Bond Valuation (L6) Flashcards
Coupon Rate
The PERIODIC Interest PMTs received by the bondholder
PAR Value
○ The principal amount, which is $1,000 on bond issues, unless stated otherwise
○ The amount that will be repaid to bond investors at the end of the loan period
Length of Time to Maturity
○ The time remaining until the bond holder receives the PAR Value
○ “Number of Periods” to Maturity OR that the Loan will be Outstanding
Market Interest Rates
○ The yield that is currently being earned in the marketplace on comparable securities
○ Rate used to discount a bond to determine what it is currently selling for in the market
Important Consideration (Bond Valuation/Pricing)
- The coupon rate, though expressed as an interest rate, is calculated as a CONSTANT DOLLAR PMT
- Interest Rate changes in the marketplace DO NOT affect the coupon rate PMTs
- RISING Interest Rates means that investors can get a larger stream of CF (higher coupon) on new bonds from the corporation.
○ Current bond holders selling bonds must do so at
a DISCOUNT - DECLINE in Market Interest Rates means coupon rates on new bonds (constant income stream) from corporations will be LESS than previous bonds issues making the older bonds worth a PREMIUM
○ Investors buying the higher coupon bonds (larger
stream of CFs) must pay a PREMIUM above PAR.
Coupon Rate (CR) or Nominal Yield
Coupon Rate = (Total Coupon PMT) / PAR
Current Yield (CY)
CY = (Total Coupon PMT) / Current Price of Bond
Yield to Maturity (YTM
- Essentially the compounded RoR if an investor buys a bond today and holds it until maturity
- YTM assumes that an investor is able to REINVEST the coupon PMTs at the YTM rate.
- YTM is useful when comparing the return on different bonds
○ MAKE SURE TO MULTIPLY [I/YR] BY 2
Yield to Call (YTC)
- The compounded RoR if an investor buys a bond today and the bond is CALLED (retired) by the issuer
- When doing calculation
○ Use CALL PRICE, not PAR Value
○ Use number of period unit CALLED, not YTM
○ MAKE SURE TO MULTIPLY [I/YR] BY 2
Accrued Interest
- When purchasing a bond, the buyer pays the seller interest that has accrued since the last interest PMT
- The new buyer then receives the full amount of interest due at the next interest PMT.
- The buyer will receive a 1099-INT that reflects the full periods interest received; however, the buyer it entitled to a deduction EQUAL to the amount of accrued interest paid to seller. (pg. 99)
Yield Curve Theories
Liquidity Preference Theory
Market Segmentation Theory
Expectations Theory
Liquidity Preference Theory
- The yield curve results in lower yields for shorter maturities because some investors prefer liquidity and are willing to pay for liquidity in the form of lower yields
- States long-term yields should be higher that short-term yields because of the added risks associated with longer-term maturities
- The added yield for long-term maturities is meant to compensate investors for the additional risk associated with longer-term maturities
Market Segmentation Theory
- The yield curve depends on Supply and Demand at a given maturity and there are distinct markets for given maturities with distinct buyers and sellers at each maturity
- When Supply > Demand (at a given maturity)
○ Rates are LOW
○ Rates need to INCREASE for Demand to INCREASE - When Demand > Supply (at a given maturity)
○ Rates are HIGH
○ Rates will begin to DECREASE for Demand to
DECREASE
Expectations Theory
- The yield curve reflects investors inflation expectations.
○ Since investors are uncertain OR believe inflation
will be higher in the future, long-term yields are
HIGHER than short-term yields - Whenever inflation is expected to be LOWER in the future, long-term rates will be lower than short-term rates, resulting in an INVERTED YIELD CURVE
Unbiased Expectations Theory (UET)
- Related to the term structure of interest rates. The theory holds that today’s longer term interest rates have imbedded in them expectations about future short term interest rates.
○ More specifically, long term rates are GEOMETRIC AVERAGES of current and expected future shorter-term interest rates.
Bond Duration
Duration is the weighted average maturity of all CFs
○ The BIGGER the Duration = MORE PRICE SENSITIVE or VOLATILE the bond is to interest rates changes
○ Duration = the moment in time the investor is IMMUNIZED from interest rate risk and reinvestment rate risk
○ Modified Duration = a bond’s price sensitivity to changes in interest rates
○ A bond portfolio should have a duration EQUAL to the investors time horizon to be effectively immunized
Calculating Bond Duration
- ZERO COUPON Bond
○ Duration = Maturity - Coupon Rates INCREASE = Duration DECREASES
- Coupon Rates DECREASE = Duration INCREASES
- YTM INCREASES = Duration DECREASES
- YTM DECREASES = Duration INCREASES
- As Term of Bond INCREASE/DECREASES = Duration INCREASES/DECREASES (Direct Relationship)
Estimating Bond Price
Duration Assumptions
Bond Strategies
- Tax Swap
○ Involves a selling a bond that has a gain and a
bond that has a loss which offset each other
○ Involves selling a bond that has a LOSS POSITION
and just buying a new bond - Barbells
○ Involves owning both SHORT TERM and LONG
TERM Bonds
○ When interest rates move, only one set of
positions needs to be sold and restructured - Laddered Bonds
○ Requires purchasing bonds with VARYIG
MATURITIES
○ As a bond matures, new bonds are purchased with
longer maturities that what is outstanding in the
portfolio
○ This strategy helps REDUCE interest rate risk
because bonds are held until maturity - Bullets
○ Very little PMTs during the interim period and then
lump-sum at the some specified date in the future
○ Most of the bonds in this strategy will mature in or
around the same time period
○ ZERO COUPON Bonds, Treasuries, and corporates
are MOST LIKELY candidates for a Bullet Strategy
since they pay little or no coupon during the period
and the payoff comes at some predetermined date
in the future
○ Typically used when the investor has a BALLOON
PMT due on a liability at some future date
Preferred Stock
Convertible Bonds
- Conversion Value is the value of the convertible bond in terms of the stock into which it can be converted
- One the primary benefit of a convertible bonds is that even if the stock does NOT perform well, the investor has a floor built in
○ The floor is the PAR value of the bond that the investor will receive if the convertible is held until maturity
Property Valuation (Calculating NOI)
