Corporate Bonds the Expected Returns Research Proposal

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To determine the degree to which the bonds of a single company, for example Champion International, are correlated with the market, we must follow the same method as was used for the Vanguard portfolios. The returns on the different Champion bonds must be gathered, as much the returns on the market for the time period studied. We are seeking to determine a beta for the debt. A regression analysis will reveal this beta. The beta will then be applied within the context of CAPM, to give an expected return.

When the beta is very low, this indicates that idiosyncratic risk is more important in explaining the expected return of the bond. The expected risk, as derived from CAPM, should be evaluated against the expected yield of the bond as priced by the open market. The degree to which the expected yield differs from the expected return as calculated using CAPM will indicate the degree to which beta is a reliable measure of expected returns. Because we know that systematic risk is a poor method of understanding expected bond returns, we should expect to find that the market yield of the Champion bond is not the same as what would be derived using the beta-based capital asset pricing model.

2) 1) Maturity impacts corporate bond prices by moving them further from the face value. The time value of the volatility is greater as the maturity is longer. The time value of a bond's cash flows is more likely to shift, and in greater intensity, the farther away the maturity is. This is because the largest flow, which is the face value, is moved farther in time. The risk therefore increases as the maturity is farther out. The result is that bond prices are typically decline as the maturity increases, in order to account for the risk represented by time value.

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2) a bond is priced based on the expected value of the cash flows, adjusted for time value. Therefore, taxes are incorporated into that calculation. Taxes account for a portion of the spread between corporate bonds and treasuries, because taxes affect the value of the payments that are received. As taxes increase, the price of the bond should decrease, in order to maintain yield.

3) Liquidity is part of a bond's risk. A highly liquid bond bears less risk, because the owner can easily sell it. An illiquid bond, however, is riskier because the owner may not be able to sell it. Short maturity bonds tend to be more liquid than long maturity bonds. As liquidity increases, the bond price should increase as well. This is because the bond does not need to give as much yield, because the risk is lower.

4) Recovery rates reflect the risk associated with default, in terms of the amount a bond-holder can expect to receive on the dollar of their investment. The higher the recovery rate, the lower the risk of the bond. This means that as recovery rates rise, bond prices should rise and yields would fall. A bond in a class with a poor recovery rate is may not be more likely to default, but the degree of damage associated with default is higher.

5) Bond ratings reflect risk. The better the rating, the lower the risk. Therefore, if a company's bond rating improves, the price will increase. This will bring the yield into a new equilibrium. The less risky the bond, the lower the yield required. Conversely, if the rating is cut, then the bond price will drop in order to provide a higher yield on the bond, better reflecting its new risk level.

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