6.1. Bond Valuation Flashcards
Bonds…
A financial asset that obligates the issuer to make specified payments to the bondholder.
A way corporations can raise money, but this must be repaid.
Provide a guaranteed, fixed income for bondholders, which is known in advance.
There is a risk the issuer won’t be able to repay debt (governments not so much, but their return is smaller than corporations).
Characteristics of bonds…
Face value / par value is the value of the bond.
The maturity date is the date when the par value is repaid to the bondholder. This is the term.
The coupon payment is the interest rate a bondholder receives.
Bond valuation…
Present value = coupon payment / (1+r).
For example, an investor buys a 4-year Tesco corporate bond with a coupon rate of 5%, yield to maturity of 3% with a par value of £100. What is the present value: £107.43.
Yield to maturity…
The discount rate that sets the present value of the promised bond payment equal to the current market price of the bond.
If a bond is sold at a premium, it always has a higher yield compared to its yield to maturity.
Yield to maturity is determined by the market and can change over time.
Rate of return of bonds and its relation to value…
Par / discount / premium
For bonds, the rate of return is not always equal to the coupon.
If the rate of return equals to coupon rate, the bond is selling at par value.
If the rate of return is larger than the coupon, the bond is at a discount.
If the rate of return is smaller than the coupon, the bond is at a premium.
Semi-annual coupon payments…
Bondholders receive a regular payment twice per year. We just change our calculation slightly.
For example, a two-year UK government bond pays semi-annual payments of 12%, yield to maturity 8% and par value of £1,000: £1,072.60
Holding period return…
Where the yield to maturity changes during a holding period. The present value should be calculated twice, based on each of the yield to maturities.
Zero coupon bonds…
Bonds that repay the principal at maturity only.
The bonds are sold at a discount to par value.
Valued using a present value formula.
What is the return of a zero coupon bond worth £1000, that is bought for £567.40 today. 5 year duration: r=12%.
Relationship between interest and bond prices…
As interest rates change, so do bond prices:
- Falling interest rates cause bond prices to increase.
- Rising interest rates cause bond prices to fall.
Investors hope that interest rates will fall so the value of their investment can rise.
Long-term bonds are more sensitive to interest rate changes than short-term bonds.
The inverse relationship between bond prices and yields is not linear. It is convex (similar to an indifference curve).
This relationship is called convexity, the degree of curvature is not the same for all bonds. It depends on factors such as the size of coupon payments, the time of maturity and the bond’s current market price.
Risk on bonds…
Bonds do have three inherent risks:
Inflation risk: if inflation rises more than the return on the bond, the investor loses purchasing power. For example, a £1000 one-year bond with a 10% coupon rate would pay £100. However, if inflation was 6%, the payoff is only £1100 / 1.06 = £1037.74.
Interest rate risk: if interest rates skyrocket during the term of the bond, the investor may lose money. Different bonds are influenced differently. Longer bonds are subject to greater interest rate risks.
Default risk: this is the risk that issuers won’t be able to repay the money they have been loaned. Companies with lots of debt and operating losses are more likely to default. Highest quality bonds are AAA rated and bonds rated BAA or BBB or above are investment grade. Poor quality / junk bonds may have ratings of BB.
