1. Chapter 11
Bond Valuation

2. Bond Valuation and Analysis
Learning Goals
Explain the behavior of market interest rates, and identify the forces that cause interest rates to change.
Describe the term structure of interest rates, and note how yield curves can be used by investors.
Understand how bonds are valued in the marketplace.
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3. Bond Valuation and Analysis
Learning Goals (cont’d)
Describe the various measures of yield and return, and explain how these standards of performance are used in bond valuation.
Understand the basic concept of duration, how it can be measured, and its use in the management of bond portfolios.
Discuss the various bond investment strategies and the different ways these securities can be used by investors.
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4. 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
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5. 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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6. 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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7. Factors Affecting Yield Spreads (cont’d)
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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8. 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
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9. What is the single biggest factor that influences the direction of interest rates?
Inflation
Inflation goes G, interest rates go G
Inflation goes H, interest rates go H
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10. Figure 11.1 The Impact of Inflation on the Behavior of Interest Rates
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11. Economic Variables that Affect Interest Rates
Economic Interest Rate Variable Change Effect
Change in money supply Slow increase D Slow decrease C
Change in money supply Fast increase C Fast decrease D
Federal Budget Deficit C Surplus D
U.S. Economic Activity Recession D Expansion C
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12. Economic Variables that Affect Interest Rates (cont’d)
Economic Interest Rate Variable Change Effect
Federal Reserve Policies Slower growth D Faster growth C
Foreign Interest Rates Higher C Lower D
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13. 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
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14. Figure 11.2 Two Types of Yield Curves
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15. 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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16. 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
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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17. Theories on Shape of Yield Curve (cont’d)
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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18. Theories on Shape of Yield Curve (cont’d)
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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19. 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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20. 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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21. The Pricing of Bonds
Bonds are priced according to the present value of their future cash flow streams
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22. 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
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23. 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
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24. 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 ½ % compounded annually when the market rate is 10%?
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25. Ways to Measure Bond Yield
Current yield
Yield-to-Maturity
Yield-to-Call
Expected Return
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26. Current Yield Simplest yield calculation Only looks at current income
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27. 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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28. Yield-to-Maturity (cont’d)
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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29. 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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30. Yield-to-Call (cont’d)
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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31. 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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32. Expected Return (cont’d)
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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33. 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
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34. 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
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35. 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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36. 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
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37. 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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38. Table 11. 1 Duration Calculation for a 7
Table Duration Calculation for a 7.5%, 15-Year Bond Priced to Yield 8%
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39. 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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40. 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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41. Bond Investment Strategies (cont’d)
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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42. Bond Investment Strategies (cont’d)
Bond Swaps
Occur 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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43. Bond Investment Strategies (cont’d)
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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44. Chapter 11 Review Learning Goals
Explain the behavior of market interest rates, and identify the forces that cause interest rates to change.
Describe the term structure of interest rates, and note how yield curves can be used by investors.
Understand how bonds are valued in the marketplace.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

45. Chapter 11 Review (cont’d)
Learning Goals (cont’d)
Describe the various measures of yield and return, and explain how these standards of performance are used in bond valuation.
Understand the basic concept of duration, how it can be measured, and its use in the management of bond portfolios.
Discuss the various bond investment strategies and the different ways these securities can be used by investors.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

46. Chapter 11
Additional Chapter Art

47. Figure 11.3A Yield Curves on U.S. Treasury Issues
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48. Figure 11.3B Yield Curves on U.S. Treasury Issues
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49. Table 11.2 Bond Immunization
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