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.³ 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 ³original´ 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    



Benchmark²risk-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 longterm 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
UpwardSloping Yield Curve 

DownwardSloping Yield Curve  

Expected higher interest rate levels Expansive monetary policy Expanding economy  



Expected lower interest rate levels Tight monetary policy Recession soon?

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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 Rf,n

= yield of an n-day security = 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

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