Fixed Income Valuation Factors
Now that you understand the characteristics that make bonds different, you can apply them to the core valuation concepts: maturity, yield measures, credit quality, convertible bond math, and discounted cash flow analysis.
Maturity
- Maturity is the time remaining until the bond's principal (par value) is repaid to the investor
- Longer maturity = greater exposure to interest rate changes = more price volatility
- The yield curve plots yields against maturities for bonds of similar credit quality
| Yield Curve Shape | What It Looks Like | What It Signals |
|---|---|---|
| Normal (positive) | Upward sloping | Economic growth expected; longer-term rates higher |
| Inverted (negative) | Downward sloping | Recession risk; short-term rates higher than long-term |
| Flat | Roughly level | Economic uncertainty; rates similar across maturities |
- In a normal yield curve, investors demand higher yields for locking up money longer (compensation for time and uncertainty)
- An inverted yield curve has historically been a reliable recession indicator
Yield Measures
This is one of the most frequently tested topics in fixed-income valuation. There are four yield measures to understand and how they relate to each other.
Current Yield
Current Yield = Annual Coupon Payment / Current Market Price
- Measures income return only: how much annual income the bond produces relative to what you paid
- Ignores capital gains or losses at maturity and the time value of money
- For a discount bond: current yield is higher than the coupon rate (you paid less than par, so the fixed coupon is a larger percentage of your purchase price)
- For a premium bond: current yield is lower than the coupon rate (you paid more than par)
Example: A bond with a $50 annual coupon trading at $950:
- Current Yield = $50 / $950 = 5.26%
- Coupon Rate = $50 / $1,000 = 5.0%
- Since it's a discount bond, current yield > coupon rate
Yield to Maturity (YTM)
- YTM is the total annualized return an investor earns if they buy the bond at today's price and hold it to maturity
- It accounts for coupon payments, the purchase price, the par value received at maturity, and time to maturity
- Considered the most comprehensive yield measure because it captures both income and capital gains/losses
Exam Tip: Gotchas
YTM assumes all coupon payments are reinvested at the same YTM rate. In practice, reinvestment rates vary, but for exam purposes, YTM is the "gold standard" yield measure.
Yield to Call (YTC)
- YTC calculates the return if the bond is called at the earliest call date rather than held to maturity
- Most relevant for callable bonds trading at a premium (these are the ones most likely to be called, because the issuer wants to refinance at lower rates)
- For premium callable bonds, YTC is generally lower than YTM
The Yield Hierarchy
This is a critical exam concept. The order of yields depends on whether the bond is trading at a premium, par, or discount.
Discount bonds (price < par):
Coupon Rate < Current Yield < YTM < YTC
- Each measure adds more return: the coupon rate is the base, current yield adjusts for the lower price, YTM adds the capital gain at maturity, and YTC compresses that gain into a shorter time frame
Premium bonds (price > par):
Coupon Rate > Current Yield > YTM > YTC
- Each measure reduces the apparent return: the coupon rate looks best, but current yield adjusts for the higher price, YTM subtracts the capital loss at maturity, and YTC compresses that loss into a shorter period
Par bonds (price = par):
Coupon Rate = Current Yield = YTM = YTC
- When a bond trades exactly at par, all yield measures are equal
Exam Tip: Gotchas
The yield hierarchy for discount vs. premium bonds is one of the most frequently tested concepts. Remember: for discount bonds, the measures go up as they get more comprehensive (Coupon Rate < Current Yield < YTM < YTC). For premium bonds, they go down. If you can't remember the order, think about whether the capital gain/loss at maturity helps or hurts the total return.
Conversion Valuation
Convertible bonds can be exchanged for a set number of the issuer's common shares. Two key formulas come up on the exam.
Conversion Ratio
Conversion Ratio = Par Value / Conversion Price
- This tells you how many shares you get if you convert
- Example: A $1,000 par bond with a $25 conversion price has a conversion ratio of 40 shares
Conversion Value (Parity)
Conversion Value = Conversion Ratio x Current Stock Price
- This tells you what the bond is worth as stock at today's share price
- Also called parity: the point where the bond's value as debt equals its value as equity
When to convert:
| Scenario | Action |
|---|---|
| Conversion value > bond market price | Conversion is attractive (stock value exceeds bond value) |
| Conversion value < bond market price | Hold the bond (bond value exceeds stock value) |
| Conversion value = bond market price | At parity; indifferent |
Example: A convertible bond has a conversion ratio of 40. The stock trades at $30.
- Conversion value = 40 x $30 = $1,200
- If the bond trades at $1,100, conversion is attractive ($1,200 > $1,100)
- If the bond trades at $1,300, hold the bond ($1,200 < $1,300)
Think of it this way: A convertible bond is a regular bond with a built-in stock option. The conversion value tells you what that option is worth right now.
Bond Ratings and Credit Spread
Credit Ratings
Bond ratings assess the issuer's ability to make interest payments and repay principal. The three major rating agencies use similar but slightly different scales.
| Category | Moody's | S&P / Fitch | Meaning |
|---|---|---|---|
| Highest quality | Aaa | AAA | Minimal credit risk |
| High quality | Aa1, Aa2, Aa3 | AA+, AA, AA- | Very low credit risk |
| Upper medium | A1, A2, A3 | A+, A, A- | Low credit risk |
| Medium (lowest investment grade) | Baa1, Baa2, Baa3 | BBB+, BBB, BBB- | Moderate credit risk |
| --- Investment grade line --- | |||
| Speculative | Ba1, Ba2, Ba3 | BB+, BB, BB- | Substantial credit risk |
| Highly speculative | B1, B2, B3 | B+, B, B- | High credit risk |
| Very high risk | Caa, Ca, C | CCC, CC, C, D | Default likely or in default |
- Investment grade: Baa3 / BBB- and above
- Below investment grade (also called high yield or junk bonds): below Baa3 / BBB-
Credit Spread
- Credit spread = Yield on a corporate bond - Yield on a comparable-maturity Treasury
- The spread compensates investors for the additional credit risk of the corporate issuer compared to the "risk-free" Treasury
- Wider spread = higher perceived credit risk
- Narrower spread = lower perceived credit risk
How spreads move with the economy:
| Economic Condition | Credit Spreads | Why |
|---|---|---|
| Growth / expansion | Narrow | Investors are confident; default risk seems low |
| Recession / uncertainty | Widen | Investors demand more compensation for default risk |
| Financial crisis | Widen sharply | Flight to quality; everyone wants Treasuries |
Exam Tip: Gotchas
Credit spreads widen during economic stress and narrow during growth. This trips up some students: in good times, risky bonds don't appear as risky, so the extra yield investors demand shrinks. In bad times, the opposite happens.
Discounted Cash Flow (DCF) Valuation
DCF is the fundamental method for determining a bond's intrinsic value. It works by calculating the present value of all the bond's future cash flows.
How It Works
A bond generates two types of cash flows:
- Coupon payments: periodic interest payments throughout the bond's life
- Par value: the face value returned at maturity
DCF discounts each of these cash flows back to today using the investor's required yield (the rate of return the investor demands).
The Decision Rule
| Comparison | Conclusion | Action |
|---|---|---|
| DCF value > market price | Bond is undervalued | Buy (you're getting a bargain) |
| DCF value < market price | Bond is overvalued | Avoid or sell (you're overpaying) |
| DCF value = market price | Bond is fairly valued | Neutral |
Key Concepts
- The discount rate is the required yield; a higher required yield produces a lower present value (and vice versa)
- DCF captures the time value of money: a dollar received today is worth more than a dollar received in the future
- This method works for any bond that has known future cash flows (coupons and par)
Think of it this way: DCF answers the question: "Given the cash flows this bond promises to pay, what should I be willing to pay for it today?" If the market is asking less than your answer, it's a good deal.
Exam Tip: Gotchas
The relationship between the discount rate and bond price is inverse. When the required yield (discount rate) goes up, the present value of future cash flows goes down, and so does the bond's price. This is the mathematical basis for the fundamental rule: interest rates up means bond prices down.