Dec 8, 2014 Investment Education: Bond Valuation (Excerpt Chapter 9)
Stocks, as we saw in an earlier chapter, and will see again in later chapters, are valued primarily by looking at the stock’s price as a multiple of earnings, cash flow, or something similar. Bonds, by contrast, are primarily valued by comparing the yield of the bond in question to the yields of other bonds with similar characteristics. A bond’s creditworthiness, the likelihood that its interest payments and principal repayments will be made on schedule, is also an important part of bond valuation. But even for risky bonds, the yields can and will be measured against other bonds with similar risk levels.
When comparing the yield of a bond to other bonds, we talk about the yield “spread”. The spread is the yield difference between the bond in question and another bond or group of bonds. Learning to think in terms of bond yield spreads is something new for many investors. In chapter 9 we discuss yield spreads, and the all important” yield curve”. Whole books could be, and have been, written about yield curves and spreads, but the material covered here should be sufficient for readers to learn to think this way about bonds, and to be able to have informed discussions about specific bonds and the bond market in general.
Prior to discussing yield spreads in Chapter 9, there is a section entitled “How Bond Yields Change”. Once you have read it, it may seem pretty obvious, but for investors new to bonds, this section answers basic questions I frequently hear from investors new to bonds. Having covered these basics, we can move on and answer such questions as: Which bonds will suffer a bigger price decline if prevailing interest rates move up by a specified amount. As in Chapter 8, our discussion is non-mathematical, but we think it is adequate to enable readers to understand the concepts of bond valuation.
Here are two excerpts from Chapter 9: From page 133:
The Yield Curve
Bond investors use yield – most commonly yield to maturity (YTM) – as the primary measure of comparison when evaluating a bond or comparing the investment attractiveness of different bonds. Sometimes other measures of yield, which we will see in Chapter 10, are more appropriate, but even these can be viewed as versions of yield to maturity. Comparing yields on different kinds of bonds (U.S. Treasury bonds, corporate industrials, corporate utilities, etc), or comparing yields on similar bonds but with different maturities, coupons, or other features, can reveal information about whether a given bond is over- or under-valued relative to other bonds. The study of yield comparisons begins with understanding the yield curve. There are many yield curves, as we will see, but the starting point for any yield comparison is the yield curve for United States Treasury bonds (U.S.T. bonds).
From page 138:
The Importance of the Yield Curve
The U.S.T. yield curve is so fundamental to bond investments that investors simply refer to it as “the curve”. When you hear someone say a bond issue is trading “80 over the curve”, it means that the issue being discussed is trading at a yield to maturity that is 80 basis points (0.8 percentage points) higher than the YTM of a U.S. Treasury issue with the same number of years to maturity.
The U.S. Treasury yield curve is both a cause of, and is affected by, economic activity in the United States and to some extent the whole world. Investors’ decisions to buy, sell, or hold short term or long term U.S.T. bonds impacts the shape of the yield curve. Investors expecting an increase in inflation will not want to hold long term bonds (10-30 years), because in an inflationary period, the $1,000 face amount of a bond that will be received at maturity will be worth a lot less if inflation has caused the prices of goods to move up since the bond was originally purchased. Thus those investors expecting an increase in inflation will sell their long term U.S.T. bonds, pushing the price down to the point where the yield has increased enough that other investors feel that the yield is high enough to compensate them for the risk of the inflationary loss of purchasing power at maturity.
Changes in the yield curve can provide bond investors with important insights that can be used to determine which bonds to include in their portfolios. For stock investors, the yield curve can be used as part of the macroeconomic analysis to help forecast changes in the economic outlook, which of course, directly impacts most company’s sales and earnings, and therefore their stock prices.
In Chapter 9, we show graphs of yield curves as part of our explanations. This should help readers fully grasp the important points of this chapter.
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