Evaluating Popular

InvestmentsLesson 5

Bond Analysis

Bonds Analysis

Aim: Why are changes in interest rates the

biggest determinant of the value of an existing bond?

Do Now: Identify whether you’d rather own a 6%

bond or a 5% bond assuming everything else about the bonds is identical.

Do Now answer: It’s better to own the 6% bond because it pays $60 in interest per year whereas the 5% bond pays only $50.

Bond Analysis

Marketable Securities Stocks and bonds are not just securities, but marketable securities, meaning that the owner has the right to sell them at any time to an investor interested in buying them.

Example: Investor M buys a 10-year bond that will mature when she retires. Her plans change six years later. She can sell the bond to another investor who will own it for the last four years of its life.

Bond Analysis

Marketable Securities (continued) We should recognize that an investor who intends to make a bond purchase can: Buy a new one from a company that is

raising money by issuing bonds Buy an existing bond from an investor

that no longer wants to own it

Bond Analysis

We can even create a scenario where the two bonds in our Do Now are offered by the same company:

Scenario: ABC Corp issues a 15-year bond in 2005, before the Great Recession. To get investors to buy its bond, it must offer a 6% coupon.

By 2010, the Great Recession has hit. The economy is struggling. Interest rates have fallen. ABC wants to raise more money, so it sells 10-year bonds. In this environment, it only has to offer a 5% coupon to get investors to purchase this bond.

Bond Analysis

If you place yourself in 2010, you can:

1. Purchase the new 10-year, 5% bond directly from the ABC Corp. It has the normal principal value of $1,000. It matures in 2020.

2. Purchase the five-year-old 15-year 6% bond from an investor who owns it but is interested in selling it. It also matures in 2020! Interestingly, the owner of this bond who

wants to sell it will not be willing to sell it to you for its $1,000 principal value!

Bond Analysis

• Put yourself in the owner’s shoes. Her bond pays $60 in interest per year. Why should she sell it to you for the same amount as a new bond that pays only $50 in interest per year? She shouldn’t and won’t. She will sell it to you,

but at a price higher than $1,000! So, what’s the point?

The value of a previously existing bond is dependent on changes in the economy’s interest rates since the bond was issued!

Bond Analysis

Specifically, the value of a previously issued bond will rise when interest rates

fall, and vice versa.

Bond Analysis

• Term Structure is the study of how the time to maturity affects the interest rate investors demand to earn.

Bond Analysis

Yield Curve is a line that plots interest rates of bonds of similar credit rating but with different maturities.• The type of bond whose yield curve is most closely

studied is US Government (Treasury) Bonds. • It is used as a benchmark for determining interest

rates for other bonds.• Yield curves are more often described by their slope

or shape – positively sloped, negatively sloped, or flat.

Bond Analysis

Bond Analysis• This yield curve represents a “normal” or positively

sloped (shaped) curve. The bonds with shorter maturity have lower yields and the longer maturity bonds have higher yields.

• There is typically greater risk associated with holding bonds for a longer time. This shape also indicates that the market expects interest rates to increase.

Bond AnalysisNegative, or inverted, curves are indicative of a weakening economy where the market believes interest rates will decline in the future.

Credit Differentials (Spreads): Studying two or more bonds with the same maturity but different credit quality to demonstrate how credit quality affects interest rates.

Bond Analysis

Junk Bonds• “Junk” bonds are a slang name for bonds issued by

companies with less than stellar financial strength• The junk bond should always have a higher yield

than the investment grade bond because of the added risk an investor takes on when buying the bond. What is significant is the size of the spread.

• A very “wide” spread indicates that investors are putting their money into the safest bonds, meaning that they are worried.

Junk Bonds• Conversely, a very “narrow” spread indicates a

strong economy. Investors are willing to accept a lower amount of incremental (extra) yield because they’re not concerned that weaker companies will fail.

• Typically in a recessionary economy, where consumer confidence is low, investors tend to be more risk averse. They sell their more risky bonds and buy safer bonds. This causes spreads to widen.

International Interest Rate Differential: The spread between US Treasury Bonds and Foreign Government Bonds from other industrialized countries shows the relative attractiveness of one nation’s bonds over another country's bonds.

Lesson Summary 1 of 21. What are stocks and bonds, investments

that their owners are free to sell, called?

2. What is the relationship between interest rates in the economy and the value of previously existing bonds?

3. What does a yield curve reveal?

4. What does an inverted yield curve reflect?

5. What is the difference between the rate that investors demand to earn on two different types of bonds?

Lesson Summary 2 of 26. What are bonds issued by less than strong

companies known as?

7. Why are changes in interest rates the biggest determinant of the value of an existing bond?

Web Challenge #1Q: Are Junk Bonds really junk?

• A: This is really an unfair name because the term “junk” implies something practically worthless.

• Challenge: A measure for whether bonds are ultimately reliable is how many default (ie: fail to pay because the company is unable). Research the default rate of Investment Grade bonds as well as that of junk bonds. With this information, describe how much riskier you believe junk bonds are.

Web Challenge #2Challenge: Uncle Sam, the U.S. of A, is thought of as the strongest country in the world. But the rate that investors demand to lend a country money is a direct indication of how risky they believe it is.

Look up the Yield Curve for the United States, Germany, China and Japan. Which country can borrow money for the lowest rate over 10 years? 30 years?

Web Challenge #3Challenge: Research the last time the U.S. Treasury Yield Curve was inverted. Try to find when the curve first inverted and how long it lasted.

Research and document what was happening in the United States during this period of time.