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Chapter 8: Bond Valuation and

the Structure of Interest Rates
 Learning Objectives

1. Describe the market for corporate bonds and three

types of corporate bonds.
2. Explain how to calculate the value of a bond and
why bond prices vary negatively with interest rate
movements.
3. Distinguish between a bond’s coupon rate, yield to
maturity, and effective annual yield.

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 Learning Objectives

4. Explain why investors in bonds are subject to

interest rate risk and why it is important to
understand the bond theorems.
5. Discuss the concept of default risk and know how
to compute a default risk premium.
6. Describe the factors that determine the level and
shape of the yield curve.

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 Corporate Bonds

Market for Corporate Bonds

Life insurance companies and pension funds buy
most corporate bonds
Transactions tend to be in very large dollar
amounts.
Less than 1% of all corporate bonds are traded
on organized exchanges
Most transactions take place through dealers
in the over-the-counter (OTC) market.

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 Corporate Bonds

Market for Corporate Bonds

Only a small fraction of the bonds outstanding
are traded each day.
The market is thin compared to markets for
money-market securities and stocks.
Corporate bonds are less marketable than
securities with large daily trading volumes.

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 Corporate Bonds

Bond Price Information

Corporate bond pricing is not considered
transparent.
It is difficult for investors to obtain important
information on prices and volume.
Many transactions are negotiated directly
between buyer and seller with little centralized
reporting of transaction details.

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 Corporate Bonds

Features of Corporate Bonds

long-term claims against company assets
face (par) value is $1,000
coupon rate is the annual coupon payment (C) divided by
a bond’s face value (F)
fixed amounts paid to lenders for the life of the contract

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 Vanilla Bonds

Types of Corporate Bonds

Vanilla bond
coupon payments fixed for the life of the bond
repay principal and retire the bonds at maturity
contracts have the features and provisions found in most bond
covenants.
annual or semiannual coupon payments

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 Zero Coupon Bonds

Types of Corporate Bonds

Zero coupon bond
no coupon payments
pays face value at maturity.
sell at deep discount

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 Convertible Bonds

Types of Corporate Bonds

Convertible bonds
may be exchanged for shares of the firm’s stock
sells for a higher price than a comparable non-convertible bond
bondholders benefit if the market value of the company’s stock
gets high enough

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 Bond Valuation

bond price
In an efficient market, the price of an asset equals the
present value of its future cash flows.
To calculate a bond’s price, follow the same process used
to value any financial asset.

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 Bond Valuation

calculate bond price

Determine the required rate-of-return
Determine expected future cash flows – the coupon
payments and par value
Compute the current market value, or price (PB) by
calculating the present value of the expected cash flows

PB = PVCoupon Payments+ PVPar Value

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 Bond Valuation

general equation for the price of a bond

C C C F
P    ... 
1 2 n n
(8.1)
(1  i ) (1  i ) (1  i )
B 1 2 n

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 Cash Flows for a Three-Year Bond

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 Bond Valuation

Bond Valuation Example

Calculator solution
Determine the price of the bond in Exhibit 8.1 with a financial
calculator

3 10 80 1,000
Enter
N i PV PMT FV
Answer -950.26

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 Bond Valuation

Par, Premium, and Discount Bonds

If a bond’s coupon rate is equal to its yield, its price
equals its face value; it is a par bond
If a bond’s coupon rate is less than its yield, its price is
less than its face value; it is a discount bond
If a bond’s coupon rate is greater than its yield, its price
is greater than its face value; it is a premium bond

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 Bond Valuation

Semiannual Compounding
Most bonds issued in Europe pay annual coupons, most
issued in the U.S. pay semiannual coupons
Eq. 8.2 shows how to value bonds that pay semi-annual
coupons

C m C m C m C mF
P     ...  mn
( 8.2 )
(1  i m ) (1  i m ) (1  i m ) (1  i m )
B 1 2 3 mn

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 Bond Valuation

Semiannual Compounding Example

What is the price of a three-year, 5% coupon bond with
a market yield of 8% and semi-annual coupon
payments?
Semi-annual market yield = 8%/2 = 4%
Semi-annual coupon payment = $50/2 = $25

$25 $25 $25 $25 $25 $25  $1000

P      
(1.04 ) (1.04 ) (1.04 ) (1.04 ) (1.04 ) (1.04 )
B 1 2 3 4 5 6

 $24.04  $23.11  $22.22  $21.37  $20.55  $810.07

 $921.36

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 Bond Valuation

Calculator Solution
Semiannual Compounding Example

6 4 25 1,000
Enter
N i PV PMT FV
Answer -921.37

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 Bond Valuation

Zero Coupon Bonds

Zero coupon bonds do not make coupon payments but
pay their face value at maturity
The price (or yield) of a zero coupon bond is a special
case of Equation 8.2, where all coupon payments equal
zero

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 Bond Valuation

Zero Coupon Bonds

Pricing equation for a zero coupon bond

F
P  mn
( 8 .3 )
(1  i m )
B mn

Zero coupon bonds pay cash only at maturity and must

sell for less than similar bonds which make periodic
interest payments

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 Bond Valuation

Zero Coupon Bond Price Example

What is the price of a zero coupon bond with a $1,000
face value, 10-year maturity, and semiannual
compounding? The market rate on similar bonds is 12%.

$1000 $1000
P    $311 .80
(1  0.12 2) (1  0.06 )
B 20 20

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 Bond Yields

Yield to Maturity (YTM)

YTM
the rate that makes the present value of the
bond’s cash flows equal the price of bond
the rate a bondholder earns if the bond is held
to maturity and all coupon and principal
payments are made as promised
– changes daily as interest rates change

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 Bond Yields

Effective Annual Yield

In bond trading, the EAR is called the effective annual
yield (EAY). The way to annualize a bond yield

EAY  (1  Quoted rate/m) - 1 m

Simple annual yield is yield per period multiplied by the

number of compounding periods; for bonds with annual
compounding, simple annual yield = semiannual yield 
2

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 Bond Yields

Yield to Maturity and Effective Annual Yield

Example
An investor buys a 30-year bond with a $1,000
face value for $800. The bond’s coupon rate is
8% and interest payments are made semi-
annually. What are the bond’s yield to maturity
and effective annual yield?

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 Bond Yields

Yield to Maturity and Effective Annual Yield

Example
Step 1:

60 -800 40 1,000
Enter
N i PV PMT FV
Answer 5.07

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 Bond Yields

Yield to Maturity and Effective Annual Yield

Example
Step 2:
Calculate YTM

.0507 2
Enter
x =
Answer .1014

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 Bond Yields

Yield to Maturity and Effective Annual Yield

Example
Step 3:
Calculate EAY

1.0507 - =
Enter
X2 1

Answer .1040

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 Bond Yields

Realized Yield
The return earned on a bond given the cash flows
actually received by investor
The interest rate at which the present value of actual
cash flows generated by the investment equals bond’s
price
The realized yield is important because it allows investors
to see what they actually earned on their investments.

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Chapter 8 – Corporate Finance - Trương Đạt Anh 30
 Interest Rate Risk

Bond Theorems
Bond theorems are statements about the math used
in bond pricing.
Bond prices are inversely related to interest rate
movements.
As interest rates decline, prices of bonds rise; as
interest rates rise, prices of bonds decline.
For a given change in interest rates, prices of
longer-term bonds change more than prices of
shorter-term bonds.
Interest rate risk increases as maturity increases,
but at a decreasing rate.
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 Relation Between Bond Price Volatility
and Maturity
Exhibit 8.2 Relation Between Bond Price Volatility and Maturity

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 Interest Rate Risk

Bond Theorems
For a given change in interest rates, prices of lower-
coupon bonds change more than prices of higher-coupon
bonds.

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 Relation Between Bond Price Volatility
and the Coupon Rate

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 Interest Rate Risk

Bond Theorem Applications

If interest rates are expected to increase, avoid long-
term bonds – they will experience the largest price
declines.
If interest rates are expected to decline, buy zero-coupon
bonds. Their prices will increase more than those of
coupon-paying bonds.

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 The Structure of Interest Rates

Risk Characteristics of Bonds

Four features of debt instruments are responsible for
most of the differences in corporate borrowing costs and
determine the level and structure of interest rates:
Marketability
Call feature
Default risk
Term-to-maturity

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 The Structure of Interest Rates

Marketability
How quickly and easily a security can be sold at at low
transaction cost and at fair market value
The selling price varies directly with the degree of marketability.
The transaction cost varies inversely with the degree of
marketability.
The yield-to-maturity varies inversely with the degree of
marketability.

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 The Structure of Interest Rates

Marketability
The difference in yields between a highly marketable
security (ihigh mkt) and a less marketable security (ilow mkt) is
the marketability risk premium (MRP)

U.S. Treasury bills are considered the most marketable of

all securities

MRP = ilow mkt – ihigh mkt > 0

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 The Structure of Interest Rates

Call Provision
Bond issuer’s option to purchase a bond from the
bondholder at a predetermined price before maturity.
When bonds are called, bondholders suffer financial loss because
they must surrender higher-yield bonds and replace them with
lower-yield bonds.

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 The Structure of Interest Rates

Call Provision
The difference in interest rates between a callable bond
and a non-callable bond is the call premium (CIP)

CIP  i - i call no call

 0
Callable bonds sell for lower prices and higher yields than
non-callable bonds
Bonds paying high yields are more likely to be called
when interest rates decline; these bonds have a high CIP

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 The Structure of Interest Rates

Default Risk
Risk that a borrower may not make payments as
promised
Lenders are paid a default risk premium for purchasing
securities with default risk
The default risk premium (DRP) is the difference
between the yield on a security with default risk, idr, and
the risk-free rate, irf
Yield on T-bills is a proxy for the risk-free rate.

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 The Structure of Interest Rates

Bond Ratings
Individuals and small businesses rely on outside agencies
for information on the default potential of bonds.
The two most prominent credit rating agencies are Moody’s
Investors Service (Moody’s) and Standard & Poor’s (S&P).
– Both services rank bonds in order of probability of default and
publish ratings as letter grades.

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 The Structure of Interest Rates

Bond Ratings
The highest grade bonds have the lowest default risk and
are rated Aaa or AAA.
Investment grade bonds are rated Aaa to Baa.
State and federal laws typically require commercial banks,
insurance companies, pension funds, certain other financial
institutions, and government agencies to purchase only
investment-grade securities.

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 Corporate Bond Rating Systems

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 Default Risk Premiums for Selected Bond
Ratings

Exhibit 8.5 Default Risk Premiums for Selected Bond Ratings

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 The Structure of Interest Rates

Term Structure of Interest Rates

The term structure of interest rates
the relationship between yield to maturity and term-to-maturity
on a bond
the graph of the term structure of interest rates is a yield curve
– The shape and position of the yield curve are not constant.
– As the overall level of interest rates changes, the yield curve shifts
up and down and changes its shape and slope.

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 The Structure of Interest Rates

basic shapes (slopes) of yield curves

1. Ascending or normal yield curves slope upward from
left to right and imply higher interest rates are likely
2. Descending or inverted yield curves slope downward
from left to right and imply lower interest rates are
likely
3. Flat yield curves imply interest rates unlikely to change

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 The Structure of Interest Rates

Shape of the Yield Curve

Three factors that influence the shape of the
yield curve
1) Real rate of interest

2) Expected rate of inflation

3) Interest rate risk

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 The Structure of Interest Rates

The Real Rate of Interest

The real rate of interest changes with the
business cycle.
Highest rates occur at the end of an economic
expansion.
Lowest rates occur at the end of an economic
contraction.
Changes in the expected future real rate of
interest can affect the level of the yield curve.

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 The Structure of Interest Rates

The Expected Rate of Inflation

If higher inflation is forecast, the yield curve will slope
upward because longer-term yields will contain a larger
inflation premium than shorter-term yields
If investors believe inflation will subside, the yield curve
will slope downward

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 The Structure of Interest Rates

Interest Rate Risk

The longer the maturity of a security, the greater its
interest rate risk – the risk of selling the security at a
lower price - and the higher its yield-to-maturity
The interest rate risk premium adds upward bias to the
slope of the yield curve

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 Yield Curves for Treasury Securities at
Three Different Points in Time
Exhibit 8.6

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 The Structure of Interest Rates

Cumulative Effect of Factors

In an economic expansion, the real rate of interest and
the inflation premium increase monotonically . Interest
rate risk increases.
In an economic contraction, the real rate of interest and
inflation premium decrease monotonically. Interest rate
risk decreases.

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