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Understanding Bond Valuation and Risk Factors

Explore the key features of bonds, including par value and coupon rates. Learn how bond valuation works based on cash flows and discount rates. Discover the concept of Yield to Maturity (YTM) and Yield to Call for assessing returns. Understand bond ratings, default risk, and factors affecting ratings.

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Understanding Bond Valuation and Risk Factors

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  1. Chapter 5 Bonds, Bond Valuation, and Interest Rates

  2. Key Features of a Bond • Par or face value. Typically $1,000. • Coupon rate. (Generally fixed.) • Maturity.

  3. Options Imbedded in Bonds • Call feature: most corporate bonds have a deferred call and a declining call premium. • Convertible: some corporate bonds can be exchanged for shares of common stock.

  4. Bond Valuation • The value (price) of a bond is the present value of future cash flows. • Bond cash flows: • Periodic interest pmts • Par value • Discount rate (rd)

  5. If coupon rate < rd, bond sells at a discount. • If coupon rate = rd, bond sells at its par value. • If coupon rate > rd, bond sells at a premium. • Bond price is inversely related to changes in rd. • Price = par at maturity.

  6. Yield to Maturity (YTM) • YTM is the rate of return earned on a bond held to maturity. Also called “promised yield.” • It assumes the bond will not default.

  7. Yield to Call • Yield to call is calculated the same way as YTM, except: • Call price replaces par as FV • Call date replaces maturity

  8. In general, if a bond sells at a premium, then coupon rate > rd, so a call is likely. • So, investors expect to earn: • YTC on premium bonds. • YTM on par & discount bonds.

  9. Bond Ratings Provide One Measure of Default Risk

  10. Bond Ratings and Bond Spreads (YahooFinance, 2006)

  11. What factors affect default risk and bond ratings? • Financial performance • Debt ratio • Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio • Current ratios

  12. Why Bad Bonds Get Good Ratings • Based on biased info • Cannot account for fraud • Not fully objective • Ratings based on past performance; cannot predict future

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