Balanced scorecard slide 1

WELCOME
CORPORATE
FINANCE 2020
VO AN HAI, MSc.
 Bond Valuation and the
Structure of Interest Rates
LEARNING OBJECTIVES
1. Describe the market for corporate bonds and
three types of corporate bonds.

2.Understanding
Explain how the financial statementsthe
to calculate and value of a bond
why it is important
and why bond prices vary negatively with
interest rate movements.

3.Understanding
Distinguish between
the balance sheet,aincome
bond’s coupon rate,
yield and
statement to maturity, and effective annual yield.
cash flows in details

4. Explain why investors in bonds are subject to

interest rate risk and why it is important to
understand the bond theorems.

5. Discuss the concept of default risk and know

how to compute a default risk premium.

6. Describe the factors that determine the level

and shape of the yield curve.
3
 Corporate Bonds
Market for Corporate Bonds
• Life insurance companies and pension
funds buy most corporate bonds
- Transactions tend to be in very large dollar amounts.
• Less than 1% of all corporate bonds are
traded on organized exchanges
- Most transactions take place through dealers in the over-the-counter
(OTC) market.
 Corporate Bonds
Market for Corporate Bonds
• Only a small fraction of the bonds
outstanding are traded each day.
- The market is thin compared to markets for money-market securities and
stocks.
- Corporate bonds are less marketable than securities with large daily
trading volumes.
- Prices in the market tend to be more volatile than those of securities with
greater trading volumes.
 Corporate Bonds
Bond Price Information
• Corporate bond pricing is not considered
transparent.
- It is difficult for investors to obtain important information on prices and
volume.
- Many transactions are negotiated directly between buyer and seller with
little centralized reporting of transaction details.
 Corporate Bonds
Features of Corporate Bonds
• Face (par) value: is the amount on which
interest is calculated and that is owed to the
bondholder when a bond reaches maturity
• Coupon payment: the interest payments
made to
bondholders
• Coupon rate: is the annual coupon payment
(C) divided by a bond’s face value (F)
 Corporate Bonds
Features of Corporate Bonds

Face (Par) value: $1000

Coupon payment: $80
Coupon rate: 8%
 Vanilla Bonds
Types of Corporate Bonds
• Vanilla bond
- coupon payments fixed for the life of the bond
- repay principal and retire the bonds at maturity
- contracts have the features and provisions found in most bond covenants.
- annual or semiannual coupon payments
 Zero Coupon Bonds
Types of Corporate Bonds
• Zero coupon bond
- no coupon payments
- pays face value at maturity.
- sell at deep discount
 Convertible Bonds
Types of Corporate Bonds
• Convertible bonds
- may be exchanged for shares of the firm’s stock
- sells for a higher price than a comparable non-convertible bond
- bondholders benefit if the market value of the company’s stock gets high
enough
 Bond Valuation
Calculate Bond Price
• Determine the required rate-of-return
• Determine expected future cash flows –
the coupon payments and par value
• Compute the current market value, or
price (PB) by calculating the present
value of the expected cash flows

PB = PVCoupon Payments+ PVPar Value

 Bond Valuation
General equation for the price of a bond
C C C F
P  1
 2
 ...  n n
(8.1)
(1  i ) (1  i ) (1  i )
B 1 2 n
Cash Flows for a Three-Year
Bond
 Cash Flows for a Three-Year
Bond
Example:
Bond price: Your friend recommends that you invest in a three-year bond issued by
Trimer, Inc., that will pay annual coupons of 10 percent. Similar investments today will
yield 6 percent. How much should you pay for the bond? (Round to the nearest dollar.)

A. $1,024
B. $979
C. $886
D. $1,107
 Cash Flows for a Three-Year
Bond
Bond price: Your friend recommends that you invest in a three-year bond issued by
Trimer, Inc., that will pay annual coupons of 10 percent. Similar investments today will
yield 6 percent. How much should you pay for the bond? (Round to the nearest dollar.)

C1 C2 Cn
A. $1,024 PB    .......... 
B. $979 (1  i ) (1  i ) 2 (1  i ) n
C. $886  1   1 
D. $1,107 1 
 (1  i ) n  1 
 (1.06)3  $1, 000
F
C   n
$100   3
 i  (1  i )  0.06  *(1.06)
   
$267.30  $839.62 $1,106.92
 Bond Valuation
Par, Premium, and Discount Bonds
• If a bond’s coupon rate is equal to the its
yield, its price equals its face value; it is a
par bond
Example: Suppose that you own a three-year
bond with a face value of $1,000 and an annual
coupon rate of 5 percent. If the market rate of
interest on similar bonds is 5%.
The price of your bond is :
 Bond Valuation
Par, Premium, and Discount Bonds
• If a bond’s coupon rate is less than its yield,
its price is less than its face value; it is a
discount bond

Example:

• If a bond’s coupon rate is greater than its

yield, its price is greater than its face value; it
is a premium bond
 Bond Valuation
Semiannual Compounding
• Most bonds issued in Europe pay annual
coupons, most issued in the U.S. pay
semiannual coupons
• Eq. 8.2 shows how to value bonds that pay
semi-annual coupons

C m C m C m C m F
P     ...  mn
( 8 .2 )
(1  i m ) (1  i m ) (1  i m ) (1  i m )
B 1 2 3 mn
 Bond Valuation
Semiannual Compounding Example
• What is the price of a three-year, 5%
coupon bond with a market yield of 8%
and semi-annual coupon payments?
- Semi-annual market yield = 8%/2 = 4%
- Semi-annual coupon payment = $50/2 = $25
$25 $25 $25 $25 $25 $25  $1000
P      
(1.04) (1.04) (1.04) (1.04) (1.04) (1.04)
B 1 2 3 4 5 6

$24.04  $23.11  $22.22  $21.37  $20.55  $810.07

$921.36
 Bond Valuation
Semiannual Compounding Example
Bond price: Jane Thorpe has been offered a seven-year bond issued by Barone, Inc., at
a price of 943.22. The bond has a coupon rate of 9 percent and pays the coupon
semiannually. Similar bonds in the market will yield 10 percent today. Should she buy
the bonds at the offered price? (Round to the nearest dollar.)

A.Yes, the bond is worth more at $1,015.

B. No, the bond is only worth $921.
C. Yes, the bond is worth more at $951.
D. No, the bond is only worth $912.
 Bond Valuation
Semiannual Compounding Example
Bond price: Jane Thorpe has been offered a seven-year bond issued by Barone, Inc., at
a price of 943.22. The bond has a coupon rate of 9 percent and pays the coupon
semiannually. Similar bonds in the market will yield 10 percent today. Should she buy
the bonds at the offered price? (Round to the nearest dollar.)

A.Yes, the bond is worth more at $1,015.

B. No, the bond is only worth $921.
C. Yes, the bond is worth more at $951.
D. No, the bond is only worth $912.
 Bond Valuation
Zero Coupon Bonds
• Zero coupon bonds do not make coupon
payments but pay their face value at
maturity
• The price (or yield) of a zero coupon bond
is a special case of Equation 8.2, where
all coupon payments equal zero
 Bond Valuation
Zero Coupon Bonds
• Pricing equation for a zero coupon bond
F
P  mn
( 8.3 )
(1  i m )
B mn

• Zero coupon bonds pay cash only at

maturity and must sell for less than
similar bonds which make periodic
interest payments
 Bond Valuation
Zero Coupon Bond Price Example
• What is the price of a zero coupon bond
with a $1,000 face value, 10-year
maturity, and semiannual compounding?
The market rate on similar bonds is 12%.
$1000 $1000
P   $311 .80
(1  0.12 2) (1  0.06)
B 20 20
 Bond Valuation
Zero Coupon Bond Price Example
Zero coupon bonds: Jarmine Corp. is planning to fund a project by issuing 10-year
zero coupon bonds with a face value of $1,000. Assuming semiannual coupons to be
the norm, what will be the price of these bonds if the appropriate discount rate is 14
percent? (Round to the closest answer.)

A. $852
B. $258
C. $419
D. $841
 Bond Valuation
Zero Coupon Bond Price Example
Zero coupon bonds: Jarmine Corp. is planning to fund a project by issuing 10-year
zero coupon bonds with a face value of $1,000. Assuming semiannual coupons to be
the norm, what will be the price of these bonds if the appropriate discount rate is 14
percent? (Round to the closest answer.)

A. $852
B. $258
C. $419
D. $841
 Bond Yields
Yield to Maturity (YTM)
• YTM
- the rate that makes the present value of the bond’s cash flows equal the
price of bond
- the rate a bondholder earns if the bond is held to maturity and all coupon
and principal payments are made as promised
 Bond Yields
Yield to Maturity (YTM)
• YTM
Example: Suppose you decide to buy a three-year bond with a 6 percent coupon
rate for $960.99. Calculate the YTM?
 Bond Yields
Effective Annual Yield
• In bond trading, the EAR is called the
effective annual yield (EAY). The way to
annualize aEAY
bond yield
(1  Quoted rate/m) - 1
m
 Bond Yields
Yield to Maturity and Effective Annual Yield
Example
• An investor buys a 30-year bond with a $1,000 face
value for $800. The bond’s coupon rate is 8% and
interest payments are made semi-annually. What are
the bond’s yield to maturity and effective annual yield?
 Bond Yields
Yield to Maturity and Effective Annual Yield
Example
 Bond Yields
Realized Yield
• The return earned on a bond given the
cash flows actually received by investor
• The interest rate at which the present
value of actual cash flows generated by
the investment equals bond’s price
• The realized yield is important because it
allows investors to see what they actually
earned on their investments.
 Bond Yields
Realized Yield
Example: Let’s return to the situation involving a three-year bond with a 6
percent coupon that was purchased for $960.99 and had a promised yield of 7.5
percent. Suppose that interest rates increased sharply and the price of the bond
plummeted. Disgruntled, you sold the bond for $750.79 after having owned it for
two years.
 Bond Yields
Realized Yield
Example:
 Interest Rate Risk
Bond Theorems
• Bond theorems are statements about the
math used in bond pricing.
- Bond prices are inversely related to interest rate movements.
- As interest rates decline, prices of bonds rise; as interest rates rise, prices
of bonds decline.
- For a given change in interest rates, prices of longer-term bonds change
more than prices of shorter-term bonds.
- Interest rate risk increases as maturity increases, but at a decreasing rate.
Relation Between Bond Price
Volatility and Maturity
Exhibit 8.2 Relation Between Bond Price
Volatility and Maturity
 Interest Rate Risk
Bond Theorems
• For a given change in interest rates,
prices of lower-coupon bonds change
more than prices of higher-coupon bonds.
 Relation Between Bond Price
Volatility and the Coupon Rate
 Interest Rate Risk
Bond Theorem Applications
• If interest rates are expected to increase,
avoid long-term bonds – they will
experience the largest price declines.
• If interest rates are expected to decline,
buy zero-coupon bonds. Their prices will
increase more than those of coupon-
paying bonds.
 The Structure of Interest Rates
Risk Characteristics of Bonds
• Four features of debt instruments are
responsible for most of the differences in
corporate borrowing costs and determine
the level and structure of interest rates:
- Marketability
- Call feature
- Default risk
- Term-to-maturity
 The Structure of Interest Rates
Marketability
• How quickly and easily a security can be
sold at at low transaction cost and at fair
market value
- The selling price varies directly with the degree of marketability.
- The transaction cost varies inversely with the degree of marketability.
- The yield-to-maturity varies inversely with the degree of marketability.
 The Structure of Interest Rates
Marketability
• The difference in yields between a highly
marketable security (ihigh mkt) and a less
marketable security (ilow mkt) is the
marketability risk premium (MRP)
MRP  i high mkt
-i low mkt
 0

• U.S. Treasury bills are considered the

most marketable of all securities
 The Structure of Interest Rates
Call Provision
• Bond issuer’s option to purchase a bond
from the bondholder at a predetermined
price before maturity.
- When bonds are called, bondholders suffer financial loss because they
must surrender higher-yield bonds and replace them with lower-yield
bonds.
 The Structure of Interest Rates
Call Provision
• The difference in interest rates between a callable
bond and a non-callable bond is the call premium
(CIP)
CIP  i - i
call no call
 0

• Callable bonds sell for lower prices and higher

yields than non-callable bonds
• Bonds paying high yields are more likely to be
called when interest rates decline; these bonds
have a high CIP
 The Structure of Interest Rates
Default Risk
• Risk that a borrower may not make payments
as promised
• Lenders are paid a default risk premium for
purchasing securities with default risk
• The default risk premium (DRP) is the
difference between the yield on a security
with default risk, idr, and the risk-free rate, irf
• Yield on T-bills is a proxy for the risk-free
rate.
 The Structure of Interest Rates
Bond Ratings
• Individuals and small businesses rely on
outside agencies for information on the
default potential of bonds.
- The two most prominent credit rating agencies are Moody’s Investors
Service (Moody’s) and Standard & Poor’s (S&P).
Both services rank bonds in order of probability of default and publish ratings
as letter grades.
 The Structure of Interest Rates
Bond Ratings
• The highest grade bonds have the lowest
default risk and are rated Aaa or AAA.
- Investment grade bonds are rated Aaa to Baa.
- State and federal laws typically require commercial banks, insurance
companies, pension funds, certain other financial institutions, and
government agencies to purchase only investment-grade securities.
Corporate Bond Rating Systems
Default Risk Premiums for
Selected Bond Ratings
Exhibit 8.5 Default Risk Premiums for
Selected Bond Ratings
 The Structure of Interest Rates
Term Structure of Interest Rates
• The term structure of interest rates
- the relationship between yield to maturity and term-to-maturity on a
bond
- the graph of the term structure of interest rates is a yield curve
The shape and position of the yield curve are not constant.
As the overall level of interest rates changes, the yield curve shifts up and
down and changes its shape and slope.
 The Structure of Interest Rates
basic shapes (slopes) of yield curves
1. Ascending or normal yield curves slope
upward from left to right and imply
higher interest rates are likely
2. Descending or inverted yield curves
slope downward from left to right and
imply lower interest rates are likely
3. Flat yield curves imply interest rates
unlikely to change
 The Structure of Interest Rates
Shape of the Yield Curve
• Three factors that influence the shape of
the yield curve
- 1) Real rate of interest
- 2) Expected rate of inflation
- 3) Interest rate risk
 The Structure of Interest Rates
The Real Rate of Interest
• The real rate of interest changes with the
business cycle.
- Highest rates occur at the end of an economic expansion.
- Lowest rates occur at the end of an economic contraction.
- Changes in the expected future real rate of interest can affect the slope of
the yield curve.
 The Structure of Interest Rates
The Expected Rate of Inflation
• If higher inflation is forecast, the yield
curve will slope upward because longer-
term yields will contain a larger inflation
premium than shorter-term yields
• If investors believe inflation will subside,
the yield curve will slope downward
 The Structure of Interest Rates
Interest Rate Risk
• The longer the maturity of a security, the
greater its interest rate risk – the risk of
selling the security at a lower price - and
the higher its yield-to-maturity
• The interest rate risk premium adds
upward bias to the slope of the yield
curve
Yield Curves for Treasury Securities at
Three Different Points in Time
Exhibit 8.6
Balanced scorecard slide 10

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