Transcript Com 4FJ3 - McMaster University

Com 4FJ3
Fixed Income Analysis
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Plain Vanilla Bond
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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
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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
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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
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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
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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
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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
• 10 years to maturity
6% coupon rate
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  PVcoupons  PVface
 30 PVIFA.035,20  1,000 PVIF (.035,20)
 426.37 502.57  $928.94
• 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
• 7 years to maturity
12% coupon rate
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
For a 10% Coupon Bond
$2,000
$1,750
Price
$1,500
$1,250
$1,000
$750
$500
0%
5%
10%
15%
20%
YTM
1-year bond
10-year bond
par
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Price/Time Relationship
Price vs. Maturity
$1,800
$1,600
Bond price
$1,400
$1,200
$1,000
$800
$600
$400
$200
$0
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10
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Time to maturity
YTM 5%
YTM 10%
YTM 15%
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Reasons for Price Changes
• Change in credit quality of issuer causes
required return to change
• non-Par bond, yield doesn’t 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 (1+r)^(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
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