Interest Rates and Bond Valuation

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1 Interest Rates and Bond Valuation Chapter 6 Key Concepts and Skills Know the important bond features and bond types Understand bond values and why they fluctuate Understand bond ratings and what they mean Understand the impact of inflation on interest rates Understand the term structure of interest rates and the determinants of bond yields Basic Valuation The value of any asset is the present value of all future cash flows n r... Value CF 1 CF 2 CF t PV = CF 1 CF CF t ( 1+r ) ( 1+ r ) ( 1+r) t. 1

2 Bond Definitions Bond Par Value Face Value Coupon Rate Coupon Payment Coupon Rate * Par Value Maturity Date Yield to Maturity Yield PV of Cash Flows as Rates Change Bond Value A bond is a long-term debt instrument. Its value is based on the present value of: A stream of coupon (interest) payments and The repayment of the par value at maturity PV of an annuity + PV of a lump sum Bond Valuation (Annual Coupon) Consider a bond with a coupon rate of 10%, paid annually. The par value is \$1000 and the bond has 5 years to maturity. The yield to maturity is 10%. What is the value of the bond? Bond Value % Value =? ,000 2

3 Bond Valuation (Annual Coupon) Consider a bond with a coupon rate of 10%, paid annually. The par value is \$1000 and the bond has 5 years to maturity. The yield to maturity is 10%. What is the value of the bond? Bond Value PV of annuity + PV of lump sum = 1, N = 5 N = 5 I/YR = 10 I/YR = 10 PMT = 100 FV = 1000 PV =? = PV =? = Bond Valuation (Annual Coupon) Consider a bond with a coupon rate of 10%, paid annually. The par value is \$1000 and the bond has 5 years to maturity. The yield to maturity is 10%. What is the value of the bond? N = 5 I/YR = 10 PMT = 100 PV = Bond Valuation (Annual Coupon) What is the value of the same bond if the yield to maturity is 11%? N = 5 I/YR = 11 PMT = 100 PV =

4 Bond Valuation (Annual Coupon) Discount Bonds When r (the yield to maturity) rises above the coupon rate, the bond s value falls below its par value, so it is said to sell at a discount. Bond Valuation (Annual Coupon) What is the value of the same bond if the yield to maturity is 8%? N = 5 I/YR = 8 PMT = 100 PV = Bond Valuation (Annual Coupon) Premium Bonds When r (the yield to maturity) falls below the coupon rate, the bond s value rises above its par value, so it is said to sell at a premium. 4

5 Bond Valuation There is an inverse relationship between interest rates and bond prices As interest rates increase, bond prices decrease As interest rates decrease, bond prices increase Graphical Relationship Between Price and YTM % 2% 4% 6% 8% 10% 12% 14% Relationship Between Coupon and YTM YTM = Coupon Rate Par Value = Bond Price YTM > Coupon Rate Par Value > Bond Price Selling at a discount YTM < Coupon Rate Par Value < Bond Price Selling at a premium 5

6 Bond Valuation (Semi-Annual) Consider a bond with a coupon rate of 9%, paid semi-annually. The par value is \$1000 and the bond has 15 years to maturity. The yield to maturity is 9%. What is the value of the bond? P/YR = 2 N = years x 2 periods per year I/YR = 9 PMT = 45 \$90 annual coupon/2 payments per year PV = Bond Valuation (Semi-Annual) What is the value of the same bond if the yield to maturity is 11%? P/YR = 2 N = 30 I/YR = 11 PMT = 45 PV = Bond Valuation (Semi-Annual) What is the value of the same bond if the yield to maturity is 7%? P/YR = 2 N = 30 I/YR = 7 PMT = 45 PV =

7 Bond Valuation (Semi-Annual) Text Example 6.1 Bond has a par value of \$1,000 and a 14% coupon rate, paid semi-annually. The bond matures in 7 years and current interest rates are 16%. What is the value of the bond? P/YR = 2 N = 14 I/YR = 16 PMT = 70 PV = Risk Price or Interest Rate 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 Price/Interest Rate Risk 7

8 Reinvestment Rate Risk Cash flows may be reinvested in the future at lower interest rates. Illustration: You have managed to save \$1,000,000 and plan to retire and live off the interest. You can invest in a 10-year bond that pays 5% or a 1- year bond that pays 7%. If you buy the 1-year bond, you first year income will be \$70,000. But what happens if interest rates fall to 3% in the second year? Risk Long-Term Bonds Higher price risk, lower reinvestment rate risk Short-Term Bonds Lower price risk, higher reinvestment rate risk Nothing is riskless! Computing YTM Yield-to-maturity is the rate implied by the current bond price Using a financial calculator, finding the YTM is the same as solving for I/YR. 8

9 YTM Consider a bond with a 10% annual coupon rate, 15 years to maturity and a par value of \$1000. The current price is \$ Will the yield be more or less than 10%? More since the bond is selling at a discount. P/YR = 1 N = 15 PV = PMT = 100 I/YR = 11 YTM Suppose a bond with a 10% coupon rate, paid semiannually, has a face value of \$1000, 20 years to maturity and is selling for \$ Is the YTM more or less than 10%? Less since the bond is selling at a premium. P/YR = 2 N = 40 PV = PMT = 50 I/YR = 8 Differences Between Debt and Equity Debt Not an ownership interest Creditors do not have voting rights Interest is considered a cost of doing business and is tax deductible Creditors have legal recourse if interest or principal payments are missed Excess debt can lead to financial distress and bankruptcy Equity Ownership interest Common stockholders vote for the board of directors and other issues Dividends are not considered a cost of doing business and are not tax deductible Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid An all equity firm can not go bankrupt 9

10 The Bond Indenture Contract between the company and the bondholders and includes The basic terms of the bonds The total amount of bonds issued A description of property used as security, if applicable Sinking fund provisions Call provisions Details of protective covenants Bond Classifications Registered vs. Bearer Forms Security Collateral secured by financial securities Mortgage secured by real property, normally land or buildings Debentures unsecured Notes unsecured debt with original maturity less than 10 years Seniority Bond Characteristics and Required Returns The coupon rate depends on the risk characteristics of the bond when issued Which bonds will have the higher coupon, all else equal? Secured debt versus a debenture Subordinated debenture versus senior debt A bond with a sinking fund versus one without A callable bond versus a non-callable bond 10

11 Bond Ratings Investment Quality High Grade Moody s Aaa and S&P AAA capacity to pay is extremely strong Moody s Aa and S&P AA capacity to pay is very strong Medium Grade Moody s A and S&P A capacity to pay is strong, but more susceptible to changes in circumstances Moody s Baa and S&P BBB capacity to pay is adequate, adverse conditions will have more impact on the firm s ability to pay Bond Ratings - Speculative Low Grade Moody s 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 Moody s C and S&P C income bonds with no interest being paid Moody s D and S&P D in default with principal and interest in arrears Government 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 11

12 Taxable and Tax-Exempt Yields A taxable bond has a yield of 8% and a municipal bond has a yield of 6% If you are in a 40% tax bracket, which bond do you prefer? 8%(1 -.4) = 4.8% The after-tax return on the corporate bond is 4.8%, compared to a 6% return on the municipal At what tax rate would you be indifferent between the two bonds? 8%(1 T) = 6% T = 25% Zero Coupon Bonds Make no periodic interest payments (coupon rate = 0%) The entire yield-to-maturity comes from the difference between the purchase price and the par value Cannot sell for more than par value Sometimes called zeroes, or deep discount bonds Treasury Bills and principal only Treasury strips are good examples of zeroes Zero Coupon Bonds A \$10,000 T-Bill matures in 1 year. If the current relevant interest rate is 2%, what is the price of the T-Bill? P/YR = 1 N = 1 I/YR =2 0 PV =

13 Zero Coupon Bonds XYZ, Inc. plans on issuing \$1,000 par value bonds as zero coupon bonds with a maturity of 20 years. If the company expects to pay a YTM of 7%, how much will they be able to sell the bonds for? P/YR = 1 N = 20 I/YR =7 PV = Floating Rate Bonds Coupon rate floats depending on some index value Examples Adjustable rate mortgages Inflation-linked Treasuries There is less price risk with floating rate bonds The coupon floats, so it is less likely to differ substantially from the yield-to-maturity Coupons may have a collar the rate cannot go above a specified ceiling or below a specified floor Other Bond Types Convertible bonds Putable bond There are many other types of provisions that can be added to a bond and many bonds have several provisions it is important to recognize how these provisions affect required returns 13

14 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 Bond Markets Bond Quotes Bond Markets Current Yield Annual Coupon/Current Bond Price \$67.50/\$1030 = 6.55% Bid Price Price dealer is willing to pay Ask Price Price dealer is willing to sell at Bid-Ask Spread Really should be called Ask-Bid spread since Ask price is higher. 14

15 Inflation and Interest Rates Real Rate of Interest This is the pure cost of money, assuming no change in purchasing power Nominal Rate of Interest This is typically the quoted rate of interest which includes compensation for inflation. The ex ante (observed) nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation 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 Exact R = r + h + rh Approximation R = r + h The Fisher Effect If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate? Exact R = (1.1)(1.08) 1 =.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. 15

16 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. Term Structure of Interest Rates Yield Curve Graphical representation of the term structure Normal Upward-sloping Long-term yields are higher than short-term yields Inverted Downward-sloping Llong-term yields are lower than short-term yields Upward-Sloping Yield Curve 16

17 Downward-Sloping Yield Curve Treasury Yield Curve Factors Affecting Required Return Default Risk Premium Bond ratings Taxability Premium Tax-exempt versus Taxable Liquidity Premium More liquid bonds will generally have lower required returns Anything else that affects the risk of the cash flows to the bondholders, will affect the required returns 17

18 Questions? 18

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