In this report, we will discuss some of the concepts relating to bond valuation and will also compare the interest rate risk and reinvestment along with some of the measures to manage them. We are sure that by the end of this brief report, we will be having a good understanding relating to valuation of fixed income securities and risks associated with them.
Referring to the calculations in excel spreadsheet, we find that the present value of the bond is $852.73. In addition, since a 6.5% bond is trading at Yield to Maturity of 8%, it is trading at discount.
Referring to the calculations in the excel spreadsheet, we find that on the change of mode of payment from annual to semi-annual basis, the value of the bond declines to $851.55
Referring to our calculations in excel spreadsheet, we found that on account of decline in the yield rate to 5%, the price of the bond increased to $1186.93. This indicates negative relationship between price of the bond and interest rates. In other words, when the interest rate falls, the price of the bond increases as the existing bonds with higher interest rate will turn attractive to the investors. Important to note, at times when interest rate falls, existing bond-holders benefit from the situation.
Current Yield= Annual Cash Flows/ Current Market Price
Referring to the our calculation in the excel spreadsheet, we found the annual coupon payment to be $128.50. Hence, considering the current market price of $1125, the current yield of the bond will be:
Interest rate risk
Interest Rate Risk refers to the effect of changes in the prevailing market rate of interest on bond values. When interest rates rises, bond value will fall. This is the source of interest rate risk that is approximated by a measure called duration that refers to percentage change in the bond price in response to 1% change in the interest rates.
Duration= -[percentage change in the bond price/yield change in percent]
Re-investment risk refers to the fact that when market rates falls, the cash flows(both principal and interest payments) from the fixed income securities has to be re-invested at lower rates reducing the returns an investor will earn.
Comparing Interest Rate Risk and Reinvestment Risk
Important to note, interest rate risk is related to losing value of the fixed income security because of changes in the interest rates over time. The change in value is measured using duration. On the other hand, reinvestment risk is all about risk related to the income the portfolio produces. This is related to call risk and prepayment risk. In both of these cases(call risk or prepayment risk), it is the reinvestment of principal cash flows at lower rates than were expected that negatively impacts the investor. Coupon bonds that contain neither call nor prepayment risk provisions will also be subjected to re-investment risk as the coupon payments must be reinvested as they are received.
Managing interest rate risk
Below are some of the ways through which interest rate risk could be managed:
i)Entering into forward agreement:
A forward contract is one of the most basic tool for measuring interest rate risk. Under this contract, the party interest in hedging its interest rate risk agrees to take fixed interest rate on a specified future date in lieu of making payments based on floating interest rates to the other counterparty. Important to note, at the end of contract only gain/loss is settled and is paid in cash.
Interest Rate Management Options are the option contracts primarily used to hedge the floating interest rate associated with mortgages and other securities. Under this form of interest rate risk management technique, to strategies are used:
- i)Grouping of interest rates calls referred to as interest rate cap.
- ii)Grouping of interest rate puts referred to as an interest rate floor.
Managing Re-investment Risk
The best source of managing reinvestment risk is to invest in long-term bonds funds that are known to diversify reinvestment risk much better than a position of just few bonds. Important to note, bond funds hold large bond positions of varying positions and allows the interest payments to be distributed directly to the fund investors or be automatically reinvested.
Current Yield. (n.d.). Retrieved November 2, 2014, from Investopedia: http://www.investopedia.com/terms/c/currentyield.asp
Eugene Brigham, M. E. Fixed Income Securities. In M. E. Eugene Brigham, Financial Management: Theory and Practice (p. 220).
Simon, H. (n.d.). Managing Interest Rate Risk. Retrieved November 2, 2014, from Investopedia: http://www.investopedia.com/articles/optioninvestor/08/manage-interest-rate-risk.asp