Bond Valuation 2

7/27/2019 Bond Valuation 2

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Bond Valuation

Risks in Bonds


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Risks Associated with Investing in Bonds

Major learning outcomes: Understand the various risks associated with

investing in bonds:Interest rateCallReinvestmentLiquidity

Exchange-rateInflation


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Bond prices and interest rates move inopposite directions.Since the price of a bond fluctuates with

market interest rates, the risk faced byinvestors is that the price of a bond will fall if

rates rise.

Longer maturity periodGreater sensitivity of

price to changes in

interest rates

Interest Rate Risk


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Inflation orpurchasing powerrisk arises from thedecline in the value

of a bonds cashflows due toinflation.

Inflation Risk

When an investor buys a bond, he or she essentially commits to

receiving a, either fixed or variable, for the duration of the bond

or at least as long as it is held


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Default risk is the risk that the issuer will fail tosatisfy the terms of the bond obligation with respectto the timely payment of principal and interest.

The percentage of a population of bonds that isexpected to default is called the default rate.

A default does not mean the investor loses the entireamount invested, a percentage of the investmentmay be recovered. This is referred to as the recoveryrate.

Default Risk


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Liquidity risk is the risk that the investor will

have to sell the bond below its indicated value,where the indication is revealed by a recenttransaction.

The primary measure of liquidity is the size ofthe spread between the bid price (what the dealeris willing to pay) and the ask price (what thedealer is willing to sell).

There is a risk that an investor might not be ableto sell his or her corporate bonds quickly due toa thin market with few buyers and sellers for the

bond.

Liquidity Risk


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Call Risk

The risk that a bond will be called by its issuer. Callable bondhavecall provisions, which allow the bond issuer to purchase the bond

back from the bondholders and retire the issue. This is usually

done when interest rate have fallen substantially since the issue

date. Call provisions allow the issuer to retire the old, high-rate

bonds and sell low-rate bonds in a bid to lower debt costs.

Reinvestment Risk

The risk that the proceeds from a bond will be reinvested at a

lower rate than the bond originally provided. For example, imagine

that an investor bought a $1,000 bond that had anannual coupon of 12%. Each year the investor receives

$120(12%*$1,000), which can be reinvested back into another

bond.But imagine that over time the market rate falls to 1%.

Suddenly, that $120 received from the bond can only be reinvestedat 1% instead of the 12% rate of the ori inal bond.


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Yield Curves and

Term Structure Theory


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The Yield Curve

A yield curve is a graphical presentation that shows the yield tomaturity for treasury securities of various maturities at a particular

date. plot of maturity vs. yield slope of curve indicates relationship between maturity and yield

maturity

yield

maturity

yield

maturity

yield

Upward sloping Downward slopingFlat


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Three theories are proposed to explain theevolution of spot rate curves:

1. Expectations Theory;

2. Liquidity preference Theory;

3. Market Segmentation Theory.

Determinants of term structure of interest rates


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Expectations theory

This theory holds that the shape of the yield

curve can be explained by the interest rate

expectations of those who participate in themarket. The expectations theory holds that

any long term rate is equal to the geometric

mean of current and future one year ratesexpected by the market participants.


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Liquidity preference

For bank deposits, depositors usually

prefer short-term deposits over long-term

deposits since they do not like to tie up

capital (liquid rather than tied up). Hence,

long-term deposits should demand high

rates.

For bonds, long-term bonds are moresensitive to interest rate changes. Hence,

investors who anticipate to sell bonds

shortly would prefer short-term bonds.


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Market segmentation

The market for fixed income securities is

segmented by maturity dates.

To the extreme, all points on the spot rate

curves are mutually independent. Each isdetermined by the forces of supply and

demand.

This theory deals with the supply and demand in

a certain maturity sector, which determines the

interest rates for that sector.


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Determinants of Interest Rates

Short term risk free rateInflation rate

Real growth rate

Time preferences

Default premiumBusiness risk

Financial risk

Collateral

Maturity premiumFuture expectations

Liquidity preferences

Prefered habitat

Special features

Call/put features

Conversion features

Other features

Interest Rate


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Short term risk free interest rate

The short term risk free interest rate is the yield on a one year

government security, say 364 daysTreasury bill.

Short term risk free interest rate = expected real rate of return +

expected inflation

Maturity premiumMaturity premium represents the

difference between the yield to maturity

short term risk free security and the

yield to maturity on a risk free security

of a longer maturity.Time to maturity

Yield to maturity


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Default premium

While there is no risk of default on government securities,

corporate bonds may default on interest and or principal payment.

When such a possibility exists, investors will ask for a default

premium in addition, of course, to the maturity premium.

Special Features

A call features raises the interest rate because the investorsare exposed to call risk.

A put features lowers the interest rate because the investorsenjoy the put option.

A conversion feature lowers the interest rate because theinvestors enjoy the option to convert.


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Bond Valuation 2

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