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CH14 Bond Valuation
Terms in this set (98)
What is a bond?
A bond is a debt financial contract where the issuer of the bond is required to make periodic interest payments and repay the principal at some predetermined point in the future.
What is a bond indenture?
A legal agreements between the issuer of the bond and the trustee that represents the investor who own the bonds
Principal value, par amount, maturity value and face value all mean the same thing. What is this?
The amount that the issuer pays the bondholder when the bond mature and the principal payment is due.
-most corporate and government bonds are issued with maturity values of $1,000. That is what it will always be in this class.
What is in an interest rate or coupon rate?
The amount of the annual interest payments on a bond is expressed a percent of the bond's maturity value. They are fixed over the life of the bond, and the investors and the issuer are certain of the payments
What is the current market interest rate?
The current market interest rate fluctuates day-to-day based on economic events and the actions of the federal reserve. The current interest rate is a variable rate that affects everyone in the economy.
How do you determine the price of a bond?
The current market interest rate is compared to the bond's coupon rate to determine the price of the bond
What is a bond's annual coupon (interest) payments?
Determined by multiplying a bond's maturity value by the bond's coupon rates
Which rate is fixed and which changes?
The current market interest rate is always changing, but the coupon rate on a fix-ed rate bond is fixed!
What is another term to express "Bond Coupon"?
What is a Fixed Rate Par Bond?
The issuer issues the bond at par value (100%) and pays fixed interest semi annually on predetermined days and repays the full par value of the bond on maturity
-Current market interest rate = Bond's coupon rate
What does it mean when a bond is a par bond?
A bond is sold for a price equal to its maturity value
What is a fixed-rate discount bond?
When the current market interest rate is greater than the bond's coupon rate
-the bond's price will be less than the bond's maturity value.
What does it mean when the bond is a discount bond?
This means that the bond is not giving as high of a return as the market says is fair. Sells at price less than 100%
-A bond with a maturity value of %1,000 with sell for less than $1,000
What is a zero-coupon bond?
A bond that has a coupon rate of 0%
-This is always a discount bond
-They don't make any coupon (interest) payments
-The issuer's only obligation is to pay the bondholder full maturity value of the bond at the end of the bond's life
What is a fixed-rate premium bond?
When the current interest rate is less than the bond's coupon rate
-the bond's price will be greater than the bond's maturity value
What does it mean when the bond is a premium bond?
Investors are willing to purchase a bond at a price higher than the bond's maturity value when the bond's coupon rate exceeds the current market interest rate
-a bond with a maturity value of $1,000 will sell for more than $1,0000
The value in the market place go up and down based off changes in interest rates. How do they relate to each other?
As interest rates increase, fixed-rate bond prices decrease
As interest rates decrease, fixed-rate bond prices increase
What are floating interest rate structures?
Bonds who's coupon rate adjusts to the current market interest rates so that the bond is always selling at or near to par value. The issuer of floating-rate bonds retains the interest rate risk associated with the bond issues.
Historically, investors have been willing to accept significantly lower interest rates on floating-rate bonds than fixed-coupon bonds. Why is this?
Because floating-rate bonds are less risky for the investor
What are treasury bonds?
Debt securities issued by the U.S. government that are considered to be risk-free because they are assumed to have no credit risk.
Describe the market for U.S. Treasury securities.
The market for U.S.Treasury securities is the largest and most liquid financial market, with over $10 trillion in securities outstanding
What is the Treasury Yield Curve?
It acts as a set of base yields or interest rates from which all other debt securities are priced - U.S. Treasury securities are used to determine the risk-free rate.
What are municipal bonds?
Bonds issued by cities, states, or municipalities to raise funds in the form of debt. (Still government, but local)
What makes these sort of bonds so attractive to investors?
Interest income received from municipal bonds are exempt from federal and certain state and local taxation!
Why are investors willing to accept lower yields (returns) on municipal bonds compared to corporate and treasury bonds?
Because of the federal income tax exception
How do investors compare Municipal Bonds interest income?
With After-Tax Income of other fix-ed income securities; taking into account the investor's marginal tax bracket
How do you calculate equivalent taxable yield?
r / (1-tax rate)
What does the equivalent taxable yield know?
Calculating the taxable equivalent yield allows investors to relate the return on a municipal bond to the current market interest rate and other bonds with comparable maturities
What are corporate bonds?
Bonds issued by corporations that are typically issued to finance the corporation's long-term capital needs and to take advantage of the deduction associated with the interest payments on debt
Why are corporate bonds more likely to default than Treasury or municipal bonds?
Because the U.S. Treasury and municipalities have taxing power to raise funds while corporations at the mercy of the market place whether their products or services produce profit or loss
What is Spread to Treasuries?
A measure of default risk
How do you calculate Spread to Treasuries?
Yield on corporate bond - Yield on Treasure with same maturity
What are convertible bonds?
Bonds issued by a corporation that usually pay a fixed rate of interest; after a certain period of time, they can be converted into a fixed number of shares of stock in the issuing corporation.
What kind of interest rates are investors willing to accept with convertible bonds?
Since investors have the option to convert the bonds to shares of stock, they are willing to accept a lower rate of interest than they would on a comparable bonds without the conversion feature.
What is asset-backed debt?
Bonds that are secured by a portfolio of mortgages on a single-family homes or a portfolio of other asset-backed loans, like car loans.
What is a callable bond?
Bonds that include a call option that allows the issuer of the bond to buy back the bonds prior to their stated maturity at a predetermine price above par value
What is a call premium?
The amount the call price is above the bond's par value
-This is an additional return, which is why someone would buy a callable bond
-A call premium can be exercised on or after a predetermined date that is usually at least 5 or 10 years from the date the bond was issued
When will an issuer exercise a call option?
If interest rates drop and the issuer can refinance at a low enough rate to make the transaction financially desirable
-If interest rates drop low enough, the issuer can issue new bonds to pay off the existing bonds, which allows the issuer to refinance its debt at the lower interest rate.
What kind of interest rates are investors willing to accept with callable bonds?
Investors require a higher rate of return on callable bonds than on noncallable bonds because callable bonds will be called only when it is in the best interest of the company and a bad deal for the investor
-the investor also received a call premium as compensation for the bonds being called before their maturity date
What are noncallable bonds?
Bonds that cannot be called under any circumstance, so the investor always has the option to hold the bond until maturity.
How many types of risks are involved when investing in fixed-rate or fixed coupon debt obligations?
What are these four risks associated with bonds?
-Interest Rate Risk
Which risk is the most difficult to assess?
Interest rate risk
What is default risk?
The risk that the bond will not pay interest or principal when due
What kind of companies have less default risk?
How do you overcome default risk?
By buying Treasury Bills - Government makes sure bonds are paid off.
What is a measure of default risk?
The Spread to Treasures
How does the spread compare with default risk?
The spread will increase as a company's default risk increases.
What is Spread to Treasuries?
The difference between the yield on a non-callable US Treasury bond and the yield on a non-callable corporate bond with an identical maturity. This is a measure of the default premium associated with the corporate bond.
What is the Spread to Treasuries a function of?
The Spread to Treasuries is a function of the type of industry the issuer belongs, the credit rating of the corporate bond and a function of the time to maturity of the bond.
What is an investment-grade bond?
a bond that is rate at a level of BBB- or better.
If a company does default on its debt, what debt as a claim on the firms assets?
If a company does default on its debt, Senior debt has a claim on the firms assets BEFORE subordinate (junior) debt.
What is Reinvestment risk?
The risk related to the fact that investors do not know the future interest rate at which they will be able to reinvest in the bonds' coupon payments
How do you overcome reinvestment risk?
By investing in zero-coupon bonds
-Since zero-coupon bonds do not make any interest payments, they do not have any reinvestment risk
What is Prepayment Risk?
The risk that a bond will be called by the issuer and retired before its maturity date
How do you overcome prepayment risk?
By only buying non-callable bonds
What is Interest Rate Risk?
The risk that changes in the market interest rates will negatively impact the value of the bond.
What is Price volatility of a bond?
The extent to which a bond's price is affected by fluctuations in the market interest rates
How do bond prices and market interest rates move?
Bond prices and market interest rates move in opposite directions
-When the market interest rate increases, the price of a fixed rate bond goes down; and when the market interest rate decreases, the price of fixed rate bonds goes up
How does the maturity of a bond relate to the bond's price volatility?
The longer the maturity of a bond, the greater the bond's price volatility
-When all other factors are held equal, long-term bonds are more affected by changes in the market interest rates than short-term bonds
How does the coupon on a bond relate to the bond's price volatility?
The lower the coupon on a bond, the higher the bond's price volatility
-When all other factors are held equal, bonds with low coupon rates are more sensitive to changes in the market interest rates than bonds with high coupon rates
How do bond prices and yields move?
They move in opposite directions, other things being equal. The magnitude of price movements will differ based on specific bond characteristics.
What is a measure of interest rate risk?
What is duration?
A measure of price volatility ( or interest rate risk ) that is calculated by finding the weighted average maturity of a bonds cash flows
How do you determine duration?
It is the percentage change in the price of an asset, divided by a change in interest rates
What is duration measured in?
How does duration compare with the size of a bond's coupon payments?
As the size of a bond's coupon payment increases, the duration of the bond decreases.
What is the formula for duration?
[ (- change in P) / P ] / (change in Y)
P- Dollar price of the bond
Y - Market Yield
What is the yield curve?
It is used to describe the relationship between the yield on a bond and its maturity
What is the yield curve also known as?
The term structure of interest rates
Describe the shape of the yield curve
Since the only difference between the bonds used int he yield curve is the maturity of bonds, the yield curve shows the relationship between the yield on the bond and the amount of time left until maturity
-It is typically upward sloping, but can be downward sloping
Describe an upward-sloping yield curve
The normal shape of the yield curve, where bonds with longer maturities have higher yields than bonds with shorter maturities
-Longer maturities, greater rate of return
Describe a downward-sloping yield curve
Occurs when a significant slowdown in inflation is anticipated, flat, or humped.
What are factors that affect the shape of the yield curve?
1. The rate of inflation or deflation
2. The economy
3. Monetary policies
What are the three common academic explanations for the shape of the yield curve?
1. Pure Expectations hypothesis
2. Liquidity Preference hypothesis
3. Market Segmentation hypothesis
What does the Pure Expectations hypothesis state?
The expected average annual return on a long-term bond is the compound average of the expected short-term interest rates.
What does the pure expectations hypothesis imply?
It implies that investors do not earn a greater yield from purchasing long-term bonds than they do from purchases many consecutive short-term bonds.
-assumption that investors are risk neutral and the upward sloping yield curve means investors are expecting higher short term interest rates in the future.
What is the Liquidity Preference Hypothesis?
Investors prefer to hold short-term maturity securities, so investors are going to require higher interest rates, known as a liquidity premium, for them to be willing to hold bonds with longer maturities.
-long-term interest rates are composed of expected short-term interest rates PLUS a liquidity premium
What is the point of a liquidity premium?
Liquidity preference hypothesis assumes that there are risk averse investors- you need to induce investors to buy longer term by paying those investors in the way of higher interest rates (liquidity premium) to go out with yield curve
How do the liquidity premium change with maturity?
The liquidity premium increases with time to maturity.
So what does this theory predict?
This theory predicts that there will be an upward-sloping yield curve even when investors expect that short-term rates will remain constant because of the liquidity premium that is paid to investors to incentivize them to purchase long-term debt instead of a series of short-term notes.
What is another way to refer to market segmentation hypothesis?
Also called preferred Habits Hypothesis
What is the Market Segmentation Hypothesis?
The market is made up of a diverse group of investors, where some investors prefer short-term investments and some investors prefer long-term investments
-if the issuer of a bond wants an investor to move away from the investor's preferred position on the yield curve, the issuer must pay a premium
How does the Market Segmentation hypothesis explain the shape of the yield curve?
The shape of the yield curve depends on supply and demand to fulfill different investors preferences
-short-term has higher demand
What are nominal interest rates?
The actual observed rate of return on an investment
What are real interest rates?
The difference between the nominal rate of interest and the rate of inflation
Real rate of interest = Nominal rate of interest - Inflation rate
What is a bond's yield a function of?
-Spread to treasuries
-bond specific traits/spreads
How do you calculate a bond's yield?
The value of a bond is found by discounting the bond's cash flows at the yield level that is required by securities of comparable maturity, risk, liquidity and call features
What is the formula for finding the Bond Yield?
Bond Yield = Rf + Spread to Treasuries + Bond-specific spread
What are two important facts associated with the valuation and bond prices in the marketplace ?
-Bond price and interest rates move in opposite directions
-Investors value bonds based on a "price to worst" call-feature scenario
What does "investors value bonds based on a "price to worst" call-feature scenario" mean?
That investors assume that the issuer of a bond will always act in its own best interest in calling or managing a bond's call features, which means that the issuer will exercise a bond's call option at the first opportunity it is economically advantageous to do so.
-interest rates down, assume that they will call the bond
What do you have to take into consideration when valuing a callable bond?
Have to take into consideration when valuing a bond if callable, value to maturity AND the value of the bond to call. The lower of two values is where the bond will trade in the market.
What are you looking for on the calculator if you are solving for the yield on a bond?
Solving for I
When solving for the yield on a bond, it is important that you pay attention to the sign that you enter for the PV, PMT, and FV inputs.
The PMT and FV inputs need to have the same sign, and the PV input needs to have the opposite signs
-Easy to enter PV as a negative number and PMT and FV as the positive number
What does PV, PMT and FV represent?
Pv is the amount the investor pays for the bond while PMT and FV are the cash flows that the investor receives from the bond
When given a problem to solve for a callable bond, the question will state that the market interest rate drops immediately after the bonds are issued. How do you input interest rate?
You use what the interest rate immediately fell to when inputting into your calculator.
-Will be semi-annual so divide that interest rate by 2
How is n affected with a callable bond?
You use the number of years that it can be called after. (Still multiply by 2 because it is semiannual)
With these problems, there will be a call premium which is typically expressed a percent. How does this affects what you input into your calculator?
This affects what you put in for FV. Multiply the face value (1,000) by the premium and put that into for FV.
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