BUSI 530 Week 3 Discussion Board Forum 2 Example

Discussion Board Forum 2: Valuing Bonds and Interest Rate Risk

BUSI 530 Managerial Finance, Discussion Board Forum 2 Thread and Replies

Thread by [Student Name]

The forum prompt and the two classmates are composites standing in for the course's own prompt; the bond figures in the thread are the writer's worked example, the bank facts come from the Federal Reserve's published review, and the textbook and research cited are real.

Thread

Silicon Valley Bank failed in March 2023 holding mostly securities backed by the U.S. government or its agencies, assets with almost no risk of default. Chapter 6 of Brealey et al. (2018) explains how that is possible: default risk is not the only risk a bondholder bears. When market interest rates rise, the present value of a bond's fixed payments falls, and the longer the bond has to run, the further its price falls.

A simple example shows the size of the effect. Take a $1,000 bond paying a 2 percent annual coupon, priced at par when market yields are 2 percent. If yields rise to 5 percent, a 2-year bond falls to about $944, a loss of under 6 percent. A 10-year bond falls to about $768, a loss of more than 23 percent: its $20 coupons are worth about $154 at the new yield and its $1,000 repayment about $614. Nothing about the issuer changed; only the discount rate did.

That is roughly what happened as the Federal Reserve raised rates through 2022. The Federal Reserve's review of the failure (Barr, 2023) reported that by the end of 2022 the fair value of the bank's held-to-maturity securities was about $15 billion below their book value. Accounting rules let the bank carry them at cost, but the loss became real when depositors, most of them uninsured, began withdrawing. On March 9 alone, depositors pulled about $42 billion, and the bank could not sell its bonds without realizing the losses.

SVB was an extreme case, not an isolated one. Jiang et al. (2024) estimated that rising rates had pushed the market value of the assets held by U.S. banks roughly $2 trillion below their book value, and found that banks with more uninsured depositors were most exposed to runs. The lesson for any manager is that safe assets are only safe if the firm can hold them to maturity. Funding long-term bonds with deposits that can leave overnight turns interest rate risk into survival risk.

Reply to Tasha

Tasha, your rule of 72 example was a good choice for chapter 5, since it shows quickly why starting retirement savings ten years earlier can double the ending balance at a 7 percent return. Your point that most people underestimate this deserves support from research. In survey data, Stango and Zinman (2009) measured what they call exponential growth bias in a large share of households, systematically underestimating how fast balances grow when interest compounds, and that people with more of this bias tended to borrow more and save less. The bias works in both directions, which makes your example even more useful: the same arithmetic that grows savings also grows credit card balances, and a balance left at 24 percent doubles in about three years. Employers who show workers a projected balance at retirement, rather than a contribution rate, are in effect doing the compounding for them. Do you think a rule of thumb like the rule of 72 is enough to correct the bias, or do people need to see the full calculation for their own balances before they change behavior?

Reply to Devon

Devon, I agreed with your explanation of the constant-growth dividend discount model, and your calculation for a utility stock with steady dividends was clear. I want to push on your conclusion that the model cannot value a company that pays no dividends. Miller and Modigliani (1961) showed that, in well-functioning markets, valuing a firm by its future dividends gives the same answer as valuing it by its future earnings less the investment needed to produce them, because a dollar retained and reinvested at a fair return is worth a dollar paid out. A non-paying firm has value because it will eventually return cash to shareholders, through dividends, repurchases or a sale. Brealey et al. (2018) handle this with a horizon value, estimating the stock's price at a future date when growth settles down and discounting it back with the dividends expected before then. For a young firm, almost all of the value sits in that horizon figure, which is why small changes in the assumed long-run growth rate move the answer so much. Would a free cash flow model have fit your growth stock example better?

References

Barr, M. S. (2023). Review of the Federal Reserve's supervision and regulation of Silicon Valley Bank. Board of Governors of the Federal Reserve System. https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf

Brealey, R. A., Myers, S. C., & Marcus, A. J. (2018). Fundamentals of corporate finance (9th ed.). McGraw-Hill Education.

Jiang, E. X., Matvos, G., Piskorski, T., & Seru, A. (2024). Monetary tightening and U.S. bank fragility in 2023: Mark-to-market losses and uninsured depositor runs? Journal of Financial Economics, 159, Article 103899. https://doi.org/10.1016/j.jfineco.2024.103899

Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34(4), 411-433. https://doi.org/10.1086/294442

Stango, V., & Zinman, J. (2009). Exponential growth bias and household finance. The Journal of Finance, 64(6), 2807-2849. https://doi.org/10.1111/j.1540-6261.2009.01518.x