CH 10
Corporate Bonds -Floating-rate bonds
Coupon rates periodically reset according to specified market date based on existing market rate -usualy has cap (cant go above) and collar (cant go below) -does not ajdust to firm changes only market
International Bonds - Eurobonds
Denominated in currency (usually that of issuing country) different than that of country in which trading takes place -EX: Eurodollar: dollar-denominated bonds sold outside the US (not just in Europe)
Yield Curve
Graph of yield to maturity as function of term to maturity -shorter maturities offer lower yields to maturity than longer term bonds
Figure 10.11 Prices of five-year credit default swaps
move almost in lockstep together
Bond Price
or use financial calculator
Figure 10.13 Returns to Two 2-Year Investment Strategies
(1+y)^2= (1+ .08995)^2= 1.188
Realized Compound Returns versus Yield to Maturity - Horizon analysis
- Analysis of bond returns over multiyear horizon - Based on forecasts of bond's YTM and investment options
After-Tax Returns
- Built-in price appreciation on original-issue discount bonds constitutes implicit interest payment to holder - IRS calculates price appreciation schedule to determine taxable interest income for built-in appreciation
Yield to Call
- Calculated like yield to maturity - Time until call replaces time until maturity; call price replaces par value - Premium bonds more likely to be called than discount bonds Example PG 297
Preferred Stock
- Commonly pays fixed dividend (similar to debt): Floating-rate preferred stock becoming more popular - Dividends not normally tax-deductible: Corporations that purchase other corporations' preferred stock are taxed on only 30% of dividends received -the failure to pay promised dividends does not result in bankruptcy like a bond -paid after bonds but before common stock -no voting power
Bond Indentures -sinking fund
- Indenture: Defines contract between issuer and holder - Sinking fund: Indenture calling for issuer to periodically repurchase some proportion of outstanding bonds before maturity --doubling option --serial bond does not require sinking fund
Credit Default Swaps (CDS)
- Insurance policy on default risk of corporate bond or loan - Designed to allow lenders to buy protection against losses on large loans -- Later used to speculate on financial health of companies
Investment grade vs speculative or junk
- Investment grade bond: Rated BBB and above by S&P or Baa and above by Moody's - Speculative grade or junk bond: Rated BB or lower by S&P, Ba or lower by Moody's, or unrated --Michael Milken and Drexel --AKA high yield bonds
Liquidity Preference Theory
- Investors demand risk premium on long-term bonds because they are less liquid than short term bonds - Liquidity premium: Extra expected return demanded by investors as compensation for greater risk of long-term bonds - Spread between forward ROI and expected short sale - fn = E(rn) + Liquidity premium
International Bonds - Foreign bonds
- Issued by borrower in different country than where bond sold - Denominated in currency of market country -foreign bonds sold in US are called Yankee bonds
Innovation in the Bond Market - Indexed bonds
- Payments tied to general price index/price of particular commodity - Treasury Inflation Protected Securities (TIPS): Par value of bond increases with consumer price index -Nominal= not adjusted (includes) for inflation (P1-P0)/P0= (end-beg)/beg
Premium vs discount bond
- Premium Bonds: Bonds selling above par value --the coupon rate is greater than the current yield and YTM - Discount Bonds: Bonds selling below par value --the coupon rate is less than the current yield and YTM
Treasury Bonds and Notes - Accrued interest and quoted bond prices
- Quoted prices do not include interest accruing between payment dates -treasury notes: maturity 1- 10 years -treasury bonds: maturity is 10-30 years -can be purchased only in denominations of $100, but $1,000 is more common with semi annual coupon payments -/2 because it is usually semi annually
Yield to Maturity and Default Risk
- Stated yield is maximum possible yield to maturity of bond - Default premium: Increment to promised yield that compensates investor for default risk --default premium= yield on corporate bond- gov rf bond
Bond Indentures - subordination clause -dividend restrictions -collateral -debenture
- Subordination clause: Restrictions on additional borrowing stipulating senior bondholders paid first in event of bankruptcy -Dividend restrictions: limit dividends to protect bondholders - Collateral: Specific asset pledged against possible default - Debenture: Bond not backed by specific collateral
Yield to Maturity versus Holding Period Return (HPR)
- Yield to maturity measures average RoR if investment held until bond matures - HPR is RoR over particular investment period; depends on market price at end of period (must be forecasted) -An increase (decrease) in the bond's YTM acts to reduce (increase) its price which means that HPR will be less (more) than initial yield HPR= coupon + (price with increase or decrease - par)/ par AKA End-beg/beg
Zero-Coupon Bonds and Treasury STRIPS
- Zero-coupon bond: Carries no coupons, provides all return in form of price appreciation -- Treasury bills issued at discount - Separate Trading of Registered Interest and Principal of Securities (STRIPS): Oversees creation of multiple zero-coupon bonds from coupon-bearing notes and bonds
Determinants of Bond Safety (5)
1. Coverage ratios: Company earnings to fixed costs 2. Leverage ratio: Debt to equity -if too high indicates excessive indebtedness, raising likelihood firm will not be able to repay bonds 3. Liquidity ratios: ability to raise cash from liquid assets -- Current: Current assets to current liabilities -- Quick: Assets excluding inventories to liabilities 4. Profitability ratios: Measures of RoR on assets or equity (overall performance) -ROA= earnings before interest and taxes/ total assets (want a higher number) -ROE= net income/ equity 5. Cash flow-to-debt ratio: Total cash flow to outstanding debt
Innovation in the Bond Market (4)
1. Inverse floaters: Coupon rate falls when interest rates rise and investor suffers (but benefit is the rates fall) 2. Asset-backed bonds: Income from specified assets used to service debt 3. Pay-in-kind bonds: Issuers can pay interest in cash or additional bonds 4. Catastrophe bonds: Higher coupon rates to investors for taking on risk -bonds transfer catastrophic risk from insurance companies to the capital markets -in event of catastrophe, investor will lose all or part of their investment
Bond Pricing (3)
1. Prices fall as market interest rate rises 2. Interest rate fluctuations are primary source of bond market risk= interest rate risk - Price risk: inverse relationship - reinvestment risk: positive relationship (want rates to go up since you can reinvest at a higher rate) 3. Bonds with longer maturities more sensitive to fluctuations in interest rate
Other Domestic Issuers (4)
1. State, local governments (municipal bonds): tax-free interest payments for instate 2. Federal Home Loan Bank Board 3. Farm Credit agencies 4. Ginnie Mae, Fannie Mae, Freddie Mac -Congress is likely to save these organizations
Figure 10.15 Term Spread: Yields on 10-Year versus 90-day Treasuries
10 year treasury is usually above 90 day unless we were in a recession or something similar
Figure 10.5 Growth of Invested Funds -Realized Compound return PG298/299
2 years till maturity V2= 1000(1+.1)^2= 1210
TABLE 10.3 Financial ratios by rating class
Aaa has much better and higher numbers than C
Bond Pricing in Excel
=PRICE (settlement date, maturity date, annual coupon rate, yield to maturity, redemption value as percent of par value, number of coupon payments per year) -Settlement date= the date you buy the bond
Figure 10.12 Treasury Yield Curve
A. Flat curve B. upward sloping curve C. downward sloping or inverted curve D. hump shaped rises then falls
Corporate Bonds - Convertible bonds
Allow bondholder to exchange bond for specified number of common stock shares -Conversion ratio= # shares one bond can be converted into -market conversion value: current value of the shares for which the bonds may be exchanged ($20/share x 40 shares) -Conversion premium: the excess of the bond price over its conversion value($950 bond - $800 conversion) -lower coupon rates and YTM
- Current Yield:
Annual coupon/ bond price EX: 8% 30 year bond selling at $1,276.76 (FV= 1000) Current yield= $80/ $1276.76= 6.27%
Bond value
Bond value = Present value of coupons + Present par value -coupon= PV of annuity -Par= PV of a single amount, the final payment of bond's Par value
Coupon rate
Bond's annual interest payment per dollar of par value
Corporate Bonds -Call provisions on corporate bonds
Callable bonds: May be repurchased by issuer at specified call price during call period -can be deferred callable meaning you have to wait a specific amount of time before calling -penalty = 1 years worth of interest usually --will decrease as time goes by -used when you want to refinance at a lower rate -firms benefit, but investor has higher risk= bondholders burden hence the higher coupon and YTM
Realized Compound Returns versus Yield to Maturity (APR) - Realized compound return
Compound rate of return on bond with all coupons reinvested until maturity V0(1+r)^2 = V2 V0= initial value of investment V2= final value after two years
Treasury Bonds and Notes - Accrued interest and quoted bond prices Example: Consider a bond with the following characteristics: Semi-annual payments, coupon rate of 6%, $1,000 par value. If 45 days have passed since the last coupon payment, what is the accrued interest?
Coupon payment= .06 x 1000= 60 364/2=182 days Second example pg 284
Figure 10.10 Yield spreads between corporate and 10-year Treasury bonds Source: Federal Reserve Bank of St. Louis.
High yield= C or other risky or junk bonds -best (AAA) pays lowest return -spread between AAA and Baa stays fairly the same except for when they squeeze together due to market confidence
Corporate Bonds -Puttable bonds
Holder may choose to exchange for par value or to extend for given number of years -If the bonds coupon rate exceeds current market yields, the bondholder will choose to extend the bond's life.
Forward Rate
Inferred short-term ROI for future period, makes expected total return of long-term bond equal to that of rolling over short-term bonds fn = forward rate
Realized Compound Returns versus Yield to Maturity - Reinvestment rate risk
Uncertainty surrounding cumulative future value of reinvested coupon payments
Bond Pricing between Coupon Dates
Invoice price = Flat price + Accrued interest Flat price= prices that appear in the financial press
Figure 10.2 Listing of Corporate Bonds
Most corporate bonds still trade on a traditional over the counter market in a network of bond dealers linked by a computer quotation system -market can be quite thin (few investors interested in a particular issue at any time) due to the variety of different types of bonds -safer bonds with higher ratings (AAA) promise lower YTM
Figure 10.3 Inverse Relationship between Bond Prices and Yields -30 year 8% coupon bond
Negative slope shows inverse relationship of prices and yields (rates) -As interest rates increase, bond prices go down. -Convexity: progressive increases in the interest rate result in progressively smaller reductions in the bond price making the price curve flatter at higher rates
FIGURE 10.14 Illustrative yield curves
Panel A: Increasing expected short rates combined with increasing liquidity premium. The result is a sharply rising yield curve. Panel B: Declining expected short rates combined with constant liquidity premium. The result is a hump-shaped yield curve.
Table 10.1 TIPS, Principal and Interest Payments -Principal and interest payments for a Treasury Inflation Protected Security - Coupon= 4%
Par value x coupon rate= coupon(interest) payment EX: 1,061.11 x .04= 42.44 Nominal first year = 40.80+20/1000= 6.08% Real= (1.0608/1.02)-1= 4%
Zero-coupon bond
Pays no coupons (interest), sells at discount, provides only payment of par value at maturity
Figure 10.6 Price Paths of Coupon Bonds in Case of Constant Market Interest Rates
Price path of two 30-year maturity bonds each selling at a yield to maturity of 8%. Bond price approaches par value as maturity date approaches. -red line shows par value -blue line was issued at 12% but market has dropped to 8% which is why it sells at a premium -Black is selling at a discount was 4% now 8% -even if market rates do not change, values change if not selling for par because it must equal par at maturity
Term Structure of Interest Rates
Relationship between yields to maturity and terms to maturity across bonds
Bond
Security that obligates issuer to make payments to holder over time - Face Value, Par Value, maturity value: Payment to bondholder at maturity of bond -debt= fixed payments or fixed-income securities
Figure 10.4 Bond Prices: Callable and Straight Debt
Straight bond has no call provision -black callable bond above 7% similar to straight bond but below 7% we expect price to not go higher which is why it would get called
Figure 10.7 Price of 30-Year Zero-Coupon Bond over Time at Yield to Maturity of 10%
bond's prices rise exponentially not linearly until its maturity
Table 10.2 Bond Prices at Different Interest Rates
The longer the period for which your money is tied up, the greater the loss, and correspondingly, the greater the drop in the bond price. -longer maturity= greater sensitivity and changes (EX: 30 year (very large changes) vs 1 year (smaller) changes) -coupon =8%, market-rate at 8% sells at par
What is the price of the following two bonds: Maturity (T) Bond A: 4 Years Bond B: 30 Years Coupon Rate (C) A: 5% B: 5% Discount Rate (r) A: 8% B: 8% Par Value (FV) A: $1,000 B: $1,000 Using financial calculator
Using Financial calculator Bond A: n=4,i/y=8, PMT=.05 x 1000=50, FV=1000, CPT PV= 900.64 Bond B n=30,i/y=8, PMT=.05 x 1000=50, FV=1000, CPT PV=662.27 Additional Example on PG 290
Yield to Maturity
YTM: Discount rate that makes present value of bond's payments equal to price. (not compounded) -- the average rate of return that will be earned on a bond if it is bought now and held until maturity --the internal rate of return on an investment in the bond -- the compounded rate of return over the life of the bond under the assumption that all bond coupons can be reinvested at that yield EX PG 294/295 to compute YTM
Expectations Hypothesis
Yields to maturity determined solely by expectations of future short-term interest rates -Relatively high yields on long term bonds reflect expectations of future increases in rates, while relatively low yields on long term rates reflect expectations of falling short term rates
FIGURE 10.1 Prices and yields of U.S. Treasury bonds, February 15, 2017
corporate bonds usually $1000 -Ask> bid always -CHG= ask price change from the previous date -bid and ask prices are quoted as a percentage of par value -Ask YTM is a percentage
