Bonds, Bond Valuation, and Interest RatesCHAPTER 5© 2020 Cen.docx

Bonds, Bond Valuation, and Interest Rates
CHAPTER 5
© 2020 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password-protected website for
classroom use.
Topics in Chapter
Key features of bonds
Bond valuation
Measuring yield
Assessing risk
classroom use.
Determinants of Intrinsic Value: The Cost of Debt
classroom use.
Key Features of a Bond (1 of 2)
Par value: Face amount; paid at maturity. Assume $1,000.
Coupon interest rate: Stated interest rate. Multiply by par

value to get dollars of interest. Generally fixed.
classroom use.
Key Features of a Bond (2 of 2)
Maturity: Years until bond must be repaid. Declines.
Issue date: Date when bond was issued.
Default risk: Risk that issuer will not make interest or principal
payments.
classroom use.
Call Provision
Issuer can refund if rates decline. That helps the issuer but
hurts the investor.
Therefore, borrowers are willing to pay more, and lenders
require more, on callable bonds.
Most bonds have a deferred call and a declining call premium.
classroom use.
What’s a sinking fund?
Provision to pay off a loan over its life rather than all at
maturity.

Similar to amortization on a term loan.
Reduces risk to investor, shortens average maturity.
But not good for investors if rates decline after issuance.
classroom use.
Sinking funds are generally handled in 2 ways
Call x% at par per year for sinking
fund purposes.
Call if rd is below the coupon rate and bond sells at a premium.
Buy bonds on open market.
Use open market purchase if rd is above coupon rate and bond
sells at a discount.
classroom use.
Value of a 10-year, 10% coupon bond if rd = 10%
classroom use.
The bond consists of a 10-year, 10% annuity of $100/year plus a

$1,000 lump sum at t = 10:PV annuity= $614.46PV maturity
value= 385.54Value of bond= $1,000.00
classroom use.
What would happen if expected inflation rose by 3%, causing r
= 13%?
When rd rises, above the coupon rate, the bond’s value falls
below par, so it sells at a discount.
classroom use.
What would happen if inflation fell, and rd declined to 7%?
If coupon rate > rd, price rises above par, and bond sells at a
premium.
classroom use.
Bond Value ($) vs. Years remaining to Maturity
(1 of 2)
Suppose 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%?
See next slide.
classroom use.
(2 of 2)
classroom use.
(2 of 3)
At maturity, the value of any bond must equal its par value.
The value of a premium bond would decrease to $1,000.
The value of a discount bond would increase to $1,000.
A par bond stays at $1,000 if rd remains constant.
classroom use.
What’s “yield to maturity”?
YTM is the rate of return earned on a bond held to maturity.
Also called “promised yield.”

It assumes the bond will not default.
classroom use.
YTM on a 10-year, 9% annual coupon, $1,000 par value bond
selling for $887
classroom use.
Find rd
classroom use.
If coupon rate < rd, bond sells at a discount.
If coupon rate = rd, bond sells at its par value.
If coupon rate > rd, bond sells at a premium.
If rd rises, price falls.
Price = par at maturity.

classroom use.
Find YTM if price were $1,134.20.
Sells at a premium.
Because coupon = 9% > rd = 7.08%,
bond’s value > par.
classroom use.
Definitions
classroom use.
9% coupon, 10-year bond, P = $887, and YTM = 10.91%

classroom use.
YTM = Current yield + Capital gains yield.
Could also find values in Years 1 and 2,
get difference, and divide by value in
Year 1. Same answer.
classroom use.
Semiannual Bonds
1. Multiply years by 2 to get periods = 2N.
2. Divide nominal rate by 2 to get periodic rate =
rd/2.
3. Divide annual INT by 2 to get PMT = INT/2.
classroom use.
Value of 10-year, 10% coupon, semiannual bond if rd = 13%.
classroom use.

Spreadsheet Functions for Bond Valuation
See Ch04 Mini Case.xls for details.
PRICE
YIELD
classroom use.
Callable Bonds and Yield to Call
A 10-year, 10% semiannual coupon,
$1,000 par value bond is selling for
$1,135.90 with an 8% yield to maturity.
It can be called after 5 years at $1,050.
classroom use.
Nominal Yield to Call (YTC)
classroom use.
If you bought bonds, would you be more likely to earn YTM or
YTC?
Coupon rate = 10% vs. YTC = rd = 7.53%. Could raise money

by selling new bonds which pay 7.53%.
Could thus replace bonds which pay $100/year with bonds that
pay only $75.30/year.
Investors should expect a call, hence YTC = 7.5%, not YTM =
8%.
classroom use.
In general, if a bond sells at a premium, then coupon > rd, so a
call is likely.
So, expect to earn:
YTC on premium bonds.
YTM on par & discount bonds.
classroom use.
rd = r* + IP + MRP + DRP + LP.
classroom use.
What is the real risk-free rate (r*)?

Rate that a hypothetical riskless security pays each moment if
zero inflation were expected.
r* changes over time depending on economic conditions.
r* can be approximated by rate on short-term Treasury
Inflation-Protected Securities (TIPS).
classroom use.
What is the nominal risk-free rate (rRF)?
The rate on a U.S. Treasury security
Short-term security: T-bill
Long-term security: T-bond
classroom use.
Estimating IP
Treasury Inflation-Protected Securities (TIPS) are indexed to
inflation.
The IP for a particular length maturity can be approximated as
the difference between the yield on a non-indexed Treasury
security of that maturity minus the yield on a TIPS of that
maturity.
classroom use.

Bond Spreads, the DRP, and the LP
A “bond spread” is often calculated as the difference between a
corporate bond’s yield and a Treasury security’s yield of the
same maturity. Therefore:
Spread = DRP + LP.
Bond’s of large, strong companies often have very small LPs.
Bond’s of small companies often have LPs as high as 2%.
classroom use.
Bond RatingsBond Ratings% defaulting within:S&P and Fitch
Moody’s 1 yr. 5 yrs.Investment grade
bonds:AAAAaa0.130.68AAAa0.000.00AA0.090.96BBBBaa0.07
1.72Junk bonds:BBBa0.626.35BB2.0611.68CCCCaa21.3635.38
classroom use.
Bond Ratings and Bond Spreads (October 2016)Long-term
BondsYield (%)Spread (%) 10-Year T-bond1.72
AAA2.210.49 AA 2.270.55 A 2.420.70 BBB3.461.74 BB
5.163.44 B 6.584.86 CCC8.376.65
classroom use.

What factors affect default risk and bond ratings?
Financial ratios
Debt ratio
Coverage ratios, such as interest coverage ratio or EBITDA
coverage ratio
Profitability ratios
Current ratios
classroom use.
Bond Ratings Median Ratios (S&P)Return on capital Debt to
capitalAAA27.6%12.4%AA27.0%28.3%A17.5%37.5%BBB13.4
%42.5%BB11.3%53.7%B8.7%75.9%CCC3.2%113.5%
classroom use.
Other Factors that Affect Bond Ratings (1 of 2)
Provisions in the bond contract
Secured versus unsecured debt
Senior versus subordinated debt
Guarantee provisions
Sinking fund provisions
Debt maturity

classroom use.
Other Factors that Affect Bond Ratings (2 of 2)
Other factors
Earnings stability
Regulatory environment
Potential product liability
Accounting policies
classroom use.
Interest rate (or price) risk for 1-year and 10-year 10% bonds
Interest rate risk:
Rising rd causes bond prices to fall1-Year1-Year10-Year10-
YearrdPrice
ChangePriceChange5.0%$1,048$1,3864.8%38.6%10.0%$1,000$
1,0004.5%33.5%15.0%$957$749
classroom use.
Value

classroom use.
What is reinvestment rate risk? (1 of 2)
The risk that CFs will have to be reinvested in the future at
lower rates, reducing income.
Illustration: Suppose you just won $500,000 playing the
lottery. You’ll invest the money and live off the interest. You
buy a 1-year bond with a YTM of 10%.
classroom use.
What is reinvestment rate risk? (2 of 2)
Year 1 income = $50,000. At year-end get back $500,000 to
reinvest.
If rates fall to 3%, income will drop from $50,000 to $15,000.
Had you bought 30-year bonds, income would have remained
constant.
classroom use.
The Maturity Risk Premium
Long-term bonds: High interest rate risk, low reinvestment rate
risk.
Short-term bonds: Low interest rate risk, high reinvestment rate
risk.
Nothing is riskless!
Yields on longer term bonds usually are greater than on shorter
term bonds, so the MRP is more affected by interest rate risk

than by reinvestment rate risk.
classroom use.
Term Structure Yield Curve
Term structure of interest rates: the relationship between
interest rates (or yields) and maturities.
A graph of the term structure is called the yield curve.
classroom use.
Hypothetical Treasury Yield Curve
classroom use.
Bankruptcy (1 of 4)
Two main chapters of Federal Bankruptcy Act:
Chapter 11, Reorganization
Chapter 7, Liquidation
Typically, company wants Chapter 11, creditors may prefer
Chapter 7.

classroom use.
Bankruptcy (2 of 4)
If company can’t meet its obligations, it files under Chapter 11.
That stops creditors from foreclosing, taking assets, and
shutting down the business.
Company has 120 days to file a reorganization plan.
Court appoints a “trustee” to supervise reorganization.
Management usually stays in control.
classroom use.
Bankruptcy (3 of 4)
Company must demonstrate in its reorganization plan that it is
“worth more alive than dead.”
Otherwise, judge will order liquidation under Chapter 7.
classroom use.
If the company is liquidated, here’s the payment priority:
Past due property taxes
Secured creditors from sales of secured assets.
Trustee’s costs
Expenses incurred after bankruptcy filing
Wages and unpaid benefit contributions, subject to limits

Unsecured customer deposits, subject to limits
Taxes
Unfunded pension liabilities
Unsecured creditors
Preferred stock
Common stock
classroom use.
Bankruptcy (4 of 4)
In a liquidation, unsecured creditors generally get zero. This
makes them more willing to participate in reorganization even
though their claims are greatly scaled back.
Various groups of creditors vote on the reorganization plan. If
both the majority of the creditors and the judge approve,
company “emerges” from bankruptcy with lower debts, reduced
interest charges, and a chance for success.
classroom use.
(
)
(
)
(
)
B

1NN
ddd
$100$100$1,000
V...
1r1r1r
$90.91...$38.55$385.54
$1,000.
=+++
+++
=+++
=
(
)
(
)
(
)
(
)
(
)
(
)
B
1NN
ddd
1NN
ddd
INTINTM
V...
1r1r1r
90901,000
887...
1r1r1r
=+++
+++

=+++
+++
Annual coupon pmt
Current yield
Current price
Change in price
Capital gains yield
Beginning price
Exp totalreturn= YTM ExpCurr yldExp cap
gains yld
=
=
=+
$90
Current yield
$887
0.101510.15%.
=
==
Cap gains yieldYTMCurrent yield
10.91%10.15%
0.76%.
=-
=-
=
Here:
rd Required rate of return on a debt se
curity.
r* Real riskfree rate.
IP Inflation premium.
MRP Maturity risk premium.
DRP Default risk premium.
LP Liquidity premium.
=
=-
=

=
=
=
Privacy Policies of YOUR FIRM
Executive Summary
This section of the Course Paper, which may be named whatever
you like (e.g., “Executive Summary,” “Introduction,”
“Preamble,” etc.), should only be a handful of sentences;
certainly no more than a page. Here, your team will describe the
nature of your business. You should explain what your firm
does, who your customers are, and briefly mention any other
key stakeholders in light of privacy concerns. This is also the
place to list your team members. And, finally, in this section,
you should explain to your audience—i.e., your company’s
staff—why privacy is important in your business. Essentially,
this is where you “sell” your audience on the fact that they must
abide by your company’s privacy policies.
Policy Statements
Policy 1.1 Policy Statement Section Overview
This is where you organize and list each applicable privacy
policy statement. These are the rules that govern your
company’s actions, and those of your staff. You need to
determine an organization schema. Look around online to find
examples of a useful style. Or, you may choose to use your
current workplace documentation as a go-by.
Policy 1.2 Policy Statements Contents
The contents of these policies should contain at least the
following features:
· The policy, itself, such as “Reasonable Expectation of Privacy
for Employees.”
· The laws, regulations, or standards that relate to the policy at
issue.
· An example, when applicable, that helps your audience
understand the policy.

· Directions on how to effect the policy. For example, if your
company processes payments by credit or debit cards, and your
policy is something like “Anyone who processes payments via
payment cards must conform their actions to PCI DSS standards
related to privacy.” then you may want to insert a link to those
standards. Or, perhaps, incorporate examples as mentioned
directly above.
This list is not exhaustive. Depending on the set of facts, you
may need to include more.
Policy 1.3 Comprehensive Policy Statements
The Policy Statements must be a comprehensive body. Do not
omit the discussion of laws that may apply to your business.
This means that you must understand what your business does,
and its privacy implications. Every company has employees, so
employees’ privacy must be addressed. While it is debatable, I
have discussed that any HRIS, or a company’s personnel records
kept otherwise, has the propensity to contain medical
information that we now know to refer to as “PHI.” Thus, you
should have some policy that governs handling those data vis-à-
vis privacy. Could your company be known as a “financial
institution?” If so, you must discuss GLB Act privacy policies.
The point is that in three to five pages you must tell your
employees everything they need to know about maintaining
appropriate privacy while conducting your business.
Policy 2.1 Scoring the Course Paper
The Course Paper is worth 100 points. I will give up to ten
points for the submission's form and format. That includes its
organization, page count and team size, and grammar and
spelling. The form and format is important because if a policy
document is disorganized, contains typographical errors, or is
hard to read otherwise, employees will not respect or even use it
as the guidance it is meant to be. Consider a numbering or
another outline styled structure to identify policy clauses.
I will give up to ten additional points for the introductory

section, and whether you included all of the required
information.
I will give up to 80 points for the policy statements. Questions I
will have in mind when reviewing your policy statements
include, Did the team incorporate what we've learned about
privacy? Can the document be read and understood by all levels
of an organization? Are the policies concise, or vague and
wordy?
Policy 2.2 Writing Assistance
Writing assistance is available by emailing a copy of your file
to the International Academic Services office (yes, even if you
are not an international student) at [email protected]. I highly
recommend that you give the IAS Team at least two or three
business days to review your work. Take into consideration the
fact that you will likely need to respond to their efforts with
some rewriting of your own, and you can start to calculate how
much in advance of the due date you should be planning on
sending them a draft.
Policy 3.1 Cautionary Tales From Prior Submissions
Here are some of the ways that students have lost points in prior
years:
· Teams and pages. Do not submit as an individual; you must be
part of a team. Do not exceed the page count. Only use
Microsoft Word (.doc or .docx) or Adobe PDF format. Each
team member must individually submit a copy of the team’s
work. You cannot rely on one member’s submission. And, when
two team members submit dissimilar work, it evinces a non-
functioning team.
· This is not a website privacy policy document. While one of
your company’s policies, assuming you have a website, should
be that your websites must include the proper policy statements,
this is not an assignment on writing a website policy statement.
If you are submitting a “Terms of Use” or “Privacy Notice,” you
are not following the requirement that your policies must
govern your business. Website Privacy Statements are aimed at

users of your website.
· Don’t skip the obvious. If you are an insurance company, and
fail to draft a policy that addresses HIPAA privacy, that’s a big
omission. If children may access your website, you better
include some acknowledgement of COPPA and CIPA’s privacy
laws. See, Policy 1.3, above.
· Get going now. While having up to five people working on
this can make it very easy to accomplish, you cannot wait until
the end of the course to start.
· Perfect the writing. Spelling errors, syntax and grammar
issues, and other poor English writing artifacts all take away
from the credibility of your policies. When your company does
not care enough to write well, your employees will not care
enough about privacy to help you avoid risks.
· This is a policy document. In some prior examples, valuable
paper “real estate” was wasted on describing marketing plans,
or a company’s history, or other immaterial data. The
introductory section is important, but it is not the crux of this
learning objective.
There are other ways that students have lost points, so please
consider the entire body of instructions and requirements.
These, in my opinion, came up often enough, or were easy
enough to avoid, to include for your benefit.

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