McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.0 Chapter 6 Interest Rates and Bond Valuation

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved More on Bond Features

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.2 More on Bond Features Securities issued by corporations may be classified roughly as equity securities (stock) or debt securities (bonds). A debt represents something that must be repaid The result of borrowing money The person or firm making the loan is the creditor, or lender The corporation borrowing the money is called the debtor, or borrower.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.3 More on Bond Features The main differences between debt and equity are: 1. Debt is not an ownership interest in the firm. Creditors generally do not have voting power. 2. The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are not tax deductible.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.4 More on Bond Features 3. Unpaid debt is a liability of the firm. If it’s not paid, the creditors can legally claim the assets of the firm. This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when equity is issued.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.5 Is it Debt or Equity? Corporations are very adept at creating exotic, hybrid securities that have many features of equity but are treated as debt. To obtain the tax benefits of debt and the bankruptcy benefits of equity. Equity represents an ownership interest, and a residual claim. Equity holders are paid after debt holders in the event of bankruptcy.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.6 Is it Debt or Equity? Maximum reward for owning a debt Fixed by the amount of the loan There is no upper limit to the potential reward from owning an equity interest.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.7 Long Term Debt: The Basics Long-term debt securities are promises made by the issuing firm to: Pay principal when due Make timely interest payments on the unpaid balance

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.8 Long Term Debt: The Basics 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 (with maturities of one year or less) Long-term (with maturities of more than one year

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.9 Long Term Debt: The Basics Debt securities are typically called: notes, debentures, or bonds. Two major forms of long-term debt: Public Issue – (we’ll concentrate on this) Privately Placed – directly placed with a lender and not offered to the public. Specific terms are up to the parties involved

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.10 The Indenture Indenture: The written agreement between the corporation (the borrower) and the lender (the creditor(s))detailing the terms of the debt issue. Sometimes referred to as the deed of trust. A legal document Can run several hundred pages

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.11 The Indenture A trustee (bank) is appointed by the corporation to represent the bondholders The trust company must: Make sure the terms of the indenture are obeyed Manage the sinking fund (described later) Represent the bondholders in default, if the company defaults on its payments

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.12 The Indenture The Indenture generally includes the following provisions: 1. The basic terms of the bonds 2. The total amount of bonds issued 3. A description of property used as security 4. The repayment arrangements 5. The call provisions 6. Details of the protective covenants

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.13 Terms of a Bond Corporate bonds usually have a face value of $1,000 Called the principal value Stated on the bond certificate If a corporation wanted to borrow $1 million, 1,000 bonds would have to be sold.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.14 Terms of a Bond Corporate bonds are usually issued in Registered Form: The form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.15 Terms of a Bond Bearer Form: The form of bond issue in which the bond is issued without record of the owner’s name; payment is made to whoever holds the bond. Difficult to recover if lost or stolen Bondholders can’t be notified of important events because the company doesn’t know who owns the bond – coupons are presented for interest payments. No longer common in the United States

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.16 Security The term collateral is commonly used to refer to any asset pledged on a debt Mortgage securities are secured by a mortgage on the real property of the borrower. Usually real estate: land or buildings The legal document that describes the mortgage is called the mortgage trust indenture or trust deed. Sometimes mortgages are on specific property More often, blanket mortgages are used Pledges all the real property owned by the company

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.17 Security Debenture: An unsecured debt (bond) for which no specific pledge of property is made usually with a maturity of 10 years or more holders only have a claim on property not otherwise pledged The Term Note: Generally, used for such instruments if the maturity of the unsecured bond is less than 10 or so years when the bond is originally issued.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.18 Seniority Seniority indicates preference in position over other lenders Debts are sometimes labeled as senior or junior to indicate seniority Some debt is subordinated In the event of default, holders of subordinated debt must give preference to other specified creditors

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.19 Repayment Bonds can be repaid “at” maturity The bondholder receives the stated, or face, value of the bond Or they may be repaid in part or in entirety “before” maturity. More typical Often handled through a sinking fund - An account managed by the bond trustee for early bond redemption. The company makes annual payments to the trustee, who uses the funds to retire a portion of the debt by either: buying up some of the bonds in the market or calling in a fraction of the outstanding bonds

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.20 Repayment There are many different kinds of sinking fund arrangements (the details would be spelled out in the indenture) for example: 1. Some sinking funds start about 10 years after the initial issuance. 2. Some sinking funds establish equal payments over the life of the bond. 3. Some high-quality bond issues establish payments to the sinking fund that aren’t sufficient to redeem the entire issue. As a consequence, there’s the possibility of a large “balloon payment” at maturity.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.21 The Call Provision Call Provision: An agreement giving the corporation the option to repurchase the bond at a specific price prior to maturity Corporate bonds are usually callable Generally, the call price is above the bond’s stated (par) value The amount by which the call price exceeds the par value of the bond is the Call Premium The amount of the call premium usually becomes smaller over time

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.22 The Call Provision Call Provisions aren’t usually operative during the first part of a bond’s life For example: a company might be prohibited from calling its bonds for the first 10 years Less of a worry for bondholders in the bond’s early years

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.23 The Call Provision Deferred Call Provision: A call provision prohibiting the company from redeeming the bond prior to a certain date. Call Protected Bond: A bond that currently cannot be redeemed by the issuer.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.24 Protective Covenants Protective Covenant: A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender. Two types: Negative Covenant: “thou shalt not” Positive Covenant: “thou shalt”

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.25 Protective Covenants Negative Covenants limit or prohibit actions that the company might take. “thou shalt nots” For Example: 1. The firm must limit the amount of dividends it pays according to some formula. 2. The firm cannot pledge any assets to other lenders. 3. The firm cannot merge with another firm. 4. The firm cannot sell or lease any major assets without approval by the lender. 5. The firm cannot issue additional long-term debt.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.26 Protective Covenants Positive Covenants specify an action that the company agrees to take or a condition the company must abide by. “thou shalts” For Example: 1. The company must maintain its working capital at or above some specified minimum level. 2. The company must periodically furnish audited financial statements to the lender. 3. The firm must maintain any collateral or security in good condition.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Bond Ratings

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.28 Bond Ratings Firms frequently pay to have their debt rated. An assessment of the creditworthiness of the corporate issuer constructed from information supplied by the corporation How likely the firm is to default Protection creditors have in the event of default The two leading bond-rating firms: Moody’s Standard and Poor’s (S&P)

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.29 Bond Ratings Table: Page 160 The highest rating a firm’s debt can have is AAA (Standard & Poor’s) or Aaa (Moody’s) Debt judged to be the best quality and have the lowest degree of default risk. The lowest rating is D Debt that is in default A bond’s credit rating can change as the issuer’s financial strength improves or deteriorates.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Some Different Types of Bonds

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.31 Government Bonds The biggest borrower in the world by a wide margin is the U.S. Government. In 2000, the total debt of the U.S. Government was $5.8 trillion. When the Government wishes to borrow money for more than one, it sells Treasury Notes and Bonds to the public: Sold every month Original maturities range from 2 to 30 years

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.32 Government Bonds Most U.S. Treasury issues are just ordinary coupon bonds. U.S. Treasury issues: Have no default risk Backed by the full faith and credit of the U.S. Government Are exempt from state income taxes But not federal income taxes

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.33 Government Bonds State and local governments also borrow money by selling notes and bonds. Called Municipal notes and bonds or just “munis” Unlike Treasury issues: Munis have varying degrees of default risk Rated much like corporate issues Munis are almost always callable.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.34 Government Bonds Muni coupons are exempt from federal income taxes (though not state income taxes) Attractive to high-income, high-tax bracket investors. Therefore, the yields on municipal bonds are much lower than the yields on taxable bonds.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.35 Government Bonds Example: Consider an investor in a 30% tax bracket, which investment would they prefer? Long-term high-quality Corporate bond yielding 8% Long-term, high-quality muni yielding 5.8% Compute the aftertax yields on the two bonds: Ignoring state and local taxes, the muni pays 5.8% on both a pretax and aftertax basis. The Corporate issue pays.08 x.70 =.056 or 5.6%

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.36 Zero Coupon Bonds Zero Coupon Bond: is a bond that makes no coupon payments thus is initially priced at a deep discount.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.37 Zero Coupon Bonds Example (Page 162): Suppose Eight-Inch Nails (EIN) Company issues a $1,000 face value, five-year zero coupon bond. The initial price is set at $497. Using the financial calculator, solve for I: N = 5 PV = FV = 1,000 I = 15%

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.38 Zero Coupon Bonds For Tax Purposes: The issuer of a zero coupon bond deducts interest every year, even though no interest is actually paid. The owner must pay taxes on interest accrued every year, even though no interest is actually received. Under current tax last, the implicit interest is determined by amortizing the loan The implicit interest each year is simply the change in the bond’s value for the year.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.39 Zero Coupon Bonds Table 6.2, Page 162 Example: A company issues a $1,000 face value, five- year zero coupon bond. The initial price is set at $497. At this price, the bond yields 15% to maturity. The implicit interest each year is simply the change in the bond’s value for the year. Year one interest: 572 – 497 = 75. Year two interest: 658 – 572 = 86, etc. Beg Year:12345 N = PV = FV = 1, Therefore: I =

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.40 Floating-Rate Bonds With floating-rate bonds (floaters), the coupon payments are adjustable. Adjustments are tied to an interest rate index such as the Treasury bill interest rate or the 30-year Treasury bond rate. In most cases, the coupon adjusts with a lag to the base rate. i.e. Treasury Bond yields during the previous three months. Inflation-linked bond: Treasury Inflation Protection Securities (TIPS) Have coupons that are adjusted according to the rate of inflation.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.41 Floating-Rate Bonds The coupon rate may have a floor and a ceiling The coupon is subject to a minimum (floor) and a maximum (ceiling) The coupon rate is said to be “capped” The upper and lower rates are sometimes called the collar.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.42 Other Types of Bonds Bonds may have unusual, or exotic, features which are only limited by the imaginations of the parties involved. Disaster or “Act of God” Bonds Investors risk interest paid in the event of a defined catastrophic event (hurricane, earthquake, etc.) Provides issuer protection Income bonds – coupons are paid to bondholders only if the firm’s income is sufficient. Convertible bonds – can be swapped for a fixed number of shares of stock anytime before maturity at the holder’s option. Put bonds – allow the holder to force the issuer to buy the bond back at a stated price

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Bond Markets

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.44 Bond Markets The largest securities market in the world in terms of trading volume (the amount of money that changes hands) is the U.S. Treasury market. The number of bond issues far exceeds the number of stock issues. A corporation would typically have only one common stock issue outstanding, but could easily have a dozen or more note and bond issues outstanding. Federal, State, and Local borrowing is enormous Even a small city would usually have a wide variety of notes and bonds outstanding

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.45 How Bonds Are Bought and Sold As per Chapter 1: Most trading in bonds takes place over the counter (OTC) There is no particular place where buying and selling occur The dealers are connected electronically. Dealers around the country (and around the world) stand ready to buy and sell.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.46 How Bonds Are Bought and Sold While the total volume of trading in bonds far exceeds that in stocks, only a very small fraction of the total bond issues that exist actually trade on a given day.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.47 Bond Price Reporting While most bond trading is OTC, there is a corporate bond market associated with the New York Stock Exchange. The Wall Street Journal provides price and volume info from this market on a relatively small number of bonds issued by larger corporations.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.48 Bond Price Reporting Figure 6.3, Page 167: Corporate Bond Quotations Bonds: AT&T 7 ½ is the bonds coupon rate The coupon is 7.5% of face value (1,000 x 7.5% = $75) Matures in 2006 Cur Yld: Current Yield is 7.4% ($75 / $1,010) Close: The bond closed at 101 or 101% of face value at the close of business the day before ($1,000 x 101% = $1,010) The bond is selling at a premium – more than face value Net Chg: + ¼ - The closing price was ¼ of 1% higher than the previous day’s closing price

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.49 Bond Price Reporting Current Yield: A bond’s coupon payment divided by its closing price. Equal to the bond’s yield to maturity only if the bond sells for par.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.50 Bond Price Reporting Trading in Treasury issues is very heavy Figure 6.4 – Sample Wall Street Journal U.S. Treasury Note and Bond Prices. Bid Price: The price a dealer is willing to pay for a security Asked Price: The price a dealer is willing to take for a security Bid-Ask Spread: The difference between the bid price and the asked price.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Inflation and Interest Rates

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.52 Real versus Nominal Rates Nominal Rates: Interest rates or rates of return that have “not” been adjusted for inflation. Simply the percentage change in the number of dollars you have. Real Rates: Interest rates or rates of return that have been adjusted for inflation. The percentage change in how much you can buy with your dollars. The percentage change in your buying power.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.53 Real versus Nominal Rates Suppose prices are currently rising by 5 percent per year (the rate of inflation is 5%) An investment is available that will be worth $ in one year (FV). It costs $100 today (PV). The investment has a 15.5% return as follows: – 100 = / 100 = 15.5% Here we did not consider the effect of inflation. This is the Nominal Return! What is the impact of inflation?

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.54 Real versus Nominal Rates Example (Page 170): Suppose pizzas cost $5 a piece at the beginning of the year. With $100, we can buy ($100 / 5) 20 pizzas. Because the inflation rate is 5%, pizzas will cost 5% more, or ($5 x.05) $5.25, at the end of the year. If we make the previous investment, how many pizzas can we buy at the end of the year?

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.55 Real versus Nominal Rates Answer: Our $ from the investment will buy us $115.50/5.25 = 22 pizzas. This is up from 20 pizzas, so our pizza rate of return is (22 – 20 = 2. 2 / 20) 10%. While the nominal return on our investment is 15.5%, our buying power goes up by only 10% due to inflation. The % change in the number of dollars we have. The real return is 10%. The % change in buying power.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.56 Fisher Effect Fisher Effect: The relationship between nominal returns real returns and inflation. Investors are ultimately concerned with what they can buy with their money They require compensation for inflation. The Fisher Effect tells us that the relationship between nominal rates, real rates, and inflation can be written as: 1 + R = (1 + r) x (1 + h) R = nominal rate, r = real rate, h = inflation rate

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.57 Fisher Effect Re: the preceding pizza example: 1 + R = (1 + r) x (1 + h) R = nominal rate, r = real rate, h = inflation rate = (1 + r) x (1 +.05) 1 + r = ( ) / (1 +.05) 1 + r = 1.10 r = 10% Rearrange: R = r + h + r x h R is approximate = r + h

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Determinants of Bond Yields

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.59 The Term Structure of Interest Rates Term Structure of Interest Rates: Is the relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is the pure time value of money. The term structure of interest rates tells us what nominal interest rates are on default-free, pure discount bonds (a single, lump-sum future payment) of all maturities.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.60 The Term Structure of Interest Rates When long-term rates are higher than short- term rates: we say the “term structure” is upward sloping Most common When short-term rates are higher, we say the “term structure” is downward sloping.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.61 The Term Structure of Interest Rates Three basic components determine the shape of the “term structure”: 1. Real Rate of Interest (previously discussed) 2. Inflation Premium (previously discussed) 3. Interest Rate Risk Premium See Figure 6.6, Page 174

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.62 The Term Structure of Interest Rates 1. Real Rate of Interest: The compensation investors demand for forgoing the use of their money The pure time value of money after adjusting for the effects of inflation The basic component underlying every interest rate, regardless of the time to maturity. When the Real Rate is high, all interest rates will tend to be higher, and vice versa. Doesn’t really determine the shape of the term structure Influences the overall level of interest rates.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.63 The Term Structure of Interest Rates 2. Inflation Premium: The prospect of future inflation very strongly influences the shape of the term structure. Investors thinking about loaning money for various lengths of time recognize that future inflation erodes the value of the dollars that will be returned. Investors demand compensation for this loss in the form of higher nominal rates – The Inflation Premium: The portion of a nominal interest rate that represents compensation for expected future inflation. If investors believe that the rate of inflation will be higher in the future, then long-term nominal interest rates will tend to be higher than short-term rates.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.64 The Term Structure of Interest Rates 3. Interest Rate Risk Premium: Longer-term bonds have much greater risk of loss resulting from changes in interest rates than do shorter- term bonds Investors demand extra compensation in the form of higher rates for bearing it. This extra compensation is called the interest rate risk premium: The compensation investors demand for bearing interest rate risk. The longer is the term to maturity, the greater is the interest rate risk, so the interest rate risk premium increases with maturity.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.65 Figure 6.6 – Upward-Sloping Yield Curve A. Upward-sloping term structure Interest rate Time to maturity Nominal interest rate Interest rate risk premium Real rate Inflation premium

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.66 Figure 6.6 – Downward-Sloping Yield Curve Interest rate B. Downward-sloping term structure Nominal interest rate Time to maturity Real rate Inflation premium Interest rate risk premium

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.67 Bond Yields and the Yield Curve: Putting It All Together Yields on Treasury Notes and Bonds of different maturities are not the same. Treasury Yield Curve: A plot of yields on Treasury Notes and Bonds relative to maturity. The shape of the yield curve is a reflection of the term structure of interest rates.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.68 Figure 6.7 – Treasury Yield Curve March 30, % mos.yr.maturities Yesterday 1 week ago 4 weeks ago Treasury Yield Curve Thursday, March 30, 2000 Yields as of 4:30 p.m. Eastern time

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.69 Bond Yields and the Yield Curve: Putting It All Together The “Term Structure of Interest Rates” is based on pure discount bonds The “Yield Curve” is based on coupon bond yields. Treasury Yields: depend on the three components that underlie the “Term Structure” The Real Rate Expected Future Inflation Interest Rate Risk Premium

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.70 Bond Yields and the Yield Curve: Putting It All Together “Treasury” Notes and Bonds have three important features: Default-free Taxable Highly Liquid

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.71 Bond Yields and the Yield Curve: Putting It All Together Investors recognize that issuers other than the Treasury have credit risk These issuers may or may not make all the promised payments on a bond Investors demand a higher yield as compensation for this credit risk. This extra compensation is called the default risk premium: The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default. Regarding bond ratings: lower-rated bonds have higher yields.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.72 Bond Yields and the Yield Curve: Putting It All Together Bond yields are calculated assuming that all the promised payments will be made. If the issuer defaults, your actual yield will be lower, probably much lower. This is particularly important when it comes to junk bonds – commonly called: “high-yield bonds”. These are really high-promised yield bonds.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.73 Bond Yields and the Yield Curve: Putting It All Together Remember that municipal bonds are free from most taxes and have much lower yields than taxable bonds. Investors demand the extra yield on a taxable bond as compensation for the unfavorable tax treatment. Taxability Premium: The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.74 Bond Yields and the Yield Curve: Putting It All Together Bonds have varying degrees of liquidity. Investors prefer liquid assets to illiquid ones, so they demand a liquidity premium: The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity. Less liquid bonds will have higher yields than more liquid bonds.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.75 Conclusion: Bond Yields represent the combined effect of six things: the first is the real rate of interest. Determining the appropriate yield on a bond requires careful analysis of each of these effects. On top of the real rate are five premiums representing compensation for: (1) expected future inflation (2) interest rate risk (3) default risk (4) taxability (5) lack of liquidity.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 6.76 Factors Affecting Required Return Default risk premium – remember bond ratings Taxability premium – remember municipal versus taxable 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