Bus 342
Fundamentals of Corporate
Finance
Chapter 7
Interest Rates and Bond Valuation
Contents
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Bond Basics
Bond Valuation
Interest Rate Risk
Bond Types
Bond Ratings
Bond Features
Bond Markets
Interest Rates, Inflation, and Term Structure
Bond Basics
Face
Value,
Coupons (annual, semiannual, …)
Zero-Coupon Bond
Par
Value
Maturity
Coupon Rate = Annual Coupon / Face Value
Yield to Maturity (YTM) or “yield”: the interest
rate required in the market on a bond.
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Example
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A treasury bond with a $10,000 face
value, a coupon rate of 5.25% and a
maturity date of Aug. 15, 2003.
Annual coupon payment is
$10,000 X 5.25% = $525
$525 / 2 = $262.50
An actual coupon payment of $262.50
every six months
Semiannual Coupons
Finding the Yield to Maturity (YTM)
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Bond Valuation
Interest Rate Risk
• The longer the time to maturity, the greater the
interest rate risk.
• The lower the coupon rate, the greater the interest
rate risk.
Bond Types
• Government Bond: US Treasury bills,
notes, and bonds, no default risk, not
subject to state income tax.
• Other Bonds: with default risk
– Municipal Bonds: not subject to federal tax
– Corporate Bonds: the issue of debt vs. equity
• Payment of interest on debt is considered a cost of
doing business and is fully tax deductible.
• Unpaid debt is a liability of the firm.
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Bond Ratings
• Basis of rating: (both may change over time)
– How likely the firm is to default
– The protection creditors have in the event of a default
• Rating Agencies: Standard & Poor’s, Moody’s
Bond Features
• Registered vs. Bearer forms
• Security:
– Debenture, Note: unsecured
– Bond: strictly speaking, secured. Also a generic term.
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Seniority
Sinking Fund
Call Provisions, Convertible Bonds
Indenture, which may contain Protective Covenants
Coupon vs. Zero-Coupon, Fixed vs. Floating Rate
Bond Markets
• Most trading takes place over the counter
• Huge market, less active,
• Not much transparency
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Bond Markets – US Treasury
Coupon Rate: 6%, meaning $30 coupon payment every six months.
Maturity: Aug. 2009, Bid= 104 + 28/32 = 104.875, Ask=104.9375,
Yesterday’s Ask = 104.9375 + 23/32 = 105.6563
YTM based on ask price is 5.25%.
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Numbers after the hyphens denote
32nds, often called ticks. "+" half tick.
(101+12.75/32)%=101.3984%
Bond Markets – US Treasury
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Treasury Bills: 13, 26, 52 weeks
Treasury Notes: 1 – 10 years
Treasury Bonds: more than 10 years
Strips: each coupon, as well as the
principal, are all issued separately.
• TIPS: Treasury Inflation Protection
Securities
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Treasury Strips
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Zero-coupon bonds issued by the US
Treasury are called STRIPS
STRIPS (Separate trading of
registered interest and principal
securities)
Coupon or interest STRIPS, called
TINT, INT, or C-STRIPS
Principal STRIPS, called TP, P, or PSTRIPS
The International Bond Market
Eurobond and Foreign Bond
• Eurobond: sold outside the country in whose currency the
issue is denominated.
Example: a bond issued by a U.S. firm, denominated in U.S.
dollars, but sold to investors in Europe and Japan.
• Foreign Bond: sold in a country and denominated in the
currency of that country, but the issuer is from another country.
• Example: a firm in Sweden, sells U.S. dollar denominated bond
to U.S. investors.
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Term Structure of Interest Rates
Inflation and Interest Rates
The Fisher Effect
• Nominal Interest Rate
= Real Interest Rate + Expected Inflation
i = r +π
• It is the real interest rate
r that matters
• In hyperinflation cases, use the exact form
i = r + π + rπ
which is from
( 1 + i) = ( 1 + r)( 1 + π)
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