Bond Valuation Flashcards
What is Current Yield?
Annual Payment Divided by current price of the bond
What is Yield to Maturity
the compounded rate of return if an investor buys a bond and holds it until maturity. This assumes investor is able to reinvest the coupon payments at the yield to maturity rate
What is Yield to Call?
Compound rate of return if an investor buys a bond today and the bond is called (retired) by the issuer. When calculating Yield to Call make sure to use number of periods until bond is called not the time limit until maturity
Explain the relationship between Coupon, Current Yield, YTM, and YTC
Summary of Yield Ladder
When bond is selling is discount: Highest to Lowest
1. Yield to Call
2. Yield to Maturity
3. Current Yield
4. Nominal Yield
Remember when Shopping, if you see a discount “Call Mom’s Cell Now!”
When Bond Is Selling at Premium Highest to Lowest
1. Nominal Yield
2. Current Yield
3. Yield to Maturity
4. Yield to Call
What are the tax implications of buying a bond with accrued interest?
Buyer is responsible for paying accrued interest seller that has accrued since last interest payment. New buyer receives full amount of interest due at next interest payment. Buyer will recceive 1099-INT that reflect full period of interst received however buyer is entitled to a deduction equal to the amount of accrued interest paid to seller.
What are the four yield curve theories?
- Liquidity Preference Theory- Investors prefer liquidity and are willing to pay for liquidity in forms of lower yield. Long-term yields should be higher than short-term yields because of added risks associated with longer term maturities
- Market Segmentation theory- When supply is greater than demand at a given maturity, rates are low. Rates will have to increase for demand to increase. When demand is greater than supply at given maturity rates are high
- Expectations Theory- When inflation is expected to be lower in the future, long-term rates will be lower than short-term rates, resulting in inverted yield curve
Usually investors believe inflation will be higher in the future, therefore long-term yields are higher than short term.
4.Unbiased Expectations Theory (UET) - Long term rates are geometric averages of current and expected future shorter-term interest rates. Today’s longer term interest rates have imbedded in them expectations about future short term rates.
What is duration?
What is modified duration?
Duration- The weighted average maturity of all cash flows
-Bigger the duration, the more price sensitive or volatile the bond is to interest rate changes. the moment in time the investor is immunized from interest rate risk and reinvestment rate risk
-Modified duration is bond’s price sensitivity to changes in interest rates. A bond portfolio should have duration equal to investor’s time horizon to be effectively immunionized
Relationship Between Duration and other variables
Term increases = Duration Increases Positive relationship Duration will always equal maturity of bond (zero Coupon bond)
Coupon and Yield to Maturity have INverse Relationship due to INterest
What are some duration assumptions?
- Duration assumes there is a linear relationship between a change in interest rates and a bond’s price change.
- Actual price change of a bond is not linear it’s curve linear
- Convexity is concept that measures the difference in price between what duration estimates and the actual price change of bond.
- Duration does a good job of estimating the price change of a bond for small changes in interest rates
- Duration does not do a good job of estimating the price change of a bond for large changes in interest rates
- Duration understates price appreciation when interest rates decrease
- duration overstates the price depreciation when interest rates increase
What are some common bond strategies
- Tax Swap- Selling bond that has a gain and bond that has a loss which offset each other
- Barbells- Involves owning both short-term and long-term bonds. When interest rates move only one of of positions need to be sold and restructured.
- Laddered Bonds- Involves purchasing bonds with varying maturities, as bonds mature, new bonds are purchased with longer maturities than what is outstanding in portfolio. This helps reduce interest rate risks because bonds are held until maturity
- Bullets- Have very little payments during the interium period and then a lump sum at some time in the future. Zero coupon bonds, treasuries and corporates are the most likely candidates for a bullet strategy since they pay little or no coupon during the period and payoff comes at some predetermined date in the future.
What are some common features of preferred stocks?
- Has both equity and debt features
- Stated as par value
- Stated dividend rate as a percentage of par
4.Price of preferred stock may move with price of common stock - Dividends do not fluctuate like a common stock dividend
- No maturity date like a bond
- Price of preferred stock is more closely tied to interest rates than common stock
Tax Advantages
-Corporations receive a 50 or 65% deduction of dividends (preferred and common stock) based on percentage of ownership of the company paying dividend for tax years beginning after December 31, 2017
What a features of a convertible bond?
- Conversion value is the value of the convertible bond in terms of the stock into which it can be converted. One of the benefits is that even if the stock doesn’t perform well, the investor has floor built in. Floor is par value of the bond that investor will receive if convertible bond is held until maturity.
PAR/Conversion Price * Current Share Price = Current Value
Property Valuation
