FINC 3330 – Chapter 6 (Interest Rates and Bond Valuation)

I. Interest Rates
A. Required Rate of Return
B. After-Tax Yield (ATY)
C. Estimation Methods
III. Bond Characteristics
IV. Bond Valuation
A. Bond Yields
B. Coupon Bonds
B. Zero-Coupon Bonds
V. Factors that Affect Bond Prices

I. Interest Rates
A. Required Rate of Return
The required rate of return is the minimum return that investors expect to earn to induce them
to invest (this definition assumes competitive markets). The required rate of return is used as a
discount rate in valuing assets. The following terms will be used to refer to the required rate of
return: discount rate, yield-to-maturity (YTM), yield-to-call (YTC), market rate, etc.

B. After-Tax Yield (ATY)

Since taxes apply to all interest and dividend income, investors should be concerned with the
ATY on the security, which is calculated as: ATY = BTY (1-t), where BTY is the before-tax yield
on the security, and t is the marginal tax rate paid by the investor. In the US, investors do not pay
any taxes on municipal securities, and they are also exempt from state (though not federal) taxes
on Treasuries.

C. Estimation Methods
(1) IR = RIR + IP + RP, where IR is the nominal interest rate, RIR is the real interest rate,
IP is the inflation premium, RP is the risk premium. The real interest rate is the nominal interest
rate that would exist on a security if no inflation were expected; inflation refers to the continual
increase in the price level of a basket of goods and services; and the risk premium is determined
based on the default risk, the liquidity risk, special provisions or covenants, and the time to
maturity. The risk-free rate is the interest rate paid on a security for which the risk premium is
zero. In the United States, the risk-free rate is given by the interest rate on the 3-month T-bill. In
other words, RIR + IP = RF, where RF is the risk-free rate.

The default risk is the risk that a security’s issuer will default on the security by missing an
interest or principal payment. The higher the default risk, the higher the interest rate that will be
demanded by the buyer of the security to compensate him or her for this default (or credit) risk
exposure. US Treasury securities are regarded as having no default risk since they are issued by
the US government, and the probability of the US government defaulting on its debt payments is
practically zero given its taxation powers and its ability to print currency. The difference between
the interest rate on a security and a Treasury security with similar liquidity, maturity and other
characteristics is called default or credit risk premium (DRP).
The liquidity risk refers to the risk that a security cannot be sold at a predictable price with low
transaction costs at short notice. If a security is illiquid, investors add a liquidity risk premium
(LRP) to the interest rate on the security. In the United States, liquid markets exist for most
government securities and the stocks and bonds issued by large corporations.

Special provisions or covenants (SCP) are provisions (e.g., taxability, convertibility, and
callability) that impact the security holder beneficially or adversely and as such are reflected in
the interest rates on securities that contain such provisions. For example, because interest
payments from municipal securities are tax-exempt, municipal securities will have lower
required rate of return than securities with similar characteristics that are not tax-exempt.

The time to maturity is simply the time a security has left until maturity. The term structure of
interest rates compares the interest rates on securities, assuming that all characteristics (i.e.,
default risk, liquidity risk) except maturity are the same. The change in interest rates as the
maturity of a security changes is called the maturity premium (MP).

In conclusion, interest rates can be expressed as a function of the factors mentioned above:
IP = f (IP, RIR, DRP, LRP, SCP, MP)

(2) The Fisher Effect: (1 + Nominal Rate) = (1 + Real Rate) (1 + Inflation Premium)

(3) The Approximation Method: R ≅ r + h

III. Bond Characteristics

Bonds are long-term debt obligations issued by corporations and government units to raise funds
to support long-term operations of the issuer (e.g., for capital expenditure projects). Bond issuers
promise investors to pay coupon interest on the borrowed funds and to repay the loan at maturity.
If the payment terms are not met by the issuer, the bondholder (investor) has a claim on the
assets of the bond issuer. A bond has the following general characteristics: par value or face
value (P) – the amount to be repaid at maturity (if the face value is not explicitly stated, then the
par value will assumed to be $1,000); coupon rate – the stated annual interest rate of the bond
calculated as the annual interest payment of the bond as a percentage of the face value; coupon
payment (C) – the dollar amount of interest paid (usually semi-annually) (the coupon payment
will be calculated as C = P x Coupon Rate / m); maturity – the specified date when the principal
amount of a bond is paid back by the bond issuer to the bondholder.

The bond indenture is the legal contract that specifies the rights and obligations of the bond
issuer and the bondholder. The bond indenture contains a number of positive and negative
covenants associated with the bond issue (rules and restrictions placed on the bond issuer and
bondholders such as the ability to call the bond issue, dividend restrictions on the issuer, etc.). By
legally documenting the rights and obligations of all parties involved in a bond issue, the bond
indenture helps lower the risk (and therefore the interest cost) of the bond issue. All matters
pertaining to the bond issuer’s performance regarding any debt covenants as well as bond
repayments are overseen by a trustee (frequently a bank trust department) who is appointed as
the bondholders’ representative or “monitor”. The trustee initiates any legal action on behalf of
the bondholders against the issuing firm if the terms of a bond’s indenture are violated.

Bonds can be classified as:

(1) Bearer and Registered Bonds. Bearer bonds are bonds on which coupons are attached.
The bondholder presents the coupons to the issuer for payments when they come due. With
registered bonds, the owner’s identification information is recorded by the issuer and the coupon
payments are mailed to the registered owner. Because of the lack of security with bearer bonds,
they have largely been replaced by registered bonds.
(2) Term and Serial Bonds. Most corporate bonds are term bonds, meaning that the entire
issue matures on a single date. Some corporate bonds (and most municipal bonds), on the other
hand, are serial bonds, meaning that the issuer contains many maturity dates, with a portion of
the issue being paid off each date. For economic reasons, many issuers like to avoid a “crisis at
maturity”. Rather than having to pay off one very large principal sum at a given time in the
future (as with the term issue), many issuers like to stretch out the period over which principal
payments are made – especially if the corporation’s earnings are quite volatile.
(3) Mortgage Bonds. Corporations issue mortgage bonds to finance specific projects that are
pledged as collateral for the bond issue. Thus, mortgage bond issues are secured debt issues.
Bondholders may legally take title to the collateral to obtain payment on bonds if the issuer of a
mortgage bond defaults. Because mortgage bonds are backed with a claim to specific assets of
the corporate issuer, they are less risky investments than unsecured bonds. As a result, mortgage
bonds have lower yields to bondholders than unsecured bonds. Equipment trust certificates are
bonds collateralized with tangible (movable) non-real estate property such as railcars and
airplanes. At the same time, municipal bonds can be classified as general obligation (GO) bonds,
which are backed by the full faith and credit of the issuer, and revenue bonds, which are sold to
finance a specific revenue-generating project and are backed by cash flows from that project.
Industrial development bonds (IDBs) are a type of revenue bond issue by municipalities on
behalf of a corporation to help build the economic base of the municipality.
(4) Debentures and Subordinated Debentures. Debentures are bonds backed solely by the
creditworthiness of the issuing firm, unsecured by specific assets or collateral. Debenture holders
generally receive their promised payments only after the secured debt holders, such as mortgage
bondholders, have been paid. Subordinated debentures are also unsecured, and they are junior in
their rights to mortgage bonds, and regular debentures. In the event of default, subordinated
debenture holders receive a cash distribution only after all nonsubordinated debt has been repaid
in full. As a result, subordinated bonds are the riskiest type of bond and generally have higher
yields than nonsubordinated bonds.
(5) Convertible Bonds. Convertible bonds are bonds that may be exchanged for another
security of the issuing firm (e.g., common stock) at the discretion of the bondholder. Conversion
is an attractive feature or option to bondholders because it gives them an investment opportunity
(an option) that is not available with nonconvertible bonds. As a result, the yield on a convertible
bond is usually lower than that on a nonconvertible bond.
(6). Bonds with Stock Warrants. Bonds can also be issued with stock warrants attached.
Similar to convertible bonds, bonds issued with stock warrants attached give the bondholder an
opportunity to detach the warrants to purchase common stock at a specified price up to a
specified date. If the bondholder decides to purchase the stock (by returning or exercising the
warrant), he or she does not have to return the underlying bond to the issuer (as under a
convertible bond). Instead, he or she keeps the bond and pays for additional stock at the price
specified in the warrant. Bondholders will exercise their warrants if the market value of the stock
is greater than the price at which the stock can be purchased through the warrant. Further, the
bondholder may sell the warrant rather than exercise it, while maintaining ownership of the
underlying bond.
(7). Callable Bonds. A call provision allows the issuer to require the bondholder to sell the
bond back to the issuer at a given (call) price, which is usually set above the par value. The
difference between the call price and the face value of the bond is the call premium. Bonds are
usually called in when interest rates drop (and bond prices rise) so that the issuer can gain by
issuing new bonds (with lower coupon rates than the existing issue). Callable bonds have higher
yields than noncallable bonds because a call provision is an unattractive feature to bondholders
(since the investor may be forced to return the bond to the issuer before he or she is ready to end
the investment, he or she can only reinvest the funds at a lower interest rate).
(8). Bonds with Sinking Fund Provisions. Many bonds have a sinking fund provision (or a
requirement that the issuer retire a certain amount of the bond issue early over a number of years,
especially as the bond approaches maturity). Since it reduces the probability of default at the
maturity date, (the “crisis at maturity”), a sinking fund provision is an attractive feature to
bondholders. Thus, bonds with a sinking fund provision are less risky to the bondholder and
generally have lower yields than comparable bonds without a sinking fund provision.

IV. Bond Ratings.

The two major bond rating agencies are Moody’s and Standard & Poor’s (S&P). Both companies
rank bonds based on the perceived probability of issuer default and assign a rating based on a
letter grade. Bonds with a triple-A rating have the lowest interest spread over similar maturity
Treasury securities. As the assessed default risk increases, Moody’s and S&P lower the credit
rating assigned on a bond issue, and the interest spread over similar maturity Treasuries paid to
bondholders generally increases. These agencies assign credit ratings on bond issues based on
factors such as: the likelihood of payment; the nature and provisions of the debt issue; the
protection afforded by, and relative position of, the debt issue in the event of bankruptcy,
reorganization, or other arrangements under the laws of bankruptcy and other laws affecting
creditors’ rights. Bonds rated Baa or better by Moody’s and BBB or better by S&P are
considered to be investment grade bonds. Bonds rated below Baa by Moody’s and BBB by S&P
are considered to be speculative grade bonds (also called junk bonds, or high-yield bonds).

V. Bond Valuation
A. Bond Yields
The yield-to-maturity (YTM) is the return the bondholder would earn on the bond if he or she
buys the bond at its current market price, receives all coupon and principal payments as
promised, and holds the bond until maturity. The yield-to-call (YTC) is the return the
bondholder would earn on the bond if he or she buys the bond at its current market price,
receives all coupon and principal payments as promised, and holds the bond until the earliest call
date. The current yield is the annual interest payment divided by the current market price.

B. Coupon Bonds
Coupon bonds pay a stated coupon rate the holders of the bond. Since the interest, or coupon,
payments (C) are generally constant (fixed) over the life of the bond, they are essentially an
annuity paid to bondholders periodically (usually semi-annually) over the life of the bond.

PV = C {1 – [1 + (r / m)] -mxn
}(r / m) + P [1 + (r / m)]
–1 -mxn

According to whether the present value of a bond is greater, equal, or lower than its face value, a
bond can be: (1) premium bond (the present value (or the current market price) is greater than
the face value – a bond will sell at a premium whenever the coupon rate on the bond is greater
than its required rate of return (or YTM)); (2) par value bond (the present value (or the current
market price) is equal to the face value – a bond will sell at a par whenever the coupon rate on
the bond is equal to its required rate of return (or YTM)); (3) discount bond (the present value
(or the current market price) is lower than the face value – a bond will sell at a discount
whenever the coupon rate on the bond is lower than its required rate of return (or YTM));

C. Zero-Coupon Bonds
For these bonds, the coupon payment is zero. Therefore, PV = P [1 + (r / m)] -mxn
.

VI. Factors that Affect Bond Prices

The factors that affect bond prices are: interest rates (there is a negative relationship between
interest rate changes and present value (or price) changes on bonds; as interest rates increase
(decrease), bond prices decrease (increase) at a decreasing (increasing) rate); time remaining to
maturity (the shorter the time to maturity for a security, the closer the price to the face value of
the bond; the longer the time to maturity for a bond, the larger the price change of the bond for a
given interest rate change - this maturity effect increases at a decreasing rate); coupon rate (the
larger a bond’s coupon, the smaller the price change on the bond for a given change in interest
rates).