CHAPTER 6
INTEREST RATE & BOND VALUATION
INTEREST RATE FUNDAMENTALS
Interest rates represent the compensation that a demander of funds
must pay a supplier.
When funds are lent, the cost of borrowing is the interest rate.
When funds are raised by issuing stocks or bonds, the cost the
company must pay is called the required return, which reflects the
supplier’s expected level of return.
INTEREST RATE FUNDAMENTALS
INTEREST RATE FUNDAMENTALS
The interest rate or required return represents the cost of money.
interest rate 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.
required return Usually applied to equity instruments such as
common stock; the cost of funds obtained by selling an ownership
interest
FACTORS VARYING INTEREST RATE
1. Inflation: a rising trend in the prices of most goods and services. Typically,
savers demand higher returns (that is, higher interest rates) when
inflation is high because they want their investments to more than keep
pace with rising prices.
2. Risk: When people perceive that a particular investment is riskier, they
will expect a higher return on that investment as compensation for
bearing the risk.
3. Liquidity preference: refers to the general tendency of investors to prefer
short-term securities. interest rates on short-term instruments will be
lower than rates on longer-term securities. Investors will hold these
securities, despite the relatively low return that they offer because they
meet investors’ preferences for liquidity.
REAL RATE VS NOMINAL RATE OF INTEREST
Imagine a perfect world in which there is no inflation, in which
investors have no liquidity preferences, and in which there is no risk.
The nominal rate of interest is the actual rate of interest charged by
the supplier of funds and paid by the demander.
NOMINAL RATE
Investors will demand a higher nominal rate of return if they expect
inflation. The additional return that investors require to compensate
them for inflation is called the expected inflation premium (IP)
Similarly, investors generally demand higher rates of return on risky
investments as compared to safe ones. The additional return that
investors require to compensate them for bearing risk is called the
risk premium (RP).
the nominal rate of interest: r1 = r* + IP + RP1
Here, r* +IP = risk free rate
NOMINAL RATE
Marilyn Carbo has $10 that she can spend on candy costing $0.25 per piece.
1. She could buy 40 pieces of candy ($10.00/ $0.25) today.
2. The nominal rate of interest on a 1-year investment is currently 7%, and the expected rate of
inflation over the coming year is 4%. Instead of buying the 40 pieces of candy today, Marilyn
could invest the $10.
After 1 year, she would have $10.70 because she would have earned 7% interest—an additional
$0.70 (0.07 * $10.00)—on her $10 investment. Totaling $10.70
During that year, inflation would have increased the cost of the candy by 4%—an additional $0.01
(0.04 * $0.25)—to $0.26 per piece.
As a result, at the end of the 1-year period Marilyn would be able to buy about 41.2 pieces of
candy ($10.70 , $0.26), or roughly 3% more (41.2 / 40.0)-1 = 1.03.
The 3% increase in Marilyn’s buying power represents her real rate of return. The nominal rate
of return on her investment (7%) is partly eroded by inflation (4%), so her real return during
the year is the difference between the nominal rate and the inflation rate (7 - 4= 3)%.
RISK PREMIUMS: ISSUER AND ISSUE CHARACTERISTICS
The risk premium consists of a number of issuer- and issue-related
components, including business risk, financial risk, interest rate risk,
liquidity risk, and tax risk, as well as the purely debt-specific risks.
RISK PREMIUMS: ISSUER AND ISSUE CHARACTERISTICS
RISK PREMIUMS: ISSUER AND ISSUE CHARACTERISTICS
RISK PREMIUMS: ISSUER AND ISSUE CHARACTERISTICS
CORPORATE BONDS
A long-term debt instrument indicates that a corporation has
borrowed a certain amount of money and promises to repay it in the
future under clearly defined terms.
coupon interest rate: The percentage of a bond’s par value that will
be paid annually, typically in two equal semiannual payments, as
interest.
LEGAL ASPECTS OF CORPORATE BONDS
Bond Indenture: A legal document that specifies both the rights of
the bondholders and the duties of the issuing corporation. It
contains standard debt provisions as well as Restrictive Provisions.
The standard debt provisions: in the bond indenture specify certain
record-keeping and general business practices that the bond issuer
must follow.
Restrictive Provisions: Bond indentures also normally include certain
restrictive covenants, which place operating and financial
constraints on the borrower.
RESTRICTIVE PROVISIONS BOND INDENTURES
1. Require a minimum level of liquidity, to ensure against loan default.
2. Prohibit the sale of accounts receivable to generate cash. Selling
receivables could cause a long-run cash shortage if proceeds were
used to meet current obligations.
3. Impose fixed-asset restrictions. The borrower must maintain a specified
level of fixed assets to guarantee its ability to repay the bonds.
4. Constrain subsequent borrowing. Additional long-term debt may be
prohibited, or additional borrowing may be subordinated to the original
loan.
In general, violations of restrictive covenants give bondholders the right
to demand immediate repayment.
LEGAL ASPECTS OF CORPORATE BONDS
Sinking-Fund Requirements: Another common restrictive provision is a
sinking-fund requirement. Its objective is to provide for the systematic
retirement of bonds prior to their maturity. To carry out this requirement,
the corporation makes semiannual or annual payments that are used to
retire bonds by purchasing them in the marketplace.
A trustee: is a third party to a bond indenture. The trustee can be an
individual, a corporation, or (most often) a commercial bank trust
department. The trustee is paid to act as a “watchdog” on behalf of the
bondholders and can take specified actions on behalf of the bondholders
if the terms of the indenture are violated.
COST OF BONDS TO THE ISSUER
In general, the longer the bond’s maturity, the higher the
interest rate (or cost) to the firm.
In addition, the larger the size of the offering, the lower will be the
cost (in % terms) of the bond.
Also, the greater the risk of the issuing firm, the higher the cost of
the issue.
Finally, the cost of money in the capital market is the basis for
determining a bond’s coupon interest rate.
GENERAL FEATURES OF A BOND ISSUE
conversion feature: A feature of convertible bonds that allows
bondholders to change each bond into a stated number of shares of
common stock.
call feature: A feature included in nearly all corporate bond issues
that gives the issuer the opportunity to repurchase bonds at a
stated call price prior to maturity.
stock purchase warrants: Instruments that give their holders the
right to purchase a certain number of shares of the issuer’s common
stock at a specified price over a certain period of time
BOND YIELDS
A bond’s yield or rate of return is frequently used to assess its
performance over a given period, typically 1 year.
The three most widely cited yields are:
Current yield
Yield to maturity (YTM)
Yield to call (YTC)
CORPORATE BONDS: BOND PRICES
CORPORATE BONDS: BOND RATINGS
BASIC VALUATION MODEL
The value of any asset is the present value of all future cash flows it
is expected to provide over the relevant time period.
V0 =
Here,
V0 = value of the asset at time zero
CFt = cash flow expected at the end of year t
r = appropriate required return (discount rate)
n = relevant time period
BOND VALUATION
Mills Company, a large defense contractor, on January 1, 2014, issued a
10% coupon interest rate, 10-year bond with a $1,000 par value that pays
interest annually.
Investors who buy this bond receive the contractual right to two cash flows:
(1) $100 annual interest (10% coupon interest rate * $1,000 par value)
distributed at the end of each year and
(2) the $1,000 par value at the end of the tenth year.
Tim Sanchez wishes to determine the current value of the Mills Company
bond
BOND VALUATION
B0 = value of the bond at time zero
I = annual interest paid in dollars
n = number of years to maturity
M = par value in dollars
rd = required return on the bond
BOND VALUATION
BOND VALUE BEHAVIOR
In practice, the value of a bond in the marketplace is rarely equal to
its par value
Some bonds are valued below par
Others are valued above par
A variety of forces in the economy, as well as the passage of time,
tend to affect value
REQUIRED RETURNS AND BOND VALUES
Whenever the required return on a bond differs from the bond’s
coupon interest rate, the bond’s value will differ from its par value.
The required return is likely to differ from the coupon interest rate
because either:
(1) economic conditions have changed since the bond was issued,
causing a shift in the cost of funds; or
(2) the firm’s risk has changed. Increases in the cost of funds or in
risk will raise the required return; decreases in the cost of funds or
in risk will lower the required return.
REQUIRED RETURNS AND BOND VALUES
When the required return is greater than the coupon interest rate, the
bond value, B0 , will be less than its par value, In this case, the bond is
said to sell at a discount.
Assuming that the Mills Company bond pays interest semiannually and
that the required stated annual return, rd , is 12% for similar-risk bonds
that also pay semiannual interest. What will be the value of the bond
today?
When the required return falls below the coupon interest rate, the bond
value will be greater than par. In this situation, the bond is said to sell at
a premium
TIME TO MATURITY AND BOND VALUES
Whenever the required return is different from the coupon interest
rate, the amount of time to maturity affects bond value
When the required return is different from the coupon interest rate
and is constant until maturity, the value of the bond will approach
its par value as the passage of time moves the bond’s value closer
to maturity.
when the required return equals the coupon interest rate, the
bond’s value will remain at par until it matures
INTEREST RATE RISK
The chance that interest rates will change and thereby change the
required return and bond value is called interest rate risk.
Bondholders are typically more concerned with rising interest rates
because a rise in interest rates, and therefore in the required return,
causes a decrease in bond value.
YIELD TO MATURITY (YTM): compound annual rate of return earned
on a debt security purchased on a given day and held to maturity.