Post on 29-Dec-2015
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Chapter 11
Bond Valuation
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Bond Valuation and Analysis
Goals
1. Explain the behavior of market interest rates, and identify the forces that cause interest rates to change.
2. Describe the term structure of interest rates.
3. Understand how bonds are valued in the marketplace.
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Bond Valuation and Analysis
Goals
4. Describe the various measures of yield and return, and explain how these standards of performance are used in bond valuation.
5. Understand the basic concept of duration, how it can be measured.
6. Discuss the various bond investment strategies.
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For bonds, the risk premium depends upon:• the default, or credit, or 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
Required ReturnOn Investment
Real Rateof Return
Expected Inflation
Premium
Risk Premiumfor Investment
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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.
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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
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Factors Affecting Yield Spreads
Revenue muni bonds yield more than general obligation muni bonds due to higher risk
Freely callable bonds yield higher than noncallable bonds
Bonds with longer maturities generally yield more than shorter maturities
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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
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What is the single biggest factor that influences the direction of interest rates?
Inflation
Inflation goes , interest rates go
Inflation goes , interest rates go
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The Impact of Inflation on the Behavior of Interest Rates
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Economic Variables that Affect Interest Rates Economic Interest Rate
Variable Change Effect
Change in money supply Slow increase DSlow decrease C
Change in money supply Fast increase CFast decrease D
Federal Budget Deficit CSurplus D
U.S. Economic Activity Recession DExpansion C
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Economic Variables that Affect Interest Rates Economic Interest Rate
Variable Change Effect
Federal Reserve Policies Slower growth DFaster growth C
Foreign Interest Rates Higher CLower D
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Term Structure of Interest Ratesand 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
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Two Types of Yield Curves
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Theories on Shape of Yield Curve
Slope of yield curve affect by:
Inflation expectations
Liquidity preferences of investors
Supply and demand
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Theories on Shape of Yield Curve
Expectations Hypothesis
Shape of yield curve is based upon investor expectations of future behavior of interest rates
If expecting higher inflation, investors demand higher interest rates on longer maturities to compensate for risk
Increasing inflation expectations will result in upward-sloping yield curve
Decreasing inflation expectations will result in downward-sloping yield curve
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Theories on Shape of Yield Curve
Liquidity Preference Theory
Shape of yield curve is based upon the length of term, or maturity, of bonds
If investors’ money is tied up for longer periods of time, they have less liquidity and demand higher interest rates to compensate for real or perceived risks
Investors won’t tie their money up for longer periods unless paid more to do so
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Theories on Shape of Yield Curve
Market Segmentation Theory Shape of yield curve is based upon the supply and
demand for funds
The supply and demand changes based upon the maturity levels: short-term vs. long-term
If more borrowers (demand) want to borrow long-term than investors want to invest (supply) long-term, then the interest rates (price) for long-term funds will go up
If fewer borrowers (demand) want to borrow long-term than investors want to invest (supply) long-term, then the interest rates (price) for long-term funds will go down
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Interpreting Shape of Yield Curve
Upward-sloping yield curves result from: Higher inflation expectations Lender preference for shorter-maturity loans Greater supply of shorter-term loans
Flat or downward-sloping yield curves result from: Lower inflation expectations Lender preference for longer-maturity loans Greater supply of longer-term loans
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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
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The Pricing of Bonds
Bonds are priced according to the present value of their future cash flow streams
Bond price Present value of the annuity
of annual interest income
Present value of thebond's par value
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The Pricing of Bonds
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
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The Pricing of Bonds
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
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The Pricing of Bonds
Bond Pricing Example: What is the market price of a
$1,000 par value 20 year bond that pays 9 ½ % compounded annually when the market rate is 10%?
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Ways to Measure Bond Yield
Current yield
Yield-to-Maturity
Yield-to-Call
Expected Return
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Current Yield
Simplest yield calculation
Only looks at current income
Current yield Annual interest
Current market price of the bond
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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
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Yield-to-Maturity
Yield-to-Maturity Example: Find the yield-to-maturity on a
7 ½ % ($1,000 par value) bond that has 15 years remaining to maturity and is currently trading in the market at $809.50?
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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
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Yield-to-Call
Yield-to-Call Example: Find the yield-to-call of a 20-year,
10 ½ % bond that is currently trading at $1,204, but can be called in 5 years at a call price of $1,085?
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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
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Expected Return
Expected Return Example: Find the expected return on a 7 ½
% bond that is currently priced in the market at $810 but is expected to rise to $960 within a 3-year holding period?
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Bond Duration
Bond Duration: A measure of bond price fluctuation, which captures both price and reinvestment risk and which is used to indicate how a bond will react in different interest rate environments
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Bond Duration
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
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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
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The Concept of Duration
Bond duration is a better indicator than bond maturity of the impact of interest rates on bond price (price fluctuation) (Remember Reinvestment…)
If interest rates are going up, hold bonds with short durations
If interest rates are going down, hold bonds with long durations
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Measuring Duration
Steps in calculating duration Step 1: Find present value of each coupon or
principal payment
Step 2: Divide this present value by current market price of bond
Step 3: Multiple this relative value by the year in which the cash flow is to be received
Step 4: Repeat steps 1 through 3 for each year in the life of the bond then add up the values computed in Step 3
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Duration Calculation for a 7.5%, 15-Year Bond Priced to Yield 8%
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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.
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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
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Bond Investment Strategies
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 years) 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
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Bond Investment Strategies
Bond Swaps 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)
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Bond Investment Strategies
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
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Review
Goals
1. Explained the behavior of market interest rates, and identify the forces that cause interest rates to change.
2. Described the term structure of interest rates, and note how yield curves can be used by investors.
3. Understood how bonds are valued in the marketplace.
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Review
Goals
4. Described the various measures of yield and return, and explain how these standards of performance are used in bond valuation.
5. Understood the basic concept of duration, how it can be measured, and its use in the management of bond portfolios.
6. Discussed the various bond investment strategies and the different ways these securities can be used by investors.
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The End!
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Chapter 11
Additional Chapter Art
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Yield Curves on U.S. Treasury Issues
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Yield Curves on U.S. Treasury Issues
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Bond Immunization