BACKGROUND ON BONDS

Bonds - are debt obligations with long-term maturities that are commonly issued by governments or corporations to
obtain long-term funds. It is used to o finance government expenditures, housing, and corporate expenditures. Many
financial institutions, such as commercial banks, issue bonds to finance their operations. In addition, most types of
financial institutions are major investors in bonds. Most bonds have maturities of between 10 and 30 years.

Bonds are issued in the primary market through a telecommunications network.

Difference of Notes and Bonds

The key difference between a note and a bond is that note maturities are less than 10 years whereas bond maturities are
10 years or more.

CLASSIFICATION OF BONDS as to OWNERSHIP STRUCTURE

1. Bearer bonds - require the owner to clip coupons attached to the bonds and send them to the issuer to receive
coupon payments.

2. Registered bonds - require the issuer to maintain records of who owns the bond and automatically send coupon
payments to the owners.

CLASSIFICATIONS as to TYPE OF ISSUER:

1. Treasury Bonds - These bonds are issued by the treasury department. This is issued to finance federal
government expenditures. These kinds of bonds can be purchased only through an auction set by the treasury
department.

2. Savings Bonds - are issued by the Treasury, but they can be purchased from many financial institutions. Savings
bonds are also issued by the Treasury Department. These bonds are meant to be purchased by individual
investors. They are issued in low-enough amounts to make them affordable for individuals. It has a 30-year
maturity and do not have a secondary market.

3. Federal Agency Bonds - are issued by federal agencies and quasi-governmental agencies.

4. Municipal Bonds - are issued by various cities. They are tax-free but have slightly lower interest rates than
corporate bonds. They are slightly riskier than bonds issued by the federal government. Municipal bonds are
classified into:

a. General Obligation Bonds - payments are supported by the municipal government’s ability to tax.

b. Revenue Bonds - must be generated by revenues of the project (toll way, toll bridge, state college
dormitory, etc.).

5. Corporate Bonds - Corporate bonds are long-term debt securities issued by corporations that promise the
payments of interests on a semiannual basis. Corporate bonds can be placed with investors through a public
offering or a private placement.

BOND VALUATION

Bond Valuation Process

The price of a bond is the present value of the cash flows that will be generated by the bond, namely periodic interest or
coupon payments and the principal at maturity.
Current Price of a Bond (PV)

Where;

C = coupon payment in each period

Par = par value
k = required return rate
n = number of period to maturity

Impact of Discount Rate on Bond Valuation

● Bond valuation is the process of determining the fair price of a bond.

● The discount rate selected to compute the present value is critical to accurate valuation, since it reflects the time
value of money and the risk associated with an investment. Small changes in the discount rate can lead to
significant changes in valuation. A higher discount rate reduces the present value of future cash flows, thus
lowering the valuation, while a lower discount rate increases the present value and raises the valuation. The
discount rate used in bond valuation is usually the bond's yield to maturity (YTM), which represents the rate of
return investors would earn if they hold the bond until maturity. It reflects the riskiness of the bond and
prevailing interest rates in the market. Basically, the discount rate's movement directly affects bond prices,
making it a critical factor in bond valuation. The discount rate reflects the required rate of return investors
demand for holding the bond. If the discount rate rises, investors expect higher returns, which reduces the
present value of the bond's future cash flows. Conversely, if the discount rate falls, investors are willing to accept
lower returns, thus increasing the present value of the bond. Therefore, the discount rate plays a crucial role in
determining the fair price of a bond in the market.

● A higher discount rate decreases the present value of future cash flows, resulting in a lower bond price.

- Example:

Rina is considering investing in a Philippine government bond that promises to pay her ₱10,000 in ten years. However,
the interest rates in the market have increased, leading to a higher discount rate. With the higher discount rate, the
future cash flow of ₱10,000 in ten years is worth less in today's terms. This is because the higher discount rate means
that you could potentially earn more by investing your money in other opportunities with higher returns.

As a result, the present value of the future ₱10,000 cash flow decreases due to the higher discount rate. This means that
the bond is now less valuable to Rina because she can earn more by investing in other opportunities with higher returns.
Therefore, the bond price decreases to reflect the lower present value of future cash flows. Investors are willing to pay
less for the bond because the higher discount rate has reduced its attractiveness compared to alternative investments
available in the market.

High risk securities have higher discount rates

It means that investments perceived to be riskier by investors, will have higher discount rates applied to them. In simpler
terms, the discount rate is the interest rate used to determine the present value of future cash flows from an investment.
When an investment is considered risky, investors will demand a higher return to compensate for the additional risk they
are taking. This higher return requirement translates into a higher discount rate being applied to that investment.

Therefore, high-risk securities, such as investments in financially unstable companies, will have higher discount rates
compared to low-risk investments like government bonds. This adjustment ensures that investors are adequately
compensated for the increased risk associated with these investments.
Exhibit 8.2 Relationship between Discount Rate and Present Value of $10,000 Payment to Be Received in 10 Years

Explanation to Exhibit 8.2:

The discount rate reduces future cash flows, so the

higher the discount rate, the lower the present value of
the future cash flows. A lower discount rate leads to a
higher present value. As this implies, when the discount
rate is higher, money in the future will be worth less than
it is today—meaning it will have less purchasing power.

Impact of Timing of Payments on Bond Valuation

1. Funds received sooner can be reinvested to earn additional returns.

2. A dollar to be received soon the higher the present value and the lesser the value to be received later.
3.
Exhibit. 8.3. Relationship between Time of Payment and Present Value of Paymen

Assuming that a return of 10% could be earned on

available funds, the impact of maturity on the present
value of a $10,000 payment is shown in this exhibit
(Exhibit 8.3).

Example/Explanation:

- If $8,000 were invested today and earned 10% annually, it would be worth $10,000 in three years. If a $10,000
payment made 20 years from now has a present value of only $1,486 and that a $10,000 payment made 50 years
from now has a present value of only $85 (based on the 10 percent discount rate).

- It is quite similar to the topic “Time Value of Money.” As mentioned above, the sooner the higher its present
value. Similarly to the core principle of TVM, the sooner that it is received the more valuable it is. A solid grasp of
TVM principles provides the necessary foundation for effective bond valuation.
Valuation of Bonds with Semiannual Payments

● Bonds with semiannual payments are valued by discounting the semiannual interest payments and the principal
repayment at the semiannual yield.

● In the financial market, the valuation of bonds with semiannual payments is a crucial aspect of bond investing.
When a bond makes semiannual payments, it means that the bondholder receives interest payments twice a
year. This differs from annual payments, where interest is paid only once a year. Valuing a bond with semiannual
payments involves calculating the present value of these periodic cash flows to determine its fair price or value
in the market.

● In reality, most bonds have semiannual payments. The present value of such bonds can be computed as follows.

1. Divide the annual coupon payment by 2 to get the semiannual coupon payment.

2. Divide the annual discount rate by 2 to reflect the semiannual periods.

3. Double the number of periods to account for semiannual payments.

4. Use the formula:

Where;

● C/2 is the semiannual coupon payment, (half of what the annual coupon payment would have been)

● k/2 is the semiannual discount rate, and;

● Par is the face value of the bond.

● The last part of the equation has 2n in the denominator's exponent to reflect the doubling of periods.

Example: Consider a bond with $1,000 par value, a 10 percent coupon rate paid semiannually, and three years to
maturity. Assuming a 12 percent required return, the present value is computed as follows:

When using a financial calculator, the present value of the bond in the previous example can be determined as follows:

The remaining examples assume annual coupon payments so that we can focus on the concepts presented without
concern about adjusting annual payments.
Relation between Coupon Rate, Required Return, and Bond Price

Overview

The relationship between a bond's coupon rate, required return, and bond price is crucial in understanding bond
valuation. The coupon rate represents the annual interest paid by the bond issuer, while the required return (or yield) is
the rate of return an investor demands for holding the bond. The bond price is determined by the present value of the
cash flows, which includes the coupon payments and the principal repayment at maturity.

Key Points

A. Coupon Rate and Bond Price:

● A bond's coupon rate does not directly affect its price. Instead, it influences the bond's competitiveness and
value in the market.
● When the coupon rate is higher than the prevailing market interest rates, the bond becomes more attractive,
and its price tends to rise.
● Conversely, if the coupon rate falls below the prevailing market interest rates, the bond becomes less desirable,
and its price tends to decrease.
B. Required Return (Yield) and Bond Price:

● The required return (or yield) is the rate of return an investor demands for holding the bond.
● The bond price is inversely related to the required return. As the required return increases, the bond price
decreases, and vice versa.
C. Interplay between Coupon Rate and Required Return:

● When the coupon rate is higher than the required return, the bond's price tends to rise.
● Conversely, if the coupon rate is lower than the required return, the bond's price tends to decrease.
D. Bond Price and Market Interest Rates:

● Bond prices and market interest rates are inversely related. As interest rates rise, bond prices fall, and vice versa.

E. Yield to Maturity (YTM):

● The YTM is the rate of return for a bond if the investor holds it until maturity.

● The YTM is calculated by discounting the bond's cash flows using the bond's current price and the coupon rate
A. Bond Credit Ratings
- Bond credit ratings are grades assigned to bonds to evaluate their credit quality.
- Higher credit ratings indicate a lower default risk, which can increase the bond's price and lower its
required return.
Ø Relationship between Coupon Rate, Required Return, and Bond Price

1. Discount bonds: Bonds Selling below Par

- If the coupon rate is below the required rate, the price of the bond is below par (PV < 1,000).
2. Par Bonds: Bonds Selling at Par
- If coupon rate equals the required rate, the price of the bond is equal to par value (PV = 1,000).
3. Premium Bonds: Bonds Selling above Par
- If the coupon rate is above the required rate, the price of the bond is above the par (PV > 1,000).
Example: Consider a zero-coupon bond (which has no coupon payments) with three years remaining to maturity and
$1,000 par value. Assume the investor’s required rate of return on the bond is 13 percent. The appropriate price of this
bond can be determined by the present value of its future cash flows:

The bond's low price is necessary for a 13% annualized return. If it had coupon payments, its price would be higher since
coupons contribute to the return. For a similar bond with a 13% coupon rate, the appropriate price would be;

Exhibit 8.4 Relationship between Required Return and Present Value for a 10 Percent Coupon Bond with Various
Maturities

Finally, consider a bond with a similar par value and term to maturity and coupon rate that offers a coupon rate of 15
percent, which is above the investor’s required rate of return. The appropriate price of this bond, as determined by its
present value, is

The price of this bond exceeds its par value because the coupon payments are large enough to offset the high price paid
for the bond and still provide a 13 percent annualized return.

Bonds Pricing

Importance of bond pricing

● Bond pricing is the process of determining the fair market value of a bond. It is crucial for various participants in
the financial markets, including investors, issuers, and regulators.
● It ensures informed decision-making, efficient market functioning, and accurate financial reporting, all of which
contribute to the overall stability of the financial system.
Explaining Bond Price Movements

● Pb - stands for Bond Price

● F - stands for Future Cash Flow
● K - stands for Rate of return
● Rf - stands for Prevailing risk-free rate
● Rp - stands for credit risk premium
Interest Risk Rate

● refers to the potential for investment losses that result from changes in interest rates.
● the risk that market value will decline in response to a rise in interest rates.
Definition and Importance of Systemic Risk

● the potential collapse of the entire market or financial system.

● Understanding and managing systemic risk is essential to safeguarding the stability and functionality of the
financial system because unlike risks that affect individual entities or sectors, systemic risk has the capacity to
cause a domino effect, leading to severe consequences for many institutions simultaneously.
Factors of Bond Price Movements

Impact of Inflationary Expectations

- Influences bond markets, impacting interest rates and bond prices. Factors like the consumer price index
and oil prices are monitored by bond portfolio managers to forecast inflation. Lower bond prices and
higher interest rates can result from increased inflation expectations brought on by a declining currency.
On the other hand, a stronger currency reduces inflation expectations, which can lead bond portfolio
managers to increase their bond purchases and raise prices.
Impact of Economic Growth
- Strong economic growth tends to generate upward pressure on interest rates, while weak economic
conditions put downward pressure on rates. Any signals about future economic conditions will affect
expectations about future interest rate movements and cause bond markets to react immediately. Bond
market participants closely monitor economic indicators that may signal future changes in the strength
of the economy.
Impact of Money Supply Growth
- When the Federal Reserve increases the money supply, it can lower interest rates, making bonds more
attractive. However, in high-inflation environments, increased borrowing and spending may raise rates
up, leading to lower bond prices. This dual effect impacts bond portfolio managers' decisions.
Impact of Budget Deficit
- As the annual budget deficit grows, the federal government's need for loanable funds increases. This can
raise the required return on Treasury bonds, leading to lower prices on existing bonds with long terms
remaining until maturity. A higher deficit has a similar effect to higher inflationary expectations, both
leading to increased borrowing and higher interest rates. However, inflationary expectations encourage
more borrowing by individuals and firms, while a higher deficit is due to increased government
borrowing.
Changes in the Credit Risk Premium over Time
- Economic conditions change over time, the probability of default on bonds changes, along with credit
risk premiums. A stimulus monetary policy was implemented by the Federal Reserve when the credit
crisis worsened to lower the interest rate that is risk-free for all maturities. As a result, the yield on
Treasury bonds fell. However, because of the rise in the risk premium on the prices of Baa-rated
corporate bonds, the yield on these bonds climbed throughout the crisis greater than counteracted the
effect of the drop in the risk-free rate.
Impact of Debt Maturity on the Credit Risk Premium
- Shorter-term debts have a lower chance of default because there is less time for the economy to shift
dramatically; they usually have lower credit risk premiums. Longer-term debt, on the other hand, is
subject to more economic uncertainty, increasing the likelihood of default and, thus, the credit risk
premium. In conclusion, because there is less chance of default, shorter debt maturities often have
lower credit risk premiums, but longer maturities have higher premiums because of the increased
uncertainty.
Sensitivity of Bond Prices to Interest Rate Movements

- Bond Price Elasticity measures the sensitivity of bond price changes in its required rate of return.

Influence of Coupon Rate on Bond Price Sensitivity

The coupon rate is the interest rate paid by bond issuers on the bond's face value.

● A zero-coupon bond, which pays all of its proceeds to the investor at maturity, is most sensitive to changes in the
required rate of return.

● A bond that pays its yield through coupon payments is less sensitive to changes in the required rate of return.

Influence of Maturity on Bond Price Sensitivity

● Maturity is the agreed-upon date on which the investment ends.

● As interest rates decrease, long-term bond prices increase because the long-term bonds will continue to offer
the same coupon rate over a longer period of time.
Duration measures the life of the bond on a present value basis. The longer a bond’s duration, the greater its sensitivity
to interest rate changes.

The numerator of the duration formula represents the present value of future
payments weighted by the time interval until the payments occur.
The denominator of the duration formula represents the discounted future cash
flows resulting from the bond, which is the present value of the bond.

where:

Ct - coupon or principal payment generated by the bond

t - time at which the payments are provided

k - bond’s yield to maturity (required rate of return)

 ● Duration of a Portfolio determines the sensitivity of their portfolio movements by insulating it from the effects of
interest rate movements.

where:
● m - number of bonds in the portfolio
● wj - bond j’s market value as a percentage of the portfolio market value
● DURj - bond j’s duration

where:
● k - prevailing yield on bonds.
● DUR - years of duration

The percentage change in a bond’s price in response to a change in yield can be expressed more directly with a simple
equation:

Where:

● %Pb - percentage change in the bond’s price

● y - change in yield

● Estimation Errors from Using Modified Duration - relying solely on modified duration to estimate the percentage
change in the price of a bond, it will tend to overestimate the price decline associated with an increase in rates
and to underestimate the price increase associated with a decrease in rates.
● Bond Convexity - estimate the percentage change in price in response to a change in yield will incorporate the
property of convexity.
Bond Investment Strategies

 Matching Strategy
Some investors build bond portfolios to match their expected expenses. Matching strategy involves estimating future
cash outflows and then developing a bond portfolio that can generate sufficient coupon or principal payments to cover
those outflows.
 Laddered Strategy
Funds are evenly allocated to bonds in each of several different maturity classes. It has many variations, but in general
this strategy achieves diversified maturities and therefore different sensitivities to interest rate risk. Nevertheless,
because most bonds are adversely affected by rising interest rates, diversification of maturities in the bond portfolio does
not eliminate interest rate risk.
 Barbell Strategy
The barbell strategy divides funds between short-term and long-term maturity bonds. Short-term bonds offer liquidity,
allowing investors to access cash quickly if needed. Long-term bonds typically provide higher yields, aiming for greater
returns. This strategy balances high returns with liquidity needs by allocating funds accordingly.
 Interest Rate Strategy
With the interest rate strategy, funds are allocated in a manner that capitalizes on interest rate forecasts. This strategy
requires frequent adjustments in the bond portfolio to reflect the prevailing interest rate forecast.

Valuation and Risk of International Bonds

- The value of an international bond represents the present value of future cash flows to be received by the bond’s
local investors.
- Factors that affect both the market price of the bond and the return on the bond to investors:
1. Risk-Free Interest Rate (Foreign Interest Rate)
2. Credit Risk
3. Exchange Rate Risk/Fluctuations

Effects or Influence of these factors

 Influence of Foreign Interest Rate Movements

As the risk-free interest rate of a currency changes, the required rate of return by investors in that country changes as
well.
A reduction in the risk-free interest rate of the foreign currency will result in a lower required rate of return by investors
who use that currency to invest, which results in a higher value of bonds denominated in that currency. (Vice Versa)
 Influence of Credit Risk
An increase in risk causes a higher required rate of return on the bond and therefore lower its present value, whereas a
reduction in risk causes a lower required rate of return of the bond and increases its present value.
 Influence of Exchange Rate Fluctuations
Changes in the value of the foreign currency denominating a bond affect the US dollar cash flows generated from the
bond and thereby affect the return to US investors who invested it.

International Bond Diversification

- When investors attempt to capitalize on investments in foreign bonds that have higher interest rates than they
can obtain locally, they may diversify their foreign bond holdings among countries to reduce their exposure to
different types of risk.
Risks

 Reduction of Interest Rate Risk

International diversification of bonds reduces the sensitivity of the overall bond portfolio to any single country’s interest
rate movement.

 Reduction of Credit Risk

Investment in bonds issued by corporations from a single country can expose investors to a relatively high degree of
credit risk. Because economic cycles differ across countries, there is less chance of systematic increase in the credit risk
of internationally diversified bonds.

 Reduction of Exchange Rate Risk

Through reduction of exchange rate risk, a small proportion of their foreign security holdings will be exposed to the
depreciation of any particular foreign currency.

 International Integration of Credit Risk

The general credit risk levels of loans among countries is correlated, because country economies are correlated.
The credit risk of the local firms increases, because the weak economy reduces their revenue, and their earnings, and
could make it difficult for them to repay their loans.

 Credit contagion
Higher credit risk in one country becomes contagious to other countries whose economies are integrated with it.