Com 4FJ3

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Com 4FJ3

• Fixed Income Analysis

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Plain Vanilla Bond

• Issuer
• Maturity Date
• Face Value (1,000)
• Coupon Rate (paid 1/2 every six months)
• Financial engineering has made things much more
  complicated

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US Bond Market Segments

• Treasury
• Agency (smallest sector)
• Municipal (tax exempt)
• Corporate, including Yankee bonds
• Asset backed securities
• Mortgage securities
• residential or commercial

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The Indenture

• Legal document that spells out all details of the
  particular issue.
• Maturity, face value, coupon rate
• Special features
• Redemption provisions
• Collateral Covenants
• Embedded options

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Term to Maturity

• Different types of markets
• Money market less than 1 year
• Short term 1 - 5 years
• Intermediate term 5 - 12 years
• Long term greater than 12 years

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Importance of Maturity

• Time period for promised cash flows
• Influences the required yield on the bond based
  on the yield curve
• Price volatility all else being equal, the
  longer the term to maturity, the greater the
  price volatility

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Principal Coupons

• Principal aka redemption value, par value, face
  value, maturity value
• Amount to be paid at maturity
• Coupon Rate aka nominal rate
• stated annual rate
• principal x coupon rate paid every year
• typically 1/2 of that paid every 6 months
• some European markets pay annually

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Odd Coupons

• Zero coupon or pure discount bonds
• Floating rate bonds
• reference rate quoted margin
• usually an interest rate, but not always
• Inverse floating rate bonds
• Deferred coupon bonds deferred, step-up or
  payment in kind. Usually junk bonds.

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Amortization

• Principal paid off over the life of the bond, not
  just at maturity
• Amortization schedule is the required payments of
  principal
• Mortgage and asset backed securities
• Term to maturity is much less meaningful
• weighted average life or average life

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Embedded Options

• Call issuer can buy back bond at a predetermined
  price.
• Put buyer can sell bond back to issuer
• Convertible buyer can trade bond for a fixed
  number of common shares of issuer
• Exchangeable trade for other securities
• Currency coupon payments in different
  currencies, issuer or buyer chooses

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Risk

• Bonds are considered lower risk than equity
• Even treasury bonds have risk
• Nine types of risk identified

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Interest Rate Risk

• When interest rates change, market prices of
  bonds change
• Called interest rate risk or market risk
• Amount of risk dependent on
• term to maturity
• coupon rate
• embedded options

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Reinvestment Risk

• How much will an investment be worth in 5 years?
• Highly dependent on interest-on-interest
• Reinvestment risk increases as coupon rate
  increases
• Zero coupon no reinvestment risk, but much more
  interest rate risk

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Call Risk

• Three problems for buyer
• cash flow pattern not certain
• if called for refinancing, high reinvestment risk
• capital appreciation limited
• Callable bonds are priced to give a higher yield
  than non-callable bonds
• Spread dependant on call parameters

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Credit Risk

• Possibility of default
• Credit spread risk
• risk premium over treasury
• change in credit rating can affect prices
• upgrade reduces spread, increases prices
• downgrade increases spread, decreases prices

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Inflation Risk

• Also known as purchasing power risk
• Interest rates include a provision for expected
  inflation
• Unexpected changes in inflation could mean that
  the proceeds of the investment is not sufficient
  for the planned use of funds
• Floating rate bonds somewhat protected

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Exchange Rate Risk

• Also called currency risk
• Affects any bond with cash flows denominated in
  foreign currency

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Liquidity Risk

• How easy is it to sell your bond?
• High bid/ask spread for bonds with low liquidity
• Important to institutional investors since they
  need to mark to market periodically, so the
  bond must trade with some frequency to determine
  a market price

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Volatility Risk

• Important for bonds with embedded options
• Option prices increase with an increase in the
  volatility of the underlying asset
• If interest rates become more volatile, the value
  of the embedded option will increase

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Risk Risk

• Not knowing what the risk of a security is.
• Many new types of securities lead to some
  misunderstanding of the risk/return
  characteristics of securities
• Complex securities can offer opportunities and
  return enhancement

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Financial Innovation

• Economic Council of Canada classifications
• market broadening instruments increase the
  liquidity of the market
• risk management instruments
• arbitrage instruments and processes take
  advantage of differences between markets
  including risk perception, information,
  taxation, and regulation

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Financial Innovation

• Bank for International Settlements
• Price-risk-transferring instruments
• Credit-risk-transferring instruments
• Liquidity-generating innovations
• Credit-generating innovations
• Equity-generating innovations

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Pricing a Bond

• Consider the following bond
• 1,000 face value 6 coupon rate
• 10 years to maturity 7 required return
• Coupons are an ordinary annuity.
• PVIFA(0.035, 20)
• Face value returned at year 10 (t 20)
• FV PV x (1 r)t

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Pricing a Bond

• Price 928.94
• The bond trades at a discount because the coupon
  rate is below required return.
• Return coupons capital gain.

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A Premium Bond

• Consider the following bond
• 1,000 face value 12 coupon rate
• 7 years to maturity 7 required return
• Coupons are an ordinary annuity.
• PVIFA(0.035, 14) 655.23
• Face value returned at year 7 (t 14)
• FV PV x (1 r)t 617.78
• Price 1,273.01, a premium of over 27.

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In General

• If the YTM of a bond is equal to the coupon rate,
  the bond sells at par.
• If the yield exceeds the coupon rate the bond
  sells at a discount.
• If the coupon rate is greater than the required
  rate of return, the bond will trade at a premium.

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Price/Yield Relationship
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Price/Time Relationship
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Reasons for Price Changes

• Change in credit quality of issuer causes
  required return to change
• non-Par bond, yield doesnt change, but time
  passes
• Market interest rates change causing required
  return to change

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Closer Payments

• What is the price of bond if the next coupon
  payment date is less than 6 months away?
• Value as 6 months away and future value the price
  for the extra days at the required return
• e.g. if purchased 22 days after previous coupon
  payment multiply by (1r)(22/181)

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Other Complications

• Cash flows uncertain for bonds with an embedded
  option or mortgage backed.
• Single discount rate for all cash flows
• could view bond as package of pure discount
  payments and price that way
• Price of floater near par unless credit spread
  has changed or it has a cap or floor

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Quotes and Accrued Interest

• Prices are typically quoted as a percent of face
  value a price of 107.5 would mean a 5,000 face
  value bond sells for 5,375
• If the bond is not in default, the buyer must
  also pay the seller the interest that has accrued
  since the last coupon payment, this total price
  is called the dirty price or full price, the
  quoted price is the clean price