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Bond Duration Risk & Value Investing

Bond Duration Risk

Part 1

  1. Definition of interest rate risk (Duration Risk) – Duration risk or interest rate risk influences the value of bonds greater as compared to the stocks and when the interest rates rise the bond prices fall and vice versa. It is a risk that the value of investment changes due to the variation in the absolute level of interest rates. This risk can be reduced with help of diversification or hedging as well (Lourosa, 2015).
  2. How to hedge the risk? – Hedging is a technique which is used to reduce risk of the investment associated with adverse movement of price of an asset. Usually a hedge is based on taking offsetting position of a particular security like bond.

Part 2

Value investing is an investing strategy where those securities are chosen which are traded for less than their intrinsic values. The value investors look for securities that they think that have been undervalued. The Earning Power Value or EPV is a method to value securities through an assumption regarding their ability for sustained earnings. The formula for EPV is,

EPV = Adjusted Earnings / Cost of Capital

Franchise has a licensed relationship nature that exists between the franchisor and franchisee. Among our holdings is General Electric with cost of capital 6.58% and the total assets value $401.46 billion on June 30th 2016 while the net income is $8.03 billion.  Not putting the values into the formula will provide $8.03 billion / 6.58% = $126.1 billion. In other words GE earned $126.1 billion annually on an investment of $8.03 billion which means that the company has approximately 15% rate of return. The basic concept behind EPV is that the firm should value the stock as per the free cash flow and not on the predicted projections as these might come true or not. Here the assumption is the current profitability is sustainable.

References

GuruFocus. (2016, October 8). General Electric Co Earnings Power Value. Retrieved from GuruFocus: http://www.gurufocus.com/term/EPV/GE/Earnings-Power-Value-EPV/General-Electric-Co

Lourosa, C. (2015, June 12). Why a Bond Fund’s ‘Duration’ Is Crucial as Interest Rates Rise. Retrieved from The Wall Street Journal: http://blogs.wsj.com/experts/2015/06/12/why-a-bond-funds-duration-is-crucial-as-interest-rates-rise/

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