1. Chapter 9 Debt Valuation and Interest

2. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-2 Slide Contents Principles Applied in This Chapter Learning Objectives 1.Overview of Corporate Debt 2.Valuing Corporate Debt 3.Bond Valuation: Four Key Relationships 4.Types of Bonds 5.Determinants of Interest Rates Key Terms

3. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-3 Learning Objectives 1.Identify the key features of bonds and describe the difference between private and public debt markets. 2.Calculate the value of a bond and relate it to the yield to maturity on the bond. 3.Describe the four key bond valuation relationships.

4. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-4 Learning Objectives (cont.) 4.Identify the major types of corporate bonds. 5.Explain the effects of inflation on interest rates and describe the term structure of interest rates.

5. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-5 Principles Applied in This Chapter Principle 1: Money Has a Time Value. Principle 2: There is a Risk-Return Tradeoff. Principle 3: Cash Flows Are the Source of Value

6. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-6 9.1 OVERVIEW OF CORPORATE DEBT

7. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-7 Corporate Borrowings There are two main sources of borrowing for a corporation: 1.Loan from a financial institution (known as private debt since it involves only two parties) 2.Bonds (known as public debt since they can be traded in the public financial markets)

8. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-8 Borrowing Money in the Private Financial Market Financial Institutions provide loans to finance firm’s day-to-day operations (working capital loans) or it might be used for the purchase of equipment or property (transaction loans). Loans may or may not be secured by a collateral.

9. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-9 Borrowing Money in the Private Financial Market (cont.) Advantages of Private Debt Placement –Speed –Reduced costs –Financing flexibility Disadvantages of Private Debt Placement –Interest costs –Restrictive covenants –The possibility of future SEC registration

10. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-10 Floating-Rate Loans In the private financial market, loans are typically floating rate loans i.e. the interest rate is adjusted based on a specific benchmark rate. The most popular benchmark rate is the London Interbank Offered Rate (LIBOR), rate at which banks offer to lend in the London wholesale or interbank market

11. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-11 Floating-Rate Loans (cont.) For example, a corporation may get a 1-year loan with a rate of 300 basis points (or 3%) over LIBOR with a ceiling of 11% and a floor of 4%.

12. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-12 Table 9-1 Types of Bank Debt

13. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-13 CHECKPOINT 9.1: CHECK YOURSELF Calculating the Rate of Interest on a Floating-Rate Loan Consider the same loan period as above but change the spread over LIBOR from.25% to.75%. Is the ceiling rate or floor rate violated during the loan period?

14. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-14 Step 1: Picture the Problem The graph on the next slide shows the LIBOR index (series 1), LIBOR plus the spread of 75 basis points (series 2), the ceiling rate (series 3), and the floor rate (series 4).

15. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-15 Step 1: Picture the Problem (cont.)

16. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-16 Step 2: Decide on a Solution Strategy We have to determine the floating rate for every week and see if it exceeds the ceiling or falls below the floor. Floating rate on Loan = LIBOR for the previous week + spread of.75%

17. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-17 Step 2: Decide on a Solution Strategy The floating rate on loan cannot exceed the ceiling rate of 2.5% or drop below the floor rate of 1.75%. –If the floating rate falls below the floor, the rate will be reset at the floor rate. –If the floating rate exceeds the ceiling, the rate will be reset at the ceiling rate.

18. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-18 Step 3: Solve LIBORLIBOR + Spread (.75%) Loan Rate 2/29/20081.98% 3/7/20081.66%2.73%2.50% 3/14/20081.52%2.44%2.41% 3/21/20081.35%2.27% 3/28/20081.60%2.10% 4/4/20081.63%2.35% 4/11/20081.67%2.38% 4/18/20081.88%2.42% 4/25/20081.93%2.63%2.50% 5/2/20082.68%2.50% Ceiling Violated

19. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-19 Step 3: Solve (cont.) The table shows the ceiling is violated during the first week and last two weeks of the loan period. The floor rate is never violated.

20. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-20 Step 4: Analyze The ceiling is the maximum rate charged on the loan while floor is the minimum rate charged on the loan. If the ceiling or floor rates are violated, the loan rate is reset to the ceiling rate or the floor rate. If there were no ceiling, the loan rate would have been 2.73% during the first week of the loan, and 2.63% and 2.68% during the last two weeks of the loan.

21. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-21 Borrowing Money in the Public Financial Market Corporations engage the services of an investment banker while raising long-term funds in the public financial market. The investment banker performs three basic functions: –Underwriting: assuming risk of selling a security issued. The client is given the money before the securities are sold to the public. –Distributing –Advising

22. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-22 Corporate Bonds Corporate bond is a debt security issued by corporation that has promised future payments and a maturity date. If the firm fails to pay the promised future payments of interest and principal, the bond trustee can classify the firm as insolvent and force the firm into bankruptcy.

23. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-23 Basic Bond Features The basic features of a bond include the following: –Bond indenture –Claims on assets and income –Par or face value –Coupon interest rate –Maturity and repayment of principal –Call provision and conversion features

24. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-24 Bond Ratings and Default Risk Bond ratings indicate the default risk i.e. the probability that the firm will make the bond’s promised payments. Rating agencies use borrower’s financial statements, financing mix, profitability, variability of past profits, and make judgments about the quality of the firm’s management in order to determine ratings.

25. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-25 Table 9.3 Interpreting Bond Ratings

26. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-26 9.2 VALUING CORPORATE DEBT

27. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-27 Valuing Corporate Debt The value of corporate debt is equal to the present value of the contractually promised principal and interest payments (the cash flows) discounted back to the present using the market’s required yield to maturity on similar risk.

28. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-28 Table 9.2 Bond Terminology

29. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-29 Valuing Bonds by Discounting Future Cash Flows Step 1: Determine bondholder cash flows, which are the the amount and timing of the bond’s promised interest and principal payments to the bondholders. Annual Interest = Par value × coupon rate Example 9.1: The annual interest for a 10-year bond with coupon interest rate of 7% and a par value of $1,000 is equal to $70, (.07 × $1,000 = $70). This bond will pay $70 every year and $1,000 at the end of 10-years.

30. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-30 Valuing Bonds by Discounting Future Cash Flows (cont.) Step 2: Estimate the appropriate discount rate on a bond of similar risk. Discount rate is the return the bond will yield if it is held to maturity and all bond payments are made.

31. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-31 Valuing Bonds by Discounting Future Cash Flows (cont.) Step 3: Calculate the present value of the bond’s interest and principal payments from Step 1 using the discount rate in step 2.

32. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-32 Calculating a Bond’s Yield to Maturity (YTM) We can think of YTM as the discount rate that makes the present value of the bond’s promised interest and principal equal to the bond’s observed market price.

33. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-33 CHECKPOINT 9.2: CHECK YOURSELF Calculating the Yield to Maturity on a Corporate Bond Calculate the YTM on the Ford bond where the bond price rises to $900 (holding all other things equal).

34. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-34 Step 1: Picture the Problem YTM=? Years Cash flow-$900$65$65$65$1,065 Purchase price = $900 Interest payments = $65 per year for years 1-11 Final payment = $1,000 in year 11 of principal. 0123 …11

35. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-35 Step 2: Decide on a Solution Strategy We can use equation 9-2a to find YTM. YTM is the rate that makes the present value of all future expected cash flows equal to the current market price. We can also solve for YTM using a calculator and a spreadsheet.

36. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-36 Step 3: Solve Using a Mathematical Equation It is cumbersome to solve for YTM by hand using the equation. It is more practical to use the financial calculator or the spread sheet.

37. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-37 Step 3: Solve (cont.) Using a Financial Calculator N = 11 I/Y = 7.89 PV = -900 PMT = 65 FV = 1,000 Using an Excel Spreadsheet = RATE(nper, pmt,pv,fv) = RATE (11,65,- 900,1000) = 7.89%

38. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-38 Step 4: Analyze The yield to maturity on the bond is 7.89%. The yield is higher than the coupon rate of interest of 6.5%. Since the coupon rate is lower than the yield to maturity, the bond is trading at a price below $1,000. We call this a discount bond.

39. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-39 Using Market-Yield-to-Maturity Data Market-yield-to-maturity data is regularly reported by a number of investor services and is quoted in terms of credit spreads or spreads to Treasury bonds. Table 9-4 contains some examples of spreads.

40. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-40 Table 9-4 Corporate Bond Spread Tables

41. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-41 Using Market Yield to Maturity Data (cont.) The spread values reported in table 9-4 represent basis points over a US Treasury security of the same maturity as the corporate bond. For example, a 30-year Ba1/BB+ corporate bond has a spread of 275 basis points over a similar 30-year US Treasury bond. Thus this corporate bond should earn 2.75% over the 4.56% earned on treasury yield or 7.31%.

42. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-42 Promised versus Expected Yield to Maturity The yield to maturity calculation assumes that the bond performs according to the terms of the bond contract or indenture. Since corporate bonds are subject to risk of default, the promised yield to maturity may not be equal to expected yield to maturity.

43. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-43 Promised versus Expected Yield to Maturity (cont.) Example Consider a one-year bond that promises a coupon rate of 8% and has a principal (par value) of $1,000. Further assume the bond is currently trading for $850. What is the promised yield to maturity?

44. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-44 Promised versus Expected Yield to Maturity (cont.) Promised YTM = { ( Interest year 1 + Principal) ÷ (Bond Value)} – 1 = {($80+$1,000) ÷ ($850)} – 1 = 27.06%

45. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-45 Promised versus Expected Yield to Maturity (cont.) The yield of 27.06% is based on the assumption of no default. Assume there is a 40% probability of default on this bond and if the bond defaults, the bondholders will receive only 60% of the principal and interest owed. What is the expected YTM on this bond?

46. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-46 Promised versus Expected Yield to Maturity (cont.) YTM default = {(Interest year 1 + Principal)} ÷ (Bond Value)} – 1 = {($80+$1000) ×.60} ÷ ($850)} – 1 = -23.76%

47. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-47 Promised versus Expected Yield to Maturity (cont.) = (27.06 ×.60) + (-23.76 ×.40) = 6.73% The financial press quotes promised yield and not expected YTM.

48. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-48 CHECKPOINT 9.3: CHECK YOURSELF Valuing a Bond Issue Calculate the present value of the AT&T bond should the yield to maturity for comparable risk bonds rise to 9% (holding all other things equal).

49. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-49 Step 1: Picture the Problem i= 9% Years Cash flows$85$85$85$1,085 0123 …20 PV of all Cash flows =? $85 annual interest $85 interest + $1,000 Principal

50. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-50 Step 2: Decide on a Solution Strategy Here we know the following: –Annual interest payments = $85 –Principal amount or par value = $1,000 –Time = 20 years –YTM or discount rate = 9% We can use the above information to determine the value of the bond by discounting future interest and principal payment to the present.

51. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-51 Step 3: Solve Using a Mathematical Formula = $ 85{ [ 1-(1/(1.09) 20 ] ÷ (.20)} + $1,000/(1.09) 20 = $85 (9.128) + $178.43 = $954.36

52. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-52 Step 3: Solve (cont.) Using a Financial Calculator –N = 20 –1/y = 9.0 –PMT = 85 –FV = 1000 –PV = 954.36 Using an Excel Spreadsheet = PV (rate, nper, pmt, fv) = PV (.09,20,85,1000) = $954.36

53. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-53 Step 4: Analyze The value of AT&T bond falls to $954.36 when the yield to maturity rises to 9%. The bonds are now trading at a discount as the coupon rate on AT&T bonds is lower than the market yield. An investor who buys AT&T bonds at its current discounted price will earn a promised yield to maturity of 9%.

54. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-54 Semiannual Interest Payments Corporate bonds typically pay interest to bondholders semiannually. We can adapt Equation (9-2a) from annual to semiannual payments as follows:

55. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-55 CHECKPOINT 9.4: CHECK YOURSELF Valuing a Bond Issue That Pays Semiannual Interest Calculate the present value of the AT&T bond should the yield to maturity on comparable bonds rise to 9% (holding all other things equal).

56. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-56 Step 1: Picture the Problem i= 9% Periods Cash flow $42.5$42.5$42.5$1,042.50 0123 …40 PV=? $42.50 Semiannual interest $42.5 interest + $1,000 Principal 40 6-month periods

57. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-57 Step 2: Decide on a Solution Strategy Here we know the following: –Semiannual interest payments = $42.50 –Principal amount or par value = $1,000 –Time = 20 years or 40 periods –YTM or discount rate = 9% or 4.5% for 6-months We can use the above information to determine the value of the bond by discounting future interest and principal payment to the present.

58. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-58 Step 3: Solve Using a Mathematical Formula = $ 42.5{ [ 1-(1/(1.045) 40 ] ÷ (.20)} + $1,000/(1.045) 40 = $42.5 (18.40) + $171.93 = $954

59. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-59 Step 3: Solve (cont.) Using a Financial Calculator –N = 40 –1/y = 4.50 –PMT = 42.50 –FV = 1000 –PV = 954 Using an Excel Spreadsheet = PV (rate, nper, pmt, fv) = PV (.045,40,42.5,1000) = $954

60. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-60 Step 4: Analyze Using semi-annual compounding we get a value of $954 for AT&T bonds. This is very close to the value of $954.26 found using annual compounding.

61. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-61 9.3 BOND VALUATION: FOUR KEY RELATIONSHIPS

62. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-62 Bond Valuation: Four Key Relationships First Relationship The value of bond is inversely related to changes in the yield to maturity. YTM = 12%YTM rises to 15% Par value$1,000 Coupon rate12% Maturity date5 years Bond Value$1,000$899.44 Bond Value Drops

63. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-63 Figure 9-1 Bond Value and the Market’s Required Yield to Maturity (5-Year Bond, 12% Coupon Rate)

64. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-64 Bond Valuation: Four Key Relationships (cont.) Second Relationship: The market value of a bond will be less than the par value (discount bond) if the market’s required yield to maturity is above the coupon interest rate and will be valued above par value (premium bond) if the market’s required yield to maturity is below the coupon interest rate.

65. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-65 Bond Valuation: Four Key Relationships (cont.) Third Relationship As the maturity date approaches, the market value of a bond approaches its par value. That’s because at maturity the bond will be taken away and the investor will receive the par value of the bond.

66. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-66 Table 9-5 Bond Prices Relative to Maturity Date

67. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-67 Figure 9-2 Value of a 12% Coupon Bond during the Life of the Bond

68. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-68 Bond Valuation: Four Key Relationships (cont.) Fourth Relationship Long term bonds have greater interest-rate risk than short-term bonds. While all bonds are affected by a change in interest rates, the prices of longer-term bonds fluctuate more when interest rates change than do the prices of shorter-term bonds (see Table 9.6)

69. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-69 9.4 TYPES OF BONDS

70. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-70 Table 9-7 Types of Corporate Bonds

71. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-71 9.5 DETERMINANTS OF INTEREST RATES

72. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-72 Determinants of Interest Rates As we observed earlier, bond prices vary inversely with interest rates. Therefore in order to understand how bond prices fluctuate, we need to know the determinants of interest rates.

73. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-73 Inflation and Real versus Nominal Interest Rates Quotes of interest rates in the financial press are commonly referred to as the nominal (or quoted) interest rates. Real rate of interest adjusts for the effects of inflation. Real Rate of Interest (approximation) ≈ Nominal interest rate – Inflation premium

74. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-74 Fisher Effect: The Nominal and Real Rate of Interest The relationship between the nominal rate of interest, r nominal, the anticipated rate of inflation, r inflation, and the real rate of interest is known as the Fisher effect.

75. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-75 CHECKPOINT 9.5: CHECK YOURSELF Solving for the Real Rate of Interest Assume now that you expect that inflation will be 5% over the coming year and want to analyze how much better off you will be if you place your savings in an account that also earns just 5%. What is the real rate of return in this circumstance?

76. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-76 Step 1: Picture the Problem Let us assume that the prices of goods and services today is $1.00 per unit. With a 5% inflation, these goods and services will cost $1.05. Thus, $10,500 expected in the savings account at the end of the year will buy you only 10,000 units (10,500/1.05) at the end of the year.

77. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-77 Step 1: Picture the Problem (cont.) Year 0Year 1 Savings Account Balance$10,000.00$10,500.00 Price Index (5% inflation)$1.00$1.05 Purchasing Power (units)10,000.00

78. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-78 Step 2: Decide on a Solution Strategy Step 3: Solve We can estimate the real rate of interest by using equation 9-4b. r real = {(1+.05) ÷ (1+.05)} – 1 = 0%

79. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-79 Step 4: Analyze Here the nominal rate of interest is equal to the expected rate of inflation. Therefore, the real rate of return is equal to zero i.e. there is no increase in purchasing power from investing the savings at 5%.

80. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-80 CHECKPOINT 9.6: CHECK YOURSELF Solving for the Nominal Rate of Interest If you anticipate that the rate of inflation will now be 4% next year, holding all else the same, what rate of return will you need to earn on your savings in order to achieve a 2% increase in purchasing power?

81. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-81 Step 1: Picture the Problem Let us assume that the prices of goods and services today is $1.00 per unit. If the expected rate of inflation is 4% and you want to be able to purchase 2% more, you will need to earn a nominal rate of interest on your savings that will allow you to buy 10,200 units at $1.04 each.

82. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-82 Step 1: Picture the Problem (cont.) Year 0Year 1 Savings Account Balance$10,000.00$10,608 Price Index (5% inflation)$1.00$1.04 Purchasing Power (units)10,000.0010,200.00 Real rate (% increase in purchasing power) 2% Interest rate of 6.08% solved in step 3

83. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-83 Step 2: Decide on a Solution Strategy Step 3: Solve We can use the Fisher model found in equation 9-4a to determine the nominal rate of interest. r nom =.02 +.04 + (.02 ×.04) =.0608 or 6.08%

84. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-84 Step 4: Analyze In order to achieve a 2% increase in purchasing power in the face of a 4% rate of inflation, you must earn a 6.08% rate on your savings.

85. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-85 Interest-Rate Determinants – Breaking It Down The nominal return or interest rate on a note or bond can be thought of including five basic components:

86. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-86 Interest Rate Determinants (cont.) The inflation premium Default–risk premium Maturity-risk premium Liquidity-risk premium

87. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-87 The Maturity-Risk Premium and the Term Structure of Interest Rates The relationship between interest rates and time to maturity with risk held constant is known as the term structure of interest rates or the yield curve. Figure 9-3 illustrates a hypothetical term structure of U.S. Treasury Bonds.

88. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-88 Figure 9-3 The Term Structure of Interest Rates or Yield Curve

89. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-89 The Shape of the Yield Curve By reviewing equation 9-5, we can gain insight into the shape of the yield curve for US Treasuries. Since there is no default risk or liquidity risk and the real-risk free rate of interest is unlikely to change, the shape of the yield curve is driven by inflation premium and maturity risk premium.

90. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-90 The Shape of the Yield Curve (cont.) During periods when inflation is expected to subside, the inflation premium should decrease over longer maturities, resulting in a downward sloping Treasury yield curve as shown in Figure 9.5. The reverse is also true as shown in Figure 9.4

91. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-91 Figure 9.4 Treasury Yield Curve during Period of Increasing Inflation

92. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-92 Figure 9.5 Treasury Yield Curve during Period of Decreasing Inflation

93. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-93 Shifts in the Yield Curve The yield curve changes over time as expectations regarding each of the four factors that underlie interest rates change. Figure 9-6 shows the yield curve one day before 911 attack and again two weeks later. Investors shifted their funds to the safety of Treasuries, pushing up the prices and bringing down the yields.

94. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-94 Figure 9-6 Changes in the Term Structure of Interest Rates around September 11, 2001

95. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-95 Shifts in the Yield Curve (cont.) The yield curve is generally upward sloping but it can assume different shapes i.e. downward sloping or flat. Figure 9-7 illustrates different shapes of yield curves at different dates, observed within a span of only 13 months.

96. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-96 Figure 9.7 Historical Term Structure of Interest Rates for Government Securities

97. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-97 Key Terms Amortizing bond Basis point Bond rating Bond indenture Call provision Collateral Conversion feature

98. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-98 Key Terms (cont.) Convertible bond Corporate bond Coupon interest rate Credit spread Current yield Debenture Default-risk premium

99. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-99 Key Terms (cont.) Discount bond Eurobonds Fisher effect Floating rate Floating rate bonds Inflation premium Interest rate risk

100. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-100 Key Terms (cont.) Junk (high-yield) bond LIBOR Liquidity-risk premium Maturity-risk premium Mortgage bond Nominal (or quoted) interest rate Non-amortizing bond

101. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-101 Key Terms (cont.) Par or face value of a bond Private market transaction Premium bond Real rate of interest Recovery rate Secured bond Spread to Treasury bonds

102. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-102 Key Terms (cont.) Subordinated debentures Syndicate Term structure of interest rates Transaction loan Unsubordinated debentures Yield curve Yield to maturity Zero coupon bond