Debt Valuation Flashcards
1
Q
What is the basic calculation for the value/price of a bond? (1)
A
- Calculated by comparing the opportunity cost of other investments
2
Q
What are the benefits of investing in gilts? (2)
A
- Generating cash flow to fulfil shortfall
- Gilt is backed by the government so there is a guaranteed return - risk-free rate
3
Q
What is the risk with investing in a corporate bond? (2)
A
- Issuer may not honour its obligations
- Issuer could default - to cover this risk, investor can demand a higher return than gilts. Risk free rate plus a premium for the risk taken on
4
Q
What is a credit rating of a bond? (4)
A
- Different bond issues are associated with differing levels of default risk
- Higher rating = less likely to default
- Investment grade: AAA, Aaa, AA, A, BBB
- Speculative grade: BB, B, CCC, CC, D
5
Q
What is the assessment process for a credit rating? (6)
A
- Ratings are forward looking - current and future business
- Management strategy
- Likelihood of default - capacity and willingness to pay - single most important factor to assess credit worthiness
- Payment priority - senior secured debt has the highest priority, followed by senior unsecured debt and last subordinated debt
- Projected recovery - investor would expect to receive if an obligation defaults. Higher the projected recovery rate, better the credit rating
- Financial stability - more stable a company’s finances are, the higher the rating
6
Q
What to ratings agencies look at when assessing the credit worthiness of a company? (9)
A
- Financial statements, capital structures, debt and asset protection
- Macroeconomic forecast
- Industry trends
- Regulatory developments
- Management quality
- The bond’s covenant
- Ability to meet payments
- Indebtedness - ‘interest bearing debt/ordinary shareholders funds’
- Profitability - operating income/sales
7
Q
What is a bond yield? (2)
A
- Identifies the return achieved from an investment
- Gross Redemption Yield and Flat Yield - bonds
8
Q
What is flat yield? (3)
A
- Also known as interest yield
- Measures the return from receiving coupons alone
- Flat yield = gross annual coupon/market price*100
9
Q
What is gross redemption yield (GRY)? (10)
A
- Also known as Yield to Maturity - represents the total return achieved from a bond assuming it is held to redemption
- Sum of the flat yield and profit yield gives the GRY
- When the bond is trading below par, the GRY will be more than the flat yield
- When the bond is trading above par, the GRY will be less than the flat yield (capital loss on redemption)
- GRY is a useful indicator to a non taxpayer who intends to hold a gilt to redemption e.g. charities
- Calculation of GRY requires known return and redemption date. Can’t be calculated for stocks or warrants
- GRY increases, price decreases and vice versa. Inverse relationship between bond prices and yields/IRS
Takes into account:
- Coupons received
- Coupons re-invested (assuming no re-investment rate risk)
- Capital gain/loss on redemption
10
Q
What is net redemption yield (NRY)? (5)
A
Considers the tax implication of a bond:
- Income tax payable on the coupon
- No tax payable on the gain
- Net coupon = gross coupon x (1-t)
- GRY formula - net coupon instead of gross coupon
- NRY useful for those who are taxpayers - CIS, ITs and insurance companies
11
Q
What is grossed up net redemption yield? (2)
A
- Used to compares assets with different tax treatments for gains and income
- Grossed up NRY = NRY / (1-t)
12
Q
What is decomposing total return on a bond? (2)
A
- GRY = estimate of the return that an investor will achieve if bought and held to redemption - assumes nothing changes other than time
- Actual returns may differ from GRY
13
Q
What are the 4 basic components of total return? (4)
A
- Yield to maturity effect - yield generated if there were no changes in IR or other factors. Often referred to as the income component e.g. predictable income generated through bond
- Interest rate effect - looks at impact of movement on yield curve on bond returns. This may be a shift - increase or decrease in yields. Or a twist - change of the shape of the curve e.g. steepening/flattening
- Sector/quality effect - impact from Chang Erin sector from which issuer comes e.g. economic cycle effecting whole sector - quality effect is the impact on the return of an upgrade or downgrade to the bond’s credit rating. Both impact yield spread between bond and benchmark
- Residual effect - what is left over after other factors have been considered
14
Q
Summarise the 4 components of total return of a bond? (1)
A
- YTM effect + interest rate effect + sector/quality effect + residual effect = total return
15
Q
What are clean prices? (3)
A
- Quoted bond/gilt prices in the FT
- Clean price does not equal dirty price
- Difference between clean and dirty price is accrued interest
16
Q
What is accrued interest? (4)
A
- When investor buys a bond, they not only pay a ‘true’ price but pay interest that has accrued to date
- Total amount paid is the ‘dirty’ price
- Accrued interest on UKG is calculated on the basis of the actual number of calendar days in the year and calendar days in each month of the coupon period ‘actual/actual’
- Exam assumes 182.5 days in a six month period
17
Q
What are dirty prices? (4)
A
- During cum coupon period, dirty price keeps increasing as interest accrues on daily basis
- Clean price + pne days accrued interest, clean price + two days accrued interest etc
- Amount actually paid (dirty price) increases over time even though clean price might be constant
- Process continues until ex coupon date - date after which buyer is not entitled to receive next coupon payment - when accrued interest is no longer an issue, and the dirty price falls back down to the clean price
18
Q
What is the ex coupon date? (6)
A
- Date on and after a buyer of a bond is not entitled to receive the next coupon payment
- Ex-coupon period for UK gilts is 7 business days
- If an investor buys during the ex coupon period, the directly price (amount paid) will be slightly lower than the clean price
- Purchase of a bond 5 days before coupon is paid - investor would want 5 days worth of interest payments. If this is during the ex coupon period, investor would receive nothing
- To compensate investor for this loss of income, price the purchasers pays will be clean price - 5 days worth of interest. This is why the dirty price is less than the clean price during the ex coupon period
- Dirty price = clean price on coupon payment date itself
19
Q
Summarise ex coupon date (4)
A
- During the cum coupon period, the dirty price exceeds the clean price
- On the ex coupon date, the dirty price drops below the clean price
- During the ex coupon period, the dirty price is less than the clean price
- On the coupon payment date, the dirty price and clean price are equal
20
Q
How do coupons effector bond prices? (4)
A
- Size of the coupon effects the degree of the price movement
- Smaller the coupon, more the bond’s price will move given interest rate change
- Low coupon bonds are more volatile than high coupon bonds
- A low coupon = most of its return is locked up in the redemption payment that is furthest away in time - more exposed to interest rate changes.
21
Q
How does time effect bond prices? (1)
A
- Long dated bonds are more volatile
22
Q
How does required yield effect bond prices? (2)
A
- Sensitivity of a bond’s price will change as its yield changes
- The lower the yield of a bond, the more sensitive it is to any changes in that yield
23
Q
What is Macaulay duration? (4)
A
- Duration reveals how sensitive a bond is - higher the duration, more sensitive the bond’s price
- Macaulay Duration (economic life of a bond) is the weighted average maturity of a bond where the weights are relative discounted cash flows in each period
- Relative measure - identifies riskiest bond from a list of bonds
- Does not quantify the sensitivity - for this modified duration is required
24
Q
What is modified duration? (2)
A
- Estimates how much a bond’s price will change if there is a 1% change in yields
- Modified duration = D/(1+r)
25
What is convexity? (5)
- Modified duration is a linear assumption and cannot predict the change in price resulting from a change in yield. It overestimates price falls and underestimates price rises
- Margin of error is due to the curved or non-liner nature of the price yield relationship - degree of curvature is convexity
- Convexity is used to calculate the convexity adjustment - added to the modified duration calculate to add accuracy.
- Can lead to disparity between calculated value and actual change (convexity error). As the modified duration line is always below the convex line, the estimated price for the bond will always be lower than the actual new price after changes in yield.
- Price change using duration will always be less accurate for larger changes in yields
26
What are the different types of yield curves? (3)
- Normal/upward
- Humped
- Downward sloping
27
What is a yield curve? (4)
- ‘Term structure of interest rates’
- Illustrates the relationship between maturity dates and yields
- Plots the yields offered on varying bonds against the maturity of those bonds
- The yield (spot rate offered by bonds) varies according to their maturity dates
28
What is a spot rate? (1)
- Interest rate for a period of time starting from today e.g. 6 month interest rate available today
29
What is a forward rate? (2)
- Expected future short term interest rate - yield is a weighted average of the spot rates
- e.g. 3 month interest rate beginning in 3 months time
30
What are the 3 yield curve theories? (3)
- Liquidity preference theory - assumes longer dated bonds are riskier than short dated bonds. Therefore, investors will reunite additional yield to compensation them for buying longer dated bonds
- Market segmentation theory - different tolerances for different maturity of bonds. If a particular issue is popular, the bond’s price will increase and yield would be lower
- Pure expectations theory - ‘long term is a geometric average of expected future short term rates). Expected future interest rate
31
What are the 3 movements on the yield curve? (3)
- Shift return - illustrates changes in the level of the yield curve. Yields increase or decrease by the same amount across all maturities
- Twist return - illustrates the change in the slop of the yield curve. Yield curve steepens or flattens. If steepens then investor can buy short dated bonds and sell long dated bond in anticipation of a twist. Investor can sell short dated and buy long dated is anticipation of flattening yield curve
- Spread return - returns generated through taking on bonds different to the benchmark - longer duration, lower credit ratings, convertibility
32
What is the relationship between rates and yields?
- Upward sloping yield curve: Forward rate is more than spot rate which is more than GRY.
- Downward sloping yield curve: Forward rate is less than spot rate which is less than GRY
33
What is interpolation? (3)
- Forecasting used to look at information between the values collected
- According to pure expectation theory, interest rates are asssumed to work on a linear basis
- (1+a)x(1+b)=(1+c)
34
How do you calculate dirty prices of a bond? (1)
clean price - accrued interest
35
How many days is in ‘semi annual’ in the IMC? (1)
- 182.5 days
