Bond Valuation and Management

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Chapter 7

• Bond Valuation and Management

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CHAPTER 7 OVERVIEW

• 7.1 Bond Valuation
• 7.2 Yield to Maturity
• 7.3 Interest Rate Risk
• 7.4 Duration and Convexity
• 7.5 Credit Quality Risk
• 7.6 High-Yield Bonds
• 7.7 Convertible Bonds
• 7.8 Bond Investment Strategies

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KEY TERMS

• Market Interest Rate
• Benchmark Interest Rate
• Zero Coupon Bonds
• Interest Reinvestment Risk
• Seasoned Bonds
• Settlement Date
• Maturity Date
• Bond Coupon Rate

• Bond Redemption Value
• Semiannual Interest
• Day Count Basis
• Average Life
• Call Provision
• Call Protection
• Bond Tender Offer
• Refunding

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Assessing a Bonds Economic Value

• Interest payment obligation
• Price
• Yield
• Maturity
• Redemption features
• Credit quality
• Market interest rate
• Degree to which it matches financial objectives

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Bond Interest

• Bonds debt securities that pay interest based on
  par value
• fixed or variable rates
• semiannual payments
• principal repayment at maturity
• Floating-Rate Bonds interest set based on
  underlying benchmark rate
• short term T-bills
• 30-year T-bonds

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Zero-Coupon Bonds

• Pay no interest
• Sold at (deep) discount such that payment at
  maturity represents purchase price plus total
  interest earned
• Introduced 1982
• Eliminate interest reinvestment risk loss in
  reinvested interest income due to rising interest
  rates

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Determining the Value of Seasoned Bonds

• Newly-issued bonds sell at or near face value.
• Value for seasoned bonds
• prevailing market interest rates
• supply/demand for similar types of bonds
• credit quality
• term-to-maturity
• tax status

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Present Value of a Bond

• Economic value of a bond PV of all expected
  interest and principal payments.

N number of years until maturity Yield market
interest rate on economically similar securities
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QUICK QUIZBond Price Interest Rates

• Holding all else equal, the value of a bond will
  _______ with a rise in market interest rates.

a. fall b. rise c. stay the same d. equal the
face amount or par value of the bond
a. fall b. rise c. stay the same d. equal the
face amount or par value of the bond
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Bond Pricing Factors

• Settlement date when buyer takes effective
  possession of security
• Maturity date date when security expires or
  ceases to accrue interest
• Bond coupon rate interest rate expressed as a
  percentage of par value
• Bond redemption value amount to be received from
  issuer on maturity date
• Semiannual interest interest pays twice per year
  in two equal payments
• Day count basis for bonds 30 days per month 360
  days per year

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YIELD TERMS

• Yield-to-maturity
• Yield-to-call
• Bond put provision
• Interest-rate risk
• Basis points
• Yield curve/term structure of interest rates
• Bond tender offer
• Refunding

• Liquidity preference hypothesis
• Segmented market hypothesis
• Hedging
• Duration
• Risk immunization
• Modified duration

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Yield-to-Maturity

• Represents investors total return from
  settlement day until security expiration
• Allows investors to compare bonds with different
  maturities and coupon rates via internal rate of
  return calculations
• Bond yields inversely related to bond prices

• Common maturities
• short term up to five years
• medium term 5-12 years
• long term 12 or more years

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Issues That Affect Term-to-Maturity

• Average Life typical period before refunding
  apropos of mortgage-backed securities
• Call Provisions contractual authority that
  allows issuers to redeem bonds prior to scheduled
  maturity
• Call Protection period of time before a
  newly-issued security is callable
• Put Provisions investor option to sell bond back
  to issuers, exercised when
• market interest rates rise
• issuer credit quality deteriorates
• serious threat of credit quality deterioration

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Interest Rate Risk

• Chance of bondholder loss due to market-wide
  fluctuations in interest rates
• Affects debt securities in secondary
  marketday-to-day fluctuations in value

• Factors that change prevailing interest rates
• changes in supply and demand for credit
• Federal Reserve policydiscount rate
• fiscal policy
• exchange rates
• economic conditions
• market psychology
• changes in expectations about inflation

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Term Structure of Interest Rates

• Interest rate relationships among bonds with same
  credit quality but different maturities
• Yield Curve line that illustrates term structure
• Liquidity Preference Hypothesis theory that
  rising yield curves give long-term bondholders a
  holding-period risk premium
• Segmented Market Hypothesis theory that yield
  curves reflect primarily the hedging and maturity
  needs of institutional investors

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Duration Risk Immunization

• All else equal, the longer the term-to-maturity,
  the mores sensitive bond prices are to interest
  rate changes
• Duration economic life of a bond measured by
  weighted-average time to receipt of interest and
  principal payments, given by

• Risk Immunization elimination of interest rate
  risk by matching duration of financial assets and
  liabilities

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Modified Duration

• Modified Duration direct estimate of the
  percentage change in a bonds market price for
  each percentage change in market interest rate
• Does not predict when interest rates will move,
  by how much , or in which direction only helps
  manage investment risk.

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KEY TERMSCredit Quality Risk

• Bond-Rating Agency
• Credit-Quality Risk
• Below-Investment-Grade/Junk Bonds
• Yield Spread
• High-Yield Bonds

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Credit-Quality Risk

• Chance of loss due to inability of bond issuer to
  make timely interest and principal payments

• Gives rise to risk structure of interest rates or
  yield spreads differences in yield for bonds
  with same maturity but different credit risks

• Credit quality of individual bondsenhanced if
  issuer buys bond insurance from third party
• Junk or non-investment quality bonds carry most
  credit risk

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Valuing Convertible Bonds

• Convertible Bond
• Indenture Agreement
• Conversion Ratio
• Conversion Price
• Conversion Value
• Common Stock Equivalent
• Premium to Conversion
• Break-Even Time

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Convertible Bond Pricing
Table 7.8
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Bond Investment Strategies

• Asset Allocation
• Laddering
• Barbell Strategy
• Bond Swaps

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WHY INVEST IN BONDS??

• Stable income
• Diversification
• Higher interest than on money market funds, CDs,
  bank accounts
• Preserve capital
• Dependable interest income flow
• Asset Allocation process of diversifying an
  investment portfolio across asset categories

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MATURITY-BASED STRATEGY Increase Returns
Minimize Price Volatility

• Laddering portfolio allocation with step-like
  sequence of maturity dates

• Barbell Strategy bond portfolio concentration at
  both short and long ends of maturity spectrum
• Bond Swap simultaneous sale and purchase of
  fixed-income securities to achieve investment
  purpose and to save on taxes