Finance E2 (Ch. 4, 5, 12)

Corporate Bonds (2)

> Degree of risk varies with each bond, even from the same issuer > Interest rate on corporate bonds varies with the level of risk > Bonds with lower risk and a higher rating (AAA) have a lower interest rates than more risky bonds (BBB)

Expectations Theory & Term Structure Facts (A)

> Explains why short-term & long-term rates move together 1. Historically, short-term rates have had the characteristic that if they increase today, they will tend to be higher in the future 2. If interest today increases -> average of future rates increases 3. Therefore, short & long-term rates move together

Expectations Theory & Term Structure Facts (B)

> Explains why yield curve has different slopes 1. When short-term rates are expected to rise in future, average of future short-term rates is above today's short rate; therefore, yield curve is upward sloping 2. When short-term rates are expected to stay same in future, average of future short rates same as today's, & yield curve is flat 3. Only when short-term rates are expected to fall will yield curve be downward sloping

Financial Guarantees for Bonds (1)

> Financially weaker security issuers frequently purchase financial guarantees to lower the risk of their bonds > A financial guarantee ensures that the lender (bond purchaser) will be paid both interest and principal in the event the issuer defaults, and are usually backed by large insurance companies

Types of Municipal Bonds

> General obligation bonds do not have specific assets pledged as security or a specific source of revenue allocated for their repayment > Revenue bonds are backed by the cash flow of a particular revenue-generating project

Types of Bonds

> Government bonds (T-bonds) > Municipal bonds > Corporate bonds

Municipal Bonds

> Issued by local, county, and state governments > Used to finance public interest projects

Risk in Municipal Bond Market

> Municipal bonds are not default free -- default rate is .63% > Local government cannot print money, and there are real limits on how high they can raise taxes without driving the population away

Types of Corporate Bonds

> Secured Bonds -- the ones with collateral attached -Lower risk, lower interest rates > Unsecured Bonds -- backed only by the general creditworthiness of the issuer -Lower priority than secured bonds if the firms defaults -Higher risk, higher interest rates

Treasury Strips

> Separate Trading of Registered Interest and Principal Securities > A STRIPS separates the periodic interest payments from the final principal payment > Treasury STRIPS: the coupon and principal payments are "stripped" from a T-Bond and sold as individual zero-coupon bonds

Financial Guarantees for Bonds (3)

A new way to insure bonds, CDS: Credit Default Swap (J.P. Morgan 1995) > A financial swap agreement that the seller of the CDS will compensate the buyer in the event of a bond default. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the bond default

Yield Curve

A plot of the yields on bonds with differing terms to maturity, but the same default risk, liquidity, and tax consideration

Corporate Bonds Become Less Liquid

A) Corporate Bond Market -- Demand shifts to the left; Price decreases, interest rate increases B) U.S. Treasury Bond Market -- Demand shifts right; Price increases, interest rate decreases

Increase in Default Risk on Corporate Bonds

A) Corporate Bond Market -- Demand shifts to the left; Price decreases, interest rate increases B) U.S. Treasury Bond Market -- Demand shifts to the right; Price increases, interest rate decreases

Tax Advantages of Municipal Bonds

A) Municipal Bond Market -- Demand shifts right; Price increases, interest rate decreases B) Treasury Bond Market -- Demand shifts left; Price decreases, interest rate increases *Logic not true when federal income tax is extremely low *Tax advantages are offset by default & liquidity risk

Default Risk

Influences interest rate When the issuer of the bond is unable or unwilling to make interest payments when promised or to pay off the face value when the bond matures

Treasury Inflation-Protected Securities (TIPS)

Innovative bond is designed to remove inflation risk from holding treasury securities The coupon rate doesn't change throughout the term of the security. The principal amount is tied to the current rate of inflation to protect investor from inflation risk The interest rates on TIPS are generally lower than the interest rates on regular treasury notes and bonds

Liquidity Premium Theory (B)

Investors prefer short-term rather than long-term bonds. This implies that investors must be paid positive liquidity premium to hold long-term bonds -- requires higher compensation because higher risk

Market Segmentation Theory (A)

Key Assumption: Bonds of different maturities are NOT substitutes at all, so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity Implication: Markets are completely segmented; interest rates at each maturity are determined separately *Interest rate for each bond with a different maturity is then determined by the supply and demand curve for that bond, with no effects from expected return on other bonds with other maturities

Liquidity Premium Theory (A)

Key Assumption: Bonds of different maturities are substitutes, which means that the expected return on one bond does influence the demand on a bond of a different maturity, but it allows investors to prefer one bond over another Implication: Bonds of different maturities are substitutes, but NOT perfect substitutes

Expectations Theory

Key Assumption: Buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity *Bonds of different maturities are perfect substitutes if they have the same expected returns *If the two investment strategies are perfect substitutes, the 2-year bond interest rate is an average of the two 1-year bonds' interest rates

Corporate Bonds (1)

Most corporate bonds are callable--the issuer may redeem the bonds after a specific date

Current Yield Calculation (2)

The current yield and yield to maturity always move together; a rise in the current yield always signals that the yield to maturity has also risen

Risk Premium

The difference (spread) between the interest rates on bonds with default risk & default-free bonds *Indicates how much additional interest people must earn in order to be willing to hold that risky bond

Risk Premium -- Liquidity Premium

The differences between interest rates on Corporate bonds & Treasury bonds reflect not only the Corporate bond's default risk, but also its liquidity risk

Treasury Bond Interest Rates (1)

NO default risk since the Treasury can print money or increase tax rates to payoff the debt However, treasury bonds do have interest rate risk!

Characteristics of Corporate Bonds (2)

Restrictive covenants are the rules and restrictions on managers designed to protect the bondholders' interests > Restrict high risk investment > Limit the amount of dividends the firm can pay > The ability of the firm to issue additional debt

Term Structure of Interest Rates

Shows the relationship among interest rates on bonds with different terms to maturity Bonds with different maturities tend to have different required rates, all else equal

Expectations Theory & Term Structure Facts (C)

*CANNOT explain why the yield curve usually has upward slope* > Short-term rates have same probability to go 8up or down in the future, so average of expected future short-term rates will be around the current short-term rate. Therefore, yield curve should be flat rather than upward sloping

Market Segmentation Theory (B)

*This theory can explain why yield curve is usually upward sloping* > People typically prefer short holding periods and thus have higher demand for short-term bonds, which have higher prices and lower interest rates than long bonds *Does NOT explain why short-term and long-term rates move together because it assumes long-term and short-term rates are determined independently*

Factors Affecting Risk Structure Interest Rates

-Default Risk -Liquidity -Income Tax Consideration

3 Theories of Term Structure

1. Expectations Theory 2. Market Segmentation Theory 3. Liquid Premium Theory

Interest Rates on Different Maturity Bonds Move Together

3 Observations: > Interest rates on bonds of different maturities move together over time > Low short-term rate -- yield curve upward sloping High short-term rate -- yield curve downward sloping > Yield curves almost always slope upward

Characteristics of Corporate Bonds (3)

> A call provision states that the issuer has the right to force the bondholder to sell the bond back > The call provision usually requires a waiting period between the time the bond is initially issued and the time when it can be called > The call price is usually set at the par price or slightly higher (usually by one year's interest cost) Call value = par value + 1-year coupon payment

Agency Bonds

> Although not technically Treasury securities, agency bonds are issued by government-sponsored enterprises > The debt has an "implicit" guarantee that the U.S. government will not allow the agencies to default

Characteristics of Corporate Bonds (1)

> Bearer bonds -No registered owner > Registered bonds -The owner must register with the firm to receive interest payments -IRS can track interest income this way

Types of Bonds

> Bonds can also be classified based on their credit ratings (default risk) > Investment grade bonds -Bonds at or above BBB > Junk Bonds -Bonds that is rated below BBB -Often, trusts and insurance companies are not permitted to invest in junk debt

Liquidity

Influences interest rate The more liquid an asset is, the more desirable it is (higher demand), holding everything else constant

Default-Free Bonds (No Default Risk)

U.S. Treasury Bonds

Government Bonds (T-Bonds)

U.S. Treasury issues notes and bonds to finance its operations

Income Tax Factor

Unlike a Treasury bond -- With a municipal bond, the holder can keep the full coupon payment without paying a tax. For the higher return, investors are willing to hold the riskier & less liquid municipal bond

Current Yield Calculation (2)

When a bond is a long-term bond, Current yield can be used as a YTM approximation > Short maturity bond: current yield is a bad approximation

Bonds

Bonds are securities that represent debt owed by the issuer to the investor, and typically have specified payments on specific dates > Face value (par value) > Coupon rate > Maturity

CASE 2: Business Cycle Expansion

Changes in interest rate due to business cycle expansion > Wealth shifts Demand to right > Investment shifts Supply to right > P? i? -- Depends on the size of the two shifts * Empirical evidence: The interest rate tends to rise during business cycle expansion and fall during recessions

CASE 1: Fisher Effect

Changes in the interest rate due to the changes in expected inflation rate > If inflation rate rises, decreases demand and increases supply; therefore, Prices decrease and Interest Rate increases *When expected inflation rises, interest rates will rise

Characteristics of Corporate Bonds (5)

Conversion > Some bonds can be converted into shares of common stock (convertible bonds) > When stock price increases substantially, bondholders have incentive to convert their bonds into stocks > Issuing convertible bonds is one way firms avoid sending a negative signal to the market -- issuing equity sends negative reaction > Convertible bonds price will be higher than nonconvertible bond price

Current Yield Calculation (1)

Current yield is an approximation of the yield to maturity on coupon bonds

Income Taxes

Even though municipal bonds have a higher default risk & higher liquidity risk, municipal bonds tend to have a lower interest rate... WHY? *Interest payments on municipal bonds are exempt from federal income tax -- a factor that has the same effect on the demand for municipal bond as an increase in its expected return

CASE 3: Low Japanese Interest Rate

In 1998, Japanese interest rates turned slightly negative -- two possible stories > (Story 1) Japan experienced prolong recession, which was accompanied by deflation Demand: Negative inflation leads to higher return, shifts demand curve right Supply: Higher real rate indicates higher cost of borrowing, shifts supply curve to left Net effect is an increase in bond prices -- falling interest rates > (Story 2) Business cycle contraction Demand: Less wealth, less demand -> shifts curve to left Supply: No one wants to buy any products -- no profitable investments -> shifts curve left But* the shift in demand is less significant than the shift in supply so the net effect was also an increase in bond prices

Risk Structure of Interest Rates

The relationship among interest rates on bonds with same maturity

Treasury Bond Interest Rates (2)

Treasury bonds have very low interest rates because they have no default risk Most of the time, treasury bond rate > treasury note rate > treasury bill rate

Current Yield Calculation (1)

When the bond is at par, the bond price = par value, what is YTM? > YTM = coupon rate > Coupon rate = coupon payment / par value > Current yield = coupon payment / bond price > Current yield = coupon rate = YTM

Characteristics of Corporate Bonds (4)

When to call? > Interest rates fall. If interest rates fall enough, the price will rise above the call price, and the firm will call the bond > If the covenants on the bond restrict the firm from some activity that it feels is in the best interest of stockholders > When a firm wishes to adjust its capital structure

Financial Guarantees for Bonds (2)

With financial guarantees, > Default risk is lower > Lower interest rate demanded by bond buyers > Make sense when interest savings > insurance fee