Bond Valuation

1. Bond Valuation Essentials of Corporate Finance Chapters 4 & 6 Materials Created by Glenn Snyder – San Francisco State University

2. Topics • What is Fixed Income? • The primary role of a fixed income research analyst? • Portfolio Investment Objective • Credit Analysis • Credit Ratings • Fundamental Research • Buy / Sell Recommendations • Bond Trading • Career Advice for a Fixed Income Research Analyst Materials Created by Glenn Snyder – San Francisco State University

3. What is Fixed Income? • Fixed Income is an investment that has an up-front capital investment and pays interest on a regular basis • Fixed Income can be in many forms: • Bonds • Other forms of Debt (loans, commercial paper) • Annuities (insurance, winning the lottery) • Preferred Stock Materials Created by Glenn Snyder – San Francisco State University

4. The Primary Role of a Fixed Income Analyst • A Fixed Income Analyst researches fixed income financial instruments to make a buy or sell recommendation for a portfolio • Common financial instruments: • Bonds • Certificates of Deposit • Money Markets • Loans • GNMAs Materials Created by Glenn Snyder – San Francisco State University

5. The Primary Role of a Fixed Income Analyst • Fixed Income analysts typically work on portfolio investment vehicles such as: • Mutual Funds • Pension Funds • Hedge Funds • Their objectives is to maximize either • The income received from the investments • The capital appreciation from the investments Materials Created by Glenn Snyder – San Francisco State University

6. Portfolio Investment Objectives • An investment objective identifies the type and discipline of the investments in the portfolio • This will also provide the analyst with the pool of securities to analyze • Examples of Investment Objectives • International Bonds (invests in international government bonds) • Municipal Bonds (invests in tax-free state and local bonds) • Floating Rate Debt (invests in variable interest rate loans) • Investment Grade Bonds (invests in bonds rated BBB or higher) • High Yield Bonds (invests in bonds rated BB and lower) Materials Created by Glenn Snyder – San Francisco State University

7. Credit Analysis • Bonds and loans are forms of credit • Credit Analysis consists of: • Credit Ratings • Ability to have the funds paid back • Ability to make interest payments • Liquidity of the instrument • Liquidity of the market Materials Created by Glenn Snyder – San Francisco State University

8. Credit Ratings • Credit Ratings are measures of overall credit quality provided by an independent rating service • Standard & Poors • Moodys • Bond Ratings • AAA – Highest Credit Quality • BBB – Lowest Investment Grade Rating • BB – Highest Junk Bond or High Yield Rating • C – Bonds that pay no interest • D – Default Materials Created by Glenn Snyder – San Francisco State University

9. Fundamental Research • Fundamental Research consists of: • Analyzing the borrower to ensure credit quality • Cash flow • Liquidity • Analyzing the security • Yield to Maturity • Yield to Call • Current Yield • Duration • Analyzing the portfolio • Diversification / Investment Restrictions Materials Created by Glenn Snyder – San Francisco State University

10. Fundamental Research – Borrower’s Credit Quality • Just as a banker would analyze a loan, a fixed income research analyst would analyze the borrower for credit quality. • Financial Statement Analysis • Cash Flow Analysis • Industry Analysis • Analysis on the bond market (including liquidity) • International bond markets may not be as liquid as the U.S. Materials Created by Glenn Snyder – San Francisco State University

11. Fundamental Research – Analyzing the Security • The fixed income analyst wants to maximize their overall return on the portfolio, while minimizing the risk • High yields will produce higher income • Sometimes high yields indicate riskiness of the borrower • Call price and yield to call • This will help determine how long to hold the bond • Duration • The weighted average maturity of a bond’s cash flows • The longer the duration, the greater the risk Materials Created by Glenn Snyder – San Francisco State University

12. Fundamental Research – Analyzing the Portfolio • A strong portfolio will be well balanced • Diversified by maturity, yield, credit quality, and risk • Mutual Funds & Pension Funds have investment restrictions • How much of the portfolio can be invested in a • Security • Industry • Country Materials Created by Glenn Snyder – San Francisco State University

13. Buy / Sell Recommendations • Once the analysis is done, the fixed income analyst will present his/her findings to the portfolio manager along with a buy or sell recommendation • The Buy / Sell recommendation tells the portfolio manager to add, hold, or drop the security from the portfolio • It can also be to increase or decrease the current weighting in the portfolio Materials Created by Glenn Snyder – San Francisco State University

14. Buy / Sell Recommendations • In many cases, the portfolio manager will question and analyze the fixed income analyst’s recommendation • The portfolio manager is not obligated to follow the recommendation • The analyst will be evaluated based on the quality of his/her recommendations • Not whether the portfolio manager followed the recommendation Materials Created by Glenn Snyder – San Francisco State University

15. Bond Trading • Bond trading is often more negotiation than placing orders • Large bond fund managers can negotiate the price of a bond down if buying large quantities • Due to the negotiation, many fixed income analysts are also traders and portfolio managers • Bonds are typically traded through a broker / dealer Materials Created by Glenn Snyder – San Francisco State University

16. Career Advice for a Fixed Income Analyst • Build financial analysis skills • Analyzing financial statements • Credit and liquidity analysis • Creating projection models • Large firm vs. small firm • A large firm will provide more training and a greater degree of specialization • At a small firm, the analyst will be integrated into the entire process (research, portfolio management, trading) • A large firm may provide for greater career mobility (switching firms), as name and reputation carry a heavy weight Materials Created by Glenn Snyder – San Francisco State University