Being in this Class means:

Being Prepared to
Participate
 Chapter 7
Interest Rates and Bond Valuation
7.1 Introduction to Bonds
7.2 Bond Markets
7.3 Bond Ratings
7.4 Some Different Types of Bonds
7.5 Inflation and Interest Rates
7.6 Bonds and Bond Valuation
© Dr. Alex Ng, Thompson Rivers University
Bonds Intro
 Debt
Not an ownership interest
Bondholders do not have voting rights
Interest is considered a cost of doing
business and is tax deductible
Bondholders have legal recourse if
interest or principal payments are
missed
Excess debt can lead to financial
distress and bankruptcy 7-3
Bond Features
• Bond:
• Evidence of debt issues by corporation or government
• Represents loan made by investors to issuer
• In return for money, investors receives legal claim on future
cash flows of borrower
• Issuer promises to:

i. Make regular coupon payments every period until

maturity of bond
ii. Pay face/par/maturity value of bond at maturity

Default – above are contractual obligations, issuers failing to keep

them are subject to legal action on behalf of bondholders (lenders)
Bond Features Cont’d
• If a bond has 5 years to maturity, an $80 annual coupon, and a
$1,000 face value, its cash flows would look like:

Time 0 1 2 3 4 5
Coupons $80 $80 $80 $80 $80

Face Value $1,000

$_____

•How much is this bond worth? It depends on current market

interest rates. If the going rate is 10%, then the bond is worth
$924.18. Why? Stay tuned.
Bond Rates and Yields
• Bond currently sells for $932.90; pays annual coupon of $70;
matures in 10 years; face value of $1,000
• Determine coupon rate, current yield and yield to maturity
(YTM)?

1. Coupon rate – annual dollar coupon expressed as a % of

face value:

Coupon rate = $70 / $_______ = _______%

2. Current yield – annual coupon divided by current market
price of bond:

Current yield = $______ / $______ = 7.5%

• Under what conditions will coupon rate be equal to current yield?

Bond Rates and Yields Cont’d

3. Yield to maturity (YTM) – rate that makes price of bond just

equal to present value of future cash flows.
The unknown “r” in:

$932.90 = $_______ x [1 – 1/(1 + r)10] / r + $_______ / (1 + r)10

Only way to find YTM is trial and error:

i. (10%): $70 x [1 – 1/(1.10)10] / 0.10 + $1,000 / (1.10)10 = $816

ii. (9%): $70 x [1 – 1/(1.09)10] / 0.10 + $1,000 / (1.09)10 = $872

iii. (8%): $70 x [1 – 1/(1.08)10] / 0.10 + $1,000 / (1.08)10 = $933

Therefore, yield to maturity is 8%.

 Bond Price Sensitivity to YTM

Bond price

$1,800
Coupon = $100
20 years to maturity
$1,600 $1,000 face value

$1,400 Notice: bond prices and YTMs are

inversely related.
$1,200

$1,000

$ 800

$ 600 Yields to
maturity,
4% 6% 8% 10% 12% 14% 16%
YTM
More on Bond Features
• Is it debt or equity?
• Cost and benefits, risk and return of debt vs equity
• Debt securities tax advantage
• Equity securities bankruptcy advantages
• As an investor, what is the cost and benefit difference?

• Long-term debt:
• Maturity date – specific date when principal of bond is paid.
(Can be short or long-term)
• Includes notes, bonds (secured) and debentures (unsecured)

• Interest rate risk:

• Risk arising for bond owners from fluctuating interest rates
• Bond prices affected by interest rates
• Sensitivity depends on time to maturity, coupon rate
Bond Pricing Theorems
• Following statements about bond pricing are always true:

1. Bond prices and market interest rates move in opposite

directions.

2. When bond’s coupon rate (greater than / equal to / less

than) market’s required return, the bond’s market value will
be (greater than / equal to / less than) its par value.

3. Given two bonds identical but for maturity, price of longer-

term bond will change more than that of short-term bond,
for a given change in market interest rates.

4. Given two bonds identical but for coupon, price of lower-

coupon bond changes more than higher-coupon bond, for a
given change in market interest rates.
Features of a May Department Stores Bond

Terms Explanations
Amount of issue $125 million Company issues $125 million
worth of bonds

Date of issue 2/28/06 Bonds were sold on 2/28/96

Maturity 3/1/36 Principal paid in 30 years

Annual coupon 9.25 Denomination of bonds is

$1,000. Each bondholder
receives $92.50 per bond per
year (9.25% of face value)

Offer price 100 Offer price is 100% of $1,000

face value per bond
Features of a May Department Stores Bond Cont’d
Terms Explanations
Coupon payments 3/1, 9/31 Coupons of $92.50 /2 = $46.25
date paid on these dates

Security None Bonds are debentures

Sinking fund Annual, Firm makes annual payments

beginning 3/1/07 toward the sinking fund
Call provision Not callable Bonds have a deferred call
before 2/28/13 feature

Call price 106.48 initially, After 2/28/13, company can

declining to 100 buy back bonds for
$1,064.80/bond declining to
$1,000 on 2/36/05

Rating Moody’s A2 Moody’s higher rating, low

probability of bond default
The Bond Indenture
The Bond Indenture
• Three-party contract between bond issuer, bondholders, and trustees

• Trustee hired by issuer to protect bondholders’ interests

• Indenture includes:

i. Basic terms of bond issue

ii. Total amount of bonds issues

iii. Description of the security (if any)

iv. Repayment arrangements

v. Call provisions

vi. Details of protective covenants

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 small corporate
issues
 Treasury securities are an exception

7-
14
Bond Markets Cont’d
• Getting a Quote, Bond Price Reporting
• Features: bids, coupon rates, maturity date, price, YTM

• Bond Pricing in Action, making money

• Use bond pricing principles to buy bonds with expectations of
price rising, anticipate interest rates. Buy low, sell high
Bond Quotations

Figure 7.4

7-
16
 Bond Ratings
Investment-Quality Bond Low Quality, speculative,
Ratings and/or “Junk”
High Grade Medium Grade Low Grade Very Low Grade
Standard & Poor’s AAA AA A BBB BB B CCC C D
Moody’s Aaa Aa A Baa Ba B Caa C C

Moody’s S&P
Aaa AAA Debt rated Aaa and AAA has the highest rating. Capacity
to pay interest and principal is extremely strong.

Aa AA Debt rated Aa and AA has a very strong capacity to pay

interest and repay principal. Together with the highest
rating, this group comprises the high-grade bond class.

A A Debt rated A has a strong capacity to pay interest and repay

principal, although it is somewhat more susceptible to the
adverse effects of changes in circumstances and economic
conditions than debt in high rated categories.
Bond Ratings Cont’d

Moody’s S&P
Baa BBB Debt rated Baa and BBB is regarded as having an adequate
capacity to pay interest and repay principal. Whereas it normally
exhibits adequate protection parameters, adverse economic
conditions or changing circumstances are more likely to lead to a
weakened capacity to pay interest and repay principal for debt in
this category than in higher rated categories. These bonds are
medium-grade obligations.

Ba,B BB,B Debt rated in these categories is regarded, on balance, as

Ca,C CC,C predominantly speculative with respect to capacity to pay interest
and repay principal in accordance with the terms of the obligation.
BB and Ba indicate the lowest degree of speculation, and CC and
Ca the highest degree of speculation. Although such debt will
likely have some quality and protective characteristics, these are
out weighed by large uncertainties or major risk exposures to
adverse conditions. Some issues may be in default.

D D Debt rated D is in default, and payment of interest and/or

repayment of principal is in arrears
Play Video

msnbc.com video Buffett on economy, mortgage mess - Shortcut.lnk

https://www.youtube.com/watch?v=xzT8vXCAb-I
Green bond issue from China

Green Bonds
https://www.bnnbloomberg.ca/video/canada-leads-in-green-bond-deals-as-
2019-issuance-hits-9-6b-above-past-years~1854214
Different Types of Bonds
• Financial engineering used to change/design new securities to
reduce/control risks, costs and minimize tax

• Hybrid securities: many features of equity but treated as debt

• Different types of bonds:

• Warrants

• Stripped bonds

• Floating-rate bonds

• Income bonds

• Real return bonds

• Convertible bonds

• Retractable bonds
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
 Bondholder must pay taxes on accrued
interest every year, even though no interest
is received 7-
21
Inflation and Returns

• What is the difference between real and nominal returns?

• How can we convert to one from the other?

Example:

Suppose we have $1,000, and Diet Coke costs $2.00 per six pack.
We can buy 500 six packs. Now suppose the rate of inflation is 5%,
so that the price rises to $2.10 in one year. We invest the $1,000
and it grows to $1,100 in one year. What is our return in dollars?
Six packs?
Inflation and Returns Cont’d

A. Dollars, our return is:

($1,100 - $1,000) / $1,000 = $100 / $1,000 =

_________

Therefore, the percentage increase in money is 10%

B. Six packs, we can buy $1,100 / $2.10 = _________ six packs, so

our return is:

(523.81 – 500) / 500 = 23.81 / 500 = 4.76%

Therefore, the percentage increase in amount of Coke is

4.76%
Inflation and Returns Cont’d

• Real versus nominal returns:

• Nominal return is percentage change in amount of money
you have

• Real return is percentage change in amount of stuff you

can actually buy
Inflation and Returns Cont’d

• Relationship between real and nominal returns described by

Fisher Effect, let:
R = nominal return

r = real return

h = inflation rate

• According to the Fisher Effect:

1 + R = (1 + r) x (1 + h)

• From the example, real return = 4.76%, nominal return = 10%,

inflation = 5%
(1 + R) = 1.10

(1 + r) x (1 + h) = 1.0476 x 1.05 = 1.10

Figure 7.5 – Upward-Sloping Yield Curve

7-
26
Figure 7.6 – Government of Canada Yield
Curve, February 27, 2015

7-
27
Valuing a Bond
• Assume the following information:
Barnhart Inc. bonds have a $1,000 face value
Promised annual coupon is $100
Bonds mature in 20 years
Market’s required return on similar bonds is 10%

1.Calculate present value of face value:

= $1,000 x [1 / 1.1020] = $1,000 x 0.14864 = $148.64

2.Calculate present value of coupon payments:

= $100 x [1 – (1 / 1.1020) / 0.10] = $100 x 8.5136 = $851.36

3.Value of each bond = $148.64 + $851.36 = $1,000

Valuing a Bond Cont’d
• Assume the following information:
Barnhart Inc. bonds have a $1,000 face value
Promised annual coupon is $100
Bonds mature in 20 years
Market’s required return on similar bonds is 12%

1.Calculate present value of face value:

= $1,000 x [1 / 1.1220] = $1,000 x 0.10366 = $103.66

2.Calculate present value of coupon payments:

= $100 x [1 – (1 / 1.1220) / 0.12] = $100 x 8.5136 = $746.94

3.Value of each bond = $103.66 + $851.36 = $850.60

Premium Bond
• Assume the following information:
Barnhart Inc. bonds have a $1,000 face value
Promised annual coupon is $100
Bonds mature in 20 years
Market’s required return on similar bonds is 8%

Why do the bonds in this, and the previous example, have prices
different from par?
Bond Pricing Equation
• Bond value = Present value of coupons
+ present value of the face value

= C x [ 1 – 1/(1 + r)t ]/r + F x 1/(1 + r)t

Where: C = promised coupon payment

F = promised face value
t = number of periods until the bond matures
r = market’s required return, YTM
Bond Valuation

Wilkinson’s has a coupon bond outstanding that pays coupon interest of $120 per
year and has 10 years to maturity. The face value of the bond is $1,000. If the yield
for similar bonds is currently 14%, what is the bond’s value? (assume interest is paid
annually) Is this bond selling for less or for more than its face value?

For Wilkinson’s, find the bond’s value if the yield for similar bonds decreases to
12%. Is this bond selling for less or more than its face value?
Example – Semiannual Coupons

 Most bonds in Canada make coupon payments

semiannually.
 Suppose you have an 8% semiannual-pay bond with a
face value of $1,000 that matures in 7 years. If the
yield is 10%, what is the price of this bond?
 The bondholder receives a payment of $40 every six
months (a total of $80 per year)
 The market automatically assumes that the yield is
compounded semiannually
 The number of semiannual periods is 14

7-
33
Example – Semiannual Coupons
continued

 1 
1 -
 1.0514  1,000
Bond Price  40   14
 901.01
0.05 1.05

 OrPMT = 40; N = 14; I/Y = 5; FV = 1000; CPT PV = -

901.01

7-
34
 Today, We learned….

Chapter 7
Interest Rates and Bond Valuation
6.1 Introduction to Bonds
6.2 Bond Markets
6.3 Bond Ratings
6.4 Some Different Types of Bonds
6.5 Inflation and Interest Rates
6.6 Bonds and Bond Valuation