The A.M. Smith Inc. company had achieved success with regard to client relation and client support. However, for the company to offer efficient services to its clients, a lot needed to be done so that the clients could effectively understand all the dynamics of the financial markets so that they could make viable decisions, especially when it comes to fixed income investments. According to Mayo (2011), all investments are made because the investor anticipates returns. The company should therefore discuss, together with the clients, various Investment elements such as the availability of sinking funds and the use of such funds to cushion corporate bond clients consumers so that the consumer confidence of the clients could be improved.
Situation Analysis for Bond analysis and valuation
Most of the clients of AM Smith Inc are above fifty five years old. Such clients have significant experience with respect to investing in bonds. However, most of them are not much conversant with various incentives such as sinking funds that are available in financial investments. Jill, as the investment analyst for the AM Smith Company must find efficient ways of improving client knowledge on such services which are available to them.
ANALYSIS
How should Jill go about explaining the relationship between coupon rates and bond prices? Why do the coupon rates for the various bonds vary so much?
Jill should clearly demonstrate to the clients the existing relationship between coupon rates and prices of bonds using comprehensive illustrations and practical examples. For instance, he should exhaustively describe the meaning of bond prices, which refers to the financial value of the bond when it matures. When the market return for a bond changes, the bonds price changes in the opposite direction (Smart et al, 2008).On the other hand, he must explain that coupon is the annual rate of interest payable on the bond. The rate of the coupon is directly related to the amount of interest received by the owner of the bond. The coupon rates for various bonds vary because coupon payments are used by bond investors to recover the financial investments in the bonds. This is because higher coupon rates translate to higher coupon payments.
How are the ratings of these bonds determined? What happens when the bond ratings get adjusted down wards?
Bond ratings show a companies ability and willingness to repay its debts and is mainly used by consumers when deciding on which bond to buy and which on ones to sell. Bond ratings entail both the qualitative and quantitative analysis. The quantitative aspect of the analysis involves analyzing the future cash flows of the company so as to gauge the ability of the company to repay the principal and the interests payments associated with the bond. The analysis further looks at the financial shields at the disposal of the company which can be used to cushion the company in case of the occurrence of various financial uncertainties. Various financial aspects such as the cash reserves of the company, the company’s revenue trends, the stability of its costs and markets are employed when forecasting the cash flows and revenue of the company for the time period converted by the bond agreement. Therefore, companies with greater financial strengths receive higher ratings as compared to those companies with weaker financial muscles.
On the other hand, the qualitative aspect of the analysis deals with the analysis of management aspects which are quite hard to quantify such as the company’s strategic plan, management strategies used by the company and the potential risks faced by the company. Both the quantitative aspects and the qualitative aspects of the analysis are combined and a conclusive rating is done to gauge the bonds. The rating is normally expressed in form of letters or a group of letters such as A, Aa, Baa, BB, C among others.
Credit ratings normally exhibit a direct relationship with the price of the bond so that lowering the price of the bond leads to a decline in the price of the bond while raising the credit rating pushes up the price of a bond.
The variation in the rates of interest may make bonds to trade at discounts or premiums, that is, at a value different from face value of the bond. This is because of the high correlation that exists between bonds and interest rates. Therefore, raising the interest rates reduces a bond’s market value while reducing the interest rates raises the market value of a bond.
A discount bond is not a bargain because discount bonds do not imply better returns for investors but it only denotes that they receive a price below par.
What is yield to maturity?
The yield to maturity, also known as the redemption yield, of a bond refers to the internal rate of return accrued by an investor who purchases a bond at current prevailing market price, assuming that the bond would hold to maturity. In other words, yield to maturity is the discount rate at which the sum of all future cash flows from the bond is equal to the price of the bond.
Yield to maturity is calculated using the formulae Yield to maturity (YTM)=[(Face value/Present value)1/Time period]-1.
What is the difference between the nominal and effective 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?
Nominal yield to maturity refers to the rates financial institutions are charging on loans, without taking into account factors such as the inflation rate and the compounding effect of bonds. On the other hand, effective yield to maturity considers and accounts for adjustments for premium or discount on a bond.
Investors should use the effective yield to maturity when making investment decisions because it considers the prevailing interest rates which ensures that returns received by investors reflect the real value of money. According to Quiry et al (2011), investment is only worth when the yield to maturity is greater than or equal to an investors required return. In addition, the effective yield to return reinvests the interest earned by an investor based on the concept of compounding effect. The effective yield to maturity is equivalent to the internal rate of return of the bond (Choudhry, 2001).The effective yield to maturity therefore reduces the chances of losing money by the investor as a result of changes in business dynamics such as inflation.
The effects of call provision on bond risk and return potential
The call provision allows the issuer of the bond to redeem it before the maturity date of the bond. Although the call provision basically benefits the issuer more than the investor, it has various benefits to the bond investor. Callable bonds allow the investor to receive an amount that is higher than the face value of the bond as a form of compensation. In addition, most callable bonds possess higher coupon rates which make potential returns to be more attractive.
Jill should explain the various factors that make each of the bonds to be risky. The most risky bond is the one issued by Telco utilities because the issuer does not have a sinking fund that can be used to redeem the bonds matures when the issuer of the bond is bankrupt. The second most risky bond is the one issued by ABC energy with rating AAA because despite having the sinking fund, the call period is not included the terms and conditions of the bond. Although the bond rated AA and issued by TransPower and the one rated AAA and issued by ABC energy all have the same maturity period of 20 years, but one has a higher coupon rate.
If the client buys ten of each of the bonds and reinvest any coupons received at the rate of five percent per year and hold them until they mature, the total amount of money to be received by the client would be the sum of the principle amount and the interest generated by the coupons multiplied by ten in each case. The following formulae will be used to compute the amount of money that the client should receive. The rate of the coupons would be1.6 %, 6.9%, -4.5% and -0.001% of the bonds’ face value for the first second, third and fourth bonds respectively.
Conclusion
In conclusion, A.M. Smithy Company should engage in vigorous client education. Such education would help the company to achieve customer satisfaction and encourage their customers to remain loyal to their products.
