Bond Valuation & Analysis

Concept of Bond
Types of Bonds

The Yield Curve

What is a bond?
 A bond is a tradable instrument that represents a
debt owed to the owner by the issuer. Most
commonly, bonds pay interest periodically (usually
semiannually) and then return the principal at
maturity.
 The par value is the value stated on the face of the
bond and is the amount issuer promises to pay to
the holder at the time of maturity.
 The coupon rate is the interest rate payable to the
bond holder.
 The maturity date is the date when the principal
amount is payable to the bond holder.
Reasons for issuing Bonds

Bonds, while a more conservative

investment than stocks, can offer certain
investors some very attractive features:
 Safety and reliable income
 To reduce the cost of capital
 To gain the benefit of leverage
 To effect tax saving
 To widen the sources of funds-Diversification
 To preserve control
Types of Bonds
 Straight Bonds
 Convertible and Non Convertible Bonds
 Zero Coupon Bonds
 Callable & Puttable Bonds
 Floating Rate Bond
 Sinking Fund Bonds
 Serial Bonds
 Mortgage or secured Bonds- Open end, Close end and limited
open end
 Collateral Trust Bonds
 Income Bonds
 Joint Bonds
 Guaranteed Bonds
 Redeemable or Irredeemable Bonds
 Participating Bonds
Types of Bonds
 What Does Joint Bond Mean?
A bond that is guaranteed by a party other than the
issuer. Also called a "joint-and-several bond.“
 What Does Guaranteed Bond Mean?
A type of bond in which the interest and principal on the
bond are guaranteed to be paid by a firm other than the
issuer of the bond.
Types of Bonds
 Participating bond -- Comparable to an income bond in
as much as the return to the holder in interest depends
on the extent of the revenues so applicable. The first
bonds to bear this name were issued in 1902 and were
designated "4 per cent and participating bonds." These
bonds were in effect collateral as well as income bonds.
The company which issued the bonds owned stock in
another company and this stock was deposited and
pledged as security for the principal of the bonds.
Interest at 4 per cent was guaranteed by the company
which issued the bonds and the bonds were also entitled
to receive interest in excess of 4 per cent as permitted
by the dividends paid on the stock securing the bonds
beyond the amount necessary first to provide for the 4
per cent as guaranteed.
Basic Bond Valuation (cont.)
 The value of a bond is determined by four variables:
 The Coupon Rate – This is the promised annual rate of
interest. It is normally fixed at issuance for the life of the bond.
To determine the annual interest payment, multiply the coupon
rate by the face value of the bond. Interest is normally paid
semiannually or annually.
 The Face Value – This is nominally the amount of the loan to
the issuer. It is to be paid back at maturity.
 Term to Maturity – This is the remaining life of the bond, and
is determined by today’s date and the maturity date. Do not
confuse this with the “original” maturity which was the life of the
bond at issuance.
 Yield to Maturity – This is the rate of return that will be earned
on the bond if it is purchased at the current market price, held
to maturity, and if all of the remaining coupons are reinvested
at this same rate. This is the IRR of the bond.
Risks of Bonds
 Bonds are generally less risky than stocks, but they do suffer from
several types of risk:
 Credit risk – Risk of default.

 Price risk – Risk of unexpected changes in rates, causing a

capital loss.
 Reinvestment risk – Risk that rates will fall and you will reinvest at

a lower rate.
 Purchasing power risk – Risk that inflation will be higher than

expected.
 Call risk – Risk that the bond will be called because of lower rates.

 Liquidity risk – The risk that you will not be able to sell the bond

at a price near its full value.

 Foreign exchange risk – Risk that a foreign currency will decline

in value, causing a decline in the value of your interest payments

and principal.
Factors Affecting Security Yields
 Risk-averse investors demand higher yields
for added risk.
 Risk is associated with variability of returns
 Increased risk generates lower security
prices or higher investor required rates of
return

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Factors Affecting Security Yields

 Security yields and prices are affected by

levels and changes in:
 Default risk (also called Credit Risk)
 Liquidity
 Tax status
 Term to maturity
 Special contract provisions such as embedded
options
Factors Affecting Security Yields

 Benchmark—risk-free treasury securities for

given maturity
 Default risk premium = risky security yield –
treasury security yield of same maturity
 Default risk premium = market expected
default loss rate
 Rating agencies set default risk ratings
 Anticipated or actual ratings changes impact
security prices and yields
Factors Affecting Security Yields
 The Liquidity of a security affects the
yield/price of the security
 A liquid investment is easily converted to
cash at minimum transactions cost
 Investors pay more (lower yield) for liquid
investment
 Liquidity is associated with short-term, low
default risk, marketable securities

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Factors Affecting Security Yields

 Tax status of income or gain on security

impacts the security yield
 Investor concerned with after-tax return or
yield
 Investors require higher yields for higher
taxed securities

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Factors Affecting Security Yields

Yat = Ybt(1 – T)

Where:
Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate
Factors Affecting Security Yields

 Term to maturity
 Interest rates typically vary by maturity.
 The term structure of interest rates defines the
relationship between maturity and yield.
 The Yield Curve is the plot of current interest yields
versus time to maturity.
Yield Curve

Yield
%

Time to Maturity

An upward-sloping yield curve indicates that Treasury

Securities with longer maturities offer higher annual yields
Yield Curve Shapes

Normal Level or Flat Inverted

The Term Structure of Interest Rates/
Yield Curve
 The "term structure" of interest rates
refers to the relationship between bonds
of different terms. When interest rates of
bonds are plotted against their terms, this
is called the "yield curve". Economists
and investors believe that the shape of the
yield curve reflects the market's future
expectation for interest rates and the
conditions for monetary policy.
The Term Structure of Interest Rates/
Yield Curve
There are three main patterns created by the term structure of
interest rates.

1) Normal Yield Curve: As its name indicates, this is the yield curve
shape that forms during normal market conditions, wherein
investors generally believe that there will be no significant
changes in the economy, such as in inflation rates, and that the
economy will continue to grow at a normal rate. During such
conditions, the market expects long-term fixed income securities
to offer higher yields than short-term fixed income securities. This
is a normal expectation of the market because short-term
instruments generally hold less risk than long-term instruments;
the farther into the future the bond's maturity, the more time and,
therefore, uncertainty the bondholder faces before being paid
back the principal. To invest in one instrument for a longer period
of time, an investor needs to be compensated for undertaking the
additional risk.
Normal Yield Curve : upward
sloping
yield

maturity

 yields rise w/ maturity (common)

Flat Yield Curve

 Flat Yield Curve: When a small or negligible

difference between short and long term
interest rates occurs due to higher inflation
expectations and tighter monetary policy then
the yield curve is known as a "shallow" or
"flat" yield curve. The higher short term rates
reflect less available money, as monetary
policy is tightened, and higher inflation later in
the economic cycle.
Flat Yield Curve
yield

maturity

 yields similar for all maturities

 Inverted Yield Curve: Downward Slope
 Inverted Yield Curve: These yield curves are rare, and they form
during extraordinary market conditions wherein the expectations of
investors are completely the inverse of those demonstrated by the
normal yield curve. In such abnormal market environments, bonds with
maturity dates further into the future are expected to offer lower yields
than bonds with shorter maturities. The inverted yield curve indicates
that the market currently expects interest rates to decline as time
moves farther into the future, which in turn means the market expects
yields of long-term bonds to decline. Remember, also, that as interest
rates decrease, bond prices increase and yields decline.
You may be wondering why investors would choose to purchase long-
term fixed-income investments when there is an inverted yield curve,
which indicates that investors expect to receive less compensation for
taking on more risk. Some investors, however, interpret an inverted
curve as an indication that the economy will soon experience a
slowdown, which causes future interest rates to give even lower yields.
Before a slowdown, it is better to lock money into long-term
investments at present prevailing yields, because future yields will be
even lower.
The Term Structure of Interest Rates
Downward-
Upward- Sloping
Sloping Yield Curve
Yield Curve

 Expected higher  Expected lower interest

interest rate levels rate levels
 Expansive monetary  Tight monetary policy
policy  Recession soon?
 Expanding economy

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Factors Affecting Security Yields

 Special Provisions
 Call Feature: enables borrower to buy back the
bonds before maturity at a specified price
 Call features are exercised when interest rates have
declined
 Investors demand higher yield on callable bonds,
especially when rates are expected to fall in the future
Factors Affecting Security Yields

 Special provisions
 Convertible bonds
 Convertibility feature allows investors to convert the
bond into a specified number of common stock shares
 Investors will accept a lower yield for convertible bonds
because investor returns include expected return on
equity participation
Estimating the Appropriate Yield

 The appropriate yield to be offered on a debt

security is based on the risk-free rate for the
corresponding maturity plus adjustments to
capture various security characteristics

Yn = Rf,n + DP + LP + TA + CALLP + COND

Estimating the Appropriate Yield
Yn = Rf,n + DP + LP + TA + CALLP + COND
Where:
Yn = yield of an n-day security
Rf,n = yield on an n-day Treasury
(risk-free) security
DP = default premium (credit risk)
LP = liquidity premium
TA = adjustment for tax status
CALLP = call feature premium
COND = convertibility discount