Chapter 6

Interest Rates
And Bond
Valuation

Copyright 2012 Pearson Prentice Hall.

All rights reserved.

Interest Rates and Required Returns:

Interest Rate Fundamentals
The interest rate is usually applied to debt instruments
such as bank loans or bonds; the compensation paid by
the borrower of funds to the lender; from the borrowers
point of view, the cost of borrowing funds.
The required return is usually applied to equity
instruments such as common stock; the cost of funds
obtained by selling an ownership interest.

2012 Pearson Prentice Hall. All rights reserved.

6-2

Interest Rates and Required Returns:

Interest Rate Fundamentals
Several factors can influence the equilibrium interest rate:
1. Inflation, which is a rising trend in the prices of most goods and services.
2. Risk, which leads investors to expect a higher return on their investment
3. Liquidity preference, which refers to the general tendency of investors to
prefer short-term securities

2012 Pearson Prentice Hall. All rights reserved.

6-3

Table 6.1 Debt-Specific Issuer- and

Issue-Related Risk Premium Components

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6-4

Bond Definition
A bond is a long-term debt instrument used
by businesses and governments to raise
money.
Most pay interest semiannually, have a
maturity between 10 and 30 years, and have
a par (face) value of $1,000 that must be
repaid at maturity.

Four Major Types of Bonds

Treasury Bondissued by the U.S. federal government
Corporate Bondissued by corporations
Municipal Bondsissued by state and local governments
Interest is exempt from federal taxes and typically state and/or local
taxes if holder lives within the issuing area

Foreign Bondsissued by foreign governments and/or

corporations

Key Features of a Bond

Par value: Face amount; paid at maturity.
Assume $1,000.
Coupon interest rate: Stated interest rate.
Multiply by par value to get dollars of interest.
Generally fixed.
Zero-coupon bonds (deep discount bonds)sold
at a substantial discount from par and all interest
is paid at maturity.
(More)
7

Key Features of a Bond

Maturity: Years until bond must be repaid.
Issue date: Date when bond was issued.
Default risk: Risk that issuer will not make
interest or principal payments.

Call Provision and Redeemable at Par

Call provisionbond issuer can refund (buy back) the bonds
if rates decline. That helps the issuer but hurts the investor.
Borrowers are willing to pay higher interest rates, and lenders
require higher interest rates, on callable bonds.
Most bonds have a deferred call and a declining call
premium.
Deferred calltime until the bond can be called
Call premiuma price above par the issuer will pay the holder if the
bond is called

Redeemable at parholder can sell bond back to issuer for

par value. Protects holder from rising rates.
9

Corporate Bonds: Legal

Aspects of Corporate Bonds
The bond indenture is a legal document that specifies both the
rights of the bondholders and the duties of the issuing corporation.
Standard debt provisions are provisions in a bond indenture
specifying certain record-keeping and general business practices
that the bond issuer must follow; normally, they do not place a
burden on a financially sound business.
Restrictive covenants are provisions in a bond indenture that place
operating and financial constraints on the borrower.

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6-10

Corporate Bonds: Legal Aspects of

Corporate Bonds (cont.)
The most common restrictive covenants do the following:
1.
2.
3.
4.

5.

Require a minimum level of liquidity, to ensure against loan default.

Prohibit the sale of accounts receivable to generate cash. Selling
receivables could cause a long-run cash shortage if proceeds were used to
meet current obligations.
Impose fixed-asset restrictions. The borrower must maintain a specified
level of fixed assets to guarantee its ability to repay the bonds.
Constrain subsequent borrowing. Additional long-term debt may be
prohibited, or additional borrowing may be subordinated to the original
loan. Subordination means that subsequent creditors agree to wait until all
claims of the senior debt are satisfied.
Limit the firms annual cash dividend payments to a specified percentage or
amount.

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6-11

Corporate Bonds: Legal Aspects of

Corporate Bonds (cont.)
Subordination in a bond indenture is the stipulation that
subsequent creditors agree to wait until all claims of the senior debt
are satisfied.
Sinking fund requirements are a restrictive provision often
included in a bond indenture, providing for the systematic
retirement of bonds prior to their maturity.
A trustee is a paid individual, corporation, or commercial bank
trust department that acts as the third party to a bond indenture and
can take specified actions on behalf of the bondholders if the terms
of the indenture are violated.

2012 Pearson Prentice Hall. All rights reserved.

6-12

Corporate Bonds: General Features

of a Bond Issue (cont.)
Bonds also are occasionally issued with stock purchase
warrants, which are instruments that give their holders
the right to purchase a certain number of shares of the
issuers common stock at a specified price over a certain
period of time. Occasionally attached to bonds as
sweeteners.
Including warrants typically allows the firm to raise debt
capital at a lower cost than would be possible in their
absence.

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6-13

Bond Valuation
Value of a 10-year, 10% annual coupon bond if rd = 10%

10%
V=?

10

...
100

100

100 + 1,000

$100
$100
$1,000
VB =
+1 . . . +
+
(1 + .10)
(1 + .10)N (1 + .10)N
= $90.91 +
$1,000.

. . . + $38.55 + $385.54 =
14

Using Your Financial Calculator

You will enter 4 variables and solve for the fifth.
You are computing the PV of the future cash flows of the
bond (interest payments and principal).
Inputs are:

FV = par or face value of bond

N = # of years to maturity or # of interest payments left
PMT = coupon rate X par valuewill be $ amount
I/Y = required return = rate similar risk, newly issued bonds are
payingalso known as the yield-to-maturity or YTM

15

Bond Valuation: Basic Bond

Valuation
The basic model for the value, B0, of a bond is given by the
following equation:

Where
B0
I
n
M
rd

=
=
=
=
=

value of the bond at time zero

annual interest paid in dollars
number of years to maturity
par value in dollars
required return on a bond

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6-16

Bond Valuation: Basic Bond

Valuation (cont.)
Mills Company, a large defense contractor, on January 1, 2007,
issued a 10% coupon interest rate, 10-year bond with a $1,000 par
value that pays interest annually.
Investors who buy this bond receive the contractual right to two
cash flows: (1) $100 annual interest (10% coupon interest rate
$1,000 par value) distributed at the end of each year, and (2) the
$1,000 par value at the end of the tenth year.
Assuming that interest on the Mills Company bond issue is paid
annually and that the required return is equal to the bonds coupon
interest rate, I = $100, rd = 10%, M = $1,000, and n = 10 years.

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6-17

Bond Valuation: Basic Bond

Valuation (cont.)

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6-18

Bond Valuation: Basic Bond

Valuation (cont.)
This is the I/Y key on
your calculator

Financial Calculator
Solution

2012 Pearson Prentice Hall. All rights reserved.

Excel Solution

6-19

Bond Valuation: Bond Value

Behavior
In practice, the value of a bond in the marketplace is rarely equal to its
par value:
Whenever the required return on a bond differs from the bonds coupon interest
rate, the bonds value will differ from its par value.
The required return is likely to differ from the coupon interest rate because
either (1) economic conditions have changed, causing a shift in the basic cost
of long-term funds, or (2) the firms risk has changed.
Increases in the basic cost of long-term funds or in risk will raise the required
return; decreases in the cost of funds or in risk will lower the required return.
In simple termswhen interest rates change the value of a bond changes.
Thus, there is a negative relationship between bond prices and interest rates
when rates increase, bond prices decrease and vice versa.

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6-20

Bond Valuation: Bond Value

Behavior (cont.)
Market interest
rates increase
to 12%

Value goes down

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Market interest
rates decrease
to 8%

Value goes up

6-21

Table 6.6 Bond Values for Various Required Returns (Mills

Companys 10% Coupon Interest Rate, 10-Year Maturity,
$1,000 Par, January 1, 2010, Issue Paying Annual Interest)

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6-22

Bond Valuation: Bond Value

Behavior (cont.)

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6-23

Figure 6.4 Bond Values and

Required Returns

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6-24

Bond Valuation: Bond Value

Behavior (cont.)
Interest rate risk is the chance that interest rates will
change and thereby change the required return and bond
value.
Rising rates, which result in decreasing bond values, are
of greatest concern.
The shorter the amount of time until a bonds maturity, the
less responsive is its market value to a given change in the
required return.

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6-25

Yield to Maturity
YTM is the rate of return earned on a bond purchased at a
specific price and held to maturity. Also called promised yield.
It assumes the bond will not default
Generally same as market interest rate on newly issued bonds of similar risk
Time consuming to calculate by hand
To calculate using your financial calculator you will need four variables and will
solve for I/Y or YTM:
FV
PVmust be entered as negative number or Error 5
N
PMT

26

YTM on a 10-year, 9% annual coupon,

$1,000 par value bond selling for $887

rd=?

1
90

PV1
.
.
.
PV10
PVM

887

...

9
90

10
90
1,000

Find rd that works!

27

Find rd (rate that causes right side

to equal left side)
Could use trial and error

INT

INT
M
... +
VB =
+
+
N
1
(1 + rd) This is what we (1 + rd)
(1 + rd)N
are looking for.

1,000
90
90
...
887 =
+
+
+
1
N
(1 + rd)
(1 + rd) (1 + rd)N
Rate that causes right
side to equal $887

10
INPUTS
N I/Y
OUTPUT10.91

-887

PV

90

1000

PMT FV
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Bond Value Behavior

If coupon rate < rd, bond sells at a discount.

If coupon rate = rd, bond sells at its par value.
If coupon rate > rd, bond sells at a premium.
If rd rises, price falls.
Negative relationship between bond values and
interest rates
Rates increase, bond value decreases
Rates decrease, bond value increases
29

Find YTM if price were

$1,134.20.
FV =
PV =
N=
PMT =
I/Y = YTM =
Sells at a premium.
Because coupon = 9% > rd
= 7.08%,
bonds value > par.

30

Semiannual Interest Bonds

(Leave Calculator Set to P/Y = 1)

1. Multiply years by 2 to get periods = 2N.

2. Divide nominal rate by 2 to get periodic
rate = rd/2.
3. Divide annual INT by 2 to get PMT =
INT/2.
INPUTS
2N rd/2
OK
OUTPUT
N I/Y

INT/2 OK
PV

PMT FV

No adjustment needed
31

Value of 10-year, 10% coupon,

semiannual bond if rd = 13%.
FV =
N=
PMT =
I/Y =
PV = Price =

32

YTM of 10-year, 10% coupon,

semiannual bond if price = $892.17.
FV =
PV =
N=
PMT =
I/Y = YTM =
YTM is an annual rate. Thus, you MUST multiply
your solution by 2 to get YTM.
33

Bond Ratings
S&P and Fitch Moodys

% defaulting within:
1 yr.

5 yrs.

Investment grade bonds:

AAA

Aaa

0.0

0.0

AA

Aa

0.0

0.1

0.1

0.7

BBB

Baa

0.3

2.8

BB

Ba

1.5

7.5

2.7

9.3

CCC

Caa

26.4

35.3

Junk bonds:

Source: Fitch Ratings

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34

Investment vs. Speculative Grade

Bonds
The highest four ratings are known as investment
grade bonds.
Some investors are limited by law to only purchasing
investment grade bonds (banks)

Any bonds rated lower than investment grade are

known as speculative grade or junk bonds.
Junk bond market developed by Michael Milken in 1980s.

35

How Bonds Become Junk

Bonds can enter the junk category two
ways:
1) Fallen Angel bond was issued as investment
grade but issuer downgraded to junk status.
2) Original Issue Junk bonds were issued with
speculative or junk rating and rating of issuer
has not improved.

36

Focus on Ethics
Can We Trust the Bond Raters?
Credit-rating agencies evaluate and attach ratings to credit instruments (e.g,
bonds). Historically, bonds that received higher ratings were almost always
repaid, while lower rated more speculative junk bonds experienced much
higher default rates.
Recently, the credit-rating agencies have been criticized for their role in the
subprime crisis. The agencies attached ratings to complex securities that did
not reflect the true risk of the underlying investments.
What effect will the new legislation likely have on the market share of the
largest rating agencies? How will the new legislation affect the process of
finding ratings information for investors?

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6-37

Questions???
Are there any questions?
Financial calculator giving you the correct
answers?

38