CHAPTER 8

INTEREST RATES AND BOND VALUATION

PROF. GOHAR G.
STEPANYAN
M1 – PRINCIPLES OF FINANCE
 CHAPTER OUTLINE

8.1 Bonds and Bond Valuation

8.2 Government and Corporate Bonds
8.3 Bond Markets
8.4 Inflation and Interest Rates
8.5 Determinants of Bond Yields
8.6 Summary and Conclusions

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 8.1 BONDS AND BOND VALUATION

 A bond is a legally binding agreement between a borrower (bond issuer)

and a lender (bondholder).
 Normally, bond is an interest-only loan with the principal repaid at the end
of the loan.

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 BOND DEFINITIONS

 Face (or par) value – the amount repaid at the end of the loan
 Coupon payment – promised interest payment
 Coupon rate – annual coupon dividend by the face value
 Maturity date – final repayment date
 Time to maturity – the number of years remaining until the repayment date
 Yield to maturity (or yield) – the current interest rate in the market for
similar bonds

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 HOW TO VALUE BONDS?

 Identify the size and timing of cash flows.

 Discount at the correct discount rate.

◦ If you know the face value of a bond and the size and timing of cash flows
(coupons), the yield to maturity is the discount rate.

 1 
1 - (1  R)T  F
Bond Value  C  
 (1  R)
T
 R
 
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 VALUING A DISCOUNT BOND WITH ANNUAL COUPONS

 Consider a bond with a coupon rate of 10% and annual coupons. The par
value is $1,000 and the bond has 5 years to maturity. The yield to maturity
is 11%. What is the value of the bond?

BV = PV of annuity + PV of face value

BV = 100 × [1 – 1/(1.11)5] / 0.11 + 1,000 / (1.11)5

BV = 369.59 + 593.45 = $963.04

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 VALUING A PREMIUM BOND WITH ANNUAL COUPONS

 Suppose you are looking at a bond that has a 10% annual coupon and a
face value of $1,000. There are 20 years to maturity and the yield to
maturity is 8%. What is the price of this bond?

BV = PV of annuity + PV of face value

BV = 100 × [1 – 1/(1.08)20] / 0.08 + 1,000 / (1.08)20

BV = 981.81 + 214.55 = $1,196.36

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 DYNAMIC BEHAVIOR OF BOND PRICES

 A bond is selling at a premium if the price is greater than the face value.

 A bond is selling at par if the price is equal to the face value.

 A bond is selling at a discount if the price is less than the face value.

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 FINDING THE YTM WITH SEMIANNUAL COUPONS

 Suppose a bond with a 10% coupon rate, semiannual coupons and 20 years
to maturity, has a face value of $1,000, but is selling for $1,197.93.
◦ Is the YTM more or less than 10%?  Less
◦ What is the semiannual coupon payment?  $50
◦ How many periods are there?  40 periods
◦ We can find the yield to maturity only by trial and error… (financial calculators
make life easy!)
◦ YTM = 4% × 2 = 8%

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 INTEREST RATE RISK

 The risk that arises for bond owners from fluctuating interest rates is called
interest rate risk.
◦ The price of a bond is sensitive to interest rate changes.

1. All other things being equal, the longer the time to maturity, the greater the
interest rate risk.

2. All other things being equal, the lower the coupon rate, the greater the
interest rate risk.

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INTEREST RATE RISK AND TIME TO MATURITY

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CURRENT YIELD VS. YIELD TO MATURITY

Annual coupon payment

Current yi eld (CY) 
Current price
Change in price
Capital gains yield (CGY) 
Beginning price

Expected total return  YTM   Expected    Expected 

 CY   CGY 

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 CURRENT YIELD VS. YIELD TO MATURITY: EXAMPLE

 We are still looking at the 10% coupon bond, with semiannual coupons and 20
years to maturity, that has a face value of $1,000, but is selling at a price of
$1,197.93.
◦ Current yield = 100 / 1,197.93 = 0.0835 = 8.35%
◦ Price in one year, assuming no change in YTM = 1,193.68
◦ Capital gain yield = (1,193.68 – 1,197.93) / 1,197.93 = -0.0035 = -0.35%
◦ YTM = 8.35% – 0.35% = 8%, which is the same yield-to-maturity computed earlier.

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 BOND PRICING PRINCIPLES

 Bonds of similar risk (and maturity) will be priced to yield about the
same return, regardless of the coupon rate.
 If you know the price of one bond, you can estimate its return and
use that to find the price of the second bond.
 This is a useful concept that can be transferred to valuing assets
other than bonds.

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 ZERO COUPON BONDS

A zero coupon bond:

◦ Does not make coupon payments.
◦ Always sells at a discount (a price lower than face value), so it is also called pure
discount bond.
$0 $0 $0 $F

0 1 2 T 1 T
F
 Present value of a zero coupon bond at time 0: PV 
(1  R ) T

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 ZERO COUPON BONDS: EXAMPLE

Find the value of a 30-year zero-coupon bond with a $1,000 par value and a
YTM of 6%.
$0 $0 $0 $1,000

0 1 2 29 30

F $1,000
PV    $174.11
(1  R ) T
(1.06) 30

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 8.2 GOVERNMENT AND CORPORATE BONDS

 Treasury Securities
◦ Federal government debt
◦ T-bills – pure discount bonds with original maturity of one year or less
◦ T-notes – coupon debt with original maturity between one and ten years
◦ T-bonds – coupon debt with original maturity greater than ten years
 Municipal Securities
◦ Debt of state and local governments
◦ Varying degrees of default risk, rated similar to corporate debt
◦ Interest received is tax-exempt at the federal level
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 AFTER-TAX YIELD COMPARISON

 A taxable bond has a yield of 8%, while a municipal bond has a yield
of 6%.
◦ If you are in a 40% tax bracket, which bond do you prefer?
 8% × (1 – 0.4) = 4.8%
 The after-tax return on the corporate bond is 4.8%, compared to a 6% return on
the municipal bond.

◦ At what tax rate would you be indifferent between the two bonds?
 8% × (1 – T) = 6%
 T = 25%

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BOND RATINGS

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 8.3 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.
 Getting up-to-date prices on individual bonds can be difficult, particularly
for smaller corporate or municipal issues.
 Treasury securities are an exception.

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BOND PRICE REPORTING

Source: Wall Street Journal 22

 CLEAN VS. DIRTY PRICES

 If the bond is purchased between coupon payment dates, the price paid is
more than the quoted price.
 The quoted price is called the clean price.

 The price actually paid is called the dirty price (also known as “full” or
“invoice” price) and includes the accrued interest.
◦ You pay $1,080 for a bond with a 12-percent coupon, payable semiannually, and
the next coupon is due in four months. The accrued interest is $20, and the bond’s
quoted price is $1,060.

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 8.4 INFLATION AND INTEREST RATES

 Real rate of interest – change in your purchasing power.

 Nominal rate of interest – quoted rate of interest, e.g. percentage

change in the number of dollars you have.
 The ex ante nominal rate of interest includes our desired real rate of
return plus an adjustment for expected inflation.

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 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
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 NOMINAL VS. REAL RATES: EXAMPLE

 If we require a 10% real return, and the expected inflation rate is 8%, what
is the nominal rate?
 R = (1.1) × (1.08) – 1 = 0.188 = 18.8%

 Approximation: R = 10% + 8% = 18%

◦ Because the real return and expected inflation are relatively high, there is
significant difference between the actual Fisher Effect and the approximation.

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 8.5 DETERMINANTS OF BOND YIELDS

 Term structure of interest rates is the relationship between short- and

long-term interest rates.
 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

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U.S. INTEREST RATES: 1800 –2010

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UPWARD-SLOPING YIELD CURVE

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DOWNWARD-SLOPING YIELD CURVE

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THE TREASURY YIELD CURVE: MAY 2011

Source: Wall Street Journal 31

 FACTORS AFFECTING BOND YIELDS

 Default risk premium – investors demand higher yield as compensation for

credit risk.
 Taxability premium – investors demand extra yield as compensation for
unfavorable tax treatment.
 Liquidity premium – less liquid bonds will have higher yields than more
liquid bonds.
 Anything else that affects the risk of the cash flows to the bondholders will
affect the required returns.
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EUROPEAN GOVERNMENT BOND YIELDS, 1963 – 2011

Source: Nowakwoski, David,

“Government Bonds/Rates: High,
Low and Normal,” Roubini Global
Economics, June 8, 2012.

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 8.6 SUMMARY AND CONCLUSIONS

In this chapter, we used the time value of money concept from previous
chapters to value bonds.
F
1. The value of a zero-coupon bond is: PV 
(1  R )T

2. The value of a level coupon bond is the sum of the PV of the annuity of
coupon payments plus the PV of the face value:
C 1  F
PV  1  T 

R  (1  R )  (1  R ) T

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 SUMMARY AND CONCLUSIONS (CONT’D)

3. The yield to maturity (YTM) of a bond is that single rate that discounts the
payments on the bond to the purchase price.

4. Bond values move in the direction opposite that of interest rates.

5. Bond yields and interest rates reflect six different factors: the real interest
rate, and five premiums representing compensation for (1) expected future
inflation, (2) interest rate risk, (3) default risk, (4) taxability, and (5) lack of
liquidity.

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