Bond Valuation
Essentials of Corporate Finance
Chapters 4 & 6
Materials Created by Glenn Snyder – San Francisco State University
Topics

What is Fixed Income?



Portfolio Investment Objective
Credit Analysis





The primary role of a fixed income research analyst?
Credit Ratings
Fundamental Research
Buy / Sell Recommendations
Bond Trading
Career Advice for a Fixed Income Research Analyst
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
2
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
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
3
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
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
4
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
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
5
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)
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
6
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
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
7
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
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
8
Fundamental Research

Fundamental Research consists of:

Analyzing the borrower to ensure credit quality



Analyzing the security





Cash flow
Liquidity
Yield to Maturity
Yield to Call
Current Yield
Duration
Analyzing the portfolio

February 26, 2007
Diversification / Investment Restrictions
Materials Created by Glenn Snyder – San Francisco State University
9
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.
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
10
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


Call price and yield to call


Sometimes high yields indicate riskiness of the borrower
This will help determine how long to hold the bond
Duration


February 26, 2007
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
11
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



February 26, 2007
Security
Industry
Country
Materials Created by Glenn Snyder – San Francisco State University
12
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
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
13
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

February 26, 2007
Not whether the portfolio manager followed the
recommendation
Materials Created by Glenn Snyder – San Francisco State University
14
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
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
15
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
February 26, 2007
Materials Created by Glenn Snyder – San Francisco State University
16