Module 3.1 Flashcards
Bond Valuation Process Bond Valuation Process
Bonds are debt obligations with long-term maturities that are commonly issued by governments or corporations to obtain long-term funds.
The price of a bond is the present value of the cash flows that will be generated by the bond, namely periodic interest or coupon payments and the principal at maturity.
Current price of a bond (PV)
PV=C/(1+k)1+C/(1+k)2+....+(C+par)/(1+k)n Where: C = coupon payment paid in each period Par = par value k = required rate of return n = number of period to maturity
Impact of the Discount Rate on Bond Valuation
The appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with similar risk and maturities.
High risk securities have higher discount rates.
Impact of the Timing of Payments on Bond Valuation
Timing affects the market price of a bond. (Exhibit 8.3)
Funds received sooner can be reinvested to earn additional returns.
Valuation of Bonds with Semiannual Payments
First, divide the annual coupon by two
Second, divide the annual discount rate by two
Third, double the number of years
PV of bond with
Semiannual payments
=(C/2)/[1+(k/2)]1+(C/2)/[1+(k/2)]2+…+[(C/2)+par]/[1+(k/2)]2n
As an example of the valuation of a bond with semiannual payments, consider a bond with $1,000 par value, a 10 percent coupon rate paid semiannually, and three years to maturity. Assuming a 12 percent required return, the present value is computed as follows:
See actual slide. N=6 i=6 fv=1000 pymt =50 answer = 950.83
Relationship between Coupon Rate, Required Return, and Bond Price
Discount bonds: Bonds Selling below Par
If coupon rate is below required rate, the price of the bond is below par (PV < 1,000).
Par Bonds: Bonds Selling at Par
If coupon rate equals the required rate, the price of the bond is equal to par value (PV = 1,000).
Premium Bonds: Bonds Selling above Par
If the coupon rate is above the required rate, the price of the bond is above the par (PV > 1,000).
Explaining Bond Price Movements
Impact of Inflationary Expectations (INF)
If the level of inflation is expected to increase (decrease), there will be upward (downward) pressure on interest rates and hence on the required rate of return on bonds.
Inflationary expectations are partially dependent on oil prices and exchange rate movements.
Impact of Economic Growth (ECON) — Strong economic growth tends to generate upward pressure on interest rates, while weak economic conditions put downward pressure on rates.
Impact of Money Supply Growth (MS)
The increased money supply may result in an increased supply of loanable funds. If demand for loanable funds is not affected, the increased money supply should place downward pressure on interest rates, causing bond portfolio managers to expect an increase in bond prices and thus to purchase bonds based on such expectations.
In a high-inflation environment, bond portfolio managers may expect a large increase in the demand for loanable, which would cause an increase in interest rates and lower bond prices.
Impact of Budget Deficit (DEF)
An increase in the budget deficit can put upward pressure on interest rates. An increase in borrowing by the federal government can indirectly affect the required rate of return on all types of bonds.
Factors That Affect the Credit (Default) Risk Premium
The general level of credit risk on bonds can change in response to a change in economic growth.
Strong economic growth can improve a firm’s cash flows and reduce the probability of default.
Weak economic conditions tend to reduce a firm’s cash flows and increase the probability of default.
Factors That Affect the Credit (Default) Risk Premium (cont.)
Changes in Credit Risk Premium over Time (Exhibit 8.5)
Yields among securities are highly correlated.
Difference between the corporate and Treasury bond yields widened during periods when the economy was weak.
Impact of Debt Maturity on the Credit Risk Premium
Tends to be larger for bonds that have a longer term to maturity (more time available for company default conditions to change).
Impact of Issuer Characteristics on the Credit Risk Premium
A bond’s price can be affected by factors such as a change in capital structure.
Summary of Factors Affecting Bond Prices
The effect of economic growth is uncertain: A high level of economic growth can adversely affect bond prices by raising the risk-free rate, but it can favorably affect bond prices by lowering the default risk premium.
Any new information about a firm that changes its perceived ability to repay its bonds could have an immediate effect on the price of the bonds.
Implications for Financial Institutions
Any factors that lead to higher interest rates tend to reduce the market values of financial institution assets and therefore reduce their valuations.
Any factors that lead to lower interest rates tend to increase the market values of financial institution assets and therefore increase their valuations.
Systemic risk — the potential collapse of the entire market or financial system
Sensitivity of Bond Prices to Interest Rate Movements
Bond Price Elasticity — The sensitivity of bond prices (Pb) to changes in the required rate of return (k). (Exhibit 8.7)
Influence of Coupon Rate on Bond Price Sensitivity
A zero-coupon bond is most sensitive to changes in the required rate of return.
The price of a bond that pays all of its yield in the form of coupon payments is less sensitive to changes in the required rate of return.
Influence of Maturity on Bond Price Sensitivity — As interest rates decrease, long-term bond prices increase by a greater degree than short-term bond prices.
Duration
Duration — a measurement of the life of the bond on a present value basis. The longer a bond’s duration, the greater its sensitivity to interest rate changes.
Duration of a portfolio
Duration of a Portfolio — the weighted average of bond durations weighted according to relative market value.
Modified Duration
Modified Duration (DUR*) — Can be used to estimate the percentage change in the bond’s price in response to a 1 percentage point change in bond yields
Estimation Errors from Using Modified Duration and Bond Convexity
Estimation Errors from Using Modified Duration — Relying strictly on modified duration to estimate the percentage change in the price of a bond may lead to overestimating the price decline when rates rise and underestimating the price increase when rates fall.
Bond Convexity — The actual response of the bond’s price to a change in bond yields is convex and is represented by the red curve in Exhibit 8.8
Convexity is more pronounced for bonds with long maturities.
Convexity is more pronounced for bonds with low (or no) coupons.
Bond Investment Strategies
Matching Strategy — Involves estimating future cash outflows and then developing a bond portfolio that can generate sufficient coupon or principal payments to cover those outflows.
Laddered Strategy — Funds are evenly allocated to bonds in each of several different maturity classes.
Barbell Strategy — Funds are allocated to bonds with a short term to maturity as well as to bonds with a long term to maturity.
Interest Rate Strategy — Funds are allocated in a manner that capitalizes on interest rate forecasts.
Valuation and Risk of International Bonds
Influence of Foreign Interest Rate Movements — As the risk-free interest rate of a currency changes, the required rate of return by investors in that country changes as well.
Influence of Credit Risk — An increase in risk causes a higher required rate of return on the bond and therefore lowers its present value, whereas a reduction in risk causes a lower required rate of return on the bond and increases its present value.
Influence of Exchange Rate Fluctuations — Changes in the value of the foreign currency denominating a bond affect the U.S. dollar cash flows generated from the bond and the return to U.S. investors who invested in it.
International Bond Diversification
International Bond Diversification — May diversify foreign bond holdings among countries to reduce their exposure to different types of risk.
Reduction of Interest Rate Risk
Reduction of Credit Risk
Reduction of Exchange Rate Risk
International Integration of Credit Risk — When one country experiences weak economic conditions, its consumers in other countries are also affected.
European Debt Crisis 2010-2012
Greece, Portugal, and Spain experienced debt crisis because of large budget deficits and inability to cover debt payments.
Because these countries commonly obtained debt financing from financial institutions in other European countries, these financial problems also spread to other countries.
Common Investment Strategies to invest in bonds
Common investment strategies used to invest in bonds are the matching strategy, laddered strategy, barbell strategy, and interest rate strategy. The matching strategy focuses on generating income from the bond portfolio that can cover anticipated expenses. The laddered strategy and barbell strategy are designed to cover liquidity needs while also trying to achieve decent returns. The interest rate strategy is useful for investors who believe that they can predict interest rate movements and therefore shift into long-term bonds when they believe interest rates will decline.
