Bonds and interest rates | My Assignment Tutor -

1Topic 4Bonds and interest ratesObjectivesOn completion of this topic, you should be able to: outline the fundamental valuation model describe the key characteristics of bonds and interpret the terminology of bonds and bondmarkets apply time-value of money techniques to the valuation of bonds explain the relationship between bond prices and interest rates discuss the determinants of market interest rates describe the term structure of interest rates and interpret a yield curve describe the key features of preferred and ordinary shares estimate the value of a simple preferred share.IntroductionThis topic builds on your TVM knowledge by applying techniques you have already learnt todifferent contexts. We examine bond characteristics, valuation, yields, types and quotations, as wellas consider some determinants of interest rates and their term structure. This latter part of thetopic will help you understand why different fixed-income securities (like bonds) have differentyields. We conclude with a brief look at shares and simple share valuation.Valuation and bondsIf you have carefully studied and practiced the TVM techniques covered in the unit thus far, youshould have all the necessary skills in time value of money analysis that you need to complete therest of this unit. You may have realised that TVM techniques have many practical uses such asplanning for retirement, comparing investment alternatives that earn income streams at differenttime intervals, calculating payment terms for debtors or creditors, choosing between a lump sumpayment or a regular income and valuing a financial investment. Now we will more directly applyour TVM tool kit to valuation. First, we consider a general valuation model and then apply that tobonds.Bonds are loans (usually long-term) provided directly from investors rather than from financialinstitutions. An investor buys a bond from an issuer, which may be a company or the government,2but there is also substantial trading of bonds in secondary markets. Bonds are a form of debt forthe issuer (borrower) and a financial asset (investment) for the investor (bondholder). They arenormally discount loans (as in the case of zero coupon bonds) or interest-only loans (in whichregular interest payments are made during the term of the loan called ‘coupons’). In both cases, theissuer is required to repay what is called the par (or face or maturity) value in full at the end of theloan period (the maturity date). The par value is a little like the principal in other loans except thatit need not be the amount that the lender provides the issuer. Instead, it is the amount that theissuer promises to pay the lender at maturity.Over time, bond prices (and values) change as a result of market interest rate changes. Thisimportant relationship between bond prices and interest rates is an inverse one; that is, as interestrates rise, bond prices fall and vice versa.Yield to maturity (YTM) is the rate that sets the present value of a bond’s cash flows equal to itsprice, so it is like the ‘r’ of an irregular cash flow stream. In fact, it is a bond’s internal rate of return(IRR) if the bond is held to maturity. To put this another way, a bond’s YTM is the average annualcompound return we get from buying this bond and holding it until maturity as long as all thepromised cash flows are made.YTM is a very important concept in both academia and practice, giving us a proxy for requiredreturn. As such, it is usually what we are talking about when we say the ‘market interest rate’ for aparticular bond. It is calculated using the actual market price and is often reported in the financialmedia. It is sometimes just referred to as ‘yield’.Be careful not to confuse a bond’s YTM with its coupon rate as they are distinctly different concepts.The coupon rate is applied to the par value to determine the amount of the coupon payment. For afixed rate bond, the coupon rate (and hence coupon payment) is fixed for the life of the bond. TheYTM is a market rate that is related to the market price of the bond, not the par value. The YTM(and hence the price of the bond) will fluctuate like all interest rates (cash rates, mortgage rates,credit rates) that are not fixed.A bond’s YTM summarises the risks involved in investing in that bond. Why? To answer thatquestion, we need to understand market interest rates and their determinants.Market interest rates and theirdeterminantsYou may recall that in introducing TVM in Topic 2 we mentioned that interest rates are a functionof a real risk free rate of return (rewarding investors for delaying consumption) plus various riskpremiums (including inflation risk). That is, an investor will expect the interest rate received on aninvestment to not only provide some basic return (which we call a real return) but also to coverthem for taking on various risks: inflation risk, i.e. the risk that inflation in the future will erode returns default risk, i.e. the risk that the issuer will not make some or all of the promised payments liquidity risk, i.e. the risk that an investment will not be easily and quickly converted to cashat fair market value3 maturity risk, which is actually made up of two opposing risks – interest rate risk (also calledprice risk) and reinvestment rate risk.o Interest rate risk is linked to the important inverse relationship between bondprice and interest rates. Interest rate risk is the risk that bond prices change inresponse to changing market interest rates and resulting in capital gains or losses.Most pertinently, if rates increase, the investor loses the opportunity to takeadvantage of higher interest rates. This risk is higher for bonds with longermaturities and/or lower coupon bonds, as their prices are more sensitive to rateschanges.o Reinvestment rate risk is the risk that market interest rates will change, causingchanges in the rate at which cash flows from bonds can be reinvested. This risk ismost relevant as interest rates fall because coupons or par value cash flows willhave to be reinvested at lower rates, resulting in a loss in income.You can therefore think of an interest rate or YTM as being made up of a real return plus apremium for each of the risks above. This is important. When you see a bond with a high YTM,think about what risks might be associated with that investment and consider whether you are ina position to take those risks. Risks associated with bonds are generally assessed by rating agencies.Another important concept related to market interest rates is the term (or maturity) structure ofinterest rates, which contrasts short-, medium- and long-term rates. A ‘yield curve’ plots thisstructure, showing interest rates for investments (such as bonds) of different maturities but withsimilar risk at a given point in time.Investors and financial managers pay attention to the yield curve because it tends to foreshadowchanges to economic growth. In the past inverted (downward-sloping) yield curves have tended toforeshadow economic downturns, while steep normal (upward-sloping) yield curves have tendedto precede an increase in economic growth. This relation may not be as strong in Australia ascountries such as USA, Canada, Germany and France, where the predictive power of the yield spreadis high (Bonser-Neal and Morley 1997; Poke and Wells 2009) but the yield curve remains animportant economic indicator.Share features and valuationYou need to be able to distinguish the key features of preferred and ordinary shares. You also needto be able to value a simple preferred share. (Valuation of ordinary shares is beyond the scope ofthis unit but is covered in Chapter 5 of your text if you are interested.)According to the fundamental model of valuation, valuation requires estimation of the asset’srequired rate of return (for discounting) and its cash flows over time. Estimating these inputs ismore difficult for shares than it is for fixed coupon bonds. The required rate of return on sharescannot be directly observed in the market, unlike the yield on bonds. In addition, shares have nomaturity date, which means we must estimate cash flows in perpetuity or make some simplifyingassumptions. Furthermore, while shareholders may receive cash flows in the form of dividends andmany companies like to pay ordinary shareholders a regular dividend, this is certainly notcompulsory. Ordinary dividends, particularly, can vary as company profits change and in somecases, as we will see in the last topic of this unit, companies may not pay dividends at all.4These differences lead to the need for a number of different models for valuing shares, dependingon the situation. Some models discount estimated dividends, some discount company free cashflows and work back to calculate share value, and some use multiples, such as the price/earningsratio, based on comparable firms. Often, the models can be treated as complementary. Goingthrough the valuation process using multiple models forces the analyst to think through manydifferent assumptions and get a better appreciation for the underlying drivers of value for acompany. The outcomes of the different models can be compared and a value range determined.Due to this complexity, we limit ourselves to valuing simple preferred shares in this introductoryunit, although this same model could be used to value an ordinary share in the very restrictive caseof no expected growth in dividend.The output of the model (or models) – the estimated share value – can be compared with the marketshare price (if available): If our estimated share value is greater than the market share price (and we have very strongreasons to be confident in our own estimate), the share would be considered undervalued inthe market and therefore we would expect the price to rise. This would lead to an analyst buyrecommendation. If our estimated share value is less than the market share price, the share would beconsidered overvalued in the market and therefore we would expect the price to fall. Thiswould lead to an analyst sell recommendation.Keep in mind, however, that in both instances we are implicitly assuming that the market price isnot correct and that somehow we know more than thousands or even millions of investors. Thisgoes against an important idea in finance called the ‘efficient market hypothesis’. We will have moreto say about this in the next topic but for now it is worth noting that the market price in a relativelyefficient and competitive market should reflect a consensus on value as buyers and sellers interact.From a managerial perspective, market price deviations from an internally generated valuationmay, amongst other things, signal inadequate communication of information to the market ormarket disagreement with the value effects of some management decisions. Both reasons arewithin the control of management and so need to be considered in order to ensure alignment oflong-term value maximisation and share price.Textbook readingWork through: Chapter 4 of your text, stopping at the end of section 4.5a. Use the bond valuationtemplates in this week’s spreadsheet template to replicate the examples insections 4.2b and 4.2c. Chapter 5, sections 5.1 and 5.2a, stopping after the first example on page 161.SummaryIn this topic, we looked at valuation of bonds and simple shares, building on our TVM knowledge.We also considered the components of interest rates and the risks with which bondholders mustcontend. The factors that influence interest rates and bond yields include the forces of supply anddemand and expectations of future rates of inflation as well as a number of risks, such as maturity,5liquidity and default risks.Put simply, higher risk means investors require higher returns (interest rates, yields) and theserequired returns represent the pre-tax cost of debt capital from the borrowing company’sperspective. In the next topic, we look in depth at risk and return, particularly as it applies to aninvestment in ordinary shares and come up with a model that can help us estimate the cost ofordinary equity capital, which is much less observable than the cost of debt.ReferencesBonser-Neal, C & Morley, TR 1997, ‘Does the yield spread predict real economic activity? Amulticountry analysis’, Economic Review – Federal Reserve Bank of Kansas City, vol. 82, no. 3, pp.37–53.Poke, J & Wells, G 2009, ‘The term spread and GDP growth in Australia’, The Economic Record, vol.85, no. 269, pp. 121–131.