Figure 4-2 illustrates the following key points:
- Whenever the going rate of interest, rd, is equal to the coupon rate, a fixed-rate
bond will sell at its par value. Normally, the coupon rate is set equal to the going
rate when a bond is issued, causing it to sell at par initially.
- Interest rates do change over time, but the coupon rate remains fixed after the
bond has been issued. Whenever the going rate of interest rises abovethe coupon
rate, a fixed-rate bond’s price will fall belowits par value. Such a bond is called a
discount bond.
- Whenever the going rate of interest falls belowthe coupon rate, a fixed-rate bond’s
price will rise aboveits par value. Such a bond is called a premium bond.
- Thus, an increasein interest rates will cause the prices of outstanding bonds to fall,
whereas a decreasein rates will cause bond prices to rise.
- The market value of a bond will always approach its par value as its maturity date
approaches, provided the firm does not go bankrupt.
These points are very important, for they show that bondholders may suffer capital
losses or make capital gains, depending on whether interest rates rise or fall after the
bond was purchased. And, as we saw in Chapter 1, interest rates do indeed change
over time.
Explain, verbally, the following equation:
What is meant by the terms “new issue” and “seasoned issue”?
Explain what happens to the price of a fixed-rate bond if (1) interest rates rise
above the bond’s coupon rate or (2) interest rates fall below the bond’s coupon
rate.
Why do the prices of fixed-rate bonds fall if expectations for inflation rise?
What is a “discount bond”? A “premium bond”?
Bond Yields
If you examine the bond market table of The Wall Street Journalor a price sheet put
out by a bond dealer, you will typically see information regarding each bond’s maturity
date, price, and coupon interest rate. You will also see the bond’s reported yield. Un-
like the coupon interest rate, which is fixed, the bond’s yield varies from day to day de-
pending on current market conditions. Moreover, the yield can be calculated in three
different ways, and three “answers” can be obtained. These different yields are de-
scribed in the following sections.
Yield to Maturity
Suppose you were offered a 14-year, 10 percent annual coupon, $1,000 par value
bond at a price of $1,494.93. What rate of interest would you earn on your invest-
ment if you bought the bond and held it to maturity? This rate is called the bond’s
yield to maturity (YTM),and it is the interest rate generally discussed by in-
vestors when they talk about rates of return. The yield to maturity is generally the
same as the market rate of interest, rd, and to find it, all you need to do is solve
Equation 4-1 for rd:
VBa
N
t 1
INT
(1rd)t
M
(1rd)N
.
162 CHAPTER 4 Bonds and Their Valuation
158 Bonds and Their Valuation
