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Interest Rates and Bonds Chapter 7
Interest Rates and Bonds Chapter 7
Interest Rates and Bonds Chapter 7
1 Chapter Outline
Chapter 7
Interest Rates and Bond Valuation
Chapter Organization
! 7.1 Bonds and Bond Valuation
Time 0 1 2 3 4 5
Coupons $80 $80 $80 $80 $80
Face Value $ 1000
Market Price $____
! 3. The yield to maturity (or “YTM”) is the rate that makes the
market price of the bond equal to the present value of its
future cash flows. It is the unknown r in the equation below:
$924.18 = $80 × [1 - 1/(1 + r)5]/r + $1000/(1 + r)5
Bond price
$1,800
Coupon = $100
20 years to maturity
$1,600
$1,000 face value
$1,000
$ 800
Amount of issue $200 million The company issued $200 million worth
of bonds.
Offer price 100 The offer price will be 100% of the $1,000
face value per bond.
Term Explanation
Call provision Not callable The bonds have a deferred call feature.
before 8/1/04 (See Appendix 7C on Canada plus calls.)
Call price 104.188 initially, After 8/1/04, the company can buy back
declining to 100 the bonds for $1,041.88 per bond,
declining to $1,000 on 8/1/14.
Moody’s DBRS
Aaa AAA Debt rated Aaa and AAA has the highest rating. Capacity to pay
interest and principal is extremely strong.
Aa AA Debt rated Aa and AA has a very strong capacity to pay interest and
repay principal. Together with the highest rating, this group
comprises the high-grade bond class.
A A Debt rated A has a strong capacity to pay interest and repay
principal, although it is somewhat more susceptible to the adverse effects
of changes in circumstances and economic conditions than debt in high
rated categories.
Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 18
T7.14 Bond Ratings (concluded)
Baa BBB Debt rated Baa and BBB is regarded as having an
adequate capacity to pay interest and repay principal.
Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing
circumstances are more likely to lead to a weakened
capacity to pay interest and repay principal for debt in
this category than in higher rated categories. These
bonds are medium-grade obligations.
! Key issues:
" What is the difference between a real return and a nominal
return?
" How can we convert from one to the other?
! Example:
Suppose we have $1000, and Diet Coke costs $2.00 per six
pack. We can buy 500 six packs. Now suppose the rate of
inflation is 5%, so that the price rises to $2.10 in one year. We
invest the $1000 and it grows to $1100 in one year. What’s our
return in dollars? In six packs?
1 + R = (1 + r) × (1 + h)
! From the example, the real return is 4.76%; the nominal return is 10%,
and the inflation rate is 5%:
(1 + R) = 1.10
Key Issue:
What factors affect observed bond yields?
! The real rate of interest
! Taxability premium
! Liquidity premium
1. Under what conditions will the coupon rate, current yield, and yield to
maturity be the same?
A bond’s coupon rate, current yield, and yield-to-maturity be the same
if and only if the bond is selling at par.
2. What does it mean when someone says a bond is selling “at par”? At
“a discount”? At “a premium”?
A par bond is selling for its face value (typically $1000 for corporate
bonds); the price of a discount bond is less than par, and the price of a
premium bond is greater than par.
3. What is a “transparent” market?
A market is transparent if it is possible to easily observe its prices and
trading volumes.
Bond
Value = C/2 × [1 - 1/(1 + r )t] / r + F / (1 + r )t
$850 = C/2 × [1 - 1/(1 + .04)21] / .04 + $1000/(1.04)21
$850 = C/2 × 14.0291 + $438.83
C/2 = $29.31
Bond K:
PV = $50 × [1 - 1/(1.055)16]/.055 + $1000/(1.055)16 = $947.69
Bond K:
PV = $50 × [1 - 1/(1.035)16]/.035 + $1,000/(1.035)16 = $1181.41