CHAPTER 3 - BONDS PRICES AND THE LEVEL OF INTEREST RATES

3.1 WHAT IS AN INTEREST RATE?

The interest rate is the amount a lender charges for the use of assets expressed as a
percentage of the principal. The interest rate is typically noted on an annual basis
known as annual percentage rate or APR. The assets borrowed could include cash,
consumer goods, or large assets such as vehicle or building.

DEEPER DEFINITION:
Interest rates are commonly used for personal loans and mortgages, though they may
extend to loans for the purchase of cars, buildings and consumer goods. Lenders
typically offer lower interest rates to borrowers who are low-risk, and higher rates to
high-risk borrowers. While lenders typically set their own rates, competition for borrower
means lenders within a certain area usually offer comparable numbers.

EXAMPLE OF INTEREST RATE:

If the bank loaned you Php 100,000 at 5% interest, they would be out Php 100,000 for
the duration of the loan. Thus, they need to be compensated for this loss of opportunity.
By taking the loan, you agree to pay them 5% interest in addition to the Php 100,000
principal for use of their money.

INTEREST RATE VS. ANNUAL PERCENTAGE RATE

INTEREST RATE ANNUAL PERCENTAGE RATE

It is the cost of borrowing the principal loan It is a broader measure of the cost of a
amount. The rate can be variable or fixed, mortgage because it includes the interest
but it is always expressed as percentage. rate plus other cost such as broker fees,
discount points, and some closing costs,
expressed as percentage.

ANNUAL PERCENTAGE RATE VS. EQUIVALENT ANNUAL RATE/ EFFECTIVE INTEREST RATE

ANNUAL PERCENTAGE RATE EFFECTIVE INTEREST RATE

It refers to the periodic interest rate for a Takes into account the effects of compound
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 loan, multiplied by the number of periods interest, and is useful for evaluating loans
each year. However, APR does not include that compound interest at regular intervals,
the effects of compound interest such as monthly or daily.
It is the periodic rate multiplied by the It is the annual rate of interest actually being
number of periods per year. earned.

SIMPLE INTEREST VS. COMPOUND INTEREST

SIMPLE INTEREST COMPOUND INTEREST

It is based on the principal amount of a It is based on the principal amount and
loan or deposit. It is a fixed percentage the interest that accumulates on it every
of the principal amount that was period.
borrowed or lent.
FORMULA: FORMULA:
where: where:
P – Principal amount P – Principal amount
r – annual interest rate r – annual interest rate
n – term of loan, in years t – number of years interest is applied
In real life situations: In real life situations:
Those generally for a single period or Often a factor in business transactions,
less than a year, though they also apply investments and financial products
to open-ended situations, such as credit intended to extend for multiple period or
balances. years.

EXAMPLE OF SIMPLE INTEREST:

A student obtains simple-interest loan to pay one year of their college tuition, which costs
Php 18,000, and the annual interest on their loan is 6%. They repay their loan over three
years. The amount of simple interest they pay is:
Computation:
Simple interest =
Simple Interest = 18 000 x 0.06 x 3
Simple Interest = Php 3, 240
Total amount paid = Php 21, 240 (18 000 + 3 240)
EXAMPLE OF COMPOUND INTEREST:
Bob the builder needs to borrow Php 500,000 for three years. But as his rich uncle is
tapped out, he takes a loan from Acme Borrowing Corporation at an interest rate of 5% per
annum compounded annually, with the full loan amount and interest payable after three
years. What would be the total interest paid by Bob?
Computation:
Compound interest =
Compound interest =
Total interest payable after three years = Php 78, 812.50

CURRENT LEGAL INTEREST RATE IN THE PHILIPPINES

Section 1. The rate of interest for the loan or forbearance of any money, goods or credits
and the rate allowed in judgments, in the absence of an express contract as to such rate of
interest, shall be six percent (6%) per annum.

FACTORS THAT AFFECT INTEREST RATE

A. Factors out of Control
1. Supply and demand
In lending, an increase in the demand for money, or a decrease in the supply of money held
by lenders, will cause interest rates to go up. For example, if a lot of people started pulling
all of their money out of their checking and savings accounts that would decrease the
supply of money that banks have to lend to their borrowers, which would likely raise interest
rate at those banks. Conversely, a decrease in the demand for money, or an increase in the
supply of money, will lower interest rates as lenders try to attract more borrowers.
2. Inflation
Inflation is when the prices of the goods and services rise, which decreases the purchasing
power of money. Inflation can be good for people carrying debt, since it lowers the value of
each peso you owe, but by the same token it is terrible for lenders. If the money a lender
receives has less value than the money it originally lent due to inflation, it is going to raise
interest rates to account for the difference.

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 B. Factors in Control
3. Credit Scores
Lenders look intensively at your credit scores to determine how risk you are to lend to. High
credit scores, which you can get by paying your bills on time and keeping a low credit
utilization ratio, indicate that you are good at paying off your debts, so the risk of lending to
you is low. If your credit scores are not great, though, the lender views you as less likely to
pay back all your loan, so it will charge you a higher interest rate to make up for that risk or
just reject you outright.

4. Loan amount and duration

Borrowing larger amounts of money means larger monthly loan payments, and taking out a
loan with longer repayment terms not only makes the loan more vulnerable to inflation (note
that this does not apply to a loan with fixed rate), but it also increases the chance that you
will face some adversity in your life that may negatively impact your ability to pay the debt.

5. Guarantee
Guarantees can take different forms, such as collateral, consigners, or a personal
guarantee. Adding a guarantee of some kind to a loan can reduce interest rates since they
lower the lender’s risk.
3.2 THE MECHANICS OF BOND PRICING

What is a Bond?
a. Bond is a long-term debt either by a firm or by the government.
b. A loan granted to other organizations by individuals and organizations with excess
funds.
c. A bond, also known as a fixed-income security, is a debt instrument created for the
purpose of raising capital. They are essentially loan agreements between the bond
issuer and an investor, in which the bond issuer is obliged to pay a specified amount
of money in a future dates.
HOW DO BONDS WORK?
When an investor purchases a bond, they are “loaning” that money (called the principal)
to the bond issuer, which is usually raising money for some project. When the bond
 matures, the issuer repays the principal to the investor. In most cases, the investor will
receive regular interest payments from the issuer until the bond matures.

KEY BOND CHARACTERISTICS

1. FACE VALUE/ PAR VALUE
It is the price at which the bonds is sold to investors when first issued; it is also the price at
which the bond is redeemed at maturity.
2. COUPON RATE
The periodic interest payments promised to bond holders are computed as a fixed
percentage of the bond’s face value. This percentage is known as the coupon rate.
3. COUPON
The peso value of the periodic interest payment promised to bondholders. This equals the
coupon rate times the face value of the bond.
4. MATURITY
It is the length of time until the principal is scheduled to be repaid.
5. CALL PROVISIONS
Bonds may contain a provision that enables the issuer to buy the bond back from the
bondholder at a pre-specified price prior to maturity. This price is known as the call price. A
bond containing a call provision is called callable bond. This provision enables issuers to
reduce their interest costs if rates fall after a bond is issued, since existing bonds can then
be replaced with lower yielding bonds. It is also known as embedded option, since it
cannot be brought or sold separately from the bond. Since a call provision is
disadvantageous to the bond holder, the bond will offer a higher yield than an otherwise
identical bond with no call provisions.
6. PUT PROVISIONS
A provision that enables the buyer to sell the bond back to the issuer at a pre-specified
price prior to maturity. This price is known as the put price. A bond containing such a
provision is said to be puttable. This provision enables bond holders to benefit from rising
interest rates since the bonds can be sold and reinvested at a higher yield than the original
bond. Since a put provision is advantageous to the bond holder, the bond will offer a lower
yield than an otherwise identical bond with no put provision.
7. SINKING FUND PROVISIONS

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 Some bonds are issued with a provision that requires the issuer to repurchase a fixed
percentage of the outstanding bonds each year, regardless of the level of interest rates. It
reduces the possibility of default. Default occurs when a bond issuer is unable to make
promised payments in a timely manner. Since a sinking fund reduces credit risk to bond
holders, these bonds can be offered with a lower yield than an otherwise identical fund with
no sinking fund.

THE BASIC BOND VALUATION MODEL

The computation of the present value of a stream of cash flow is the same methodology
for computing the value of a bond – its value is based on the cash flow that investors
expect during his life. According to Bexley and Brigham (2012), cash flow consist of interest
payments during the life of the bond plus a return of the principal amount borrowed (par
value) when the bond matures.
Take the case of a bond that pays Php500 in interest annually. The principal (par value)
is Php2, 500. The interest rate on the bond is 4%. It is assumed that the interest payments
are paid at the end of each year. The bond will mature in 10 years.

Maturity Value = Php 12,500

PV =
PV = +…+
PV= 480.77 + 462.28 + 444.50 + 427.40 + 410.96 + 395.96 + 365.35 + 351.29 + 337.78 +
8444.55
PV= Php 12,500.
3.3 BOND THEOREMS

Burten G. Malkiel identified the relationship between bond prices and changes in market
interest rates. He stated five fundamental principles to relate bond prices and market
interest rates which are known as bond pricing theorems. These are discussed as:
1. Bonds prices move inversely to market interest changes.
 2. The variability in bond prices and term to maturity are positively related. For a given
change in the level of market interest rates, changes in the bond prices are greater
for long-term maturities.
3. The sensitivity to changes in market interest rates increases at a diminishing rate as
the time remaining until the bond’s maturity increases.
4. Absolute increase in market interest rates and subsequent bond price changes are
not symmetrical. For a given maturity, a decrease in market interest rate causes a
price rise that is larger than the price decline resulting from an equal increase in
market interest rate.
5. Bond price volatility is related to its coupon rate. The percentage change in a bond’s
price due to a change in the market interest rate will be smaller if its coupon rate is
higher.
3.4 REAL INTEREST RATE
DEFINITION
A real interest rate is an interest rate that has been adjusted to remove the effects of
inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to
an investor. The real interest rate reflects the rate of time-preference for current goods over
future goods. The real interest rate of an investment is calculated as the difference between
the nominal interest rate and the inflation rate:

Real interest rate = Nominal Interest Rate – Inflation (Expected or actual)

In cases where inflation is positive, the real interest rate is lower than the advertised
nominal interest rate.

EXAMPLE: If a loan has a 12% interest rate and the inflation rate is 8%, then the real
return on that loan is 4%.

According to the time-preference theory of interest, the real interest rate reflects the
degree to which an individual prefers current goods over future goods. A borrower who is
eager to enjoy the present use of funds shows a stronger time-preference for current goods
over future goods and is willing to pay a higher interest rate for loaned funds. Similarly a
lender who strongly prefers to put off consumption to the future shows a lower time-
preference and will be willing to loan funds at a lower rate. Adjusting for inflation can help
reveal the rate of time-preference among market participants.

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 Fisher Effect Definition

The Fisher Effect is an economic theory created by Irving Fisher that describes the
relationship between inflation and both real and nominal interest rates.

What Does Nominal Mean and How it Compares to Real Rates

The nominal interest rate is the interest rate before taking inflation into account, in
contrast to real interest rates and effective interest rates. Nominal is a common financial
term with several different contexts. It can refer to something small or far below the real
value or cost, an unadjusted rate or change in value, or the face value of an asset such as
a bond.

IMPORTANCE OF REAL INTEREST RATE

They needed to attract deposits. Therefore, real interest rates were better for savers
than indicated by looking at base rates. In a liquidity trap, lower interest rates may be
ineffective in boosting demand because there are many other factors at work.

NOMINAL INTEREST RATE VS. REAL INTEREST RATE

NOMINAL INTEREST RATE REAL INTEREST RATE
It is the simplest type of interest rate. It is It is a reflection of the change in purchasing
in the actual monetary price that power derived from an investment or given
borrowers pay to lenders to use their up by the borrower.
money.
It does not take inflation into account. It does take inflation into account.

3.5 LOANABLE FUNDS THEORY OF INTEREST

What is Loanable funds?

The term loanable funds is used to describe funds that are available for
borrowing. Loanable funds consist of household savings and/or bank loans. Because
investment in new capital goods is frequently made with loanable funds, the demand
and supply of capital is often discussed in terms of the demand and supply of loanable
funds.
 The Loanable Funds Theory describes the relationship between money
available for borrowing and interest rates. Both the supply of money available for
borrowing and demand for money to be borrowed depend upon interest rates. The
loanable funds market consists of borrowers and loaners of funds.

PRINCIPLE OF EQUILIBRIUM INTEREST RATE

The loanable funds market works on the principle of equilibrium. All lenders and
borrowers of loanable funds are participants in the loanable funds market. The total
amount of funds supplied by lenders makes up the supply of loanable funds, while the
total amount of funds demanded by borrowers makes up the demand for loanable
funds. Demand for loanable funds will balance with the supply of loanable funds at a
specific interest rate. The interest rate varies with market conditions, so the demand for
-- and supply of -- loanable funds remain equal. Changes in either the demand for funds
or the supply of funds will result in a change in interest rate to restore equilibrium. An
increase in demand for funds, for example, causes an increase in the interest rate,
which in turn increases the available supply. The opposite is also true. Consumers have
access to loanable funds primarily through bank loans. Businesses and governments
can also issue bonds to access loanable funds.

The loanable funds market is illustrated in Figure. The demand curve for loanable
funds is downward sloping, indicating that at lower interest rates borrowers will demand
more funds for investment. The supply curve for loanable funds is upward sloping,
indicating that at higher interest rates lenders are willing to lend more funds to investors.
The equilibrium interest rate is determined by the intersection of the demand and supply
curves for loanable funds, as indicated in Figure.

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 The interest rate is the cost of demanding or borrowing loanable funds. Alternatively,
the interest rate is the rate of return from supplying or lending loanable funds. The interest rate
is typically measured as an annual percentage rate. For example, a firm that borrows
Php20,000 in funds for one year, at an annual interest rate of 5%, will have to repay the lender
Php21,000 at the end of the year; this amount includes the Php20,000 borrowed plus
Php1,000 in interest (Php20,000 × .05).

If the firm borrows Php20,000 for two years at an annual interest rate of 5%, it will have
to repay the lender Php22,050 at the end of two years. After one year, the firm will owe the
lender Php21,000 as explained above; however, because the loan is for two years, the firm
does not have to repay the lender until the end of the second year. During the second year, the
firm is charged compound interest, which means it is charged interest on both the principal of
Php20,000 and the accumulated unpaid interest of Php1,000. It is as though the firm receives
a new loan at the beginning of the second year for Php21,000. Thus, at the end of the second
year, the firm repays the lender Php21,000 + (21,000 × .05) = Php22,050.

In general, the amount that has to be repaid on a loan of X pesos for t years at an
annual interest rate of r is given by the formula

For example, if X = Php20,000, r = .05, and t = 2, the amount repaid is found to be

Php20,000 × (1.05) 2 = Php22,050.
3.6 PRICE EXPECTATIONS AND INTEREST RATES

What Is Expectations Theory

Expectations theory attempts to predict what short-term interest rates will be in the future
based on current long-term interest rates. The theory suggests that an investor earns the same
amount of interest by investing in two consecutive one-year bond investments versus investing
in one two-year bond today. The theory is also known as the "unbiased expectations theory."

Understanding Expectations Theory

The expectations theory aims to help investors make decisions based upon a forecast of
future interest rates. The theory uses long-term rates, typically from government bonds, to
forecast the rate for short-term bonds. In theory, long-term rates can be used to indicate where
rates of short-term bonds will trade in the future.

Example of Calculating Expectations Theory

Let's say that the present bond market provides investors with a two-year bond that pays
an interest rate of 20% while a one-year bond pays an interest rate of 18%. The expectations
theory can be used to forecast the interest rate of a future one-year bond.

 The first step of the calculation is to add one to the two-year bond’s interest rate. The
result is 1.2.

 The next step is to square the result or (1.2 * 1.2 = 1.44).

 Divide the result by the current one-year interest rate and add one or ((1.44 / 1.18)
+1 = 1.22).

 To calculate the forecast one-year bond interest rate for the following year,
subtract one from the result or (1.22 -1 = 0.22 or 22%).

In this example, the investor is earning an equivalent return to the present interest rate of
a two-year bond. If the investor chooses to invest in a one-year bond at 18% the bond yield for
the following year’s bond would need to increase to 22% for this investment to be
advantageous.

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  Expectations theory attempts to predict what short-term interest rates will be in the
future based on current long-term interest rates

 The theory suggests that an investor earns the same amount of interest
by investing in two consecutive one-year bond investments versus investing in one
two-year bond today

 In theory, long-term rates can be used to indicate where rates of short-term bonds
will trade in the future

Disadvantages of Expectations Theory

Investors should be aware that the expectations theory is not always a reliable tool. A common
problem with using the expectations theory is that it sometimes overestimates future short-term rates,
making it easy for investors to end up with an inaccurate prediction of a bond’s yield curve.

Another limitation of the theory is that many factors impact short-term and long-term bond
yields. The Federal Reserve adjusts interest rates up or down, which impacts bond yields including
short-term bonds. However, long-term yields might not be as impacted because many other factors
impact long-term yields including inflation and economic growth expectations. As a result, the
expectations theory doesn't take into account the outside forces and fundamental macroeconomic
factors that drive interest rates and ultimately bond yields.

3.7 INTEREST RATES OVER THE BUSINESS CYCLE

What Is a Business Cycle?

 The business cycle is also known as the economic cycle or trade cycle. The
business cycle describes the rise and fall in production output of goods and services in an
economy. Business cycles are generally measured using the rise and fall in the real gross
domestic product (GDP) or the GDP adjusted for inflation.

The business cycle should not be confused with market cycles, which are measured
using broad stock market indices. The business cycle is also different from the debt cycle,
which refers to the rise and fall in household and government debt.

Stages of the Business Cycle

1. Expansion

This is the first stage. When the expansion occurs, there is an increase in
employment, incomes, production, and sales. People generally pay their debts on time.
The economy has a steady flow in the money supply and investment is booming.

2. Peak

The second stage is a peak when the economy hits a snag, having reached the
maximum level of growth. Prices hit their highest level, and economic indicators stop
growing. Many people start to restructure as the economy's growth starts to reverse.

3. Recession

These are periods of contraction. During a recession, unemployment rises,

production slows down, and sales start to drop because of a decline in demand, and
incomes become stagnant or decline.

4. Depression

Economic growth continues to drop while unemployment rises and production

plummets. Consumers and businesses find it hard to secure credit, trade is reduced,

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 and bankruptcies start to increase. Consumer confidence and investment levels also
drop.

5. Trough

This period marks the end of the depression, leading an economy into the next
step: recovery.

6. Recovery

In this stage, the economy starts to turn around. Low prices spur an increase in
demand, employment and production start to rise, and lenders start to open up their
credit coffers. This stage marks the end of one business cycle.

The business cycle is characterized by expansion and contraction.

EXPANSION CONTRACTION
the economy experiences growth a period of economic decline.
Contractions are also called recessions.
is measured from the trough (or measured from the peak to the trough.
bottom) of the previous business
cycle to the peak of the current
cycle

Investors and the Business Cycle

If you use short-term debt, you will have to renew your loan every year; and the
rate charged on each new loan will reflect the then-current short term rate. Interest rates
return to their previous highs. Those high interest payments would cut into and perhaps
eliminate your profits. Your reduced probability could increase your firm’s risk to the
point where your bond rating was lowered, causing lenders to increase the risk premium
built into your interest rate. That would further increase your interest payments, which
would further reduce your profitability, worry lenders still more, and make them reluctant
to renew your loan. If your lenders refuse to renew the loan and demanded its
 repayment, as they would have every right to do, you might have to sell assets at a loss,
which could result in bankruptcy.

On the other hand, if you used long-term financing, your interest costs would
remain constant per year, so an increase in interest rates in the economy would not hurt
you. You might even be able to acquire some of your bankrupt competitors at bargain
prices; bankruptcies increase dramatically when the interest rates rise, primarily
because many firms use so much short-term debt.

Does all if this suggest that firms should avoid short-term debt? Not at all. If
inflation falls over the next few years, so will the interest rates. Financing decisions
would be easy if we could make accurate forecasts of future interest rates.
Unfortunately predicting interest rates with consistent accuracy is nearly impossible.
However, although it is difficult to predict future interest rate levels, it its east to predict
that interest rates will fluctuate, they always have, and they always will. That being the
case, sound financial policy calls for using a mix of long and short-term debt as well as
equity to position the firm so that it can survive in any interest rate environment. Further
the optimal financial policy depends in an important way on the nature of the firm’s
assets, the easier it is to sell assets to generate cash, and the more feasible it is to use
more short-term debt. This makes it logical for a firm to finance current assets such as
building and equipment with long-term debt.

VIDEO LECTURE:

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  https://youtu.be/I7FDx4DPapw

NEWS ITEM:

 https://www.google.com/amp/s/www.nytimes.com/2019/05/30/business/bond-yield-
curve-recession.amp.html

CASE STUDY:

 https://www.investopedia.com/articles/bonds/09/bond-market-interest-rates.asp

REFERENCES:
 https://www.investopedia.com/terms/i/interestrate.asp
 https://www.investopedia.com/ask/answers/042315/what-difference-between-
compounding-interest-and-simple-interest.asp
 https://www.nextadvisor.com/6-factors-that-affect-your-interest-rate/
 https://www.investopedia.com/terms/i/interestrate.asp
 https://www.myaccountingcourse.com/accounting-dictionary/interest-rate
 https://www.investinganswers.com/dictionary/b/bond
 https://www.google.com/amp/s/www.bbalectures.com/bond-pricing-theorems/amp/
 https://www.investopedia.com/terms/r/realinterestrate.asp
 https://www.economicshelp.org/blog/1765/interest-rates/real-interest-rates
 Business Finance book by Mr. Albert N. Gamatero
 https://www.cliffsnotes.com/study-guides/economics/capital-market/capital-
loanable-funds-interest-rate
 http://www.economicsdiscussion.net/interest/loanable-funds-theory/the-
loanable-funds-theory-of-interest-economics/25866
 https://www.investopedia.com/terms/r/realinterestrate.asp
 https://bizfluent.com/about-5499678-loanable-funds-theory.html
 https://www.investopedia.com/terms/e/expectationstheory.asp
 https://www.investopedia.com/terms/b/businesscycle.asp