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Chapter 9 FIXED INCOME SECURITIES:
VALUATION AND RISKS• Why are bonds viable investment
alternatives?• What are the risks faced by bond
investors?• How bonds are priced?• What are the basic bond pricing
theorems?• How can interest rate risk be measured?• How can credit risk be evaluated?• How are bond risk and required return
related?
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Why bonds?
• Income
• Potential for capital gains
• Paper versus real losses
• Diversification
• Tax advantages
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Figure 9.1 – Yield on Long-Term Treasury Bonds vs. the Dividend Yield from the S&P500
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Risks associated with investing in bonds
• Credit risk• Interest rate risk • Reinvestment risk• Purchasing power risk• Call risk• Liquidity risk• Foreign exchange risk
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Bond valuation
• Basics of bond pricing– Identifying the bond’s cash flows
– Bond price is present value of its cash flows
– Semiannual coupons
– Accrued interest
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Bond valuation – Cont.
• Yield-to-maturity
• Relationship between coupon rate and yield to maturity
• Current yield
• Yield to call
• Actual return versus yield to maturity
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Figure 9.2 - Reinvestment Rate and the Actual Rate of Return for a Bond
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Five bond pricing theorems• Bond prices move inversely to changes in
interest rates• Bonds with longer maturities are more price
sensitive• Price sensitivity increases at a decreasing
rate• Bonds with lower coupon rates are more
price sensitive• A price increase caused by a decrease in
interest rates is larger than a price decrease caused by an increase in interest rates of the same magnitude
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Figure 9.3 – Bond Price vs. Yield to Maturity
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Figure 9.4 – Price Sensitivity and Maturity
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Figure 9.5 – Price Sensitivity and Coupon Rate
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Figure 9.6 – Price Changes for Increase and Decrease in Yield
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Assessing interest rate risk
• What is duration?
• Finding a bond’s duration
• Duration and price sensitivity
• Duration and price changes
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Figure 9.7 – Relationship Between Duration and Maturity
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Figure 9.8 – Relationship Between Duration and Coupon Rate
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Figure 9.9 – Relationship Between Duration and Yield to Maturity
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Credit risk
• Bond ratings– Description of bond ratings– Determinants of bond ratings– Bond ratings and default rates– Graham & Dodd on credit risk and bond
selection
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Risk and required return for bonds
• General relationship (equation 9.8) r = f (i, ∆p, ir, rr, dr, cr, lr, fxr)
• Bond yields and maturity
• Bond yields and credit risk
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Figure 9.10 – Yield Spread Between T-Bonds and T-Bills
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Figure 9.11 – Quality Yield Spreads in the U.S. Capital Markets