How Do We Value Bonds?
In equity valuation, analysts typically use asset-based valuation, discounted cash flow analysis or a market pricing methodology. For bonds, relative value analysis is used. What then is this method of determining bond value?
Relative value ranks and compares the market value of a corporate bond with other issues of similar duration, sector, credit ratings and/or business fundamentals by measuring its yield spread over a designated benchmark (e.g. a USD-denominated bond would use the US Treasury yield curve as a benchmark). For instance, a newly issued 5-years corporate bond priced at 6% yield when US 5-years interest rates are at 1.5% would give a credit spread of 4.5%. The greater the perceived risk of the bond, the larger the credit spread.
How do bond investors apply relative value?
Bonds can be traded on the primary and secondary markets with the secondary markets very much similar to the public equity market. There are a few ways which relative value can be applied as shown below:
Yield pick-up trades
Investors can apply relative value when it comes to yield pick-up trades. For example, a 5-year corporate bond with a BBB rating trades at 88 basis points (100 basis points = 1%) above the Treasury curve while a 5-year A-rated bond trades at 84 basis points. Disregarding the slight quality (in terms of credit ratings) difference between both bonds, an investor can sell the A-rated bond for the BBB-rated bond for a 4 basis point pick up.
Credit rating trades
Investors can attempt to identify and take positions in issues which might potentially have a future upgrade in their credit ratings. An upgrade would cause an increase in the price of the bond, tightening credit spreads. This allows capital appreciation and adds to the total return for a bond investment.
Yield-curve adjustment trades
Investors can also use relative value analysis and take a view on anticipated changes/shifts in the yield curve. If long-term interest rates are expected to fall (i.e. the long end of the curve flattens), the investor may shift into longer duration bonds to maximize the positive effect of changes in interest rates (remember, bond prices always move inversely to yield).
Value in Action
Relative value is commonly used to determine bond value in both the primary and secondary market. This simple valuation technique can be applied to various trading strategies for bond investors.
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All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie does not own any shares in the companies mentioned above.
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