Chapter 11: Bond Valuation

Measuring Return Required Return: the rate of return an investor must earn on an investment to be fully compensated for its risk

Bonds with longer maturities generally yield more than shorter maturities What is the single biggest factor that influences the price of bonds? Interest Rates Interest rates go up, bond prices go down Interest rates go down, bond prices go up What is the single biggest factor that influences the direction of interest rates? Inflation Inflation goes up, interest rates go up Inflation goes down, interest rates go down Economic Variables that Affect Interest Rates Changes in money supply The size of the federal budget deficit The level of economic activity Policies of the Federal Reserve The level of the interest rate in major foreign markets Term Structure of Interest Rates and Yield Curves Term Structure of Interest Rates: relationship between the interest rate or rate of return (yield) on a bond and its time to maturity Yield Curve: a graph that represents the relationship between a bonds term to maturity and its yield at a given point in time Two Types of Yield Curves

Theories on Shape of Yield Curve Slope of yield curve affect by: Inflation expectations Liquidity preferences of investors Supply and demand Expectations hypothesis Liquidity Preference Theory Market Segmentation Theory Basic Bond Investing Strategy If you expect interest rates to increase, buy shortterm bonds If you expect interest rates to decrease, buy longterm non-callable bonds

Required Rate on Investment = Real Rate of Return + Expected Inflation Premium + Risk Premium for Investment For bonds, the risk premium depends upon: the default, or credit, risk of the issuer the term-to-maturity any call risk, if applicable Major Bond Sectors Bond market is comprised of a series of different market sectors: U.S. Treasury issues Municipal bond issues Corporate bond issues Differences in interest rates between the various market sectors are called yield spreads Factors Affecting Yield Spreads Municipal bond rates are usually 20-30% lower than corporate bonds due to tax-exempt feature Treasury bonds have lower rates than corporate bonds due to no default risk The lower the credit rating (and higher the risk), the higher the interest rate Discount (low-coupon) bonds yield less than premium (high-coupon) bonds Revenue muni bonds yield more than general obligation muni bonds due to higher risk Freely callable bonds yield higher than noncallable bonds

The Pricing of Bonds

Bonds are priced according to the present value of their future cash flow streams Bond price = Present value of annuity of annual interest income + Present value of the bonds par value BP = ( I x PVIFA ) + ( PV x PVIF ) Bond prices are driven by market yields Appropriate yield at which the bond should sell is determined before price of the bond Required rate of return is determined by market, economic and issuer characteristics Required rate of return becomes the bonds market yield Market yield becomes the discount rate that is used to value the bond Bond prices are comprised of two components: Present value of the annuity of coupon payments, plus Present value of the single cash flow from repayment of the principal at maturity Compounding refers to frequency coupons are paid Annual compounding: coupons paid once per year

Semi-annual compounding: coupons paid every six months Ways to Measure Bond Yield Current Yield Simplest yield calculation Only looks at current income Current Yield = Annual Interest / Current Market Price of the Bond Yield-to-Maturity The fully compounded rate of return earned by an investor over the life of a bond, including interest income and price appreciation. Yield-to-Call Similar to yield-to-maturity Assumes bond will be called on the first call date Uses bonds call price (premium) instead of the par value True yield received if the bond is held to call Expected Return Used by investors who expect to actively trade in and out of bonds rather than hold until maturity date Similar to yield-to-maturity Uses estimated market price of bond at expected sale date instead of the par value

The Concept of Duration Generally speaking, bond duration possesses the following properties: Bonds with higher coupon rates have shorter durations Bonds with longer maturities have longer durations Bonds with higher YTM lead to shorter durations Bond duration is a better indicator than bond maturity of impact of interest rates on bond price (price volatility) If interest rates are going up, hold bonds with short durations If interest rates are going down, hold bonds with long durations Measuring Duration Steps in calculating duration Step 1: Find present value of each coupon or principal payment Step 2: Divide this present value by current market price of bond Step 3: Multiple this relative value by the year in which the cash flow is to be received Step 4: Repeat steps 1 through 3 for each year in the life of the bond then add up the values computed in Step 3 Bond Immunization Strategy to derive a specified rate of return regardless of what happens to market interest rates over holding period Seeks to offset the opposite changes in bond valuation caused by price effect and reinvestment effect Price effect: change in bond value caused by interest rate changes Reinvestment effect: as coupon payments are received, they are reinvested at higher or lower rates than original coupon rate Bond immunization occurs when the average duration of the bond portfolio just equals the investment time horizon

Bond Investment Strategies

Conservative Approach Main focus is high current income High credit quality bonds are used Usually longer holding periods Aggressive Approach Main focus is capital gains Usually shorter holding periods with frequent bond trading Use forecasted interest rate strategy to time bond trading Buy-and-hold strategy Replace bonds as they mature or quality declines Bond ladder strategy Set up ladder by investing equal amounts into varying maturity dates (i.e. 3-, 5-, 7- and 10 years) As bonds mature, purchase new bonds with 10-year maturity to keep ladder growing Provides higher yields of longer-term bonds and dollar-cost averaging benefits Bond Swaps Occur when investor sells one bond and simultaneously buys another bond in its place Yield pickup swap strategy Sell a lower yielding bond and replace it with a comparable credit quality bond with higher yield Often done between different bond sectors (i.e. industrial bonds vs. utility bonds) Tax swap strategy Sell a bond that has declined in value, use the capital loss to offset other capital gains, and repurchase another bond of comparable credit quality Watch out for wash salesnew bond cannot be an identical issue to old bond
Prepared by: Garcia, Crizette Fraginal, Sharmay R. Nacino, Adora Jasmin P. Camillo, Camille N. Sanchez, Rubina

Bond Duration
Bond Duration: A measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments Improvement over yield-to-market because factors in reinvestment risk Compares the sensitivity to changes in interest rates Bond Duration is the average amount of time that it takes to receive the interest and the principal Calculates the weighted average of the cash flows (interest and principal payments) of the bond, discounted to the present time