Level I Review | Valuation of Debt Securities

Study session 16 in the Level I CFA Program curriculum concludes the topic area with three more readings in fixed income (56-59) covering analysis and valuation.
Introduction to Valuation of Debt Securities
Conceptually, there is little here that you haven’t seen in the equities section. The value of any financial asset is just the present value of expected cash flows. The cash flow function and the Present Value function on your calculator can do most of the work for you but you need to understand the concept and the ‘why’. *Important: Always remember that most bond problems will be semiannual coupons so you need to double the years and divide the rate and the payment by two for your PV calculator work.
The relationship between the coupon rate, discount rate (i.e. current rates in the market) and the price (relative to par) is an important note and will come back throughout the other two exams.

  • If the coupon rate is above the current rate for similar instruments in the market, the bond will be priced higher than par. If you can get a higher rate, you would expect to pay more than the face value.
  • If the coupon rate is less than the current rate in the market, the bond will be priced at a discount. You wouldn’t pay face value for something to get less than offered in the market.

Understand the process behind the binomial model and Monte Carlo simulation for valuation, as well as advantages/limitations but you really do not need to know much more than a conceptual basis just yet.
Yield Measures, Spot Rates, and Forward Rates
Don’t confuse the current yield with the coupon rate. The current yield is the coupon divided by the bond price, the actual yield given the price. The coupon rate is the coupon divided by par, the stated yield.
Understand Yield to Maturity and that it is only realized if the bond is held and under the assumption of reinvestment. If the security is sold earlier than maturity, the investor faces interest rate risk.
Understand how to work through a bond equivalent yield problem and converting it to an annual-pay YTM. The conceptual material on yield-to-call and yield-to-put is important. Understand the assumptions and what it means for an investor holding the debt. The calculations are fairly basic and can be done on the PV function.
Introduction to the Measurement of Interest Rate Risk
Understand both the full valuation and duration/convexity approach with a focus on advantages/disadvantages to each. The full valuation approach is appropriate for a parallel and non-parallel change in the yield curve but is very time consuming with a large portfolio. The duration/convexity approach is simpler but is not appropriate for non-parallel shifts in the yield curve.
The concept behind options is very important, especially call options and negative convexity. Understand the difference between  the price of a security at high or low rates when there is a call or put option. You’ll see this again on the Level 2 exam so learn it now.
Duration is another topic that I could just copy/paste from the Level 2 notes. You need to understand the concept and the formula. Start with the standard formula before you worry about modified duration or the Macaulay formula.
Fundamentals of Credit Analysis
The reading is like a 101 on credit analysis and good for your general knowledge of the industry. There are a few important concepts but they are all overall general concepts.
Understand the forms of credit risk:

  • Spread risk is the loss of value from an increase in yield spread over other bonds due to the perceived increase in default risk of the issuer, notice it is from the perception of risk but not necessarily an actual downgrade
  • Downgrade risk is the loss when an issuer is downgraded by an agency due to creditworthiness
  • Market liquidity risk is the loss due to lack of sufficient participation to buy/sell the bonds in the quantity desired

Understand the difference between equity and credit analysis, and the four Cs of Credit

  • Capacity is the ability of the borrower to meet debt obligations
  • Collateral is the quality and value of the assets supporting the debt
  • Covenants are the terms and conditions in a bond agreement
  • Character is the quality of management and willingness to satisfy debt obligations

The different ratios and ratio analysis in the reading are extremely important but reviewed in other sections. You can address them here or in the other sections, but you must know them.
Know the difference between affirmative covenants (obligations the company must hold like paying interest, taxes and submitting audited statements) and negative covenants (limitations on the company like debt ratios and the amount of cash that can be paid out to equity holders).
Study session 17 in the Level I CFA Program curriculum consists of six readings covering derivatives. The material is still fairly conceptual but is pretty lengthy.
‘til next time, happy studyin’
Joseph Hogue, CFA

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