Canada -> DBRS, Moody’s, S&P (Fitch recently opened office in Toronto)
 High Grade
o DBRS’s AAA – capacity to pay is exceptionally strong
o DBRS’s AA – capacity to pay is very strong
 Medium Grade
o DBRS’s A – capacity to pay is strong, but more susceptible to changes in circumstances
o DBRS’s BBB – capacity to pay is adequate, adverse conditions will have more impact on the
firm’s ability to pay
o AAA --- BBB: are known as investment grade bond
8. Bond Ratings – Speculative
 Low Grade
o DBRS’s BB, B, CCC, CC
o Considered speculative with respect to capacity to pay.
 Very Low Grade
o DBRS’s C – bonds are in immediate danger of default
o DBRS’s D – in default, with principal and/or interest in arrears
 o Junk Bonds or High-Yield Bonds
9. U.S. Companies Rated AAA, Higher Than U.S. Government Bonds
 By Thomas Kenny
 Updated November 14, 2019
10. Stripped or 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, or deep discount bonds
 For Tax Purposes
o Issuer deducts interest though not paying any
o Bondholder must pay taxes on accrued interest every year, even though no interest is received
11. Floating Rate Bonds
 Coupon rate floats depending on some index value (or tied to Treasury bill rate)
 There is less price risk with floating rate bonds
o The coupon floats, so it is less likely to differ substantially from the yield-to-maturity
 Coupons may have a “collar” – the rate cannot go above a specified “ceiling” or below a specified
“floor”
12. Other Bond Types
 Catastrophe bonds (prop. and ins. companies)
 Income bonds (C depends on level of corporate income)
 Convertible bonds (can be converted to shares at B/H’s discretion)
 Put bond (retractable bond)
 There are many other types of provisions that can be added to a bond and many bonds have several
provisions
o it is important to recognize how these provisions affect required returns
7.5 Bond Markets
 Primarily over-the-counter (OTC) 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 corporate issues
 Treasury securities are an exception
Bond price reporting Figure 7.4

13. Bond price reporting Clean and Dirty Price

 Clean Price: It is the price of a bond net of accrued interest; this 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.
Example on Clean and Dirty Price
Suppose you buy a bond with a 12 percent annual coupon, payable semi-annually. You actually pay
$1,080 for this bond. Further, on the day you buy it, the next coupon is due in four months, so you are
between coupon dates.
What is the invoice or dirty price?
What is the clean or quoted price?
Dirty price is what you paid to buy the bond: $1,080 is the dirty, or invoice price.
Accrued interest = (2/6)*$60 = $20
Quoted price = $1,080 - $20 = $1,060
14. Bond Supply & Demand (IAC)

of
bon

of

15. Term Structure of Interest Rates

 Term structure is the relationship between time to maturity and yields, all else equal, for default-risk
free, pure discount bonds
o Tells us the pure time value of money
 Yield curve – graphical representation of the term structure for govt. coupon bonds
o Normal – upward-sloping, long-term yields are higher than short-term yields
o Inverted – downward-sloping, long-term yields are lower than short-term yields
o Humped or “bell shaped” – observed in 1990s, due to demand and supply of U. S. Govt. bonds.
 Humped or “bell shaped”
 a significant portion of 1990s bond investors were boomers in their prime earning years looking to
invest in safe, long-term bonds to provide for retirement income
 A normal yield curve is upward sloping as there is a greater demand for liquidity (i.e., short-term t-
bills)

16. Yield Components for a Corporate Bond

Interest Rate = Real Rate + Inflation Premium + Interest Rate Risk Premium + Default Risk Premium +
Liquidity Premium
17. Duration (IAC onward)
 Interest rate risk of pure discount bonds

 Which one has more interest rate risk?

 Measure of effective maturity
 Incorporates both time to maturity and coupon rate
 In general: % price changes of a bond with high duration are greater than for a bond with low
duration
 Managers hedge their returns by matching duration of assets = duration of liabilities
 This way, market values on both sides of the balance sheet adjust so as to keep market value of net
worth constant
 “Portfolio immunization”
• Steps to calculate Macaulay duration (Named after Frederick Macaulay):
1) Calculate PV of each payment using the bond’s YTM (note: Sum of PV’s = price of bond)
2) Find the relative value or RV of each payment. RV = PV/ Price
3) Weight the maturity of each payment by its RV.
Weighted value = WV = RV x time of payment
4) Duration = Sum of WV

 Eg: Duration of a $1,000 face value, 1% annual coupon bond with 5 year maturity (YTM = 10%)

1) Alternative Approach to Calculate Macaulay Duration

 t = period in which the coupon is received

C = periodic coupon payment
 y = periodic yield
n = total number of periods
M = maturity value
P = market price of bond
 Macaulay duration
=(1×100/1.1+2×100/1.12+3×100/1.13+4×100/1.14+5×100/1.15
+5×1000/1.15)/1000 = 4.1699 yrs
 For $1,000, 10% annual coupon, 10% YTM 5 year bond, Macaulay duration = 4.1699 years
Price = $1,000
o Modified duration = D* = D_
1+r
o Modified duration = - Volatility = -v
o Volatility = v = -D_
1+r
r = original YTM (Periodic YTM)
V = - 4.1699/1.1 = -3.79%
 If YTM increases by 1% to 11%, then price falls by v%
 Here, if YTM is 11%, price = (100 – 3.79)% x 1,000 = 962.10
 Can also calculate change in bond price this way: (volatility)x(change in rate)x(initial bond price)
= change in bond price
 (-3.79)(+1)(1,000)= -$37.9 change
  1,000 (initial bond price) – 37.9 (change in bond price) = 962.10 new price
 If YTM falls by 1% (i.e., to 9%), price rises by v%:
 (-3.79)(-1)(1,000) = $37.9 change => 1,000 + 37.9 = 1,037.9 new price
 No correction for convexity in adms4540
Convexity

Bond Refunding
The Nipigon Lake Mining Company has a $20 million outstanding bond issue bearing a 16 percent
coupon that it issued in 2003. The bonds mature in 2028 but are callable in 2019 for a 6 percent call
premium. Nipigon Lake’s investment banker has assured it that up to $30 million of new nine-year
bonds maturing in 2028 can be sold carrying a 6.5 percent coupon. To eliminate timing problems with
the two issues, the new bonds will be sold a month before the old bonds are to be called. Nipigon Lake
would have to pay the coupons on both issues during this month but can defray some of the cost by
investing the issue at 4 percent, the short-term interest rate. Flotation costs for the $30 million new issue
would total $1,125,000 and Nipigon Lake’s marginal tax rate is 40 percent. The additional $10 million
from the new bond issue could be invested in a 9 year project with an expected NPV of $2
million.Construct a framework to determine whether it is in Nipigon Lake’s best interest to call the
previous issue. In constructing a framework to analyze a refunding operation, there are four steps:
appropriate after-tax discount rate, costs of refunding, interest savings, and the NPV of the refunding
operation.
 Step 1: Find the appropriate after tax discount rate
r = (1 – t) x coupon on new issue
r = (1 - 0.4) x 0.065 = 3.9%
 Step 2: The costs of refunding
1) Call premium costs:
6% call premium x ($20,000,000) = $1,200,000
2) Flotation Costs: Although flotation costs are a one-time expense, for tax purposes they are amortized
over the life of the issue, or five years, whichever is less. For Nipigon Lake, flotation costs amount to
$1,125,000.This results in an annual expense for the first five years after the issue.
• $1,125,000/5yrs = $225,000
• Flotation costs produce an annual tax shield of $90,000.
$225,000 x (40% tax rate) = $90,000
• The tax savings on the flotation costs are a five-year annuity and would be discounted at the
after-tax cost of debt (6.5%(1 - 0.40) = 3.9%). This amounts to a savings of $401,792:
90,000 x PVIFA (3.9%, 5 yrs) = 90,000*4.46436 = 401,792
• Net flotation costs = Flotation Costs – PV of tax savings
=1,125,000 – 401,792 = 723,208
3) Find the additional interest:
Extra interest paid on old issue= $20,000,000 x (16% x 1/12)
= $266,667
After tax extra interest paid on old issue=$266,667 x (1 - 0.40)
= $160,000
Interest on short term investment: $30,000,000 x (4% x 1/12) = $100,000
After-tax interest on short term investment=$100,000 x (1- 0.40)
= $60,000
The total additional interest is:
Extra interest paid $160,000
Extra interest earned (60,000)
Total additional interest $100,000
 Total after-tax investment cost is therefore:
Call premium $1,200,000
Flotation costs 723,208
Additional interest 100,000
Total investment $2,023,208
 Step 3: Interest savings on new issue
Interest on old bond =$20,000,000 x 16% = $3,200,000
Interest on new bond = $30,000,000 x 6.5% = $1,950,000
Annual savings = $1,250,000
After-tax savings = $1,250,000 x (1 - 0.40) = $750,000
PV of annual after tax savings over nine years discounted at after-tax rate
= $750,000 x PVIFA (3.9%, 9 yrs)
= $750,000 x 7.4693 = $5,601,997
 Step 4: NPV for the refunding operation
Interest savings $5,601,997
NPV of the extra $10m from the new issue $2,000,000
Investment costs –$2,023,208
NPV $5,578,789
NPV is positive therefore proceed with refunding