Chapter 6

Interest Rates
And Bond
Valuation

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All rights reserved.
 Learning Goals

LG1 Describe interest rate fundamentals, the term

structure of interest rates, and risk premiums.

LG2 Review the legal aspects of bond financing and

bond cost.

LG3 Discuss the general features, yields, prices,

popular types, and international issues of
corporate bonds.

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 Learning Goals (cont.)

LG4 Understand the key inputs and basic model

used in the valuation process.

LG5 Apply the basic valuation model to bonds and

describe the impact of required return and time
to maturity on bond values.

LG6 Explain yield to maturity (YTM), its

calculation, and the procedure used to value
bonds that pay interest semiannually.

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 Interest Rates and Required Returns:
Interest Rate Fundamentals

• The interest rate is usually applied to debt instruments

such as bank loans or bonds; the compensation paid by
the borrower of funds to the lender; from the borrower’s
point of view, the cost of borrowing funds.
• The required return is usually applied to equity
instruments such as common stock; the cost of funds
obtained by selling an ownership interest.

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 Interest Rates and Required Returns:
Interest Rate Fundamentals

• Several factors can influence the equilibrium interest rate:

1. Inflation, which is a rising trend in the prices of most goods and services.
2. Risk, which leads investors to expect a higher return on their investment
3. Liquidity preference, which refers to the general tendency of investors to
prefer short-term securities

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 Matter of Fact

• Fear Turns T-bill Rates Negative

– Near the height of the financial crisis in December 2008, interest rates on
Treasury bills briefly turned negative, meaning that investors paid more to
the Treasury than the Treasury promised to pay back.
– Why would anyone put their money into an investment that they know will
lose money?
– Remember that 2008 saw the demise of Lehman Brothers, and fears that
other commercial banks and investments banks might fail were rampant.
– Evidently, some investors were willing to pay the U.S. Treasury to keep their
money safe for a short time.

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 Interest Rates and Required
Returns: The Real Rate of Interest
• The real rate of interest is the rate that creates
equilibrium between the supply of savings and the
demand for investment funds in a perfect world, without
inflation, where suppliers and demanders of funds have
no liquidity preferences and there is no risk.
• The real rate of interest changes with changing economic
conditions, tastes, and preferences.
• The supply-demand relationship that determines the real
rate is shown in Figure 6.1 on the following slide.

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 Figure 6.1
Supply–Demand Relationship

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 Interest Rates and Required Returns:
Nominal or Actual Rate of Interest (Return)

• The nominal rate of interest is the actual rate of interest charged

by the supplier of funds and paid by the demander.
• The nominal rate differs from the real rate of interest, r* as a result
of two factors:
– Inflationary expectations reflected in an inflation premium (IP), and
– Issuer and issue characteristics such as default risks and contractual
provisions as reflected in a risk premium (RP).

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 Interest Rates and Required Returns:
Nominal or Actual Rate of Interest (cont.)

• The nominal rate of interest for security 1, r1, is given by the

following equation:

• The nominal rate can be viewed as having two basic components: a

risk-free rate of return, RF, and a risk premium, RP1:

r1 = RF + RP1

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 Interest Rates and Required Returns:
Nominal or Actual Rate of Interest (cont.)

• For the moment, ignore the risk premium, RP1, and focus
exclusively on the risk-free rate. The risk free rate can be
represented as:
RF = r* + IP
• The risk-free rate (as shown in the preceding equation) embodies
the real rate of interest plus the expected inflation premium.
• The inflation premium is driven by investors’ expectations about
inflation—the more inflation they expect, the higher will be the
inflation premium and the higher will be the nominal interest rate.

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 Figure 6.2
Impact of Inflation

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 Term Structure of Interest Rates

• The term structure of interest rates is the relationship between

the maturity and rate of return for bonds with similar levels of risk.
• A graphic depiction of the term structure of interest rates is called
the yield curve.
• The yield to maturity is the compound annual rate of return earned
on a debt security purchased on a given day and held to maturity.

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 Figure 6.3
Treasury Yield Curves

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 Term Structure of Interest
Rates: Yield Curves (cont.)
• A normal yield curve is an upward-sloping yield curve
indicates that long-term interest rates are generally higher
than short-term interest rates.
• An inverted yield curve is a downward-sloping yield
curve indicates that short-term interest rates are generally
higher than long-term interest rates.
• A flat yield curve is a yield curve that indicates that
interest rates do not vary much at different maturities.

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 Term Structure of Interest Rates:
Theories of Term Structure

Expectations Theory
– Expectations theory is the theory that the yield curve
reflects investor expectations about future interest
rates; an expectation of rising interest rates results in an
upward-sloping yield curve, and an expectation of
declining rates results in a downward-sloping yield
curve.

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 Term Structure of Interest Rates:
Theories of Term Structure (cont.)

Expectations Theory (example)

– Suppose that a 5-year Treasury note currently offers a
3% annual return. Investors believe that interest rates
are going to decline, and 5 years from now, they expect
the rate on a 5-year Treasury note to be 2.5%.
According to the expectations theory, what is the return
that a 10-year Treasury note has to offer today? What
does this imply about the slope of the yield curve?

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 Term Structure of Interest Rates:
Theories of Term Structure (cont.)
Expectations Theory (example)
– Consider an investor who purchases a 5-year note today and
plans to reinvest in another 5-year note in the future. Over the
10-year investment horizon, this investor expects to earn about
27.5%, ignoring compounding (that’s 3% per year for the first
5 years and 2.5% per year for the next 5 years). To compete with
that return, a 10-year bond today could offer 2.75% per year.
That is, a bond that pays 2.75% for each of the next
10 years produces the same 27.5% total return that the series of
two, 5-year notes is expected to produce. Therefore, the 5-year
rate today is 3% and the 10-year rate today is 2.75%, and the
yield curve is downward sloping.

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 Term Structure of Interest Rates:
Theories of Term Structure (cont.)

Liquidity Preference Theory

– Liquidity preference theory suggests that long-term
rates are generally higher than short-term rates (hence,
the yield curve is upward sloping) because investors
perceive short-term investments to be more liquid and
less risky than long-term investments. Borrowers must
offer higher rates on long-term bonds to entice
investors away from their preferred short-term
securities.

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 Term Structure of Interest Rates:
Theories of Term Structure (cont.)

Market Segmentation Theory

– Market segmentation theory suggests that the market
for loans is segmented on the basis of maturity and that
the supply of and demand for loans within each
segment determine its prevailing interest rate; the slope
of the yield curve is determined by the general
relationship between the prevailing rates in each
market segment.

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 Risk Premiums: Issue and
Issuer Characteristics

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 Table 6.1 Debt-Specific Issuer- and
Issue-Related Risk Premium Components

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