Bond Valuation (L6)

Question 1

Coupon Rate

Answer 1

The PERIODIC Interest PMTs received by the bondholder

Question 2

PAR Value

Answer 2

○ 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

Question 3

Length of Time to Maturity

Answer 3

○ The time remaining until the bond holder receives the PAR Value

○ “Number of Periods” to Maturity OR that the Loan will be Outstanding

Question 4

Market Interest Rates

Answer 4

○ 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

Question 5

Important Consideration (Bond Valuation/Pricing)

Answer 5

• 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.

Question 6

Coupon Rate (CR) or Nominal Yield

Answer 6

Coupon Rate = (Total Coupon PMT) / PAR

Question 7

Current Yield (CY)

Answer 7

CY = (Total Coupon PMT) / Current Price of Bond

Question 8

Yield to Maturity (YTM

Answer 8

• 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

Question 9

Yield to Call (YTC)

Answer 9

• 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

Question 10

Accrued Interest

Answer 10

• 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)

Question 11

Yield Curve Theories

Answer 11

Liquidity Preference Theory

Market Segmentation Theory

Expectations Theory

Question 12

Liquidity Preference Theory

Answer 12

• 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

Question 13

Market Segmentation Theory

Answer 13

• 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

Question 14

Expectations Theory

Answer 14

• 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

Question 15

Unbiased Expectations Theory (UET)

Answer 15

• 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.

Question 16

Bond Duration

Answer 16

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

Question 17

Calculating Bond Duration

Answer 17

• 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)

Question 18

Estimating Bond Price

Answer 18

Question 19

Duration Assumptions

Answer 19

Question 20

Bond Strategies

Answer 20

• 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

Question 21

Preferred Stock

Answer 21

Question 22

Convertible Bonds

Answer 22

• 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

Question 23

Property Valuation (Calculating NOI)

Answer 23