Bonds: Understanding Types and Benefits

Bonds

• Bonds raise long-term capital for corporations and governments.
• Investors pay the initial cost (price) and receive coupon (interest) periodically, and the face value of the bond when it matures.
• Zero-coupon bonds do not pay coupon payments over the life of the bond, only the face value at maturity.
• Convertible bonds can be converted into a pre-determined number of stocks in the future.
• Indexed bonds have a rate of return eroded by inflation, with the coupon related to inflation movements.
• Callable bonds allow the seller to buy the bond back from the investor in the future.
• Perpetual bonds have no maturity date.
• Treasury bonds are issued by the federal government.
• Municipal bonds are issued by state governments or government agencies.

Bond Pricing and YTM

• YTM reflects the market's required return on the bond.
• If the market requires a higher return than the bond's coupon rate, the bond's price will drop (discount).
• If the market requires a lower return than the bond's coupon rate, the bond's price will increase (premium).
• Changes in market interest rates affect YTM, with rising interest rates increasing YTM and decreasing bond prices, and vice versa.

Relationship Between YTM, Coupon Rate, and Time to Maturity

• If the coupon rate is higher than YTM, the bond is sold at a price above face value (expensive/premium).
• As time to maturity decreases, the bond price decreases, and as time to maturity increases, the bond price increases.
• When YTM decreases, the bond price increases, decreasing the effective annual return.
• If interest rates go down, this decreases YTM, increasing bond price.
• If the coupon rate is lower than YTM, the bond is sold at a price below face value (cheap/discount).
• As time to maturity decreases, the bond price increases, and as time to maturity increases, the bond price decreases.
• When YTM increases, the bond price decreases, increasing the effective annual return.
• If interest rates go up, this increases YTM, decreasing bond price.

Pure Expectations Theory

• Pure Expectations Theory assumes the current yield curve solely reflects investors' expectations of future short-term interest rates.
• Long-term interest rates are determined by the market's expectation of future short-term interest rates (forward rates).
• Investors are indifferent between holding short-term or long-term securities, provided any combination of investment gives the same total return over the same investment period.

Yield Curve Shape

• Normal (upward-sloping) yield curve: long-term bonds have higher yields compared to short-term bonds, indicating expectations of stronger economic growth and potentially higher inflation in the future.
• Inverted (downward-sloping) yield curve: short-term bonds have higher yields compared to long-term bonds, indicating expectations of slower economic growth or a recession in the future.
• Flat yield curve: rarely seen, indicating a changing economy.

Discount Factors/Spot Rates/Forward Rates

• Discount factors are determined from the market price and cashflows of a bond, starting with the shortest maturity, to obtain the corresponding spot rate and create a yield curve.
• Forward rates are market expectations of interest rates in the future.
• Comparing forward rates to spot rates indicates what the market thinks will happen in the future for bonds.
• Spot rates vs. forward rate curves provide an indication of what the market is thinking in the future for bonds.

Interest Rate Changes

• High interest rates: decrease in bond prices, providing an opportunity for investors.
• Low interest rates: increase in bond prices, making them more valuable.

Liquidity Preference Theory

• Liquidity Preference Theory assumes the current yield curve reflects investors' expectations of future short-term interest rates and their preference for liquidity.
• Investors prefer to hold shorter-term securities, exposed to less interest rate risk, and are willing to pay extra for reducing this risk exposure.
• Investors are only willing to invest in long-term securities, exposed to higher interest rate risk, if offered a high enough return premium for the increased risk.

Relative Valuation

• The median is preferred over the mean as a comparison point, as it is unaffected by extreme outliers or non-symmetric distributions of scores.
• The median is a better representation of the true average if the sample has outliers.

Types of Bonds

• Bonds are issued by corporations and governments to raise long-term capital
• Investors pay the initial cost (price) and receive coupon (interest) periodically
• When the bond matures, investors receive the face value of the bond (initial cost)
• Zero-coupon bonds do not pay coupon payments, only the face value at maturity
• Convertible bonds can be converted into a predetermined number of stocks in the future
• Indexed bonds have a rate of return affected by inflation, with coupon payments related to inflation movements
• Callable bonds allow the seller to buy the bond back from the investor in the future
• Perpetual bonds have no maturity date
• Treasury bonds are issued by the federal government
• Municipal bonds are issued by state governments or government agencies

Bond Pricing and YTM

• YTM (Yield to Maturity) reflects the market's required return on the bond
• If the market requires a higher return than the bond's coupon rate, the bond's price falls (discount)
• If the market requires a lower return than the bond's coupon rate, the bond's price increases (premium)
• Changes in market interest rates affect YTM
• When market interest rates rise, YTM increases, and bond prices fall
• When market interest rates fall, YTM decreases, and bond prices rise

Relationship Between YTM, Coupon Rate, and Time to Maturity

• Expensive/Premium Bonds: sold at a price above face value, with a higher coupon rate than YTM
• Cheap/Discount Bonds: sold at a price below face value, with a lower coupon rate than YTM
• When YTM decreases, the bond price increases, and the effective annual return decreases
• When YTM increases, the bond price decreases, and the effective annual return increases

Pure Expectations Theory

• Assumes the current yield curve solely reflects investors' expectations of future short-term interest rates
• Long-term interest rates are determined by the market's expectation of future short-term interest rates (forward rates)
• Investors are indifferent between holding short-term or long-term securities, assuming the same total return

Yield Curve Shape

• Normal/Upward Sloping: long-term bonds have higher yields, indicating stronger economic growth and higher inflation expectations
• Inverted/Downward Sloping: short-term bonds have higher yields, indicating slower economic growth or recession expectations
• Flat Yield Curve: rarely seen, only during economic changes, indicating a shift in the yield curve

Discount Factors, Spot Rates, and Forward Rates

• Discount Factors are determined from the market price and cashflows of a bond, used to obtain the corresponding spot rate and create a yield curve
• Forward rates are market expectations of interest rates in the future
• Comparing forward rates to spot rates can indicate market expectations of future interest rate changes
• Using spot rates vs. forward rates can indicate market expectations of future bond prices

Liquidity Preference Theory

• Assumes the current yield curve reflects investors' expectations of future short-term interest rates and their preference for liquidity
• Investors prefer shorter-term securities with lower interest rate risk, requiring a higher return premium for increased risk
• Shorter-term securities: lower risk, lower return (discount rate), higher prices
• Long-term securities: higher risk, higher return (discount rate), lower prices

Relative Valuation

• The median is a more reliable comparison point than the mean
• The median is unaffected by extreme outliers or non-symmetric distributions of scores
• The median is a better representation of the true average if the sample has outliers

Types of Bonds

• Bonds are issued by corporations and governments to raise long-term capital
• Investors pay the initial cost (price) and receive coupon (interest) periodically
• When the bond matures, investors receive the face value of the bond (initial cost)
• Zero-coupon bonds do not pay coupon payments, only the face value at maturity
• Convertible bonds can be converted into a predetermined number of stocks in the future
• Indexed bonds have a rate of return affected by inflation, with coupon payments related to inflation movements
• Callable bonds allow the seller to buy the bond back from the investor in the future
• Perpetual bonds have no maturity date
• Treasury bonds are issued by the federal government
• Municipal bonds are issued by state governments or government agencies

Bond Pricing and YTM

• YTM (Yield to Maturity) reflects the market's required return on the bond
• If the market requires a higher return than the bond's coupon rate, the bond's price falls (discount)
• If the market requires a lower return than the bond's coupon rate, the bond's price increases (premium)
• Changes in market interest rates affect YTM
• When market interest rates rise, YTM increases, and bond prices fall
• When market interest rates fall, YTM decreases, and bond prices rise

Relationship Between YTM, Coupon Rate, and Time to Maturity

• Expensive/Premium Bonds: sold at a price above face value, with a higher coupon rate than YTM
• Cheap/Discount Bonds: sold at a price below face value, with a lower coupon rate than YTM
• When YTM decreases, the bond price increases, and the effective annual return decreases
• When YTM increases, the bond price decreases, and the effective annual return increases

Pure Expectations Theory

• Assumes the current yield curve solely reflects investors' expectations of future short-term interest rates
• Long-term interest rates are determined by the market's expectation of future short-term interest rates (forward rates)
• Investors are indifferent between holding short-term or long-term securities, assuming the same total return

Yield Curve Shape

• Normal/Upward Sloping: long-term bonds have higher yields, indicating stronger economic growth and higher inflation expectations
• Inverted/Downward Sloping: short-term bonds have higher yields, indicating slower economic growth or recession expectations
• Flat Yield Curve: rarely seen, only during economic changes, indicating a shift in the yield curve

Discount Factors, Spot Rates, and Forward Rates

• Discount Factors are determined from the market price and cashflows of a bond, used to obtain the corresponding spot rate and create a yield curve
• Forward rates are market expectations of interest rates in the future
• Comparing forward rates to spot rates can indicate market expectations of future interest rate changes
• Using spot rates vs. forward rates can indicate market expectations of future bond prices

Liquidity Preference Theory

• Assumes the current yield curve reflects investors' expectations of future short-term interest rates and their preference for liquidity
• Investors prefer shorter-term securities with lower interest rate risk, requiring a higher return premium for increased risk
• Shorter-term securities: lower risk, lower return (discount rate), higher prices
• Long-term securities: higher risk, higher return (discount rate), lower prices

Relative Valuation

• The median is a more reliable comparison point than the mean
• The median is unaffected by extreme outliers or non-symmetric distributions of scores
• The median is a better representation of the true average if the sample has outliers

Relative Valuation

• Relative valuation involves comparing the price of an asset to the prices of similar or comparable assets in the market.
• Market prices are standardized to create price multiples, which enable comparisons between assets.
• Relative valuation is popular because it reflects market perceptions and moods, making it easier to justify valuations.
• The median is preferred over the mean as a comparison point because it is more reliable and unaffected by extreme outliers or non-symmetric distributions.

Issues in Relative Valuation

• The choice of comparables is subjective and can significantly affect the valuation.
• Market conditions can influence the prices of comparables, leading to inaccurate valuations.
• Differences in growth rates between companies can lead to misleading conclusions.
• Scale and size differences between companies can result in valuation discrepancies.

Non-Linear Regression

• Non-linear regression assumes a linear relationship between the multiple and its fundamentals.
• Non-stationarity occurs when the relationship between the multiple and financial variables is not stable.
• Multi-collinearity occurs when independent variables are correlated with each other, making coefficients unreliable.

Bonds

• Bonds are long-term debt instruments issued by corporations and governments to raise capital.
• Investors pay the initial price and receive coupon (interest) payments periodically, and the face value when the bond matures.
• Types of bonds include:
  • Convertible bonds: can be converted into a pre-determined number of stocks.
  • Indexed bonds: rate of return is eroded by inflation.
  • Callable bonds: seller can buy the bond back from the investor.
  • Perpetual bonds: have no maturity date.
  • Treasury bonds: issued by federal governments.
  • Municipal bonds: issued by state governments or government agencies.

Bond Pricing and Yield to Maturity (YTM)

• YTM reflects the market's required return on the bond.
• If the market requires a higher return than the bond's coupon rate, the bond's price will drop (discount).
• If the market requires a lower return than the bond's coupon rate, the bond's price will increase (premium).
• Changes in market interest rates affect YTM and bond prices.

Characteristics of Bonds

• Par value bond: coupon rate equals YTM.
• Discount bond: coupon rate is less than YTM.
• Premium bond: coupon rate is greater than YTM.

Pure Expectations Theory

• Assumes the current yield curve reflects investors' expectations of future short-term interest rates.
• Long-term interest rates are determined by market expectations of future short-term interest rates (forward rates).
• Investors are indifferent between holding short-term or long-term securities, provided any combination gives the same total return.

Yield Curve Shape

• Normal (upward sloping): long-term bonds have higher yields, indicating expectation of stronger economic growth and higher inflation.
• Inverted (downward sloping): short-term bonds have higher yields, indicating expectation of slower economic growth or recession.
• Flat yield curve: rare and occurs when the economy is changing.

Discount Factors, Spot Rates, and Forward Rates

• Discount factor is determined from the market price and cashflows of a bond.
• Spot rate is used to create a yield curve.
• Forward rates reflect market expectations of interest rates in the future.
• Comparing forward rates to spot rates indicates market expectations.

High and Low Interest Rates

• High interest rates decrease bond prices, providing an opportunity for investors.
• Low interest rates increase bond prices, making them more valuable.

Liquidity Preference Theory

• Assumes the current yield curve reflects investors' expectations of future short-term interest rates and their preference for liquidity.
• Investors prefer shorter-term securities, which are exposed to less interest rate risk.
• Investors demand a higher return premium for taking on increased risk in long-term securities.
• This is the liquidity premium.
• Implications:
  • Shorter-term securities: lower risk, lower return (discount rate), and higher prices.
  • Long-term securities: higher risk, higher return (discount rate), and lower prices.