Valuing bonds Cheat Sheet by NatalieMoore

Po

= Asset's price today (at time 0)

t

= time

n

= Assets life / period it distri­butes cash flows

$M

= par value maturity amount

The rate of return that investors expect or require an investment to earn given its risk.

Purchase of investment means investor loses the opport­unity to invest their money in another asset. Opport­unity cost.

In a market economy, ownership of an asset confers rights to stream of benefits generated by asset.

Asset value = present value of all its future benefits

e.g. landlord. Incoming = Rental payments from tenants. Outgoing = Liabil­ities for mainta­ining premises, paying taxes, etc.

Step 1:

Estimate $$ an investment distri­butes over time

Therefore pricing an asset requires knowledge of

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the approp­riate discount rate to convert future benefits into a present value

If an assets future benefits are uncertain then investors will apply a larger rate when discou­nting those benefits to present value

Investors will pay a higher price for investment with more credible promise.

Marginal benefit of owning an asset = right to receive cash flows it pays

Floati­ng-rate bonds

Bonds that make coupon payments that vary through time. The coupon payments are usually tied to a benchmark market interest rate

provide some protection against interest rate risk

Makes borrowers future cash obliga­tions unpred­ictable

London Interbank Offered Rate (LIBOR)

The interest rate that banks in London charge each other for overnight loans. Widely used as a benchmark interest rate for short-term fl oatingrate debt.

Spread

The difference between the rate that a lender charges for a loan and the underlying benchmark interest rate

to the benchmark interest rate, according to the risk of the borrower

Capital indexed bonds / inflation linked bonds

Issued by Aus govt, face value changes each year with inflation

Subord­inated unsecured debt

Debt instru­ments issued by an entity which is backed only by the credit of the borrowing entity which is paid only after senior debt is paid

Mortgage bonds

A bond secured by real estate or buildings

Debentures

Usually backed by property

Pure discount bonds

Bonds that pay no interest and sell below par value. Also called zero-c­oupon bonds.

Exchan­geable bonds

Bonds issued by corpor­ations which may be converted into shares of a company other than the company that issued the bonds.

Call price

The price at which a bond issuer may call or repurchase an outsta­nding bond from investors

Sinking fund

A provision in a bond indenture that requires the borrower to make regular payments to a third-­party trustee for use in repurc­hasing outsta­nding bonds, gradually over time

Fundam­ent­ally, a bond is just a loan

Principal

The amount of money on which interest is paid

Par value (bonds)

The face value of a bond, which the borrower repays at maturity

Coupon

A fixed amount of interest that a bond promises to pay investors

Indenture

A legal document stating the conditions under which a bond has been issued

Specifies when the borrower must make coupon payments

Coupon yield

The amount obtained by dividing the bond’s coupon by its current market price (which does not always equal its par value). Also called current yield

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Call feature allows the issuer to redeem the bond at a predet­ermined price prior to maturity

Premium

A bond that sells for more than its par value

As more investors buy the price goes up

Discount

A bond sells at a discount when its market price is less than its par value

When macroe­conomic factors change

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Return on a particular bond can also change as market reassesses borrower's default risk (risk issuer could default on payments)

Treasury bonds

Debt instru­ments issued by the federal government with maturities of up to 30 years

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Finance new invest­ments

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Range from 1 - 100 years

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Most corporate bonds have a par value of $1,000 and pay interest semian­nually

Larger than the stock market

bond prices are quoted as a percentage of par values

Basis point

1/100 of 1 percent; 100 basis points equal 1.000 percent

Junk bonds

Bonds rated below investment grade. Also known as high-yield bonds

Bond makes a fixed coupon payment each year

Most bonds make 2 payments a year

A bonds market price changes frequently as time passes

Whether a bond sells at a discount or a premium, its price will converge to par value (+ final interest payment) as maturity date draws near.

Most important factor is prevailing market interest rate

When required return on a bond changes, bonds price changes in opposite direction

Prices of long-term bonds display greater sensit­ivity to changes in interest rates than do prices of short-term bonds

Risk that changes in market interest rates will move bond price

Inherent in these instru­ments

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Investors want to achieve a better standard of living by saving and investing their money

Approx­imately equals difference between stated or nominal return and inflation rate

Many types of bonds in modern financial markets

Others have exotic features that make returns volatile and unpred­ictable

Primary market trading

Might be through auction process

Once issued in primary market, investors trade them with each other in secondary market

But bond market is large which means investors have a wide range of choices