2024 Spring | Financial Management

Interest Rates and Bond Valuation

Reference: Ch7

Lecturer:

Calvin Jian-Jia Chiou

邱健嘉
1
 Learning objectives

• Define important bond features and types of bonds

• Explain bond values and yields and why they fluctuate

• Describe bond ratings and what they mean

• Outline the impact of inflation on interest rates

• Illustrate the term structure of interest rates and the determinants of bond
yields

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 Chapter Outline

• Bonds and Bond Valuation

• More about Bond Features
• Bond Ratings
• Some Different Types of Bonds
• Bond Markets
• Inflation and Interest Rates
• Determinants of Bond Yields

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 Bond Features and Prices

• When a corporation or government wishes to borrow money from the public on a

long-term basis, it usually does so by issuing or selling debt securities that are
generally called bonds
– Normally interest-only loans
• Suppose the Beck Corporation wants to borrow $1,000 for 30 years. The interest
rate on similar debt issued by similar corporations is 12%. Beck will thus pay .12 ×
$1,000 = $120 in interest every year for 30 years. At the end of 30 years, Beck will
repay the $1,000.
– Coupon is the stated interest payment made on a bond (i.e., $120)
– Face value, or par value, is the principal amount of a bond that is repaid at the end of the
term (i.e., $1,000)
– Coupon rate is the annual coupon divided by the face value of the bond (i.e., $120/$1,000
= .12, or 12%)
– Maturity is the specified date on which the principal amount of a bond is paid (i.e., 30
years)

4
 Bond Values and Yields

• Over time, interest rates change in the marketplace, but the cash flows from a
bond remain the same; as a result, the value of the bond will fluctuate
– When interest rates rise, the present value of the bond’s remaining cash flows declines, and
the bond is worth less
– When interest rates fall, the bond is worth more

• To find the value of a bond at a particular point in time, we need the following
pieces of information:
– Number of periods remaining until maturity
– Face value
– Coupon
– Yield to maturity (YTM), or yield, which is the rate required in the market on a bond

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Quotes of T-Bill

6
 Bond Values and Yields:
An Example (Par Value Bond)
Suppose Xanth Co. were to issue a bond with 10 years to maturity. The Xanth bond
has an annual coupon of $80. Similar bonds have a yield to maturity of 8 percent.
What would this bond sell for?
– Bond will pay $80 per year for the next 10 years in coupon interest. In 10 years, Xanth will
pay $1,000 to the bond owner.
• At the going rate of 8%, the PV of the $1,000 paid in 10 years is:
– Present value = $1,000/1.0810 = $1,000/2.1589 = $463.19
• Bond offers $80 per year for 10 years; PV of this annuity stream is:
Annuity present value = $80 × (1 − 1/1.0810) /.08
= $80 × (1 − 1/2.1589) /.08
= $80 × 6.7101
= $536.81
• Add the values for the two parts together to get the bond’s value:
– Total bond value = $463.19 + 536.81 = $1,000
• This bond sells for exactly the face value, so it is a par value bond
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 Cash Flows for Xanth Co. Bond

• Cash flows for the bond have an annuity component (the coupons) and a lump
sum (the face value paid at maturity)

• Cash flows for the bond are shown below:

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 Bond Values and Yields:
An Example (Discount Bond)
Suppose a year has gone by. The Xanth bond now has nine years to maturity. If the
interest rate in the market has risen to 10%, what will the bond be worth?
• Present value of the $1,000 paid in nine years at 10 percent is:

– Present value = $1,000/1.109 = $1,000/2.3579 = $424.10

• Bond now offers $80 per year for nine years; the present value of this annuity
stream at 10% is:
Annuity present value = $80 × (1 − 1/1.109) /.10
= $80 × (1 − 1/2.3579) /.10
= $80 × 5.7590
= $460.72
• Add the values for the two parts together to get the bond’s value:
– Total bond value = $424.10 + 460.72 = $884.82
• This bond sells for less than face value, so it is a discount bond

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 Bond Values and Yields:
An Example (Premium Bond)

What would the Xanth bond sell for if interest rates had dropped by 2% instead of
rising by 2%? In other words, assume the bond has a coupon rate of 8% when the
market rate is now only 6%.
• The present value of the $1,000 face amount is:

Present value = $1,000/1.069 = $1,000/1.6895 = $591.90

• The present value of the coupon stream is:
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = $80 × (1 − 1/1.069) /.06
= $80 × (1 − 1/1.6895) /.06
= $80 × 6.8017
= $544.14
• Add the values for the two parts together to get the bond’s value:
– Total bond value = $591.90 + 544.14 = $1,136.03
• This bond sells for more than face value, so it is a premium bond

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 General Expression for Value of a Bond

• If a bond has the following:

– A face value of F paid at maturity;

– A coupon of C paid per period;

– t periods to maturity; and

– A yield of r per period

• Its value is calculated as follows:

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 Semiannual Coupons

• In practice, bonds issued in the United States usually make coupon payments
twice a year. So, if an ordinary bond has a coupon rate of 14 percent, then the
owner will get a total of $140 per year, but this $140 will come in two payments of
$70 each. Suppose we are examining such a bond. The yield to maturity is quoted
at 16 percent.
• Bond yields are quoted like APRs; the quoted rate is equal to the actual rate per
period multiplied by the number of periods. In this case, with a 16 percent
quoted yield and semiannual payments, the true yield is 8 percent per six months.
The bond matures in seven years. What is the bond’s price? What is the effective
annual yield on this bond?
• Based on our discussion, we know the bond will sell at a discount because it has a
coupon rate of 7 percent every six months when the market requires 8 percent
every six months. So, if our answer exceeds $1,000, we know we have made a
mistake.
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 Semiannual Coupons

• To get the exact price, we first calculate the present value of the bond’s face value
of $1,000 paid in seven years. This seven-year period has 14 periods of six months
each. At 8 percent per period, the value is:
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = $1,000/1.0814 = $1,000/2.9372 = $𝟑𝟒𝟎. 𝟒𝟔
• The coupons can be viewed as a 14-period annuity of $70 per period. At an 8
percent discount rate, the present value of such an annuity is:
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = $70 × (1 − 1/1.0814 )/.08
= $70 × (1 − .3405)/.08
= $70 × 8.2442 = $𝟓𝟕𝟕. 𝟏𝟎
• The total present value gives us what the bond should sell for:
𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = $340.46 + 577.10 = $𝟗𝟏𝟕. 𝟓𝟔
• To calculate the effective yield on this bond, note that 8 percent every six months
is equivalent to:
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = 1 + .08 2 − 1 = .1664, 𝑜𝑟 16.64%
• The effective yield is 16.64 percent.
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 Interest Rate Risk

• Interest rate risk arises from fluctuating interest rates, and the degree of interest
rate risk a bond has depends on its sensitivity to interest rate changes, which
directly depends on two things:
1. Time to maturity
2. Coupon rate
• All other things being equal:
1. The longer the time to maturity, the greater the interest rate risk
2. The lower the coupon rate, the greater the interest rate risk
• Interest rate risk increases at a decreasing rate
• We can illustrate the effect of interest rate risk using the 100-year BellSouth
(AT&T) issue:

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 Interest Rate Risk and Time To Maturity

• Notice the slope of the line connecting prices

is much steeper for the 30-year bond than
for the 1-year bond
– This tells us a relatively small change in interest
rates will lead to a substantial change in the
bond’s value
• The reason bonds with lower coupons have
greatest interest rate risk is essentially the
same
– The bond with the higher coupon has a larger
cash flow early in its life, so its value is less
sensitive to changes in the discount rate

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 Finding the Yield to Maturity:
More Trial and Error
• Suppose we are interested in a six-year, 8% coupon bond with annual payments.
A broker quotes a price of $955.14. What is the yield on this bond?
• Price of a bond can be written as the sum of its annuity and lump sum
components. Knowing there is an $80 coupon for six years and a $1,000 face
value, we can say that the price is:
– $955.14 = $80 × [1 − 1/(1 + r)6]/r + 1,000/(1 + r)6
– where r is the unknown discount rate, or yield to maturity; we cannot solve it for r explicitly
so we must use trial and error
• Bond has an $80 coupon and is selling at a discount, so the yield is greater than 8
percent. If we compute the price at 10%, we will see 10% is too high because the
value we calculate ($912.89) is lower than the actual price ($955.14):
– Bond value = $80 × (1 − 1/1.106) /.10 + $1,000 /1.106
– = $80 × 4.3553 + $1,000/1.7716
– = $912.89

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 Finding the Yield to Maturity:
More Trial and Error (continued)

• A bond’s yield to maturity should not be confused with its current yield, which is
the bond’s annual coupon divided by its price

• In the example we just worked on the previous slide, the bond’s annual coupon
was $80, and its price was $955.14
– Current yield was $80/$955.14 = .0838, or 8.38 percent
– Yield to maturity was 9 percent (found by trial and error)

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Summary of Bond Valuation

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 Current Events

• A bond has a quoted price of $1,080.42. It has a face value of $1,000, a

semiannual coupon of $30, and a maturity of five years. What is its current yield?
What is its yield to maturity? Which is bigger? Why?
• Notice that this bond makes semiannual payments of $30, so the annual payment
is $60. The current yield is thus $60/$1,080.42 = 5.55 percent. To calculate the
yield to maturity, refer back to Example 7.1. In this case, the bond pays $30 every
six months and has 10 six-month periods until maturity. So, we need to find r as
follows:
$1,080.42 = $30 × [1 − 1/ 1 + 𝑟 10 ]/𝑟 + 1,000/ 1 + 𝑟 10
• After some trial and error, we find that r is equal to about 2.1 percent. But, the
tricky part is that this 2.1 percent is the yield per six months. We have to double it
to get the yield to maturity, so the yield to maturity is 4.2 percent, which is less
than the current yield. The reason is that the current yield ignores the built-in loss
of the premium between now and maturity.
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 Bond Yields

• You’re looking at two bonds identical in every way except for their coupons and, of
course, their prices. Both have 12 years to maturity. The first bond has a 10
percent annual coupon rate and sells for $935.08. The second has a 12 percent
annual coupon rate. What do you think it would sell for?
• Because the two bonds are similar, they will be priced to yield about the same
rate. We first need to calculate the yield on the 10 percent coupon bond.
Proceeding as before, we know that the yield must be greater than 10 percent
because the bond is selling at a discount. The bond has a fairly long maturity of 12
years. We’ve seen that long-term bond prices are relatively sensitive to interest
rate changes, so the yield is probably close to 10 percent. A little trial and error
reveals that the yield is actually 11 percent:

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 Bond Yields

𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $100 × (1 − 1/1.1112 )/.11 + $1,000/1.1112

= $100 𝑥 6.4924 + $1,000/3.4985
= $649.24 + 285.84 = $935.08

• With an 11 percent yield, the second bond will sell at a premium because of its
$120 coupon. Its value is:
𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = $120 × (1 − 1/1.1112 )/.11 + $1,000/1.1112
= $120 𝑥 6.4924 + $1,000/3.4985
= $779.08 + 285.84
= $1,064.92

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 How to calculate bond prices and yields using a financial
calculator
• Using Example 7.3 (on the previous slide), the first bond sells for $935.08 and has a 10%
annual coupon rate. What’s the yield?

• For the second bond, we now know the relevant yield is 11%. It has a 12% annual coupon and
12 years to maturity, so what’s the price?

• Suppose we have a bond with a price of $902.29, 10 years to maturity, and a coupon rate of
6%. Assuming this bond pays semiannual interest, what’s the bond’s yield?

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 More about Bond Features

• Securities issued by corporations may be classified roughly as equity securities and

debt securities
– Generally, equity represents an ownership interest, and it is a residual claim, meaning
equity holders are paid after debt holders

• Differences between debt and equity are the following:

– Debt is not an ownership interest in the firm. Creditors generally do not have voting power.
– Corporation’s payment of interest on debt is considered a cost of doing business and is tax
deductible (up to certain limits). Dividends paid to stockholders are not tax deductible.
– Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the
assets of the firm. This action can result in liquidation or reorganization, two of the possible
consequences of bankruptcy. Thus, one of the costs of issuing debt is the possibility of
financial failure. This possibility does not arise when equity is issued.

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 Long-term Debt: The Basics

• All long-term debt securities are promises made by the issuing firm to pay
principal when due and to make timely interest payments on the unpaid balance
• Maturity of a long-term debt instrument is the length of time the debt remains
outstanding with some unpaid balance
– Short-term debt securities, or unfunded debt, have a maturity of one year or less
– Long-term debt securities have maturities of more than one year
• Debt securities are typically called notes, debentures, or bonds
– Difference between notes and bonds is original maturity, with those of 10 years or less
being called notes and longer-term issues being called bonds
• Major forms of long-term debt are public-issue and privately placed, with the main
difference being privately placed debt is directly placed with a lender and not
offered to the public.

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Features of an Apple Bond

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 The Indenture

• The indenture (i.e., deed of trust) is the written agreement between the
corporation (the borrower) and the lender detailing the terms of the debt issue
• Indenture generally includes the following provisions:
– Basic terms of the bonds
– Total amount of bonds issued
– Description of property used as security
– Repayment arrangements
– Call provisions
– Details of the protective covenants
• Usually, a trustee (e.g., a bank) is appointed by the corporation to represent the
bondholders and the trustee must:
– Make sure the terms of the indenture are obeyed
– Manage the sinking fund
– Represent the bondholders in default

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 Terms of a Bond

• Principal value is stated on bond certificate

• Par value of a bond is almost always the same as the face value, with the terms
used interchangeably in practice
– Corporate bonds historically had a face value of $1,000
– Municipal bonds often have par valued of $5,00
– Treasury bonds with par values of $10,000 or $100,000 are common
• Corporate bonds are usually in registered form, meaning the registrar of the
company records ownership of each bond with payment being made directly to
the owner of record
• Bonds can also be in bearer form, in which case the bond is issued without
record of the owner’s name with payment being made to whomever holds the
bond
– Difficult to recover if bonds are lost or stolen
– Because the company does not know who owns its bonds, it cannot notify bondholders of
important events

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 Security

• Debt securities are classified according to the collateral and mortgages used to
protect the bondholder
• Mortgage securities are secured by a mortgage on the real property of the
borrower, with the property involved typically being real estate (e.g., land or
buildings)
– Legal document that describes the mortgage is called a mortgage trust indenture or trust
deed
– Sometimes mortgages are on specific property (e.g., railroad car)
– Blanket mortgage pledges all real property owned by the company
• Bonds usually represent unsecured obligations of the company
– A debenture is an unsecured debt, usually with a maturity of 10 years or more
• Most public bonds issued in the U.S. by industrial and financial companies are typically
debentures
– A note is an unsecured debt, usually with a maturity under 10 years

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 Seniority and Repayment

• Seniority indicates preference in position over other lenders, with debts

sometimes labeled as senior or junior to indicate seniority
– Some debt is subordinated (e.g., subordinated debenture), and holders of such debt must
give preference to other specified creditors
– Debt cannot be subordinated to equity
• Bonds can be repaid at maturity, at which time the bondholder will receive the
stated, or face, value of the bond; or they may be repaid in part or in entirety
before maturity
– Early repayment is common and is often handled through a sinking fund, an account
managed by the bond trustee for early redemption
– There are various types of sinking fund arrangements; for example:
• Some sinking funds start about 10 years after the initial issuance

• Some sinking funds establish equal payments over the life of the bond

• Some high-quality bond issues establish payments to the sinking fund that are not
sufficient to redeem the entire issue

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 The Call Provision

• Call provision is an agreement giving the corporation the option to repurchase a

bond at a specified price prior to maturity
– Corporate bonds are usually callable
• Call price is usually above the bond’s stated value (i.e., par value), with the
difference between the call price and the stated value being the call premium
• Deferred call provisions prohibit the company from redeeming a bond prior toa
certain date
– During period of prohibition, the bond is said to be call-protected
• “Make-whole” call is a new type of call provision where bondholders receive
approximately what the bonds are worth if they are called
– To find the make-whole call price, calculate the PV of the remaining interest and principal
payments at a rate specified in the indenture

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 Protective Covenants

• A protective covenant limits certain actions that might be taken during the loan’s
term, usually to protect the lender’s interest
1. Negative covenant is a “thou shalt not” type of covenant that limits or prohibits actions the
company might take; examples include:
• Firm must limit amount of dividends paid, according to some formula
• Firm cannot pledge any assets to other lenders
• Firm cannot merge with another firm
• Firm cannot sell or lease any major assets without lender’s approval
• Firm cannot issue additional long-term debt
2. Positive covenant is a “thou shalt” type of covenant that specified an action the company
agrees to take or a condition the company must abide by; examples include:
• Company must maintain working capital at or above some specified minimum level
• Company must periodically furnish audited financials to lender
• Firm must maintain any collateral or security in good condition

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 Bond Ratings

• Firms often pay to have their debt rated, with ratings serving as an assessment of
the creditworthiness of the corporate issuer
– Leading bond-rating firms are Moody’s and Standard & Poor’s (S&P)
– Definitions of creditworthiness used by Moody’s and S&P are based on how likely the firm
is to default and the protection creditors have in the event of a default
• Ratings can change as the issuer’s financial strength changes
– Highest rating a firm’s debt can have is AAA or Aaa, and such debt is judged to be the best
quality and to have the lowest degree of risk
– AA or Aa ratings indicate very good quality debt and are much more common
– Investment-grade bonds are rated at least BBB or Baa
– Large part of corporate borrowing takes the form “junk” bonds, which are rated below
investment grade if rated at all
• Rating agencies don’t always agree (e.g., “crossover” bonds)

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Bond Ratings (continued)

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 Government Bonds

• Biggest borrower in the world—by a wide margin—is everybody’s favorite family

member, Uncle Sam
• When the government wishes to borrow money for more than one year, it sells
Treasury notes and bonds to the public
– U.S. Treasury issues, unlike essentially all other bonds, have no default risk
– Treasury issues are exempt from state income taxes
• State and local governments also borrow money by selling notes and bonds (i.e.,
municipal notes and bonds, or “munis”)
– Have varying degrees of default risk and are rated much like corporate issues
– Almost always callable
– Coupons are exempt from federal income taxes; because of the tax break they receive,
yields on munis are much lower than yields on taxable bonds

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 Taxable Versus Municipal Bonds

• Suppose taxable bonds are currently yielding 8 percent, while at the same time, munis of
comparable risk and maturity are yielding 6 percent. Which is more attractive to an investor in
a 40 percent bracket? What is the break-even tax rate? How do you interpret this rate?
• For an investor in a 40 percent tax bracket, a taxable bond yields 8 x (1 − .40) = 4.8 percent
after taxes, so the muni is much more attractive. The break-even tax rate is the tax rate at
which an investor would be indifferent between a taxable and a nontaxable issue. If we let t*
stand for the break-even tax rate, then we can solve for it as follows:

. 08 × 1 − 𝑡 ∗ = .06
∗
.06
1−𝑡 = = .75
.08
𝑡 ∗ = .25
• An investor in a 25 percent tax bracket would make 6 percent after taxes from either bond.

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 Zero Coupon Bonds

• Zero coupon bonds, or zeroes, are bonds that make no coupon payments and are
thus initially priced at a deep discount
– For tax purposes, the issuer of a zero coupon bond deducts interest every year even
though no interest is actually paid
– Similarly, the owner must pay taxes on interest accrued every year, even though no interest
is actually received

• Attractive investment for tax-exempt investors with long-term dollar-denominated

liabilities (e.g., pension funds) because the future dollar value is known with
relative certainty

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 Interest Expense for Ein’s Zeroes

• Suppose the Eight-Inch Nails (EIN) Company issues a $1,000 face value, five-year
zero coupon bond. The initial price is set at $508.35
• Even though no interest payments are made on the bond, zero coupon bond
calculations use semiannual periods to be consistent with coupon bond
calculations
• Using semiannual periods, it is straightforward to verify that, at this price, the
bond yields about 14% to maturity
• The total interest paid over the life of the bond is $1,000 − 508.35 = $491.65.

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 Floating-rate Bonds

• With floating-rate bonds (floaters), coupon payments are adjustable, with

adjustments tied to an interest rate index (e.g., Treasury bill interest rate or 30-
year Treasury bond rate)
• Value depends on how coupon payment adjustments are defined
– In most cases, the coupon adjusts with a lag to some base rate
• Most floaters have the following features:
– Holder has right to redeem note at par on the coupon payment date after some specified
amount of time (i.e., put provision)
– Coupon rate has floor and ceiling, meaning the coupon is subject to a minimum and a
maximum. In this case, the coupon rate is said to be “capped,” and the upper and lower
rates may be called the collar
• Inflation-linked bonds have coupons that are adjusted according to the inflation
rate (principal amount may be adjusted as well)
– May be called “TIPS,” or Treasury Inflation-Protected Securities

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 Other Types of Bonds

• Catastrophe, or cat, bonds cover U.S.-named storms and earthquakes, with

investors losing some or all of their money if one of these triggering events occurs
• In 2019, Conservation Capital issued Rhino impact bonds (RIB) designed to
increase the population of black rhinos in Kenya and South Africa
– Bondholders receive payments based on the “outcome payments” model; in
this case, payments will be based on the population of black rhinos in five years
• Coronavirus bonds came to market during the COVID-19 pandemic; proceeds
were to go toward pandemic-related work
• A warrant is a bond feature that gives the buyer of the bond the right to purchase
shares of stock in the company at a fixed price
– Very valuable feature is the stock price climbs substantially

– Bonds with warrants are often issued at a very low coupon rate

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 Other Types of Bonds (continued)

• Income bonds are similar to conventional bonds, except that coupon payments
depend on company income
– Coupons are paid to bondholders only if firm’s income is sufficient
• A convertible bond can be swapped for a fixed number of shares of stock anytime
before maturity at the holder’s option
• A put bond allows the holder to force the issuer to buy back the bond at a stated
price; this is the reverse of the call provision
• Reverse convertible is a relatively new item
– One type generally offers a high coupon rate, but the redemption at maturity can be paid in
cash at par value or paid in shares of stock
• Death bonds involve companies purchasing life insurance policies from
individuals who are expected to die within the next 10 years and then selling
bonds that are paid off from the life insurance proceeds when the policyholders
pass away
• Structured notes are bonds that are based on stocks, bonds, commodities, or
currencies

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 Sukuk

• Worldwide demand for assets that comply with sharia, or Islamic law and cultural
tradition, has grown dramatically
– One of the major differences between Western financial practices and sharia is that Islamic
law does not permit charging or paying riba, or interest
• To accommodate the restriction on interest payments, Islamic bonds, or sukuk,
have been created
– There are many possible structures to sukuk, such as partial ownership in a debt (sukuk al-
murabaha) or an asset (sukuk al-ijara)
– In the case of a sukuk al-ijara, there is a binding promise to repurchase a certain asset by
the issuer at maturity
• Before the sukuk matures, rent is paid on the asset
• Most sukuk are bought and held to maturity; therefore, secondary markets in
sukuk are extremely illiquid

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 How Bonds are Bought and Sold

• Total volume of trading in bonds far exceeds that in stocks

• Most trading in bonds takes place over the counter, or OTC
• One reason the bond markets are so big is that the number of bond issues far
exceeds the number of stock issues, and there are two reasons for this:
1. A corporation would typically have only one common stock issue outstanding, whereas a
large corporation could easily have a dozen or more note and bond issues outstanding
2. Federal, state, and local borrowing is enormous
• A financial market is transparent if it is possible to easily observe its prices and
trading volume
– On the New York Stock Exchange, for example, it is possible to see the price and quantity
for every single transaction
– In the bond market, it is often not possible to observe either, resulting in a lack of
transparency

42
 Bond Price Reporting

• In 2002, transparency in the corporate bond market began to improve, as new

regulations required dealers to report trade information through the Trade
Reporting and Compliance Engine (TRACE)
– TRACE bond quotes are available online
• Each day, representative prices for outstanding Treasury issues are reported
– Bid price is the price a dealer is willing to pay for a security
– Asked price is the price a dealer is willing to take for a security
– Bid-ask spread is difference between the bid price and asked price
– Treasury prices are quoted as a percentage of face value
• If the bid price is 132.23 and the face value is $1,000, the quote represents $1,322.30

– Change in the asked price from the previous day, measured as a percentage of face value,
is also quoted

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Sample Wall Street
Journal U.S.
Treasury Note and
Bond Prices

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 A Note about Bond Price Quotes

• Clean price is the price of a bond net of accrued interest

– This is the price that is typically quoted
• Dirty price is the price of a bond including accrued interest, also known as the full
or invoice price
– This is the price the buyer actually pays
• Suppose you buy a bond with a 12% annual coupon, payable semiannually. You
actually pay $1,080 for this bond, so $1,080 is the dirty, or invoice, price. Further,
on the day you buy it, the next coupon is due in four months, so you are between
coupon dates. Notice that the next coupon will be $60.
– Accrued interest on a bond is calculated by taking the fraction of the coupon period that
has passed, in this case two months out of six, and multiplying this fraction by the next
coupon, $60
– Accrued interest in this example is 2/6 × $60 = $20. The bond’s quoted price (i.e., clean
price) would be $1,080 − 20 = $1,060

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 Real Versus Nominal Rates

• Real rates are interest rates or rates of return that have been adjusted for
inflation
• Nominal rates are interest rates or rates of return that have not been adjusted
for inflation
• Suppose prices are currently rising by 5% per year. In other words, the rate of
inflation is 5%. An investment is available that will be worth $115.50 in one year. It
costs $100 today.
– Notice that with a present value of $100 and a future value in one year of $115.50, this
investment has a 15.5 percent rate of return
– In calculating this 15.5 percent return, we did not consider the effect of inflation, so this is
the nominal return
• What is the impact of inflation here?
– Suppose pizzas cost $10 each at the beginning of the year. With $100, we can buy 10
pizzas. Because the inflation rate is 5%, pizzas will cost 5% more, or $10.50, at the end of
the year.

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 The Fisher Effect

• Fisher effect describes the relationship between nominal returns, real returns,
and inflation
• Let R stand for the nominal rate, r stand for the real rate, and h stand for the
inflation rate; Fisher effect can be written as:

• In the example on the previous slide, the nominal rate was 15.50% and the
inflation rate was 5%. What was the real rate?
1 + .1550 = 1 + 𝑟 × 1 + .05
1 + 𝑟 = 1.1550/1.05 = 1.10
𝑟 = .10, 𝑜𝑟 𝟏𝟎%
• We can rearrange the Fisher effect as follows:

• Nominal rate is approximately equal to real rate plus inflation rate:

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 The Fisher Effect: An Example

• If investors require a 10 percent real rate of return, and the inflation rate is 8
percent, what must be the approximate nominal rate? The exact nominal rate?
• The nominal rate is approximately equal to the sum of the real rate and the
inflation rate: 10% + 8% = 18%. From the Fisher effect, we have:
1+𝑅 = 1+𝑟 × 1+ℎ
= 1.10 × 1.08
= 1.1880

• Therefore, the nominal rate will actually be closer to 19 percent.

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 Inflation and Present Values:
Discounting Nominal Cash Flows
• What is the effect of inflation on PV calculations? You can either:
– Discount nominal cash flows at a nominal rate; or
– Discount real cash flows at a real rate
• Suppose you want to withdraw money each year for the next three years, and you
want each withdrawal to have $25,000 worth of purchasing power as measured in
current dollars. If the inflation rate is 4% per year, then the withdrawals will have
to increase by 4% each year to compensate. The withdrawals each year will be:
C1 = $25,000(1.04) = $26,000
C2 = $25,000(1.04)2 = $27,040
C3 = $25,000(1.04)3 = $28,121.60
• What is the PV of these cash flows if the appropriate nominal discount rate is
10%?
PV = $26,000/1.10 + $27,040/1.102 + $28,121.60/1.103 = $67,111.65

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 Inflation and Present Values:
Discounting Real Cash Flows
• To calculate the PV using real cash flows, we need the real discount rate. Using the
Fisher equation, the real discount rate is:
1 + R = (1 + r)(1 + h)
1 + .10 = (1 + r)(1 + .04)
r = .0577, or 5.77%
• By design, the real cash flows are an annuity of $25,000 per year. So, the present
value in real terms is:
PV = $25,000[1 − (1/1.05773)]/.0577 = $67,111.65
• You could also use the growing annuity equation; withdrawals are increasing at
4% per year, so the present value is:
3
1 + .04
1−
𝑃𝑉 = $26,000 1 + .10 = $26,000 2.58122 = $67,111.65
.10 − .04

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 Term Structure of Interest Rates

• At any point in time, short-term and long-term interest rates will generally be
different

• The term structure of interest rates is the relationship between nominal

interest rates on default-free, pure discount securities and time to maturity; that
is, the pure time value of money
– When long-term rates are higher than short-term rates, we say that the term structure is
upward sloping
– When short-term rates are higher than long-term rates, we say the term structure is
downward sloping
– Term structure can also be “humped”, which is usually because rates increase at first, but
then begin to decline as we look at longer- and longer-term rates

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 Term Structure of Interest Rates (continued)

• What determines the shape of the term structure?

1. Real rate of interest
2. Expected future inflation
3. Interest rate risk premium

• Inflation premium is the portion of a nominal interest rate that represents

compensation for expected future inflation
– Upward-sloping term structure may reflect anticipated increases in inflation, while a
downward-sloping term structure probably reflects the belief that inflation will be falling in
the future
• Interest rate risk premium is the compensation investors demand for bearing
interest rate risk
– Interest rate risk premium increases with maturity, but it increases at a decreasing rate

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Term Structure of Interest Rates (concluded)

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 Bond Yields and the Yield Curve:
Putting It All Together
• Treasury yield curve is a plot of the yields on Treasury notes and bonds relative to
maturity
– Shape of yield curve reflects the term structure of interest rates
– Term structure is based on pure discount bonds, whereas the yield curve is based on
coupon bond yields

• Treasuries depend on the three components that underlie the term structure:
– Real rate
– Expected future inflation
– Interest rate risk premium

• Recall Treasury notes and bonds are default-free, they are taxable, and they are
highly liquid

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 Bond Yields and the Yield Curve:
Putting It All Together (continued)
• A bond’s yield is calculated assuming all promised payments will be made
– If the issuer defaults, your actual yield will be lower
• Default risk premium is the portion of a nominal interest rate or bond yield that
represents compensation for the possibility of default
– Lower-rated bonds have higher yields
• Taxability premium is the portion of a nominal interest rate or bond yield that
represents compensation for unfavorable tax status
– Recall, municipal bonds are free from most taxes
• Liquidity premium is the portion of a nominal interest rate or bond yield that
represents compensation for lack of liquidity

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 Conclusion

• Bond yields represent the combined effect of no fewer than six things:
– Real rate of interest
– Premiums representing compensation for the following:
1. Expected future inflation
2. Interest rate risk
3. Default risk
4. Taxability
5. Lack of liquidity

• Determining the appropriate yield on a bond requires careful analysis of each of

these effects

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 Key Takeaways

• What are the cash flows associated with a bond?

• What is the indenture? What are protective covenants? Give some examples.
• What is a junk bond?
• Why might an income bond be attractive to a corporation with volatile cash flows?
Can you think of a reason why income bonds are not more popular?
• In general, what are bid and ask prices?
• What is the difference between a nominal and a real return? Which is more
important to a typical investor?
• What is the term structure of interest rates? What determines its shape?
• What is the Treasury yield curve?

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