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BOND ANALYSIS

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CAPITALIZATION OF INCOME METHOD

• PROMISED YIELD-TO-MATURITY– In equation form

where P=the current market price of bond

n=the number of years to maturity

Ct=the annual coupon payment

y=the prevailing yield to maturity

n

tt

t

y

cP

1 )1(

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CAPITALIZATION OF INCOME METHOD

• INTRINSIC VALUE– In equation form

n

tt

t

y

cV

1 )1(

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CAPITALIZATION OF INCOME METHOD

• SOLVING FOR V, – Given the current market price (P), the

investment decision is• if V is the intrinsic value and

V>P buy the bond

V<P don’t buy

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CAPITALIZATION OF INCOME METHOD

• ALTERNATIVELY– SOLVING FOR y*

y*>y bond overprice

y*<y bond underpriced

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BOND ATTRIBUTES

• SIX ATTRIBUTES that affect a bond’s value– LENGTH OF TIME TO MATURITY– COUPON RATE– CALL PROVISIONS– TAX STATUS– MARKETABILITY– LIKELIHOOD OF DEFAULT

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LENGTH OF TIME TO MATURITY

• COUPON RATE AND LENGTH TO MATURITY– these attributes determine size and timing of

cash flow– yield-to-maturity

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TAX STRUCTURE

• TAX STRUCTURE– Taxation affects bond prices and yields

• low-coupon bonds selling at a discount provide return in

– coupon payments

– gains from price appreciations

• taxes on appreciations may be deferred until bond sale or maturity

• discount bonds have a tax advantage

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TAX STRUCTURE

• TAX STRUCTURE– Taxation affects bond prices and yields

• because of tax effect, discount bonds should have a slightly lower before-tax yield

• low-coupon bonds will have a slightly higher intrinsic value

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MARKETABILITY

• MARKETABILITY– refers to the ability of the investor to resell

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MARKETABILITY

• MARKETABILITY – bid-ask spread is one indicator of marketability

• the higher the spread, the less marketable

• the lower the spread, the more marketable

– bonds that are actively traded should have a lower YTM and a higher V

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MARKETABILITY

• MARKETABILITY– bonds that are actively traded should have a

lower YTM and a higher V

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LIKELIHOOD OF DEFAULT

• LIKELILHOOD OF DEFAULT– Bond ratings provided by professional services.

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LIKELIHOOD OF DEFAULT

• LIKELILHOOD OF DEFAULT– Two most famous include

• Moody’s Investors Services, Inc.• Standard & Poor’s Corporate ratings

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LIKELIHOOD OF DEFAULT

• LIKELIHOOD OF DEFAULT– Categories

• investment grade usually the bonds in the top four ratings

• speculative• often called junk bonds

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LIKELIHOOD OF DEFAULT

• LIKELIHOOD OF DEFAULT– Bond ratings provided by professional services.

• better ratings are generally associated with– larger financial leverage

– larger firm size

– larger and steadier profits

– large cash flows

– lack of subordination to other debt series