The Bond That Doesn't Trade
A fund holds a $10M face-value corporate bond, 6% coupon, 4 years remaining, rated BBB. It last traded 14 months ago at 98. Since then the issuer's sector has deteriorated: a peer with similar rating now trades at a yield of 8.5%. The fund's policy is to value at 'last observable trade' if within 18 months. The portfolio manager wants to keep 98 because marking to the peer yield would trigger a collateral call. The auditor asks the valuation analyst to opine on fair value.
1. Should the bond be carried at 98 (last trade) or at a yield-based fair value? Show the calculation.
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Fair value should reflect what a market participant would pay at the measurement date, not a stale trade. A 14-month-old price in a deteriorated sector is not current evidence.
Yield-based value (annual coupon 6%, yield 8.5%, 4 years, face 100):
- PV coupons: 6 × [1 − 1.085^−4]/0.085 = 6 × 3.2756 ≈ 19.65
- PV principal: 100 / 1.085^4 = 100 / 1.3859 ≈ 72.16
- Price ≈ 91.81 per 100, i.e., ~$9.18M on $10M face.
So 98 (~$9.8M) overstates value by roughly $0.6M. The 18-month policy is a convenience, not a valuation principle; the analyst should mark to the yield-based estimate, disclose the method, and note the last trade as corroborating history only.
2. The PM argues the peer yield is not the issuer's yield. How should the analyst address the comparability gap?
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The PM has a point - but it argues for an adjustment, not for ignoring the evidence.
Adjustments to consider:
- Credit spread: confirm the peer is truly comparable in rating, seniority, and sector. If the issuer is stronger, apply a smaller spread.
- Liquidity: the subject bond is illiquid (no trade in 14 months); a liquidity premium should raise the required yield, lowering value further, not support 98.
- Coupon/term: match duration and structure; a 6% coupon vs. peer's coupon affects price for the same yield.
Conclusion: the peer yield is a starting point, adjusted for issuer-specific credit and illiquidity. Both adjustments point below 98. The analyst should present a range (e.g., 91–94) and explain the drivers, rather than defend a stale print.
3. What governance issue does the collateral-call motive raise, and how should the analyst document the conclusion?
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Valuation must be independent of the consequences of the number. A PM asking to keep a price to avoid a collateral call is a conflict of interest.
Documentation:
- State the valuation date, the method (yield-based using adjusted peer spread), and inputs (yield, term, coupon).
- Record the last trade and why it was not relied upon (staleness, sector deterioration).
- Note the liquidity adjustment and its direction.
- Disclose the PM's request and that it did not influence the conclusion.
- Present a sensitivity range around the central estimate.
The analyst should escalate the pressure to the valuation committee or compliance. The defensible position is fair value per the method, with the collateral consequence flagged separately as a risk, not baked into the price.