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.The impact of changing market interest rates on bond values & managing interest rate risk.

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 cash flows –Determine the discount rate Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-3

Bond Valuation The interest rate at which the cash flows are discounted is the required return. The required return depends on: –market conditions (including inflationary expectations) –risk 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. 6-4

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. –Long-term bond prices are more responsive than short-term bond prices –Bonds with a low coupon rate are more sensitive than bonds with a high coupon rate Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-5

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, and is referred to as the yield to maturity (YTM). Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-6

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-7 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. 6-8

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-9 Legal Aspects of Corporate Bonds (cont.) Common restrictive covenants: –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.

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 four categories of bond ratings are “investment grade;” lower ratings are “junk bonds.” Copyright © 2009 Pearson Prentice Hall. All rights reserved. 6-10

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