8 Bond Valuation and Risk

PRELIMINARY COMMENTS Unfortunately, we do not have time to delve deeply into Ch. 8. However, there are a few key concepts about interest-rate risk that we need to focus on, which are summarized on the following slides.

Bond Prices Move Inversely to Rates  Suppose an investor purchases a $1000 par value bond that has an 8 percent coupon rate and that the current interest rate for bonds with similar risks is 6%. Would the bond sell for a premium or discount?  Suppose an investor purchases a $1000 par value bond that has an 8 percent coupon rate and the current interest rate for bonds with similar risks is 10%. Would the bond sell for a premium or discount?

Bond Risks and Prices  Higher risk  Higher discount rates  Lower bond prices  Lower risk  Lower discount rates  Higher bond prices Note Inverse Relationship Between Risk, required returns and Bond Prices

Interest-rate Risk Interest-rate risk is the risk that comes with locking into an interest rate for long periods of time. Since interest rates change, the fixed rate the bond pays may become unattractive and the bond price might therefore loose value. For example, suppose you invest in a bond that has a 5% fixed rate over 10 years. If interest rates on similar new bonds move to 6%, you are not happy that you are stuck with 5%. In addition, if you try to sell your bond early, other investors will demand a discount since your 5% bond is not very attractive. This causes the price of the bond to drop.

Interest-rate Risk & Maturity  Long-term bond prices are more sensitive to changes in market rates than short-term bond prices  ???? If you were a bond investor and you thought interest rates were going to increase, would you rather lengthen or shorten the average maturity of your bond portfolio?

 Bond investors not only use average maturity of a portfolio to measure interest-rate sensitivity, but they also use a similar concept called duration.  Duration measures bond price sensitivity by determining the life of bond on a present value basis  Duration = Sum of discounted, time-weighted cash flows divided by price Interest-rate Risk & Maturity (cont.)

 The price of a low coupon bonds is more sensitive to changes in interest rates than the price of a high coupon bond  ???? If you were a bond investor and you thought interest rates were going up, would you rather increase or decrease the average coupon rate of your bond portfolio? Interest-rate Risk & Coupon Rates

Sensitivity of 10-Year Bonds with Different Coupon Rates to Interest Rate Changes

Factors that affect bond prices  Increased in inflation will cause increased return required by investors, which will cause bond prices to decrease  Example: high oil prices can increase inflationary expectations, which can cause interest rates to increase, which can cause bond prices to fall. So bond investors expecting higher oil prices will tend to sell some of their bond holdings  Strong economic growth places upward pressure on interest rates, causing a decline in bond prices.  An increase in the federal budget deficit places upward pressure on interest rates, causing a decline in bond prices.