Cliff Ang, VP at Compass Lexecon, introduces bond valuation fundamentals: the five core attributes of a bond (issuer, principal, coupon rate, maturity, embedded options), and the difference between bond price (what you pay) and bond value (what you think it's worth). He explains why frequently traded bonds trade near their true value, while illiquid bonds create pricing challenges.
Chapters
Welcome to this course on bond valuation and analysis in R. My name is Cliff Ang. I am Vice President at Compass Lexicon, an economic consulting firm. I advise clients on a variety of financial issues such as valuation and corporate finance. I'm also the author of Analyzing Financial Data and Implementing Financial Models Using R. My book serves as a reference and I encourage everyone to check it out for additional material. In this course, we focus on the simplest but most common of the group of fixed income a bond. A bond is a debt instrument that requires the issuer to repay the lender the amount he or she borrows plus interest over a specified period of time. Using bonds allow us to learn the fundamental concepts of bond valuation and analysis without the unnecessary complications that arise when using more complex fixed income securities. Each bond has some basic characteristics that define it. We now describe some of these main characteristics. Each bond has an issuer. This is the entity that borrows the money. Some examples are corporations, governments, or municipalities. The amount borrowed is called the principal. The principal is also called the par value or face value of the bond. The amount of interest paid is denoted by the coupon rate. Coupon rates can be paid out at different frequencies, such as annually, semi, annually, or quarterly. Coupons can be fixed for the life of the bond or the they can be floating, meaning they change at each payment period. Most bonds have a maturity date. This is when the bond ceases to become outstanding and the principal is paid back. However, some bonds don't mature. An example are Consol bonds issued by the British government. Finally, some bonds also have embedded options. These are features that change the cash flow profile of a bond so such as cutting short the maturity of the bond. An example of this is a callable bond where the issuer can buy back the bond from the investor earlier than the original maturity date. Bonds with embedded options generally require more complex analyses and are beyond the scope of this course. To focus on the fundamental concepts of bond valuation and analysis, we will conduct analysis on a simple yet realistic bond. For the duration of this course, we will use bonds that pay fixed annual coupons. Our bond will also have a fixed maturity date with no embedded options. In this course, we will use the terms bond price and bond value interchangeably. However, you should be aware that there is a difference between these two terms. The price of a bond is the amount you pay to buy the bond. The value of a bond is how much you think the bond is worth. Why is this important? Suppose a buyer believes a bond is worth $105, while the seller believes that same bond is worth $95. The two may trade when the price of the bond is $100. This is because the buyer will pay $100 for something he thinks is worth 105, and the seller will accept the 100 because she thinks the bond is only worth 95. As this example shows, the value of a bond is different for different sellers and different buyers. But if the bond trades frequently, the price of the bond could be considered an average price that eliminates buyer and seller specific valuation differences. So for actively traded bonds, price may be considered the best estimate of the bond's value. However, because many bonds are infrequently traded, the odds are against you in finding such a bond. Okay, that was a lot of material. Now let's practice.
