# Interest Rates and Bond Valuation Corporate Finance | CMA Exam | CPA Exam BEC

These lectures cover bond features , bond rating, bond trading,  bond valuation, nominal rate, Fisher effect, real rate, yield to maturity, and government bonds.

## Fisher Effect Interest rate | Corporate Finance

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 generically called bonds. In this section, we describe the various features of corporate bonds and some of the terminology associated with bonds. We then discuss the cash flows associated with a bond and how bonds can be valued using our discounted cash flow procedure.

BOND FEATURES AND PRICES
As we mentioned in our previous chapter, a bond is normally an interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan. For example, suppose the Beck Corporation wants to borrow \$1,000 for 30 years. The interest rate on similar debt issued by similar corporations is 12 percent. 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. As this example suggests, a bond is a fairly simple financing arrangement. There is, however, a rich jargon associated with bonds, so we will use this example to define some of the more important terms.

In our example, the \$120 regular interest payments that Beck promises to make are called the bond’s coupons. Because the coupon is constant and paid every year, the type of bond we are describing is sometimes called a level coupon bond. The amount that will be repaid at the end of the loan is called the bond’s face value, or par value. As in our example, this par value is usually \$1,000 for corporate bonds, and a bond that sells for its par value is called a par value bond. Government bonds frequently have much larger face, or par, values. Finally, the annual coupon divided by the face value is called the coupon rate on the bond; in this case, because \$120/1,000 = 12%, the bond has a 12 percent coupon rate.

The number of years until the face value is paid is called the bond’s time to maturity. A corporate bond will frequently have a maturity of 30 years when it is originally issued, but this varies. Once the bond has been issued, the number of years to maturity declines as time goes by.

BOND VALUES AND YIELDS
As time passes, interest rates change in the marketplace. The cash flows from a bond, however, stay 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 determine the value of a bond at a particular point in time, we need to know the number of periods remaining until maturity, the face value, the coupon, and the market interest rate for bonds with similar features. This interest rate required in the market on a bond is called the bond’s yield to maturity (YTM). This rate is sometimes called the bond’s yield for short. Given all this information, we can calculate the present value of the cash flows as an estimate of the bond’s current market value.

Securities issued by corporations may be classified roughly as equity securities and debt securities. At the crudest level, a debt represents something that must be repaid; it is the result of borrowing money. When corporations borrow, they generally promise to make regularly scheduled interest payments and to repay the original amount borrowed (that is, the principal). The person or firm making the loan is called the creditor or lender. The corporation borrowing the money is called the debtor or borrower
From a financial point of view, the main differences between debt and equity are the following:

Debt is not an ownership interest in the firm. Creditors generally do not have voting power.

The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax deductible. 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.
S IT DEBT OR EQUITY?
Sometimes it is not clear if a particular security is debt or equity. For example, suppose a corporation issues a perpetual bond with interest payable solely from corporate income if and only if earned. Whether this is really a debt is hard to say and is primarily a legal and semantic issue. Courts and taxing authorities would have the final say.

Corporations are adept at creating exotic, hybrid securities that have many features of equity but are treated as debt. Obviously, the distinction between debt and equity is important for tax purposes. So, one reason that corporations try to create a debt security that is really equity is to obtain the tax benefits of debt and the bankruptcy benefits of equity.

As a general rule, equity represents an ownership interest, and it is a residual claim. This means that equity holders are paid after debt holders. As a result of this, the risks and benefits associated with owning debt and equity are different. To give just one example, note that the maximum reward for owning a debt security is ultimately fixed by the amount of the loan, whereas there is no upper limit to the potential reward from owning an equity interest.

LONG-TERM DEBT: THE BASICS
Ultimately, 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. Beyond this, a number of features distinguish these securities from one another. We discuss some of these features next.

The maturity of a long-term debt instrument is the length of time the debt remains outstanding with some unpaid balance. Debt securities can be short-term (with maturities of one year or less) or long-term (with maturities of more than one year).1 Short-term debt is sometimes referred to as unfunded debt.
S IT DEBT OR EQUITY?
Sometimes it is not clear if a particular security is debt or equity. For example, suppose a corporation issues a perpetual bond with interest payable solely from corporate income if and only if earned. Whether this is really a debt is hard to say and is primarily a legal and semantic issue. Courts and taxing authorities would have the final say.

Corporations are adept at creating exotic, hybrid securities that have many features of equity but are treated as debt. Obviously, the distinction between debt and equity is important for tax purposes. So, one reason that corporations try to create a debt security that is really equity is to obtain the tax benefits of debt and the bankruptcy benefits of equity.

As a general rule, equity represents an ownership interest, and it is a residual claim. This means that equity holders are paid after debt holders. As a result of this, the risks and benefits associated with owning debt and equity are different. To give just one example, note that the maximum reward for owning a debt security is ultimately fixed by the amount of the loan, whereas there is no upper limit to the potential reward from owning an equity interest.

LONG-TERM DEBT: THE BASICS
Ultimately, 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. Beyond this, a number of features distinguish these securities from one another. We discuss some of these features next.

The maturity of a long-term debt instrument is the length of time the debt remains outstanding with some unpaid balance. Debt securities can be short-term (with maturities of one year or less) or long-term (with maturities of more than one year).1 Short-term debt is sometimes referred to as unfunded debt.

Firms frequently pay to have their debt rated. The two leading bond-rating firms are Moody’s and Standard & Poor’s (S&P). The debt ratings are an assessment of the creditworthiness of the corporate issuer. The 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.

It is important to recognize that bond ratings are concerned only with the possibility of default. Earlier, we discussed interest rate risk, which we defined as the risk of a change in the value of a bond resulting from a change in interest rates. Bond ratings do not address this issue. As a result, the price of a highly rated bond can still be quite volatile.
The 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. For example, the 100-year BellSouth issue we discussed earlier was rated AAA. This rating is not awarded very often: As of 2014, only four nonfinancial U.S. companies had AAA ratings. AA or Aa ratings indicate very good quality debt and are much more common.
A large part of corporate borrowing takes the form of low-grade, or “junk,” bonds. If these low-grade corporate bonds are rated at all, they are rated below investment grade by the major rating agencies. Investment-grade bonds are bonds rated at least BBB by S&P or Baa by Moody’s.
Rating agencies don’t always agree. To illustrate, some bonds are known as “crossover” or “5B” bonds. The reason is that they are rated triple-B (or Baa) by one rating agency and double-B (or Ba) by another, a “split rating.” For example, in March 2014, real estate investment company Omega Healthcare Investors sold an issue of 10-year notes rated BBB– by S&P and Ba1 by Moody’s.

A bond’s credit rating can change as the issuer’s financial strength improves or deteriorates. For example, in January 2014, Moody’s cut the bond rating on PlayStation 4 manufacturer Sony from Baa3 to Ba1, lowering the company’s bond rating from investment grade to junk bond status. Bonds that drop into junk territory like this are called fallen angels. Although sales of the new PS4 were a positive factor noted by Moody’s, the rating agency felt that the majority of Sony’s core business such as TVs, mobile phones, digital cameras, and personal computers faced difficult times ahead.

Credit ratings are important because defaults really do occur, and when they do, investors can lose heavily. For example, in 2000, AmeriServe Food Distribution, Inc., which supplied restaurants such as Burger King with everything from burgers to giveaway toys, defaulted on \$200 million in junk bonds. After the default, the bonds traded at just 18 cents on the dollar, leaving investors with a loss of more than \$160 million.

Even worse in AmeriServe’s case, the bonds had been issued only four months earlier, thereby making AmeriServe an NCAA champion. Although that might be a good thing for a college basketball team such as the University of Kentucky Wildcats, in the bond market it means “No Coupon At All,” and it’s not a good thing for investors.

In this section, we briefly look at bonds issued by governments and also at bonds with unusual features.
GOVERNMENT BONDS
The biggest borrower in the world—by a wide margin—is everybody’s favorite family member, Uncle Sam. In early 2014, the total debt of the U.S. government was \$17.5 trillion, or about \$55,000 per citizen (and growing!). When the government wishes to borrow money for more than one year, it sells what are known as Treasury notes and bonds to the public (in fact, it does so every month). Currently, outstanding Treasury notes and bonds have original maturities ranging from 2 to 30 years.
Most U.S. Treasury issues are just ordinary coupon bonds. There are two important things to keep in mind, however. First, U.S. Treasury issues, unlike essentially all other bonds, have no default risk because (we hope) the Treasury can always come up with the money to make the payments. Second, Treasury issues are exempt from state income taxes (though not federal income taxes). In other words, the coupons you receive on a Treasury note or bond are taxed only at the federal level.
For information on municipal bonds including prices, check out emma.msrb.org.

State and local governments also borrow money by selling notes and bonds. Such issues are called municipal notes and bonds, or just “munis.” Unlike Treasury issues, munis have varying degrees of default risk, and, in fact, they are rated much like corporate issues. Also, they are almost always callable. The most intriguing thing about munis is that their coupons are exempt from federal income taxes (though not necessarily state income taxes), which makes them very attractive to high-income, high–tax bracket investors.
FLOATING-RATE BONDS
The conventional bonds we have talked about in this chapter have fixed-dollar obligations because the coupon rates are set as fixed percentages of the par values. Similarly, the principal amounts are set equal to the par values. Under these circumstances, the coupon payments and principal are completely fixed.
OTHER TYPES OF BONDS
Many bonds have unusual or exotic features. So-called catastrophe, or cat, bonds provide an interesting example. In August 2013, Northshore Re Limited, a reinsurance company, issued \$200 million in cat bonds (reinsurance companies sell insurance to insurance companies). These cat bonds covered hurricanes and earthquakes in the U.S. In the event of one of these triggering events, Northshore Re would receive cash flows to offset its loss.

The largest single cat bond issue to date is a series of six bonds sold by Merna Reinsurance in 2007. The six bond issues were to cover various catastrophes the company faced due to its reinsurance of State Farm. The six bonds totaled about \$1.2 billion in par value. During 2013, about \$7.6 billion in cat bonds were issued, and there was about \$20.6 billion par value in cat bonds outstanding at the end of the year.
ncome bonds are similar to conventional bonds, except that coupon payments depend on company income. Specifically, coupons are paid to bondholders only if the firm’s income is sufficient. This would appear to be an attractive feature, but income bonds are not very common.

A convertible bond can be swapped for a fixed number of shares of stock anytime before maturity at the holder’s option. Convertibles are relatively common, but the number has been decreasing in recent years.

A put bond allows the holder to force the issuer to buy back the bond at a stated price. For example, International Paper Co. has bonds outstanding that allow the holder to force International Paper to buy the bonds back at 100 percent of face value if certain “risk” events happen. One such event is a change in credit rating from investment grade to lower than investment grade by Moody’s or S&P. The put feature is therefore just the reverse of the call provision.

The reverse convertible is a relatively new type of structured note. 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. For example, one recent General Motors (GM) reverse convertible had a coupon rate of 16 percent, which is a very high coupon rate in today’s interest rate environment. However, at maturity, if GM’s stock declined sufficiently, bondholders would receive a fixed number of GM shares that were worth less than par value. So, while the income portion of the bond return would be high, the potential loss in par value could easily erode the extra return.

Perhaps the most unusual bond (and certainly the most ghoulish) is the “death bond.” Companies such as Stone Street Financial purchase life insurance policies from individuals who are expected to die within the next 10 years.

Bonds are bought and sold in enormous quantities every day. You may be surprised to learn that the trading volume in bonds on a typical day is many, many times larger than the trading volume in stocks (by trading volume we simply mean the amount of money that changes hands). Here is a finance trivia question: What is the largest securities market in the world? Most people would guess the New York Stock Exchange. In fact, the largest securities market in the world in terms of trading volume is the U.S. Treasury market.
One reason the bond markets are so big is that the number of bond issues far exceeds the number of stock issues. There are two reasons for this. First, a corporation would typically have only one common stock issue outstanding (there are exceptions to this that we discuss in our next chapter). However, a single large corporation could easily have a dozen or more note and bond issues outstanding. Beyond this, federal, state, and local borrowing is simply enormous. For example, even a small city would usually have a wide variety of notes and bonds outstanding, representing money borrowed to pay for things like roads, sewers, and schools. When you think about how many small cities there are in the United States, you begin to get the picture!

Because the bond market is almost entirely OTC, it has historically had little or no transparency. 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 contrast, in the bond market, it is often not possible to observe either. Transactions are privately negotiated between parties, and there is little or no centralized reporting of transactions.

Although the total volume of trading in bonds far exceeds that in stocks, only a small fraction of the total bond issues that exist actually trade on a given day. This fact, combined with the lack of transparency in the bond market, means that getting up-to-date prices on individual bonds can be difficult or impossible, particularly for smaller corporate or municipal issues. Instead, a variety of sources of estimated prices exist and are commonly used.

BOND PRICE REPORTING
In 2002, transparency in the corporate bond market began to improve dramatically. Under new regulations, corporate bond dealers are now required to report trade information through what is known as the Trade Reporting and Compliance Engine (TRACE). Our nearby Work the Web box shows you how to get bond quotes.
A NOTE ABOUT BOND PRICE QUOTES
If you buy a bond between coupon payment dates, the price you pay is usually more than the price you are quoted. The reason is that standard convention in the bond market is to quote prices net of “accrued interest,” meaning that accrued interest is deducted to arrive at the quoted price. This quoted price is called the clean price. The price you actually pay, however, includes the accrued interest. This price is the dirty price, also known as the “full” or “invoice” price.

In examining interest rates, or any other financial market rates such as discount rates, bond yields, rates of return, and required returns, it is often necessary to distinguish between real rates and nominal rates. Nominal rates are called “nominal” because they have not been adjusted for inflation. Real rates are rates that have been adjusted for inflation.
THE FISHER EFFECT
Our discussion of real and nominal returns illustrates a relationship often called the Fisher effect (after the great economist Irving Fisher). Because investors are ultimately concerned with what they can buy with their money, they require compensation for inflation. Let R stand for the nominal rate and r stand for the real rate.