Learning Objectives - PowerPoint PPT Presentation

1 / 30
About This Presentation
Title:

Learning Objectives

Description:

Sinking funds and call provisions can have a dramatic effect on a bond's duration ... Longest-duration security provides the maximum price variation ... – PowerPoint PPT presentation

Number of Views:25
Avg rating:3.0/5.0
Slides: 31
Provided by: wide4
Category:

less

Transcript and Presenter's Notes

Title: Learning Objectives


1
Learning 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

2
Bond and Fixed-Income Fundamentals
  • Secured and Unsecured Bonds
  • Perpetual Bonds
  • Sinking Fund Provisions
  • Call provision
  • Bond Ratings
  • Junk Bonds
  • Bond Quotes

3
The 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.

11-2
4
Bond 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

5
Secured 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.

6
Unsecured 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.

7
The 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

8
Bond 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.




9
Bond 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.




10
Bond 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.


11
Bond 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.


12
Fundamentals of the bond Valuation Process
  • The Value of a Bond.

13
Computing Bond Yields
  • Yield Measure Purpose

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
14
Rates of Return
  • Approximate Promised Yield
  • APY C (Par Market Price)/ NMaruity
  • .60 ( Market Price) .4 (Par)
  •  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)

15
Corporate 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
16
Term 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.




17
Figure 12-1 Term Structure of Interest Rates
Normal
18
The 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.


19
The 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.


20
(No Transcript)
21
Investment 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.




22
Investment 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).

23
What 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

24
What Determines the Price Volatility for Bonds
  • The maturity effect
  • The coupon effect
  • The yield level effect
  • Some trading strategies

25
The 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

26
The 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

27
Characteristics 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

28
Modified 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
29
Duration 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
30
Trading 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
Write a Comment
User Comments (0)
About PowerShow.com