Chapter 5

Bonds, Bond Valuation, and

Interest Rates

1
Topics in Chapter
 Key features of bonds
 Bond valuation
 Measuring yield
 Assessing risk

2
 A bond is a long term contract under
which a borrower agrees to make
payments of interest and principal on
specific dates to the holders of the
bond.

3
Types of bonds: differs with respect to
expected return and degree of risk
 Treasury bonds: issued by U.S. federal government. No default risk.
Their prices decline as the interest rate rises.
 Corporate bonds: issued by corporations. They are exposed to default
risk. Default risk is also called credit risk and higher the credit risk,
higher the interest rate the issuer must pay.
 Municipal bonds: also called “munis” are issued by state and local
governments. They have default risk. But they have one advantage,
that the interest earned on “munis” is almost exempt from federal
taxes. They have interest rates that are considerably lower than those
on corporate bonds with the same default risk.
 Foreign bonds: issued by foreign governments or foreign corporations.
They are exposed to default risk. They also face foreign exchange risk
because they are denominated in another currency.

4
 Convertible bonds: have the option to convert the bonds into a
fixed number of shares of common stock.
 Income bond is required to pay interest only if earnings are high
enough to cover the interest expense.
 Indexed bonds also called purchasing power bonds are famous
in countries with high inflation rates. Interest payment and
maturity payment rise automatically when the inflation rate
rises thus protecting bond holders against inflation.

5
Key Features of a Bond
 Par value: stated face value of the bond. It generally represents the
amount of money that the firm borrows and promises to repay on the
maturity date. Par value, also known a face or principal value, is how
much the bondholder will receive at maturity

 Coupon rate: Stated payment which is also called the coupon

payment.
 Coupon rate is different from the interest rate.
 Coupon rate remains fixed throughout the life of the bond, but the
interest rate may go up and down in the economy.

(More…)
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 Maturity: Years until which the par value of
the bond must be repaid. Declines each year
after it has been issued.

 Issue date: Date when bond was issued.

 Default risk: Risk that issuer will not make

interest or principal payments.

7
Call Provision
Some corporate bonds contain a call provision which gives the issuing corporation,
the right to call the bonds for redemption.
Call provision states that the company must pay the bondholders an amount greater
than the par value if they are called. The additional sum paid is termed call
premium.
Issuer can call for redemption if interest rates decline. That helps the issuer but

hurts the investor.

If interest rate goes up (I>C) the company will not call the bond and the investor

will be stuck with the original coupon rate even though interest rates elsewhere in
the economy have increased.
In interest rate falls (I<C) the company will call the bond and pay off the investors

who must then reinvest the proceeds at the current market rate which is lower than
the rate they are getting on the original bond.
Most bonds are not called until several years after they are issued and have a

deferred call and the bonds are said to have call protection.

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 Event risk is the chance that some
sudden event will occur and increase
the credit risk of the company hence
lowering the bond rating and the value
of bonds. Such firms must pay the
investors extremely high interest rates

9
What’s a sinking fund?
 Provision to pay off a loan over its life
rather than all at maturity.
 Similar to amortization on a term loan.
 Reduces risk to investor.

10
Sinking funds are generally
handled in 2 ways
 1. The company can call in for redemption a certain
percentage of the bonds each year at par value. Bonds are
numbered serially and those called for redemption are
determined by a lottery administered by the trustee.
 2. Company may buy the required number of bonds in open
market. Company would chose the least cost method. If interest
rates have risen, causing bond prices to fall then it will buy
bonds in the open market at a discount, if interest rates have
fallen, it will call the bonds.

11
Bond Valuation
 Value of any financial asset (bond in
this case) is simply the PV of the cash
flows the asset is expected to
produce in the future.
 Cash flows from a specific bond depend
on it’s contractual features as described
in the previous section.

12
 Bond Valuation

0 1 2 n
r
...

Value CF1 CF2 CFn

CF1 CF2 CFn

PV = + + ... + .
1+ r 1
1 + r 2
1+ r n
13
 What is the value of a 10-year, 10% coupon bond WITH FACE
VALUE OF 1000, if rd = 10%

0 1 2 10
10% ...
V=? 100 100 100 + 1,000

$100 $100 $1,000

VB  + . . . + +
1 + r d  1+ r d 
1 10 10
1 + rd 
= $90.91 + . . . + $38.55 + $385.54
= $1,000.
14
 Rd or I/Y= bond’s required rate of return which is the market
interest rate for that type of bond. This is the discount rate that
is used to calculate the PV of the bond’s cash flows. It is not the
coupon interest rate. In financial calculator it is entered as I/Y
 N= number of years before the bond matures
 Coupon payment = dollars of interest paid each year = (coupon
rate)(par value). For a bond with 10%coupon and a $1000 par
value, the annual interest is $100. In financial calculator
PMT=100. If the bond had been semi annual payment bond,
the payment would have been $50 every 6 months.
 FV= par or maturity value of the bond. This amount must be
paid off at the maturity and it is often equal to $1000.

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 What will be the value of a 15 year bond
with an annual coupon rate of 10% and a
par value of 1000.
 N=15
 I/Y=10
 PV= ?
 PMT=100
 FV=1000
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Points to remember
 Whenever the going market rate of interest, rd (Ii/Y in
financial calculator) is equal to the coupon rate, a fixed rate

bond will sell at its par value.

 The coupon rate remains fixed after the bond is
issued, but interest rates in the market move up
and down.
 An increase in the market interest rate, rd, will
cause the price of the bond to fall, whereas
decrease in rates will cause the bond price to rise.

17
 What would happen if expected inflation
rose by 5%, causing r = 15%?

INPUTS 15 15 100 1000

N I/YR PV PMT FV
OUTPUT -707.63

If coupon rate < rd the coupon rate, the

bond’s value falls below par, so it sells
at a discount and it is called a
discount bond. 18
 What would happen if inflation
fell, and rd declined to 5%?

INPUTS 15 5 100 1000

N I/YR PV PMT FV
OUTPUT -1518.98

If coupon rate > rd, price rises above

par, and bond sells at a premium and
it is called a premium bond.
19
What’s “yield to maturity”?
 YTM is the rate of return earned on a bond held to
maturity. Also called “promised yield.”
 It assumes the bond will not default.
 Rate of return on the bond is a combination of rate
of return due to interest payment (current yield) and
rate of return due to price change (capital gains
yield).
 At rd 5%, capital gains you are making in one year is
value of bond at end of year 14 minus value of bond
at end of year 13.

20
 Definitions
Annual coupon pmt
Current yield = Current price

Change in price
Capital gains yield =
Beginning price

Exp total Exp Exp cap

return = YTM = Curr yld + gains yld
21
Changes in the bond values
over time: capital gains yield
 Bonds in the above example are issued at par at 10% interest rate.
What would be the value of the bond 1 year after it was issued?
 Now the term to maturity is 14 yrs. Everything else is the same.
 N=14
 I/Y=10
 PV=?
 PMT=100
 FV=1000
 Answer= -1000
 Value of the bond would remain at 1000 as long as the interest rate
remains constant as the coupon rate, 10%

22
 Now interest rates in the economy fall and rd falls below the coupon
rate from 10% to 5%. What would be the value of the bond one year
later, Everything remaining the same.
 Value would be 1494.93.
 Rd falls below the coupon rate and the bond is selling at a premium.
 Logic: because rd has fallen to 5% with 1000 to invest, you can buy
new bonds, but these new bonds will give you 50 as interest instead of
100. Naturally investors would prefer 100 to 50, so they would be
willing to pay more than 1000 for a bond to obtain higher returns. All
investors would react similarly as a result the price would go up to
1494.93

23
 If interest rate rise from 10 to 15, value
of the bond would be 713.78.
 Bond would sell below it’s par value or
at a discount.

24
 At 5%, Value of bond at year 14 is
already calculated before which is
1494.73.
 Value of bond at year 13 is 1469.68.
 So the value of the bond has
depreciated from year 14 to 13 by an
amount of -25.05 (capital loss)

25
 Current yield = 100/1494.93 = 6.69%
 Capital gains yield = -25.25/1494.93 =
-1/69%
 Total rate of return or yield = 5%

26
 Opposite is the case for discount bonds.
 Value of the bond at the End of 13 year at
15% is 720.84.
 Value appreciated by 7.06
 Current yield = 100/713.78 = 14.01%
 Capital gains yield = 7.06/713.78 = 0.99%
 Total rate of return or yield = 15%

27
Points to remember
 When rd=coupon rate, fixed rate bond will sell at par.
 Interest rate changes over time, but the coupon rate remains
fixed after the bond has been issued.
 When interest rate rises above coupon rate, price of fixed rate
bonds fall below its par value. Such a bond is called discount
bond.
 When interest rate falls below coupon rate, price of fixed rate
bonds rise above its par value. Such a bond is called premium
bond.
 Increase in interest rates will cause the prices of outstanding
bonds to fall, whereas decrease in rates will cause bond prices
to rise.

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Bond Value ($) vs Years
remaining to Maturity

1495 rd = 5%.

rd = 10%. M
1,000

rd = 10%.
714

29
30 25 20 15 10 5 0
 YTM on a 10-year, 9% annual coupon,
$1,000 par value bond selling for $887

0 1 9 10
rd=?
...
90 90 90
PV1 1,000
.
.
.
PV10
PVM
887 Find rd that “works”!
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 Find rd

INT INT M
VB  + ... + +
1 + r d  1 + r d  1 + r d 
1 N N

90 ... + 90 1,000
887  1 + 10 +
1 + r d  1+ r d  1 + r d 
10

INPUTS 10 -887 90 1000

N I/YR PV PMT FV
OUTPUT 10.91
31
 Find YTM if price were
$1,134.20.

INPUTS 10 -1134.2 90 1000

N I/YR PV PMT FV
OUTPUT 7.08

Sells at a premium. Because

coupon = 9% > rd = 7.08%,
bond’s value > par.

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 9% coupon, 10-year bond, P = $887, and YTM
= 10.91%, par value = $1000

$90
Current yield = $887

= 0.1015 = 10.15%.

33
YTM = Current yield +
Capital gains yield.

Cap gains yield = YTM - Current yield

= 10.91% - 10.15%
= 0.76%.

Could also find values in Years 1 and 2,

get difference, and divide by value in
Year 1. Same answer.
34
 Semiannual Bonds

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

2. Divide nominal or quoted interest rate
by 2 to get periodic rate = rd/2.
3. Divide annual coupon interest payment
by 2 to get PMT = INT/2.
INPUTS 2n rd/2 OK INT/2 OK
N I/YR PV PMT FV
OUTPUT
35
 Value of 10-year, 10% coupon,
semiannual bond if rd = 13%.par value
=$1000

2(10) 13/2 100/2

INPUTS 20 6.5 50 1000
N I/YR PV PMT FV
OUTPUT -834.72

36
Bond Yields
 Unlike bond interest rates, which is
fixed, bond yield varies from, day to
day depending on current market
conditions.
 Yield can be calculated in different ways

37
Yield to maturity
 14 yr, 10% annual coupon, 1000 par
value bond at a price of 1494.93 What
rate of interest would you earn on your
invetsment if the bonds are held till
maturity?
 This rate is called the yield to maturity
(YTM).
 Answer 5%
38
Yield to call
 If the company has the option to call the bond, you
would not have the option of holding that bond till
maturity. Therefore YTM would not be earned.
 Micro drive issued 10% callable bonds and the interest
rate fell from 10% to 5%, then the company could call
the 10% bonds and replace with 5% bonds and save
100-50= 50 interest per bond per year. This is good
for the company but not for the bond holders.
 In this case investors will estimate its expected rate of
return as yield to call (YTC).

39
 Micro drive had the option to call the bond 10 years after the issue date at a price
of $1100. Suppose that one year after the issuance the going interest rate had
declined, causing the price of the bonds to rise to $1494.93. What is bond’s YTC?
 N=9
 PV=-1494.93
 FV=1100
 PMT=100
 I/Y=?
 Answer 4.21
 YTC is 4.21% i:e: the returns you would earn if you bought the bond at aprice of
1494.93 and it was called 9 years form today.
 Will Micro drive call the bonds????
 That entirely depends on the going interest rate when the bonds become callable.
 If the going interest rate remains at 5% then micro drive could save 5% by calling
them and replacing 10% bonds with 5% bonds.

40
Callable Bonds and Yield to
Call
 A 10-year, 10% semiannual coupon,
$1,000 par value bond is selling for
$1,135.90 with an 8% yield to maturity.
It can be called after 5 years at $1,050.
 What is the YTC?

41
Nominal Yield to Call (YTC)

INPUTS 10 -1135.9 50 1050

N I/YR PV PMT FV
OUTPUT 3.765 x 2 = 7.53%

42
 In general, if a bond sells at a premium,
then (1) coupon > rd, so (2) a call is
likely.
 So, expect to earn:
 YTC on premium bonds.
 YTM on par & discount bonds.

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Determinants of market interest rates
rd = r* + IP + DRP + LP + MRP.
Here:
rd = Required rate of return on a debt security.
r* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.
LP = Liquidity premium.
MRP = Maturity risk premium.

44
Real risk free rate of interest
r*
 It is defined as the interest rate that
would exist on a riskless security if no
inflation were expected.

45
Estimating Inflation premium
 Investor’s are well aware of the inflation
effects on the interest rate, so when
they lend money they build an inflation
premium (IP) equal to the average
expected inflation rate over the life of
the security.
 rRF = r*+IP

46
Default risk premium DRP
 If the issuer defaults on payment,
investors receive less than the promised
return on the bond.
 The quoted interest rate includes a
default risk premium----the greater the
default risk, higher the bond’s yield to
maturity.

47
Bond Spreads, the DRP, and
the LP
 Bond rating is very important. As the rating
falls, yield of the bond increases.
 A “bond spread” is often calculated as the
difference between a corporate bond’s yield
and some other security yield of the same
maturity.

48
Liquidity premium
 A liquid asset can be converted to cash easily.
 Because liquidity is very important, so
investor’s include Liquidity premium.
 Bond’s of large, strong companies often have
very small LPs. Bond’s of small companies
often have LPs as high as 2%.

49
Maturity risk premium MRP
 All bonds are exposed to two additional
sources of risk: interest rate risk and
reinvestment risk.
 The net effect of these two sources of
risk upon a bond’s yield is called MRP.

50
Interest rate risk
 Interest rates go up and down, and an
increase in the interest rates leads to a
decline in the value of the bonds. This
decline in value due to rising interest
rates is called interest rate risk.

51
What is reinvestment rate
risk?
 The risk of an income decline due to a drop in
interest rates is called reinvestment risk.
 The risk that CFs will have to be reinvested in

the future at lower rates, reducing income.

Illustration: Suppose you just won $500,000
playing the lottery. You’ll invest the money
and live off the interest. You buy a 1-year
bond with a YTM of 10%.

52
 Year 1 income = $50,000. At year-end
get back $500,000 to reinvest.

 If rates fall to 3%, income will drop

from $50,000 to $15,000.

53
The Maturity Risk Premium
 Yields on longer term bonds usually are
greater than on shorter term bonds, so the
MRP is more affected by interest rate risk
than by reinvestment rate risk.

54
Bankruptcy
 Two main chapters of Federal
Bankruptcy Act:
 Chapter 11, Reorganization
 Chapter 7, Liquidation
 Typically, company wants Chapter 11,
creditors may prefer Chapter 7.

55
 If company can’t meet its obligations, it files
under Chapter 11. That stops creditors from
foreclosing, taking assets, and shutting down
the business.
 Company has 120 days to file a
reorganization plan.
 Court appoints a “trustee” to supervise
reorganization.
 Management usually stays in control.

56
 Company must demonstrate in its
reorganization plan that it is “worth
more alive than dead.”
 Otherwise, judge will order liquidation
under Chapter 7.

57
If the company is liquidated,
here’s the payment priority:
 Past due property taxes
 Secured creditors from sales of secured assets.
 Trustee’s costs
 Expenses incurred after bankruptcy filing
 Wages and unpaid benefit contributions, subject to limits
 Unsecured customer deposits, subject to limits
 Taxes
 Unfunded pension liabilities
 Unsecured creditors
 Preferred stock
 Common stock

58
 In a liquidation, unsecured creditors generally
get zero. This makes them more willing to
participate in reorganization even though
their claims are greatly scaled back.
 Various groups of creditors vote on the
reorganization plan. If both the majority of
the creditors and the judge approve,
company “emerges” from bankruptcy with
lower debts, reduced interest charges, and a
chance for success.

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