Investments: Bond valuation Flashcards
Coupon Rate
- periodic interest payment received by a bond holder
- coupon payment entered as a payment on the financial calculator
Par Value
- principal amount that will be repaid to bond investors at the end of the loan period.
- $1000 on bond issues unless stated otherwise
Length of time to maturity
- time remaining until the bond holder receives the par value.
- number of periods or loan will be outstanding
Market interest rates
- 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
How does a rise in interest rates affect the bond market?
- 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
How do falling interest rates affect the bond market?
- 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
Coupon rate or nominal yield
Coupon Rate = coupon payment/par value
Current Yield
Current Yield = coupon payment/price of the bond
Current Yield - Example
Yield to maturity (YTM)
- 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
Calculate Bond Holding Period Return
**important tested frequently
Yield to call (YTC)
- 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
Yield Summary
Premium - YTM and YTC are smallest
Par - all elements are equal
Discount - YTM and YTC are biggest
The Yield Ladder
If you see a discount “Call Moms Cell Now!”
Accrued Interest
- 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.
What are the yield curve theories
- liquidity preference theory
- market segmentation theory
- expectations theory
Liquidity Preference Theory
- 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.
Market Segmentation Theory
- 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.
Expectations Theory
- 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
Unbiased expectations Theory
- 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.
Bond Duration
- 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.
What is modified bond duration?
A bonds price sensitivity to changes in interest rates.
What is bond durations relationship to the term of the bond?
- direct relationship
- term of bond increases, duration increases
What is bond durations relationship to yield to maturity and coupon rate?
- 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.
Bond Duration Calculation Examples
Estimating Bond Price
Duration can be used to estimate price change of a bond, based on a change in interest rates.
Duration assumptions
- 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
Tax Swap
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
Barbells
- owning both short term and long term bonds
- when interest rates move, only one set of positions need to be sold and restructured
Laddered Bonds
- 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
Bullets - bond strategy
- 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
Preferred Stock
*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.
Convertible Bonds
- 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!!!
Property Valuation
-use formula to determine how much an investor is willing to pay for a piece of property.
Property Value - Net Operating Income example
