BOND VALUATION AND RISK

8-1 BOND VALUATION PROCESS

 Bonds are debt obligations with long-term maturities that are commonly issued by
governments or corporations to obtain long-term funds.
 Bond valuation is conceptually similar to the valuation of capital budgeting projects,
businesses, or even real estate.
 The appropriate price reflects the present value of the cash flows to be generated by the
bond in the form of periodic interest (or coupon) payments and the principal payment to be
provided at maturity.
 The coupon payment is based on the coupon rate multiplied by the par value of the bond.

8-1a Impact of the Discount Rate on Bond Valuation

 The discount rate selected to compute the present value is critical to accurate valuation.
 Since investors require higher returns on riskier securities, they use higher discount rates to
discount the future cash flows of these securities. Consequently, a high-risk security will
have a lower value than a low-risk security even though both securities have the same
expected cash flows.

8-1b Impact of the Timing of Payments on Bond Valuation

 The market price of a bond is also affected by the timing of the payments made to
bondholders. Funds received sooner can be reinvested to earn additional returns. Thus, a
dollar to be received soon has a higher present value than one to be received later.

8-1c Valuation of Bonds with Semiannual Payments

 First, the annualized coupon should be split in half because two payments are made per
year.
 Second, the annual discount rate should be divided by 2 to reflect two six-month periods per
year.
 Third, the number of periods should be doubled to reflect 2 times the number of annual
periods.
 After these adjustments are incorporated, the present value is determined as follows:

8-1d Relationships between Coupon Rate, Required Return, and Bond Price
 Discount Bonds- bonds that sell at a price below their par value
  The larger the investor’s required rate of return relative to the coupon rate, the larger the
discount of a bond with a particular par value.
 First, if the coupon rate of a bond is below the investor’s required rate of return, the present
value of the bond (and therefore the price of the bond) should be below the par value.
 Second, if the coupon rate equals the investor’s required rate of return, the price of the
bond should be the same as the par value.
 Finally, if the coupon rate of a bond is above the investor’s required rate of return, the price
of the bond should be above the par value.

8-2 EXPLAINING BOND PRICE MOVEMENTS

 the price of a bond should reflect the present value of future cash flows (coupon payments
and the par value), based on a required rate of return (k), so that

 Since the required rate of return on a bond is primarily determined by the prevailing risk-
free rate (Rf), which is the yield on a Treasury bond with the same maturity, and the credit
risk premium (RP) on the bond, it follows that the general price movements of bonds can be
modelled as

 The bond price is affected by a change in either the risk-free rate or the risk premium.
 An increase in the risk-free rate on bonds results in a higher required rate of return on bonds
and therefore causes bond prices to decrease. Thus bond prices are exposed to interest rate
risk, or the risk that their market value will decline in response to a rise in interest rates.
 Bonds are also exposed to credit risk: an increase in the credit (default) risk premium also
causes investors to require a higher rate of return on bonds and therefore causes bond
prices to decrease.

8-2a Factors That Affect the Risk-Free Rate

 The long-term risk-free rate is driven by inflationary expectations (INF), economic growth
(ECON), the money supply (MS), and the budget deficit (DEF):

o Impact of Inflationary Expectations. If the level of inflation is expected to increase,

there will be upward pressure on interest rates and hence on the required rate of
return on bonds. Conversely, a reduction in the expected level of inflation results in
downward pressure on interest rates and thus on the required rate of return on
bonds.
 Inflationary expectations are partially dependent on oil prices, which affect
the cost of energy and transportation. This is why bond portfolio managers
must forecast oil prices and their potential impact on inflation in order to
forecast interest rates. A forecast of lower oil prices results in expectations
of lower interest rates, causing bond portfolio managers to purchase more
bonds. A forecast of higher oil prices results in expectations of higher
interest rates, causing bond portfolio managers to sell some of their
holdings.
 Inflationary expectations are also partially dependent on exchange rate
movements. Inflationary expectations are likely to rise when a weaker dollar
is expected because it will increase the prices of imported supplies. U.S.
interest rates are expected to rise and bond prices are expected to decrease
 when the dollar is expected to weaken. Foreign investors anticipating dollar
depreciation are less willing to hold U.S. bonds because in that case the
coupon payments will convert to less of their home currency.
 Expectations of a strong dollar should have the opposite results. A stronger
dollar reduces the prices paid for foreign supplies, thus lowering retail
prices. Expectations of a stronger dollar may encourage bond portfolio
managers to purchase more bonds, which places upward pressure on bond
prices.

o Impact of Economic Growth. Strong economic growth tends to generate upward

pressure on interest rates, while weak economic conditions put downward pressure
on rates. Any signals about future economic conditions will affect expectations
about future interest rate movements and cause bond markets to react
immediately. Conversely, any economic announcements that signal a weaker than
expected economy tend to increase bond prices because investors anticipate that
interest rates will decrease and thereby cause bond prices to rise. Hence investors
buy bonds, which places immediate upward pressure on bond prices. Bond market
participants closely monitor economic indicators that may signal future changes in
the strength of the economy, which signal changes in the risk-free interest rate and
in the required return from investing in bonds.

o Impact of Money Supply Growth. The increased money supply may result in an
increased supply of loanable funds.

o Impact of Budget Deficit. As the annual budget deficit changes, so does the federal
government’s demand for loanable funds. The higher budget deficit leads to the
same expected outcome as higher inflationary expectations. In both cases, there is
an increase in the amount of funds borrowed, which leads to higher interest rates.
However, inflationary expectations result in more borrowing by individuals and
firms, whereas an increased budget deficit results in more borrowing by the federal
government.

8-2b Factors That Affect the Credit (Default) Risk Premium

 The general level of credit risk on corporate or municipal bonds can change in response to a
change in economic growth (ECON):

 Strong economic growth tends to improve a firm’s cash flows and reduce the probability
that the firm will default on its debt payments. While weak economic conditions tend to
reduce a firm’s cash flows and increase the probability that it will default on its bonds.
 The credit risk premium is relatively low when economic growth is strong and when the
economy is weak, the credit risk premium is higher: thus, investors will provide credit in such
periods only if they are compensated for the high degree of credit risk.

o Changes in the Credit Risk Premium over Time. the difference between the
corporate and Treasury bond yields widened during periods when the economy was
weak, such as during the 2008–2009 credit crisis when investors required a higher
credit risk premium.
 o Impact of Debt Maturity on the Credit Risk Premium. The credit risk premium tends
to be larger for bonds that have longer terms to maturity. Bonds issued by a
corporation with long term maturity have a higher risk of default, because the
corporation’s ability to repay this debt is dependent on its performance over the
years until it reaches the maturity. Because economic conditions over the years are
very uncertain, so is the corporation’s performance and its ability to repay long-term
debt. On the other hand, when a corporation issues bonds with short term maturity,
let’s say 1 month, it should be capable of completely repaying this debt, because
conditions should not change drastically over the next month.

o Impact of Issuer Characteristics on the Credit Risk Premium. A bond’s price can also
be affected by factors specific to the issuer of the bond, such as a change in its
capital structure. If a firm that issues bonds subsequently obtains additional loans, it
may be less capable of making its coupon payments, thus its credit risk increases.
Consequently, investors would now require a higher rate of return if they were to
purchase those bonds in the secondary market, which would cause the market value
(price) of the bonds to decrease

8-2c Summary of Factors Affecting Bond Prices

 When considering the factors that affect the risk-free rate and the risk premium, the general
price movements in bonds can be modelled as follows:

8-2d Implications for Financial Institutions

  Any factors that lead to higher interest rates tend to reduce the market values of financial
institution assets and therefore reduce their valuations. Conversely, any factors that lead to
lower interest rates tend to increase the market values of financial institution assets and
therefore increase their valuations.
 Many financial institutions attempt to adjust the size of their bond portfolio according to
their expectations about future interest rates.
o When they expect interest rates to rise, they sell bonds and use the proceeds to
purchase short-term securities that are less sensitive to interest rate movements.
o If they anticipate that the risk premiums of risky bonds will increase, they shift
toward relatively safe bonds that exhibit less credit risk.
 Systemic Risk. The potential collapse of the entire market or financial system. When specific
conditions cause a higher risk-free rate and a very high risk premium, they adversely affect
the prices of most bonds.

8.3 SENSITIVITY OF BOND PRICES TO INTEREST RATE MOVEMENTS

8-3a Bond Price Elasticity

 The sensitivity of bond prices (Pb) to changes in the required rate of return (k) is commonly
measured by the bond price elasticity (P eb), which is estimated as

 Influence of Coupon Rate on Bond Price Sensitivity. A zero-coupon bond, which pays all of
its proceeds to the investor at maturity, is most sensitive to changes in the required rate of
return because the adjusted discount rate is applied to one lump sum in the distant future.
Conversely, the price of a bond that pays all its yield in the form of coupon payments is less
sensitive to changes in the required rate of return because the adjusted discount rate is
applied to some payments that occur in the near future.

 Influence of Maturity on Bond Price Sensitivity. As interest rates (and therefore required
rates of return) decrease, long-term bond prices (as measured by their present value)
 increase by a greater degree than short-term bond prices because the long-term bonds will
continue to offer the same coupon rate over a longer period of time than the short-term
bonds. Of course, if interest rates increase, prices of the long-term bonds will decline by a
greater degree.

8-3b Duration
 measurement of the life of the bond on a present value basis.
 The longer a bond’s duration, the greater its sensitivity to interest rate changes. A commonly
used measure of a bond’s duration (DUR) is