Interest Rates and Bond Valuation. Chapter 7. Key Concepts and Skills. Know the important bond features and bond types Understand bond values and why they fluctuate Understand bond ratings and what they mean Understand the impact of inflation on interest rates
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Interest Rates and Bond Valuation
1.Par value: Face amount; paid at maturity. Assume $1000.
2.Coupon interest rate: Stated interest rate. Multiply by par to get $ of interest. Generally fixed.
example - of Louisiana bearer bond - paid $181.25 semi-annually (how much per year)??
par value = $5000; coupon rate = ??
3.Maturity: Years until bond must be repaid. Declines.
4.Issue date: Date when bond was issued.
. . .
B = ?
100 + 1000
= $90.91 + . . . + $38.55 + $385.54
The bond consists of a 10-yr, 10%
annuity of $100/yr plus a $1,000
lump sum at t = 10:
PV maturity value
Value of bond
INPUTS1010 100 1,000
NI/YR PV PMTFV
What would happen if expected inflation rose by 3%, causing r = 13%?
1013 100 1000
NI/YR PV PMTFV
When r rises, above the coupon rate, the bond’s value falls below par, so it sells at a discount.
107 100 1,000
NI/YR PV PMTFV
When r falls, below the coupon rate,
the bond’s value rises above par,
so it sells at a premium.
The bond was issued 20 years ago and now has 10 years to maturity. What would happen to its value over time if the required rate of return remained at 10%, or at 13%, or at 7%?
Bond Value ($)
3025 20 15 10 5 0
Years remaining to Maturity
Interest rate risk: Rising r causes bond’s price to fall. Longer maturity bond is more sensitive to r change than shorter maturity bond
Not an ownership interest
Creditors do not have voting rights
Interest is considered a cost of doing business and is tax deductible
Creditors have legal recourse if interest or principal payments are missed
Excess debt can lead to financial distress and bankruptcy
Common stockholders vote for the board of directors and other issues
Dividends are not considered a cost of doing business and are not tax deductible
Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid
An all equity firm can not go bankrupt
Current yield=Annual coupon pmt.
Cap gains yield=Change in price
Coupon rate =Annual coupon payment
Exp. total= YTM = Expected + Exp. Capital
return Curr. yld.gains yield
“Real” versus “nominal” rates
= real risk-free rate.
T-Bond rate if no inflation;
1% to 4%.
= any nominal rate.
= Rate on T-securities.
r= Real risk-free rate
h= Inflation premium
DRP= Default risk premium
LP= Liquidity premium
MRP= Maturity risk premium
Gross U.S. Treasury Issuance (in blue)
Investment Grade Corporate Bond Issuance (in red)
Billions of dollars
‘95 ‘96 ‘97 ‘98 ‘99
In late 1990s, the volume of investment grade corporate bond issues has overtaken Treasury issues because US government had a surplus & did not need to issue so much debt.