Chapter 6: Interest Rates and Bond Valuation

FIN3403: Corporate FinanceChapter 6: Interest Rates and Bond ValuationBond Features and Prices time 10maturity)In our example, the $120 regular interest payments that Beck promises to make are calledthe bond's coupons.Because the coupon is constant and paid every year, the type of bond we are describing issometimes called a level coupon bondThe amount that will be repaid at the end of the loan is called the bond's face value orpar value.As inn our example, this par value is usually $1,000 for corporate bonds, and a bond thatsells for its par value is called a par value bond.corporationbondsGovernment bonds frequently have much larger face, or par, values.Finally, the annual coupon divided by the face value is called the coupon rate on thebond; in this case, because $120/$1,000 = 12, or 12 percent, the bond has a 12 percentcoupon rate.Bond Values and YieldsWhen interest rates rise, the present value of the bond's remaining cash-flows declines,and the bond is worth less. When Interest rates fall, the bond is worth more.To determine the value of a bond at a particular point in time, we need to know thenumber of periods remaining until maturity, the face value , the coupon, and the marketinterest rate for bonds with similar features.This interest rate required in the market on the bond is called the bond's yield-tematurity (YTM). This rate is sometimes called the bond's yield for short.changes over timeIS usually the same as a bond's coupon rateAs illustrated inFigure 6.1, the Xanth bond's cash flows have an annuity component (the coupons) and alump sum (the face value paid at maturity). We thus estimate the market value of the bond by calculating thepresent value of these two components separately and adding the results together. First, at the going rate of 8percent, the present value of the $1,000 paid in 10 years is:Present value = $1,000/1.08" = $1,000/2.1589 = $463.19Second, the bond offers $80 per year for 10 years; the present value of this annuity stream is:Annuity present value = $80 x (1 1/1.0819)/08= $80 x (1 1/2.1589)/.08= $80 x 6.7101= $536.81We can now add the values for the two parts together to get the bond's value:Total bond value = $463.19 + 536.81 = $1,000This bond sells for exactly its face value. The going interest rate in the market is 8percent. Considered as an interest-only loan, what interest rate does this bond have? Withan $80 coupon, this bond pays exactly 8 percent interest only when it sells for $1,000. FIN3403: Corporate FinanceChapter 6: Interest Rates and Bond ValuationInterest Rate RiskThe risk that arises for bond owners from fluctuating interest rates is called interest raterisk. How much interest rate risk a bond has depends on how sensitive its price is tointerest rate charges.As we will see momentarily, you should keep the following in mind when looking at abond:1. All other things being equal, the longer the time to maturity, the greater the interest raterisk.2. All other things being equal, the lower the coupon rate, the greater the interest rate risk.Finding the Yield to Maturity: More Trial and ErrorA bond's yield to maturity should not be confused with its current yield, which is abond's annual coupon divided by its price.More on Bond FeaturesFrom a financial point of view, the main differences between debt and equity are thefollowing:1. Debt is not an ownership interest in the firm. Creditors generally do not have votingpower.2. The corporation's payment of interest on debt is considered a cost of doing business andis fully tax deductible. Dividends paid to stockholders are not tax deductible.3. Unpaid debt is liability of the firm. If is it not paid, the creditors can legally claim theassets of the firm. The action can result in liquidation or reorganization, two of thepossible consequences of bankruptcy. Thus, one of the costs of issuing debt is thepossibility of financial failure. This possibility does not arise when equity is issued.Is it Debt or Equity?As a general rule, equity represents an ownership interest, and it is a residual claim.This means that equity holders are paid after debt holders.As a result, the risks and benefits associated with owning debt and equity are different.To give one example, note that the maximum reward for owning a debt security isultimately fixed by the amount of the loan, whereas there is no upper limit to the potentialreward from owning an equity interest.Long-Term Debt: The BasicsUltimately, all long-term debt securities are promises made by the issuing firm to payprincipal when due and to make timely interest payments on the unpaid balance.The IndentureThe bond indenture is a legal document. It can run several hundred pages and generallymakes for very tedious reading. It is an important document, however, because itgenerally includes the following provisions:1. The basic terms of the bonds.2. The total amount of bonds issued.3. A description of property used as security. FIN3403: Corporate FinanceChapter 6: Interest Rates and Bond Valuation4. The repayment arrangements.5. The call provisions.6. Details of the protective covenants.RepaymentA sinking fund is an account managed by the bond trustee for the purpose of repayingthe bonds.The company makes annual payments to the trustee, who then uses the funds to retire aportion of the debt.The trustee does this by either buying up some of the bonds in the market or calling in afraction of the outstanding bonds.The Call ProvisionA call provision allows the company to repurchase, or "call", part or all of the bond issueat stated prices over a specific period. Corporate bonds are usually callable.Protective Covenants protectiendersA protective covenant is that part of the indenture or loan agreement that limits certainactions a company might otherwise wish to take during the term of the loan. Protectivecovenants can be classified into two types: negative covenants and positive (oraffirmative) covenants.A negative covenant is a: thou shalt not" type of covenant. It limits or prohibits actionsthat the company might take.Bond RatingsFirms frequently pay to have their debt rated.The two leading bond-rating firms are Moody's and Standard and Poor's (S&P).The debt ratings are an assessment of the creditworthiness of the corporate issuer.The definitions of creditworthiness used by Moody's and S&P are based on how likelythe firm is to default and the protection creditors have in the event of a default.It is important to recognize that bond ratings are concerned only with the possibility ofdefault.The rating classes and some information concerning them are shown in the followingtable.Investment-Quality BondLow-Quality, Speculative, and/orRatings"Junk" Bond RatingsHigh GradeMediumow GradeVery Low GradeGradeStandard's PoorAAAAAABBBBBBCCCCCCDMoody'sAaaAaABaaBaBCaaCaC FIN3403: Corporate FinanceChapter 6: Interest Rates and Bond ValuationMoody'sS&PAaaAAADebt rated Aaa and AAA has the highest rating. Capacity to payinterest and principal is extremely strong.AaAADebt rated Aa and AA has a very strong capacity to pay interest andrepay principal. Together with the highest rating, this group constitutesthe high-grade bond class.AADebt rated A has a strong capacity to pay interest and repay principal,although it is somewhat more susceptible to the adverse effects ofchanges in circumstances and economic conditions than debt in higher-rated categories.BaaBBBDebt rated Baa and BBB is regarded as having an adequate protectionparameters, adverse economic conditions or changing circumstancesare more likely to lead a to a weakened capacity to pay interest andrepay principal for debt in this category than in higher-rated categories.These bonds are medium-grade obligations.Ba; BBB; BDebt rated in these categories is regarded, on balance, asCaaCCCpredominantly speculative with respect to capacity to pay interest andCaCCrepay principal in accordance with the terms of the obligation. BB andBa indicate the lowest degree of speculation, and Ca, CC, and C thehighest degree of speculation.CCAlthough such debt is likely to have some quality and protectivecharacteristics, these are outweighed by large uncertainties or majorrisk exposures to adverse conditions. Issues rated C by Moody's aretypically in default.DDebt rated D is in default, and payment of interest and/or repayment ofprincipal I sin arrears.Note: At times, both Moody's and S&P use adjustments (called notches) to these ratings.S&P uses plus and minus signs: A+ the strongest A rating and A- the weakest. Moody'suses a 1, 2, or 3 designation, withl being the highest.Beginning in the 1980s, a growing part of corporate borrowing has taken the form of low-grade, or "junk, bonds. If these low grade corporate bonds are rated at all, they are ratedbelow investment grade by the major rating agencies.Government BondsWhen the government wishes to borrow money for more than one year, it sells what areknown as Treasury notes and bonds to the public (in fact, it does so every month).Treasury notes have original maturities ranging from 2 to 10 years, while Treasury bondshave longer maturities, extending out as far as 30 years.State and local governments also borrow money by selling notes and bonds. Such issuesare called municipal notes and bonds, or "munis."Zero Coupon BondsA bond that pays no coupons at all must be offered at a price that is much lower than itsstated value. Such bonds are called zero coupon bonds, or zeroes. FIN3403: Corporate FinanceChapter 6: Interest Rates and Bond ValuationFloating- Rate BondsWith floating-rate bonds (floaters), the coupon payments are adjustable. The adjustmentsare tied to an interest rate index such as the Treasury bill interest rate or the 30-yearTreasury bond rate. The value of a floating-rate bond depends on exactly how the couponpayment adjustments are defined.Other Types of BondsMany bonds have unusual, or exotic, features. Unfortunately, there are far too manyvariations for us to cover in detail here. We therefore focus on only a few of the commontypes.Structured notes are bonds that are based on stocks, bonds, commodities, or currencies.One particular type of structured note has a return based on a stock market index.At expiration, if the stock index has declines, the bond returns the principal. However, ifthe stock index return-say, 80 percent. Another type of structured note will return twicethe stock index return, but with the potential for loss of principal.A convertible bond can be swapped for a fixed number of shares of stock anytime beforematurity at the holder's option. Convertibles are relatively common, but the number hasbeen decreasing in recent years.A put bond allows the holder to force the issuer to buy bonds back at a stated price. Theput feature is therefore the reverse of all call provision and is a relatively newdevelopment.A given bond may have many unusual features. For example, two exotic bonds includeCoCo bonds, which have a coupon payment, and NoNo bonds, which are zero couponbonds.CoCo bonds and NoNo bonds are contingent convertible, putable, callable, subordinatedbonds.The contingent convertible clause is similar to the normal conversion feature, except thecontingency feature must be met.For example, a contingency feature may require that the company stock trade at 110percent of the conversion price for 20 out of 30 days.Valuing a bond of this sort can be quite complex, and the yield to maturity calculation isoften meaningless.SukukWorldwide demand for assets that comply with sharia, or Islamic law and culturaltradition, has grown dramatically.Sukuk bonds totaled about $540 billion in 2019. One of the major differences betweenWestern financial practices and sharia is that Islamic law does not permit charging orpaying riba. or interest. Given our current discussion about bonds, this means that anyonefollowing sharia cannot buy or issue conventional bonds.To accommodate the restriction on interest payments, Islamic bonds, or sukuk, have beencreated.There are many possible structures to sukuk, such as partial ownership in a debt (sukukal-murabaha) or an asset (sukuk al-ijara), there is a binding promise to repurchase acertain asset by the issuer at maturity. FIN3403: Corporate FinanceChapter 6: Interest Rates and Bond ValuationBefore the sukuk matures, rent is paid on the asset. While we have noted that traditionalbons can be relatively illiquid, most sukuk are brought and held to maturity. As a result,secondary markets in sukuk are extremely illiquid.How Bonds Are Bought and SoldMost trading in bonds takes place over the counter, or OTC.Recall that this means that there is no particular place where buying and selling occur.Instead, dealers around the country (and around the world) stand ready to buy and sell.The various dealers are connected electronically.Bond Price ReportingThe next two pieces of information are the bid and asked prices.In general, in any OTC or dealer market, the bid price represents what a dealer is willingto pay for a security, and the asked price (or "ask" price) is what a dealer is willing totake for it.The difference between the two prices is called the bid-ask spread (or "spread"), and itrepresents the dealer profit.Treasury prices are quoted as a percentage of face value. The bid price, or what a dealeris willing to pay for the bond, on the 5/15/2038 bond is 146.230.With a $1,000 face value, this quote represents $1, 462.30. the asked price, or the price atwhich the dealer is willing to sell the bond, is 146.250, or $1462.30.A Note on Bond Price QuotesIf you buy a bond between coupon payment dates, the rpice you pay is usually more thanthe price you are quoted.The reason is that standard convention in the bond market is to quote prices net of"accrued interest." Meaning that accrued interest is deducted to arrive at the quoted price.The quoted price is called the clean price. The price you actually pay, however, includesthe accrued interest.Real Versus Nominal RatesIn examining interest rates, or any other financial market rates such as discount rates,bond yields, rates of return, and required returns, it is often necessary to distinguishbetween real rates and nominal rates.Nominal rates are called "nominal" because they have not been adjusted for inflation,Real rates are rates that have been adjusted for inflationThe Fisher EffectThis third component is usually small, so it is often dropped. The nominal rate is thenapproximately equal to the real rate plus the inflation rate: FIN3403: Corporate FinanceChapter 6: Interest Rates and Bond ValuationThe Term Structure of Structure of Interest RatesFigure 6.5 U.S. Interest rates: 1800 to mld-202016Long-term ratesShort-term rates1412E108642018002040608019002040608020002025Source: Jeremy J. Siegel, Stocks for the Long Run 5th ed. (New York: McGraw-Hill, 2014), as updated by theauthors.he relationship between short- and long-term interest rates is known as the term structure of interest rates.Ibe a little more precise, the term structure of interest rates tells us what nominal interest rates are on default-free, pure discount bonds of all maturities. These rates are, in essence, "pure" interest rates because they involtno risk of default and a single, lump-sum future payment. In other words, the term structure tells us the puretime value of money for different lengths of timeWhen long-term rates are higher than short-term rates, we say that the term structure is upward sloping, andwhen short-term rates are higher, we say it is downward sloping. The term structure also can be "humped.When this occurs, it is usually because rates increase at first, but then begin to decline as we look at longer- atlonger-term rates. The most common shape of the term structure, particularly in modern times, is upwardsloping, but the degree of steepness has varied quite a bit. FIN3403: Corporate FinanceChapter 6: Interest Rates and Bond ValuationFigure 6.7 The Treasury yield curveJanuary 22, 20211.00%0.60%-4.00%1,as CurrentYearSource: www.wsj.com. January 21, 2021As you probably now suspect, the shape of the yield curve is a reflection of the term structure of interest rateIn fact, the Treasury yield curve and the term structure of interest rates are almost the same thing. The onlydifference is that the term structure is based on pure discount bonds, whereas the yield curve is based oncoupon bond yields. As a result, Treasury yields depend on the three components that underlie the termstructure: the real rate, expected future inflation, and the interest rate risk premium.ConclusionIf we combine all of the things we have discussed regarding bond yields, we find thatbond yields represent the combined effect of no fewer than six things.The first is the real rate of interest. On top of the real rate are five premiums representingcompensation for (1) expected future inflation, (2) interest rate risk, (3) default risk, (4)taxability, and (5) lack of liquidity. As a result, determining the appropriate yield on abond requires careful analysis of each of these effects.