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Bond valuation essay Flashcards

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1
Q

Bond essay structure 1-7

A

-Introduction
-Types of bonds?
-Interest rates and the term structure
-Default risk
-Tax effects
-Option characteristics
-Conclusion

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2
Q

Introduction includes?

A

-Define what bonds are/ types of bonds
-Briefly explain bond valuation
- Bond market stat (damson,marsh,Staunton ,2024).

-Structure of the essay

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3
Q

What are bonds?

A

A bond is a debt security issued by governments, companies, or transnational organisations.

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4
Q

What does a bond offer?

A

Regular coupon payments ad repayment of face value at maturity

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5
Q

Brief explanation of different types of bonds

A

zero-coupon
inflation-linked
or option characteristics

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6
Q

What does long term evidence from market such as UK and Us show?

A

bonds have historically provided modest real returns of around 1.4% to 1.6% annually, significantly lower than equities (Dimson, Marsh, and Staunton, 2024)

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7
Q

Why do we need to understand what affects bond valuations?

A

It is important because with lower returns even small changes in interest rates can make a big difference, emphasizing why bond valuation is so sensitive.

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8
Q

Main factors affecting bond valuation?

A

1.Interest rates and the term structure
2.Default risk
3.Tax effects
4.Embedded options

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9
Q

Consequences of changes in the factors affecting bond valuation?

A

Directly impact a bond’s price by altering investor required yields.

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10
Q

Different types of bonds

A
  1. Standard fixed coupon bond
  2. Zero-coupon bonds
  3. Inflation linked bonds
  4. Floating-rate bonds
    5.Callable and Putable bonds
  5. Convertible bonds
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11
Q

Standard-fixed coupon bonds

A

Offer predictable regular payments

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12
Q

Zero-coupon bonds

A

No coupon payment but instead are issued at a discount

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13
Q

How do investors make money from a zero-coupon bond?

A

Profit comes from the difference between the discounted purchase price and the face value received at maturity.

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14
Q

Inflation-linked bonds

A

Adjust coupon and principle payments based in an inflation index.

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15
Q

Benefit of inflation-linked bonds?

A

Protects investors from inflation risk

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16
Q

Floating-rate bonds

A

Have coupons tied to benchmark interest rates

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17
Q

Benchmark interest rates example

A

LIBOR (London interbank offered rate)
SOFR (secured overnight financing rate)

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18
Q

Callable and putable bonds

A

Allow issuers or investors to alter the bond’s life

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19
Q

Convertible bonds

A

Grant investors the right to convert bonds into shares

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20
Q

What does YTM stand for?

A

Yield to maturity

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21
Q

What is the YTM?

A

the interest rate that makes the PV of the bond cash flows equal the market price.

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22
Q

What does the term structure or yield curve show?

A

The relationship between yields and maturities

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23
Q

Spot rates

A

Spot rates are the YTM of bonds with only a single cash flow (no coupons)

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24
Q

Forward rate

A

Interest rates agreed today for loans starting in the future

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25
Interest rate and bond price relationship?
Inverse relationship. When interest rate rises, bond prices fall and vice versa.
26
Why is is there an inverse relationship between bond prices and interest rates?
Because existing bonds become more or less attractive compared to new ones. When rates rise new bonds offer higher yields, making existing bonds with lower coupon rates less attractive
27
4 main theories that seek to explain why zero-coupon bonds with different maturities have different YTMs?
1. Pure expectations 2. Liquidity preferences 3. Segmented markets 4. Preferred habitat
28
Pure expectations implication
YTM is set so all bonds have the same expected one-period return
29
Pure expectations assumption and implication
That investors are risk neutral and this implies that the maturity of the bond is irrelevant
30
Examples of pure expectations
If the investor has a 2-period investment horizon they can follow two alternative strategies. Either they could buy a 2-period zero-coupon bond, or they could buy two 1-period zero-coupon bonds at time 0 and time 1. Under pure expectations these strategies will have the same returns.
31
What do Dimson, Marsh, and Staunton (2016) show about pure expectation theory
Show evidence that there are higher returns on long term government bonds than short term government bonds and so this hypothesis can be rejected.
32
Liquidity preferences theory
predicts that investors prefer short-term bonds
33
Why do investors prefer short-term bonds?
Less risky and therefore there is a lack of long-term investors.
34
What would make investors chose long-term bonds?
A higher expected return.
35
Segmented markets theory
Argues that bond issuers and investors have strong preferences of maturities
36
Implications of segmented market theory?
That the market is segmented as no differences in yield can encourage investors to hold bonds with maturities the don't like
37
Preferred habitat theory
Related to segmented markets, but investors may shift maturities if they are paid enough.
38
When do premiums on bonds arise?
When there is increase in a bonds demand
39
Default risk
Investors in bonds face the risk that the issuer wont pay the coupon payments or the face value of the bonds.
40
Who do investors rely on to assess default risk?
Credit rating agencies.
41
What do credit rating agencies do?
Classify bonds on likelihood of loss
42
Examples of credit agencies
Moody's and S&P
43
Bond ratings given by credit agencies?
AAA/AA - very high quality A/BBB – High quality BB/B – speculative CCC/D – Very poor quality.
44
What does a lower rated bond mean?
That is is riskier and must offer a higher yield to attract investors.
45
How do bond agencies analyze companies?
A variety of financial ratios.
46
What financial ratios are used to valuate bonds?
Coverage ratio(earnings to fixed costs) Leverage ratio (extent of borrowing) Liquidity ratios Profitability ratios
47
What happens if a bonds rating is downgraded?
Can largely impact yield and bond price. If downgraded price usually drops
48
Why does price drop if a bond is downgraded?
Because investors now demand a higher return to take on extra risk
49
Criticism of bond agencies?
Conflict of interest
50
What is the conflict of interest for bond agencies?
They earn fees from higher credit ratings. They may lose business if ratings are too low.
51
What happened in 2008? And what cause it?
Agencies in 2008 failed to properly assess risks and correctly rate subprime mortgages leading to the financial crisis
52
Tax effects on bond valuation?
Cash flow from certain bonds may have tax advantages.
53
Why would investors choose bonds with tax effects?
Investors in high tax brackets may accept lower yields on these bonds.
54
Bond with tax advantage example
Coupon payments from a Municipal bond (a security issued on behalf of a local authority) is not subject to federal tax (Elton et al, 1980)
55
What does option characteristics refer to in bond valuation?
Some bonds contain options for the investor or the bond holder
56
Option characteristics examples
1. A call option 2. Sinking fund option 3.Conversion option
57
A call option
The right a firm has to buy back the bond at a specified price
58
Call option: What is the price the firm can buy back the bond for?
Generally the face value plus a premium. Generally the premium declines over time and the likelihood of a call are higher in later years.
59
Sinking fund option
When an issuer buys some of the bonds each year over the life of the bond.
60
What options does a corporation have when meeting a sinking fund obligation?
The corporation also has the option of purchasing the bond directly or of calling the bonds it needs to meet the sinking fund.
61
Conversion option
When the investor has the option to convert bonds into equity. The bond is used to pay for the equity.
62
Traits of a conversion option bond
Often have lower coupons because investors get potential stock conversion.

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