CHAPTER 8

Interest Rates and Bond Valuation

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 is the required market interest rate on the bond.

8-2
 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 (i.e., bond)

values.

8-3
 THE BOND-PRICING EQUATION

 1 
1 -
 (1  r) T  F
Bond Value  C  
 (1  r)
T
 r
 

8-4
 BOND EXAMPLE

• Consider a U.S. government bond with as 6 3/8%

coupon that expires in December 2016.
• 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 3/8%, the payment is $31.875.
• On January 1, 2012 the size and timing of cash flows are:

$ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 3 1 .8 7 5 $ 1,0 3 1 .8 7 5

1 /1 /12 6 / 30 /12 12 / 31 /12 6 / 30 /16 12 / 31 /16

8-5
 BOND EXAMPLE
• On January 1, 2012, the required yield is 5%.
• The current value is:

$ 31 . 875  1  $ 1, 000
PV  1 10 
 10
 $ 1, 060 . 17
. 05 2  (1 . 025 )  (1 . 025 )

8-6
 BOND EXAMPLE: CALCULATOR
Find the present value (as of January 1, 2012), of a 6
3/8% coupon bond with semi-annual payments, and a
maturity date of December 2016 if the YTM is 5%.
N 10

I/Y 2.5

PV – 1,060.17
1,000×0.06375
PMT 31.875 =
2
FV 1,000
8-7
 BOND EXAMPLE
• Now assume that the required yield is 11%.
• How does this change the bond’s price?

$ 31 . 875  1  $ 1, 000
PV  1  (1 . 055 ) 1 0   (1 . 055 ) 1 0  $ 825 . 69
. 11 2  

8-8
 YTM AND BOND VALUE

When the YTM < coupon, the bond

1300 trades at a premium.
Bond Value

1200

1100 When the YTM = coupon, the

bond trades at par.
1000

800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8 Discount Rate
When the YTM > coupon, the bond trades at a discount. 8-9
 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)

8-10
 INTEREST RATE RISK
• Price Risk
• Price risk is simply the risk that the price of a security will
fall.
• 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.

8-11
 REINVESTMENT RATE RISK
• The risk that future coupons from a bond will not be reinvested
at the prevailing interest rate when the bond was initially
purchased.
• Reinvestment risk is more likely when interest rates are
declining.
• Reinvestment risk affects the yield-to-maturity of a bond, which
is calculated on the idea that all future coupon payments will be
reinvested at the interest rate when the bond was first
purchased.

8-12
 REINVESTMENT RATE RISK
• Two factors that have a bearing on the degree of reinvestment risk are:

Maturity of the bond - The longer the maturity of the bond, the higher
the likelihood that interest rates will be lower than they were at the
time of the bond purchase.

Interest rate on the bond - The higher the interest rate, the bigger the
coupon payments that have to be reinvested, and consequently the
reinvestment risk.

8-13
 INTEREST RATE RISK
• Reinvestment Rate Risk
• 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.

8-14
 MATURITY AND BOND PRICE
VOLATILITY
Bond Value

Consider two otherwise identical bonds.

The long-maturity bond will have much
more volatility with respect to changes
in the discount rate.

Par

Short Maturity Bond

C Discount Rate
Long Maturity
Bond 8-15
 COUPON RATES AND BOND PRICES
Bond Value

Consider two otherwise identical bonds.

The low-coupon bond will have much
more volatility with respect to changes in
the discount rate.

Par
High Coupon Bond
Low Coupon Bond

C Discount Rate

8-16
 COMPUTING YIELD TO
MATURITY
• Yield to maturity is the rate implied by the current bond price.

• Finding the YTM requires trial and error if you do not have a
financial calculator, and it is similar to the process for finding
r with an annuity.

• If you have a financial calculator, enter N, PV, PMT, and FV,

remembering the sign convention (PMT and FV need to have
the same sign, PV the opposite sign).

8-17
 YTM WITH ANNUAL COUPONS

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

8-18
 YTM WITH SEMIANNUAL
COUPONS
• Suppose a bond with a 10% 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%?

• What is the semi-annual 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%

8-19
 CURRENT YIELD VS. YIELD
TO MATURITY
• Current Yield = annual coupon / price
• Yield to maturity = current yield + capital gains yield
• Example: 10% coupon bond, with semi-annual
coupons, face value of 1,000, 20 years to maturity,
$1,197.93 price
• Current yield = 100 / 1197.93 = .0835 = 8.35%
• Price in one year, assuming no change in YTM = 1,193.68
• Capital gain yield = (1193.68 – 1197.93) / 1197.93 =
-.0035 = -.35%
• YTM = 8.35 - .35 = 8%, which is the same YTM computed earlier

8-20
 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

8-21
 PURE DISCOUNT BONDS
Information needed for valuing pure discount bonds:
• Time to maturity (T) = Maturity date - today’s date
• Face value (F)
• Discount rate (r)

$0 $0 $0 $F

0 2 T  1 T

Present value of a pure discount bond at time 0:

F
PV 
(1  r ) T
8-22
 PURE DISCOUNT BONDS:
EXAMPLE
Find the value of a 15-year zero-coupon bond with a $1,000 par value and
a YTM of 12%.

$0 $0 $0 $ 1,0 0 0 0$ 0$,1

0 22930

0 2 29 30

F $ 1,000
PV    $ 174 .11
(1  i ) T
(1 .06 ) 30

8-23
 BOND PRICING WITH A
SPREADSHEET
• There are specific formulas for finding bond prices and yields on a
spreadsheet.
• PRICE(Settlement, Maturity, Rate, Yld, Redemption,
Frequency, Basis)
• YIELD(Settlement, Maturity, Rate, Pr, Redemption,
Frequency, Basis)
• Settlement and maturity need to be actual dates
• The redemption and Pr need to given as % of par value

8-24
 GOVERNMENT BONDS
• Treasury Securities
• Federal government debt
• 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
• Municipal Securities
• Debt of state and local governments
• Varying degrees of default risk, rated similar to corporate
debt
• Interest received is tax-exempt at the federal level
8-25
 AFTER-TAX YIELDS

• A taxable bond has a yield of 8%, and a municipal bond

has a yield of 6%.

• If you are in a 40% tax bracket, which bond do you prefer?

• 8%(1 - .4) = 4.8%
• The after-tax return on the corporate bond is 4.8%, compared to a 6%
return on the municipal
• At what tax rate would you be indifferent between the two bonds?
• 8%(1 – T) = 6%
• T = 25%

8-26
 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

8-27
 CORPORATE BONDS
•• Default
Default Risk
Risk Premium
Premium ((DRP
DRP))
DRP
DRPj j==ijtijt––iTtiTt

iijtjt == interest
interest rate
rate on
on security
security jj at
at time
time tt
iiTtTt == interest
interest rate
rate on
on similar
similar maturity
maturity U.S.
U.S.
Treasury
Treasury security
security atat time
time tt

8-28
 BOND CREDIT RATINGS
Bond Credit Ratings (Source: Text Table 6-10)
Explanation Moody’s S&P
Best quality; smallest degree of risk Aaa AAA
Aa1 AA+
High quality; slightly more long-term risk than top rating Aa2 AA
Aa3 AA-
A1 A+
Upper medium grade; possible impairment in the future A2 A
A3 A-
Baa1 BBB+
Medium grade; lacks outstanding investment characteristics Baa2 BBB
Baa3 BBB-
Ba1 BB+
Speculative issues; protection may be very moderate Ba2 BB
Ba3 BB-
B1 B+
Very speculative; may have small assurance of interest and
B2 B
principal payments
B3 B-
Issues in poor standing; may be in default Caa CCC
Speculative in a high degree; with marked shortcomings Ca CC
Lowest quality; poor prospects of attaining real investment C C
standing D
8-29
 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

8-30
 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 C
• S&P C & D
• Highly uncertain repayment and, in many cases, already in default,
with principal and interest in arrears.

8-31
 BOND MARKETS
• Primarily over-the-counter 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 a small

company or municipal issues

8-32
 TREASURY QUOTATIONS

8 Nov 28 132:23 132:24 -12 5.14

• What is the coupon rate on the bond?

• When does the bond mature?
• What is the bid price? What does this mean?
• What is the ask price? What does this mean?
• How much did the price change from the previous day?
• What is the yield based on the ask price?

8-33
 CLEAN VERSUS DIRTY PRICES
• Clean price: quoted price
• Dirty price: price actually paid = quoted price plus accrued interest
• Example: Consider T-bond in previous slide, assume today is July 15,
2012
• Number of days since last coupon = 61
• Number of days in the coupon period = 184
• Accrued interest = (61/184)(.04*1,000) = 13.26
• Prices (based on ask):
• Clean price = 1,327.50
• Dirty price = 1,327.50 + 13.26 = 1,340.76
• So, you would actually pay $1,340.76 for the bond.

8-34
ACCRUED INTEREST AND PRICES

•• Accrued
Accruedinterest
interestmust
mustbe bepaid
paidbybythe
thebuyer
buyerof
ofaabond
bondto
to
the
theseller
sellerof
ofaabond
bondififthe
thebond
bondisispurchased
purchasedbetween
between
interest
interestpayment
paymentdates.
dates.

•• The
Theprice
priceof
ofthe
thebond
bondwithwithaccrued
accruedinterest
interestisiscalled
calledthe
the
full
fullprice
priceor
orthe
thedirty
dirtyprice
price,,the
theprice
pricewithout
withoutaccounting
accounting
for
foraccrued
accruedinterest
interestisisthe
theclean
cleanprice
price..

8-35
 ACCRUED INTEREST ON BONDS

•• Accrued
Accruedinterest
intereston
onT-notes
T-notesand
andT-bonds
T-bondsisiscalculated
calculatedas:
as:

INT Actual number of days since last coupon payment

Accrued interest  
2 Actual number of days in coupon period

•• The
Thefull
full(or
(ordirty)
dirty)price
priceof ofaaT-note
T-noteor
orT-bond
T-bondisisthe
thesum
sum
of
ofthe
theclean
cleanprice
price((VVbb))and
andthe
theaccrued
accruedinterest
interest

8-36
 ACCRUED INTEREST EXAMPLE
•• You
Youbuybuyaa6%
6%coupon
coupon$1,000
$1,000par
parT-bond
T-bond59 59days
daysafter
afterthe
thelast
lastcoupon
couponpayment.
payment.
Settlement
Settlementoccurs
occursinintwo
twodays.
days. You
Youbecome
becomethetheowner
owner61 61days
daysafter
afterthe
thelast
last
coupon
couponpayment
payment(59+2),
(59+2),andandthere
thereare
are121
121days
daysremaining
remaininguntil
untilthe
thenext
nextcoupon
coupon
payment.
payment. The
Thebond’s
bond’sclean
cleanprice
pricequote
quoteisis120:19.
120:19. What
Whatisisthe
thefull
fullor
ordirty
dirty
price
price(sometimes
(sometimescalled
calledthe
theinvoice
invoiceprice)?
price)?

$60 61
Accrued Interest    $10.05
2 (121  61)

•• The
Theclean
cleanprice
priceisis120:19
120:19or
or120
12019/32%
19/32%of
of$1,000
$1,000or
or$1,205.9375.
$1,205.9375.
•• Thus,
Thus,the
thedirty
dirtyprice
priceisis$1,205.9375
$1,205.9375++$10.05
$10.05==$1,215.9875.
$1,215.9875.

8-37
 INFLATION AND INTEREST
RATES
• Real rate of interest – change in purchasing power
• Nominal rate of interest – quoted rate of interest, change in purchasing
power and inflation
• The ex ante nominal rate of interest includes our desired real rate of
return plus an adjustment for expected inflation.

8-38
 REAL VERSUS NOMINAL RATES
• (1 + R) = (1 + r)(1 + h), where
• R = nominal rate
• r = real rate
• h = expected inflation rate

• Approximation
• R=r+h

8-39
 THE FISHER EFFECT: EXAMPLE

• If we require a 10% real return and we expect inflation to be 8%, what

is the nominal rate?
• R = (1.1)(1.08) – 1 = .188 = 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.

8-40
 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.

8-41
 PRACTICE QUESTIONS
1. If Treasury bills are currently paying 4.5 percent and the inflation rate is 2.1
percent, what is the approximate real rate of interest? The exact real rate?

2. Laurel, Inc., and Hardy Corp. both have 7 percent coupon bonds
outstanding, with semiannual interest payments, and both are priced at par
value. The Laurel, Inc., bond has 2 years to maturity, whereas the Hardy
Corp. bond has 15 years to maturity. If interest rates suddenly rise by 2
percent, what is the percentage change in the price of these bonds? If interest
rates were to suddenly fall by 2 percent instead, what would the percentage
change in the price of these bonds be then? Illustrate your answers by
graphing bond prices versus YTM. What does this problem tell you about
the interest rate risk of longer-term bonds?

8-42
 PRACTICE QUESTIONS
3. Tesla Corporation needs to raise funds to finance a plant expansion, and it
has decided to issue 25-year zero coupon bonds to raise the money. The
required return on the bonds will be 7 percent.
a. What will these bonds sell for at issuance?
b. Using the IRS amortization rule, what interest deduction can the company
take on these bonds in the first year? In the last year?
c. Repeat part (b) using the straight-line method for the interest deduction.
d. Based on your answers in (b) and (c), which interest deduction method
would Tesla Corporation prefer? Why?

8-43