Principles of

Chapter 3 Corporate Finance

Tenth Edition

Valuing Bonds

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 3-2

Topics Covered
1 Using The Present Value Formula to Value Bonds

2 How Bond Prices Vary With Interest Rates

3 The Term Structure of Interest Rates

4 Explaining the Term Structure

5 Real and Nominal Rates of Interest

6 Corporate Bonds and the Risk of Default

Guess the word
3-3

Trò chơi: Đuổi hình bắt chữ

B
 Guess the word
3-4

Trò chơi: Đuổi hình bắt chữ

C
 Guess the word
3-5

Trò chơi: Đuổi hình bắt chữ

A
 Guess the word
3-6

Trò chơi: Đuổi hình bắt chữ

P A

or
F U
 Guess the word
3-7

Trò chơi: Đuổi hình bắt chữ

M R T
Guess the word
3-8

Trò chơi: Đuổi hình bắt chữ

or
Y T M
 3-9

What is a Bond?
• The following entities issue bonds to raise long-term loans:
➢ The federal government
➢ State and local governments
➢ Companies
• The type of bonds where the identities of bonds' owners are recorded and the coupon
interest payments are sent automatically are called “Registered bonds”.
• Generally, a bond can be valued as a package of:
➢ Annuity
➢ Single payment
• Generally, bonds issued in USA, UK, Canada, Japan pay interest semi-annually.
• Treasury bonds do not have default risk, but are subject to inflation risk.
 3-10

What is a Bond?
• The U.S. Treasury issues inflation-indexed bonds known as TIPs. TIPs (Treasury
Inflation-Protected Securities) are issued by the U.S. Treasury. The U.S. Treasury
began issuing TIPs in 1997. These are also known as Inflation-indexed bonds. The real
cash flows on TIPs are fixed, but the nominal cash flows, which includes interest and
principal, are increased as the Consumer Price Index (CPI) increases. Thus the buying
power of the lender in protected.
• Defaulted bonds often pay some level of residual.
 3-11

Bond Features
YTM
(r)

Fixed coupon
Bond Price
C = coupon rate x
(PV)
face value

Face value / Par

value
Example: $1,000
 3-12

Valuing a Bond

YTM
(r %)

coupon rate
Price of a bond
(%)
(PV)

Face value
Example: $1,000
 3-13

Valuing a Bond
 PV
3-14

Self-study

• Cash flows associated with a bond to the investor: Bonds provide two types of cash
flows: interest payments and the principal payment. Interest payments occur each
period, usually annually or semi-annually. Periodic interest payments are also called
coupon payments. Thus this forms an annuity. Principal payment occurs at the time of
maturity of the bond and is a lump sum payment.
• The price of long-term bonds fluctuates more than the price of short-term bonds for a
given change in interest rates. (Assuming that the coupon rate is the same for both)
 YTM
3-15

Self-study

• The yield to maturity on a bond is really its internal rate of return (IRR).
• The yield to maturity is the single discount rate that is used to calculate the present value
of cash flows received from buying a bond. It is used for calculating the bond value.
Conceptually it is the same as the internal rate of return (IRR). It is also stock-in-trade
of any bond dealer.
 3-16

DurationSelf-study

• Duration can be thought of as the weighted average time of a bond's cash flow. The
weights are determined by the present value factors. Duration is expressed in units of
time. Duration is an important concept for two reasons. First, the volatility of a bond is
directly related to its duration. Second, one way to hedge interest rate risk is through a
strategy of duration matching.
• The duration of a zero-coupon bond is the same as its maturity.

1  PV (C1 ) 2  PV (C 2 ) 3  PV (C 3 ) T  PV (C T )
Duration = + + + ... +
PV PV PV PV

duration
Modified Duration = volatility (%) =
1 + yield
 3-17

Duration
Self-study
 3-18

Volatility
Self-study

• Volatility is calculated as Duration/ (1 + yield). Bonds with longer duration also have
greater volatility. Bond's volatility is directly related to duration. Volatility is also the
slope of the curve relating the bond price to the interest rate.
• Volatility of a bond is given by:
- Duration/ (1 + yield)
- Slope of the curve relating the bond price to the interest rate
• The longer a bond's duration, the greater its volatility.
 3-19

Change in bond price

Self-study
 3-20

Structure of interest rate Self-study

• The term structure of interest rate is the relationship between yield to maturity and
maturity.
• If the term structure of interest rate is flat the nine-year interest rate is equal to the ten-
year interest rate.
• The term structure of interest rates is the plot of interest rates on the y-axis and the
maturity on the x-axis. It is also called the yield curve. It shows how interest rates and
maturity are related. Economists have developed several theories to explain the shape of
the yield curve.
• The term structure of interest rates can be described as the relationship between spot
interest rates and maturity of a bond.
 3-21

Structure of interest rate

Self-study

➢ Short- and long-term interest rates do not always move in

parallel. Between September 1992 and April 2000 U.S. short-
term rates rose sharply while long term rates declined.
 3-22

Structure of interest rate

Self-study

YTM (r)

1981
1987 & Normal

1976
Year
1 5 10 20 30
Spot Rate - The actual interest rate today (t=0)
Forward Rate - The interest rate, fixed today, on a loan
made in the future at a fixed time.
Future Rate - The spot rate that is expected in the future
Yield To Maturity (YTM) - The IRR on an interest bearing
instrument
 3-23

Structure of interest rate

Self-study

What Determines the Shape of the Term Structure?

Expectations Theory

Term Structure & Capital Budgeting

➢ CF should be discounted using Term Structure info
➢ Since the spot rate incorporates all forward rates,
then you should use the spot rate that equals the term
of your project.
➢ If you believe in other theories take advantage of the
arbitrage.
 Relationship between bond prices and 3-24

interest rates
Self-study

• Interest rates and bond prices are inversely related. High interest rates cause bond prices
to fall and vice-versa. For a given change in interest rates, prices of long-term bonds
fluctuate more than for short-term bonds. Similarly, for a given change in interest rates
low coupon bond prices fluctuate more than for high coupon bonds.
 Spot rates & Forward rates 3-25

Self-study

• Yield to maturity is the weighted average of spot interest rates and estimated forward
rates.
• A forward rate prevailing from period three through to period four can be extracted from
spot interest rate with 3 and 4 years to maturity.
• Interest represented by "r2" is: Spot rate on a two-year investment (APR).
• One person can invest today at the 2-year forward rate of interest by buying a 2-year
bond and selling a 1-year bond with the same coupon.
• The relationship between spot and forward rates: A forward rate is the internal rate of
return derived from the future value of bonds given spot rates from two different
maturity bonds.
 Spot rates (%)

0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
2009 Aug 15 2009
2011 Aug 15

2013 Aug 15

2015 Aug 15

2017 Aug 15

2019 Aug 15

2021 Aug 15

2023 Aug 15

Maturity
Self-study

2025 Aug 15

2027 Aug 15

2029 Aug 15

2031 Aug 15

2033 Aug 15

2035 Aug 15

2037 Aug 15
U.S. Treasury Strip Spot Rates as of February
Spot rates & Forward rates
3-26
 Expectation theory 3-27

Self-study

• The expectations theory implies that the only reason for a declining term structure is
that investors expect spot interest rates to fall.
• The expectations theory postulates that the current forward rates are the expected value
of the corresponding future spot rates.
• The expectations hypothesis states that the forward interest rate is the expected future
spot rate.
 Real rates and nominal rates 3-28

Self-study

• Classical Theory of Interest Rates (Economics), developed by Irving

Fisher.
• Nominal Interest Rate = The rate you actually pay when you borrow
money.
• Real Interest Rate = The theoretical rate you pay when you borrow
money, as determined by supply and demand

r
Supply

Real r

Demand

$ Qty
 Real rates and nominal rates 3-29

Self-study

• The relationship between nominal interest rate and real interest rate is given by:

• It can also be written as:

• Real interest rate is the inflation adjusted nominal interest rate.

Real rates and nominal rates 3-30

Self-study
 Bond Ratings
3-31

Self-study

➢ Key to bond ratings. The highest-quality bonds are rated triple A. Bonds
rated triple B or above are investment grade. Lower-rated bonds are called
high-yield, or junk, bonds.

➢ Prices and yields of a sample of corporate bonds, December 2008.

 3-32

True / False
The yield to maturity on a bond is really its internal rate of return.
TRUE
In the US, most bonds make coupon payments annually.
FALSE
The duration of any bond is the same as its maturity.
FALSE
The duration of a zero coupon bond is the same as its maturity.
TRUE
 3-33

True / False
The longer a bond's duration greater is its volatility.
TRUE
The term structure of interest rate is the relationship between yield
to maturity and maturity.
TRUE
If the term structure of interest rate is flat the nine-year interest rate
is equal to the ten-year interest rate.
TRUE
 3-34

True / False
Short-term and long-term interest rates always move in parallel.
FALSE
The expectations theory implies that the only reason for a declining
term structure is that investors expect spot interest rates to fall.
TRUE
The relationship between nominal interest rate and real interest rate
is given by: (1 + rnominal) = (1 + rreal)(1 + inflation rate)
TRUE
 3-35

True / False
Treasury bonds do not have default risk, but are subject to inflation
risk.
TRUE
Indexed bonds were completely unknown in the U.S. before 1997.
FALSE
The U.S. Treasury issues inflation-indexed bonds known as TIPs.
TRUE
 3-36

True / False
Forward rates are always higher than spot rates.
FALSE
Defaulted bonds often pay some level of residual?
TRUE
 3-37

Web Resources
Click to access web sites
Internet connection required

http://cxa.marketwatch.com/finra/BondCenter
www.ft.com
www.smartmoney.com
www.wsj.com
www.finpipe.com
www.investinginbonds.com
www.investorguide.com
http://money.cnn.com/markets/bondcenter
www.federalreserve.gov
www.stls.frb.org
www.ustreas.gov