CHAPTER 7: INTEREST RATES AND BOND VALUATION

BONDS AND BOND VALUATION

When a corporation or government wishes to borrow money from

the public on a long-term basis, it usually does so by issuing and
selling debt securities that are generically called bonds
A bond is normally an interest-only loan, meaning the borrower
pays the interest every period, but none of the principal is repaid
until the end of the loan
Coupon: the stated interest payment made on a bond
o Level Coupon Bond: when the coupon is constant and paid
every year
Face Value (Par Value): the principal amount of a bond that is
repaid at the end of the term
Coupon Rate: the annual coupon divided by the face value of a
bond
Maturity: specified date at which the principal amount of a bond
is paid
There is an inverse relationship between interest rates and the
value of a bond:
o When interest rates rise, the present value of the bonds
remaining cash flows declines, and the bond is worth less
o When interest rates fall, the present value of the bonds
remaining cash flows increases, and the bond is worth
more
Yield to Maturity (YTM): the market interest rate that equates a
bonds present value of interest payments and principal
repayment with its price
A bonds cash flows have an annuity component (the coupons)
and a lump sum (the face value paid at maturity)
o We can estimate of the market value of the bond by
calculating the present value of these two components
separately and adding the results
Discount Bond: a bond that sells for less than the face value, or
at a discount
Premium Bond: a bond that sells for more than the face value, or
at a premium
Bond Value = C *[1 1/(1+r)t] / r + F/(1+r)t
Where C = coupon paid per period
Where r = yield per period
Where t = periods to maturity
Where F = face value paid at maturity
 Bond Value = Present Value of Coupons + Present
Value of Face Amount
Most bonds are issued at par, with the coupon rate set equal to
the prevailing interest rate (market yield)
o This coupon rate doesnt change over time
o The coupon yield changes and reflects the return the
coupon represents based on current market prices for the
bond
o The YTM is the interest rate that equates the present value
of the bonds coupons and principal repayments with the
current market price (IE: the total annual return the
purchaser would receive if the bond were held to maturity)
When interest rates are above the bonds coupon rate, the bond
sells at a discount
When interest rates are below the bonds coupon rate, the bond
sells at a premium
Interest Rate Risk: the risk that arises for bond owners from
fluctuating interest rates (market yields)
o How much interest risk a bond has depends on how
sensitive its price is to interest rate changes
o Sensitivity depends on:
Time to maturity
Coupon rate
o All other things being equal:
The longer the time to maturity, the greater the
interest rate risk
The lower the coupon rate, the greater the interest
rate risk

MORE ON BOND FEATURES

Debt: represents something that must be repaid; the result of

borrowing money
Main differences between debt and equity:
o Debt is not an ownership interest in the firm
Creditors/lenders usually dont have voting power
o The corporations payment of interest on debt is
considered a cost of doing business and is fully tax
deductible
Dividends paid to shareholders are not tax deductible
o Unpaid debt is a liability to the firm. If it is not repaid, the
creditors can legally claim the assets of the firm. This
action can result in liquidation or reorganization, two of the
possible consequences of bankruptcy. One of the costs of
issuing debt is the possibility of financial failure
 This possibility doesnt arise when equity is issued
Equity represents ownerships interest, and it is a residual claim
o Equity holders are paid after debt holders
All long-term debt securities are promises by the issuing firm to
pay the principal when due and to make timely interest
payments on the unpaid balance
o Maturity: refers to the length of time the debt remains
outstanding with some unpaid balance
o Debt securities are typically called notes, debentures, or
bonds
o Can be short-term or long-term, public or private
Indenture: written agreement between the corporation and the
lender detailing the terms of the debt issue
o A trustee is appointed by the corporation to represent the
bondholders
Makes sure the terms of the indenture are obeyed
Manages the sinking fund
Represents the bondholders in the event that the
company defaults on its payments
o Legal document that includes the following provisions:
The basic terms of the bonds
The amount of the bonds issued
A description of property used as security if the
bonds are secured
The repayment arrangements
The call provisions
Details of the protective covenants
o Registered Form: registrar of company records ownership
of each bond; payment is made directly to the owner of
record
o Bearer Form: bond issued without record of the owners
name; payment is made to whoever holds the bond
o Debt securities are classified according to the collateral
and mortgages used to protect the bondholder
Collateral: securities pledged as security for payment
of debt
Mortgage Securities: secured by a mortgage on the
real property of the borrower
o Debenture: unsecured debt, usually with a maturity of 10
years or more
o Note: unsecured debt, usually with a maturity under 10
years
 o Seniority: indicates preference in position over other
lenders, and debts are sometimes labeled as senior or
junior
In the event of default, holders of subordinated debt
must give preference to other specified creditors
o Sinking Fund: account managed by the bond trustee for
early bond redemption
o Call Provision: agreement giving the corporation the option
to repurchase the bond at a specified price before maturity
Call Premium: amount by which the call price
exceeds the par value of a bond
Deferred Call: call provision prohibiting the company
from redeeming the bond before a certain date
Call Protected: bond during period in which it cannot
be redeemed by the issuer
Canada Plus Call: call provision that compensates
bond investors for interest differential, making it
unattractive for an issuer to call a bond
o Protected Covenant: part of the indenture limiting certain
transactions that can be taken during the term of the loan,
usually to protect the lenders interest
Negative Covenant: thou shalt not
Firm must limit amount of dividends it pays
according to some formula
Firm cannot pledge any assets to other lenders
Firm cannot merge with another firm
Firm cannot sell or lease any major assets
without approval by the lender
Firm cannot issue additional long-term debt
Positive Covenant: thou shalt
Company must maintain its working capital at
or above some specified minimum level
Company must periodically furnish audited
financial statements to the lender
Company must maintain any collateral or
security in good condition

BOND RATINGS

Firms frequently pay to have their debt rated

o An assessment of the creditworthiness of the corporate
issuer
o Based on how likely the firm is to default and what
protection creditors have in the event of a default
SOME DIFFERENT TYPES OF BONDS

Financial Engineering: when financial managers or their

investment bankers design new securities or financial products
o Reduces and controls risk, and minimizes taxes
o Reduce financing costs of issuing and servicing debt, as
well as costs of complying with rules laid down by
regulatory authorities
Stripped/Zero-Coupon Bond: a bond that makes no coupon
payments, thus initially priced at a deep discount
o Issuer of bond deducts interest every year even though no
interest is actually paid
o Owner must pay taxes on interest accrued every year as
well, even though no interest is actually paid
o Less attractive to taxable investors
Floating-Rate Bond: coupon payments are adjustable
o Adjustments are tied to the Treasury bill rate or another
short-term interest rate
o Controls the risk of price fluctuations as interest rates
change
o A bond with a coupon equal to the market yield is priced at
par
o Value of floating-rate bond depends on exactly how the
coupon payment adjustments are defined
o Put Provision: holder has the right to redeem their note at
par on the coupon payment date after some specified
amount of time
o Coupon rate has a floor and ceiling
Income Bonds: coupon payments depend on company income
Real Return Bond: coupons and principal indexed to inflation to
provide a stated real return
Convertible Bond: can be swapped for a fixed number of shares
of stock anytime before maturity at the holders option
Asset-Backed Bond: backed by a diverse pool of illiquid assets
such as A/R, credit card debt, or mortgages
Retractable/Put Bond: bond that may be sold back to the issuer
at a pre-specified price before maturity

BOND MARKETS

Most trading in bonds takes places over the counter (OTC)

o Little or no transparency
A financial market is transparent if it is possible to
easily observe its prices and trading volume
 o Transactions are negotiated privately between parties, and
there is little or no centralized reporting of transactions
Number of bond issues far exceeds the number of stock issues
Clean Price: the price of a bond net of accrued interest; this is
price that is typically quoted
Dirty Price: the price of a bond including accrued interest; also
known as the full or invoice price. This is the price the buyer
actually pays
Accrued interest on a bond is calculated by taking the fraction of
the coupon period that has passed and multiplying it by the next
coupon
Bond Fund: a mutual fund that invests in bonds and other debt
securities
o Include mortgages, and provincial, corporate, and
municipal debt

INFLATION AND INTEREST RATES

Real Rates: interest rates or rates of return that have been

adjusted for inflation
Nominal Rates: interest rates or rates of return that have not
been adjusted for inflation
o The nominal rate on an investment is the percentage
change in the number of dollars you have
Fisher Effect: the relationship between nominal returns, real
returns, and inflation
1 + R = (1 + r) * (1 + h)
Where R = nominal rate
Where r = real rate
Where h = compensation for the decrease in the value of money
originally invested because of inflation
o Can be rearranged as:
R = (r + h) + (r * h)

Either discount nominal cash flows at a nominal rate, or discount

real cash flows at a real rate

DETERMINANTS OF BOND YIELDS

Term Structure of Interest Rates: the relationship between

nominal interest rates on default-free, pure discount securities
and time to maturity; that is, the pure time value of money
When long-term rates are higher than short-term rates, we say
that the term structure is upward sloping (and vice versa)
 Inflation Premium: the portion of a nominal interest rate that
represents compensation for expected future inflation
Interest Rate Risk Premium: the compensation investors demand
for bearing interest rate risk
Canada Yield Curve: a plot of the yields on Government of
Canada notes and bonds relative to maturity
Canada bonds are default-free, taxable, and highly liquid
Default Risk Premium: the portion of a nominal interest rate or
bond yield that represents compensation for the possibility of
default
Liquidity Premium: the portion of a nominal interest rate or bond
yield that represents compensation for lack of liquidity