Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
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.
7-1
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
7-2
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
7-3
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
7-4
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
7-5
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
7-6
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
7-7
