Valuation of Fixed-Income Securities in Agribusiness - Agribusiness Education and Research International

Understanding of Securities for Fixed Income

Investors considered the valuation of Fixed-Income Securities in Agribusiness. The investment options that produce predetermined fixed income for investors are fixed income securities. If kept to maturity, bonds and debentures give investors the ability to receive stable nominal returns with a low risk of loss of principal. Nevertheless, through speculating on interest rate fluctuations, bonds often give investors the chance to gain more dividends. Even though long-term fixed income securities are bonds and debentures, all of them are debt securities. In general, debt securities issued by the government and public sector units are usually referred to as bonds. On the other hand, debt securities issued by joint-stock firms in the private sector are called debentures. An unsecured bond backed by a company’s general credit is often called a debenture. Bonds and debentures, however, are also utilized interchangeably.

Bonds may be classified as long-term debt instruments that constitute a contractual obligation to pay the issuer to the holder of both principal and interest thereon. Government bonds and corporate bonds are two important types of bonds issued in the financial markets. Although no maturity is refunded to the holder by the lender, the holder of the bonds may sell them off at any time before maturity. The price would depend on the level of interest rates at the time if a bond is going to be sold before maturity. Therefore, interest rate risk is revealed to the holders of the bonds. So, on the part of bond buyers and sellers, it is important to understand how to price, evaluate, and handle the fundamentals of bonds.

Bond Pricing Theorems

Bonds of fixed income securities are sold at a fixed interest rate known as the coupon rate. The coupon rate estimate is based on the bond’s face value and maturity. The coupon rate at the time of issuance tends to be equal to the prevailing market interest rate. Interest rates can adjust depending on the market situation. If the current market interest rate is higher than a bond’s coupon rate, the bond produces a lower yield which makes investors less attractive. The price of the bond, therefore, falls below its face value. On the other hand, if the market interest rate falls below the coupon rate, the price of the bond will rise and the bond becomes common and is sold at its face value at a premium. The general assumption, therefore, is that the price of bonds varies inversely with changes in market interest rates.

The relationship between bond prices and changes in market interest rates was established by Burton G. Malkiel. He mentioned five basic principles that link bond prices to market interest rates, known as theorems for bond pricing. Those are addressed as:

The prices of bonds shift inversely to shifts in market interest.
Positively, the fluctuations in bond prices and term to maturity are related. Changes in bond prices are greater for long-term maturities in the event of a given change in the level of market interest rates.
As the remaining period before the maturity of the bond increases, the exposure to changes in market interest rates increases at a decreasing rate.
Absolute market interest rate rises and resulting shifts in bond prices are not symmetrical. A reduction in the market interest rate for a given maturity induces a price increase that is greater than the price decrease resulting from an equivalent increase in the market interest rate.
Volatility in the bond price is attributed to the coupon rate. If the coupon rate is higher, the percentage rise in a bond’s price due to a change in the market interest rate would be lower.

The amount of price volatility needed to respond to the shift in interest rates in question is a function of the number of years to maturity. In the case of a long-term bond, as opposed to a short-term bond, a rise in the market interest rate results in a relatively significant price change. Long-term bonds are more resilient than short-term bonds to interest rate shifts. This is why short-term bonds usually have less interest rate risk exposure.

Bond Risk Analysis

Fixed income securities are perceived to be less volatile in contrast to other financial assets or securities. Securities are not entirely risk-free, but they are less volatile. Investment in bonds is thus a function of the different forms and sources of risk. Due to defalcation or changes in the market interest rate, the actual return from a bond can vary from the expected return. The return from bond investments may be affected by both systemic and unsystematic risk. However, default risk and interest rate risk are the main risks involved in bond investments.

Default risk:

Default risk applies to the company’s inability on the stipulated dates to repay the principal and/or interest thereon. Inefficient financial results and the ineffectiveness of management contribute to default risk. The risk of default occurs because of the non-payment of all or part of the interest and principal. In such a scenario, bond investors incur losses that reduce their bond returns. Such a risk can be identified and calculated through a credit rating. Credit assessment is a method of qualitative analysis of the market and management of the company and of quantitative analysis of the financial performance of the company.

Interest rate risk:

Since the price of the bond seldom changes in the financial markets, the coupon interest rates are the main income from the bond. These interests are typically purchased annually or semi-annually by a bondholder. Investors may then reinvest their interest sums at the prevailing market interest rate in order to earn interest on the principal. An investor, as long as he keeps safe, can do so. At a price that might be equal to the nominal value, buyers may sell the bond off. Market interest rates could change during the holding period. The lender will be able to reinvest the annual interest received from the bond at a higher rate if the interest rate rises, which maximizes the return. In addition to that, if the market interest rate goes up, the bond price will fall below its face value.