Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 6 Interest Rates And Bond Valuation

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-2 Learning Goals 1.Bond characteristics. 2.Apply the basic valuation model to bonds. 3.Calculate yield to maturity (YTM) and explain its meaning. 4.Understand the impact of changing market interest rates on bond values.

Corporate Bonds Bond: long-term debt instrument that pays fixed interest for a specified period of time. The bond’s principal is reflected in its par value ($________________ for most bonds). The bond’s maturity date is the time at which a bond becomes due and the principal must be repaid. The bond’s coupon rate is the specified interest rate (as a percent of par) that must be paid periodically. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-3

Bond Valuation The price, or value of any investment asset is the present value of expected cash flows. To value a bond, we must: –Determine the ________________________ Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-4

Bond Valuation The interest rate at which the cash flows are discounted is the required return. The required return depends on: –__________ conditions (including inflationary expectations) –________ and other characteristics of the bond and the issuer. Higher risk results in a higher required return and lower market values. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-5

Bond Yield The required return on a bond is also referred to as the “yield to maturity” (________________). The bond’s yield-to-maturity (YTM) is the annual percentage return, based on the bond price and promised cash flows. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-6

Bond Yields and Bond Prices If the required return on a bond equals the bond’s coupon rate, the bond price equals par. If the required return on a bond exceeds its coupon rate, the bond price will be less than par: it is a “______________________” bond. If the required return is less than the coupon rate, the bond price is higher than par: it is a “_______________________” bond. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-7

Bond Yields and Bond Prices As market interest rates change, bond yields change, causing bond prices to move in the opposite direction. Not all bond prices are equally sensitive to a change in market interest rates. Prices of –Long-term bonds are more responsive than short- term bonds –Bonds with a low coupon rate are more sensitive than bonds with a high coupon rate Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-8

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-9 Bond Valuation: Bond Fundamentals (cont.) Table 6.7 Bond Values for Various Required Returns (Mills Company’s 10% Coupon Interest Rate, 10-Year Maturity, $1,000 Par, January 1, 2010, Issue Paying Annual Interest)

Interest Rate/Required Return The interest rate or required return represents the cost of financing for the borrower. The interest rate is the rate of return for the lender. Over time, the level of interest rates is closely tied to inflation, as shown on the next slide. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-10

Copyright © 2009 Pearson Prentice Hall. All rights reserved Interest Rates & Required Returns: Inflation and the Cost of Money (cont.) Figure 6.2 Impact of Inflation

Nominal Interest Rate The nominal rate of interest is the actual or stated rate of interest on a loan or liability. The nominal rate is affected by two factors: –Inflationary expectations –Issuer and issue characteristics such as default risk and contractual provisions Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-12

Copyright © 2009 Pearson Prentice Hall. All rights reserved Legal Aspects of Corporate Bonds The bond indenture is a legal document that specifies both the rights of the bondholders and the duties of the issuing corporation. The bond indenture includes: –Standard provisions –Restrictive provisions

Legal Aspects of Bonds Standard debt provisions specify certain record keeping and general business procedures that the issuer must follow (pay taxes, maintain assets, provide audited financial statements). Restrictive covenants place operating and financial constraints on the borrower. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-14

Copyright © 2009 Pearson Prentice Hall. All rights reserved Legal Aspects of Corporate Bonds (cont.) Common restrictive covenants include provisions that specify: –Minimum equity levels –Prohibition against factoring receivables –Fixed asset restrictions –Constraints on subsequent borrowing –Limitations on cash dividends. In general, violations of restrictive covenants give bondholders the right to demand immediate repayment.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Corporate Bonds: General Features The conversion feature of convertible bonds allows bondholders to exchange their bonds for a specified number of shares of common stock. Bondholders will exercise this option only when the market price of the stock is greater than the conversion price. A call feature, which is included in most corporate issues, gives the issuer the opportunity to repurchase the bond prior to maturity at the call price.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Corporate Bonds: General Features (Cont.) In general, the call premium is equal to one year of coupon interest and compensates the holder for having it called prior to maturity. Issuers will exercise the call feature when interest rates fall and the issuer can refund the issue at a lower cost. Issuers typically must pay a higher rate to investors for the call feature compared to issues without the feature.

Bond Risk & Bond Ratings The risk of corporate and municipal bonds is reflected in the “rating” assigned by Moody’s, Standard & Poor’s or other rating agencies. The top _____________ categories of bond ratings are “investment grade;” lower ratings are “_________________ bonds.” Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-18

Copyright © 2009 Pearson Prentice Hall. All rights reserved Corporate Bonds: Bond Ratings Table 6.3 Moody’s and Standard & Poor’s Bond Ratings a