01 fm&i chap 5 bond mkt

Chapter 5: Bond Markets

■ provide a background on bonds

■ describe the different types of bonds and their characteristics

■ explain how bonds are priced,

■ explain bond price movements

Background on Bonds

⚫ Long-term debt securities issued by government

agencies or corporations

⚫ The issuer is obligated to pay interest (or coupon)

payments periodically (annually or semiannually) and the par value (principal) at maturity

⚫ Bonds are often classified according to the type of

issuer: treasury bonds, federal agency bonds,

municipal bonds, and corporate bonds

⚫ Most bonds have maturities of between 10 and 30

years

⚫ Can be issued as bearer bonds or registered

bonds

How Bond Markets Facilitate the Flow of Funds

Participation of Financial Institutions

in Bond Markets

Background on Bonds

financing with bonds is the coupon rate

Determined by market rates and risk at the time of issuance

Usually fixed throughout term

Determines periodic interest payments

equates present values of future coupon

and principal payments with the bond price

 The YTM is the investor’s expected rate of return if the bond is held to maturity

Background on Bonds

+ Using financial calculator

+ Using Excel (IRR function)

+ Using trial and error and interpolation

Background on Bonds

Bonds by issuers:

Corporate Bonds Corporations

Treasury Bonds

⚫ Issued by the U.S Treasury to finance

federal government expenditures

⚫ The minimum denomination for Treasury

notes and bonds is now $100 (VN: 100,000)

⚫ Maturity

Notes, < 10 Years

Bonds, > 10 to 30 Years

⚫ Active OTC Secondary Market

⚫ Semiannual Interest Payments

⚫ Benchmark Debt Security for Any Maturity

Treasury Bonds

 Normally held in the middle of each quarter.

 Financial institutions submit bids for their own accounts or for their clients.

 Bids are submitted on a competitive or a

noncompetitive basis

⚫Competitive bids specify a price and a dollar

amount of securities to be purchased

⚫Noncompetitive bids specify only a dollar

amount of securities to be purchased

Municipal Bonds

⚫ Issued by state and local governments.

the municipal government’s ability to tax.

the project (tollway, toll bridge, state college

dormitory, etc.) for which the bonds were issued.

⚫ Typically promise semiannual interest payments.

⚫ Minimum denomination of municipal bonds is

usually $5,000.

⚫ Most municipal bonds contain a call provision

Municipal Bonds

Credit Risk of Municipal Bonds

⚫ Ratings of Municipal Bonds: Rating agencies

assign ratings to municipal bonds based on the ability

of the issuer to repay the debt

⚫ Impact of the Credit Crisis: During weak economic

conditions, some state and local governments with

large budget deficits may not be able to sell

additional bonds, even when offering a higher yield, if investors are concerned that the governments may default on their debt

⚫ Insurance against Credit Risk of Municipal

Bonds: Some municipal bonds are insured to protect

against default

Municipal Bonds

Yields Offered on Municipal Bonds

The municipal bond must pay a risk premium to compensate for the possibility of default risk

The municipal bond must pay a slight premium

to compensate for being less liquid than

Treasury bonds with the same maturity

The income earned from a municipal bond is

exempt from federal taxes allowing municipal bonds to offer a lower yield than Treasury

bonds

Corporate Bonds

⚫ When corporations want to borrow for long-term periods they issue corporate bonds

Usually pay semiannual interest in the U.S

Most have maturities between 10-30 years

Public offering vs private placement

Limited exchange, larger OTC secondary

market

Investors seek safety of principal and steady income

Bond Features

Bond owners are creditors Stockholders are owners of the company

Creditors generally do not have voting

rights

Stockholders have voting rights

Interest payments are often fixed, not

dependent on profitability

Dividends are dependent on profitability

Interest payments is tax deductable Dividends are not tax deductable (from

after tax profit)

If company cannot pay back debt,

creditors can push for asset liquidation

or reorganization

The same action is not possible for stockholders

If the company go bankrupt, bond

owners will be paid first

Equity is a residual claim (paid by the remaining amount, after paying to all creditors)

Corporate Bonds

Bond features

⚫ Sinking fund provision - a requirement that the firm retire a certain amount of the bond issue each year

⚫ Protective covenants – restrictions placed on the issuing firm that are designed to protect

bondholders from being exposed to increasing risk during the investment period

⚫ Call provisions - Normally requires a price above

par value when bonds are called The difference between the bond’s call price and par value is the

call premium.

Corporate Bonds

⚫ Bond collateral - Bonds can be classified

according to whether they are secured by

collateral and by the nature of that collateral

⚫ Variable rate bonds – Long term debt securities with a coupon rate that is periodically adjusted

⚫ Convertibility - Allows investors to exchange the

bond for a stated number of shares of the firm’s common stock

⚫ Default Rate - The general level of defaults on corporate bonds is a function of economic

conditions

⚫ Investment grade: BBB, Baa or higher

⚫ Junk bonds: BB, Ba or lower

Corporate Bonds

⚫ Low-coupon and zero-coupon bonds

Provide investors known rate of return

Imputed interest income taxed if not in sheltered investment plan

tax-Attractive to pension funds with expected payouts

⚫ Variable-rate bonds

⚫ Convertible bonds

Corporate Bonds

⚫ Variable-rate bonds

⚫ Convertible bonds

⚫ Junk Bonds

Junk bonds are also called high-yield bonds or

noninvestment rated bonds (below Moody’s Baa or S&P’s BBB rated bonds)

The risk premium is between three and seven

percent above Treasury bonds

Secondary market supported by dealer market

The primary investors in junk bonds are mutual

funds, life insurance companies, and pension funds

Corporate Bonds

Listed on an over-the-counter market or on an

exchange such as the American Stock Exchange

Corporate Bonds

⚫ Using Bonds to Finance a Leveraged Buyout - The proceeds from debt are used to buy the outstanding shares of stock, so that the firm is owned by a small number of owners

⚫ Using Bonds to Revise the Capital Structure

Debt is normally perceived to be a cheaper source

of capital than equity as long as the corporation can meet its debt payments

In some cases, corporations issue bonds and then use the proceeds to repurchase some of their

existing stock This strategy is referred to as a for-equity swap

debt-Bond Valuation

⚫ Financial principle: Value of a financial asset is

the sum of present values of future cash flows from the asset

⚫ The price of a bond is the Present Value of all

cash flows generated by the bond (i.e coupons and face value) discounted at the required rate of

return

⚫ The appropriate discount rate for valuing any

asset is the yield that could be earned on

alternative investments with similar risk and

maturities

⚫ High risk securities have higher discount rates

-Use Excel

-Use short-cut formula

t t

r

F r

r

C

PV

) 1

(

) ) 1

(

1 1

.(

1

+

+ +

−

=

Bond Pricing

Example

What is the price of a 8 % annual coupon bond, with a $1,000 face value, which matures in 10 years? Assume a required return of 12%

Bond Pricing

99

773

$

) 12

1 (

080 ,

1 )

12

1 (

80

) 12

1 (

80

10 10

1

=

+ +

+

=

PV PV

Bond Pricing

089 ,

1

$

) 04

1 (

060 ,

1 )

04

1 (

60

) 04

1 (

60

5 6

1

=

+ +

+

=

PV

PV

$

) 06 1 (

060 ,

1 )

06 1 (

60

) 06 1 (

60

5 4

1

=

+ +

+

=

PV PV

) 15 1 (

060 ,

1 )

15 1 (

60

) 15 1 (

60

5 4

1

=

+ +

+

=

PV PV

⚫ If discount rate > Coupon rate (15%<6%)

=> Value < Face value (689.03 < 1000)

Bond Pricing

Example (continued)

What is the price of the bond if the required rate of return is 4% AND the coupons are paid semi-annually?

Bond Pricing

83 089 ,

1

$

) 02 1 (

030 ,

1 )

02 1 (

30

) 02 1 (

30 )

02 1 (

30

10 9

2 1

=

+ +

+ +

Bond Pricing

Example (continued)

Q: How did the calculation change, given

semi-annual coupons versus semi-annual coupon

payments?

Time Periods

Paying coupons twice a

year, instead of once

doubles the total number of

cash flows to be discounted

in the PV formula.

Discount Rate

Since the time periods are

now half years, the discount rate is also changed from the annual rate to the half year rate.

Factors Affecting Bond Prices

⚫ Bond prices change when required rate of

returns change

⚫ Required rate of returns change because of

changes in risk-free interest rate or risk premium

⚫ Risk-free interest rate

Factors Affecting Bond Prices

⚫ Factors That Affect the Risk-Free Rate

Impact of Inflationary Expectations (INF)

⚫If the level of inflation is expected to increase (decrease), there will be upward (downward) pressure on interest rates and hence on the required rate of return on bonds

⚫Inflationary expectations are partially dependent

on oil prices and exchange rate movements

Impact of Economic Growth (ECON)- Strong

economic growth tends to generate upward

pressure on interest rates, while weak economic conditions put downward pressure on rates

Factors Affecting Bond Prices

⚫ Impact of Money Supply Growth (MS)

 The increased money supply may result in an increased

supply of loanable funds If demand for loanable funds is not affected, the increased money supply should place

downward pressure on interest rates, causing bond portfolio managers to expect an increase in bond prices and thus to purchase bonds based on such expectations

 In a high-inflation environment, we may expect a large

increase in the demand for loanable, which would cause an increase in interest rates and lower bond prices.

⚫ Impact of Budget Deficit (DEF)- An increase in the

budget deficit can put upward pressure on interest rates

An increase in borrowing by the federal government can indirectly affect the required rate of return on all types of bonds

Factors Affecting Bond Prices

⚫ Factors That Affect the Credit (Default) Risk

Premium

The general level of credit risk on bonds can

change in response to a change in economic

Factors Affecting Bond Prices

Changes in Credit Risk Premium over Time

⚫ Yields among securities are highly correlated

⚫ Difference between the corporate and Treasury

bond yields widened during periods when the economy was weak

Impact of Issuer-Specific Characteristics on Credit Risk

⚫ A bond’s price can be affected by factors such

as a change in capital structure

Explaining Bond Price Movements

⚫ Summary of Factors Affecting Bond Prices

) ,

, ,

(

) ,

(

DEF MS

ECON INF

f

RP R

o The effect of economic growth is uncertain: a high level

of economic growth can adversely affect bond prices by raising the risk-free rate, but it can favorably affect bond prices by lowering the default risk premium.

o Any new information about a firm that changes its

perceived ability to repay its bonds could have an immediate effect on the price of the bonds.

o Systemic risk: the potential collapse of the entire

market or financial system

Framework for Explaining Changes in Bond Prices over Time

Sensitivity of Bond Prices to Interest

Rate Movements

⚫ Bond Price Elasticity - The sensitivity of bond prices

(Pb) to changes in the required rate of return (k)

o Influence of Coupon Rate on Bond Price Sensitivity.

o A zero-coupon bond is most sensitive to changes in the required rate of return.

o The price of a bond that pays all of its yield in the form

of coupon payments is less sensitive to changes in the required rate of return.

o Influence of Maturity on Bond Price Sensitivity - As

interest rates decrease, long-term bond prices increase by

a greater degree than short-term bond prices

k

P

in change

percentage

in change

percentage

=

Interest Rate Risk

⚫ Interest risk is the risk that bond owners’ income will fluctuate when interest rates change (bond prices change => gain/loss (= selling price – buying price) changes)

Sensitivity of Prices of Bonds with Different Coupon Rates to Interest Rate Changes

Sensitivity of Prices of Bonds with Different Coupon Rates to Interest Rate Changes

Sensitivity of 10-Year Bonds with Different Coupon Rates to Interest Rate Changes

Sensitivity of Bond Prices to Interest

Rate Movements

⚫ Duration - a measurement of the life of the bond on a

present value basis The longer a bond’s duration, the greater its sensitivity to interest rate changes

return of

rate required

investors' (reflects

maturity to

yield s

bond'

provided are

payments he

at which t time

bond

by the generated

payment principal

or coupon where

) 1

(

) 1

(

) (

1 1

k C k

t C DUR

t

n

t

t t

n

t

t t

Sensitivity of Bond Prices to Interest

Rate Movements

⚫ Duration of a portfolio - the weighted average of

bond durations weighted according to relative market value

duration s

' bond

ue market val portfolio

the of

percentage a

as ue market val s

' bond

portfolio

in the bonds

of number where

1

j DUR

j w

m

DUR w

DUR

j j

m

j

j j

Sensitivity of Bond Prices to Interest

Rate Movements

⚫ Modified duration - Can be used to estimate the

percentage change in the bond’s price in response to

a 1 percentage point change in bond yields

k

DUR DUR

+

=1

*

yield

in change

prices

bond'

in change

percentage

%where

y DUR

P

b b

Relationship between Bond Yields and Prices

Bond Investment Strategies

⚫ Matching Strategy - Involves estimating future

cash outflows and then developing a bond portfolio that can generate sufficient coupon or principal

payments to cover those outflows

⚫ Laddered Strategy - Funds are evenly allocated to bonds in each of several different maturity classes

⚫ Barbell Strategy - Funds are allocated to bonds

with a short term to maturity as well as to bonds

with a long term to maturity

⚫ Interest Rate Strategy - Funds are allocated in a manner that capitalizes on interest rate forecasts

⚫ Bonds are issued to finance government

expenditures, housing, and corporate expenditures Financial institutions issue bonds to finance their

operations In addition, financial institutions are

major investors in bonds

⚫ Bonds can be classified in four categories according

to the type of issuer: Treasury bonds, federal

agency bonds, municipal bonds, and corporate

bonds The issuers are perceived to have different levels of credit risk In addition, the bonds have

different degrees of liquidity and different provisions Thus, quoted yields at a given point in time vary

across bonds

⚫ The value of a debt security (such as bonds) is the present value of future cash flows generated by that security, using a discount rate that reflects the

investor’s required rate of return As market interest rates rise, the investor’s required rate of return

increases The discounted value of bond payments declines when the higher discount rate is applied

Thus, the present value of a bond declines, which

forces the bond price to decline

⚫ Bond prices are affected by the factors that influence interest rate movements, including economic growth, the money supply, oil prices, and the currency Bond prices are also affected by a change in credit risk