Fixed Income Investments - Cash Flow
Bonds With Difficult Expected Cash Flow Estimation
The bonds for which it is difficult to estimate expected cash flows fall into three categories:
- Bonds for which the issuer or investor has an option or right to change the contract due date for the payment of the principal. These include callable bonds, puttable bonds, MBSs and ABSs.
- Bonds for which coupon payment rate is reset occasionally based on a formula with values that change, such as reference rates, prices or exchange rates. A floating-rate bond would be an example of this type of category.
- Bonds for which investor has the option to convert or exchange the security for common stock.
The problems when estimating the cash flows of these types of bonds include:
- In the case of bonds for which the issuer or investor has the option/right to change the contract due date for the payment of principal, the bonds can be affect by future interest rates. If rates decline, a corporation may issue new bonds at a lower cost and call the older bonds. The same thing happens with MBSs and ABSs. As rates decline, borrowers have the right to refinance their loans at cheaper rates. This causes the bond to be paid off earlier than the stated maturity date.
- When rates increase, a puttable bond will be sold back to the issuing corporation at the put price once the increase in rates drives the price of the security below the put price.
- For bonds in which the coupon payment rate is reset occasionally based on a formula with changing values, because the rate is always changing based on other variables it is hard to estimate the cash flows. Also, for bonds that give the investor the option to convert or exchange the security for common stock, the cash flows will stop altogether once the investor decides that it would be more profitable to exchange the fixed income security for equity. The investor will have no certain idea as to when this may occur, making it difficult to value the cash flows until the maturity of the bond.
- Because the value of the bond rests on the performance of the securities that back the bond, it is hard to determine whether the bonds may be converted into those securities.
Determining Appropriate Interest Rates
The minimum interest rate that an investor should accept is the yield that is available in the market place for a risk-free bond, or the Treasury market for a
For non-treasury bonds such as corporate bonds, the rate or yield that would be required would be the on-the-run government security plus a premium that takes up the additional risks that come with non-treasury bonds.
As for the maturity, an investor could just use the final maturity date of the issue compared to the Treasury security. However, because each cash flow is unique in its timing, it would be better to use the maturity that matches each of the individual cash flows.
Computing a Bond's Value
First of all, we need to find the present value (PV) of the future cash flows in order to value the bond. The present value is the amount that would be needed to be invested today to generate that future cash flow. PV is dependent on the timing of the cash flow and the interest rate used to calculate the present value. To figure out the value the PV of each individual cash flow must be found. Then, just add the figures together to determine the bonds price.
|PV at time T = expected cash flows in period T / (1 + I) to the T power|
After you develop the expected cash flows, you will need to add the individual cash flows:
|Value = present value @ T1 + present value @ T2 + present value @Tn|
Let's throw some numbers around to further illustrate this concept.
Example: The Value of a Bond
Bond GHJ matures in five years with a coupon rate of 7% and a maturity value of $1,000. For simplicity's sake, the bond pays annually and the discount rate is 5%.
The cash flow for each of the years is:
Year one = $70 Year Two = $70 Year Three = $70, Year Four is $70 and Year Five is $1,070.
PV of the cash flows is: Year one = 70 / (1.05) to the 1st power = $66.67
Year two = 70 / (1.05) to the 2nd power = $ 63.49
Year three = 70 / (1.05) to the 3rd power = $ 60.47
Year four = 70 / (1.05) to the 4th power = $ 57.59
Year five = 1070 / (1.05) to the 5th power = $ 838.37
Now to find the value of the bond:
Value = 66.67 + 63.49 + 60.47 + 57.59 + 838.37
Value = 1, 086.59
Bonds & Fixed IncomeGet to know the relationships that determine a bond's price and its payout.
Bonds & Fixed IncomeTo determine the value of a bond today - for a fixed principal (par value) to be repaid in the future at any predetermined time - we can use an Excel spreadsheet.
Bonds & Fixed IncomeA guide to help to understand the simple math behind fixed-coupon corporate bonds.
Bonds & Fixed IncomeLearn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
Bonds & Fixed IncomeFind out which bonds you should be investing in and when you should be buying them.
Home & AutoBond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
Options & FuturesWe break down the stodgy stereotype to see what these investments can do for you.
Bonds & Fixed IncomeUnderstanding bond prices and yields can help any investor in any market.
InvestingMost of us have borrowed money at some point in our lives, and just as people need money, so do companies and governments. Companies need funds to expand into new markets, while governments need ...
Mutual Funds & ETFsIt is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
A debt investment in which an investor loans money to an entity ...
A technique for determining the fair value of a particular bond. ...
A bond that is issued for less than its par (or face) value, ...
The amount by which the market price of a bond is lower than ...
The remaining life of a financial instrument. In bonds, it is ...
A long-term debt security that includes an option to lengthen ...
Learn about factors that influence the price of a bond, such as interest rate changes, credit rating, yield and overall market ... Read Answer >>
Learn more about some of the factors that influence the valuation of bonds on the open market, and why bond prices and yields ... Read Answer >>
Read about bond valuation, particularly the differences between how a traditional bond is valued and how a convertible bond ... Read Answer >>
Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate ... Read Answer >>
Discover how bonds are traded as investment securities and understand the various terms used in bond trading, including par ... Read Answer >>
Learn about the main factors that impact the price of fixed income securities, and understand the various types of risk associated ... Read Answer >>