Reading 44: Introduction to Fixed-Income Valuation

Question 1

Identify the 3 critical assumptions that represent the internal rate of return on the bond’s cash flows.

Answer 1

1. The investor holds onto the bond until maturity.
2. The issuer makes all promised payments on time in their full amount.
3. The investor is able to reinvest all coupon payments received during the term of the bond at the stated yield-to-maturity until the bond’s maturity date.

Question 2

Describe forward rates and the forward curve.

Answer 2

Forward rates are the market’s current estimate of future spot rates.

A forward market is for future delivery, beyond the settlement horizon of the cash market. A forward rate is the interest rate on a bond or money market instrument traded in the forward market.

Question 3

Identify the 3 respects in which money market yields differ from yields in the bond market.

Answer 3

1. Bond yields-to-maturity are annualized and compounded. Money market yields are annualized but not compounded.
2. Bond yields-to-maturity can be calculated by applying standard time value of money analysis. Money market yields are often quoted in terms of nonstandard interest rates.
3. Bond yields-to-maturity are typically stated for a common periodicity for all terms-to-maturity. Money market instruments that have different times-to-maturity have different periodicities for the stated annual rate.

Question 4

Define the spot rate and the spot rate curve.

Answer 4

A spot rate (or zero rate) is the yield on a zero-coupon bond for a given maturity.

The spot rate curve is the ideal data set for analyzing the term structure of interest rates, which would be yields-to-maturity on zero-coupon government bonds (spot rates) for a range of maturities.

Question 5

What is the manner in which the number of days between two dates is calculated for government bonds?

Answer 5

The actual/actual day-count convention is usually applied. The actual number of days is used including weekends, holidays, and weekdays.

Question 6

Explain the spread.

Answer 6

The spread refers to the difference between the yield-to-maturity on a bond and the benchmark (aka the risk-free rate). It captures all microeconomic factors specific to the issuer, such as credit risk of the issuer, changes in the issuer’s credit rating, liquidity, and tax status of the bond. The spread is also known as the risk premium over the risk-free rate of return.

Question 7

Define matrix pricing, and explain the spread and benchmark of matrix pricing.

Answer 7

Matrix pricing: Method used to estimate market discount rate and price of bonds that aren’t actively traded. Prices of comparable bonds are used to interpolate the price of the subject bond.

Spread: Difference between yield-to-maturity on new bond and benchmark bond. Reflects additional compensation offered by the issuer to compensate investors for difference in credit risk, liquidity risk, and tax status of the bond relative to the benchmark.

Benchmark: Government bond with a similar term to maturity.

Question 8

How is the value or price of a bond computed?

Answer 8

As the present value of expected future cash flows from the bond.

Question 9

Give the equation for the current yield, and explain why it is a crude measure of the rate of return to an investor?

Answer 9

Equation

Annual cash coupon payment / Bond price

It is a crude measure because it:
Neglects the frequency of coupon payments in the numerator.
Neglects any accrued interest in the denominator.
Neglects any gains (losses) from purchasing the bond at a discount (premium) and redeeming it for par.

Question 10

A yield curve for coupon bonds shows what?

Answer 10

The yields-to-maturity for coupon-paying bonds of different maturities.