Topic 4: Bond Valuation Flashcards
What is a bond?
A method to generate finance used by companies. The method involves taking loans from investors. The loan is provided as a tradable debt instrument known as a bond.
Bonds are referred to as fixed income securities since they traditionally pay a fixed rate of interest.
Bonds also have a fixed maturity date which is when the loan must be repaid.
Face value
The fixed principal amount of a bond that is repaid at the end of the loan.
Coupon
The fixed stated interest payment made on a bond.
Coupon rate
The interest rate paid on the loan
i.e
Annual coupon / face value of the bond
Note: Check examples for calculations and bond cash flows
Pure discount bond
No coupon payments. As an investor you only receive the face value at the maturity date
Coupon Bonds
Coupon payments are made on top of the face value at maturity date
Consols
Only coupon payments made. There is no maturity date and in principle the coupon payments continue forever. They are a form of a perpetuity.
Yield to Maturity (YTM)
The rate required in the market on a bond, also known as ‘yield’ or ‘market rate’. This is the yield that effectively determines the price of a bond.
the overall interest rate earned by an investor who buys a bond at the market price and holds it until maturity. Mathematically, it is the discount rate at which the sum of all future cash flows (from coupons and principal repayment) equals the price of the bond.
Bond valuation formula
C * [1 - (1/(1+r)^t)] / r + F / (1 + r)^t
Where:
C = coupon paid per period
r = yield to maturity or yield per period
t = period to maturity
F = Face value of paid at maturity
Note: Check examples on notes (4.2)
Discount Bonds
A bond that sells for less than it’s face value
i.e: yield to maturity > Coupon rate
“Bond is sold at a discount”
Premium Bonds
A bond that sells for more than it’s face value
i.e: Coupon rate > yield to maturity
“Bond is sold at a premium”
Semi Annual coupons
Corporate bonds typically pay a coupon semi-annually, which means that, if the interest rate on the bond is 4%, each $1000 bond will pay the bondholder a payment of $20 every six months (a total of $40 per year).
Note: Check examples (4.3) IMPORTANT
Interest Rate Risk
One of the biggest factors affecting bond prices is the market rate of interest or YTM. Also known as the interest rate risk.
If interest rate increases then bond prices decrease
If interest rate decreases then bond prices increase
Note: longer term bonds are more sensitive to changes in interest rates.
Long dated bonds
These bonds have proportionally more distant cash flows. Therefor the present value is more affected by changes in interest rate. Meaning long dates bonds are more susceptible to interest rate risk.
Short dated bonds
Have proportionally more near-term cash flows. PV of these is less affected by changes in the interest rate risk. Short term bonds are less susceptible to interest rate risk.
