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INTRODUCTION TO

CORPORATE FINANCE
Laurence Booth W. Sean Cleary

Chapter 6 Bond Valuation and Interest


Rates

Prepared by
Ken Hartviksen and Robert Ironside

CHAPTER 6
Bond Valuation and Interest
Rates

Lecture Agenda

Learning Objectives
Important Terms
Basic Structure of Bonds
Valuing Bonds
Bond Yields
Interest Rate Determinants
Other Types of Bonds/Debt Instruments
Summary and Conclusions

Concept Review Questions


Appendix Bond Duration
CHAPTER 6 Bond Valuation and
Interest Rates

6-3

Learning Objectives

The basic features of different types of bonds


How to value bonds given an appropriate discount rate
How to determine the discount rate or yield given the
market value of a bond
How market interest rates or yields affect bond investors
How bond prices change over time
The factors (both domestic and global) that affect
interest rates

CHAPTER 6 Bond Valuation and


Interest Rates

6-4

Important Chapter Terms

Balloon payment
Bills
Bond indenture
Bullet payment
Call prices
Callable bonds
Canada Savings Bonds
Collateral trust bonds
Coupons
Current yield
Debentures
Debt ratings
Default free

Default risk
Discount (premium)
Duration
Equipment trust certificates
Expectations theory
Extendible bonds
Face value
Floating rate bonds
Interest payments
Interest rate parity (IRP)
theory
Interest rate risk
Issue-specific premiums
Liquidity preference theory
Maturity value

CHAPTER 6 Bond Valuation and


Interest Rates

6-5

Important Chapter Terms

Mortgage bonds
Nominal interest rates
Notes
Paper
Par value
Protective covenants
Purchase fund provisions
Real return bonds

Retractable bonds
Risk-free rate
Sinking fund provisions
Spread
Term structure of
interest rates
Term to maturity
Yield curve
Yield to maturity
Zero coupon bond

CHAPTER 6 Bond Valuation and


Interest Rates

6-6

The Basic Structure of Bonds


Bond Valuation and Interest Rates

What is a Bond?
In its broadest sense, a bond is any debt
instrument that promises a fixed income
stream to the holder
Fixed income securities are often classified
according to maturity, as follows:

Less than one year Bills or Paper


1 year < Maturity < 7 years Notes
< 7 years Bonds

CHAPTER 6 Bond Valuation and


Interest Rates

6-8

Basic Structure of Bonds


A typical bond has the following
characteristics:
A fixed face or par value, paid to the holder of the
bond, at maturity
A fixed coupon, which specifies the interest payable
over the life of the bond
Coupons are usually paid either annually or semi-annually

A fixed maturity date

CHAPTER 6 Bond Valuation and


Interest Rates

6-9

Basic Structure of Bonds


Note:
The coupon rate, the maturity date, par value are all
set (fixed) at the time the bond was originally sold to
the market
The coupon rate will reflect the required rates of
interest at the time of bond issue.
After issue, interest rates, and required rates of return
will change. Because everything is fixed except the
required rate of return and the bond price, as rates
change, so too will bond prices!
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 10

Basic Structure of Bonds


Bonds may be either:
Bearer bonds
Registered bonds

Bond indenture - the contract between the


issuer of the bond and the investors who hold it
The market price of a bond is equal to the
present value of the payments promised by the
bond
(See the basic pattern of cash flows from a traditional bond on the next slide)

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 11

Basic Structure of Bonds


Cash Flow Pattern for a Traditional Coupon-Paying Bond
6-1 FIGURE

00

11

II

22

II

33

II

II

nn

II
FF

I = interest payments, and F = principal repayment

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 12

Cash Flow Pattern of a Bond


0

Purchase Coupon
Price
Cash Outflows
to the Investor

Coupon

Coupon

Coupon

Coupon +
Face Value

Cash Inflows
to the Investor

The Purchase Price or Market Price of a bond is simply the present


value of the cash inflows, discounted at the bonds yield-to-maturity
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 13

Bond Features and Provisions


Bond Valuation and Interest Rates

Bond Indenture
The bond indenture is the contract between
the issuer and the holder. It specifies:

Details regarding payment terms


Collateral
Positive & negative covenants
Par or face value (usually increments of $1,000)
Bond pricing usually shown as the price per $100 of
par value, which is equal to the percentage of the
bonds face value

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 15

More Bond Terminology


Term-to-maturity the time remaining to the
bonds maturity date
Coupon rate the annual percentage interest
paid on the bonds face value. To calculate
the dollar value of the annual coupon,
multiply the coupon rate times the face value.
If the coupon is paid twice a year, divide the annual
coupon by two
Example: A $1000 bond with an 8% coupon rate will
have an $80 coupon if paid annually or a $40 coupon
if paid semi-annually.
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 16

Security & Protective Provisions


Mortgage bonds secured by real assets
Debentures either unsecured or secured
with a floating charge over the firms assets
Collateral trust bonds secured by a pledge
of financial assets, such as common stock,
other bonds or treasury bills
Equipment trust certificates secured by a
pledge of equipment, such as railway rolling
stock
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 17

Security & Protective Provisions


Covenants
Positive covenants things the firm agrees to do
Supply periodic financial statements
Maintain certain ratios

Negative covenants things the firm agrees not to


do
Restrictions on the amount of debt the firm can take on
Prevents the firm from acquiring or disposing of assets

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 18

More Bond Features More Bond Features


Call feature allows the issuer to redeem or
pay off the bond prior to maturity, usually at a
premium
Retractable bonds allows the holder to sell
the bonds back to the issuer before maturity
Extendible bonds allows the holder to
extend the maturity of the bond
Sinking funds funds set aside by the issuer
to ensure the firm is able to redeem the bond
at maturity
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 19

Security & Protective Provisions


Convertible bonds can be converted into
common stock at a pre-determined
conversion price

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 20

Bond Valuation
Annual Coupon Payments
Bond Valuation and Interest Rates

Bond Valuation
The value of a bond is a function of:

The bonds par (face) value


Term to maturity
Coupon rate
Investors required rate of return (discount rate is also
known as the bonds yield to maturity)

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 22

Bond Value
General Formula

[ 6-1]

1
1 ( 1 k )n
b
B I
kb

1
F
n
(
1

k
)

Where:
I = interest (or coupon ) payments
kb = the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 23

Bond Valuation: Example


What is the market price of a ten year, $1,000 bond
with a 5% coupon, if the bonds yield-to-maturity is
6%?

1 1 kb n
F
BI

n
k
1

b
b
1 1.06 10
1, 000
50

10
0.06
1.06

Calculator Approach:
1,000
50
10
I/Y
CPT PV 926.40

FV
PMT
N
6

$926.40
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 24

Bond Valuation
Semi-Annual Coupon Payments
Bond Valuation and Interest Rates

Bond Valuation: Semi-Annual Coupons


So far, we have assumed that all bonds have annual
pay coupons. While this is true for many Eurobonds, it
is not true for most domestic bond issues, which have
coupons that are paid semi-annually
To adjust for semi-annual coupons, we must make
three changes:
Size of the coupon payment (divide the annual coupon payment
by 2 to get the cash flow paid each 6 months )
Number of periods (multiply number of years to maturity by 2 to
get number of semi-annual periods)
Yield-to-maturity (divide by 2 to get the semi-annual yield)
Once you solve for the semi-annual yield, you will want to
convert it back to an annualized rate of return (YTM).
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 26

Bond Valuation: Semi-Annual Coupons


For example, suppose you want to value a 5 year,
$10,000 Government of Canada bond with a 4%
coupon, paid twice a year, given a YTM of 6%.

kb
1

I
2

B
kb
2

400

2 n

$9,146.98

kb
1

.06
1
2
0.06
2

Calculator Approach:
10,000
FV
400 2 =
PMT
5x2=
N
6 2 = I/Y
CPT PV 926.40

2n

2 x 5

10, 000
.06
1

2 x5

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 27

Factors Affecting Bond Prices


Bond Valuation and Interest Rates

Factors Affecting Bond Prices


There are three factors that affect the price
volatility of a bond

Yield to maturity
Time to maturity
Size of coupon

We will look at each of these in turn.

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 29

Inverse Relationship Between Bond


Prices and Yields to Maturity
When interest rates (required rate of return
on the bond) increase, bond prices fall.

(See Figure 6 2 on the next slide)

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 30

Factors Affecting Bond Prices


Bond Price-Yield Curve
6 - 2 FIGURE

Price ($)

Market Yield (%)

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 31

Bond Convexity
The convexity of the price/YTM graph reveals
two important insights:
The price rise due to a fall in YTM is greater than the
price decline due to a rise in YTM, given an identical
change in the YTM
For a given change in YTM, bond prices will change
more when interest rates are low than when they are
high

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 32

Coupon Rate Relationship to Yield-toMaturity


The relationship between the coupon rate and the
bonds yield-to-maturity (YTM) determines if the
bond will sell at a premium, at a discount or at par
If

Then

Bond Sells at a:

Coupon < YTM

Market < Face

Discount

Coupon = YTM

Market = Face

Par

Coupon > YTM

Market > Face

Premium

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 33

Factors Affecting Bond Prices


Inverse Relationship Between Yields and Prices

Yield to maturity (investors required return)


Bond prices go down when the YTM goes up
Bond prices go up when the YTM goes down
Look at the graph on the next slide. It shows how
the price of a 25 year, 10% coupon bond changes
as the bonds YTM varies from 1% to 30%
Note that the graph is not linear instead it is
said to be convex to the origin

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 34

Price & Yield: 25 Year Bond, 10% Coupon


As interest rates
increase, bond prices
fall, but fall at a
decreasing rate

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 35

Other Factors Affecting Bond Prices


Term to Maturity and Size of Coupon

Term to maturity - long bonds have greater


price volatility than short bonds
Size of coupon low coupon bonds have
greater price volatility than high coupon
bonds

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 36

Other Factors Affecting Bond Prices


Time to Maturity

Time to maturity
Long bonds have greater price volatility than short
bonds
The longer the bond, the longer the period for which the
cash flows are fixed
More distant cash flows are affected more in the
discounting process (remember the exponential nature of
compoundingand that discounting is the inverse of
compounding)
The most distant cash flow from a bond investment is the
most important (it is the face value of the bond) and this
cash flow is affected the greatest in the discounting
process.
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 37

Other Factors Affecting Bond Prices


Size of the Coupon Rate

Size of coupon
Low coupon bonds have greater price volatility
than high coupon bonds
High coupons act like a stabilizing device, since a
greater proportion of the bonds total cash flows occur
closer to today & are therefore less affected by a change
in YTM
The greatest price volatility is found with stripped bonds
(no coupon payments)

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 38

Interest Rate Risk & Duration


The sensitivity of bond prices to changes in
interest rates is a measure of the bonds
interest rate risk
A bonds interest rate risk is affected by:

Yield to maturity
Term to maturity
Size of coupon

These three factors are all captured in one


number called Duration
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 39

Duration
Duration is a measure of interest rate risk
The higher the duration, the more sensitive
the bond is to changes in interest rates
A bonds duration will be higher if its:
YTM is lower
Term to maturity is longer
Coupon is lower

(See the Appendix to this slide set for a complete discussion of duration)

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 40

Bond Quotations
Bond Valuation and Interest Rates

Bond Prices
Discount and Premium Priced Bonds

Bonds trading at prices > par - premium


priced
Bonds trading at prices < par discount
priced

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 42

Bond Quotations
Issuer

Coupon

Maturity

Price

Yield

Canada

5.500

2009-Jun-01

103.79

4.16

The bond equivalent yield


The bonds maturity
date.
The
bonds price is in
to maturity (BEY) It takes on meaning
on the
dollars
assuming a par
The
coupon
rate
in
percent.
The
issuer
of
the
bond.
expressed in percent on anbond reportingvalue
pageof $100. Since this
annualized basis.
because there bond
will beprice
a is greater than
current date. The
$100, it is called a
difference betweenpremium
the two priced bond.
dates is the number of
years to maturity.
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 43

Cash Versus Quoted Prices


The quoted price is the price reported by the
media
The cash price is the price paid by an investor
The cash price includes both the quoted price plus
any interest that has accrued since the last coupon
payment date

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 44

Cash Versus Quoted Price: Example

Assume that you want to purchase a $1,000


bond with a 5% coupon, paid semi-annually.
Today is July 15th. The last coupon was paid
June 30th. If the quoted price is $902, how
much is the cash price?

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 45

Cash Versus Quoted Price: Solution


The cash price is equal to:
Quoted price of $902
Plus 15 days of interest

Cash price = Quoted Price+ Accrued Interest


15

365

902 1, 000 0.05


902 2.05
$904.05

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 46

Bond Yields
Bond Valuation and Interest Rates

Bond Yields
The Yield to Maturity = Investors Required Rate of Return

Yield-to-maturity (YTM) the discount rate


used to evaluate bonds
The yield earned by a bond investor who:

Purchases the bond at the current market price


Holds the bond to maturity
Reinvests all of the coupons at the YTM for the remaining
term to maturity (the reinvestment rate assumption)

Is the bonds Internal Rate of Return (IRR)

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 48

Bond Yield to Maturity

[ 6-2]

1
1

( 1 YTM)n
B I
YTM

1
F
n
(
1

YTM)

The yield to maturity is that discount rate that causes


the sum of the present value of promised cash flows to
equal the current bond price.
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 49

Solving for YTM


To solve for YTM, solve for YTM in the following
formula:

1 1 YTM n
F
BI

n
YTM
1 YTM

There is a Problem:
You cant solve for YTM algebraically; therefore, must either
use a financial calculator, Excel, trial & error or approximation
formula.

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 50

Solving for YTM


Example: What is the YTM on a 10 year, 5% coupon
bond (annual pay coupons) that is selling for $980?
1 1 YTM n
F
BI

n
YTM
1 YTM

1 1 YTM 10
1, 000
980 50

10
YTM
1 YTM

Financial Calculator
1,000 FV
980 +/- PV
50
PMT
51
N
I/Y
5.26%

YTM 5.26%

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 51

Solving for YTM: Semi-annual Coupons


When solving for YTM with a semi-annual pay
coupon, the yield obtained must be multiplied
by two to obtain the annual YTM
Example: What is the YTM for a 20 year,
$1,000 bond with a 6% coupon, paid semiannually, given a current market price of
$1,030?

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 52

Solving for YTM: Semi-annual Coupons


What is the YTM for a 20 year, $1,000 bond with a 6%
coupon, paid semi-annually, given a current market price of
$1,030?

1 1 YTM n
F
BI

n
YTM
1

YTM

1 1 YTM 40
1, 000
1, 030 30

40
YTM
1 YTM

YTM 2.87 x 2 5.74%

Financial Calculator
1,000
FV
1,030 +/- PV
30
PMT
40
N
I/Y
2.87 x 2
= 5.746%

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 53

Using the Approximation Formula to


Solve for Yield to Maturity
Bond Valuation and Interest Rates

The Approximation Formula


This formula gives you a quick estimate of the
yield to maturity
It is an estimate because it is based on a linear
approximation (again you will remember the
exponential nature of compound interest)

Should you be concerned with the error


inherent in the approximated YTM?

NO
Remember a YTM is an ex ante calculation as a
forecast, it is based on assumptions which may or
may not hold in this case, therefore as a forecast or
estimate, the approximation approach should be fine.
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 55

The Approximation Formula


F = Face Value = Par Value = $1,000
B = Bond Price
I = the semi annual coupon interest
N = number of semi-annual periods left to maturity

F-B
I
Semi - annual Yield to Maturity n
FB
2
YTM 2 semi - annual YTM
YTM (1 semi - annual YTM) 2 1

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 56

Example
Find the yield-to-maturity of a 5 year 6%
coupon bond that is currently priced at $850.
(Always assume the coupon interest is paid
semi-annually.)
Therefore there is coupon interest of $30 paid semi-annually
There are 10 semi-annual periods left until maturity

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 57

Example with Solution


Find the yield-to-maturity of a 5 year 6% coupon bond
that is currently priced at $850. (Always assume the
coupon interest is paid semi-annually.)
$1,000 $850
F-B
$30
I
$15 $30
10
Semi - annual Yield to Maturity n

0.0486
FB
$1,850
$925
2
2
YTM 2 semi - annual YTM 0.0486 2 0.09273 9.3%
YTM (1 semi - annual YTM) 2 1 (1.0486) 2 1 9.97%

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Theactual
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CHAPTER 6 Bond Valuation and
Interest Rates

6 - 58

The Logic of the Equation


Approximation Formula for YTM

The numerator simply represents the average semi-annual


returns on the investmentit is made up of two
components:
The first component is the average capital gain (if it is a discount bond)
or capital loss (if it is a premium priced bond) per semi-annual period.
The second component is the semi-annual coupon interest received.

The denominator represents the average price of the bond.


Therefore the formula is basically, average semi-annual
return on average investment.
Of course, we annualize the semi-annual return so that we
can compare this return to other returns on other
investments for comparison purposes.
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 59

Yield To Call
Bond Valuation and Interest Rates

Yield to Call
If a bond has a call feature, the issuer can call
the bond prior to its stated maturity
To calculate the yield to call, simply replace
the maturity date with the first call date

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 61

Yield to Call

[ 6-3]

1
1

( 1 YTC)n
B I
YTC

1
CP
n
(
1

YTC)

The yield to call is that discount rate that causes the


present value of all promised cash flows including the
call price (CP) to equal the current bond price.
CHAPTER 6 Bond Valuation and
Interest Rates

6 - 62

Solving for YTC: Semi-annual Coupons


YTC on a 20-year 6 percent bond that is callable in five years at a call price of
$1,050. The bond pays semi-annual coupons and is selling for $1,030.

Financial Calculator
1,050
FV
1,030 +/- PV
30
PMT
10
N
I/Y
3.081 x 2
= 6.16%

1
( 1 YTC)n
B I
CP
YTC
( 1 YTC)n

$1,050
( 1 YTC)10
$1,030 $30

10
YTC

( 1 YTC)

YTC 3.081% semi annually


YTC 3.081% 2 6.16%

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 63

Current Yield
Bond Valuation and Interest Rates

Current Yield
The current yield is the yield on the bonds current
market price provided by the annual coupon
It is not a true measure of the return to the bondholder because
it does not consider potential capital gain or capital losses based
on the relationship between the purchase price of the bond and
its par value.

[ 6-4]

Annual interest
CY
B

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 65

Current Yield
Example

The current yield is the yield on the bonds current


market price provided by the annual coupon
Example: If a bond has a 5.5% annual pay coupon and
the current market price of the bond is $1,050, the
current yield is:

Annual Coupon
Current Market Price
55

1, 050
5.24%

Current Yield =

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 66

Short-Term Interest Rates


Bond Valuation and Interest Rates

Interest Rate Determinants


Interest is the price of money
Interest rate changes are often measured in Basis
points 1/100 of 1%

Interest rates go:


Up when the demand for loanable funds rises
Down when the demand for loanable funds falls

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 68

Risk-free Interest Rate


Usually use the yield on short federal
government Treasury bills as a proxy for the
risk-free rate (RF)
The risk-free rate is comprised of two
components:
Real rate compensation for deferring consumption
Expected inflation compensation for the expected
loss in purchasing power
(See Figure 6 3 to see rates of inflation and yields on long Canada bonds since
1961)

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 69

Inflation and Yields over Time


6 - 3 FIGURE

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 70

Fisher Equation
If we call the risk-free rate the nominal rate, then
the relationship between the real rate, the
nominal rate and expected inflation is usually
referred to as the Fisher Equation (after Irving
Fisher)

[ 6-5]

RF Real rate Expected inflation

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 71

Fisher Equation
When inflation is low, can safely use the
approximation formula:

RNominal = RReal + Expected Inflation


When inflation is high, use the exact form of the
Fisher Equation:

1 RNominal = 1 RReal 1 Expected

CHAPTER 6 Bond Valuation and


Interest Rates

Inflation

6 - 72

Fisher Equation
Example

If the real rate is 3% and the nominal rate is 5.5%,


what is the approximate expected future inflation
rate?

RNominal = RReal + Expected Inflation


5.5 3 Expected Inflation
Expected Inflation 2.5%

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 73

Global Influences on Interest Rates


Canadian domestic interest rates are heavily
influenced by global interest rates
Interest rate parity (IRP) theory states that FX
forward rates will be established that equalize
the yield an investor can earn, whether
investing domestically or in a foreign
jurisdiction
A country with high inflation and high interest rates will
have a depreciating currency

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 74

Term Structure of Interest Rates


(Long-term Interest Rates)
Bond Valuation and Interest Rates

Term Structure of Interest Rates


Is that set of rates (YTM) for a given risk-class
of debt securities (for example, Government
of Canada Bonds) at a given point in time.
When plotted on a graph, the line is called a
Yield Curve

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 76

Term Structure of Interest Rates


The Yield Curve is the graph created by putting term
to maturity on the X axis, YTM on the Y axis and then
plotting the yield at each maturity.
The four typical shapes of yield curves:
Upward sloping (the most common and persistent shape historically
when short-term interest rates and inflation are low)
Downward sloping (occurs at peaks in the short-term interest rate
cycle, when inflation is expected to decrease in the future)
Flat (occurs when rates are transitioning)
Humped (occurs when rates are transitioning or perhaps market
participants are attracted in large numbers to particular maturity
segment of the market)
(See Figure 6-4 for Yield curves that existed at various times in Canada)

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 77

Historical Yield Curves


1990, 1994, 1998, 2004
6 - 4 FIGURE
16
14
12

Percent

10
8
6
4
2
0

1 mth

3 mths

6 mths

1 yr

2yrs

5 yrs

7 yrs

10 yrs

30 yrs

Term Left to Maturity


1990

1994

1998

CHAPTER 6 Bond Valuation and


Interest Rates

2004

6 - 78

Theories of the Term Structure


Three theories are used to explain the shape
of the term structure
Liquidity preference theory
Investors must be paid a liquidity premium to hold less
liquid, long-term debt

Expectations theory
The long rate is the average of expected future short interest
rates

Market segmentation theory


Distinct markets exist for securities of different maturities

CHAPTER 6 Bond Valuation and


Interest Rates

6 - 79

Term Structure of Interest Rates


Risk Premiums

More risky bonds (ie. BBB rated Corporate Bonds) will


have their own yield curve and it will plot at higher
YTM at every term to maturity because of the default
risk that BBBs carry
The difference between the YTM on a 10-year BBB
corporate bond and a 10-year Government of Canada
bond is called a yield spread and represents a defaultrisk premium investors demand for investing in more
risky securities.
Spreads will increase when pessimism increases in the
economy
Spreads will narrow during times of economic
expansion (confidence)
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Yield Curves for Different Risk Classes


Risk Premiums (Yield Spreads)

16
14
12

Yield
Spread

Percent

10
8
6
4
2
0

1 mth

3 mths

6 mths

1 yr

2yrs

5 yrs

7 yrs

10 yrs

30 yrs

Term Left to Maturity


BBB Corporates

Government of Canada Bonds

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Risk Premiums
The YTM on a corporate bond is comprised of:

[ 6-6]

k b YTM RF / - Maturity yield differential Spread

The maturity yield differential is explained by the term


structure
Spread is the additional yield due to default risk
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Debt Ratings
All publicly traded bonds are assigned a risk
rating by a rating agency, such as Dominion
Bond Rating Service (DBRS), Standard &
Poors (S&P), Moodys, Fitch, etc.
Bonds are categorized as:
Investment grade top four rating categories (AAA,
AA, A & BBB)
Junk or high yield everything below investment
grade (BB, B, CCC, CC, D, Suspended)

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Why do Bonds Have Different Yields?

Default risk the higher the default risk, the


higher the required YTM
Liquidity the less liquid the bond, the higher
the required YTM
Call features increase required YTM
Extendible feature reduce required YTM
Retractable feature reduce required YTM

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Other Types of Bonds/Debt Instruments


Bond Valuation and Interest Rates

Treasury Bills
Short-term obligations of government with an initial
term to maturity of one year or less
Issued at a discount & mature at face value
The difference between the issue price and the face
value is treated as interest income
To calculate the price of a T bill, use the following
formula:

PT Bill

F
n
1 BEY
B

Where:
P = market price of the T Bill
F = face value of the T Bill
BEY = the bond equivalent yield
n = the number of days until maturity
B = the annual basis (365 days in Canada)

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Treasury Bills: Example


What is the price of a $1,000,000 Canadian T bill with
80 days to maturity and a BEY of 4.5%?

PT Bill

B
1, 000, 000

80
1 .045

365
$990, 233.32
1 BEY

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Solving for Yield on a T Bill


To solve for the yield on a T bill, rearrange the previous
formula and solve for BEY.
Example: What is the yield on a $100,000 T bill with
180 days to maturity and a market price of $98,200?

F P B

P n
100, 000 98, 200 365

98, 200
180
3.72%

BEY

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Zero Coupon Bonds


A zero coupon bond is a bond issued at a
discount that matures at par or face value
A zero coupon bond has no reinvestment rate
risk, since there are no coupons to be
reinvested
To calculate the price of a zero coupon bond,
solve for the PV of the face amount

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Zero Coupon Bonds


Example: What is the market price of a $50,000
zero coupon bond with 25 years to maturity that is
currently yielding 6%?

1 kb

50, 000

1.06

25

$11, 649.93
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Floating Rate & Real Return Bonds


Floating rate bonds have a coupon that floats
with some reference rate, such as the yield on
T bills
Because the coupon floats, the market price will
typically be close to the bonds face value

Real return bonds are issued by the


Government of Canada to protect investors
against unexpected inflation
Each period, the face value of the bond is grossed up
by the inflation rate. The coupon is then paid on the
grossed up face value.
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Canada Savings Bonds


A Canada Savings Bond (CSB) is a special type of bond
issued by the Government of Canada
It is issued in two forms:
Regular interest interest is paid annually
Compound interest interest compounds over the life of the
bond

CSBs are redeemable at any chartered bank in Canada


at their face value plus accrued interest (after the first
three months after issue)
There is no secondary market for CSBs (they are nonnegotiable meaning that they cannot be traded in a
market between investors.
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Summary and Conclusions


In this chapter you have learned:
About the nature of bonds as an investment
How to value a bond using discounted cash flow
concepts
About the determinants of interest rates and theories
used to explain the term structure of interest rates

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Concept Review Questions


Bond Valuation and Interest Rates

Concept Review Question 1


Bonds and Mortgages

In what ways are bonds different from


mortgages?

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Appendix A Bond Duration


Bond Valuation and Interest Rates

Duration
An alternative measure of bond price sensitivity is the bonds
duration.
Duration measures the life of the bond on a present value
basis.
Duration can also be thought of as the average time to receipt
of the bonds cash flows.
The longer the bonds duration, the greater is its sensitivity to
interest rate changes.

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Duration Rules-of-Thumb
Duration of zero-coupon bond (strip bond) = the term left until
maturity.
Duration of a consol bond (ie. a perpetual bond) = 1 + (1/k)
where: k = required yield to maturity

Duration of an FRN (floating rate note) = 1/2 year

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Other Duration Rules-of-Thumb


Duration and Maturity

Duration increases with maturity of a fixed-income asset, but at a decreasing


rate.

Duration and Yield

Duration decreases as yield increases.

Duration and Coupon Interest

The higher the coupon or promised interest payment on the security, the lower
its duration.

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Economic Meaning of Duration


duration is a direct measure of the interest rate sensitivity
or elasticity of an asset or liability. (ie. what impact will a
change in YTM have on the price of the particular fixedincome security?)
interest rate sensitivity is equal to:
dP
P

= - D [ dk/(1+k)]

Where:
P=
C = Coupon (annual)
k = YTM
N = Number of periods
F = Face value of bond

Price of bond

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Interest Rate Elasticity


the percent change in the bonds price
caused by a given change in interest rates
(change in YTM)

(The following slide illustrates how bond price sensitivity can be graphed
against changing discount rates)

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Price Elasticity of Stripped Bonds


30 year stripped bond price given different YTM.

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Price Sensitivity of a Stripped Bond


Take our previous example where a $20,000 30-year stripped
bond has a required rate of return of 12%:
P0

= $20,000(PVIFn=30, k = 12%)
= $20,000 (.0334)
= $668.00

Assume now that interest rates fall by 16.7% from 12% to 10%.
What is the percentage change in price of the bond?
P0

= $20,000(PVIFn=30, k = 10%)
= $20,000 (.0573)
= $1,146.00

Percentage change in price = ($1,146 - $668) / $668


=71.6%

This stripped bond had a 71.6% increase in price with a 2% decrease


(200 bp) decrease in required rate of return.
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Duration and Coupon Rates


A bonds duration is affected by the size of the coupon rate
offered by the bond.
The duration of a zero coupon bond is equal to the bonds term to
maturity. Therefore, the longest durations are found in stripped bonds or
zero coupon bonds. These are bonds with the greatest interest rate
elasticity.
The higher the coupon rate, the shorter the bonds duration. Hence the
greater the coupon rate, the shorter the duration, and the lower the
interest rate elasticity of the bond price.

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Duration
The numerator of the duration formula represents the present value of
future payments, weighted by the time interval until the payments
occur. The longer the intervals until payments are made, the larger will
be the numerator, and the larger will be the duration. The
denominator represents the discounted future cash flows resulting
from the bond, which is the bonds present value.
n

Ct (t )

t
t 1 (1 k )
DUR n
Ct

t
t 1 (1 k )
where : Ct the coupon or principal payment generated by the bond
t the time at which the payments are provided
k the bond ' s yield to maturity

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Duration Example

A Formula-based Duration Calculation for a Three Year, 7% Coupon Bond


As an example, the duration of a bond with $1,000 par value and a 7
percent coupon rate, three years remaining to maturity, and a 9
percent yield to maturity is:

$70
$70(2) $1070(3)

1
2
(1.09) (1.09)
(1.09) 3
DUR
$70
$70
$1070

1
2
(1.09) (1.09) (1.09) 3
2.80 years

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Duration Example
A Formula-based Duration Calculation for a Zero Coupon Bond
As an example, the duration of a zero-coupon bond with $1,000 par
value and three years remaining to maturity, and a 9 percent yield to
maturity is:

$1000(3)
(1.09) 3
DUR
$1000
(1.09) 3
3.0 years

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Example of a Duration Calculation


Using a Spreadsheet Model

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Duration of a Portfolio

Bond portfolio mangers commonly attempt to immunize their


portfolio, or insulate their portfolio from the effects of interest
rate movements.
This is a common challenge when the investment portfolio is
dedicated to funding a future liability.

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Duration of a Portfolio
Insurance Company Example
A life insurance company knows that they need $100 million 30 years from
now cover actuarially-determined claims against a group of life insurance
policies just no sold to a group of 30 year olds.
The insurance company has invested the premiums into 30-year government
bonds. Therefore there is no default risk to worry about. The company
expects that if the realized rate of return on this bond portfolio equals the
yield-to-maturity of the bond portfolio, there wont be a problem growing that
portfolio to $100 million. The problem is, that the coupon interest payments
must be reinvested and there is a chance that rates will fall over the life of the
portfolio.
If this happens the portfolios terminal value will be less than the liability the
insurance company needs to finance. This shortfall in investment returns will
have to be borne at the expense of the Insurance companys shareholders.

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Duration of a Portfolio ...


Interest Rate Risk

The life insurance company example illustrates a key risk in


fixed-income portfolio management - interest rate risk.
The portfolio manager, before-the-fact calculates the bond
portfolios yield-to-maturity. This is an ex ante calculation.
As such, a nave assumption assumption is made that the
coupon interest received each year is reinvested at the yieldto-maturity for the remaining years until the bond matures.
Over time, however, interest rates will vary and reinvestment
opportunities will vary from that which was forecast.

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Duration of a Portfolio
Immunization

The insurance company will want to IMMUNIZE their portfolio


from this reinvestment risk.
The simplest way to do this is to convert the entire bond
portfolio to zero-coupon/stripped bonds. Then the ex ante
yield-to-maturity will equal ex post (realized) rate of return.
(ie. the ex ante YTM is locked in since there are no
intermediate cash flows the require reinvestment).
If the bond portfolio manager matches the duration of the bond
portfolio with the expected time when they will require the
$100 m, then interest rate risk will be largely eliminated.

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Copyright
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this
work beyond that permitted by
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