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8/3/2019 Fundamental of Corporate Finance,chpt7
1/12
Chapter 7
Interest Rates and
Bond Valuation
Prepared and Taught by Lecturer : YIN SOKHNG
E-mail: [email protected]
Tel:(855) 16889872 / 17989972
Chapter Outline
7.1 Bond Definition
7.2 More about Bond Features
7.3 Bond Ratings
7.4 Different Types of Bonds
7.5 Bond Markets
7.6 Inflation and Interest Rates
7.7 Determinants of Bond Yields7.8 Bond Risky
2Instructed by YIN SOKHENG, Master in Finance
3
7.1 Bond Definition
The corporation or government are borrow moneyfrom the public by issuing or selling debt securitiesthat are generically called bonds.
Normally an interest-only loan (when issued at par),the principal is paid until the end of the loan.
Interest paid in the form of a periodic coupon.
Term basis:
Shortterm basis
Longterm basis.
Instructed by YIN SOKHENG, Master in Finance
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The Bond Indenture Contract between the corporation (borrower)
and the creditor (bondholders) that includes The basic terms of the bonds
The total amount of bonds issued
A description of property used as security, if
applicable
Repayment agreements
Call provisions
Details of protective covenants
7.2 More about Bond Features
Instructed by YIN SOKHENG, Master in Finance
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The Indenture Forms of a Bond
Registered Form: The corporation keeps track of the
owner.
Bearer Form: Certificate is the only evidence of ownership.
Security
Collateralsecured by other securities
Mortgagesecured by real property, normally land or
buildings; Chattel Mortgage (mortgage on a specific
property)
Debenturesunsecured bond with original maturity of 10
years or more Notesunsecured bond with original maturity less than 10
years
Instructed by YIN SOKHENG, Master in Finance
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Bonds Compared to Stock
Bondholders arecreditors
Bonds a liability
Interest is fixedcharge
Interest is expense
Interest tax deductible
No voting
Stockholders are owners
Stock is equity
Dividends not fixedcharges
Dividends not expense
Dividends not taxdeductible
Voting
Instructed by YIN SOKHENG, Master in Finance
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Bond Term
Par value (face value), F
Coupon rate, R
Coupon payment, C
Maturity date, T
Discount rate or Yield to maturity, r or YTM
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7.3 Bond Ratings
Investment Quality High Grade
Moodys Aaa and S&P AAA capacity to pay is
extremely strong
Moodys Aa and S&P AA capacity to pay is verystrong
Medium Grade
Moodys A and S&P A capacity to pay is strong, but
more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay isadequate, adverse conditions will have more impacton the firms ability to pay
Instructed by YIN SOKHENG, Master in Finance
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Bond Ratings - Speculative
Low Grade
Moodys Ba, B, Caa and Ca S&P BB, B, CCC, CC
Considered speculative with respect to capacity to
pay. The B ratings are the lowest degree of
speculation.
Very Low Grade
Moodys C and S&P C income bonds with no
interest being paid
Moodys D and S&P D in default with principal andinterest in arrears
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7.4 Different Types of Bonds
zero coupon bonds or discount bonds
e.g. T-billsOne year and less, no coupons
fixed payment loanse.g. mortgages, car loans- Between 3 and 15years
coupon bonds
e.g. -T-notesBetween 2 and 10 years,
-T-bondsLonger than 10 years,
-Corporate bondsLonger than 10 years
consols: no maturity date (forever).
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Zero coupon bonds
discount bonds
purchased price less than face value, F > P
face value at maturity
no interest payments
365
)(1
TrFP
P = Current price F = Face value r = discount rate T = Number of maturity date
Tr
FP
)1( OR
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Zero coupon bonds
Yield to maturity, YTM
OR
1
360
d
P
Fr
r =F - P
P
x360
d
Instructed by YIN SOKHENG, Master in Finance
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Fixed-payment loan
loan is repaid with equal (monthly) payment, PMT
each payment is combination of principal and
interest
Tmmmi
PMT
i
PMT
i
PMTPV
1...
112
i
i
m
T
m
PVPMT
)1(
11
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r is annual rate
(effective annual interest rate, EAR)
but payments are monthly, & compoundmonthly
r = (1+ im)12 -1
im = (1+ r)1/12 -1
im is the periodic rate
note: APR (annual percentage rate)
APR = im
x 12
Instructed by YIN SOKHENG, Master in Finance
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Coupon Bond
purchase price, PV
promised of a series of payments until maturity face value at maturity, F (principal, par value)
coupon payments (6 months), C
size of coupon payment
annual coupon rate, R
face value
6 mo. pmt.,C = (F x R)/2
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Value of a coupon bond = PV of coupon payment annuity+ PV of face value
0
C$
1
C$
2
C$
1T
FC $$
T
Information needed to value coupon bonds:Coupon payment dates and time to maturity (T)
Coupon payment (C) per period and Face value (F)
Coupon rate (R) and Discount rate (r or YTM)
TTr
F
rr
CPV
)1()1(
11
Instructed by YIN SOKHENG, Master in Finance
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PV, F and YTM
PV = F then YTM = coupon rate
PV < F then YTM > coupon rate (at a discount)
PV > F then YTM < coupon rate (at a premium)
PV and YTM move in opposite directions
interest rates and value of debt securities move in
opposite directions
if rates rise, bond prices fall
if rates fall, bond prices rise
Instructed by YIN SOKHENG, Master in Finance
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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 rates at which cash flows
can be reinvested
Short-term bonds have more reinvestment rate risk
than long-term bonds
Instructed by YIN SOKHENG, Master in Finance
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Figure 7.2
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Current yield,
approximation of YTM for coupon bonds
ic =annual coupon payment, C
bond price, PV
ic
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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
YTM = [C + (FPV)/T]/(F + PV)/2
C = Coupon payment
F = Face/Par value of bond
PV = Current price of bond
T = Maturity date
Instructed by YIN SOKHENG, Master in Finance
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Holding period return sell bond before maturity
return depends on
holding period interest payments
resale price
t
tt
tP
PP
P
CRET
1
giRETc
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Holding period return
RET : Rate of Return at Holding Period
: Current yield
C : Coupon payment
: Price at T period
: Price at T+1 period
g : Rate of Capital Gains or the Change of
Price
ic
PtPt+1
Instructed by YIN SOKHENG, Master in Finance
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Consols Bond
0
C$
1
C$
2
C$ ...$C
forever
r
CPV
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7.5 Bond Markets
Primarily over-the-counter transactions with
dealers connected electronically
Extremely large number of bond issues, butgenerally low daily volume in single issues
Makes getting up-to-date prices difficult,
particularly on small company or municipal
issues
Treasury securities are an exception
Instructed by YIN SOKHENG, Master in Finance
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Bond Quotations
Highlighted quote:
ATT 7 06 7.7 554 97.63 -0.38
What company are we looking at?
What is the coupon rate? If the bond has a $1000 face
value, what is the coupon payment each year?
When does the bond mature?
What is the current yield? How is it computed?
How many bonds trade that day?
What is the quoted price? How much did the price change from the previous day?
Instructed by YIN SOKHENG, Master in Finance
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Treasury Quotations
Highlighted quote:
9.000 Nov 18 133:27 133.28 24 5.78
What is the coupon rate on the bond?
When does the bond mature?
What is the bid price? What does this mean?
What is the ask price? What does this mean?
How much did the price change from the previous
day?
What is the yield based on the ask price?
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7.6 Inflation and Interest Rates
Real rate of interestchange in purchasing
power
Nominal rate of interestquoted rate ofinterest, change in purchasing power and
inflation
The ex ante nominal rate of interest includes
our desired real rate of return plus an
adjustment for expected inflation
Instructed by YIN SOKHENG, Master in Finance
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Inflation
if inflation is high
lenders demand higher nominal rate, especially
for long term loans
long-term i depends A LOT on inflation
expectations
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The Fisher Effect
The Fisher Effect defines the relationship
between real rates, nominal rates and inflation
(1 + R) = (1 + r)(1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate
Approximation
R = r + h
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Inflation and Present Value
rrCPV
T
1
11
r = Discount rate
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Term Structure of Interest Rates
Term structure is the relationship between timeto maturity and yields, all else equal
It is important to recognize that we pull out theeffect of default risk, different coupons, etc.
Yield curvegraphical representation of theterm structure
Normalupward-sloping, long-term yields are
higher than short-term yields Inverted downward-sloping, long-term yields are
lower than short-term yields
7.7 Determinants of Bond Yields
Instructed by YIN SOKHENG, Master in Finance
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Figure 7.6.A. Upward-Sloping Yield Curve
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Figure7.6. B. Downward-Sloping Yield Curve
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7.8 Bond risky
Why are bonds risky?
Default risk
Risk that the issuer fails to make promised payments on
time
Zero for govt debt
Other issuers: corporate, municipal, foreign have somedefault risk
Greater default risk means a greater yield
Instructed by YIN SOKHENG, Master in Finance
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Inflation risk Most bonds promise fixed dollar payments
Inflation erodes the real value of these payments
Future inflation is unknown
Larger for longer term bonds
Interest rate risk Changing interest rates change the value (price) of a bond
in the opposite direction.
All bonds have interest rate risk
But it is larger for the long term bonds
Instructed by YIN SOKHENG, Master in Finance