Chapter 7

Interest Rates and

Bond Valuation

Slides Prepared By:

Larbi Hammami
Desautels Faculty of
Management
McGill University

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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.
• Know how bond prices are quoted.
• Understand the impact of inflation on interest rates.
• Understand the term structure of interest rates and
the determinants of bond yields.

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7.1 Bonds and Bond Valuation

Bond Definitions
• Bond
• Par value (face value)
• Coupon rate
• Coupon payment
• Maturity date
• Yield or Yield to maturity (YTM)

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Chapter Outline

7.1 Bonds and Bond Valuation

7.2 More on Bond Features
7.3 Bond Ratings
7.4 Some Different Types of Bonds
7.5 Bond Markets
7.6 Inflation and Interest Rates
7.7 Determinants of Bond Yields
Summary and Conclusions
Appendix A
Appendix B
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7.1 Bonds and Bond Valuation

Present Value of Cash Flows as Rates Change

• Bond Value = PV of coupons + PV of face
• Bond Value = PV annuity + PV of lump sum
• Remember, as interest rates increase the PV’s
decrease and vice versa.
• So, as interest rates increase, bond prices decrease
and vice versa.

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7.1 Bonds and Bond Valuation

Valuing a Discount Bond with Annual Coupons

• Consider a bond with a coupon rate of 10% and coupons
paid annually. The par value is $1,000 and the bond has
5 years to maturity. The yield to maturity is 11%.
What is the value of the bond?
− Using the formula:
• B = PV of annuity + PV of lump sum
• B = $100 × [1 – 1/(1.11)5]/0.11 + $1,000/(1.11)5
• B = $369.59 + $593.45 = $963.04
− Using the calculator:
• N = 5; I/Y = 11; PMT = 100; FV = 1000
• CPT PV = –963.04
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7.1 Bonds and Bond Valuation

Valuing a Premium Bond with Annual Coupons

• Suppose you are looking at a bond that has a 10%
annual coupon and a face value of $1,000. There are 20
years to maturity and the yield to maturity is 8%.
What is the value of the bond?
− Using the formula:
• B = PV of annuity + PV of lump sum
• B = $100 × [1 – 1/(1.08)20]/0.08 + $1,000/(1.08)20
• B = $981.81 + $214.55 = $1,196.36
− Using the calculator:
• N = 20; I/Y = 8; PMT = 100; FV = 1000
• CPT PV = –1196.36
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7.1 Bonds and Bond Valuation

Graphical Relationship Between Price and Yield-to-Maturity

1500
1400
1300
1200
1100
1000
900
800
700
600
2% 4% 6% 8% 10% 12% 14%

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7.1 Bonds and Bond Valuation

Bond Prices: Relationship Between Coupon and Yield

• If YTM = coupon rate, then par value = bond price
• If YTM > coupon rate, then par value > bond price
− Why?
− Selling at a discount, called a discount bond.
• If YTM < coupon rate, then par value < bond price
− Why?
− Selling at a premium, called a premium bond.

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7.1 Bonds and Bond Valuation

• The Bond Pricing Equation

Bond Value = C¿

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7.1 Bonds and Bond Valuation

Example - Semiannual Coupons

• Most bonds in Canada make coupon payments
semiannually.
• Suppose you have an 8% semiannual-pay bond with
a face value of $1,000 that matures in 7 years.
If the yield is 10%, what is the price of this
bond?
− The bondholder receives a payment of $40 every
six months (a total of $80 per year).
− The market automatically assumes that the yield
is compounded semiannually.
− The number of semiannual periods is 14.
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7.1 Bonds and Bond Valuation

Example - Semiannual Coupons (cont.)

Bond Price = $ 40×

[ ]
1− 14
1
1.05 $1,000
+ 14 =$901.01
0.05 1.05
− Or PMT = 40; N = 14; I/Y = 5; FV = 1000;
CPT PV = –901.01

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7.1 Bonds and Bond Valuation

Interest Rate Risk

• Arises from fluctuating interest rates.
• Two things determine how sensitive a bond will be
to interest rate risk:
1. Time to Maturity - All other things being equal, the
longer the time to maturity, the greater the interest
rate.
2. Coupon rate - All other things being equal, the
lower the coupon rate, the greater the interest rate
risk.
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7.1 Bonds and Bond Valuation

Figure 7.3 - Interest Rate Risk and Time to Maturity

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7.1 Bonds and Bond Valuation

Computing Yield-to-Maturity
• Yield-to-maturity is the rate implied by the current
bond price.
• Finding the YTM requires trial and error if you do not
have a financial calculator and is similar to the
process for finding r with an annuity.
• If you have a financial calculator, enter N, PV, PMT
and FV, remembering the sign convention (PMT and
FV need to have the same sign, PV the opposite
sign).

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7.1 Bonds and Bond Valuation

Example - Finding the YTM

• Consider a bond with a 10% annual coupon rate, 15
years to maturity and a par value of $1000. The
current price is $928.09.
Will the yield be more or less than 10%?
− N = 15; PV = –928.09; FV = 1000; PMT = 100
CPT I/Y = 11%
=> YTM = 11%

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7.1 Bonds and Bond Valuation

Example - YTM with Semiannual Coupons

• Suppose a bond with a 10% coupon rate and
semiannual coupons has a face value of $1000, 20
years to maturity and is selling for $1,197.93.
Is the YTM more or less than 10%?
What is the semiannual coupon payment?
How many periods are there?
− N = 40; PV = –1197.93; PMT = 50; FV = 1000;
CPT I/Y = 4% (Is this the YTM?)
=> YTM = 4% × 2 = 8%
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7.1 Bonds and Bond Valuation

Table 7.1 Summary of bond valuation

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7.1 Bonds and Bond Valuation

Bond Pricing Theorems

• Bonds of similar risk (and maturity) will be priced to
yield about the same return, regardless of the
coupon rate.
• If you know the price of one bond, you can estimate
its YTM and use that to find the price of the second
bond.
• This is a useful concept that can be transferred to
valuing assets other than bonds.

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7.2 More on Bond Features

Differences Between Debt and Equity

• Debt
− Debt refers to funds owed by the company
towards another party called bondholders,
− Bondholders do not have voting rights.
− Interest is considered a cost of doing business
and is tax deductible.
− Bondholders have legal recourse if interest or
principal payments are missed.
− Excess debt can lead to financial distress and
bankruptcy.
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7.2 More on Bond Features

Differences Between Debt and Equity (cont.)

• Equity
− Equity refers to an ownership interest.
− Common shareholders 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
shareholders have no legal recourse if dividends are
not paid.
− An all-equity firm can not go bankrupt.
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7.2 More on Bond Features

The Bond Indenture

• Contract between the company and the
bondholders; it includes:
− The basic terms of the bonds.
− The total amount of bonds issued.
− A description of property used as security, if
applicable.
− Sinking fund provisions.
− Call provisions.
− Details of protective covenants.
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7.2 More on Bond Features

Bond Classifications
• Registered vs. Bearer Forms
• Security
− Collateral - secured by financial securities.
− Mortgage - secured by real property, normally land or buildings.
− Debentures - unsecured debt with original maturity of 10 years
or more.
− Notes - unsecured debt with original maturity less than 10
years.
• Seniority
− Sinking Fund - Account managed by the bond trustee for early
bond redemption.

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7.2 More on Bond Features

Bond Classifications (cont.)

• Call Provision
− Call premium
− Deferred call
− Call protected
− Canada plus call
• Protective Covenants
− Negative covenants
− Positive covenants

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7.2 More on Bond Features

Bond Characteristics and Required Returns

• The coupon rate depends on the risk characteristics
of the bond when issued.
• Which bonds will have the higher coupon, all else
equal?
− Secured debt versus a debenture
− Subordinated debenture versus senior debt
− A bond with a sinking fund versus one without
− A callable bond versus a non-callable bond

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7.3 Bond Ratings

Bond Ratings - Investment Quality

• High Grade
− DBRS’s AAA - capacity to pay is exceptionally
strong.
− DBRS’s AA - capacity to pay is very strong.
• Medium Grade
− DBRS’s A - capacity to pay is strong, but more
susceptible to changes in circumstances.
− DBRS’s BBB - capacity to pay is adequate, adverse
conditions will have more impact on the firm’s ability
to pay.
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7.3 Bond Ratings

Bond Ratings - Speculative

• Low Grade
− DBRS’s BB, B, CCC, CC
− Considered speculative with respect to capacity to
pay.
• Very Low Grade
− DBRS’s C - bonds are in immediate danger of
default.
− DBRS’s D - in default, with principal and/or
interest in arrears.
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7.4 Some Different Types of Bonds

Stripped or Zero-Coupon Bonds

• Make no periodic interest payments (coupon rate =
0%).
• The entire yield-to-maturity comes from the
difference between the purchase price and the par
value.
• Cannot sell for more than par value.
• Sometimes called zeroes, or deep discount bonds.
• Bondholder must pay taxes on accrued interest
every year, even though no interest is received.

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7.4 Some Different Types of Bonds

Floating Rate Bonds

• Coupon rate floats depending on some index value.
• There is less price risk with floating rate bonds
− The coupon floats, so it is less likely to differ
substantially from the yield-to-maturity.
• Coupons may have a “collar” - the rate cannot go
above a specified “ceiling” or below a specified
“floor”.

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7.4 Some Different Types of Bonds

Other Bond Types

• Catastrophe bonds
• Income bonds
• Convertible bonds
• Put bond (retractable bond)
• There are many other types of provisions that can
be added to a bond and many bonds have several
provisions - it is important to recognize how these
provisions affect required returns.

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7.5 Bond Markets

• Primarily over-the-counter transactions with dealers

connected electronically
• Extremely large number of bond issues, but
generally low daily volume in single issues
• Makes getting up-to-date prices difficult, particularly
on small corporate issues
• Treasury securities are an exception

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7.5 Bond Markets

Figure 7.4 Sample bond quotations

Data from holdings of the iShares ETF XBB
Examples
Bond Price Yield
Canada 2 12/1/2051 104.33 1.81%
Ontario 2.6 06/02/2027 106.89 1.36%
Quebec 3.5 09/01/2026 106.29 1.21%
BMO 3.19 03/01/2028 109.59 1.64%
Bell Canada 3.35 03/12/2025 106.03 1.61%
Cenovus Energy 3.5 02/07/2028 105.72 2.54%
Granite REIT 12/18/2030 98.46 2.56%

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7.6 Inflation and Interest Rates

• Real rate of interest - compensation for change in

purchasing power
• Nominal rate of interest - quoted rate of interest,
includes compensation for change in purchasing
power and inflation

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7.6 Inflation and Interest Rates

The Fisher Effect

• The Fisher Effect defines the relationship between
real rates, nominal rates and inflation
• Exact relationship is (1 + R) = (1 + r)(1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate
• Approximation of the above relationship is:
R=r+h

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7.6 Inflation and Interest Rates

Example
• If we require a 10% real return and we expect
inflation to be 8%, what is the nominal rate?
• R = (1.1) × (1.08) – 1 = 0.188 or 18.8%
• Approximation: R = 10% + 8% = 18%
• Since the real return and expected inflation are
relatively high, there is significant difference between
the actual Fisher Effect and the approximation.

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7.7 Determinants of Bond Yields

Term Structure of Interest Rates

• Term structure is the relationship between time to
maturity and yields, all else equal
• It is important to recognize that we pull out the effect of
default risk, different coupons, etc.
• Yield curve - graphical representation of the term
structure
− Normal - upward-sloping, long-term yields are
higher than short-term yields
− Inverted - downward-sloping, long-term yields are
lower than short-term yields
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7.7 Determinants of Bond Yields

Figure 7.5 Upward-sloping term structure

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7.7 Determinants of Bond Yields

Figure 7.5 Downward-sloping term structure

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7.7 Determinants of Bond Yields

Figure 7.6 Government of Canada yield curve

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7.7 Determinants of Bond Yields

Factors Affecting Required Return

• Default risk premium - remember bond ratings.
• Liquidity premium - bonds that have more frequent
trading will generally have lower required returns.
• Anything else that affects the risk of the cash flows
to the bondholders, will affect the required returns.

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Summary and Conclusions

• You should know:

− How to price a bond or find the yield.
− Bond prices move inversely with interest rates.
− Bonds have a variety of features that are spelled
out in the indenture.
− Bonds are rated based on their default risk.
− Most bonds trade OTC.
− Fisher effect links interest rates and inflation.
− Term structure of interest rates shows the
relationship between interest rates and maturity.
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Quick Quiz

• How do you find the value of a bond and why do

bond prices change?
• What is a bond indenture and what are some of
the important features?
• What are bond ratings and why are they
important?
• How does inflation affect interest rates?
• What is the term structure of interest rates?
• What factors determine the required return on
bonds?

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Appendix A

Duration Hedging
• Duration is the key to measuring interest rate risk.
• Duration measures the combined effect of maturity,
coupon rate, and YTM on bond’s price sensitivity.
− Measure of the bond’s effective maturity
− Measure of the average life of the security
− Weighted average maturity of the bond’s cash
flows

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Appendix A

Duration Hedging (cont.)

Duration Formula
PV ( C1 )× 1+ PV (C 2) ×2+ ⋯ + PV (CT ) ×T
D=
PV

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Appendix B

Callable Bonds and Bond Refunding

• Replacing all or part of a bond issue is called
refunding.
• Bond refunding raises two questions:
− Should firms issue callable bonds?
− If callable bonds have been issued, when should
the bonds be called?

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Appendix B

Should Firms Issue Callable Bonds?

• A call works to the advantage of the issuer.
− If interest rates fall and bond prices go up, the option to
buy back the bonds at the call price is valuable.
− But bondholders demand higher interest rates on callable
bonds.
− Any expected gains to issuer from being allowed to refund
the bond will be offset by higher initial interest rates.
• In bond refunding, firms will typically replace the called bonds
with a new bond issue.
− The new bonds will have a lower coupon rate than the
called bonds.
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