Tutorial 10 - CHAPTER 18 - Part 1

THE ANALYSIS AND VALUATION OF BONDS

1. The present value equation is more useful for the bond investor largely because the bond
investor has fewer uncertainties regarding future cash flows than does the common stock
investor. By investing in bonds with relatively no default risk (i.e., government securities)
the investor can value a bond based primarily on expected cash flows (coupon rate and
par value), required return (market yield), and the number of periods in the investment
horizon (maturity date). Even with corporate bonds, default (credit) risk is incorporated
into bond ratings. Examining market data based on time to maturity and credit rating
allows determination of the market interest rate on similar bonds. Each of these factors
can be incorporated into the present value equation.

By contrast, common stocks have no stated maturity date and the valuation process is
predominantly an estimate of future earnings. Although the present value method can be
used for common stock analysis by estimating dividend payments and change in price
over a given time frame, the uncertainties involved are much greater.

2. The most crucial assumption in both cases that the investor makes is that cash flows will
be received in full and reinvested at the promised yield. This assumption is crucial
because it is implicit in the mathematical equation that solves for promised yield. If the
assumption is not valid, an alternative method must be used, or the calculations will yield
invalid solutions.

3. The expectations hypothesis imagines a yield curve that reflects what bond investors
expect to earn on successive investments in short-term bonds during the term to maturity
of the long-term bond. The liquidity preference hypothesis envisions the generally
upward-sloping yield curve owing to the fact that investors prefer the liquidity of
short-term loans but will lend long if the yields are higher. The segmented market
hypothesis contends that the yield curve mirrors the investment policies of institutional
investors who have different maturity preferences. Student exercise as to which one best
explains the alternative shapes of the yield curve; a viable response is to consider
combinations of these three as helpful explanations of actual yield curve behavior.
4(a). The term structure of interest rates refers to the relationship between yields and maturities
for fixed income securities with similar credit risk. Expectations regarding future interest
rate levels give rise to differing supply and demand pressures in the various maturity
sectors of the bond market. These pressures are reflected in differences in the yield
movements of bonds of different maturity.

The “term structure of interest rates,” or “yield curve,” will normally be upward sloping
in a period of relatively stable expectations. The theoretical basis for the upward sloping
curve is the fact that investors generally demand a premium, the longer the maturity of
the issue, to cover the risk through time, and also to compensate for the greater price
volatility of longer maturity bonds.

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4(b). According to the expectations theory of yield curve determination, if borrowers prefer to
sell short maturity issues at the time lenders prefer to invest in longs, which happens
when interest rates are expected to fall, longer maturity issues will tend to yield less than
shorter maturity issues. The yield curve will be downward sloping. This generally occurs
in periods when restrictive monetary policy by the Federal Reserve System, in an attempt
to control inflation and inflation expectations causes very high short-term interest rates.
In these circumstances, demand for short-term maturities is severely dampened.

4(c). The “real” rate of interest is simply the difference between nominal interest rates and
some measure of inflation, such as the current consumer price index or GNP deflator. In
other words, it is an inflation-adjusted interest rate.

4(d). Over the past several years, fairly wide spreads have existed between AAA-corporates
and Treasuries. Investor preference for Treasuries stems from several factors. Treasury
securities typically are extremely liquid and provide investors with more flexibility.
Secondly, Treasury securities typically do not have restrictive call features generally
encountered with high-grade corporates. Thus, in a period of high interest rates, investors
purchasing long-term securities anticipate an eventual decline in inflation and interest
rates and thus prefer to lock in higher long-term yields. Third, in times of economic
uncertainty or uncertainty about the values of other assets, a “flight to quality” may
increase demand for Treasuries, thus increasing their prices and lowering their yields.

5. The mini-coupon bonds would be preferable to the higher coupon bond for three reasons:

1. A mini-coupon bond will have a longer duration than the current bond because
of the smaller coupon. Its price will be more volatile for a given change in market
interest rates and this is a plus under the assumption of a decline in interest rates
over the next three years.

2. The mini-coupon bonds have less reinvestment risk because more of the return
comes from the price change over time, which is assumed to increase at the YTM
rate. In contrast, the total coupon for the 14 percent bond must be reinvested at the
13.75 percent rate; this could be difficult if rates are declining during this period.

3. The mini-coupon bonds have greater call protection, as they are callable at 103,
or more than double the current market. In contrast, if rates decline about 2
percent, the current coupon bond could be called at 114 (against the current
market of about 102). Between the two mini-coupon bonds, the large pension
fund would buy the original issue discount bond with its lower price and higher
yield to maturity. This price discrepancy between the two bonds that are
otherwise similar reflects the fact that an investor subject to income taxes has to
pay a capital gain each year of the OID. It is possible to also make an argument
for the other mini-coupon bond on the basis of its longer duration because it has a
lower yield to maturity, all else the same. The point is, because you expect lower
rates, you want the longest duration security.
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6
6(a). Current yield = Annual dollar coupon interest / Price = 70/960 = 7.3%.

The annual yield to maturity (YTM), using a financial calculator, is found using these
inputs: PV = -960; FV = 1000; PMT = 35; n = 10. The resulting periodic interest rate is
3.993% semiannually or 7.99% annual (APR basis). As the problem asks for the nearest
whole percent, the answer is 8%.

Horizon yield (also called total return) accounts for coupon interest, interest on interest,
and proceeds from sale of the bond.
The first step is to find the future value of the reinvested coupons:
PMT = 35, n = 6, reinvestment rate = 3%; using these inputs, the future value is $226.39.

Next, we determine the projected sale price at the end of three years. In this case it will
equal $1,000 because the required return of 7% is the same as the bond’s coupon rate.

Adding these value, the value of the cash flows at the end of year 3 is $1,226.39.

Finally, we find the semiannual total return = ($1,226.39/$960)1/6 - 1 = 0.04166.

Doubling this to find the APR, we have a horizon yield of 8.33%.

6(b). The shortcomings of the yield measures are as follows:

(l) Current yield does not account for interest on interest (compounding) or changes in
bond price during the holding period. It also does not allow for a gain or loss from a bond
purchased at a discount or premium.
(2) Yield to maturity assumes that the bond is held to maturity and that all coupon interest
can be reinvested at the yield-to-maturity rate. Because yields change constantly, that
assumption is incorrect. However, yield to maturity is the industry standard for
comparing one bond with another.
(3) Total return (as calculated) assumes that all coupons can be invested at a constant
reinvestment rate and requires assumptions about holding period, reinvestment rate, and
yield on the bond at the end of the investor's holding period. Although it is a more
complete measure of return, it is only as accurate as its inputs.

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7. The essence of the answer is to price each bond’s cash flows using the spot interest rates.

The non-arbitrage price of bond A is

10 + 10 + 110 = 9.524 + 8.573 + 80.431 = 98.53

1.05 (1.08)2 (1.11)3

The market price of Bond A is 98.40, which is 13 cents (13.2 basis points of market
price) less than the nonarbitrage price.

The nonarbitrage price of Bond B is

6 + 6 + 106 = 5.714 + 5.144 + 77.506 = 88.36

1.05 (1.08)2 (1.11)3

The market price of Bond B is 88.34, only 2 cents (2.3 basis points of market price) less
than the nonarbitrage price.

Conclusion: Despite having the lower yield to maturity (10.65 percent versus 10.75
percent), Bond A is the better value because the excess of its nonarbitrage price over
market price is greater than for Bond B.

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