Chapter 9 FIXED INCOME SECURITIES: VALUATION AND RISKS

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?

Why bonds?

• Income

• Potential for capital gains

• Paper versus real losses

• Diversification

• Tax advantages

Figure 9.1 – Yield on Long-Term Treasury Bonds vs. the Dividend Yield from the S&P500

Risks associated with investing in bonds

• Credit risk• Interest rate risk • Reinvestment risk• Purchasing power risk• Call risk• Liquidity risk• Foreign exchange risk

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

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

Figure 9.2 - Reinvestment Rate and the Actual Rate of Return for a Bond

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

Figure 9.3 – Bond Price vs. Yield to Maturity

Figure 9.4 – Price Sensitivity and Maturity

Figure 9.5 – Price Sensitivity and Coupon Rate

Figure 9.6 – Price Changes for Increase and Decrease in Yield

Assessing interest rate risk

• What is duration?

• Finding a bond’s duration

• Duration and price sensitivity

• Duration and price changes

Figure 9.7 – Relationship Between Duration and Maturity

Figure 9.8 – Relationship Between Duration and Coupon Rate

Figure 9.9 – Relationship Between Duration and Yield to Maturity

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

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

Figure 9.10 – Yield Spread Between T-Bonds and T-Bills

Figure 9.11 – Quality Yield Spreads in the U.S. Capital Markets