Bonds and Their Valuation

Bonds and Their Valuation

Key Features of Bonds

  • What is a bond?

    • A long-term debt instrument where a borrower agrees to pay specified principal and interest to bondholders on specific dates.

Bond Markets

  • Bond trading primarily occurs in the over-the-counter (OTC) market.

  • Large financial institutions own and trade most bonds.

  • Major publications like The Wall Street Journal track the Treasury, corporate, and municipal bonds, listing daily trading activity of various bonds, including investment-grade and high-yield.

Core Features of a Bond

  • Par Value:

    • The face amount of the bond, usually $1,000, paid at maturity.

  • Coupon Interest Rate:

    • The stated interest rate (typically fixed) paid by the issuer; determined by multiplying by par value to get actual dollar interest payment.

  • Maturity Date:

    • The duration until the bond must be repaid.

  • Issue Date:

    • The date when the bond was issued.

  • Yield to Maturity (YTM):

    • The rate of return anticipated on the bond if held until maturity; also known as the promised yield.

Call Provision

  • Effect of a Call Provision:

    • Allows the issuer to refund the bond issue if interest rates decline.

    • This helps issuers but is disadvantageous for investors.

    • Callable bonds often require a higher premium from investors due to increased risk.

Sinking Funds

  • What is a sinking fund?

    • A provision allowing the issuer to pay off the bond progressively over its life instead of all dues at maturity.

    • Similar to a loan amortization procedure.

    • Reduces risk to investors by shortening average maturity but may disadvantage them if rates drop after issuance.

  • Execution Methods for Sinking Funds:

    • Call a percentage of issue at par if the required rate of return is below the coupon rate (bonds are at a premium).

    • Buy bonds in the open market if the required rate of return is over the coupon rate (bonds are at a discount).

Understanding Bond Values

  • The present value (PV) of a bond involves calculating its cash flows over time and discounting them at the required rate of return.

  • Example:

    • For a bond with a par value of $1,000, a 10-year term, and a $100 annual coupon payment, the value can be calculated using Excel (using the PV function).

Calculating Value of Bonds with Different Coupon Rates

  1. Bond with 10% coupon: Value at par (YTM = coupon rate).

  2. Bond with 13% coupon: Sells at premium (value > par).

  3. Bond with 7% coupon: Sells at a discount (value < par).

Changes in Bond Value Over Time

  • As bonds approach maturity, their values converge to par value ($1,000).

    • Premium bonds decrease in value, while discount bonds increase, and par bonds remain stable.

Yield to Maturity (YTM) Evaluation

  • YTM Calculation:

    • Determined by finding the discount rate that equates the present value of future cash flows (coupons and par value) to the bond's price.

    • Example scenarios involve bonds selling at premiums or discounts.

Risks Associated with Bonds

  • Price Risk:

    • The risk that the bond’s value will decline due to rising interest rates.

    • Longer-term bonds have more price risk than shorter-term bonds.

  • Reinvestment Risk:

    • The risk that cash flows from a bond will have to be reinvested at lower rates if market rates decline.

Examples of Price and Reinvestment Risk

  • A lottery winner investing $500,000 may face different income levels based on the type of bond (10-year vs. series of 1-year bonds) they choose.

Bonds and Default Risk

  • Default Risk:

    • If the issuer defaults, investors risk receiving less than the promised return.

  • Influencing factors include the issuer’s financial strength and bond contract terms.

Types of Bonds

  • Mortgage bonds, debentures, subordinated debentures, investment-grade bonds, junk bonds.

  • Bond ratings indicate the probability of default, with Aaa rated bonds being the safest and lower-tier bonds representing higher risk.

Bankruptcy and Reorganization

  • Bankruptcy Chapters:

    • Chapter 11 is for reorganization, while Chapter 7 involves liquidation.

  • In reorganization, companies may emerge with lower debts and a chance for survival if their plans are approved.

Priority of Claims in Liquidation

  1. Secured creditors from asset sales.

  2. Trustee's costs.

  3. Wages (subject to limits).

  4. Taxes and unfunded pension liabilities.

  5. Unsecured creditors, preferred stock, and common stock last.

Conclusions on Bond Investing

  • Understanding price risk and reinvestment risk is crucial for bond investors to make informed decisions.

  • Evaluating the dynamics of various bond types and features helps navigate investment strategies effectively.