titman_ch_09
TRANSCRIPT
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Debt Valuationand InterestRates
Chapter 9
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Slide Contents
Learning Objectives
Principles Used in This Chapter
1.Overview of Corporate Debt
2.Valuing Corporate Debt
3.Bond Valuation: Four Key Relationships
4.Types of Bonds
5.Determinants of Interest Rates
Key Terms
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Learning Objectives
1. Identify the key features of bonds anddescribe the difference between privateand public debt markets.
2. Calculate the value of a bond and relate itto the yield to maturity on the bond.
3. Describe the four key bond valuationrelationships.
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Learning Objectives (cont.)
4. Identify the major types of corporatebonds.
5. Explain the effects of inflation on interest
rates and describe the term structure ofinterest rates.
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Principles Used in This Chapter
Principle 1: Money Has a Time Value.
Debt securities require that the borrower repaythe lender over time so cash flows have to be
adjusted for time value of money.
Principle 2: There is a Risk-ReturnTradeoff.
The rate used to discount future cash flowsdepends on the risk of default by the borrower.
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Principles Used in This Chapter(cont.)
Principle 3: Cash Flows Are the Source ofValue
Debt securities provide value to the lender
through the interest payments on theoutstanding loan amount and the repayment ofthe loan balance itself.
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9.1 Overview ofCorporate Debt
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Corporate Borrowings
There are two main sources of borrowingfor a corporation:
1. Loan from a financial institution (known asprivate debt)
2. Bonds (known as public debt since they can
be traded in public financial markets)
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Corporate Borrowings (cont.)
Smaller firms choose to raise money frombanks in the form of loans because of thehigh costs associated with issuing bonds.
Larger firms generally raise money frombanks for short-term needs and depend onthe bond market for long-term financingneeds.
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Borrowing Money in the PrivateFinancial Market
Financial Institutions are an importantsource of capital for corporations. The loanmight be used to finance firms day-to-day
operations or it might be used for thepurchase of equipment or property.
Such loans are considered privatemarket transactions since it only
involves the two parties to the loan.
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Borrowing Money in the PrivateFinancial Market (cont.)
In the private financial market, loans aretypically floating rate loans i.e. theinterest rate is periodically adjusted based
on a specific benchmark rate.
The most popular benchmark rate is theLondon Interbank Offered Rate(LIBOR)
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Borrowing Money in the PrivateFinancial Market (cont.)
LIBORis the daily interest rate that isbased on the interest rates at which banksoffer to lend in the London wholesale or
interbank market.
Interbank market is the market where banksloan each other money.
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Borrowing Money in the PrivateFinancial Market (cont.)
For example, a corporation may get a 1-year loan with a rate of 300 basis points(or 3%) over LIBOR with a ceiling of 11%
and a floor of 4%.
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Checkpoint 9.1
Calculating the Rate of Interest on a Floating Rate Loan
The Slinger Metal Fabricating Company entered into a loan agreementwith its bank to finance the firms working capital. The loan called fora floating rate that was 25 basis points (.25%) over an index based onLIBOR. In addition, the loan adjusted weekly based on the closing
value of the index for the previous week within the bounds of amaximum annual rate of 2.5% and a minimum of 1.75%. Calculatethe rate of interest for the weeks 2 through 10.
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Checkpoint 9.1
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Checkpoint 9.1
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Checkpoint 9.1
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Checkpoint 9.1
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Checkpoint 9.1:Check Yourself
Consider the same loan period as above butchange the spread over LIBOR from .25% to .75%.Is the ceiling rate or floor rate violated during theloan period?
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Step 1: Picture the Problem
The graph on the next slide shows theLIBOR index (series 1), LIBOR plus thespread of 75 basis points (series 2) the
ceiling rate (series 3), and the floor rate(series 4).
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Step 1: Picture the Problem (cont.)
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
1 2 3 4 5 6 7 8
InterestRate
Floating Rate Loans
Series1
Series2
Series3
Series4
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Step 2: Decide on a SolutionStrategy
We have to determine the floating rate forevery week and see if it exceeds theceiling or falls below the floor.
Floating rate on Loan
= LIBOR for the previous week + spread of .75%
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Step 2: Decide on a SolutionStrategy
The floating rate on loan cannot exceedthe ceiling rate of 2.5% or drop below thefloor rate of 1.75%.
If the floating rate falls below the floor, therate will be reset at the floor rate.
If the floating rate exceeds the ceiling, the rate
will be reset at the ceiling rate.
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Step 3: SolveLIBOR LIBOR +
Spread(.75%)
Loan Rate
2/29/2008 1.98%
3/7/2008 1.66% 2.73% 2.50%
3/14/2008 1.52% 2.44% 2.41%3/21/2008 1.35% 2.27% 2.27%
3/28/2008 1.60% 2.10% 2.10%
4/4/2008 1.63% 2.35% 2.35%
4/11/2008 1.67% 2.38% 2.38%4/18/2008 1.88% 2.42% 2.42%
4/25/2008 1.93% 2.63% 2.50%
5/2/2008 2.68% 2.50%
CeilingViolated
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Step 3: Solve (cont.)
The table shows the ceiling is violatedduring the first week and last two weeks ofthe loan period. The floor rate is never
violated.
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Step 4: Analyze
The ceiling is the maximum rate charged on theloan while floor is the minimum rate charged onthe loan. If the ceiling or floor rates are violated,the loan rate is reset to the ceiling rate or the
floor rate.
If there were no ceiling, the loan rate would havebeen 2.73% during the first week of the loan, and
2.63% and 2.68% during the last two weeks ofthe loan.
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Borrowing Money in the PublicFinancial Market
Firms also raise money by selling debtsecurities to individual investors andfinancial institutions such as mutual funds.
In order to sell debt securities to thepublic, the issuing firm must meet thelegal requirements as specified by thesecurities laws.
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Borrowing Money in the PublicFinancial Market
Corporate bond is a debt security issuedby corporation that has promised futurepayments and a maturity date.
If the firm fails to pay the promised futurepayments of interest and principal, thebond trustee can classify the firm asinsolvent and force the firm intobankruptcy.
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Basic Bond Features
The basic features of a bond include thefollowing:
Bond Indenture
Claims on Assets and Income Par or Face Value
Coupon Interest Rate
Maturity and Repayment of Principal
Call Provision and Conversion Features
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Bond Ratings and Default Risk
Bond ratings indicate the default risk i.e.the probability that the firm will make thepromised payments.
Bond ratings affect the rate of return thatlenders require of the firm and the firmscost of borrowing.
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Bond Ratings and Default Risk(cont.)
Consistent with Principle 2 (There is aRisk-Return Tradeoff), the lower the bondrating, the higher the risk of default and
higher the rate of return demanded in thecapital market.
Bond ratings are provided by three ratingagencies Moodys, Standard & Poors,and Fitch Investor Services.
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9.2 ValuingCorporate Debt
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Valuing Corporate Debt
The value of corporate debt is equal to thepresent value of the contractuallypromised principal and interest payments
(the cash flows) discounted back to thepresent using the markets required yield.
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Valuing Corporate Debt (cont.)
The valuation of corporate debt relies onthe first three basic principles of finance:
Principle 1: Money Has a Time Value. Principle 2: There is a Risk-Return Tradeoff.
Principle 3: Cash Flows are the Source ofValue.
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Step-by-Step: Valuing Bonds byDiscounting Future Cash Flows
Step 1: Determine the amount and timing ofbondholder cash flows. The total cash flows equalthe promised interest payments and principalpayment.
Annual Interest = Par value coupon rate
Example 9.1: The annual interest for a bond withcoupon interest rate of 7% and a par value of$1,000 is equal to $70, (.07 $1,000 = $70).
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Step-by-Step: Valuing Bonds byDiscounting Future Cash Flows (cont.)
Step 2: Estimate the appropriate discountrate on a similar risk bond. Discount rateis the return the bond will yield if it is held
to maturity and all bond payments aremade.
Discount rate can be either calculated or
obtained from various sources (such asYahoo! Finance).
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Step-by-Step: Valuing Bonds byDiscounting Future Cash Flows (cont.)
Step 3: Calculate the present value of thebonds interest and principal paymentsfrom Step 1 using the discount rate
estimated in step 2.
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Calculating a Bonds Yield toMaturity (YTM)
We can think of YTM as the discount ratethat makes the present value of the bondspromised interest and principal equal to
the bonds observed market price.
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Checkpoint 9.2
Calculating the Yield to Maturity on a CorporateBondCalculate the yield to maturity for the following bond issued by Ford MotorCompany (F) with a price of $744.80, where we assume that interest payments
are made annually at the end of each year and the bond has a maturity ofexactly 11 years.
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Checkpoint 9.2
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Checkpoint 9.2
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Checkpoint 9.2
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Checkpoint 9.2:Check Yourself
Calculate the YTM on the Ford bond wherethe bond price rises to $900 (holding allother things equal).
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Step 1: Picture the Problem
YTM=?
Years
Cash flow -$900 $65 $65 $65 $1,065
Purchase price = $900
Interest payments = $65 per year for years 1-11
Final payment = $1,000 in year 11 of principal.
0 1 2 3 11
St 2 D id S l ti
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Step 2: Decide on a SolutionStrategy
We can use equation 9-2a to find YTM.YTM is the rate that makes the presentvalue of all future expected cash flows
equal to the current market price.
We can also solve for YTM using acalculator and a spreadsheet.
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Step 3: Solve
Using Mathematical Equation
It is cumbersome to solve for YTM by handusing the equation. It is more practical to
use the financial calculator or the spreadsheet.
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Step 3: Solve (cont.)
Using Financial Calculator
Enter:
N = 11
I/Y = 7.89PV = -900
PMT = 65
FV = 1,000
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Step 3: Solve (cont.)
Using an Excel Spreadsheet
YTM = RATE(nper, pmt,pv,fv)
= RATE (11,65,-900,1000)
= 7.89%
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Step 4: Analyze
The yield to maturity on the bond is7.89%. The yield is higher than thecoupon rate of interest of 6.5%. Since the
coupon rate is lower than the yield tomaturity, the bond is trading at a pricebelow $1,000. We call this a discountbond.
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Using Market Yield to Maturity Data
Market yield to maturity is regularlyreported by a number of investor servicesand is quoted in terms ofcredit spreads
or spreads to Treasury bonds.
Table 9-4 contains some examples ofyield spreads.
Using Ma ket Yield to Mat it Data
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Using Market Yield to Maturity Data(cont.)
The spread values in table 9-4 represent basispoints over a US Treasury security of the samematurity as the corporate bond. For example, a
30-year Ba1/BB+ corporate bond has a spread of275 basis points over a similar 30-year USTreasury bond.
Thus this corporate bond should earn 2.75% overthe 4.56% earned on treasury yield or 7.31%.
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Promised Returns versus Expected
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Promised Returns versus ExpectedYield to Maturity
The yield to maturity calculation assumesthat the bond performs according to theterms of the bond contract or indenture.
Since corporate bonds are subject to riskof default, the promised yield to maturitymay not be equal to expected yield tomaturity.
Promised Returns versus Expected
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Promised Returns versus ExpectedYield to Maturity (cont.)
Example 9.2 Consider a one-year bondthat promises a coupon rate of 8% andhas a principal (par value) of $1,000.
Further assume the bond is currentlytrading for $850. What is the promisedyield to maturity?
Promised Returns versus Expected
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Promised Returns versus ExpectedYield to Maturity (cont.)
Promised YTM
= {(Interest year 1 + Principal) (Bond Value)} 1
= {($80+$1,000) ($850)} 1
= 27.06%
Promised Returns versus Expected
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Promised Returns versus ExpectedYield to Maturity (cont.)
The yield of 27.06% is based on theassumption of no default.
Assume there is a 40% probability ofdefault on this bond and if the bonddefaults, the bondholders will receive only60% of the principal and interest owed.
What is the expected YTM on this bond?
Promised Returns versus Expected
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Promised Returns versus ExpectedYield to Maturity (cont.)
YTMdefault= {(Interest year 1 + Principal)} (Bond Value)} 1
= {($80+$1000) .60} ($850)} 1
= -23.76%
Promised Returns versus Expected
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Promised Returns versus ExpectedYield to Maturity (cont.)
= (27.06 .60) + (-23.76 .40)
= 6.73%
The financial press quotes promised yield
and not expected YTM.
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Checkpoint 9.3
Valuing a Bond IssueConsider a $1,000 par value bond issued by AT&T (T) with a maturitydate of 2026 and a stated coupon rate of 8.5%. On January 1, 2007, thebond had 20 years left to maturity, and the markets required yield tomaturity for similar rated debt was 7.5%. If the markets required yield tomaturity on a comparable risk bond is 7.5%, what is the value of thebond?
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Checkpoint 9.3
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Checkpoint 9.3
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Checkpoint 9.3
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Checkpoint 9.3:Check Yourself
Calculate the present value of the AT&T bondshould the yield to maturity for comparable riskbonds rise to 9% (holding all other things equal).
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Step 1: Picture the Problem
i= 9%
Years
Cash flows $85 $85 $85 $1,085
0 1 2 3 20
PV of allCash flows=?
$85 annualinterest $85 interest
+ $1,000Principal
Step 2: Decide on a Solution
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Step 2: Decide on a SolutionStrategy
Here we know the following:
Annual interest payments = $85
Principal amount or par value = $1,000
Time = 20 years
YTM or discount rate = 9%
We can use the above information to
determine the value of the bond bydiscounting future interest and principalpayment to the present.
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Step 3: Solve
Using Mathematical Equation
Bond Value
= $ 85{[1-(1/(1.09)20] (.20)} +$1,000/(1.09)20
= $85 (9.128) + $178.43
= $954.36
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Step 3: Solve (cont.)
Using an Excel Spreadsheet
Bond Value = PV (rate, nper, pmt, fv)
= PV (.09,20,85,1000)= $954.36
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Step 4: Analyze
The value of AT&T bond falls to $954.36when the yield to maturity for comparablerisk bond rises to 9%. The bonds are nowtrading at a discount as the coupon rate onAT&T bonds is lower than the market yield.
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Step 4: Analyze (cont.)
An investor who buys AT&T bonds at itscurrent discounted price will earn apromised yield to maturity of 9%.
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Semiannual Interest Payments
Corporate bonds typically pay interest tobondholders semiannually. We can adaptEquation (9-2a) from annual tosemiannual payments as follows:
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Checkpoint 9.4
Valuing a Bond Issue That PaysSemiannual InterestReconsider the bond issued by AT&T (T) with a maturity date of2026 and a stated coupon rate of 8.5%. AT&T pays interest to
bondholders on a semiannual basis on January 15 and July 15.On January 1, 2007, the bond had 20 years left to maturity. Themarkets required yield to maturity for a similarly rated debtwas 7.5% per year or 3.75% for six months. What is the valueof the bond?
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Checkpoint 9.4
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Checkpoint 9.4
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Checkpoint 9.4
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Checkpoint 9.4
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Checkpoint 9.4:Check Yourself
Calculate the present value of the AT&T bondshould the yield to maturity on comparable bondsrise to 9% (holding all other things equal).
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Step 1: Picture the Problem
i= 9%
Periods
Cash flow $42.5 $42.5 $42.5 $1,042.50
0 1 2 3 40
PV=?
$42.50Semiannualinterest
$42.5 interest+ $1,000Principal
406-monthperiods
Step 2: Decide on a Solution
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pStrategy
Here we know the following: Semiannual interest payments = $42.50
Principal amount or par value = $1,000
Time = 20 years or 40 periods YTM or discount rate = 9% or 4.5% for 6-
months
We can use the above information to
determine the value of the bond bydiscounting future interest and principalpayment to the present.
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Step 3: Solve
Using Mathematical Equation
Bond Value
= $ 42.5{[1-(1/(1.045)40] (.20)} + $1,000/(1.045)40= $42.5 (18.40) + $171.93
= $954
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Step 3: Solve (cont.)
Using a Financial Calculator
Enter:
N = 40
1/y = 4.50 PMT = 42.50
FV = 1000
PV = 954
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Step 3: Solve (cont.)
Using an Excel Spreadsheet
Bond Value = PV (rate, nper, pmt, fv)
= PV (.045,40,42.5,1000)= $954
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Step 4: Analyze
Using semi-annual compounding we get avalue of $954 for AT&T bonds. This is veryclose to the value of $954.26 found usingannual compounding.
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9.3 BondValuation:
Four KeyRelationships
Bond Valuation: Four Key
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yRelationships
First Relationship The value of bond isinversely related to changes in the yield tomaturity.
YTM = 12% YTM rises to15%
Par value $1,000 $1,000
Coupon rate 12% 12%
Maturity date 5 years 5 years
Bond Value $1,000 $899.44
BondValueDrops
Bond Valuation: Four Key
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yRelationships (cont.)
Bond Valuation: Four Key
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Relationships (cont.)
Since future interest rates cannot bepredicted, a bond investor is exposed tothe risk of changing values of bonds asinterest rates change.
The risk to the investor that the value ofhis or her investment will change is known
as interest rate risk.
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Relationships (cont.)
Second Relationship: The market value ofa bond will be less than its par value if theyield to maturity is above the couponinterest rate and will be valued above parvalue if the yield to maturity is below thecoupon interest rate.
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Relationships (cont.)
There are two sources of return from bondinvestment:
Periodic interest payments
Capital gain or loss when the bond is sold
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Relationships (cont.)
When a bond can be bought for less thanits par value, it is called discount bond.For example, buying a $1,000 par valuebond for $950.
Bonds will trade at a discount when theyield to maturity on the bond exceeds the
coupon rate.
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Relationships (cont.)
When a bond can be bought for more thanits par value, it is called premium bond.For example, buying a $1,000 par valuebond for $1,110.
Bonds will trade at a premium when theyield to maturity on the bond is less than
the coupon rate.
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Relationships (cont.)
Third Relationship As the maturity dateapproaches, the market value of a bondapproaches its par value.
Regardless of whether the bond wastrading at a discount or at a premium, theprice of bond will converge towards par
value as the maturity date approaches.
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Bond Valuation: Four Key
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Relationships (cont.)
Fourth Relationship Long term bonds havegreater interest rate risk than short-termbonds.
While all bonds are affected by a change ininterest rates, long-term bonds areexposed to greater volatility as interest
rates change.
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9.4 Types ofBonds
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Types of Bonds
Table 9-7 contains a listing of major types oflong-term debt securities that are sold in thepublic financial market.
The differences among the various types of bondare based on the following bond attributes:Secured versus Unsecured, Priority of claim,Initial offering market, Abnormal risk, Coupon
level, Amortizing or non-amortizing, andConvertibility.
T f B d ( )
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Types of Bonds (cont.)
Secured versus Unsecured
Secured bonds have specific assets pledgedto support repayment of the bond.
Unsecured bond are referred to asdebentures.
Bonds secured by lien on real property is calleda mortgage bond.
T f B d ( t )
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Types of Bonds (cont.)
Priority of Claim The priority of claim refers to the order of
repayment when the firms assets aredistributed, as in the case of liquidation.
Secured bonds are paid first followed bydebentures; Among debentures, subordinateddebentures have lower priority than secureddebt and unsubordinated debentures.
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Types of Bonds (cont.)
Initial Offering Market
Bonds are classified by where they wereoriginally issued (in the domestic bond marketor not).
For example, Eurobonds are issued in aforeign country but are denominated indomestic currency. For example, a US
corporation issuing bonds in Germany in USdollars.
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Types of Bonds (cont.)
Abnormal Risk
Junk, or high-yield, bonds have a below-investment grade bond rating. These bondshave a high risk of default as the firms thatissued these bonds are facing severe financialproblems.
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Types of Bonds (cont.)
Coupon Level
Bonds with a zero or very low coupon arecalled zero coupon bonds.
These bonds are issued at substantial discountsfrom their par value and promise to repay azero or very low coupon rate each year. Thepar value is repaid at the maturity of the bond.
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Types of Bonds (cont.)
Amortizing or Non-Amortizing
The payments from amortizing bonds, like ahome mortgage, include both the interest andprincipal.
The payments from a non-amortizing bondsinclude only interest. At maturity, the bondsrepay the par value of bond.
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Types of Bonds (cont.)
Convertibility
Convertible bonds are debt securities that canbe converted into a firms stock at a pre-specified price.
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9.5 Determinantsof Interest Rates
Determinants of Interest Rates
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Determinants of Interest Rates
As we observed earlier, bond prices varyinversely with interest rates.
Therefore in order to understand bondpricing we need to know the determinantsof interest rates.
Real Rate of Interest and theInflation Premium
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Inflation Premium
Quotes of interest rates in the financialpress are commonly referred to as thenominal (or quoted) interest rates.
Real rate of interest adjusts the nominalrate for the expected effects of inflation.
Real Rate of Interest and theInflation Premium (cont )
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Inflation Premium (cont.)
The nominal return or interest rate on anote or bond can be thought of includingfour basic components:
Fisher Effect
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Fisher Effect
The relationship between the nominal rateof interest, rnominal , the anticipated rate ofinflation, rinflation , and the real rate ofinterest is known as the Fisher effect.
Fisher Effect (cont )
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Fisher Effect (cont.)
Example 9.3 What will be the real rate ofinterest if the nominal rate of interest is10% and the anticipated rate of inflation is3%?
Fisher Effect (cont )
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Fisher Effect (cont.)
rreal
= {(1+.10) (1+.03)} 1
= .0679 or 6.79%
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Fisher Effect (cont.)
We can approximate the real rate ofinterest as follows:
Real Rate of Interest Nominal interest rate Inflation
premium
Checkpoint 9 5
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Checkpoint 9.5
Solving for the Real Rate of InterestYou have managed to build up your savings over the three yearsfollowing your graduation from college to a respectable $10,000 andare wondering how to invest it. Your banker says they could pay you5% on your account for the next year. However, you recently saw onthe news that the expected rate of inflation for next year is 3.5%. If
you are earning a 5% annual rate of return but the prices of goodsand services are rising at a rate of 3.5%, just how much additionalbuying power would you gain each year? Stated somewhat differently,what real rate of interest would you earn if you made the investment?
Checkpoint 9 5
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Checkpoint 9.5
Checkpoint 9.5: Check Yourself
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Checkpoint 9.5:Check Yourself
Assume now that you expect that inflation will be5% over the coming year and want to analyze howmuch better off you will be if you place yoursavings in an account that also earns just 5%.What is the real rate of return in this circumstance?
Step 1: Picture the Problem
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Step 1: Picture the Problem
Let us assume that the prices of goods andservices today is $1.00 per unit.
With a 5% inflation, these goods andservices will cost $1.05.
Thus, $10,500 expected in the savingsaccount at the end of the year will buy youonly 10,000 units (10,500/1.05) at the end
of the year.
Step 1: Picture the Problem (cont )
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Step 1: Picture the Problem (cont.)
Year 0 Year 1
Savings Account Balance $10,000.00 $10,500.00
Price Index (5% inflation) $1.00 $1.05
Purchasing Power (units) 10,000.00 10,000.00
Step 2: Decide on a SolutionStrategy
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Strategy
We can estimate the real rate of interestby using equation 9-4b.
Step 3: Solve
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Step 3: Solve
rreal = {(1+.05) (1+.05)} 1
= 0%
Step 4: Analyze
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Step 4: Analyze
Here the nominal rate of interest is equalto the expected rate of inflation.Therefore, the real rate of return is equalto zero i.e. there is no increase in
purchasing power from investing thesavings at 5%.
Checkpoint 9.6
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Solving for the Nominal Rate of InterestAfter considering a number of investment opportunities, youhave decided that you should be able to earn a real return of2% on your $10,000 in savings over the coming year. If theexpected rate of inflation is expected to be 3.5% over thecoming year, what nominal rate of return must you anticipatein order to earn the 2% real rate of return?
Checkpoint 9.6
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Checkpoint 9.6
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Checkpoint 9.6: Check Yourself
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If you anticipate that the rate of inflation will nowbe 4% next year, holding all else the same, whatrate of return will you need to earn on your savingsin order to achieve a 2% increase in purchasingpower?
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Step 1: Picture the Problem
Let us assume that the prices of goods andservices today is $1.00 per unit.
If the expected rate of inflation is 4% andyou want to be able to purchase 2% more,you will need to earn a nominal rate ofinterest on your savings that will allow youto buy 10,200 units at $1.04 each.
Step 1: Picture the Problem (cont.)
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Step 1: Picture the Problem (cont.)
Year 0 Year 1
Savings Account Balance $10,000.00 $10,608
Price Index (5% inflation) $1.00 $1.04
Purchasing Power (units) 10,000.00 10,200.00
Real rate (% increase inpurchasing power)
2%
Interest rate of6.08% solvedin step 3
Step 2: Decide on a SolutionStrategy
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Strategy
Here we know the real rate of interest andthe expected rate of inflation.
We can use the Fisher model found inequation 9-4a to determine the nominalrate of interest.
Step 3: Solve
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Step 3: Solve
rnominal =.02 + .04 + (.02 .04)
= .0608 or 6.08%
Step 4: Analyze
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Step 4: Analyze
In order to achieve a 2% increase inpurchasing power in the face of a 4% rateof inflation, you must earn a 6.08% rateon your savings.
Default Premium
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Default Premium
In addition to accounting for the timevalue of money and inflation, the interestrate that a firms bonds pay must alsooffer a default premium i.e. risk that the
issuer will fail to repay interest andprincipal in a timely manner.
Maturity Premium The TermStructure of Interest Rates
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St uctu e o te est ates
Long-term bonds are more sensitive tointerest rate changes.
Maturity premium is the compensationthat investors demand for bearing interestrate risk on long-term bonds.
Maturity Premium The TermStructure of Interest Rates (cont.)
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( )
The relationship between interest ratesand time to maturity with risk heldconstant is known as the term structureof interest rates or the yield curve.
Figure 9-3 illustrates a hypothetical yieldcurve of US Treasury Bonds.
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Shifts in the Yield Curve
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The term structure of interest rateschanges over time as expectationsregarding each of the three factors thatunderlie interest rates change.
Figure 9-4 shows the yield curve one daybefore 911 attack and again two weeks
later.
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Shifts in the Yield Curve (cont.)
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( )
We observe a significant shift in the yieldcurve in figure 9-4 for short-term interestrates.
Investors shifted their funds to the safetyof Treasury securities, pushing up theprices and bringing down the yields.
Shifts in the Yield Curve (cont.)
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( )
The yield curve is generally upward slopingbut it can assume different shapes i.e.downward sloping or flat.
Figure 9-5 illustrates different shapes ofyield curves at different dates.
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Key Terms
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y
Amortizing bond Bond rating
Bond indenture
Call provision Collateral
Conversion feature
Key Terms (cont.)
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y ( )
Convertible bond Corporate bond
Coupon interest rate
Credit spread Current yield
Debenture
Default premium
Key Terms (cont.)
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Discount bond Eurobonds
Fisher effect
Fixed rate loan Floating rate bonds
Floating rate
Inflation premium
Key Terms (cont.)
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Interest rate risk Junk (high-yield) bonds
LIBOR
Maturity premium Mortgage bonds
Nominal (or quoted) rate of interest
Non-amortizing bond
Key Terms (cont.)
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Par or face value of a bond Private market transaction
Premium bond
Real rate of interest Recovery rate
Secured debt
Spread to Treasury
Key Terms (cont.)
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Subordinated debentures Term structure of interest rates
Transaction loans
Unsubordinated debentures Yield curve
Yield to maturity
Zero coupon bond