Bonds, Bond Prices and the Determination of Interest Rates

1
Chapter 6

• Bonds, Bond Prices and the Determination of
  Interest Rates

2
Debt instruments in Capital Markets

• Capital Markets Trade financial instruments of
  maturity greater than 1 year
• Bonds Long-term debt obligations issued by
  corporations and government units
• Borrowers return the face value of the debt after
  a specified period (eg 10 yrs)
• Borrower also pay interest in the form of interim
  coupon payments (eg annual, semi-annual,
  quarterly)
• In the event of borrower default, the lender may
  have claim to the assets of the bond issuer.
• Bond Markets Secondary markets that allow
  investors to trade bonds prior to maturity, and
  include three major classifications of bond types
• Treasury notes and bonds (federal government)
  25 of market
• Municipal bonds (local government) 17 of
  market
• Corporate bonds 58 of market

3
Market Size
reprinted from Saunders Cornett Financial
markets and institutions, 3rd edition,
McGraw-Hill Irwin 2006
4
Investing in Bonds
Note how much larger the market for new debt
is Even in the late 1990s, which were boom years
for new equity issuances New debt issuances still
outpaced equity by over 51.
5
Holding Period Return

• Examples
• 10 year bond (Face value100) and a 6 coupon
  rate.
• You sell the bond one year later.
• The interest rate in one year changes to 5
• or -0.52

6
Holding Period Return

• Examples
• 10 year bond (Face value100) and a 6 coupon
  rate.
• You sell the bond one year later.
• The interest rate in one year changes to 7
• or 13.11

7
Distinction Between Interest Rates and Returns

• Holding Period Return
• the return to holding a bond and selling it
  before maturity.

8
Exercise 2 Understanding returns!

• Question You buy a 5 coupon bond that sells for
  1000. One year later you sell the bond.
  Assuming interest rates are now 6.25, what is
  your capital gain and total return?

9
Derivation of Bond Demand Curve

• Point A P 900, i 5.3 Bd 100 billion
• Point B P 850, i 11.1 Bd 200 billion
• Point C P 800, i 17.6 Bd 300 billion
• Point D P 750, i 25.0 Bd 400 billion
• Point E P 700, i 33.0 Bd 500 billion
• Demand Curve is Bd in Figure 1 which connects
  points A, B, C, D, E.
• Has usual downward slope
• At higher interest rates (lower prices), demand
  for bonds increases
• Hence more investors are willing to buy bonds!

10
The Demand For Bonds
Interest Rate i () i increases ?
Price of Bonds, P() P Increasing ?
Quantity of Bonds, B ( Billion)
11
Derivation of Bond Supply Curve

• Point F P 750, i 33.0, Bs 100 billion
• Point G P 800, i 25.0, Bs 200 billion
• Point C P 850, i 17.6, Bs 300 billion
• Point H P 900, i 11.1, Bs 400 billion
• Point I P 950, i 5.3, Bs 500 billion
• Supply Curve is Bs that connects points F, G, C,
  H, I, and has upward slope
• At lower interest rates, it is less costly to
  finance borrowing
• Hence more firms are willing to borrow by issuing
  bonds!

12
The Supply Of Bonds
13
The Bond Market
1. When P 900, i 5.3, Bs gt Bd (excess
supply) P ? to P, i ?to i 2. When P 700, i
33.0, Bd gt Bs (excess demand) P ? to P, i ?
to i Market Equilibrium 1. Occurs when Bd Bs,
at P 800, i 17.6
14
Factors That Shift Supply Curve
15
The Supply Of Bonds

• Profitability of Investment Opportunities
• Business cycle expansion, investment
  opportunities ?, Bs ?, Bs shifts out to right
• Expected Inflation
• ?e ?, Bs ?, Bs shifts out to right
• Government Activities
• Deficits ?, Bs ?, Bs shifts out to right

BS1
BS2
16
Summary of Shifts in the Supply of Bonds

• Expected Profitability of Investment
  Opportunities
• In a business cycle expansion, the supply of
  bonds increases
• Conversely, in a recession, when there are far
  fewer expected profitable investment
  opportunities, the supply of bonds falls
• Expected Inflation
• An increase in expected inflation causes the
  supply of bonds to increase
• Government Activities
• Higher government deficits increase the supply of
  bonds
• Conversely, government surpluses decrease the
  supply of bonds

17
Shifts in the Bond Demand Curve
Bd2
Bd1
18
Summary of Shifts in the Demand for Bonds

• Wealth
• When the economy is expanding what happens to
  wealth? the demand for bonds?
• Conversely, in a recession, when income and
  wealth are falling, the demand for bonds falls
• Expected returns
• What effect do higher expected interest rates
  have on demand for bonds?
• Decrease the demand for long-term bonds
• Conversely, lower expected interest rates in the
  future increase the demand for long-term bonds

19
Summary of Shifts in the Demand for Bonds

• Risk
• What effect does an increase in the riskiness of
  bonds have on the demand for bonds?
• Conversely, an increase in the riskiness of
  alternative assets (like stocks) causes the
  demand for bonds to rise
• Liquidity
• Increased liquidity of the bond market results in
  an increased demand for bonds
• Conversely, increased liquidity of alternative
  asset markets (like the stock market) lowers the
  demand for bonds

20
How Factors Shift the Demand Curve

• Wealth
• Economy ?, wealth ?, Bd ?, Bd shifts out to right
• Expected Return
• i ? in future, Re for long-term bonds ?, Bd
  shifts out to right
• pe ?, relative Re ?, Bd shifts out to right

21
How Factors Shift the Demand Curve

• Risk
• Risk of bonds ?, Bd ?, Bd shifts out to right
• Risk of other assets ?, Bd ?, Bd shifts out to
  right
• Liquidity
• Liquidity of bonds ?, Bd ?, Bd shifts out to
  right
• Liquidity of other assets ?, Bd ?,Bd shifts out
  to right

22
Bond Market and Interest Rates
23
Bond Risks

• Long-term bonds High interest rate risk, low
  reinvestment rate risk.
• Short-term bonds Low interest rate risk, high
  reinvestment rate risk.
• Do all bonds of the same maturity have the same
  price and reinvestment rate risk?
• No, low coupon bonds have less reinvestment rate
  risk but more price risk than high coupon bonds.

24
Risk associated with bonds

• Interest rate (Price) risk
• Risk of a decline in price due to increases in
  interest rates
• Reinvestment risk
• Risk that a decline in interest rates will lead
  to a decline in the income from a bond portfolio

25
Interest Rate Risk
kd
1-year
Change
10-year
Change
5
1,048
1,386
4.8 -4.4
38.6 -25.1
10
1,000
1,000
15
956
749

• Why do bonds with longer maturities have more
  interest rate risk?

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Value
10-year
1,500
.
.
1-year
.
.
.
1,000
.
500
kd
0
0
5
10
15
27
Maturity and the Volatility of Bond Returns
(cont.)

• Prices and returns more volatile for long-term
  bonds because have higher interest-rate risk
• No interest-rate risk for any bond whose maturity
  equals holding period

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Reinvestment risk

• Example You won 500,000. Youll invest the
  money and live off the interest. You buy a
  1-year bond with a YTM of 10.
• What is your Year 1 income?
• 50,000
• At year-end how much do you reinvest?
• 500,000
• If rates fall 3, what happens to you income?
• Reduced to 35,000
• Had you bought 30-year bonds, income would have
  remained constant.
• You Gain from i ?, lose when i ?

29
Reinvestment Risk

• Occurs when you hold series of short bonds over
  long holding period
• i at which reinvest uncertain
• Gain from i ?, lose when i ?

30
Business Cycle Expansion
Interest Rate i () i increases ?
Price of Bonds, P() P Increasing ?

• Wealth ?, Bd ?, Bd shifts out to right
• Investment ?, Bs ?, Bs shifts out to right
• If Bs shifts more than Bd then P ?, i ?

Quantity of Bonds, B
31
Government Bonds

• Types of Government Securities
• T-Bill Maturity lt 1 year, no coupon payment
• T-notes Maturity 2-10 yrs, semi-annual coupon
• T-bonds Maturity gt 10 years, semi-annual coupon
• TIPS (Treasury Inflation Protection Securities)
• Created in 1997 so that the government could
  survey the market for expected inflation.
• STRIPS
• The coupon and principal payments are stripped
  from a T-Bond and sold as individual zero-coupon
  bonds.

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Treasury Inflation Protected Securities (TIPS)

• How it works
• The coupon rate is fixed (often referred to as
  the real rate)
• the face value of the note is adjusted for
  inflation, semi-annually, based on the CPI index
• Since the base (face) value is adjusted upwards
  with inflation, the coupon payment is always
  adjusted for inflation, hence its reference as
  the real rate.
• Since rational buyers know that bonds adjust for
  inflation, they discount this into the price of
  the bond. If the government offers a TIP security
  with the same maturity as a Treasure note paying
  6, then the price paid for the TIP will be 6
  less the expected inflation.
• If the TIPS yield 3.5 annually while the same
  maturity Treasury yield 6, then this indicates
  that the market expects inflation to be around
  2.5 annually.

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Zero coupon securities - STRIPS

• Zero Coupon Securities
• Offer no coupon payments
• Have longer maturities than discount securities
  that similarly offer not coupons
• Benefit No reinvestment risk (fixed interest
  rates over entire maturity of investment)
• Cost Negative cash flow instrument pay taxes
  on implied interest earned
• Typical Buyers of zero coupon securities
• Pension funds with fixed future payments
• Tax sheltered savings plans (401k) where tax
  liabilities are deferred
• Financial innovations with zero coupon offerings
• In 1982, Merrill Lynch and Salomon Brothers
  created a synthetic zero coupon Treasury receipt
  of duration longer than 2 years (Called TIGRs)
• They pulled apart a treasury security into
  separate components
• Each coupon payment is separated creating a zero
  coupon bond
• The pieces were sold off for an amount greater
  than the whole
• Separate Trading of Registered Interest and
  Principal Securities (STRIPS)
• Due to the high demand for these securities, the
  Treasury began to perform this service directly
  to the public

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STRIPS how it works

• How it works
• Choose appropriate duration Treasury bond (5, 10
  years or longer)
• Deposit in a bank custody account
• Investment banks sells receipts (ownership
  claims) to particular characteristics of the
  account
• Each characteristic ownership claim gets a unique
  receipt

The result is 21 securities, each sold to an
investor who receives a receipt to the bank
custody account, specifying which portion of the
bond that they are entitled to. The bank
stripping the security profits by selling each
component so that in aggregate, the proceeds are
larger than the cost of the original 100 Million
investment.
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STRIPS

• Market efficiency
• The market is more complete. An investor can
  invest in a 13.5 yr Treasury
• a security not otherwise offered by the
  government
• Theoretical spot rates based on intermediate
  maturity bonds are no longer theoretical.
• In the secondary market, each component of this
  stripped security will have independent price
  changes, so pricing is more efficient.
• Treasury issued Strips In 1985, the Treasury
  announced its Separate Trading of Registered
  Interest and Principal Securities (STRIPS).
• For maturities of 10 years and longer, the
  Treasury will strip the security for the buyer.
• The treasury does not issue or sell Strips
  directly to the public, but they are offered
  through government security brokers.
• These brokers/dealers buy original securities at
  Auction and strip them.

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Corporate Bonds

• Typically have a face value of 1,000,
• Some have a face value of 5,000 or 10,000
• Pay interest semi-annually
• Corporate bonds are taxable
• Cannot be redeemed anytime the issuer wishes,
  unless a specific clause states this (call
  option).
• Degree of risk varies with each bond, even from
  the same issue.
• Due to having lower claims on the assets of the
  firm or the collateral put up against the bond

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Risk Structure of Long Bonds in the U.S.
Figure 5.1 Long Term Bond Yields, 19192004
Interest rates of bonds with different
riskshttp//www.federalreserve.gov/release/h15/da
ta.htm
39
Corporate Bonds Characteristics of Corporate
Bonds

• Restrictive Covenants
• Mitigates conflicts with shareholder interests
• May limit dividends, new debt, ratios
• Call Provisions
• Issuer has the right (not the obligation) to
  retire the bonds
• Higher yield
• Sinking fund
• Alternative opportunities
• Convertible Bonds
• Bondholder can convert the issue to issuer equity
• Bondholders pay for this feature convertible
  bonds are sold at a lower yield
• Similar to a stock option, but usually more
  limited

40
Corporate Bond Indentures

• Indenture The contract that specifies the
  promises that the corporate bond issuer makes to
  the investor.
• Maturity
• Seniority order the claim is paid in the event
  of bankruptcy
• Security collateral backing
• Rate of interest
• Retirement provisions
• Lender rights
• Restrictive Covenants
• Bond Covenants These are the above rules
  expressed in the indenture
• For example stating a ceiling for the firms
  debt ratio.

41
Corporate Bonds, Indentures Asymmetric
information problems

• Asymmetric information
• Bond indentures help to solve problems associated
  with asymmetric information
• Adverse selection
• The more restrictions (covenants) written into
  the bond indenture, the better the type of the
  issuer.
• A bad issuer will be unwilling to commit to
  stringent lending conditions, so those that do
  are likely to be good borrowers.
• Moral Hazard
• Bond covenants prevent borrowers from changing
  their type.
• The conditions of the contract are well defined
  in the indenture, and deviation allows the
  investor to go to court and make claim on the
  firms assets

42
Credit Ratings

• Credit ratings are used to establish the credit
  worthiness of a bond issue
• Is a measure of a bond issuers ability to pay
  its debts
• The issuer must hire a rating agency to certify
  their type and resolve the adverse selection
  problem
• This is a market solution to adverse selection
• Similar to hiring an auditor for financial
  statements, there is a potential conflict of
  interest (firm is paying the rater).
• Rating agencies also watch these firms over time,
  and will raise or lower the credit rating
  depending on the firms performance
• This mitigates the moral hazard problem
• The market often considers rating moves as a lag
  to information already priced by public markets
  (ie. the moves are expected and not particularly
  useful)
• Not all debt is rated Lemons dont need to pay
  someone to tell the market that they are lemons.

43
Corporate Bond Retirement Provisions

• Callable Bonds Issuer has the right to retire
  all/part of the issue prior to maturity
• This protects the issuer in the event that
  interest rates fall can refinance at lower
  interest rates using new debt to pay off the old
  debt
• Issuer must pay a higher yield to attract
  investors
• Putable Bonds Bondholder has the right to sell
  back the issue prior to maturity
• Investors sell the issue back to the borrower at
  par (face) value
• Attractive feature when firm risk increases or
  interest rates increase
• Investors pay a premium for this feature (receive
  a lower yield)
• Sinking fund Firm redeems bonds periodically
  before maturity
• Each year (or other time period) bonds are
  randomly selected for retirement
• This reduces default risk since borrower
  liability reduces each year
• This is a penalty to investors in a falling
  interest rate environment (acts like a random
  call feature)

44
Corporate Bonds Characteristics of Corporate
Bonds

• Secured Bonds
• Mortgage bonds
• Equipment trust certificates
• Unsecured Bonds
• Debentures
• Subordinated debentures
• Variable-rate bonds
• Junk Bonds
• Debt that is rated below BBB
• Often, trusts insurance companies are not
  permitted to invest in junk debt
• Michael Milken developed this market in the
  mid-1980s,
• Provided liquidity of investors willing to take
  on greater risk
• Acted as a bank in order to help the renegotiate
  a firms debt in order to avoid default
• Accused of insider trading (sentenced to 3 years
  in prison, and 200M fine)

45
Corporate Bond Types

• Subordinated debenture A debenture bond is not
  secured by any collateral or claim of property.
• Subordinated refers to the fact that it ranks
  after secured debt and more senior debentures
• This is debt backed by the full faith and credit
  of the firm
• If default occurs, then the investor becomes a
  creditor and stands in line, according to
  seniority of note, to make claim on the assets of
  the bankrupt firm.
• The level of security of a bond will determine
  the price paid for the bond

• If a bond is unsecured, and not backed by
  tangible assets, then lenders are considering
  only
• Reputation of the firm as a borrower
• Credit record
• Financial stability of the firm

46
Increase in Default Risk on Corporate Bonds
47
Increase in Default on Corporate Bonds

• Corporate Bond Market
• Risk of corporate bonds ?, Dc ?, Dc shifts left
• Pc ?, ic ?
• Treasury Bond Market
• Relative risk of Treasury bonds ?, DT ?, DT
  shifts right
• PT ?, iT ?
• Outcome
• Risk premium, ic - iT, rises

48
Liquidity Factor (cont.)

• Corporate bonds are not as liquid because fewer
  bonds for any one corporation are traded
• thus it can be costly to sell these bonds in an
  emergency because it may be hard to find buyers
  quickly.
• Risk Premium
• The difference between interest rates on
  corporate bonds and Treasury bonds
• Reflects both the corporate bonds default risk
  and its liquidity too.
• This is why a risk premium is sometimes called a
  liquidity premium.

49
Decrease in Liquidity of Corporate Bonds
50
Corporate Bond Becomes Less Liquid

• Corporate Bond Market
• Liquidity of corporate bonds ?, Dc ?, Dc shifts
  left
• Pc ?, ic ?
• Treasury Bond Market
• Relatively more liquid Treasury bonds, DT ?, DT
  shifts right
• PT ?, iT ?
• Outcome
• Risk premium, ic - iT, rises
• Risk premium reflects not only corporate bonds'
  default risk but also lower liquidity

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Investing in Bonds