Chapter 7; Interest Rates and Bond Valuation

Bonds

Debt securities that corporations (or the government) issue to borrow money from the investing public.

• the Corporation borrowing is the issuer, and investors who buy the bonds are bondholders.

  • They are interest only loans

Coupon

The stated interest payment made on a bond.

• the PMT

  • Calculated by taking coupon rate x FV

    • Divide by 2 during semiannual periods

Face Value (par value)

The principal amount of a bond that is repaid at the end of the term.

• Fixed and doesn’t change during the life of the bond.

  • FV on calculator

Yield to Maturity (YTM)

The rate required in the market on a bond.

• Interest rate used to discount the promised cash flows.

  • I/Y on calculator

    • divide by 2 for semiannual periods.

2 Interest Rates for Bonds

1. Coupon rate

2. The Yield to Maturity (YTM)

The Coupon Rate

Used to calculate the coupon payments.

Coupon rate = YTM

The bond prices are at par

• price = face value

Coupon rate < YTM

The bond prices are at a discount

• price < face value

Coupon rate > YTM

The bond prices are at a premium

• Price > face value

Current Yield

A bond’s annual coupon divided by its price.

Indenture

The written agreement between the corporation and the lender detailing the terms of the debt issue.

Registered form

The form of bond issue in which the registrar of the company records ownership of each bond.

• Payment is made directly to the owner of record.

Bearer Form

The form of bond issue in which the bond is issued without the owner’s name.

• Payment is made to whomever holds the bond.

Debenture

An unsecured debt, usually with a maturity of 10 years or more.

Note

An unsecured debt, usually with a maturity under 10 years.

Sinking fund

An account managed by the bond trustee for early bond redemption.

Call provsion

An agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity.

Call Premium

The amount by which the call price exceeds the par value of a bond.

Deferred Call provision

A call provision prohibiting the company from redeeming a bond prior to a certain date.

Call-protected bond

A bond that, during a certain period cannot be redeemed by the issuer.

Protective covenant

A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender’s interest.

Semi-annual compounding

When pricing the bond, divide the coupon rate by 2, and the YTM by 2 to get the semi-annual rates.

• Also multiply the number of years to maturity by 2, since each year is divided into two periods.

Zero Coupon bonds (Zeroes)

Bonds with a coupon rate of 0%

• Offered at a price lower than the face value (deep discount bonds)

• We still price them assuming a semi-annual frequency.

What type of relationship does bond prices and YTM have?

They have a inverse relationship.

• As the YTM changes, the price of the bond changes.

Bond Ratings

Assessment of the creditworthiness of the issuer based on how likely the issuer is to default.

Investment grade bonds

Rated BBB or higher by S&P.

• Higher ratings indicate the capacity of the issuer to pay is strong.

Speculative/Low Quality/Junk Bonds

Higher likelihood of default.

• These have high YTMs

• Lower than BBB

Government Bonds

Bonds issued by the US federal government are called treasuries

• Ex: treasury bills, notes, and bonds.

Treasury securities

are considered default free (high ratings!)

Municipal securities (Munis)

Debt securities issued by state and local governments.

• These are not default free, and are rate like corporate debt.

  • interest received is tax-exempt at the federal level.

Nominal Rate

The percentage change in the number of dollars you have.

• Hasn’t been adjusted for inflation

Real rate

The percentage change in your purchasing power.

• Have been adjusted for inflation

Fisher Effect

The relationship between nominal, real and inflation rates.

• (1+R) = (1+r)(1+h)

  • R is nominal rate

  • r is real rate

  • h is inflation