Bond Valuation Essentials of Corporate Finance Chapters 4 & 6 Materials Created by Glenn Snyder – San Francisco State University

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 2 Topics What is Fixed Income?  The primary role of a fixed income research analyst? Portfolio Investment Objective Credit Analysis  Credit Ratings  Fundamental Research  Buy / Sell Recommendations  Bond Trading Career Advice for a Fixed Income Research Analyst

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 3 What is Fixed Income? Fixed Income is an investment that has an up-front capital investment and pays interest on a regular basis Fixed Income can be in many forms:  Bonds  Other forms of Debt (loans, commercial paper)  Annuities (insurance, winning the lottery)  Preferred Stock

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 4 The Primary Role of a Fixed Income Analyst A Fixed Income Analyst researches fixed income financial instruments to make a buy or sell recommendation for a portfolio Common financial instruments:  Bonds  Certificates of Deposit  Money Markets  Loans  GNMAs

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 5 The Primary Role of a Fixed Income Analyst Fixed Income analysts typically work on portfolio investment vehicles such as:  Mutual Funds  Pension Funds  Hedge Funds Their objectives is to maximize either  The income received from the investments  The capital appreciation from the investments

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 6 Portfolio Investment Objectives An investment objective identifies the type and discipline of the investments in the portfolio  This will also provide the analyst with the pool of securities to analyze Examples of Investment Objectives  International Bonds (invests in international government bonds)  Municipal Bonds (invests in tax-free state and local bonds)  Floating Rate Debt (invests in variable interest rate loans)  Investment Grade Bonds (invests in bonds rated BBB or higher)  High Yield Bonds (invests in bonds rated BB and lower)

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 7 Credit Analysis Bonds and loans are forms of credit Credit Analysis consists of:  Credit Ratings  Ability to have the funds paid back  Ability to make interest payments  Liquidity of the instrument  Liquidity of the market

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 8 Credit Ratings Credit Ratings are measures of overall credit quality provided by an independent rating service  Standard & Poors  Moodys Bond Ratings  AAA – Highest Credit Quality  BBB – Lowest Investment Grade Rating  BB – Highest Junk Bond or High Yield Rating  C – Bonds that pay no interest  D – Default

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 9 Fundamental Research Fundamental Research consists of:  Analyzing the borrower to ensure credit quality Cash flow Liquidity  Analyzing the security Yield to Maturity Yield to Call Current Yield Duration  Analyzing the portfolio Diversification / Investment Restrictions

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 10 Fundamental Research – Borrower’s Credit Quality Just as a banker would analyze a loan, a fixed income research analyst would analyze the borrower for credit quality.  Financial Statement Analysis  Cash Flow Analysis  Industry Analysis Analysis on the bond market (including liquidity)  International bond markets may not be as liquid as the U.S.

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 11 Fundamental Research – Analyzing the Security The fixed income analyst wants to maximize their overall return on the portfolio, while minimizing the risk  High yields will produce higher income Sometimes high yields indicate riskiness of the borrower  Call price and yield to call This will help determine how long to hold the bond  Duration The weighted average maturity of a bond’s cash flows The longer the duration, the greater the risk

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 12 Fundamental Research – Analyzing the Portfolio A strong portfolio will be well balanced  Diversified by maturity, yield, credit quality, and risk Mutual Funds & Pension Funds have investment restrictions  How much of the portfolio can be invested in a Security Industry Country

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 13 Buy / Sell Recommendations Once the analysis is done, the fixed income analyst will present his/her findings to the portfolio manager along with a buy or sell recommendation The Buy / Sell recommendation tells the portfolio manager to add, hold, or drop the security from the portfolio  It can also be to increase or decrease the current weighting in the portfolio

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 14 Buy / Sell Recommendations In many cases, the portfolio manager will question and analyze the fixed income analyst’s recommendation  The portfolio manager is not obligated to follow the recommendation  The analyst will be evaluated based on the quality of his/her recommendations Not whether the portfolio manager followed the recommendation

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 15 Bond Trading Bond trading is often more negotiation than placing orders  Large bond fund managers can negotiate the price of a bond down if buying large quantities Due to the negotiation, many fixed income analysts are also traders and portfolio managers Bonds are typically traded through a broker / dealer

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 16 Career Advice for a Fixed Income Analyst Build financial analysis skills  Analyzing financial statements  Credit and liquidity analysis  Creating projection models Large firm vs. small firm  A large firm will provide more training and a greater degree of specialization  At a small firm, the analyst will be integrated into the entire process (research, portfolio management, trading)  A large firm may provide for greater career mobility (switching firms), as name and reputation carry a heavy weight