4221 Final Exam

premium bonds

bonds selling above par value coupon rate > current yield > YTM

discount bonds

bonds selling below par value YTM > current yield > coupon rate

yield to maturity (YTM)

discount rate that makes present value of bond's payments equal to price - bond's IRR - interest rate that makes the PV of a bond's payments equal to its price; assumes that all bond coupons can be reinvested at the YTM YTM = current yield + capital gains yield

corporate risks

*credit (deterioration)*: - default - downgrade *liquidity* *prepayment:* - sigh of financial health of a company, but investors are getting their $ back at an unscheduled time - if a company wants to pay its debt early, you as an investor now get a handful of cash which you have to reinvest (companies usually do prepayment b/c interest rates are low and so investors have to reinvest their money in some security that has a lower rate) *interest rate* *reinvestment rate*

investment grade vs. high-yield

*investment grade:* bonds that are rated Baa or above by Moody's or BBB or above by S&P *high-yield:* (aka speculative yield) a high-paying bond with a lower credit rating than investment-grade corporate bonds, treasury bonds and municipal bonds. high-yield bonds carry a rating below BBB from S&P and below Baa from Moody's - higher risk of default - aka junk bonds

primary market

*whispers:* initial price targets quoted in credit spread *book building:* much faster than an IPO in the equity market; IG issues are usually announced the same day the book closes *pricing:* how is the coupon and issue priced determine *distribution:* if the book is 2x oversubscribed and you requested $10M what will your allocation be?

determinants of bond safety

- *coverage ratios:* company earnings to fixed costs - *leverage ratio:* debt to equity - *liquidity ratios:* how well can a company generate cash (cash on hand) - *current ratio:* current assets to current liabilities (> 1 is good) - *profitability ratios:* measures of return on revenue on assets or equity - *cash flow-to-debt ratio:* total cash flow to outstanding debt

bond contracts

- *red herring:* a preliminary prospectus, so named because of the warning, printed in red, that the document is still under review by the SEC and subject to change - *prospectus (indentures):* defines contract between issuer and holder

prospectus details

- *subordination clause:* restrictions on additional borrowing stipulating senior bondholders paid first in event of bankruptcy - *collateral:* specific asset pledged against possible default (collateral-backed bonds = viewed as safer) - *debenture:* bond not backed by specific collateral

bond basics

- a bond is a form of debt, just like a loan - specifically, an interest-only loan - bonds are also called fixed-income securities - interest payments are made each period - no principal is paid until the maturity date - last payment, at maturity, includes 2 cash flows (principal aka par value or face value and last interest payment)

pricing between coupon dates

- accrued interest is interest that has been earned since the last coupon payment accrued interest = (annual coupon/# payments a year) * (days since last payment/days in coupon period) - invoice/full price = flat price + accrued interest (flat price = "clean" price) (invoice price is "dirty" price) - bonds are "quoted clean and traded dirty" example: - bond is purchased on April 15 (31+28+31+15 = 105 days) - coupon period is Jan 1 to June 30 ~= 182 days accrued interest = (60/2)*(105/182) = $17.31 pay extra in interest

TIPS principal and interest payments

- as inflation increases, coupon payments increase (TIPS compensates for rises in inflation)

bond prices at different interest rates

- bond prices become more volatile as maturity increases - longer-term bonds have higher price risks aka interest risk compared to shorter-term bonds - more volatility in lower yields

types of corporate bonds

- bullet bonds: no optionality - callable bonds: may be repurchased by issuer at specified call price during call period; riskier to investors, therefore they sell at a lower price (does the issuer or investor benefit from the call option? --> exercises this option when it benefits them...issuers advantage, investors disadvantage) - convertible bonds: allow bondholder to exchange bond for specified number of common stock shares (more expensive; like a traditional bullet bond)

yield to call

- calculated like YTM. time until call replaces time until maturity; *call price replaces par value* - if interest rates fall, price of straight bond can rise considerably, but the price of the callable bond is flat over a range of low interest rates because the risk of call is high - when interest rates are high, the risk of call is negligible and the values of the straight and the callable bond converge - premium bonds more likely to be called than discount bonds *example* issued: nov 1, 2020 maturity: nov 1, 2050 semiannual coupons NPER: 30 x 2 = 60 YTM = 0.06/2 = 0.03 PMT = 40 FV = 1000 =PV(0.03, 60, 40, 1000) = $1276.76 callable: nov 1, 2025 call price: $1300 YTC -> =RATE(10, 40, 1276.76, 1300) = 3.29% x 2 = 6.58% **YTC > YTM which means bond probably has low likelihood of being called (as the call terms become worse for the investor, the YTC lowers)

reasons corporations issue corporate bonds

- finance capital expenditures - facilitate expansion through M&A - fund share buyback programs - general corporate purposes

preferred stock

- hybrid security; part bond, part stock - generally pays fixed dividend - dividends not normally tax-deductible - preferred dividends are paid before common

more types of bond

- pay-in-kind (PIK) bonds: issuers can pay interest in additional bonds (or cash) - inverse floaters: coupon rate falls when interest rates rise (more volatile than average bonds) - asset-backed bonds: income from specified assets used to service debt (any bond that has another stream of cash flows tied to it; ginnie mae, fannie mae, freddie mac all are mortgage cash flows) - catastrophe bonds: higher coupon rates to investors for taking on risk

interest rates

- prices fall as market rate (yield) rises - interest rate fluctuations are primary source of bond market risk - bonds with longer maturities are more sensitive to fluctuations in market interest rate

corporate bonds continued

- puttable bonds: holder may choose to exchange for par value or to extend for given number of years - floating-rate bonds: coupon rates periodically reset according to specified market date call (option: issuer, when: interest falls, investor price < bullet) put (option: investor, when: interest increases, investor price > bullet)

bond basics continued

- the interest payment is known as the coupon - the coupon is expressed as a % of face value - 8% coupon bond with a $1000 face value would pay $80/year - coupon payments typically paid annually or semi-annually - zero-coupon bond only pays face value at maturity

pricing treasury bonds

- treasuries are quote in price increments of 1/128 of a dollar - a treasury note has 9 years to maturity, has a 6% coupon, has an ask price of $128 65/128 per $100 par value and makes semi-annual payments. what is the YTM at the ask price? 128 + (65/128) = 128.507813 per $100 face value 128.507813 x 10 = 1285.078 per $1000 face value NPER = 9 x 2 = 18 PV = -1285.07813 FV = 1000 PMT = $60/2 = $30 I/Y = ? =RATE(18, 30, -1285.078, 1000) I/Y = 1.225 x 2 = 2.45%

zeros and STRIPS

- zero-coupon bond: carries no coupons, provides all return in form of price appreciation - separate trading of registered interest and principal of securities (STRIPS): oversees creation of zero-coupon bonds from coupon-bearing notes and bonds

YTM vs. holding period return

YTM: - the average return if the bond is held to maturity - depends on the coupon rate, maturity, and par value - all of these are readily observable holding period return: - the rate of return over a particular investment period - depends on the bond's price at the end of the holding period, an unknown future value - can only be forecasted - aka realized compound return (face value + selling price + coupon)/(face value)

horizon analysis

analysis of bond returns over multiyear horizon, based on forecasts of bond's yield to maturity and investment options

current yield

annual coupon divided by bond price - rate of return just from coupons

credit default swaps (CDS)

insurance policy on default risk of corporate bond or loan - can be used for hedging (offload risk) - speculating (you can also buy CDS if you don't own any of the bonds; in 2007 market crash, ppl who didn't own any mortgage-backed assets bought CDS on them so when housing crashed, they got insurance $) **similar to put option = makes $ when prices go down

agencies and munis

other domestic issuers: - ginnie mae (GNMA), fannie mae (FNMA), freddie mac (FHLMC) --> make mortgages more accessible - federal home loan bank board - farm credit agencies municipal bonds: - state, county, local government - interest tax-free at federal level, often at state and local level too

price and yield relationship

prices and yields have an inverse relationship ex: as interest rates increase, bond prices decrease and vice versa - bond price curve is convex **bonds are riskier when interest rates are low

realized compound return (RCR)

the compound rate of return on bond w/ all coupons reinvested until maturity -RCR does not equal YTM if reinvestment rate of coupons is not equal to YTM - if you're reinvesting your coupons at a higher rate, then RCR will be higher

reinvestment rate risk

uncertainty surrounding cumulative future value of reinvested coupon payments