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Bond Analysis and Valuation Corporate Bonds-They Are More Complex than You Think When John Sullivan was hired as chief investment strategist at the New York headquarters of A. M. Smith Inc., he had indicated that one of his main goals would be to significantly expand the fixed-income unit of the firm's overall investment portfolio. A.M. Smith. Incorporated, a prestigious investment services firm, had branches in 28 major metropolitan cities across the United States, as well as a few overseas branches in the United Kingdom, Canada, Singapore, and Australia. The size and performance of its equity portfolio ranked it in the top 10% of all investment companies worldwide, largely due to its excellent customer relations, research staff and client support services. However, with the recent, prolonged drop in interest rates, a constant surge in fixed-income underwriting deals seemed to be circling around the firm's radar. John realized that the firm's client base, although pretty knowledgeable about equity investing, would need to be adequately informed, trained, and educated about the finer nuances of fixed-income investing if he stood any chance of attaining his goal. So, he hired Jill Dougherty, who had worked for a bond trading firm for almost 10 years, prior to going back to Wharton Tull-time to earn her MBA degree this past year. She also managed to pick up her CFA designation along the way. ohn told Jill that her first major assignment would be to conduct edu- walional seminars/workshops for current and prospective clients regarding the basic and advanced aspects of fixed income investing. Complex than You Think 26 Case 9 Corporate Bonds-They Are More Complex Case 9 Questions: 55+ age group, Villy these workshop rings potential ho, as he brows information of the to indoctrina with these bond ibility, duration, con utility bond deal 1. "W oft Ho surely go along With about 75% of our clients being in the 55+ ape should have no problem in signing these folks up for these and convincing them about the stability and earnings ciated with corporate bond investing." stressed John, as through the spreadsheel containing the contact inform firm's wealthiest investors. "You would, however, have to in them about the various terms and features associated with the such as yield to maturity, call provisions, convertibility, durat vexity, and the like," he added. "With the $55-million utility be hanging in the balance, any help we can give our best clients in standing the relative investment merits of this deal will surely po way in generating a ton of fixed-income business for the firm, der you think?" queried John. "You bet!" replied Jill, as she contemplate John's statements. "I'll get right to work on these workshops, John You and I both know that these corporate bond investments are more complex than you think!" Jill immediately started preparing for the fixed-income investing workshops by surveying a sample of the firm's best clients regarding their grasp of key bond terms, features, and characteristics. She was surprised to learn how little these successful clients knew about the technical aspects of fixed-income investing, and how eager, motivated. and interested they were to know more about the opportunities offered by bond investing. Jill knew that she would have a good turnout at the seminar. She referred back to her investment analysis textbook to dig out some definitions and examples that she could use in her Power Point presentation. She downloaded current data for outstanding bonds of various maturities, ratings, and coupon rates (see Table 1) and started preparing her slides. 6. Table 1 Corporate Bond Information Face Coupon Rate Rating Quoted Price Unta Maturity Sinking Fund 6 Fund Period ABC Energy $1.000 ABC Energy $1.000 TransPower $1000 Telco U s $1.000 Yes 3 Years 10 AAA $809.10 521164 AM $1025.00 AA $1300.00 Yes 20 20 20 30 Yes a 5 Years 5 Years Case 9 Corporate Bonds-They Are More Complex than You Think 37 1. you hops. Questions: 1. "Why is there so much variation in the coupon rates and prices of these various bonds?" asks one of Jill's wealthiest clients. How should Jill respond? asso- -wsed the inate onds, con- deal der- ong on't ated hn. ore 2. "How are corporate bond ratings determined asks another client, "And how and why do these ratings change once they are arrived at?" What should Jill say? 3. During the presentation, one client is confused about the fact that some of these bonds sell for less than their face value, while others sell at a premium. She asks whether the cheaper bonds are a bargain. How should Jill go about clearing up her confusion? ing 4. During the survey stage, a majority of the firm's clients had no idea about yield to maturity. Using the example of the bonds listed in Table 1. explain what this term means and how one can go about calculating it. be 5. During the slideshow, Jill often made reference to a corporate bond's nominal yield and its effective yield, confusing some cli- ents about the definition and interpretation of each term. How should Jane explain the difference between nominal and effec- tive yield to maturity for each bond listed in Table 1? Which one should the investor use when deciding between corporate bonds and other securities of similar risk? Please explain. 6. Jill knows that the call period and its implications will be of particular concern to the audience. How should she go about explaining the effects of the call provision on bond risk and return potential? 7. How should Jill go about explaining the riskiness of each bond? Rank the bonds in terms of their relative riskiness. 8. One of Jill's best clients poses the following question: "If I buy 10 of each of these bonds, reinvest any coupons received at the rate of 6% per year, and hold them until they mature, what will my realized return be on each bond investment? How should Jill go about demonstrating the solution to this question? Bond Analysis and Valuation Corporate Bonds-They Are More Complex than You Think When John Sullivan was hired as chief investment strategist at the New York headquarters of A. M. Smith Inc., he had indicated that one of his main goals would be to significantly expand the fixed-income unit of the firm's overall investment portfolio. A.M. Smith. Incorporated, a prestigious investment services firm, had branches in 28 major metropolitan cities across the United States, as well as a few overseas branches in the United Kingdom, Canada, Singapore, and Australia. The size and performance of its equity portfolio ranked it in the top 10% of all investment companies worldwide, largely due to its excellent customer relations, research staff and client support services. However, with the recent, prolonged drop in interest rates, a constant surge in fixed-income underwriting deals seemed to be circling around the firm's radar. John realized that the firm's client base, although pretty knowledgeable about equity investing, would need to be adequately informed, trained, and educated about the finer nuances of fixed-income investing if he stood any chance of attaining his goal. So, he hired Jill Dougherty, who had worked for a bond trading firm for almost 10 years, prior to going back to Wharton Tull-time to earn her MBA degree this past year. She also managed to pick up her CFA designation along the way. ohn told Jill that her first major assignment would be to conduct edu- walional seminars/workshops for current and prospective clients regarding the basic and advanced aspects of fixed income investing. Complex than You Think 26 Case 9 Corporate Bonds-They Are More Complex Case 9 Questions: 55+ age group, Villy these workshop rings potential ho, as he brows information of the to indoctrina with these bond ibility, duration, con utility bond deal 1. "W oft Ho surely go along With about 75% of our clients being in the 55+ ape should have no problem in signing these folks up for these and convincing them about the stability and earnings ciated with corporate bond investing." stressed John, as through the spreadsheel containing the contact inform firm's wealthiest investors. "You would, however, have to in them about the various terms and features associated with the such as yield to maturity, call provisions, convertibility, durat vexity, and the like," he added. "With the $55-million utility be hanging in the balance, any help we can give our best clients in standing the relative investment merits of this deal will surely po way in generating a ton of fixed-income business for the firm, der you think?" queried John. "You bet!" replied Jill, as she contemplate John's statements. "I'll get right to work on these workshops, John You and I both know that these corporate bond investments are more complex than you think!" Jill immediately started preparing for the fixed-income investing workshops by surveying a sample of the firm's best clients regarding their grasp of key bond terms, features, and characteristics. She was surprised to learn how little these successful clients knew about the technical aspects of fixed-income investing, and how eager, motivated. and interested they were to know more about the opportunities offered by bond investing. Jill knew that she would have a good turnout at the seminar. She referred back to her investment analysis textbook to dig out some definitions and examples that she could use in her Power Point presentation. She downloaded current data for outstanding bonds of various maturities, ratings, and coupon rates (see Table 1) and started preparing her slides. 6. Table 1 Corporate Bond Information Face Coupon Rate Rating Quoted Price Unta Maturity Sinking Fund 6 Fund Period ABC Energy $1.000 ABC Energy $1.000 TransPower $1000 Telco U s $1.000 Yes 3 Years 10 AAA $809.10 521164 AM $1025.00 AA $1300.00 Yes 20 20 20 30 Yes a 5 Years 5 Years Case 9 Corporate Bonds-They Are More Complex than You Think 37 1. you hops. Questions: 1. "Why is there so much variation in the coupon rates and prices of these various bonds?" asks one of Jill's wealthiest clients. How should Jill respond? asso- -wsed the inate onds, con- deal der- ong on't ated hn. ore 2. "How are corporate bond ratings determined asks another client, "And how and why do these ratings change once they are arrived at?" What should Jill say? 3. During the presentation, one client is confused about the fact that some of these bonds sell for less than their face value, while others sell at a premium. She asks whether the cheaper bonds are a bargain. How should Jill go about clearing up her confusion? ing 4. During the survey stage, a majority of the firm's clients had no idea about yield to maturity. Using the example of the bonds listed in Table 1. explain what this term means and how one can go about calculating it. be 5. During the slideshow, Jill often made reference to a corporate bond's nominal yield and its effective yield, confusing some cli- ents about the definition and interpretation of each term. How should Jane explain the difference between nominal and effec- tive yield to maturity for each bond listed in Table 1? Which one should the investor use when deciding between corporate bonds and other securities of similar risk? Please explain. 6. Jill knows that the call period and its implications will be of particular concern to the audience. How should she go about explaining the effects of the call provision on bond risk and return potential? 7. How should Jill go about explaining the riskiness of each bond? Rank the bonds in terms of their relative riskiness. 8. One of Jill's best clients poses the following question: "If I buy 10 of each of these bonds, reinvest any coupons received at the rate of 6% per year, and hold them until they mature, what will my realized return be on each bond investment? How should Jill go about demonstrating the solution to this
