Chapter 11 Bond Valuation Measuring Return Required Return

Chapter 11 Bond Valuation

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

Major Bond Sectors • Bond market is comprised of a series of different market sectors: – Treasury 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 -3

Factors Affecting Yield Spreads • 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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -4

Factors Affecting Yield Spreads (cont’d) • Freely callable bonds yield higher than noncallable bonds • Bonds with longer maturities generally yield more than shorter maturities Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -5

What is the single biggest factor that influences the price of bonds? • Interest Rates Interest rates go G, bond prices go H Interest rates go H, bond prices go G Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -6

What is the single biggest factor that influences the direction of interest rates? • Inflation goes G, interest rates go G Inflation goes H, interest rates go H Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -7

Economic Variables that Affect Interest Rates Economic Variable Change in money supply Interest Change Slow increase Slow decrease Rate Effect Decrease Increase Change in money supply Fast increase Fast decrease Increase Deficit Surplus Increase Decrease Recession Expansion Decrease Increase Federal Budget Economic Activity Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -8

Economic Variables that Affect Interest Rates (cont’d) Economic Variable Federal Reserve Policies Interest Change Slower growth Faster growth Rate Effect Decrease Increase Foreign Interest Rates Higher Lower Increase Decrease 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. 11 -10

Figure 11. 2 Two Types of Yield Curves Copyright © 2014 Pearson Education, Inc.

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. 11 -12

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. 11 -13

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 shortterm 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. 11 -14

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 longterm bonds Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -15

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. 11 -16

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. 11 -17

The Pricing of Bonds • Bonds are priced according to the present value of

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. 11 -19

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. 11 -20

The Pricing of Bonds (cont’d) • Bond Pricing 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%? Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -21

Ways to Measure Bond Yield • Current yield • Yield-to-Maturity • Yield-to-Call • Expected

Current Yield • Simplest yield calculation • Only looks at current income Copyright ©

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. 11 -24

Yield-to-Maturity (cont’d) • Yield-to-Maturity Example: – Find the yield-to-maturity on a 7. 5 % ($1, 000 par value) bond that has 15 years remaining to maturity and is currently trading in the market at $809. 50? Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -25

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. 11 -26

Yield-to-Call (cont’d) • Yield-to-Call Example: – Find the yield-to-call of a 20 -year, 10. 5 % bond that is currently trading at $1, 204, but can be called in 5 years at a call price of $1, 085? Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -27

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. 11 -28

Expected Return (cont’d) • Expected Return Example: – Find the expected return on a 7. 5% bond that is currently priced in the market at $809. 50 but is expected to rise to $960 within a 3 -year holding period? Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -29

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. 11 -30

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. 11 -31

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. 11 -32

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. 11 -33

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 ratio by the year in which the bond makes each cash payment – 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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -34

Table 11. 1 Duration Calculation for a 7. 5%, 15 -Year Bond Priced to

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. 11 -36

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. 11 -37

Chapter 11 Review • Learning 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 and note how yield curves can be used by investors. 3. Understand how bonds are valued in the marketplace. Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -38

Chapter 11 Review (cont’d) • Learning Goals (cont’d) 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, and its use in the management of bond portfolios. 6. Discuss various bond investment strategies and the different ways these securities can be used by investors. Copyright © 2014 Pearson Education, Inc. All rights reserved. 11 -39

Chapter 11 Additional Chapter Art