In a previous article, we introduced the CFA Institute
Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7 modules, covering all
the essential topics in finance, economics, ethics and regulations. This series of articles will highlight the
core knowledge of each chapter.
Chapter 9 provides an overview of quantitative concepts. The
learning outcome of chapter 9 is as follows:
·
Identify issuers of debt securities;
·
Describe features of debt securities;
·
Describe seniority ranking of debt securities
when default occurs;
·
Describe types of bonds;
·
Describe bonds with embedded provisions;
·
Describe securitisation and asset-backed
securities;
·
Define current yield;
·
Describe the discounted cash flow approach to
valuing debt securities;
·
Describe a bond’s yield to maturity;
·
Explain the relationship between a bond’s price
and its yield to maturity;
·
Define yield curve;
·
Explain risks of investing in debt securities;
·
Define a credit spread.
Valuing debt securities is relatively straightforward
compared with, say, valuing equity securities (see the Equity Securities
chapter) because bonds typically have a finite life and predictable cash flows.
The value of a debt security is usually estimated by using a discounted cash
flow (DCF) approach. The DCF valuation approach is a valuation approach that
takes into account the time value of money. Recall from the discussion of the
time value of money in the Quantitative Concepts chapter that the timing of a cash
flow affects the cash flow’s value. The DCF valuation approach estimates the
value of a security as the present value of all future cash flows that the
investor expects to receive from the security.
The cash flows for a debt security are typically the future
coupon payments and the final principal payment. The value of a bond is the
present value of the future coupon payments and the final principal payment
expected from the bond. This valuation approach relies on an analysis of the
investment fundamentals and characteristics of the issuer. The analysis
includes an estimate of the probability of receiving the promised cash flows
and an establishment of the appropriate discount rate. Once an estimate of the
value of a bond is calculated, it can be compared with the current price of the
bond to determine whether the bond is overvalued, undervalued, or fairly
valued.
A bond’s current yield is calculated as the annual
coupon payment divided by the current market price. This measure is simple to
calculate and is often quoted. A bond’s current yield provides bondholders with
an estimate of the annualised return from coupon income only, without concern
for the effect of any capital gain or loss resulting from changes in the bond’s
value over time. The current yield should not be confused with the discount
rate used to calculate the value of the bond.
For fixed-rate bonds and zero-coupon bonds, the timing and
promised amount of the interest payments and final principal payment are known.
Thus, the value of a fixed-rate bond or zero-coupon bond can be expressed as
where V0 is the current value of the bond, CFt is the bond’s
cash flow (coupon payments and/or par value) at time t, r is the discount rate,
and n is the number of periods until the maturity date. The bond’s cash flows
and the timing of the cash flows are defined in the bond contract, but the
discount rate reflects market conditions as well as the riskiness of the
borrower.
The discount rate that equates the present value of a bond’s
promised cash flows to its market price is the bond’s yield to maturity,
or yield. An investor can compare this yield to maturity with the required rate
of return on the bond given its riskiness to decide whether to purchase it.
A bond’s yield to maturity can be expressed as
where P0 represents the current market price of the bond,
and rytm represents the bond’s yield to maturity.
When investors try to determine the appropriate discount
rate (yield to maturity or required rate of return) for a particular bond, they
often begin by looking at the yields to maturity offered by government bonds.
The term structure of interest rates, often referred to simply as the term
structure, shows how interest rates on government bonds vary with maturity. The
term structure is often presented in graphical form, referred to as the yield
curve. The yield curve graphs the yield to maturity of government bonds
(y-axis) against the maturity of these bonds (x-axis). It is important when
developing a yield curve to ensure that bonds have identical features other
than their maturity, such as identical coupon rates. In other words, the bonds
considered should only differ in maturity.
Investing in debt securities is generally considered less
risky than investing in equity securities, but bondholders still face a number
of risks. These risks include credit risk, interest rate risk, inflation risk,
liquidity risk, reinvestment risk, and call risk.
Credit risk, sometimes referred to as default risk,
is the risk of loss if the borrower, or bond issuer, fails to make full and
timely payments of interest and/or principal.
Investors may be able to assess the credit risk of a bond by reviewing
its credit rating. Independent credit rating agencies assess the credit quality
of particular bonds and assign them ratings based on the creditworthiness of
the issuer. Exhibit 3 presents the credit ratings systems of Standard &
Poor’s, Moody’s Investors Service, and Fitch Ratings.
Interest rate risk is the risk that interest rates
will change. Interest rate risk usually refers to the risk associated with
decreases in bond prices resulting from increases in interest rates.
Nearly all debt securities expose investors to inflation
risk because the promised interest payments and final principal payment
from most debt securities are nominal amounts—that is, the amounts do not
change with inflation.
Liquidity risk refers to the risk of being unable to
sell a bond prior to the maturity date without having to accept a significant
discount to market value. Bonds that do not trade very frequently exhibit high
liquidity risk.
Reinvestment risk refers to the fact that in a period
of falling interest rates, the coupon payments received during the life of a
bond and/or the principal payment received from a bond that is called early
must be reinvested at a lower interest rate than the bond’s original coupon
rate.
Call risk, sometimes referred to as prepayment risk,
refers to the risk that the issuer will buy back (redeem or call) the bond
issue prior to maturity through the exercise of a call provision.
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