Chapter 11 Bond Valuation

Copyright ©2014 Pearson Education, Inc. All rights reserved.11-2 For bonds, the risk premium depends upon: the default, or credit, risk of the issuer the term-to-maturity any call risk, if applicable Measuring Return Required Return: the rate of return an investor must earn on an investment to be fully compensated for its risk

Copyright ©2014 Pearson Education, Inc. All rights reserved.11-3 Major Bond Sectors Bond market is comprised of a series of different market sectors: –U.S. Treasury issues –Municipal bond issues –Corporate bond issues Differences in interest rates between the various market sectors are called yield spreads

Copyright ©2014 Pearson Education, Inc. All rights reserved.11-4 Factors Affecting Yield Spreads Municipal bond rates are usually 20-30% lower than corporate bonds due to tax-exempt feature Treasury bonds have lower rates than corporate bonds due to no default risk The lower the credit rating (and higher the risk), the higher the interest rate Discount (low-coupon) bonds yield less than premium (high- coupon) bonds Revenue municipal bonds yield more than general obligation municipal bonds due to higher risk Freely callable bonds yield higher than non-callable bonds Bonds with longer maturities generally yield more than shorter maturities

Copyright ©2014 Pearson Education, Inc. All rights reserved.11-5 Interest rates go , bond prices go  Interest rates go , bond prices go  What is the single biggest factor that influences the price of bonds? Interest Rates

Copyright ©2014 Pearson Education, Inc. All rights reserved.11-6 What is the single biggest factor that influences the direction of interest rates? Inflation Inflation goes , interest rates go  Inflation goes , interest rates go 

Copyright ©2014 Pearson Education, Inc. All rights reserved.11-7 Figure 11.1 The Impact of Inflation on the Behavior of Interest Rates

Copyright ©2014 Pearson Education, Inc. All rights reserved.11-8 Economic Variables that Affect Interest Rates EconomicInterestRate VariableChangeEffect Change in money supplySlow increaseDecrease Slow decreaseIncrease Change in money supplyFast increase Increase Fast decrease Decrease Federal BudgetDeficitIncrease SurplusDecrease U.S. Economic ActivityRecessionDecrease ExpansionIncrease

Copyright ©2014 Pearson Education, Inc. All rights reserved.11-9 Term Structure of Interest Rates and Yield Curves Term Structure of Interest Rates: relationship between the interest rate or rate of return (yield) on a bond and its time to maturity Yield Curve: a graph that represents the relationship between a bond’s term to maturity and its yield at a given point in time

Copyright ©2014 Pearson Education, Inc. All rights reserved Figure 11.2 Two Types of Yield Curves

Copyright ©2014 Pearson Education, Inc. All rights reserved Theories on Shape of Yield Curve Slope of yield curve affect by: –Investors’ expectations regarding the future behavior of interest rates –Liquidity preferences of investors –Market segmentation (supply and demand for bonds of different maturities)

Copyright ©2014 Pearson Education, Inc. All rights reserved Theories on Shape of Yield Curve (cont’d) Expectations Hypothesis –Shape of yield curve is based upon investor expectations of future behavior of interest rates –When investors expect interest rates to go up, they will only purchase long-term bonds if those bonds offer higher yields than short-term bonds; hence the yield curve will be upward sloping –When investors expect interest rates to go down, they will only purchase short-term bonds if those bonds offer higher yields than long-term bonds; hence the yield curve will be downward sloping

Copyright ©2014 Pearson Education, Inc. All rights reserved Theories on Shape of Yield Curve (cont’d) Liquidity Preference Theory –Shape of yield curve is based upon the difference in risk between short-term and long-term bonds –If investors’ view long-term bonds as being riskier than short- term bonds, then rates on long-term bonds must be higher than rates on short-term bonds –Investors may view long-term bonds as being riskier because long-term bonds are less liquid and are subject to greater interest rate risk

Copyright ©2014 Pearson Education, Inc. All rights reserved Theories on Shape of Yield Curve (cont’d) Market Segmentation Theory –Suggests that the bond market consists of distinct segments (based on maturity) due to the preferences of investors and borrowers –Supply and demand for funds in these distinct segments determine the level of short- and long-term interest rates –Therefore, an upward sloping yield curve is not a sign that investors expect rates to rise or a sign that investors see long-term bonds as being riskier than short-term bonds –Instead, an upward sloping curve means that the supply of short-term funds is high relative to borrowers’ needs, so rates on short-term bonds are lower than rates on long- term bonds

Copyright ©2014 Pearson Education, Inc. All rights reserved Interpreting Shape of Yield Curve Upward-sloping yield curves result from: –Expectation of rising interest rates –Lender preference for shorter-maturity loans –Greater supply of shorter-term loans Flat or downward-sloping yield curves result from: –Expectation of falling interest rates –Lender preference for longer-maturity loans –Greater supply of longer-term loans

Copyright ©2014 Pearson Education, Inc. All rights reserved Basic Bond Investing Strategy If you expect interest rates to increase, buy short-term bonds If you expect interest rates to decrease, buy long-term non-callable bonds

Copyright ©2014 Pearson Education, Inc. All rights reserved The Pricing of Bonds Bonds are priced according to the present value of their future cash flow streams

Copyright ©2014 Pearson Education, Inc. All rights reserved The Pricing of Bonds (cont’d) Bond prices are driven by market yields Appropriate yield at which the bond should sell is determined before price of the bond –Required rate of return is determined by market, economic and issuer characteristics –Required rate of return becomes the bond’s market yield –Market yield becomes the discount rate that is used to value the bond

Copyright ©2014 Pearson Education, Inc. All rights reserved The Pricing of Bonds (cont’d) Bond prices are comprised of two components: –Present value of the annuity of coupon payments, plus –Present value of the single cash flow from repayment of the principal at maturity Compounding refers to frequency coupons are paid –Annual compounding: coupons paid once per year –Semi-annual compounding: coupons paid every six months

Copyright ©2014 Pearson Education, Inc. All rights reserved The Pricing of Bonds (cont’d) Bond Pricing Example: –What is the value of a $1,000 par value 20 year bond that pays 9.5 % compounded annually when the market rate is 10%? (Bond Valuation worksheet)

Copyright ©2014 Pearson Education, Inc. All rights reserved Ways to Measure Bond Yield Current yield Yield-to-Maturity Yield-to-Call Expected Return

Copyright ©2014 Pearson Education, Inc. All rights reserved Current Yield Simplest yield calculation Only looks at current income

Copyright ©2014 Pearson Education, Inc. All rights reserved Yield-to-Maturity Most important and widely used yield calculation True yield received if the bond is held to maturity Assumes all interest income is reinvested at rate equal to market rate at time of YTM calculation—no reinvestment risk Calculates value based upon PV of interest received and the appreciation of the bond if held until maturity Difficult to calculate without a financial calculator

Copyright ©2014 Pearson Education, Inc. All rights reserved Yield-to-Maturity (cont’d) Yield-to-Maturity Example: –What is the market price of a $1,000 par value 20 year bond that pays 9.5 % compounded annually when the market rate is 10%? (Bond Valuation worksheet) –The bond is selling for $935

Copyright ©2014 Pearson Education, Inc. All rights reserved Yield-to-Call Similar to yield-to-maturity Assumes bond will be called on the first call date Uses bonds call price (premium) instead of the par value True yield received if the bond is held to call

Copyright ©2014 Pearson Education, Inc. All rights reserved Yield-to-Call (cont’d) Yield-to-Call Example: –What is the market price of a $1,000 par value 20 year bond that pays 9.5 % compounded annually when the market rate is 10%? (Bond Valuation worksheet) –The bond is selling for $935 –The call premium is the par value plus one years interest. The call is deferred for another 5 years.

Copyright ©2014 Pearson Education, Inc. All rights reserved Expected Return Used by investors who expect to actively trade in and out of bonds rather than hold until maturity date Similar to yield-to-maturity Uses estimated market price of bond at expected sale date instead of the par value

Copyright ©2014 Pearson Education, Inc. All rights reserved Expected Return (cont’d) Expected Return Example: –If the bond in our example is expected to be held for another 10 years and interest rates are expected to fall to 8%, what will the value be in 10 years?

Copyright ©2014 Pearson Education, Inc. All rights reserved Expected Return (cont’d) Expected Return Example: –If the bond in our example is expected to be worth in 10 years, what is the expected return? (sometimes called the realized YTM)

Copyright ©2014 Pearson Education, Inc. All rights reserved Bond Duration Bond Duration: A measure of bond price volatility, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments

Copyright ©2014 Pearson Education, Inc. All rights reserved Bond Duration (cont’d) Improvement over yield-to-market because factors in reinvestment risk Compares the sensitivity to changes in interest rates Bond Duration is the average amount of time that it takes to receive the interest and the principal Calculates the weighted average of the cash flows (interest and principal payments) of the bond, discounted to the present time

Copyright ©2014 Pearson Education, Inc. All rights reserved The Concept of Duration Generally speaking, bond duration possesses the following properties: –Bonds with higher coupon rates have shorter durations –Bonds with longer maturities have longer durations –Bonds with higher YTM lead to shorter durations

Copyright ©2014 Pearson Education, Inc. All rights reserved The Concept of Duration (cont’d) Bond duration is a better indicator than bond maturity of impact of interest rates on bond price (price volatility) –If interest rates are going up, hold bonds with short durations –If interest rates are going down, hold bonds with long durations

Copyright ©2014 Pearson Education, Inc. All rights reserved Measuring Duration What will happen to the bond price if interest rates increase by.13%?

Copyright ©2014 Pearson Education, Inc. All rights reserved Bond Immunization Strategy to derive a specified rate of return regardless of what happens to market interest rates over holding period Seeks to offset the opposite changes in bond valuation caused by price effect and reinvestment effect –Price effect: change in bond value caused by interest rate changes –Reinvestment effect: as coupon payments are received, they are reinvested at higher or lower rates than original coupon rate Bond immunization occurs when the average duration of the bond portfolio just equals the investment time horizon.

Copyright ©2014 Pearson Education, Inc. All rights reserved Bond Investment Strategies Conservative Approach –Main focus is high current income –High credit quality bonds are used –Usually longer holding periods Aggressive Approach –Main focus is capital gains –Usually shorter holding periods with frequent bond trading –Use forecasted interest rate strategy to time bond trading

Copyright ©2014 Pearson Education, Inc. All rights reserved Bond Investment Strategies (cont’d) Buy-and-hold strategy –Replace bonds as they mature or quality declines Bond ladder strategy –Set up “ladder” by investing equal amounts into varying maturity dates (i.e. 3-, 5-, 7- and 10- year) –As bonds mature, purchase new bonds with 10- year maturity to keep ladder growing –Provides higher yields of longer-term bonds and dollar-cost averaging benefits

Copyright ©2014 Pearson Education, Inc. All rights reserved Bond Investment Strategies (cont’d) Bond Swaps –Occur when investor sells one bond and simultaneously buys another bond in its place Yield pickup swap strategy –Sell a lower yielding bond and replace it with a comparable credit quality bond with higher yield –Often done between different bond sectors (i.e. industrial bonds vs. utility bonds)

Copyright ©2014 Pearson Education, Inc. All rights reserved Bond Investment Strategies (cont’d) Tax swap strategy –Sell a bond that has declined in value, use the capital loss to offset other capital gains, and repurchase another bond of comparable credit quality –Watch out for wash sales—new bond cannot be an identical issue to old bond

Copyright ©2014 Pearson Education, Inc. All rights reserved Seven Key Principles to Successful Investing &v=uQzwbQ1YRcg