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 Firm’s debt/equity mix

Cost of debt
Market risk aversion Cost of equity Firm’s business risk

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%

- Inflation -1% - 8%

= Real Int. % =11% =4%

If inflation = 8%
& req’d real return = 11%
Then Nominal rate =? = =19%
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 bond’s yield
and a Treasury security’s yield of the same
maturity. Therefore:
 Spread = DRP + LP.
 Bond’s of large, strong companies often have
very small LPs. Bond’s 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%
12%
Interest Rate

10%
MRP
8%
IP
6%
r*
4%
2%
0% 11

13

15

17

19
1

Years to Maturity

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 CF’s = 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
 Cost of borrowing  Creditor
 Interest Paid (Expense) –  Requires return to invest
generates tax benefit (Svgs)
$ in bonds based on risk
 Cost of Debt
 Interest Received (earned)
= Rd or Kd;
(Revenue) - pay tax on it


 After-tax cost = Rd (1-t)

 Capital Appreciation
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)N (1 + rd)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, bond’s 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, it’s price

approaches the face or maturity value of $1000

34
Bond Pricing in Excel

Years to Mat: 10
Coupon rate: 10%
Annual Pmt: $100
Par value = FV: $1,000
Going rate, rd: 10%

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
bond’s price falls and sells at discount
 If market rate of interest drops below
the stated (coupon) rate, then bond’s
price increases and sells at a premium
 **INVERSE RELATIONSHIP b/w Market
i% and Bond’s 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
 What’s 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, what’s 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
 What’s “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 bond’s life
 Interest rate equating bond’s 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 + rd)1 (1 + rd)N (1 + rd)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%, bond’s 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 Exp Exp cap

= YTM = +
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.
INPUTS 2N rd/2 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 it’s 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 = rd =
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
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, 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 Fitch Moody’s 1 yr. 5 yrs.
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

coverage capital capital
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%
CCC 0.4 3.2% 113.5% 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 bond’s price to fall.
i % 1-year Change 10-year Change
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. You’ll
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 @ bondholder’s option
 Income:
 Pays interest only if interest earned by issuer;
won’t 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 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.

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,
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
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