Chapter 07 – Interest Rates and Bond Valuation
Chapter 7
INTEREST RATES AND BOND VALUATION
CHAPTER WEB SITES
Section
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CHAPTER ORGANIZATION
7.1 Bonds and Bond Valuation
Bond Features and Prices
7.2 More about Bond Features
7.3 Bond Ratings
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7.4 Some Different Types of Bonds
Government Bonds
7.5 Bond Markets
7.6 Inflation and Interest Rates
7.7 Determinants of Bond Yields
7.8 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
7.1. Bonds and Bond Valuation
A. Bond Features and Prices
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B. Bond Values and Yields
The cash flows from a bond are the coupons and the face value.
The value of a bond (market price) is the present value of the
expected cash flows discounted at the market rate of interest.
Yield to maturity (YTM) – the required market rate or return, or
rate that makes the discounted cash flows from a bond equal to the
bond’s market price.
Real World Tip: Not all bond interest is paid in cash. Isle of Arran
Discount bond – a bond that sells for less than its par value. This is
the case when the YTM is greater than the coupon rate.
Example: Suppose the YTM on bonds similar to that of Wilhite
Co. (see the previous example) is 13% instead of 11%. What is the
bond price?
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Real-World Tip: It is unfortunate that many students fail to grasp
Lecture Tip: You should stress the issue that the coupon rate and
Lecture Tip: You may wish to further explore the loss in value of
$115 in the example in the book. You should remind the class that
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C. Interest Rate Risk
Real-World Tip: In 1998, newscasters frequently referred to rates
reaching historic lows. As a refresher, the lowest rate in 1998 on
10-year Treasuries (monthly, annualized returns for the constant
maturity index) was 4.53%. Rates increased after that point and
then fell to a low of 3.33% in June of 2003 and rebounded some to
4.10% in October of 2004 (still below the “historic lows” in
1998!)
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Real-World Tip: Upon learning the concept of interest rate risk,
students sometimes conclude that bonds with low interest-rate risk
(i.e. high coupon bonds) are necessarily “safer” than otherwise
identical bonds with lower coupons. In reality, the contrary may be
You may wish to point out that one potentially undesirable feature
of high-coupon bonds is the required reinvestment of coupons at
the computed yield-to-maturity if one is to actually earn that yield.
D. Finding the Yield to Maturity: More Trial and Error
It is a trial and error process to find the YTM via the general
formula above. Knowing if a bond sells at a discount (YTM >
coupon rate) or premium (YTM < coupon rate) is a help, but using
a financial calculator is by far the quickest, easiest, and most
accurate method.
Chapter 07 – Interest Rates and Bond Valuation
Lecture Tip: Students should understand that finding the yield to
maturity is a tedious process of trial and error. It may help to pose
Lecture Tip: You may wish to discuss the components of required
returns for bonds in a fashion analogous to the stock return
discussion in the next chapter. As with common stocks, the
required return on a bond can be decomposed into current income
and capital gains components. The yield-to-maturity (YTM) equals
the current yield plus the capital gains yield.
The capital gains yield equals the change in bond price divided by
the initial outlay. Given no change in market rates, the “one-year-
later” price must be $1,065.65. Therefore, the capital gains yield
is (1,065.65 – 1,080.42) / 1,080.42 = -.0137 = -1.37%. Summing,
the YTM = 5.55% – 1.37% = 4.18% (slight difference due to
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7.2. More on Bond Features
A. Is It Debt or Equity?
B. Long-Term Debt: The Basics
C. The Indenture
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Terms of a bond – face value, par value, and form
Registered form – ownership is recorded, payment made
directly to owner
Bearer form – payment is made to holder (bearer) of bond
Lecture Tip: Although the majority of corporate bonds have a
$1,000 face value, there are an increasing number of “baby
Security – debt classified by collateral and mortgage
Collateral – strictly speaking, pledged securities
Call provision – allows company to “call” or repurchase part or all
of an issue
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Lecture Tip: Domestically issued bearer bonds will become
obsolete in the near future. Since bearer bonds are not registered
Lecture Tip: Ask the class to consider the difference in yield for a
about the risk-return tradeoff.
7.3. Bond Ratings
Lecture Tip: The question sometimes arises as to why a potential
Real-World Tip: Ask your students which is riskier – junk bonds or
IBM common stock? If they guess the former, they would get an
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Ethics Note: A major scandal broke in 1996 when allegations
were made that Moody’s Investors Service, Inc. was issuing
7.4. 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.
International Tip: The government of Russia issued bonds in 1996
Video Note: “Bonds” follows the bond underwriting process through secondary market
sales.
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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
International Note: A Wall Street Journal article described how
an American with the Agency for International Development has
B. Zero-Coupon Bonds
Zero-coupon bonds are bonds that are offered at deep discounts
because there are no periodic coupon payments. Although no cash
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Real-World Tip: Most students are familiar with Series EE savings
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
Lecture Tip: “Marketable Treasury Inflation–Indexed Securities”
have floating coupon payments, but the interest rate is set at
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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.
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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.
7.5. Bond Markets
A. How Bonds are Bought and Sold
B. Bond Price Reporting
C. A Note on Bond Price Quotes
When bonds are quoted without accrued interest this is called the
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7.6. Inflation and Interest Rates
A. Real versus Nominal Rates
B. The Fisher Effect
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
C. Inflation and Present Values
7.7. Determinants of Bond Yields
A. The Term Structure of Interest Rates
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Interest rate risk premium – reward for bearing interest rate risk
B. Bond Yields and the Yield Curve: Putting It All Together
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.
7.8. Summary and Conclusion