1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Interest Rates and Bond Valuation Chapter Seven

2. 7.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Key Concepts and Skills Know the important bond features and bond types Understand bond values and why they fluctuate Understand bond ratings and what they mean Understand the impact of inflation on interest rates Understand the term structure of interest rates and the determinants of bond yields

3. 7.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Outline Bonds and Bond Valuation More on Bond Features Bond Ratings Some Different Types of Bonds Bond Markets Inflation and Interest Rates Determinants of Bond Yields

4. 7.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Definitions 7.1 Bond – interest-only loan Par value (face value) – principal amount of a bond Coupon rate – annual coupon pay/face value Coupon payment – interest payment Maturity date – date when face value is paid Yield or Yield to maturity – interest rate: when bond price is equal to the bond’s PV

5. 7.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Present Value of Cash Flows as Rates Change Bond Value = PV of coupons + PV of par Bond Value = PV annuity + PV of lump sum Remember, as interest rates increase the PV’s decrease So, as interest rates increase, bond prices decrease and vice versa

6. 7.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Valuing a Discount Bond with Annual Coupons Consider a bond with a coupon rate of 10% and coupons paid annually. The par value is $1000 and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond? –Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.11) 5 ] /.11 + 1000 / (1.11) 5 B = 369.59 + 593.45 = 963.04

7. 7.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Valuing a Premium Bond with Annual Coupons Suppose you are looking at a bond that has a 10% annual coupon and a face value of $1000. There are 20 years to maturity and the yield to maturity is 8%. What is the price of this bond? –Using the formula: B = PV of annuity + PV of lump sum B = 100[1 – 1/(1.08) 20 ] /.08 + 1000 / (1.08) 20 B = 981.81 + 214.55 = 1196.36

8. 7.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Graphical Relationship Between Price and Yield-to-Maturity

9. 7.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Prices: Relationship Between Coupon and Yield If YTM = coupon rate, then par value = bond price (return = “dividend yield” + capital gains yield) If YTM > coupon rate, then par value > bond price –Why? –Selling at a discount, called a discount bond If YTM < coupon rate, then par value < bond price –Why? –Selling at a premium, called a premium bond

10. 7.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Bond-Pricing Equation

11. 7.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.

12. 7.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example – Semiannual Coupons Most bonds in Canada make coupon payments semiannually. Suppose you have a 8% semiannual-pay bond with a face value of $1,000 that matures in 7 years. If the yield is 10%, what is the price of this bond? –The bondholder receives a payment of $40 every six months (a total of $80 per year) –The market automatically assumes that the yield is compounded semiannually –The number of semiannual periods is 14

13. 7.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example – Semiannual Coupons continued

14. 7.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 the interest rates at which cash flows can be reinvested –Short-term bonds have more reinvestment rate risk than long-term bonds

15. 7.14 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 7.2 – Interest Rate Risk and Time to Maturity

16. 7.15 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Computing 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

17. 7.16 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example – Finding the YTM Consider a bond with a 10% annual coupon rate, 15 years to maturity and a par value of $1000. The current price is $928.09. –Will the yield be more or less than 10%? –N = 15; PV = -928.09; FV = 1000; PMT = 100 –CPT I/Y = 11%

18. 7.17 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. YTM with Semiannual Coupons Suppose a bond with a 10% coupon rate and semiannual coupons has a face value of $1000, 20 years to maturity and is selling for $1197.93. –Is the YTM more or less than 10%? –What is the semiannual coupon payment? –How many periods are there? –N = 40; PV = -1197.93; PMT = 50; FV = 1000; CPT I/Y = 4% (Is this the YTM?) –YTM = 4%*2 = 8%

19. 7.18 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Table 7.1 – Summary of Bond Valuation

20. 7.19 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Pricing Theorems Bonds of similar risk (and maturity) will be priced to yield about the same return, regardless of the coupon rate If you know the price of one bond, you can estimate its YTM and use that to find the price of the second bond This is a useful concept that can be transferred to valuing assets other than bonds

21. 7.20 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Prices with a Spreadsheet There is a specific formula for finding bond prices on a spreadsheet –PRICE(Settlement,Maturity,Rate,Yld,Redemption, Frequency,Basis) –YIELD(Settlement,Maturity,Rate,Pr,Redemption, Frequency,Basis) –Settlement and maturity need to be actual dates –The redemption and Pr need to given as % of par value Click on the Excel icon for an example

22. 7.21 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Differences Between Debt and Equity 7.2 Debt –Not an ownership interest –Bondholders do not have voting rights –Interest is considered a cost of doing business and is tax deductible –Bondholders have legal recourse if interest or principal payments are missed –Excess debt can lead to financial distress and bankruptcy Equity –Ownership interest –Common shareholders vote for the board of directors and other issues –Dividends are not considered a cost of doing business and are not tax deductible –Dividends are not a liability of the firm and shareholders have no legal recourse if dividends are not paid –An all equity firm can not go bankrupt

23. 7.22 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Bond Indenture Contract between the company and the bondholders and includes –The basic terms of the bonds –The total amount of bonds issued –A description of property used as security, if applicable –Sinking fund provisions –Call provisions –Details of protective covenants

24. 7.23 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Classifications Registered vs. Bearer Forms Security –Collateral – secured by financial securities –Mortgage – secured by real property, normally land or buildings –Debentures – unsecured debt with original maturity of 10 years or more –Notes – unsecured debt with original maturity less than 10 years Seniority –Sinking Fund – Account managed by the bond trustee for early bond redemption

25. 7.24 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Classifications Continued Call Provision –Call premium –Deferred call –Call protected –Canada plus call Protective Covenants –Negative covenants –Positive covenants

26. 7.25 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Characteristics and Required Returns The coupon rate depends on the risk characteristics of the bond when issued Which bonds will have the higher coupon, all else equal? –Secured debt versus a debenture –Subordinated debenture versus senior debt –A bond with a sinking fund versus one without –A callable bond versus a non-callable bond

27. 7.26 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Ratings – Investment Quality 7.3 High Grade –DBRS’s AAA – capacity to pay is exceptionally strong –DBRS’s AA – capacity to pay is very strong Medium Grade –DBRS’s A – capacity to pay is strong, but more susceptible to changes in circumstances –DBRS’s BBB – capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay

28. 7.27 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Ratings - Speculative Low Grade –DBRS’s BB, B, CCC, CC –Considered speculative with respect to capacity to pay. Very Low Grade –DBRS’s C – bonds are in immediate danger of default –DBRS’s D – in default, with principal and/or interest in arrears

29. 7.28 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Stripped or Zero-Coupon Bonds 7.4 Make no periodic interest payments (coupon rate = 0%) The entire yield-to-maturity comes from the difference between the purchase price and the par value Cannot sell for more than par value Sometimes called zeroes, or deep discount bonds Bondholder must pay taxes on accrued interest every year, even though no interest is received

30. 7.29 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Floating Rate Bonds Coupon rate floats depending on some index value There is less price risk with floating rate bonds –The coupon floats, so it is less likely to differ substantially from the yield-to-maturity Coupons may have a “collar” – the rate cannot go above a specified “ceiling” or below a specified “floor”

31. 7.30 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Other Bond Types Disaster bonds Income bonds Convertible bonds Put bond (retractable bond) LYON bond There are many other types of provisions that can be added to a bond and many bonds have several provisions – it is important to recognize how these provisions affect required returns

32. 7.31 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Markets 7.5 Primarily over-the-counter transactions with dealers connected electronically Extremely large number of bond issues, but generally low daily volume in single issues Makes getting up-to-date prices difficult, particularly on small corporate issues Treasury securities are an exception

33. 7.32 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Bond Quotations From Figure 7.3 Canada5.000 Dec 01/03 101.9 3.05 –Issue is a Government of Canada bond –Coupon rate is 5% (assumed to be semiannual) –Maturity date is December 1, 2003 –Price that a bondholder can sell for is $1,019 –Yield to maturity is 3.05% compounded semiannually

34. 7.33 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Inflation and Interest Rates 7.6 Real rate of interest – compensation for change in purchasing power Nominal rate of interest – quoted rate of interest, includes compensation for change in purchasing power and inflation

35. 7.34 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Fisher Effect The Fisher Effect defines the relationship between real rates, nominal rates and inflation Exact relationship is (1 + R) = (1 + r)(1 + h), where: –R = nominal rate –r = real rate –h = expected inflation rate Approximation of the above relationship is: –R = r + h

36. 7.35 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example – Fisher Effect If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate? R = (1.1)(1.08) – 1 =.188 = 18.8% Approximation: R = 10% + 8% = 18% Since the real return and expected inflation are relatively high, there is significant difference between the actual Fisher Effect and the approximation.

37. 7.36 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Term Structure of Interest Rates 7.7 Term structure is the relationship between time to maturity and yields, all else equal It is important to recognize that we pull out the effect of default risk, different coupons, etc. Yield curve – graphical representation of the term structure –Normal – upward-sloping, long-term yields are higher than short-term yields –Inverted – downward-sloping, long-term yields are lower than short-term yields

38. 7.37 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 7.4 – Upward-Sloping Yield Curve

39. 7.38 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 7.4 – Downward-Sloping Yield Curve

40. 7.39 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 7.5 – Government of Canada Yield Curve November 29, 2002

41. 7.40 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Factors Affecting Required Return Default risk premium – remember bond ratings 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

42. 7.41 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Quick Quiz How do you find the value of a bond and why do bond prices change? What is a bond indenture and what are some of the important features? What are bond ratings and why are they important? How does inflation affect interest rates? What is the term structure of interest rates? What factors determine the required return on bonds?

43. 7.42 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary 7.8 You should know: –How to price a bond or find the yield –Bond prices move inversely with interest rates –Bonds have a variety of features that are spelled out in the indenture –Bonds are rated based on their default risk –Most bonds trade OTC –Fisher effect links interest rates and inflation –Term structure of interest rates shows the relationship between interest rates and maturity