Chapter 8

Factors That Affect the Credit (Default) Risk Premium Impact of Issuer Characteristics on the Credit Risk Premium

A bond's price can be affected by factors such as a change in capital structure.

Influence of Coupon Rate on Bond Price Sensitivity

A zero-coupon bond is most sensitive to changes in the required rate of return. The price of a bond that pays all of its yield in the form of coupon payments is less sensitive to changes in the required rate of return.

Influence of Credit Risk

An increase in risk causes a higher required rate of return on the bond and therefore lowers its present value, whereas a reduction in risk causes a lower required rate of return on the bond and increases its present value.

Factors That Affect the Risk-Free Rate Impact of Budget Deficit (DEF

An increase in the budget deficit can put upward pressure on interest rates. An increase in borrowing by the federal government can indirectly affect the required rate of return on all types of bonds.

Implications for Financial Institutions

Any factors that lead to higher interest rates tend to reduce the market values of financial institution assets and therefore reduce their valuations. Any factors that lead to lower interest rates tend to increase the market values of financial institution assets and therefore increase their valuations.

Influence of Maturity on Bond Price Sensitivity

As interest rates decrease, long-term bond prices increase by a greater degree than short-term bond prices.

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.

Bond Valuation Process

Bonds are debt obligations with long-term maturities that are commonly issued by governments or corporations to obtain long-term funds. 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.

Influence of Exchange Rate Fluctuations

Changes in the value of the foreign currency denominating a bond affect the U.S. dollar cash flows generated from the bond and the return to U.S. investors who invested in it.

Valuation of Bonds with Semiannual Payments

First, divide the annual coupon by two Second, divide the annual discount rate by two Third, double the number of years

Interest Rate Strategy

Funds are allocated in a manner that capitalizes on interest rate forecasts.

Barbell Strategy

Funds are allocated to bonds with a short term to maturity as well as to bonds with a long term to maturity.

Laddered Strategy

Funds are evenly allocated to bonds in each of several different maturity classes.

European Debt Crisis

Greece, Portugal, and Spain experienced debt crisis because of large budget deficits and inability to cover debt payments. Because these countries commonly obtained debt financing from financial institutions in other European countries, these financial problems also spread to other countries.

Relationship between Coupon Rate, Required Return, and Bond Price 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).

Relationship between Coupon Rate, Required Return, and Bond Price Discount bonds: Bonds Selling below Par

If coupon rate is below required rate, the price of the bond is below par (PV < 1,000).

Relationship between Coupon Rate, Required Return, and Bond Price 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).

Factors That Affect the Risk-Free Rate Impact of Inflationary Expectations (INF)

If the level of inflation is expected to increase (decrease), there will be upward (downward) pressure on interest rates and hence on the required rate of return on bonds.

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.

International Bond Diversification

May diversify foreign bond holdings among countries to reduce their exposure to different types of risk. Reduction of Interest Rate Risk Reduction of Credit Risk Reduction of Exchange Rate Risk International Integration of Credit Risk — When one country experiences weak economic conditions, its consumers in other countries are also affected.

Current Price of a Bond (PV)

PV= C/(1+k)^1 + C/(1+K)^2 +..... C = coupon payment paid in each period par = par value k = req rate of return n = number of period to maturity

Factors That Affect the Risk-Free Rate Impact of Economic Growth (ECON)

Strong economic growth tends to generate upward pressure on interest rates, while weak economic conditions put downward pressure on rates.

Factors That Affect the Credit (Default) Risk Premium Impact of Debt Maturity on the Credit Risk Premium

Tends to be larger for bonds that have a longer term to maturity (more time available for company default conditions to change).

Impact of the Discount Rate on Bond Valuation

The appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with similar risk and maturities. High risk securities have higher discount rates.

Summary of Factors Affecting Bond Prices

The effect of economic growth is uncertain: A high level of economic growth can adversely affect bond prices by raising the risk-free rate, but it can favorably affect bond prices by lowering the default risk premium. Any new information about a firm that changes its perceived ability to repay its bonds could have an immediate effect on the price of the bonds.

Factors That Affect the Credit (Default) Risk Premium

The general level of credit risk on bonds can change in response to a change in economic growth. -Strong economic growth can improve a firm's cash flows and reduce the probability of default. -Weak economic conditions tend to reduce a firm's cash flows and increase the probability of default.

Factors That Affect the Risk-Free Rate Impact of Money Supply Growth (MS)

The increased money supply may result in an increased supply of loanable funds. If demand for loanable funds is not affected, the increased money supply should place downward pressure on interest rates, causing bond portfolio managers to expect an increase in bond prices and thus to purchase bonds based on such expectations. In a high-inflation environment, bond portfolio managers may expect a large increase in the demand for loanable, which would cause an increase in interest rates and lower bond prices.

Bond Price Movements

The required return on a bond is determined primarily by the prevailing risk-free rate Rf and the risk premium RP. An increase in the risk-free rate raises the required return on all bonds, including risky bonds

Bond Price Elasticity

The sensitivity of bond prices (Pb) to changes in the required rate of return (k).

Impact of the Timing of Payments on Bond Valuation

Timing affects the market price of a bond. Funds received sooner can be reinvested to earn additional returns.

Factors That Affect the Credit (Default) Risk Premium Changes in Credit Risk Premium over Time

Yields among securities are highly correlated. Difference between the corporate and Treasury bond yields widened during periods when the economy was weak.

Duration

a measurement of the life of the bond on a present value basis. The longer a bond's duration, the greater its sensitivity to interest rate changes

Systemic risk

the potential collapse of the entire market or financial system.

Duration of a Portfolio

the weighted average of bond durations weighted according to relative market value.