Bond Valuation Flashcards
Segmented Markets
investors and issuers of debt seem to have a strong preference for debt of a certain maturity.
Furthermore, they seem to be insensitive to differentials in yields between debt of this maturity and debt of a different maturity.
Market segmentation theory argues that investors are sufficiently risk averse that they operate only in their desired maturity spectrum.
For example, insurance companies offering policies that are unlieky to require payment for a long time would seek to invest in long term bonds where the interest earned on the bond is known, and if it exceeds what was promised on the insurance contract, it substantially reduces the insurance company’s risk
. Thus what determines long-term rates is solely the supply and demand of long-term funds. Similarly, short-term rates are determined only by supply and demand of short-term funds
Pure Expectations
The pure expectations theory explains the term structure in terms of expected one-period spot rates. Advocates of the expectations theory believe that the yield on a one-year bond is set so that the return on the one-year bond is the same as the return on a six-month bond plus the expected return on a six-month bond purchased six months hence. If the expectations theory is correct, then an upward sloping yield curve is an indication that short-term rates are expected to increase. Similarly, a flat yield curve is an indication that short-term rates are expected to remain the same. Finally, a downward sloping yield curve indicates that short-term rates are expected to decline
Expectations theory assumes that the investors setting prices do not care about risk (are risk neutral). In this case, no matter what their time horizon, they will select the security or securities that give them the highest expected return. And so maturity of bond does not matter. This is exactly the opposite of the market segmentation theory
Preferred habitat
Preferred habitat theory rests on the premise that investors who match the life of their assets with the life of their liabilities are in the lowest risk position. Matching the life of the assets and liabilities is their preferred position. If there is sufficient extra return to be earned on assets of other lives, they will adjust their position to include more of these higher-yielding assets. If this theory is correct, premiums will exist for maturities where there is insufficient demand. These premiums are necessary to induce investors to leave their preferred habitat. If there are a large number of firms issuing long-term debt relative to the number of investors interested in long-term debt, a premium will have to be offered on long-term debt. If many firms and institutions wish to issue short-term debt and there are few investors who wish to invest short terms, a premium will have to be offered on short-term debt.
Liquidity Preferences
Predicts that investors require a higher expected one-period return to hold bonds with a longer horizon.
Liquidity premium theory is also based on investors analyzing the returns from holding bonds of varying maturities. However, unlike expectations theory, liquidity premium theory assumes investors must be offered a higher expected return to hold a bond with a horizon different from their preferred horizon. Furthermore, it is assumed that there is a shortage of longer-term investors so that extra return must be offered on long-term bonds to induce investors to hold them.
Types of bonds
. federal government bonds - Government bonds represent the borrowing of the federal government. They represent the largest percentage of the total debt market and are by far the most liquid.
2. corporate bonds - Corporate bonds are debt obligations of corporations. Corporate issues can be publicly traded or privately placed, usually with a bank or insurance company, The publicly traded corporate market is much less active than the government market, with many of the issues rarely if ever trading after the initial offering.
3. mortgage bonds - Mortgages are debt obligations backed by real estate. Most mortgages are originated by a bank, insurance company, or other financial institution.
4. municipal bonds - The final m
Default risk - role of rating agencies
Unlike government bonds, for corporate bonds and municipal bonds, there is a risk that the coupon or principal payments will not be met. For these bonds it is necessary to make a distinction between promised return and expected return.
Bond rating services divide bonds into discrete classes with moodys corporate ratings placing aaa as very high quality and ccc as poor quality.
When the credit ratings of a bond changes, it can have a large impact on the yield and price of a bond.
One criticism of bond rating agencies is a conflict of interest
Agencies earn fees from the credit ratings.
May lose business if the bond ratings are too low
How objective are the credit ratings?
Agencies failed to successfully correctly rate subprime mortgages in 2007/2008.
Role of tax
The cash flows from certain bonds have a tax advantage. These bonds should sell at a different yield to maturity than bonds without this tax advantage. The most obvious example of such bonds is municipal bonds. The coupon payments from municipal bonds are not subject to federal taxation and usually are not subject to tax in the state where they are issued. Because of the benefits of such favourable tax treatment, the yield to maturity on these bonds is less than the yield to maturity on comparable taxable issues. Generally the yield to maturity is 30%–40% lower on municipal bonds than on similar taxable issues.
one with a sufficiently low or high coupon to cause it to sell at a price very different than its face value. For these bonds, capital appreciation or loss is a significant part of the investor’s return in addition to interest income. Consider a low coupon bond. The coupon payments are subject to taxation at ordinary income tax rates. Low coupon bonds would have two components to their return: the return from the coupon plus the return from the price appreciation. The total return must be competitive with other bonds of similar characteristics. The portion of return from the price appreciation is taxable as a capital gain. For most investors the capital gain rate is lower than the income tax rate. Thus low coupon bonds have a tax advantage because a portion of their return receives favorable tax treatment. Given this tax advantage, low coupon bonds should and do have a lower (before tax) yield to maturity.
Option characteristics
Bonds sometimes contain a feature that constitutes an option for either the issuer of the bond or the holder of the bond.
The most common option included in bond contracts is the possibility of a call by the issuing firm. The call privilege is the right by the issuing firm to repurchase the bond at a fixed price. The price is generally the par value (face value) of the bond plus a premium (called the call premium).
The possibility of a call reduces the value of the bond to the investor. An investor can assume that the firm will call at times when the bond without the call feature is worth more than the price at which it is actually called. This difference is a loss to the investor.
Another option associated with bonds is the sinking fund option. Many bond issues require that part of the issue be retired over the life of the bond. For example, bond covenants may require that 5% of the issue be retired at the end of each year over the bond’s 10-year life. The corporation has the option of purchasing the bonds directly or of calling the bonds it needs to meet its sinking fund obligation. Obviously it will meet its obligation in the least expensive way. Because the bonds are chosen in a random way, all investors risk having their bonds called to meet the sinking fund obligation
A third option found in certain bond contracts is the conversion option. This option benefits the bondholders. The bondholder has the option of converting the bond into common equity. The bond is used to pay for the equity. Assume a $1,000 par bond is convertible into 50 shares of common equity. Then the investor is paying $20 per share. The convertible bond can be viewed as a bond plus an option to buy 50 shares at $20 per share.
