BOND MARKETS

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BOND MARKETS

• CHARACTERISTICS
• yields
• coupon
• maturity
• tax features
• liquidity
• risk
• ratings
• callability
• indenture restrictions
• subordination
• convertability

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MONEY MARKET INSTRUMENTS - LIQUID ASSETS

• Also called cash assets
• T-bills
• Commercial Paper
• Bankers Acceptances
• Eurodollar deposit
• short term tax-exempts
• money market funds and accounts (check writing -
  insured)

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BONDS AND NOTES

• Bonds 5-40 years maturity
• Notes 1-7 years maturity
• Types include treasury, corporate, gov. agency,
  municipal.
• Look at quotes - see websites
  Investinginbonds.com, Tradebonds.com,
  Bonds-online.com

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YIELD SPREADS
Yn Yr I P where Yn is the nominal yield,
Yr is the real yield - yield on U.S. Treasury
inflation-indexed bonds (see WSJ), I is
the expected inflation rate over the life of
the bond - regular Treasury yield minus
inflation-indexed yield, P is the risk premium
- bond yield minus same maturity U.S. Treasury
yield. P widens during recession and
narrows in expansion. It can be measured by the
difference (spread) between the yield on a risky
bond and a risk-free bond (U.S. Treasury).
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Spreads Due to Inflation
Note The terms yields and rates (like
interest rates) are used interchangeably.
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ANALYSIS OF CORPORATE BONDS

• Economic significance (cyclicality) of company
• industry/ quality of management/ performance in
  recession - e.g. Chrysler wants cash cushion.
• Financial resources of the company (liquidity,
  asset
• protection, capital structure).
• Indenture provisions include collateral / sinking
  fund / call provisions / creation of additional
  debt /
• working capital dividend restriction
• Ratings - below Baa or BBB not investment quality
• SPREADS DATA economagic.com, riskmetrics.com

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Spreads Due to Risk Differences
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Mortgage Yield Spread
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ANALYSIS OF MUNICIPAL BONDS

• General Obligations
• Rating
• Economic Strength of Community
• Revenue Raising Potential
• Relative Magnitude of fixed charges
• Attitude and Fiscal discipline of Officials
• Revenue Bonds
• analyze financial prospects of the project
  supporting payment only revenues support
  payments

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TAX EXEMPT YIELDS -STATE LOCAL
QUESTION How do you know if its best to buy
tax exempt or taxable bonds? YT Taxable
yield YTE Tax exempt yield T Tax
rate YTE YT (1 - T) or, YT YTE / (1 -
T) gt T 1 - (YTE / YT) If we know YTE and
YT we can estimate the "indifferent" T - implicit
marginal buyer's tax rate
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If your personal tax rate is Tp then your after
tax yield on a taxable bond is YAT YT (1
- Tp) Therefore, if your Tp gtT, then buy Tax
Exempt Bond (only approximate for bonds trading
above or below par because capital gains are
taxable) QUESTION If the taxable bond yield is
8 percent, the tax exempt yield is 6 percent and
your tax rate is 30 percent, which bonds should
you buy?
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ANS YAT .08(1 - .30) .056 gt buy tax
exempts QUESTION Investor expects a Democrat
to win the presidential election- expect tax
rates will rise - what should happen to municipal
yields? - fall QUESTION What happens if we get
a flat tax at 17? - taxable yields fall and tax
exempts rise
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• COLLATERALIZED OBLIGATIONS
• mortgage
• car loans
• credit card debt
• David Bowie royalties

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BOND VALUATION AND YIELDS
PROMISED YIELD TO MATURITY assumes bond held
to maturity assumes coupons reinvested at YTM
rate. Find k given bond price, Bn , coupons, C,
maturity, n, and par value, Par. if all
payments are made we get the promised yield, k,
if we pay price Bn. Otherwise, we need to
substitute the expected coupon and par payment
rather than the promised payments and then find k.
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BOND PRICING
Find and estimate of Bn given expected coupons
and Par, E(C) and E(Par), and k.
QUESTION What happens if k increases?
B decreases What happens if k decreases? B
increases
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REALIZED YIELD - CALCULATED AFTER THE FACT
Assume you sell after 2 periods - find k
in Bp Purchase Price Bs Sales
Price This assumes coupons reinvested at
k CURRENT YIELD
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BOND VALUATION
CouponPVAk,n ParPVk,n To get the
bond price you can use a financial calculator or
you can compute a present value annuity factor
And a present value factor for one cash flow And
plug them into the formula above
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Using the equation above PROBLEM Suppose a
bond offers a 10 coupon, on 1000 par, for 3
years and the expected inflation rate is 2, the
real rate is 3 and the bonds risk premium is
1. What is its price? B 100PVA .06, 3
1000PV .06, 3 100(2.673) 1000(.84)
1107
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QUESTION If the company only agrees to pay
1000 at maturity, wont those who buy this
bond lose 107 at maturity? QUESTION Would
you buy this bond? Why? - greater coupon than
par bonds.
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A par bond would cost 1000 but only pay a 60
coupon. The present value of the difference in
coupons (100 - 60)(2.673) 107 which is the
difference in price between this bond and a par
bond. Alternatively, a bond that offered a 2
coupon when rates are 6 will have a price of
B 20PVA.06, 3 1000PV.06, 3
893 or 107 less than the par bond.
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FINDING THE YIELD TO MATURITY
PROBLEM Suppose you observe a bond in the
market with a price of 803 that pays a coupon
of 10 till maturity in 5 years. What is its
implied yield to maturity? Try 16 803
100(PVA?,5) 1000(PV?,5) 100(3.274)
1000(.476) 803
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PRICING WITH SEMI-ANNUAL COUPONS
PROBLEM Suppose a bond pays 10 coupon,
semi- annually, has 10 years till maturity and
has a required return (or YTM) of 8. What is
its price? B 50(PVA.04,20)
1000(PV.04,20) 50(13.59) 1000(.456)
1135.5
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FINDING THE REALIZED YIELD
QUESTION If you buy a 20 coupon, par bond, with
3 years maturity and you hold it for three years
are you sure to earn 20? ANSWER No because
the calculation of YTM assumes that the coupons
are reinvested at 20, if rates change your
realized yield will change because you'll earn
more or less than 20 on the reinvested coupons.
For example, when you bought the bond YTM was
20. But suppose rates fell to 5 the day after
you bought and stay there for three years.
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Your realized yield will be implied in use PV
FVPVk,n FV1/(1k)n . Solve for k to get
realized yield, the true yield which depends
upon how much you initially invest (PV present
value) and how much you accumulate by the time
that you sell in the future (FV future
value). 1000 (200(1.05)2 200(1.05)
1200)PVk,3 1630.5PVk,3 gt 1000/1630.5
PVk,3 1/(1k)3 .6133 gt k 17.7
realized yield falls because
reinvestment rate falls
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QUESTION Then how can you truly lock-in a
rate? ANSWER Buy a bond with no coupons -
called zero coupon bonds. QUESTION Some find
this attractive but is there a problem with
being locked-in? ANSWER Yes. How about if rates
rise. You lose out on earning extra interest
on reinvested coupons.
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QUESTION Suppose you are asked to value a zero
coupon bond. How do you set it up? ANSWER
Only use the second term in the valuation
formula given above. QUESTION Which bonds will
appreciate assuming capital gains tax is
reduced? ANSWER Discount bonds.