Title: Learning Objectives
1Learning Objectives
- 1. Explain the fundamental characteristics of a
bond issue. - 2. Explain the meaning and impact of bond
ratings. - Understand how to read bond quotes in the
financial press. - 4. Explain differences among various concepts of
yield such as Current yield Yield-to-maturity
Yield-to-call Anticipated Realized Yield. - 5. Bond Duration and Portfolio Immunization
2Bond and Fixed-Income Fundamentals
- Secured and Unsecured Bonds
- Perpetual Bonds
- Sinking Fund Provisions
- Call provision
- Bond Ratings
- Junk Bonds
- Bond Quotes
3The Bond Contract
- A bond normally represents a long term
contractual obligation of the firm to pay
interest to the bondholder as well as the face
value of the bond at maturity. - Par value is the face value of the bond.
- Coupon rate is the actual rate on the bond.
- Zero-Coupon bonds are deep discount bonds which
compensate the investor through capital
appreciation. Maturity date is the date on which
the par value is paid. - Serial payment under which bonds are paid off in
installments over the life of the issue.
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4Bond Indenture
- A bond indenture is a legal document which covers
the major provisions in a bond agreement,
administered by an independent trustee. - Sinking Fund Provision
- Call Provision
- Put Provision
5Secured Bonds
- A mortgage bond is backed by real property
pledged as a collateral. - Equipment trust certificates are used by firms
in the transportation industry. - Proceeds from the sale of certificates are used
to purchase new equipment which serves as
collateral for the certificate.
6Unsecured Bonds
- Federal, state and local government issues are
unsecured. - Debentures are long-term corporate unsecured
bonds. Senior, Junior, Subordinated. - Income bonds require interest to be paid only to
the extent that it is earned as current income.
Failure to make interest payments will not force
the firm into bankruptcy.
7The Composition of the Bond Market
- Federal government is the single largest
borrower. - T-bills, T-notes, T-bonds and T-Strips
- Treasury Inflation Protection Securities (TIPS)
- Federally Sponsored Credit Agency Issues
- Federal Home Loan Bank
- Export-Import Bank
- Federal Intermediate Credit Banks
- Federal Farm Credit Bank
8Bond Market Investors
- The bond market is dominated by large
institutional investors. - They account for the more than 85 of trading.
- Individual investors are active in low
denomination (1000) corporate bonds tax-free
municipal bonds and through bond mutual funds.
9Bond Market Investors (Cont.)
- Banks are strong participants in the municipal
bond market. - Foreign investors bank roll 10-15 of U.S.
Government debts. - The bond market is a strong primary market but a
relatively weak secondary market. - Bonds generally trade O.T.C. except for a few
that are listed on NYSE and AMEX.
10Bond Ratings Sources
- Two major bond-rating agencies are
- Moodys Investor Services, a subsidiary of Dunn
Bradstreet. - Standard Poors, a subsidiary of McGraw Hill.
- Secondary bond-rating agencies are
- Fitch Investors Service
- Duff Phelp, Inc.
11Bond Ratings
- A bond rating measures the likelihood of default.
Financial ratio analysis accounts for half of
the evaluation. - Analysts also consider cash flow, earnings
measures and industry factors. - Bond yields and bond ratings are inversely
related.
12Fundamentals of the bond Valuation Process
13Computing Bond Yields
Nominal Yield
Measures the coupon rate
Current yield
Measures current income rate
Promised yield to maturity
Measures expected rate of return for bond held to
maturity
Promised yield to call
Measures expected rate of return for bond held to
first call date
Measures expected rate of return for a bond
likely to be sold prior to maturity. It
considers specified reinvestment assumptions and
an estimated sales price. It can also measure
the actual rate of return on a bond during some
past period of time.
Realized (horizon) yield
14Rates of Return
- Approximate Promised Yield
- APY C (Par Market Price)/ NMaruity
- .60 ( Market Price) .4 (Par)
- Â Yield to Call
- AYC C (Call Price Market Price)/ NCall
- .60 ( Market Price) .4 (Call Price)
- Approximate Realized Yield
- ARY C (Realized Price Market Price)/
NRealize .60 (
Market Price) .4 (Realize Price)
15Corporate Bond Quotes
- Cur
Net - Bonds Yld Vol Close Chg
- ATT 81/8 22 7.7 52 1053/8 1/4
Issued by ATT
52 of these bonds traded that day
8.125 coupon rate
matures in 2022
Current yield coupon/market price 7.7
The closing price was 105 3/8 of par which was
up 1/4 from the prior day
16Term Structure of Interest Rates
- The relationship between maturity and interest
rates. It is also known as the Yield Curve. - Expectations Hypothesis suggests that the
long-term rate is an average of the expectations
of the future short-term rates over the
applicable time horizon. - Reinforced by borrower/lender strategies.
17Figure 12-1 Term Structure of Interest Rates
Normal
18The Movement of Interest Rates (cont.)
- Liquidity Preference Theory states that the shape
of the yield curve is upward sloping. Investors
will pay a higher price for short-term securities
because they are more easily turned into cash
without the risk of large price changes. - Investors demand higher returns from longer-term
securities.
19The Movement of Interest Rates (cont.)
- Market Segmentation Theory focuses on the demand
side of the market. - Banks tend to prefer Short Term liquid securities
to match the nature of their deposits. - Life insurance companies invest in Long-Term
bonds to match their Long-Term obligations.
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21Investment Strategy Interest-Rate
Considerations
- Bond Pricing Rules
- 1. Bond prices and interest rates are inversely
related. - 2. Prices of long-term bonds are more sensitive
to a change in yields to maturity than
short-term bonds. - 3. Bond price sensitivity increases at a
decreasing rate as maturity increases.
22Investment Strategy Interest-Rate
Considerations (cont.)
- 4. Bond prices are more sensitive to a decline
in market YTM than to a rise in YTM. - 5. Prices of low-coupon bonds are more sensitive
to a change in YTM than high coupon bonds. - 6. Bond prices are more sensitive when YTM is
low than when YTM is high. - 7. Margin trading magnifies profits and losses
of bond investments by a factor of 1/(margin
requirement).
23What Determines the Price Volatility for Bonds
- Five observed behaviors
- 1. Bond prices move inversely to bond yields
(interest rates) - 2. For a given change in yields, longer maturity
bonds post larger price changes, thus bond price
volatility is directly related to maturity - 3. Price volatility increases at a diminishing
rate as term to maturity increases - 4. Price movements resulting from equal absolute
increases or decreases in yield are not
symmetrical - 5. Higher coupon issues show smaller percentage
price fluctuation for a given change in yield,
thus bond price volatility is inversely related
to coupon
24What Determines the Price Volatility for Bonds
- The maturity effect
- The coupon effect
- The yield level effect
- Some trading strategies
25The Duration Measure
- Since price volatility of a bond varies inversely
with its coupon and directly with its term to
maturity, it is necessary to determine the best
combination of these two variables to achieve
your objective - A composite measure considering both coupon and
maturity would be beneficial
26The Duration Measure
- Developed by Frederick R. Macaulay, 1938
- Where
- t time period in which the coupon or
principal payment occurs - Ct interest or principal payment that occurs in
period t - i yield to maturity on the bond
27Characteristics of Duration
- Duration of a bond with coupons is always less
than its term to maturity because duration gives
weight to these interim payments - A zero-coupon bonds duration equals its maturity
- There is an inverse relation between duration and
coupon - There is a positive relation between term to
maturity and duration, but duration increases at
a decreasing rate with maturity - There is an inverse relation between YTM and
duration - Sinking funds and call provisions can have a
dramatic effect on a bonds duration
28Modified Duration and Bond Price Volatility
- An adjusted measure of duration can be used to
approximate the price volatility of a bond
Where m number of payments a year YTM
nominal YTM
29Duration and Bond Price Volatility
- Bond price movements will vary proportionally
with modified duration for small changes in
yields - An estimate of the percentage change in bond
prices equals the change in yield time modified
duration
Where ?P change in price for the bond P
beginning price for the bond Dmod the modified
duration of the bond ?i yield change in basis
points divided by 100
30Trading Strategies Using Duration
- Longest-duration security provides the maximum
price variation - If you expect a decline in interest rates,
increase the average duration of your bond
portfolio to experience maximum price volatility - If you expect an increase in interest rates,
reduce the average duration to minimize your
price decline - Note that the duration of your portfolio is the
market-value-weighted average of the duration of
the individual bonds in the portfolio