1. International Center For Environmental Finance.
Environmental Finance Policy
Presentation #?:
Interest Rates and Bond Valuations

2. BONDS
When government (or corporation) wishes to borrow money from the public on a long-term basis, it usually does so by issuing or selling debt securities that are generically called bonds.

3. BOND FEATURES AND PRICES
Bonds are loans made on:
1. Standardized documents to borrowers whose credibility is publicly known,
2. where the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan

4. BOND FEATURES AND PRICES
Example:
Suppose municipality XYZ wants to borrow $1,000 for 30 years.
Interest rate on similar debt issued by similar municipalities is 12 percent.
XYZ will thus pay 0.12 x $1,000 = $120
in interest every year for 30 years.
At the end of 30 years, XYZ will repay $1,000.

5. BOND FEATURES AND PRICES
In our example, the $120 regular interest payments that XYZ promises to pay are called the bond’s coupons
The amount that will be repaid at the end of the loan is called the bond’s face value, or par value.
The annual coupon divided by the face value is called the coupon rate on the bond. In our example, the bond has a 12 percent coupon rate ($120/1,000=12%)

6. BOND FEATURES AND PRICES
The number of years until the face value is paid is called the bond’s time to maturity.
In our example, the bond has a maturity of 30 years, but this varies. Once the bond has been issued, the number of years to maturity declines as time goes by.

7. BOND FEATURES AND PRICES
Summary of terms:
coupon is the stated interest payment made on a bond
Face value (or par value) is the principal amount of a bond that is repaid at the end of the term
Coupon rate is the annual coupon divided by the face value of a bond
Maturity is the specified date on which the principal amount of a bond is paid

8. BOND VALUES AND YIELDS
As time passes, interest rates change in the market place
The cash flow from a bond, however, stay the same
As a result, the value of the bond will flactuate

9. BOND VALUES AND YIELDS
To determine the value of a bond at a particular point in time, we need to know the number of periods remaining until maturity, the face value, the coupon, and the market interest rate for bonds with similar features
This interest rate required is called the bond’s yield to maturity (YTM)

10. BOND VALUES AND YIELDS Example:
Suppose municipality XYZ were to issue a bond with:
10 years to maturity
annual coupon of $80
and similar bonds have YTM of 8 percent
WHAT WOULD THIS BOND SELL FOR?

11. BOND VALUES AND YIELDS
Cash Flows from the bond
Year 1 2 3 4 5 6 7 8 9 10
Coupon
Face
values
$80
$1,000
$1,080
As shown above, XYZ bond’s cash flows have an annuity component (coupons) and a lump sum (face value paid at maturity)

12. BOND VALUES AND YIELDS
To estimate the market value of the bond we calculate the present value of annuity component and a lump sum separately and add the results together.

13. BOND VALUES AND YIELDS
1. Present Value of $1,000 in 10 years at the going market rate of 8 percent is:
PV=$1,000/1.0810=$1,000/2, =$463.19
2. The bond offers $80 per year for 10 years, thus:
Annuity PV=$80 x (1-1/1.0810)/.8
=$80 x =$536.81
3.Total bond value=$ $536.81
= $1,000

14. BOND VALUES AND YIELDS
The bond in our example sells exactly for its face value. This is not a coincidence. With an $80 coupon, this bond pays exactly 8 percent only when it sells for $1,000

15. BOND VALUES AND YIELDS
Now, lets see what happens when interest rates change.
Suppose a year gone by, which leaves XYZ bond with 9 years to maturity
Interest rates risen from 8 to 10 percent
SO, what will the bond be worth?

16. BOND VALUES AND YIELDS
To find out what this bond worth now, we repeat the present value calculations with 9 years instead of 10, and a 10 percent yield instead of 8 percent yield.
PV= $1,000/1.109=$424.10
The bond now offers $80 per year for 9 years, thus:
Annuity PV=$80 x (1-1/1.109)/.10=$460.72
3. Total bond value=$ $460.72=$884.8
Therefore, the bond should sell for about $885

17. BOND VALUES AND YIELDS
Now XYZ bond sells for less than its $1,000 face value. WHY?
Considered as an interest-only loan of $1,000, this bond only pays 8 percent while market interest rate is 10 percent.
Because this bond pays less than the going rate, investors are only willing to lend less than the $1,000 promised repayment.
Because the bond sells for less than face value, it is said to be discount bond.

18. BOND VALUES AND YIELDS
The only way to get the interest rate up to 10 percent is to lower the price to less than $1,000 so that the purchaser has a built-in gain.
For the XYZ bond the price of $885 is $115 less than the face value, so an investor who purchased and kept the bond would get $80 per year and would have a $115 gain at maturity as well. This gain compensates the lender for the below-market coupon rate.

19. BOND VALUES AND YIELDS
Now, let us consider a case when interest rates had dropped by 2 percent instead of rising by 2 percent.
The bond would sell for more than $1,000. Such a bond is said to sell at a premium and is called a premium bond.
The XYZ bond now has a coupon rate of 8 percent when the market rate is only 6 percent

20. BOND VALUES AND YIELDS
To find out what this bond worth now, we repeat the present value calculations with 9 years and 6 percent yield.
PV= $1,000/1.069=$591.89
Annuity PV=$80 x (1-1/1.069)/ =$544.14
3. Total bond value=$ $ =$1,136.03

21. BOND VALUES AND YIELDS
Based on our examples, we can now write the general expression for the value of a bond.
If a bond has:
A face value of F paid at maturity
A coupon of C paid per period
t periods to maturity
A yield of r per period

22. BOND VALUES AND YIELDS Bond value is:
Bond Value=C x[1-1(1+r)t]/r + F/(1+r)t
Bond Value=Present value + Present Value
of the coupons of the face
amount

23. INTEREST RATE RISK
Interest Rate Risk is the risk that arises from fluctuating interest rates.
Bond’s interest rate risk depends on how sensitive its price is to interest rate changes.
Bond’s interest sensitivity depends on two things: the time to maturity and the coupon rate

24. INTEREST RATE RISK
When looking at a bond following things should be considered:
All other things being equal, the longer the time to maturity, the greater the interest rate risk.
All other things being equal, the lower the coupon rate, the greater the interest rate risk

25. INTEREST RATE RISK
To illustrate first of these 2 points we compute and plot prices under different interest rate scenarios for 10 percent coupon bonds with maturities of 1 year and 30 years.
Time to Maturity
Interest Rate
1 Year
30 Years 5%
$1,047.62
$1,768.62 10
1,000.00 15
956.52
671.7 20
916.67
502.11

26. Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities

27. INTEREST RATE RISK
Notice how the slope of the line connecting the prices is much steeper for the 30-year maturity than it is for the 1-year maturity.
This steepness means that a relatively small change in interest rates will lead to a substantial change in the bond’s value.
In comparison, the 1-year bond is relatively insensitive to interest rate changes

28. PART II – LONG TERM DEBT
The Indenture
Bond Ratings

29. LONG TERM DEBT: The Basics
There are a number of features that distinguish long-term securities from one another:
The maturity of a long-term debt instrument is the length of time the debt remains outstanding with some unpaid balance. Debt securities can be short-term or long-term.
Two major forms of long-term debt are public issue and privately placed.

30. LONG TERM DEBT: The Basics
There are many other dimensions to long term debt, including such things as:
Security
Call features
Sinking funds
Ratings
Protective covenants
The following table illustrates these features for hypothetical bond

31. TERM EXPLANATION Amount of issue $125 million
The company issued $125 million of bonds
Date of issue
5/10/2001
The bonds were sold on 5/10/2001
Maturity
5/10/2031
The principal will be paid 30 years after the issue date
Face value
$1,000
The denomination of the bond is $1,000
Annual coupon
9.25
Each bondholder will receive $92.5 per bond per year (9.25% of face value)
Offer price
100
The offer price will be 100% of the $1,000 face value per bond
Coupon payment dates
5/1, 11/1
Coupons of $92.50/2=$46.25 will be paid on these dates
Security
none
The bonds are debentures
Sinking fund
Annual, Beginning 5/10/2016
The firm will make annual payments towards the sinking fund
Call provision
Not callable before 5/10/2012
The bonds have a deferred call feature
Call price
initially declining to 100
After 5/10/2012, the company can buy the bonds for $1, per bond, with this price declining to $1,000 on 5/10/24
Rating
Moody's A2
This is one of Moody's highest ratings, The bonds have a low probability of default

32. The Indenture
The indenture is the written document between the borrower and its creditors.
Usually a trustee is appointed by the borrower to represent bondholders. Trustee must:
make sure the terms of the indenture are obeyed.
manage the sinking fund
represent the bondholders in default.

33. The Indenture
The bond indenture is a legal document and generally includes the following provisions:
The basic terms of the bond
The total amount of bonds issued
A description of property used as security
The repayment arrangements
The call provisions
Details of the protective covenants

34. The Indenture SECURITY
Collateral is a general term that frequently means securities (bonds and stocks) that are pledged as security for payment of debt.
Mortgage securities are secured by a mortgage on the real property of the borrower.
Debenture is an unsecured bond, for which no specific pledge of property is made. Debenture holders only have a claim on property that remains after mortgages and collateral trusts are taken into account.

35. The Indenture SENIORITY
Seniority indicates preference in position over other lenders, and debts are sometimes labeled as senior and junior to indicate seniority.

36. The Indenture REPAYMENT
Bonds can be repaid at maturity, or they can be repaid in part or in entirety before maturity. Early repayment is often handled through a sinking fund.

37. The Indenture SINKING FUND
A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt.
The trustee does this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds

38. The Indenture SINKING FUND
There are many different kinds of sinking fund arrangements. For example:
Some sinking funds start about 10 years after the initial issuance
Some sinking funds establish equal payments over the life of the bond
Some high quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue. As a consequence, there is the possibility of a large “balloon payment” at maturity

39. The Indenture THE CALL PROVISION
Call provision is an agreement giving the corporation the option to repurchase the bond at a specified price before maturity
Generally, the call price is above the bond’s stated value. The difference between call price and stated value is the call premium.
Sometimes, an issuer might be prohibited from calling its bond for the first 10 years. This is a deferred call provision.

40. The Indenture PROTECTIVE COVENANTS
A protective covenant is a part of the indenture or loan agreement that limits certain actions that might be taken during the term of the loan, usually to protect the lender’s interest.
Protective covenants can be classified in two types:
Negative covenants
Positive (or affirmative) covenants

41. The Indenture NEGATIVE COVENANT
A negative covenant is a “thou shalt not” type of covenant. For example:
The firm must limit the amount of dividents it pays according to some formula.
The firm cannot pledge any assets to other lenders
The firm cannot merge with another firm
The firm cannot sell or lease any major assets without approval by the lender
The firm cannot issue additional long-term debt.

42. The Indenture POSITIVE COVENANT
A positive covenant is a “thou shalt” type of covenant. For example:
The company must maintain its working capital at or above some specified minimal level.
The company must periodically furnish audited financial statements to the lender
The firm must maintain any collateral or security in good condition

43. LONG TERM DEBT BOND RATINGS
The debt ratings are an assessment of the creditworthiness of the corporate issuer.
The two leading bond rating firms are Moody’s and Standard and Poor’s (S&P)

44. Low-Quality, Speculative –”Junk” Bond Rating
BOND RATINGS
Investment-Quality Bond Ratings
Low-Quality, Speculative –”Junk” Bond Rating
High Grade
Medium Grade
Low grade
Very Low Grade
S&P
AAA AA A
BBB BB B
CCC CC C D
Moody's
Aaa Aa
Baa Ba
Caa Ca

45. BOND RATINGS Moody's S&P Aaa AAA
Debt rated Aaa and AAA has the highest rating. Capacity to pay interest and interest is extremely strong. Aa AA
Debt rated Aa and AA has a very strong capacity to pay interest and repay principal. Together with the highest rating, this group comprises the high grade bond class. A
Debt rated A has a strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than debt in high rated categories

46. BOND RATINGS Moody's S&P Baa BBB
Debt rated Baa and BBB is regarded as having an adequate capacity to pay interest and repay principal. These bonds are medium-grade obligations
Ba, B
BB, B
Debt rated in these categories is regarded, on balance, as predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of obligation. BB and Ba indicate the lowest degree of speculation, and CC and Ca the highest degree of speculation. Some issues may be in default.
Caa
CCC CC

47. BOND RATINGS
Moody's
S&P C
This rating is reserved for income bonds on which no interest is being paid D
Debt rated D is in Default, and payment of interest and/or repayment of principal is in arrears