Interest Rates and Bond Valuation 1

BOND BASICS

IBM

$1,000 LOAN

Interest each year at coupon rate$1,000 at maturity

Interest Rates and Bond Valuation 2

Bond Valuation

Discount bond cash flows at required rate of return (yield to maturity)Don’t use coupon rate If you do, you’ll find value is $1,000

Interest rates increase, bond values decrease

Interest rates decrease, bond values increase

Interest Rates and Bond Valuation 3

Bond Valuation

Maturity 4% 6% 8% 10% 12% 14%

1 $1,038.46 $1,018.87 $1,000.00 $981.82 $964.29 $947.37As bonds approach maturity, value converges to $1,000

5 $1,178.07 $1,084.25 $1,000.00 $924.18 $855.81 $794.0210 $1,324.44 $1,147.20 $1,000.00 $877.11 $773.99 $687.0315 $1,444.74 $1,194.24 $1,000.00 $847.88 $727.57 $631.4720 $1,543.61 $1,229.40 $1,000.00 $829.73 $701.22 $602.6125 $1,624.88 $1,255.67 $1,000.00 $818.46 $686.27 $587.6230 $1,691.68 $1,275.30 $1,000.00 $811.46 $677.79 $579.84 Longer term, more volatile

Maturity 2% 4% 6% 8% 10% 12%5 $1,188.54 $1,089.04 $1,000.00 $920.15 $848.37 $783.71

10 $1,359.30 $1,162.22 $1,000.00 $865.80 $754.22 $660.9915 $1,513.97 $1,222.37 $1,000.00 $828.81 $695.76 $591.3520 $1,654.06 $1,271.81 $1,000.00 $803.64 $659.46 $551.8325 $1,780.94 $1,312.44 $1,000.00 $786.50 $636.92 $529.4130 $1,895.86 $1,345.84 $1,000.00 $774.84 $622.92 $516.69 Lower coupon rate, more volatile

Required Rate of Return

8% Coupon Rate BondRequired Rate of Return

6% Coupon Rate Bond

Interest Rates and Bond Valuation 4

Interest Rate Risk

Longer time to maturity, more interest rate risk (bond price more volatile)

Lower coupon rate, more interest rate risk (bond price more volatile)

CT: Why 100-year bonds?

Interest Rates and Bond Valuation 5

Bond Valuation

Discount bond cash flows at required rate of return (yield to maturity)Don’t use coupon rate If you do, you’ll find value is $1,000

Interest rates increase, bond values decrease

Interest rates decrease, bond values increase

Interest Rates and Bond Valuation 6

Calculating YTM (Required Return) and Bond Price Bond has 7% coupon rate, 5 years to maturity

and is priced at $1,257. What is yield to maturity?

Bond has 3% coupon rate, 30 years to maturity and is priced at $985. What is yield to maturity?

Bond has 6% coupon rate, a YTM of 10% and 20 years to maturity. What is the price?

Bond has 5% coupon rate, a YTM of 4% and 3 years to maturity. What is the price?

Interest Rates and Bond Valuation 7

Bond Features

Terms Call provision Protective covenants

Interest Rates and Bond Valuation 8

Bond Terms

Most bonds…$1,000 face value at maturity Interest is paid semi-annually

We’ll ignore this in our calculationsDebentures: unsecured

Remember bonds are loans

Interest Rates and Bond Valuation 9

Call Provision

Allows company to repay loan earlyCall price is generally above face valueCall price declines over time

Often can’t call bond for a period of years after bond issued

Most corporate bonds are callable Most Treasury bonds are not

Interest Rates and Bond Valuation 10

Call Provision

Why would a bond with a coupon rate of 6% be called?

Will interest rates on callable bonds generally be higher or lower than rates on bonds that can’t be called?

CT 5: Costs and benefits of call provision.

Interest Rates and Bond Valuation 11

Protective Covenants

Protect lender (purchaser of bond) Negative covenants

Limit dividendsLimit issuing additional debt

Positive covenantsMaintain times interest earned ratioMaintain debt ratio

What happens if covenants violated?

Interest Rates and Bond Valuation 12

Bond Ratings

S&P and Moodys paid to rate creditworthiness of bond issuerCorporate and government bondsLess biased evaluation than stock analysts

Junk bonds: not investment gradePension funds and some mutual funds only

buy investment grade bondHigh-yield, high risk bonds

CT 8 and 9: Why gave bonds

rated? Why are junk bonds and U.S. bonds not

rated?

Interest Rates and Bond Valuation 13

Government Bonds

U.S. TreasuryTwo year notes to 30-year bondsGenerally not callableNo default risk???

Biggest borrower in the world… Interest is not subject to state income

tax Illinois tax rate is 3%

Interest Rates and Bond Valuation 14

Municipal Bonds

Issued by state and municipal governmentsSome default risk???

Orange County, Bridgeport, CN

After-tax yield6% IBM coupon vs. 5% Illinois couponTaxpayer with 30% marginal tax rate

Interest Rates and Bond Valuation 15

Zero Coupon Bonds

Just receive $1,000 at maturity Issuer deducts imputed interest each year even

though pays no cash Generally increase in value of bond is imputed

interest Owner of bond pays tax on interest each year

even though none received Very volatile (risky) bonds Sinking fund

Interest Rates and Bond Valuation 16

Bond Prices

Price quoted is percent of face value97 ½ is $975; 103 is $1,030

Current yield = required rate of return Remember bond prices converge

towards $1,000 at maturityDiscount bonds increase; premium bonds

decrease

Interest Rates and Bond Valuation 17

Investing In Bonds

$1,000 per bond How many bonds to diversify? Market not transparent Difficulty in assessing default risk

CT 13: Implications for investors since

bond market not transparent?

Interest Rates and Bond Valuation 18

Bond Mutual Funds

Pool investors funds Professional management Specialize in certain types of bonds

GovernmentHigh Yield (Junk)Municipal

Don’t blindly chase higher yields unless…

Interest Rates and Bond Valuation 19

What Determines Interest Rates? Real rate of return Inflation risk premium Default risk premium Maturity risk premium Liquidity risk premium

Interest Rates and Bond Valuation 20

Real Rate of Return

Inflation-adjusted Treasury bills No inflation risk No default risk No maturity risk No liquidity risk

Rates: 1.20% as of 01/09 Over 4% , in 10/01

Interest Rates and Bond Valuation 21

Inflation Risk Premium

Inflation reduces value of future dollars Add premium for anticipated inflation

Interest Rates and Bond Valuation 22

Inflation Risk Premium

Steep yield curve Inverted yield

curve Figure 6.7, Page

175 Future economic

activity?

Interest Rates and Bond Valuation 23

Default Risk Premium

Higher risk, higher required return GM and Ford

Interest Rates and Bond Valuation 24

Maturity Risk Premium

Long-term bonds more volatileMore risk, demand higher return

CT 1: Are Treasury

securities risk-free?

Interest Rates and Bond Valuation 25

Liquidity Premium

Corporate bonds don’t trade on an exchange like stocksTreasury bonds very liquidMany corporate bonds not very liquid

Interest Rates and Bond Valuation 26

What Determines Interest Rates? Real rate of return + Inflation risk premium + Default risk premium + Maturity risk premium + Liquidity risk premium + = Required Rate of Return