Bond valuation and duration analysis

Question 1

What is a bond?

Answer 1

a debt instrument issued by a company (corporate bond) , a country or state/city

• infinite life and may have a periodic payment (a coupon) and some final payment (par value).
• bonds that don’t make a periodic payment are known as zero coupon bond. They only pay the par value back at maturity.

Question 2

How can bond prices be communicated?

Answer 2

• price itself which represents the sum of the present value of the cash flows.
• the interest rate used to determine the bond price (yield to maturity)

Question 3

What are short term bonds?

Answer 3

government treasury bills
long-term bonds (10-year government bonds)

Question 4

why may long-term bonds be good?

Answer 4

• source of long term finance
• cheaper alternative than bank loans
• cheaper then forms of equity financing
• form of debt financing

Question 5

what are bonds yield to maturity?

Answer 5

• the interest rate implied by the payment structure.
• interest rate at which the present value of the income streams equals the current bond price.
• yields quoted on an annual basis
• inverse relationship between the price of bond and yield to maturity. If YTM increases bond price will fall

YTM represents the total return of investment over the life of the bond.

Question 6

What are the 2 types of corporate bonds?

Answer 6

Callable bonds
- called by firms at a given price
- firm has the right but not the obligation to buy the bond from the holder at a given price before maturity date.
- reduce price of bond.

Convertible bonds
- carry the option for the holders to convert the bond (form of debt) into equity (ordinary share) which increases the value of the bond as they have some sort of control over the business as they become a shareholder and will be paid dividends.
- bond holder is not obliged to convert the bond into equity and they may be used as interest bearing equities.

Question 7

Bond pricing?

Answer 7

• unless told otherwise the par value of bond is 1,000
• par value paid at maturity
• if coupon rate higher then YTM then bond will always be priced at a premium (higher then par value).
• if coupon rate is lower then YTM the bond will be priced at a discount (lower then par value)
• if the same then priced at exactly par value.

Question 8

What is the function of bonds?

Answer 8

• primary function of bonds as an investment vehicle is to make fixed payments.
  therefore essential that those burdened with the debt obligation can pay in full on time.

Question 9

What are bond ratings?

Answer 9

they are a way of evaluating the issuer to determine default risk.

S&P and Moody’s assign rating when a bond is first in issues, this helps determine what the bond interest will be. (Triple A is good)

Question 10

what is important to remember?

Answer 10

That bond prices and yield to maturities are just a snap shot in time.

• Calculating the bond price and yield to maturity on any bond during a period may result in different values.

these values represent a combination of investor expectations with regards to risk and future economic activity.

Question 11

What does the duration of a bond mean?

Answer 11

Duration measures the sensitivity of bond prices to changes in the yield to maturity.

Question 12

What are the properties of duration?

Answer 12

• coupon paying bonds D < T
• inverse relationship between coupon and duration.
• a zero-coupon bond has D = T
  INVERSE RELATIONSHIP between yield to maturity and duration.

Question 13

what do modified duration and duration do?

Answer 13

widely used to measure a portfolios exposure to movements in the yield curve.

Question 14

what happens when you only use modified duration?

Answer 14

you can overstate the price fall

you can adjust for this using the convexity factor formula