Chapter 6: Bond Valuation

Question 1

Coupon Rate

Answer 1

The periodic interest payment received by a bond holder. Keystroke = PMT
*Although coupon rate is expressed as an interest rate, it is calculated as a constant dollar payment.

Question 2

Par Value

Answer 2

The principal amount which is $1000 on bond issues. Keystroke = FV

Question 3

Length to Maurity

Answer 3

Time remaining until bond holder receives par value. Keystroke = N

Question 4

Market Interest Rates

Answer 4

The yield that is currently being earned in the marketplace on comparable securities. Keystroke = I/Y

*Important Consideration: (pg 90)
- If market interest rates rise, then holder receives larger stream of cash flow (higher coupon) on new bonds. And, therefore, current bond holders must sell their bonds at a discount to remain competitive with the new issues from the corporation.
- If market interest rates decreases, then lower coupon rates on new bonds & current bond holders can sell at premium above par value.

Question 5

Zero Coupon/Accrual Bond

Answer 5

Also known as an accrual bond:
- Do not pay interest to holders but are sold at DEEP discount and offer full par/face value at maturity.
- the imputed (estimated) interest of these bonds is what is referred to as “phantom income”. Phantom income because it has not yet been realized but has to be accounted for for taxes.
- optimal to hold zero coupon bond in IRA because not taxed
- Duration is always equal to its maturity

Question 6

Nominal Yield/Coupon Rate - CR

Answer 6

• The annual coupon payment divided by par value
  CR = Coupon Payment/Par

Question 7

Current Yield - CY

Answer 7

• The annual coupon payment divided by current price of bond
  CY = Coupon Payment/Price of the Bond

Question 8

Yield to Maturity (YTM)

Answer 8

Essentially, it is the compounded RoR if an investor buys a bond today and holds it until maturity. Useful for comparing the return on different bonds.

*Exam Tip: Always assume semiannual compounding unless otherwise stated
*Yield = think % (solving for I/Y).

Question 9

Yield to Call (YTC)

Answer 9

• The compounded RoR if investor buys a bond today and the bond is called (retired) by the issuer.

*Calculation: use # periods to when it’s called NOT not maturity. ALSO still use par value ($1,000 usually) for determining PMT *Yield = think % (solving for I/Y).

Question 10

Yield Summary

Answer 10

*Exam Tip: often Q on relationship between Coupon, Current Yield, YTM, and YTC

*Exam Tip: “If out shopping and see a Discount, CALL mom!”

Question 11

Yield Curve Theories (3)

Answer 11

1) Liquidity Preference Theory: lower yield for shorter maturities because some investors prefer liquidity and are willing to pay for liquidity in the form of lower yields.
2) Market Segmentation Theory: yield curve depends on supply and demand at a given maturity and there are distinct markets for given maturities
3) Expectations Theory: yield curve reflects investor’s inflation expectations.

Inverted Yield Curve:
**Higher inflationary expectation is a driving force for an inverted yield curve as the Fed raised short term rates faster than the long term rates to adjust to the higher risk.
- The “natural” position is an upward slope, which indicates a more “normal” environment.

Question 12

Unbiased Expectations Theory (UET)

Answer 12

The unbiased expectations theory is 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.

*Formula provided (although need to understand - pg 98)

Question 13

Bond Duration

Answer 13

The weighted average maturity if all cash flows.
- The bigger the duration, the more price sensitive/volatile the bond is to interest rates. The smaller the duration, the less sensitive.
- Duration is the moment in time the investor is immunized from interest rate & reinvestment risk
*EXAM TIP: to immunize a portfolio, the duration must equal time horizon. BE CAREFUL do not confuse with maturity

**Exam Tip:
- Direct relationship between bond duration & term of a bond. As the term increases, the duration will also increase.
- INverse relationship btwn bond duration & coupon rate/YTM. Remember - CR & YTM are INterest rates & there is an INverse relationship.
SO: The shorter the duration, the shorter the term & the higher the coupon rate & YTM.

2 Ways to calculate Bond Duration:
1) CFP Provided formula
2) PV of CF Chart

Question 14

Estimating Bond Price

Answer 14

Duration can also be used to estimate the price change of a bond based upon a change in interest rates.
*Formula provided

Question 15

Bond Strategies

Answer 15

1) Tax Swap: selling a bond that has a gain and one that has a loss which offset each other
2) Barbells: owning both st & lt bonds (when interest rates move, only one set of positions needs to be sold and restructured)
3) Laddered Bonds: bonds with varying maturities. New bonds are purchased with longer maturities than what is outstanding in the portfolio. This tactic helps to reduce interest rate risk because bonds are held until maturity.
4) Bullets: very little payments during the interim period and then a lump sum at a specified date in the future. These are typically used when investor has a balloon payment due on a liability.

Question 16

Preferred Stock

Answer 16

Has both debt & equity features. Has tax advantage where corporations receive 50 or 65% deduction of dividends.
- Dividend does not fluctuate unlike a common stock dividend
- Price is more closely tied to interest rates than common stock
- No maturity date like a bond

Question 17

Convertible Bonds

Answer 17

• Primary benefit of a convertible bond: even if the stock does not perform well, the investor has a floor built in. The floor is the par value received if held to maturity.
• Conversion Value: value of a convertible bond in terms of the stock into which it can be converted.

*MEMORIZE formula for Conversion Value

Question 18

Property Valuation

Answer 18

Determining how much an investor is willing to pay for a piece of property.

*Formula not given - MEMORIZE

Question 19

Net Operating Income

Answer 19

*CFP Exam Tip: Take net income and add back depreciation and financing activities