978-0077861704 Chapter 7 Lecture Note Part 2

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Chapter 07 – Interest Rates and Bond Valuation

1. Bond Ratings

Lecture Tip: The question sometimes arises as to why a potential

issuer would be willing to pay rating agencies tens of thousands of

dollars in order to receive a rating, especially given the possibility

that the resulting rating could be less favorable than expected.

This is a good place to remind students about the pervasive nature

of agency costs and point out a real-world example of their effects

on firm value. You may also wish to use this issue to discuss some

of the consequences of information asymmetries in financial

markets.

Real-World Tip: Ask your students which is riskier – junk bonds or

IBM common stock? If they guess the former, they would get an

argument from those IBM shareholders who lost billions of dollars

as prices fell from the $120’s to $42. More value was lost by IBM

shareholders in 1991 – 92 than in the junk bond market from the

1980’s to that point!

Ethics Note: A major scandal broke in 1996 when allegations

were made that Moody’s Investors Service, Inc. was issuing ratings

on bonds it had not been hired to rate, in order to pressure issuers

to pay for their service. In a Wall Street Journal story dated May 2,

1996, it was reported that, after choosing to use rating services

other than Moody’s, officials in Chippewa County, Michigan

received a letter from the Executive Vice President warning that

the “absence of a rating … might imply that we believe that there

exist deficiencies” in the financing arrangements. Further,

Moody’s billed the county anyway, “as part of a long-standing

policy.” Moody’s actions resulted in an antitrust inquiry by the

U.S. Justice Department and the departure of several of the firm’s

senior management. However, in March 1999, the U.S. Justice

Department announced that they were dropping the antitrust

investigation into Moody’s without taking any action.

2. Some Different Types of Bonds

A. Government Bonds

Long-term debt instruments issued by a governmental entity.

Treasury bonds are bonds issued by a federal government; a state

or local government issues municipal bonds. In the U.S.,

Treasuries are exempt from state taxation and “munis” are exempt

from federal taxation.

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Chapter 07 – Interest Rates and Bond Valuation

International Tip: The government of Russia issued bonds in 1996

for the first time since the 1917 revolution. Demand was so great

that the amount of the issue was raised from $200 million to $1

billion. The prime minister of Russia stated that the market’s

reaction “reflected the trust international investors have

in Russia.” It should be noted, however, that the yield required by

investors in the five-year bonds was 9.36%, nearly 3.5% higher

than similar U.S. Treasury issues. Russia’s borrowing spree ended

in a financial meltdown and unilateral default on much of its debt.

Video Note: “Bonds” follows the bond underwriting process through secondary market

sales.

Real-World Tip: In June, 1996, The Wall Street Journal reported

that officials in New York City were considering the issuance of

municipal bonds backed by the assets of “deadbeat parents.” The

plan was to work like this: investors would buy the high-yield

bonds, funds would go to some of the families to whom back child-

support payments are owed, and the city would go after the assets

of those with payments in arrears in order to make the interest

payments on the bonds. What makes the deal so attractive to the

city is that, besides addressing the “deadbeat parents” issue, the

city is not backing the financial obligation; rather, the city simply

promises to enforce the child-support laws. According to

Finance Commissioner Fred Cerullo, “We find this proposal

interesting … it’s very consistent with the city’s position of helping

the families of deadbeat dads, and our position on [asset]

securitization.” And, as the Journal points out, if this proposal

sounds strange, “who would have thought 20 years ago that credit

cards and other so-called receivables would be securitized and

sold on a regular basis?”

International Note: A Wall Street Journal article described how

an American with the Agency for International Development has

helped introduce municipal bonds to India. As the article notes,

“The concept is to use dwindling funds to offer government the

most rudimentary tools of capitalism, such as the mundane but

beneficial muni bond. The idea is to help poor nations tap vast

new sources for vital infrastructure development while developing

goodwill, and investment opportunities, for U.S. investors.” And

the key to this exercise? The ability to get the bonds rated by a

credit-rating agency.

B. Zero-Coupon Bonds

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Chapter 07 – Interest Rates and Bond Valuation

Zero-coupon bonds are bonds that are offered at deep discounts

because there are no periodic coupon payments. Although no cash

interest is paid, firms deduct the implicit interest on these “original

issue discount bonds,” while holders report it as income. Interest

expense equals the periodic change in the amortized value of the

bond.

Real-World Tip: Most students are familiar with Series EE savings

bonds. Point out that these are actually zero coupon bonds. The

investor pays one-half of the face value and must hold the bond for

a given number of years before the face value is realized. As with

any other zero-coupon bond, reinvestment risk is eliminated, but

an additional benefit of EE bonds is that, unlike corporate zeroes,

the investor need not pay taxes on the accrued interest until the

bond is redeemed. Further, it should be noted that interest on these

bonds is exempt from state income taxes. And, savings bonds yields

are indexed to Treasury rates.

C. Floating-Rate Bonds

Floating-rate bonds – coupon payments adjust periodically

according to an index.

put provision – holder can sell back to issuer at par

collar – coupon rate has a floor and a ceiling

Lecture Tip: Imagine this scenario: General Motors receives cash

from a lender in return for the promise to make periodic interest

payments that “float” with the general level of market rates.

Sounds like a floating-rate bond, doesn’t it? Well, it is, except that

if you replace “General Motors” with “Joe Smith,” you have just

described an adjustable-rate mortgage. The rates on ARMs are

often tied to rates on marketable securities, and the mortgage

interest cost will be adjusted, typically on an annual basis, to

reflect changes in the interest rate environment. From the bank’s

perspective, the homeowner has signed (issued) a “floating-rate

bond” that the bank holds as its investment. Additionally, many

variable rate mortgages involve collars. A detailed summary of the

factors that affect interest rate changes is provided on a daily basis

in The Wall Street Journal.

Lecture Tip: “Marketable Treasury Inflation-Indexed Securities”

have floating coupon payments, but the interest rate is set at

auction and fixed over the life of the bond. The principal amount is

periodically adjusted for inflation, and the coupon payment is

based on the current inflation-adjusted principal amount. The

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Chapter 07 – Interest Rates and Bond Valuation

CPI-U is used to adjust the principal for inflation. The bonds will

pay either the original par value or the inflation-adjusted

principal, whichever is greater, at maturity. For more information,

see the Bureau of the Public Debt online at

www. publicdebt .treas.gov.

I-bonds are an inflation-indexed savings bond designed for the

individual investor. They pay an interest rate equal to a fixed rate

plus the inflation rate. The fixed rate is fixed for the 30-year

possible life of the bond, and the inflation rate is adjusted every six

months. Interest is added to the bond value each month but

compounded semiannually. Like Series EE bonds, interest is

exempt from state and local taxes, and can be deferred for federal

tax purposes for 30 years or until the bond is redeemed, whichever

is sooner. Some investors may qualify for preferred tax treatment if

the bonds are redeemed to pay for qualifying educational

expenses.

D. Other Types of Bonds

Income bonds – coupon is paid if income is sufficient

Convertible bonds – can be traded for a fixed number of shares of

stock

Put bonds – shareholders can redeem for par at their discretion

Real World Tip: Near the end of the 1990s, firms began issuing

bonds that have come to be known as “death puts” because they

are designed to appeal to investors approaching their own demise.

“To attract more retail investors, some enterprising underwriters

are selling corporate bonds that give you a little reward for dying:

Your estate has the right to put the bond back to the issuer and

collect par value. Depending on what you paid for the “death put”

bond and how interest rates have changed, your estate could make

a nice profit by exercising the put option. The sooner you die, the

greater the potential profit. And the proceeds can be used however

you wish; they are not restricted to paying death duties.” (Forbes,

March 8, 1999)

These are essentially updated versions of the old “flower bonds”

formerly issued by the U.S. Treasury, which paid off at par upon

the death of the holder, as long as they were applied to the

deceased’s tax bill.

One more innovation you might want to discuss with students are

“Bowie Bonds,” so named because rock star David Bowie first

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Chapter 07 – Interest Rates and Bond Valuation

securitized his catalog of music by issuing bonds based on future

royalties from his compositions. Since then, Michael Jackson, Iron

Maiden, and the Supremes have all expressed interest in similar

deals. And, from a purely financial point of view, it makes sense,

doesn’t it? Still, a cynic would say that it’s a sure sign that the

rockers have reached (or passed) middle age …

E. Sukuk

Bonds issued to comply with Shariah, or Islamic law, which does

not permit charging or paying interest. The bonds typically confer

partial ownership of some aspect of the firm to the bondholder.

3. Bond Markets

A. How Bonds are Bought and Sold

Most transactions are OTC (over-the-counter)

The OTC market is not transparent

Daily bond trading volume (in dollars) exceeds stock trading

volume, but trading in individual issues tends to be very thin

B. Bond Price Reporting

The last decade has seen a dramatic increase in the transparency of

the bond market.

C. A Note on Bond Price Quotes

When bonds are quoted without accrued interest this is called the

“clean price.” The “dirty price” is the quoted price plus accrued

interest and is the price that is actually paid. The accrued interest is

computed by taking a pro rata share of the coupon payment.

Example: Suppose the last coupon was paid 50 days ago and there

are 182 days in the current coupon period. If the semiannual

coupon payment is $40, then the accrued interest would be

(50/182)*40 = $10.99. This amount would be added to the quoted

price to determine the “dirty price.”

4. Inflation and Interest Rates

A. Real versus Nominal Rates

Nominal rates – rates that have not been adjusted for inflation

Real rates – rates that have been adjusted for inflation

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Chapter 07 – Interest Rates and Bond Valuation

B. The Fisher Effect

The Fisher Effect is a theoretical relationship between nominal

returns, real returns, and the expected inflation rate. Let R be the

nominal rate, r the real rate, and h the expected inflation rate; then,

(1 + R) = (1 + r)(1 + h)

A reasonable approximation, when expected inflation is relatively

low, is R = r + h.

A definition whereby the real rate can be found by deflating the

nominal rate by the inflation rate: r = [(1 + R) / (1 + h)] – 1.

Lecture Tip: In late 1997 and early 1998 there was a great deal of

talk about the effects of deflation among financial pundits, due in

large part to the combined effects of continuing decreases in

energy prices, as well as the upheaval in Asian economies and the

subsequent devaluation of several currencies. How might this

affect observed yields? According to the Fisher Effect, we should

observe lower nominal rates and higher real rates and that is

roughly what happened. The opposite situation, however, occurred

in and around 2008.

C. Inflation and Present Values

Discount nominal cash flows at a nominal rate, or real cash flows

at a real rate. If you are consistent, the same answer results.

5. Determinants of Bond Yields

A. The Term Structure of Interest Rates

Term structure of interest rates –relationship between nominal

interest rates on default-free, pure discount bonds and maturity

Inflation premium – portion of the nominal rate that is

compensation for expected inflation

Interest rate risk premium – reward for bearing interest rate risk

B. Bond Yields and the Yield Curve: Putting It All Together

Treasury yield curve – plot of yields on Treasury notes and bonds

relative to maturity

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Chapter 07 – Interest Rates and Bond Valuation

Default risk premium – the portion of a nominal rate that

represents compensation for the possibility of default

Taxability premium – the portion of a nominal rate that represents

compensation for unfavorable tax status

Liquidity premium – the portion of a nominal rate that represents

compensation for lack of liquidity

C. Conclusion

The bond yields that we observe are influenced by six factors: (1)

the real rate of interest, (2) expected future inflation, (3) interest

rate risk, (4) default risk, (5) taxability, and (6) liquidity.

6. Summary and Conclusion

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