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
• 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 rates reset
  periodically to keep in line with a change in an
  underlying benchmark interest rate
• short term T-bills
• 30-year T-bonds

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Zero-Coupon Bonds (Zeros)

• 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
• Do zero-coupon bondholders have to pay tax on
  interest income?
• Yes, each year, holders of zero-coupon bonds must
  pay taxes on a prorated share of the bonds
  expected appreciation between the time of
  purchase and the time of maturity.

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Determining the Value of Seasoned Bonds

• Newly-issued bonds sell at or near face value.
• Value for seasoned bonds(bonds traded from one
  investor to another traded in _____ market.)
• 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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Example

• Solving for Price 10-yr, 8 Coupon Bond, Face
  1,000, Yield 6
• On a semiannual basis

Ct 40 (SA) P 1000 T 20 periods r 3 (SA)
PB 1,148.77
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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
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Price and Yield
Price
Yield
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Bond Pricing Factors

• Settlement date when buyer takes effective
  possession of security one-day settlement
  period? settlement date follows the transaction
  date by one day
• 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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Yield-to-Maturity

• 1. If a newly-issued 30-year bond has a promised
  interest rate equal to 7 of par (1,000) and is
  purchased in the secondary market at a 5
  discount, the expected yield to maturity on the
  bond is
•  a. 6.61.
• b. 7.
• c. 7.35.
• d. 7.42.
•  

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Issues That Affect Term-to-Maturity

• Average Life typical period before refunding
  apropos of mortgage-backed securities that is,
  an estimate of the number of terms to maturity,
  taking the possibility of early payments into
  account.
• Mortgage rates decline ? homeowners prepay their
  mortgage quickly?reduce the expected average life
  of bondholders investment and vice versa..
• Call Provisions contractual authority that
  allows issuers to redeem bonds prior to scheduled
  maturity an option but not an obligation to the
  issuer
• When is it exercised? A significant ____ in
  interest rates bond issuers credit quality
  _______.
• Call provision? good or bad for investors??
  compensated by asking higher expected return
• 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- Its
  happening!
• serious threat of credit quality
  deterioration-Its expected to happen!

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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
• Expected rate of inflation rise ? market rates of
  interest go up ? bond prices decline
• Goodeconomic news, such as a lower unemployment
  ? raises the possibility of higher future
  inflation ? bond prices____

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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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Example Yield Curve
Yields
Upward Sloping
Downward Sloping
Maturity
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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
• Denominator the bonds current market price.
• Numerator the present value of cash flows
  multiplied by their year of receipt
• The shorter is duration, the less sensitive is a
  bonds price to fluctuation in market interest
  rates.
• Manage your bond investment by duration-Bond
  investors can eliminate risk from fluctuating
  prices and reinvestment risk by letting duration
  equal their investment horizon.

• 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
• Modified duration 17.4 ? the bonds price
  decline 17.4 with a 1 rise in interest rates,
  or the price rise 17.4 with a 1 decrease in
  interest rates.
• Modified duration 4.1 ? with a 1 decrease in
  interest rates, the bonds price ____ _______.
• 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
• Sources of yield spreads
• Default risk ?EX This is the reason that the
  priced to yield is different between Treasury
  securities and AAA bonds with the same maturity.
• Coupon reinvestment risk ? Particularly between
  conventional vs. zeros.

• Credit quality of individual bondsenhanced if
  issuer buys bond insurance from third party
• Junk or non-investment quality bonds, as
  specified by bond rating agencies such as Moodys
  and Standard Poors, carry most credit risk?
  compensating investors by high yields ? high
  yield bonds

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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