Fixed Income Valuation Factors

This section covers how analysts evaluate and compare bonds using duration, maturity, yield measures, conversion features, credit spreads, and discounted cash flow analysis.

Duration as a Valuation Tool

Duration is both a bond characteristic and a valuation factor that helps determine fair value by quantifying interest rate sensitivity:

• Portfolio duration = weighted average of individual bond durations
• Longer duration = greater price change per 1% interest rate move
• A portfolio with duration of 7 will lose approximately 7% of its value if rates rise 1%

Advisers adjust portfolio duration based on interest rate outlook:

• Expect rates to rise - shorten duration (reduce price sensitivity)
• Expect rates to fall - lengthen duration (maximize price appreciation)

Immunization = matching portfolio duration to the investment time horizon, neutralizing both interest rate risk and reinvestment risk.

Practical example: An adviser managing a bond portfolio for a client who needs funds in 5 years would target a portfolio duration near 5 years, immunizing against interest rate changes.

Exam Tip: Gotchas

• Duration is an approximation, not an exact prediction. It works well for small rate changes (1-2%), but becomes less accurate for large moves because of convexity.
• Zero-coupon bonds have duration equal to their maturity (no interim cash flows to shorten it). This makes them the most price-sensitive bonds for a given maturity.

Maturity

Maturity is the date when the bond's principal is repaid. It directly affects a bond's risk profile and required return:

• Longer maturity = greater price sensitivity to rate changes (but duration is the more precise measure)
• Longer-maturity bonds require higher yields to compensate for greater risk (reflected in a normal yield curve)

Term structure of interest rates (yield curve) shows the relationship between maturity and yield:

• Inverted yield curve is historically a reliable recession predictor
• Yield curve shape reflects market expectations about future interest rates and economic conditions

Think of it this way: The longer you lend money, the more uncertainty you face. More things can go wrong over 30 years than 2 years, so investors demand higher returns for longer commitments.

Yield to Call (YTC)

• Annualized return assuming the bond is called at the first call date
• Uses the call price (not par) and years to call (not years to maturity)
• Most relevant when a bond trades at a premium and calling is likely
• Generally lower than yield to maturity (YTM) for premium bonds (shorter time to receive return, plus loss of premium is accelerated)

When to use YTC vs. YTM:

Yield to Maturity (YTM)

• Total annualized return if the bond is held to maturity and all coupons are reinvested at the YTM rate
• Accounts for coupon, price gain/loss, and reinvestment
• The most commonly used yield measure for comparing bonds

YTM and pricing relationship:

Think of it this way: YTM spreads out the gain or loss at maturity over the life of the bond. A discount bond earns extra return each year from the eventual price appreciation to par.

Coupon

The coupon rate is the fixed annual interest rate stated on the bond that determines periodic cash flows:

• Higher coupon = lower duration = lower price volatility (more cash flow received sooner reduces sensitivity)
• Lower coupon = higher duration = higher price volatility
• Zero coupon = duration equals maturity (maximum price sensitivity)

A bond's coupon rate never changes after issuance. What changes is the market's required yield, which drives the bond's price above or below par.

Exam Tip: Gotchas

• Higher coupon = LESS price volatility, not more. This is counterintuitive. Larger, earlier cash flows reduce a bond's duration and its sensitivity to rate changes.

Conversion Valuation

Applies to convertible bonds and convertible preferred stock - securities that can be exchanged for a fixed number of common shares:

Key formulas:

Example: $1,000 par convertible bond, conversion price = $25

• Conversion ratio = $1,000 / $25 = 40 shares
• If stock trades at $30: conversion value = 40 x $30 = $1,200 (conversion is profitable)
• If stock trades at $20: conversion value = 40 x $20 = $800 (conversion is NOT profitable; bond trades on its bond value)

Key characteristics:

• Convertible bonds offer lower coupon rates than equivalent non-convertible bonds (the conversion privilege has value)
• The bond will trade at the greater of its straight bond value (based on coupon/yield) or its conversion value
• When stock price is well below conversion price, the convertible trades like a regular bond (bond floor)
• When stock price is well above conversion price, the convertible trades like equity (tracks the stock)
• Convertible bonds have less downside risk than common stock (bond floor) but less upside than stock (conversion premium)

Forced conversion: Issuers call the convertible bond when conversion value exceeds the call price, forcing holders to convert rather than accept the lower call price. Investors do not lose money; they convert to stock worth more than the call price.

Exam Tip: Gotchas

• Always use par value ($1,000) to calculate conversion ratio, not the current market price. Conversion terms are set at issuance.
• When conversion value EXCEEDS the call price, the issuer will call the bond to FORCE conversion. This is a common exam scenario.

Bond Ratings as a Valuation Factor

Credit ratings directly affect required yield and market price:

• Downgrade = price falls, yield rises (investors demand more compensation for increased risk)
• Upgrade = price rises, yield falls (lower risk requires less compensation)
• Rating changes create immediate price movements as the market reprices the bond

Investment-grade bonds trade at lower yields (tighter spreads) than high-yield bonds because of their lower default risk.

Credit Spread

The credit spread is the yield difference between a bond and a comparable-maturity risk-free Treasury security, expressed in basis points (100 bps = 1%):

• Measures the additional yield investors demand for taking on credit risk
• Wider spread = higher perceived risk
• Narrower spread = lower perceived risk

Credit spreads by rating:

Credit spreads and the economy:

• Spread duration measures how much a bond's price changes for a 1% change in credit spread
• Credit spreads are a key component of discounted cash flow analysis for bonds

Exam Tip: Gotchas

• During a recession, credit spreads WIDEN even if Treasury yields are falling. This means corporate bond prices can fall even when Treasury prices are rising. Do not confuse interest rate movements with spread movements.

Discounted Cash Flow (DCF)

A bond's intrinsic value is the present value of all future cash flows (coupons + principal) discounted at the required rate of return:

• Required rate of return = risk-free rate + credit spread
• DCF incorporates the time value of money: a dollar received today is worth more than a dollar received in the future
• Higher discount rate → lower present value → lower bond price

Using DCF for valuation decisions:

• If DCF value > market price: bond is undervalued (buy)
• If DCF value < market price: bond is overvalued (sell)
• YTM is the discount rate that sets DCF value = market price

Think of it this way: A bond is simply a stream of future cash payments. DCF asks: "What is that stream of payments worth today, given what I could earn elsewhere?" The answer is the bond's fair price.

Exam Tip: Gotchas

• DCF is the theoretical foundation for all bond pricing. The required rate of return combines the risk-free rate (Treasuries) plus the credit spread for that bond's risk level.
• If DCF value exceeds market price, the bond is undervalued: buy. If it is below market price, the bond is overvalued: sell.