Fundamental of Corporate Finance, chpt7

1
Chapter 7
Interest Rates and
Bond Valuation
Prepared and Taught by Lecturer : YIN SOKHNG
E-mail: yin_sokheng@yahoo.com
Tel: (855) 16889872 / 17989972
Chapter Outline
7.1 Bond Definition
7.2 More about Bond Features
7.3 Bond Ratings
7.4 Different Types of Bonds
7.5 Bond Markets
7.6 Inflation and Interest Rates
7.7 Determinants of Bond Yields
7.8 Bond Risky
2 Instructed by YIN SOKHENG, Master in Finance
3
7.1 Bond Definition
The corporation or government are borrow money
from the public by issuing or selling debt securities
that are generically called bonds.
Normally an interest-only loan (when issued at par),
the principal is paid until the end of the loan.
Interest paid in the form of a periodic coupon.
Term basis:
Short term basis
Long term basis.
Instructed by YIN SOKHENG, Master in Finance
2
4
The Bond Indenture
Contract between the corporation (borrower)
and the creditor (bondholders) that includes
The basic terms of the bonds
The total amount of bonds issued
A description of property used as security, if
applicable
Repayment agreements
Call provisions
Details of protective covenants
7.2 More about Bond Features
5
The Indenture
Forms of a Bond
Registered Form: The corporation keeps track of the
owner.
Bearer Form: Certificate is the only evidence of ownership.
Security
Collateral secured by other securities
Mortgage secured by real property, normally land or
buildings; Chattel Mortgage (mortgage on a specific
property)
Debentures unsecured bond with original maturity of 10
years or more
Notes unsecured bond with original maturity less than 10
years
6
Bonds Compared to Stock
Bondholders are
creditors
Bonds a liability
Interest is fixed
charge
Interest is expense
Interest tax deductible
No voting
Stockholders are owners
Stock is equity
Dividends not fixed
charges
Dividends not expense
Dividends not tax
deductible
Voting
3
7
Bond Term
Par value (face value), F
Coupon rate, R
Coupon payment, C
Maturity date, T
Discount rate or Yield to maturity, r or YTM
8
7.3 Bond Ratings
Investment Quality
High Grade
Moodys Aaa and S&P AAA capacity to pay is
extremely strong
Moodys Aa and S&P AA capacity to pay is very
strong
Medium Grade
Moodys A and S&P A capacity to pay is strong, but
more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is
adequate, adverse conditions will have more impact
on the firms ability to pay
9
Bond Ratings - Speculative
Low Grade
Moodys Ba, B, Caa and Ca
S&P BB, B, CCC, CC
Considered speculative with respect to capacity to
pay. The B ratings are the lowest degree of
speculation.
Very Low Grade
Moodys C and S&P C income bonds with no
interest being paid
Moodys D and S&P D in default with principal and
interest in arrears
4
10
7.4 Different Types of Bonds
zero coupon bonds or discount bonds
e.g. T-bills One year and less, no coupons
fixed payment loans
e.g. mortgages, car loans- Between 3 and 15years
coupon bonds
e.g. -T-notes Between 2 and 10 years,
-T-bonds Longer than 10 years,
-Corporate bonds Longer than 10 years
consols: no maturity date (forever).
11
Zero coupon bonds
discount bonds
purchased price less than face value, F > P
face value at maturity
no interest payments
(

=
365
) (
1
T r
F P
P = Current price
F = Face value
r = discount rate
T = Number of maturity date
T
r
F
P
) 1 ( +
= OR
12
Zero coupon bonds
Yield to maturity, YTM
OR
1
360
|
.
|
\
|
=
d
P
F
r
r =
F - P
P
x
360
d
5
13
Fixed-payment loan
loan is repaid with equal (monthly) payment, PMT
each payment is combination of principal and
interest
( ) ( ) ( )
T
m m m
i
PMT
i
PMT
i
PMT
PV
+
+ +
+
+
+
=
1
...
1 1
2
(
(
(
(
=
i
i
m
T
m
PV
PMT
) 1 (
1
1
14
r is annual rate
(effective annual interest rate, EAR)
but payments are monthly, & compound
monthly
r = (1+ i
m
)
12
-1
i
m
= (1+ r)
1/12
-1
i
m
is the periodic rate
note: APR (annual percentage rate)
APR = i
m
x 12
15
Coupon Bond
purchase price, PV
promised of a series of payments until maturity
face value at maturity, F (principal, par value)
coupon payments (6 months), C
size of coupon payment
annual coupon rate, R
face value
6 mo. pmt.,C = (F x R)/2
6
16
Value of a coupon bond = PV of coupon payment annuity
+ PV of face value
0
C $
1
C $
2
C $
1 T
F C $ $ +
T
Information needed to value coupon bonds:
Coupon payment dates and time to maturity (T)
Coupon payment (C) per period and Face value (F)
Coupon rate (R) and Discount rate (r or YTM)
T T
r
F
r r
C
PV
) 1 ( ) 1 (
1
1
+
+
(
+
=
17
PV, F and YTM
PV = F then YTM = coupon rate
PV < F then YTM > coupon rate (at a discount)
PV > F then YTM < coupon rate (at a premium)
PV and YTM move in opposite directions
interest rates and value of debt securities move in
opposite directions
if rates rise, bond prices fall
if rates fall, bond prices rise
18
Interest Rate Risk
Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-
term bonds
Reinvestment Rate Risk
Uncertainty concerning rates at which cash flows
can be reinvested
Short-term bonds have more reinvestment rate risk
than long-term bonds
7
19
Figure 7.2
20
Current yield,
approximation of YTM for coupon bonds
i
c
=
annual coupon payment, C
bond price, PV
i
c
21
Yield-to-maturity
Yield-to-maturity is the rate implied by the current
bond price
Finding the YTM requires trial and error if you do not
have a financial calculator and is similar to the process
for finding r with an annuity
YTM = [C + (F PV)/T]/(F + PV)/2
C = Coupon payment
F = Face/Par value of bond
PV = Current price of bond
T = Maturity date
8
22
Holding period return
sell bond before maturity
return depends on
holding period
interest payments
resale price
t
t t
t
P
P P
P
C
RET

+ =
+1
g i RET
c
+ =
23
Holding period return
RET : Rate of Return at Holding Period
: Current yield
C : Coupon payment
: Price at T period
: Price at T+1 period
g : Rate of Capital Gains or the Change of
Price
i
c
P
t
P
t+1
24
Consols Bond
0
C $
1
C $
2
C $
... $C
forever
r
C
PV =
9
25
7.5 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 company or municipal
issues
Treasury securities are an exception
26
Bond Quotations
Highlighted quote:
ATT 7 06 7.7 554 97.63 -0.38
What company are we looking at?
What is the coupon rate? If the bond has a $1000 face
value, what is the coupon payment each year?
When does the bond mature?
What is the current yield? How is it computed?
How many bonds trade that day?
What is the quoted price?
How much did the price change from the previous day?
27
Treasury Quotations
Highlighted quote:
9.000 Nov 18 133:27 133.28 24 5.78
What is the coupon rate on the bond?
When does the bond mature?
What is the bid price? What does this mean?
What is the ask price? What does this mean?
How much did the price change from the previous
day?
What is the yield based on the ask price?
10
28
7.6 Inflation and Interest Rates
Real rate of interest change in purchasing
power
Nominal rate of interest quoted rate of
interest, change in purchasing power and
inflation
The ex ante nominal rate of interest includes
our desired real rate of return plus an
adjustment for expected inflation
29
Inflation
if inflation is high
lenders demand higher nominal rate, especially
for long term loans
long-term i depends A LOT on inflation
expectations
30
The Fisher Effect
The Fisher Effect defines the relationship
between real rates, nominal rates and inflation
(1 + R) = (1 + r)(1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate
Approximation
R = r + h
11
31
Inflation and Present Value
( )
(
(
(
(
=
r
r
C PV
T
1
1
1
r = Discount rate
32
Term Structure of Interest Rates
Term structure is the relationship between time
to maturity and yields, all else equal
It is important to recognize that we pull out the
effect of default risk, different coupons, etc.
Yield curve graphical representation of the
term structure
Normal upward-sloping, long-term yields are
higher than short-term yields
Inverted downward-sloping, long-term yields are
lower than short-term yields
7.7 Determinants of Bond Yields
33
Figure 7.6.A. Upward-Sloping Yield Curve
12
34
Figure7.6. B. Downward-Sloping Yield Curve
35
7.8 Bond risky
Why are bonds risky?
Default risk
Risk that the issuer fails to make promised payments on
time
Zero for govt debt
Other issuers: corporate, municipal, foreign have some
default risk
Greater default risk means a greater yield
36
Inflation risk
Most bonds promise fixed dollar payments
Inflation erodes the real value of these payments
Future inflation is unknown
Larger for longer term bonds
Interest rate risk
Changing interest rates change the value (price) of a bond
in the opposite direction.
All bonds have interest rate risk
But it is larger for the long term bonds

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