Chapter 5

Bonds, Bond Valuation, and

Interest Rates

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

2
 Determinants of Intrinsic Value: The Cost of
Debt

Net operating Required investments

profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 ... + FCF

Value = + +
(1 + WACC)1 (1 + WACC)2 (1 +
WACC)

Weighted average
cost of capital
(WACC)

Market interest rates Firms debt/equity mix

Cost
Costof
ofdebt
debt
Market risk aversion Cost of equity Firms business risk
Cost of equity
3
 Interest Rates & Interest-
Bearing Securities
Interest rates:
Based on supply & demand for money

Driven by risk factors

Role of Federal Reserve

Basis Point
.01% or .0001
4
 Risk & Term Structure of
Interest Rates

rd = r* + IP + DRP + LP + MRP

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.

5
Risk & Term Structure
r = r* + IP + DRP + LP + MRP
r = nominal interest rate of a particular security (or
required rate of return)
r* = real risk-free interest rate
typically 1-4% depending on monetary policy
assumes expected inflation = zero
IP = Inflation premium
Ave. inflation over life of bond
DRP = Default risk premium
Compensation for possible default
Function of bond ratings

6
Risk & Term Structure

r = r* + IP + DRP + LP + MRP
LP = Liquidity Premium
Compensation for possible difficulty selling
bond quickly at fair market value
MRP = Maturity Risk Premium
Compensation for possible loss in value due
to increase in interest rates over maturity of
bond.
Affects longer maturities more than shorter.

7
 Premiums Added to r* (real risk-
free rate) for Different Types of
Debt
ST Treasury:
only IP for ST inflation
LT Treasury:
IP for LT inflation, MRP
ST corporate:
ST IP, DRP, LP
LT corporate:
IP, DRP, MRP, LP
8
 Inflation & Interest Rates
Nominal Interest= 12%
12% -8%

- Inflation -1% =4%

= Real Int. % =11%

8%
If inflation =
11%
& reqd real return =
=19%
Then Nominal rate =? =
9
 Relationship b/w Nominal &
Real Interest Rates, &
Inflation
Nom = Real + Inflation
But, inflation not additive, it grows or
compounds, so multiply
Nom = (Real) x (Infl)
And (1+Nom) = (1 + real) x (1 + infl)
Is better determinant; known as Fisher
effect

10
Estimating Inflation Premium
(IP)
Treasury Inflation-Protected Securities
(TIPS) are indexed to inflation.
IP for a particular length maturity can
be approximated as the difference
between the yield on a non-indexed
Treasury security of that maturity
minus the yield on a TIPS of that
maturity.

11
Bond Spreads, the DRP,
and the LP
A bond spread is often calculated as
the difference between a corporate
bonds yield and a Treasury securitys
yield of the same maturity. Therefore:
Spread = DRP + LP.
Bonds of large, strong companies often
have very small LPs. Bonds of small
companies often have LPs as high as
2%.
12
Term Structure Yield Curve
Term structure of interest rates:
the relationship between interest
rates (or yields) and maturities.
A graph of the term structure is
called the yield curve.

13
Hypothetical Treasury Yield
Curve

14
 What factors can explain
shape of this yield curve?
Upward slope due to:
Increasing expected inflation
Increasing maturity risk premium

What about liquidity & default risk?

15
 Treasury vs. Corporate
Yield Curves relationships
Corp yield curves are higher than
Treasuries, but not necessarily parallel.
Spread b/w the two yield curves
widens as corporate bond rating
decreases due to:
DRP & LP

16
Computing Yields
Estimate the inflation premium (IP)
for each future year. This is the
estimated average inflation over
that time period.
Step 2: Estimate the maturity risk
premium (MRP) for each future
year.

17
 Assume investors expect inflation to be 5% next
year, 6% the following year, and 8% per year
thereafter.
Step 1: Find the average expected
inflation rate over years 1 to n:
IP1 = 5%/1.0 = 5.00%.

IP10 = [5 + 6 + 8(8)]/10 = 7.5%.

IP20 = [5 + 6 + 8(18)]/20 = 7.75%.

Must earn these IPs to break even versus inflation;
that is, these IPs would permit you to earn r*
(before taxes).
18
 Assume the MRP is zero for Year 1 and
increases by 0.1% each year.

Step 2: Find MRP based on

this equation:
MRPt = 0.1%(t - 1).
MRP1 = 0.1% x 0 = 0.0%.

MRP10 = 0.1% x 9 = 0.9%.

MRP20 = 0.1% x 19 = 1.9%.

Step 3: Add the IPs and MRPs to r*:

rRFt = r* + IPt + MRPt .

rRF = Quoted market interest

rate on treasury securities.
Assume r* = 3%:
rRF1 = 3% + 5% + 0.0% = 8.0%.
rRF10 = 3% + 7.5% + 0.9% = 11.4%.
rRF20 = 3% + 7.75% + 1.9% = 12.65%.
 Upward vs. Downward
sloping yield curves due
to?
Real risk-free rate = 3%
Expected inflation for
Year 1 =7%, Yr 2 = 5%; Yr 3 = 3%
What are interest rates for 1, 2, & 3 yr
borrowings?

21
Interest Rates & MRP
problem
Assume the real risk-free rate (r*) is 4% and
inflation is expected to be 7 percent in
Year1; 4% in yr 2; and 3% thereafter.
Assume all Treasury Bonds are highly liquid
and free of default risk. If 2-yr and 5-yr T-
Bonds both yield 11%, what is the difference
in the maturity risk premiums (MRPs) on the
two bonds; that is, what is MRP5 MRP2?
22
 Interest Rates & Inflation
Problem
Due to the recession, the rate of inflation
expected for the coming year is only 3.5%.
However, the rate of inflation in Yr 2 and
thereafter is expected to be constant at some
level above 3.5%. Assume the real risk-free
rate (r*) = 2% for all maturities, and there are
no maturity premiums. If 3-year T-Bonds yield
3% (0.03) more than the 1-year T-Bonds, what
rate of inflation is expected after year 1?

23
Coupon Bonds
Bond = Debt = Borrowing
Fixed Maturity (Maturity Date) = N
Par Value=Face Value=Maturity Value=$1000=FV
Coupon Rate=Stated Rate (locked in in bond
contract)
Coupon payment= Coupon rate x face value=PMT
Market Rate of interest = Yield to Maturity = rate
used to discount bond CFs = I

**PV cash flow of bonds always opposite sign of PMT & FV!!!

24
Bond Perspectives

Debt Asset
Needs $ Has $
Borrower Lender
Issuer or seller Buyer or Investor
Debtholder
Bondholder
Creditor
Cost of borrowing
Interest Paid (Expense)
Requires return to invest
generates tax benefit $ in bonds based on risk
(Svgs) Interest Received (earned)
Cost of Debt (Revenue) - pay tax on it
= Rd or Kd;
Capital Appreciation
After-tax cost = Rd (1-t)
25
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.

(More)
26
Key Features of a Bond
Maturity: Years until bond must be
repaid. Declines.
Issue date: Date when bond was
issued.
Default risk: Risk that issuer will
not make interest or principal
payments.

27
 Value of Financial Security
Value of any asset based on the net present
value of the expected future cash flows
discounted by the interest (discount) rate
that reflects risk factors
Discount (interest rate) depends on:
Riskiness of CFs reflected by DRP, MRP, LP
General level of interest rates, which reflects
inflation, supply & demand for $, production
opportunities, time preferences for
consumption
28
 Value of a 10-year, 10%
coupon bond if rd = 10%

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

$100 $100 $1,000

VB = +... + +
(1 + rd)1
(1 + rd) (1 + rd)N
N

= $90.91 + . . . + $38.55 + $385.54

= $1,000.
29
 The bond consists of a 10-year, 10%
annuity of $100/year plus a $1,000
lump sum at t = 10:

PV annuity =$ 614.46
PV maturity value = 385.54
Value of bond =$1,000.00

INPUTS
10 10 100 1000
N I/YR PV PMT FV
OUTPUT -1,000

30
 What would happen if expected
inflation rose by 3%, causing r =
13%?

INPUTS 10 13 100 1000

N I/YR PV PMT FV
OUTPUT -837.21

When market interest rate (rd)rises

above coupon rate, bonds value (PV
or price) falls below par, so sells @
discount. 31
 What happens if one year passes but
the market i stays at 13%?

INPUTS 9 13 100 1000

N I/YR PV PMT FV
OUTPUT -846.05

32
 What happens if a second year
passes but the market i stays at
13%?

INPUTS 8 13 100 1000

N I/YR PV PMT FV
OUTPUT -856.04

33
 What happens if 9 years pass but
the market i stays at 13%?

INPUTS 1 13 100 1000

N I/YR PV PMT FV
OUTPUT -973.45

As a bond approaches maturity, its price

approaches the face or maturity value of $1000

34
Bond Pricing in Excel

35
 What would happen if
inflation fell, and rd
declined to 7%?
INPUTS 10 7 100 1000
N I/YR PV PMT FV
OUTPUT -1,210.71

If coupon rate > mrkt i% (rd), price

rises above par, and bond sells at a
premium.
36
Bond Pricing in Excel
PV = ? $1210.71

Years to Mat: 10

Coupon rate: 10%

Annual Pmt: $100

Par value = FV: $1,000

Going rate, rd: 7%

37
Summary of Bond price
and interest rate
relationships
If market rate of interest increases
above the stated (coupon) rate, then
bonds price falls and sells at discount
If market rate of interest drops below
the stated (coupon) rate, then bonds
price increases and sells at a premium
**INVERSE RELATIONSHIP b/w Market i
% and Bonds PRICE!***

38
Bond prices & changing
interest rates
Suppose the bond was issued 20
years ago and now has 10 years to
maturity. What would happen to
its value over time if required rate
of return remained at 10%, or at
13%, or at 7%?

39
Bond Value ($) vs Years
remaining to Maturity

1,372 rd = 7%.
1,211

rd = 10%. M
1,000

837
rd = 13%.
775

40
30 25 20 15 10 5 0
Bond Price Movements over
time
At maturity, value of any bond
must equal its par value.
Value of a premium bond
decreases to $1,000.
Value of a discount bond increases
to $1,000.
A par bond stays at $1,000 if mrkt
i% (rd)remains constant.
41
 Whats market value of 10 year
10% coupon bond when market
= 7%?

INPUTS 10 7 100 1000

N I/YR PV PMT FV
OUTPUT ?

Bond sells at a premium::

Price today = $1,210.71.

42
 If you buy a 10%, 10 year bond
today for $1,210.71, and hold it
to maturity, whats your rate of
return?

INPUTS 10 (1210.71) 100 1000

N I/YR PV PMT FV
OUTPUT ?

Solve for i% = 7% = Yield to

maturity (YTM)

43
 Whats yield to
maturity?
YTM is rate of return earned on a bond held to
maturity. Also called promised yield.
It assumes bond will not default.
Includes both interest pmt component & cap
gains over bonds life
Interest rate equating bonds price today to
NPV of PMTs & FV. (Think market rate of
interest)
Vs. Annualized Return which reflects only a
one-year holding period 44
 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 i % (rd) that works!
45
 Find YTM (i % or rd)

INT INT M
VB = 1+ ... + (1 + r )N+
(1 + rd) d (1 + r d)N
90 ... 90 1,000
887 = + + +
(1 + rd) 1
(1 + rd) (1 + rd)N
N

INPUTS 10 -887 90 1000

N I/YR PV PMT FV
OUTPUT 10.91
46
YTM in Excel

Years to Mat: 10

Coupon rate: 9%

Annual Pmt: $90.00

Current price: $887.00

Par value = FV: $1,000.00

47
Bond Prices & Int. Rates

If coupon rate < mrkt i % (rd), bond

sells at a discount.
If coupon rate = i %, bond sells at
its par value.
If coupon rate > i%, bond sells at a
premium.
If market i% rises, price falls.
Price = par at maturity.
48
 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% >
mrkt i% = 7.08%, bonds
value > par.
49
 Definitions
Current yield = Interest Yield

Capital gains yield =Change in value

Exp total = YTM = Exp +Exp cap

return Curr yld gains yld

50
 Definitions

Annual coupon pmt

Current yield =
Current price

Capital gains yield =Change in price

Beginning price

Exp total = YTM = Exp + Exp cap

return Curr yld gains yld
51
 9% coupon, 10-year bond, P
= $887, and YTM = 10.91%

$90
Current yield =
$887
= 0.1015 = 10.15%.

52
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. 53
 Semiannual Bonds

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. 2N rd/2
INPUTS OK INT/2 OK
N I/YR PV PMT FV
OUTPUT
54
 Value of 10-year, 10%
coupon, semiannual bond if
rd = 13%.

2(10) 13/2 100/2

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

55
Spreadsheet Functions
for Bond Valuation

PRICE
YIELD

56
 Call Provision
Issuer can refund if rates decline. That
helps the issuer but hurts the investor.
Therefore, borrowers are willing to pay
more, and lenders require more, on
callable bonds.
Most bonds have a deferred call and a
declining call premium
Yield to call: yearly rate of return
earned on a bond until its called
57
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.

58
Nominal Yield to Call (YTC)

INPUTS 10 -1135.9 50 1050

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

59
If you bought bonds, would you
be more likely to earn YTM or
YTC?
Coupon rate = 10% vs. YTC = r d =
7.53%. Could raise money by
selling new bonds which pay 7.53%.
Could thus replace bonds which pay
$100/year with bonds that pay only
$75.30/year.
Investors should expect a call,
hence YTC = 7.53%, not YTM = 8%.

60
Investor returns on
callable bonds
In general, if a bond sells at a
premium, then coupon > market
rate, so a call is likely.
So, investors expect to earn:
YTC on premium bonds.
YTM on par & discount bonds.

61
Whats 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, shortens
average maturity.
But not good for investors if rates
decline after issuance.
62
Sinking funds are
generally handled in 2
ways
Call x% at par per year for sinking
fund purposes.
Call if rd is below the coupon rate and
bond sells at a premium.
Buy bonds on open market.
Use open market purchase if rd is
above coupon rate and bond sells at a
discount.
63
 Bond Ratings % defaulting within:
S&P and Moody 1 yr. 5 yrs.
Fitch s
Investment grade bonds:
AAA Aaa 0.0 0.0
AA Aa 0.0 0.1
A A 0.1 0.6
BBB Baa 0.3 2.9
Junk bonds:
BB Ba 1.4 8.2
B B 1.8 9.2
CCC Caa 22.3 36.9
Source: Fitch Ratings 64
Bond Ratings and Bond
Spreads (YahooFinance, March 2009)
Long-term Bonds Yield (%) Spread (%)
10-Year T-bond 2.68
AAA 5.50 2.82
AA 5.62 2.94
A 5.79 3.11
BBB 7.53 4.85
BB 11.62 8.94
B 13.70 11.02
CCC 26.30 23.62 65
What factors affect default
risk and bond ratings?
Financial ratios
Debt ratio
Coverage ratios, such as interest
coverage ratio or EBITDA coverage
ratio
Profitability ratios
Current ratios

(More)
66
Bond Ratings Median
Ratios (S&P)
Interest Return on Debt to
coverag capital capital
e
AAA 23.8 27.6% 12.4%
AA 19.5 27.0% 28.3%
A 8.0 17.5% 37.5%
BBB 4.7 13.4% 42.5%
BB 2.5 11.3% 53.7%
B 1.2 8.7% 75.9%
67
Other Factors that Affect
Bond Ratings
Provisions in the bond contract
Secured versus unsecured debt
Senior versus subordinated debt
Guarantee provisions
Sinking fund provisions
Debt maturity

(More)
68
 Other factors
Earnings stability
Regulatory environment
Potential product liability
Accounting policies

69
Interest rate (or price) risk for
1-year and 10-year 10%
bonds

Interest rate risk: Rising mrkt i

% (rd) causes bonds price to fall.
i % 1-year Change 10-yearChange
5% $1,048 $1,386
4.8% 38.6%
10% 1,000 1,000
4.4% 25.1%
15% 956 749
70
Value

1,500 10-year

1,000 1-year

500

0 rd
0% 5% 10% 15% 71
What is reinvestment rate
risk?
The risk that CFs will have to be
reinvested at future lower rates,
reducing income.
Illustration: Suppose you just won
$500,000 playing the lottery. Youll
invest the money and live off
interest. You buy a 1-year bond
with a YTM of 10%.
72
 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. Had you
bought 30-year bonds, income
would have remained constant.

73
The Maturity Risk Premium
Long-term bonds: High interest rate
risk, low reinvestment rate risk.
Short-term bonds: Low interest rate
risk, high reinvestment rate risk.
Nothing is riskless!
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.

74
 Other types of Bonds
Zero coupon:
Pays no coupon & sells @ disct below par
Convertible:
To stock @fixed price @ bondholders
option
Income:
Pays interest only if interest earned by
issuer; wont bankrupt co.

75
 Other types of Bonds
Revenue:
Interest paid from revenue generated by
project being financed by bonds
Floating rate:
Adjusts coupon rate periodically based on
market interest rates

76
Bankruptcy
Two main chapters of Federal
Bankruptcy Act:
Chapter 11, Reorganization
Chapter 7, Liquidation
Typically, company wants Chapter
11, creditors may prefer Chapter 7.

77
 If company cant 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.

78
 Company must demonstrate in its
reorganization plan that it is
worth more alive than dead.
Otherwise, judge will order
liquidation under Chapter 7.

79
If the company is
liquidated, heres the
payment

priority:
Past due property taxes
Secured creditors from sales of secured assets.
Trustees 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

80
 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.

81