Chapter McGraw-Hill Ryerson © 2007 McGraw-Hill Ryerson Limited Interest Rates and Bond Valuation Prepared by Anne Inglis, Ryerson University 7

7-1 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

7-2 Chapter Outline Bonds and Bond Valuation More on Bond Features Bond Ratings Some Different Types of Bonds Bond Markets Inflation and Interest Rates Determinants of Bond Yields Summary and Conclusions

7-3 Bond Definitions 7.1 Bond Par value (face value) Coupon rate Coupon payment Maturity date Yield or Yield to maturity

7-4 Present Value of Cash Flows as Rates Change Bond Value = PV of coupons + PV of par Bond Value = PV annuity + PV of lump sum Remember, as interest rates increase the PV’s decrease So, as interest rates increase, bond prices decrease and vice versa

7-5 Valuing a Discount Bond with Annual Coupons Consider a bond with a coupon rate of 10% and coupons paid annually. The par value is $1000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond? Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.11) 5 ] / / (1.11) 5 B = = Using the calculator: N = 5; I/Y = 11; PMT = 100; FV = 1000 CPT PV =

7-6 Valuing a Premium Bond with Annual Coupons Suppose you are looking at a bond that has a 10% annual coupon and a face value of $1000. There are 20 years to maturity and the yield to maturity is 8%. What is the price of this bond? Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.08) 20 ] / / (1.08) 20 B = = Using the calculator: N = 20; I/Y = 8; PMT = 100; FV = 1000 CPT PV =

7-7 Graphical Relationship Between Price and Yield-to-Maturity

7-8 Bond Prices: Relationship Between Coupon and Yield If YTM = coupon rate, then par value = bond price If YTM > coupon rate, then par value > bond price Why? Selling at a discount, called a discount bond If YTM < coupon rate, then par value < bond price Why? Selling at a premium, called a premium bond

7-9 The Bond-Pricing Equation

7-10 Example – Semiannual Coupons Most bonds in Canada make coupon payments semiannually. Suppose you have an 8% semiannual-pay bond with a face value of $1,000 that matures in 7 years. If the yield is 10%, what is the price of this bond? The bondholder receives a payment of $40 every six months (a total of $80 per year) The market automatically assumes that the yield is compounded semiannually The number of semiannual periods is 14

7-11 Example – Semiannual Coupons continued Or PMT = 40; N = 14; I/Y = 5; FV = 1000; CPT PV =

7-12 Interest Rate Risk Price 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 the interest rates at which cash flows can be reinvested Short-term bonds have more reinvestment rate risk than long-term bonds

7-13 Figure 7.2 – Interest Rate Risk and Time to Maturity

7-14 Computing Yield-to-Maturity Yield-to-maturity is the rate implied by the current bond price Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding r with an annuity If you have a financial calculator, enter N, PV, PMT and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign)

7-15 Example – Finding the 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%? N = 15; PV = ; FV = 1000; PMT = 100 CPT I/Y = 11%

7-16 YTM with Semiannual Coupons Suppose a bond with a 10% coupon rate and semiannual coupons has a face value of $1000, 20 years to maturity and is selling for $ Is the YTM more or less than 10%? What is the semiannual coupon payment? How many periods are there? N = 40; PV = ; PMT = 50; FV = 1000; CPT I/Y = 4% (Is this the YTM?) YTM = 4%*2 = 8%

7-17 Table 7.1 – Summary of Bond Valuation

7-18 Bond Pricing Theorems Bonds of similar risk (and maturity) will be priced to yield about the same return, regardless of the coupon rate If you know the price of one bond, you can estimate its YTM and use that to find the price of the second bond This is a useful concept that can be transferred to valuing assets other than bonds

7-19 Bond Prices with a Spreadsheet There is a specific formula for finding bond prices on a spreadsheet PRICE (Settlement, Maturity, Rate, Yield, Redemption, Frequency, Basis) YIELD(Settlement,Maturity,Rate,Pr,Redemption, Frequency,Basis) Settlement and maturity need to be actual dates The redemption and Pr need to given as % of par value Click on the Excel icon for an example

7-20 Differences Between Debt and Equity 7.2 Debt Not an ownership interest Bondholders do not have voting rights Interest is considered a cost of doing business and is tax deductible Bondholders have legal recourse if interest or principal payments are missed Excess debt can lead to financial distress and bankruptcy

7-21 Differences Between Debt and Equity Continued Equity Ownership interest Common shareholders 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 shareholders have no legal recourse if dividends are not paid An all equity firm can not go bankrupt

7-22 The Bond Indenture Contract between the company and the bondholders; 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

7-23 Bond Classifications Registered vs. Bearer Forms Security Collateral – secured by financial securities Mortgage – secured by real property, normally land or buildings Debentures – unsecured debt with original maturity of 10 years or more Notes – unsecured debt with original maturity less than 10 years Seniority Sinking Fund – Account managed by the bond trustee for early bond redemption

7-24 Bond Classifications Continued Call Provision Call premium Deferred call Call protected Canada plus call Protective Covenants Negative covenants Positive covenants

7-25 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

7-26 Bond Ratings – Investment Quality 7.3 High Grade DBRS’s AAA – capacity to pay is exceptionally strong DBRS’s AA – capacity to pay is very strong Medium Grade DBRS’s A – capacity to pay is strong, but more susceptible to changes in circumstances DBRS’s BBB – capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay

7-27 Bond Ratings - Speculative Low Grade DBRS’s BB, B, CCC, CC Considered speculative with respect to capacity to pay. Very Low Grade DBRS’s C – bonds are in immediate danger of default DBRS’s D – in default, with principal and/or interest in arrears

7-28 Stripped or Zero-Coupon Bonds 7.4 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 Bondholder must pay taxes on accrued interest every year, even though no interest is received

7-29 Floating Rate Bonds Coupon rate floats depending on some index value 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”

7-30 Other Bond Types Disaster bonds Income bonds Convertible bonds Put bond (retractable 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

7-31 Bond Markets 7.5 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 corporate issues Treasury securities are an exception

7-32 Bond Quotations From Figure 7.3 Canada5.500 Jun 01/ Issue is a Government of Canada bond Coupon rate is 5.5% (assumed to be semiannual) Maturity date is June 1, 2009 Price that a bondholder can sell for is $1, Yield to maturity is 4.28% compounded semiannually

7-33 Inflation and Interest Rates 7.6 Real rate of interest – compensation for change in purchasing power Nominal rate of interest – quoted rate of interest, includes compensation for change in purchasing power and inflation

7-34 The Fisher Effect The Fisher Effect defines the relationship between real rates, nominal rates and inflation Exact relationship is (1 + R) = (1 + r)(1 + h), where: R = nominal rate r = real rate h = expected inflation rate Approximation of the above relationship is: R = r + h

7-35 Example – Fisher Effect If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate? R = (1.1)(1.08) – 1 =.188 = 18.8% Approximation: R = 10% + 8% = 18% Since the real return and expected inflation are relatively high, there is significant difference between the actual Fisher Effect and the approximation.

7-36 Term Structure of Interest Rates 7.7 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. Yield curve – graphical representation of the term structure Normal – upward-sloping, long-term yields are higher than short-term yields Inverted – downward-sloping, long-term yields are lower than short-term yields

7-37 Figure 7.4 – Upward-Sloping Yield Curve

7-38 Figure 7.4 – Downward-Sloping Yield Curve

7-39 Figure 7.5 – Government of Canada Yield Curve May 2, 2006

7-40 Factors Affecting Required Return Default risk premium – remember bond ratings Liquidity premium – bonds that have more frequent trading will generally have lower required returns Anything else that affects the risk of the cash flows to the bondholders, will affect the required returns

7-41 Quick Quiz How do you find the value of a bond and why do bond prices change? What is a bond indenture and what are some of the important features? What are bond ratings and why are they important? How does inflation affect interest rates? What is the term structure of interest rates? What factors determine the required return on bonds?

7-42 Summary 7.8 You should know: How to price a bond or find the yield Bond prices move inversely with interest rates Bonds have a variety of features that are spelled out in the indenture Bonds are rated based on their default risk Most bonds trade OTC Fisher effect links interest rates and inflation Term structure of interest rates shows the relationship between interest rates and maturity