7.3 Introduction to the Valuation of Fixed-Income Securities - 7.3 Introduction to the Valuation of Fixed-Income Securities

Key Concepts

• Fixed-Income Securities
• Present Value (PV)
• Yield to Maturity (YTM)
• Coupon Rate
• Market Interest Rates

Fixed-Income Securities

Fixed-Income Securities are financial instruments that provide a fixed stream of income to the holder. These include bonds, notes, and other debt instruments issued by governments, corporations, and other entities. The primary feature of these securities is the promise to pay a specified amount of interest (coupon) and return the principal at maturity.

Example: A corporate bond issued by a company promises to pay an annual coupon of 5% and return the principal amount of $1,000 at the end of 10 years. This bond is a fixed-income security because it guarantees a fixed income stream and a return of the initial investment.

Present Value (PV)

Present Value is the current worth of a future sum of money or stream of cash flows given a specified rate of return. It is a fundamental concept in finance used to determine the value of fixed-income securities. The PV of a bond is calculated by discounting its future cash flows (coupons and principal) to the present using an appropriate discount rate.

Example: If a bond pays annual coupons of $50 for 10 years and returns the principal of $1,000 at maturity, the PV is calculated by summing the present values of each coupon payment and the principal repayment. If the discount rate is 6%, the PV would be less than the face value of $1,000 because the discount rate is higher than the coupon rate.

Yield to Maturity (YTM)

Yield to Maturity is the total return anticipated on a bond if it is held until it matures. YTM is considered a long-term bond yield but is expressed as an annual rate. It takes into account the bond's current market price, its par value, coupon interest rate, and time to maturity.

Example: If a bond with a face value of $1,000 and a coupon rate of 5% is currently trading at $950, the YTM would be the discount rate that makes the present value of the bond's future cash flows equal to $950. This YTM would be higher than the coupon rate because the bond is trading at a discount.

Coupon Rate

The Coupon Rate is the annual interest rate paid on a bond, expressed as a percentage of its face value. It is the rate at which the issuer promises to pay interest to the bondholder. The coupon rate is fixed for the life of the bond and determines the periodic coupon payments.

Example: A bond with a face value of $1,000 and a coupon rate of 6% will pay annual interest of $60 ($1,000 * 6%). This $60 is the coupon payment that the bondholder will receive each year until maturity.

Market Interest Rates

Market Interest Rates are the rates at which borrowers and lenders agree to transact in the market. These rates affect the valuation of fixed-income securities because they determine the discount rate used to calculate the present value of future cash flows. When market interest rates rise, bond prices fall, and vice versa.

Example: If market interest rates increase from 5% to 7%, the price of a bond with a 5% coupon rate will decrease because new bonds are being issued at the higher rate. Investors will demand a lower price for the existing bond to compensate for its lower coupon rate relative to the new market rates.