Corporate Finance Thirteenth Edition

Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe / Bradford D. Jordan

Chapter 8
Interest Rates and Bond Valuation

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 Key Concepts and Skills
• Know the important bond features and bond types.
• Understand bond values and why they fluctuate.
• Understand bond ratings and what they mean.
• Understand the impact of inflation on interest rates.
• Understand the term structure of interest rates and the
determinants of bond yields.

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 Chapter Outline
8.1 Bonds and Bond Valuation
8.2 Government and Corporate Bonds
8.3 Bond Markets
8.4 Inflation and Interest Rates
8.5 Determinants of Bond Yields

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 8.1 Bonds and Bond Valuation
A bond is a legally binding agreement between a borrower
and a lender that specifies the:
• Par (face) value.
• Coupon rate.
• Coupon payment.
• Maturity date.

The yield to maturity (YTM) is the required market interest

rate on the bond.
Generally an interest-only loan, with regular interest
payments (called coupons) and the principal payment at
the end.

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 Bond Valuation
Primary Principle:
• Value of financial securities = PV of expected future
cash flows.
Bond value is, therefore, determined by the present
value of the coupon payments and par value.
Interest rates are inversely related to present values
(i.e., bond prices).

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 The Bond-Pricing Equation

1
1− 1 2
1+0
Bond value = +× +
0 (1 + 0)1

Bond value = Present value of the coupons + Present

value of the face amount

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 Bond Example
Consider a U.S. government bond with as 6.375 percent
coupon that expires in December 2025.
• The par value of the bond is $1,000.
• Coupon payments are made semiannually (June 30 and
December 31 for this particular bond).
• Since the coupon rate is 6.375 percent, the semiannual
payment is $31.875.
• On January 1, 2021, the size and timing of cash flows are:

Access the text alternative for slide images

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 Bond Example
On January 1, 2021, the required yield (YTM) is 5
percent.
The current value is:
$31.875 é 1 ù $1, 000
PV = 1 - + = $1, 060.17
.05 êë 1.02510 úû 1.02510
2

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 Bond Example: Price Change
Now assume that the required yield is 11 percent.
How does this change the bond’s price?

$31.875 1 1000
!" = 1− + = $ 825.69
0.11 1.055./ 1.055./
2

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 YIELD TO MATURITY
• The YTM is the rate required in the market on a
bond, also called the yield.
• The coupon rate is often different from the yield.
When the value = principal, however, the coupon rate
equals the yield.
• The YTM can be thought of as the EAR.

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 Bond Concepts
Bond prices and market interest rates move in opposite
directions.
When coupon rate = YTM, price = par value
When coupon rate > YTM, price > par value (premium
bond)
When coupon rate < YTM, price < par value (discount
bond)

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 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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 YTM with Annual Coupons
Consider a bond with a 10 percent 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 percent?
• N = 15; PV = −928.09; FV = 1,000; PMT = 100
• CPT I / Y = 11%

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 YTM with Semiannual Coupons
Suppose a bond with a 10 percent 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 percent?
• 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%

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 Current Yield
The annual coupon divided by the current bond price. This is the
effective rate of interest for a bond at its current price. This is the
actual income rate of return as opposed to the coupon rate or
YTM.
+,,-+. /0-10,
Current yield =
123/4

Yield to maturity
= Current yield + Capital gains yield (%Price change)

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 Current Yield versus Yield to Maturity
Example: 10 percent coupon bond, with semi-annual coupons,
face value of 1,000, 20 years to maturity, $1,197.93 price.
a. What is the current yield and YTM?
b. What will be the price of the bond is one year’s time?

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 Current Yield versus Yield to Maturity
Example: 10 percent coupon bond, with semi-annual coupons,
face value of 1,000, 20 years to maturity, $1,197.93 price.
a. What is the current yield and YTM?
Current yield = 100/1197.93 = 8.35%
a. What will be the price of the bond is one year’s time?
assuming no change in YTM
+, / /,,,
!"#$% #& '&% (%)" = . /− 23
+
,. ,. /+. ,. /+. ,. 23
= /, /52. 63
1,197.93=/,/52.63
!"#$% $7)&8% = 1,197.93
=0.35%

=> YTM = 8.35% – 0.35% = 8%

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 Current Yield versus Yield to Maturity
Example: 10 percent coupon bond, with semi-annual coupons,
face value of 1,000, 20 years to maturity, $1,197.93 price.
a. What is the current yield and YTM?
Current yield = 100/1197.93 = 8.35%
a. What will be the price of the bond is one year’s time?
assuming no change in YTM
+, / /,,,
!"#$% #& '&% (%)" = . /− 23
+
,. ,. /+. ,. /+. ,. 23
= /, /52. 63
1,197.93=/,/52.63
!"#$% $7)&8% = 1,197.93
=0.35%

=> YTM = 8.35% – 0.35% = 8%

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 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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 Zero Coupon Bonds: Example
Find the value of a 15-year zero coupon bond with a
$1,000 par value and a YTM of 12 percent. Assume
semiannual compounding.

$ $1000
!" = *
= /0
= $174.11
(1 + () (1 + 6%)

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 Bond Pricing with a Spreadsheet 2

Example:
You are looking at a bond that has 22 years to maturity. The coupon rate is 8
percent and coupons are paid semiannually. The yield-to-maturity is 9 percent.
What is the current price?
RATE 4.50% (9%/2)
NPER 44 (22*2)
PMT 4 (8%*100/2)
FV 100 (Using 100 par so that PV will give price as % of par)
Price $90.49 Formula: −PV(4.50%,44,4,100)

You are looking at a bond that has 22 years to maturity. The coupon rate is 8
percent and coupons are paid semiannually. The current price is $96.017. What is
the yield to maturity?
NPER 44 (22*2)
PMT 4 (8%*100/2)
PV −96.017 (Entered as a % of par and negative for sign convention)
FV 100
YTM 8.40% (Returns as a whole percent, format to get decimal places)
=2*RATE(44,4,-96.017,100)
Formula:
(Have to multiply by 2 because it returns a semiannual rate)

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 8.2 US Government Bonds
Issued by the US government, the largest borrower in the
world.
• T-bills—pure discount bonds with original maturity less than one
year.
• T-notes—coupon debt with original maturity between one and
ten years.
• T-bonds—coupon debt with original maturity greater than ten
years.

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 8.2 Municipal Bonds
Municipal Bonds:
• Issued by state and local governments, but can default.
• Varying degrees of default risk, rated similar to corporate debt.
• Interest received is tax-free at the federal level.

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 Corporate Bonds
• Greater default risk relative to government bonds
• The promised yield (YTM) may be higher than the
expected return due to this added default risk.

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 After-tax Yields
A taxable bond has a yield of 8 percent, and a municipal
bond has a yield of 6 percent.
If you are in a 30 percent tax bracket, which bond do you
prefer?
• .08(1 − .3) = .056, or 5.6%
• The aftertax return on the corporate bond is 5.6 percent,
compared to a 6 percent return on the municipal.

At what tax rate would you be indifferent between the two

bonds?
• .08(1 − T) = .06, or 6%
• T = .25, or 25%

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 Bond Ratings
• Moody’s, Fitch, and Standard & Poor’s (S&P) rate bonds
based on their probability of default.
• Lenders generally require that bonds with low ratings pay
higher yields.
• INVESTMENT GRADE bonds are higher quality than
SPECULATIVE GRADE (JUNK) BONDS

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 Bond Ratings

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 Bond Ratings—Investment Quality
High Grade:
• Moody’s Aaa and S&P AAA—capacity to pay is extremely
strong.
• Moody’s Aa and S&P AA—capacity to pay is very strong.

Medium Grade:
• Moody’s A and S&P A—capacity to pay is strong, but more
susceptible to changes in circumstances.
• Moody’s Baa and S&P 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
Low Grade:
• Moody’s Ba and B.
• S&P BB and B.
• Considered speculative with respect to capacity to pay.
Very Low Grade:
• Moody’s Caa, Ca and C.
• S&P CCC, CC, C, and D.
• Highly uncertain repayment and, in many cases, already in
default, with principal and interest in arrears.

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 8.3 Bond Markets
• Bonds are traded over the counter (OTC), meaning
that dealers buy and sell bonds from various
parties.
• BID - the price the dealer will pay you for a bond
• ASK - the price at which the dealer will sell you a
bond
• BID-ASK SPREAD - the positive difference between
the bid and ask prices, and it is how the dealer
makes money.

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 Treasury Quotations

§ Bid price = 99.282. If

you want to sell $100
par value T-bonds, the
dealer is willing to pay
$99.282.
§ Ask price =99.292. If
you want to buy $100
par value T-bonds, the
dealer is willing to sell
them for $99.292.
§ This bond’s ask price
fell 0.01% from
yesterday
§ The yield is 6.643%.

https://www.wsj.com/market-data/bonds/treasuries
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 8.4 Inflation and Interest Rates
Real rate of interest—change in purchasing power
• NOMINAL INTEREST RATES have not been adjusted for
inflation.
• REAL INTEREST RATE have been adjusted for inflation.

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 8.4 Inflation and Interest Rates
You plan on buying several books for $5 each. You put exactly
$100 in an investment today that returns 15.5% annually.
How many books can you afford? Assume an inflation rate of 5%.
If we purchased books today, it would be 20 books. Investment
growth: $100 x 1.155 = $115.50
Book price: $5 x 1.05 = $5.25
Book purchase: $115.50 / $5.25 = 22 books
We could have bought 23 books if no inflation.
So, even though our investment grew at 15.5%, our purchasing
power only grew by:
(22 − 20 books)/20 books= 10%
Þ the REAL RATE of return on my investment is 10%,
Þ the NOMINAL RATE is 15.5%.

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 THE FISHER EFFECT
(1 + R) = (1 + r) × (1 + h), where,
• R = nominal rate.
• r = real rate.
• h = expected inflation rate.
Approximation,
• R = r + h.

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 Inflation-Linked Bonds
Most government bonds face inflation risk
TIPS (Treasury inflation-protected securities), however,
eliminate this risk by providing promised payments
specified in real, rather than nominal, terms

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 The Fisher Effect: Example
A rise in the rate of inflation causes the nominal rate
to rise enough so that the real rate of interest is
unaffected.
If we require a 10 percent real return and we expect
inflation to be 8 percent, what is the nominal rate?
R = (1.1) × (1.08) − 1 = .188, or 18.8%
Approximation: R = 10% + 8% = 18%
Because the real return and expected inflation are
relatively high, there is a significant difference between
the actual Fisher Effect and the approximation.

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 8.5 Determinants of Bond Yields
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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 Factors Affecting Required Return
Default risk premium—remember bond ratings
Taxability premium—remember municipal versus
taxable
Liquidity premium—bonds that have more frequent
trading will generally have lower required returns
(remember bid-ask spreads)
Anything else that affects the risk of the cash flows to
the bondholders will affect the required returns.

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 Quick Quiz
How do you find the value of a bond, and why do bond
prices change?
What are bond ratings, and why are they important?
How does inflation affect interest rates?
What is the term structure of interest rates?
What factors determine the required return on bonds?

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 Suggested exercises

Concept Questions
4, 17

Questions and Problems

1, 2, 7, 11, 12, 15, 16, 17, 18, 21

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