Investments: Bond valuation

Question 1

Coupon Rate

Answer 1

• periodic interest payment received by a bond holder

- coupon payment entered as a payment on the financial calculator

Question 2

Par Value

Answer 2

• principal amount that will be repaid to bond investors at the end of the loan period.
• $1000 on bond issues unless stated otherwise

Question 3

Length of time to maturity

Answer 3

• time remaining until the bond holder receives the par value.
• number of periods or loan will be outstanding

Question 4

Market interest rates

Answer 4

• yield 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

How does a rise in interest rates affect the bond market?

Answer 5

• investors can get a larger stream of cash flows (higher coupon) on new bonds from the corporation.
• current bond holders selling bonds must do so at a discount to stay competitive with new bonds

Question 6

How do falling interest rates affect the bond market?

Answer 6

• coupon rates on new bonds (constant income stream) from corporations will be less than previous bonds making older bonds worth a premium.
• investors buying these older higher coupon bonds must pay a premium above par value

Question 7

Coupon rate or nominal yield

Answer 7

Coupon Rate = coupon payment/par value

Question 8

Current Yield

Answer 8

Current Yield = coupon payment/price of the bond

Question 9

Current Yield - Example

Answer 9

Question 10

Yield to maturity (YTM)

Answer 10

• compounded rate of return if an investor buys a bond today and holds it until maturity.
• assumes that an investor is able to reinvest coupon payments at the yield to maturity rate
• always assume semiannual compounding on the CFP exam unless told otherwise

Question 11

Calculate Bond Holding Period Return

Answer 11

**important tested frequently

Question 12

Yield to call (YTC)

Answer 12

• compounded rate of return if an investor buys a bond today and the bond is called (retired) by the issuer.
• when calculating:

Use number of periods until bond is called, not until maturity

-use call price, not the par value as FV

Question 13

Yield Summary

Answer 13

Premium - YTM and YTC are smallest

Par - all elements are equal

Discount - YTM and YTC are biggest

Question 14

The Yield Ladder

Answer 14

If you see a discount “Call Moms Cell Now!”

Question 15

Accrued Interest

Answer 15

• when purchasing a bond, buyer pays seller interest that has accrued since last interest payment.
• buyer then received full amount of interest due at next interest payment.
• buyer receives a 1099-INT that reflects full periods interest received
• buyer received deduction equal to amount of accrued interest paid.

Question 16

What are the yield curve theories

Answer 16

1. liquidity preference theory
2. market segmentation theory
3. expectations theory

Question 17

Liquidity Preference Theory

Answer 17

• 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.
• long term yields should be higher than short term yields because of added risk associated with longer term maturities.

Question 18

Market Segmentation Theory

Answer 18

• yield curve depend on supply and demand at a given maturity. There are markets for each maturity, with buyers and sellers at each maturity.
• supply is greater than demand at a maturity, rates are low. Rates will have to increase to increase demand.
• demand is greater than supply at a maturity, rates are high. Rates will have to decrease to drive down demand.

Question 19

Expectations Theory

Answer 19

• 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.
• if inflation is expected to be lower in the future, long term rates will be lower than short term rates = inverted yield curve

Question 20

Unbiased expectations Theory

Answer 20

• todays longer term interest rates have imbedded in them expectations about future short term interest rates.
• long term interest rates are geometric averages of current and expected future short-term interest rates.

Question 21

Bond Duration

Answer 21

• Duration is the weighted average maturity of all cash flows.
• bigger the duration, more price sensitive to interest rate changes.
• duration is the moment in time the investor is immunized from interest rate risk and reinvestment risk
• to be effectively immunized a bond portfolio should have duration equal to the investors time

*formula picture
Horizon.

Question 22

What is modified bond duration?

Answer 22

A bonds price sensitivity to changes in interest rates.

Question 23

What is bond durations relationship to the term of the bond?

Answer 23

• direct relationship

- term of bond increases, duration increases

Question 24

What is bond durations relationship to yield to maturity and coupon rate?

Answer 24

• inverse relationship
• yield to maturity or coupon rate increase, bond duration decreases
• yield to maturity or coupon rate decrease, bond duration increases
• zero coupon bond will always have duration equal to maturity.

Question 25

Bond Duration Calculation Examples

Answer 25

Question 26

Estimating Bond Price

Answer 26

Duration can be used to estimate price change of a bond, based on a change in interest rates.

Question 27

Duration assumptions

Answer 27

• linear relationship between change in interest rates and a bonds price.
• duration does a good job of estimating price change for small interest changes

Bad job of estimating price change for large interest rate changes

-duration understates the price appreciation when interest rates decrease

Overstates the price depreciation when interest rates increase

Question 28

Tax Swap

Answer 28

Selling a bond that had a gain and bond that had a loss to offset each other

Or

Selling a bond that has a loss and buying a new bond

Question 29

Barbells

Answer 29

• owning both short term and long term bonds

- when interest rates move, only one set of positions need to be sold and restructured

Question 30

Laddered Bonds

Answer 30

• purchasing bonds with varying maturities
• bonds mature, new bonds are purchased with longer maturities than what exist in the portfolio.

-helps eliminate interest rate risk since bonds are held until
Maturity

Question 31

Bullets - bond strategy

Answer 31

• little payments during the interim period and then a lump sum at some specified date in the future.
• most bonds will mature in or around the same time period.
• zero coupon bonds, treasuries or corporates work for this strategy.
• used when an investor had a balloon payment on a liability in the future

Question 32

Preferred Stock

Answer 32

*has both debt and equity features

Debt features:

• stated par value
• stated dividend rate as a percentage of par

Equity features:
Price of preferred stock may move with the price of the common stock.

Differences:

• dividend does not fluctuate
• no maturity date like a bond
• price of preferred stock tied to interest rates not common stock

*corporations received 50-65% deduction of dividends.

Question 33

Convertible Bonds

Answer 33

• conversion value is value of convertible bond in terms of the stock in which it can be converted. 
• one primary benefits is that if stock does not perform well the investor has a floor built in. Floor is the par value of the bond if convertible held until maturities.
• formula not included on formula sheet need to memorize!!!

Question 34

Property Valuation

Answer 34

-use formula to determine how much an investor is willing to pay for a piece of property.

Question 35

Property Value - Net Operating Income example