A fixed-income security is a financial
obligation to an entity that promises to pay a specified sum of money at
specified future dates.
Covenants
Affirmative covenants are actions that the
issuer promises to carry out. Negative covenants impose restrictions on the
issuer’s activities.
Bond market sectors
·
Internal bond market: domestic
bond market, foreign bond market
·
External bond market or
Eurobond market: unregistered security underwritten by international syndicate.
Outside of jurisdiction of a single country
·
Sovereign bonds: Issued by
countries central government. Can be issued by either internal or external bond
markets.
Methods of distributing securities
·
Regular auction cycle/multiple
price method: winning bidders are allocated securities at the yield/price that
they specifically bid.
·
Regular auction cycle/single
price method: All the winning bidders are awarded securities at the highest
yield except by the government.
·
Ad-hoc method: Governments
announced auctions but when the prevailing market conditions appear favorable.
·
Tap system: Additional bond that they are going to be tapped.
Previously outstanding bond issues that are now going to be tapped. A procedure
that allows borrowers to sell bonds or other short-term debt instruments from
past issues. The bonds are issued at their original face value, maturity and
coupon rate, but sold at the current market price. This method of issuing
additional debt was adopted by the British and French governments. Tap issues
allow an organization to avoid certain transaction or legal costs and expedite
fund raising. The issuer bypasses many of the initial formalities surrounding a
bond issue, such as the prospectus, and proceeds to auction off the new
securities. Issuing on tap is often suited for smaller fund-raising attempts,
where the cost of a new issue is too high when compared to the amount borrowed.
Fixed Principal Securities
Risk free securities backed by US
government.
·
Treasury Bills: Short term.
Less than a year
·
Treasury Notes: Medium term.
Between 1 and 10 years. Pay semiannual coupons.
·
Treasury Bonds: Long term. Greater
than 10 years. Pay semiannual coupons.
Inflation-indexed Treasury
Securities
These are treasuries (notes and bonds) that
provide protection against inflation.
·
The semiannual coupon rate is
fixed at issuance.
·
The par value adjusts
semiannually for inflation as measured by the CPI-U (consumer Price Index for
all urban consumers).
o
The U.S. government taxes the
adjustment each year.
o
Investors are interested in
after-tax returns from TIPS.
·
The fixed coupon rate is
applied to the inflation-adjusted par value to determine the coupon amount.
Example: A Treasury Inflation Protection
Security with a par value of $1000 has a real rate of 4.5%. After the first six
months, the inflation rate as measured by the change in CPI-U is 4%. The
inflation adjustment to the principal after the first six months is 1000 X
(4/2)% = $20 and therefore the adjusted principal amount is $1020. So basically
we use $1020 to calculate the semiannual coupon. Therefore, the coupon payment
after the first six months is 1020 x 4.5%/2 = $22.95. So the compensation for
inflation over the period is 22.95 – 22.50 = $0.45
On-the-run versus off-the-run
issues
·
On-the-run issues are the most
recently auctioned issues. These issues are more actively traded and therefore
more liquid.
·
Off-the-run issues are older
issues that have been replaced by on-the-run issues as the most recent issues.
Treasury Strips
The U.S. government doesn’t issue zero
coupon bonds for maturities greater than one year. Certain dealers buy large
quantities of Treasury bonds and to sell treasury strips. Investments in strips
result in negative cash flows for investors in the years prior to maturity as
the accrued interest of the bond is taxed each year. Zero coupon bonds created
by STRIPS program are obligations of the U.S. government. For example, a 5 Year
Treasury bond can be broken down into 11. 10 individual strips for interest and
one strip for principal.
Agency Bonds
Agency bonds are issued by agencies of the
U.S. government, but not all of them are guaranteed by the U.S. government.
Even so, they are high quality securities with very little risk of default.
·
Federally related institutions:
Jannie mae.
·
Government sponsored enterprise:
Freddie mac, fannie mae.
U.S. Agency Mortgage-backed
Securities
Stripped Mortgage Back Securities: principal-only (PO) and interest-only (IO) strips
These are MBS that are divided into
principal-only (PO) and interest-only (IO) strips, which are affected differently
by prepayments.
·
PO strips are entitled to all
the principal repayments and prepayments. They perform well as an investment
when prepayment rates are high (because the rates are low, therefore value of
PO is high).
·
IO strips are only entitled to
interest payments from the mortgage pool. The quicker the principal repayments
are received, the lower the total amount of interest collected from the
mortgages and the poorer the performance of IO strips as an investment. When
rates goes down, cash flows goes down as well because of refinancing, therefore
value of IO does not necessarily
go up depending on refinancing and outstanding principal amount.
Municipal Bonds
Most municipal bonds tend to be tax exempt.
Tax-exempt bonds are exempt from federal income taxes, but not from federal
capital gains taxes. At the state level, interest on bonds issued within the
state is usually tax exempt, but interest on out-of-state bonds is fully
taxable.
Tax-Backed Versus Revenue Bonds
·
Tax-backed debt is issued by
states, cities, schools, etc. are back by full faith, credit and taxing power
of the issuing authority.
o
General Obligation Bonds
o
Appreciation-backed bonds
o
Debt supported by public
enhancement programs
·
Revenue bonds are issued to
finance specific projects, and are serviced by the revenues generated from the
project themselves. Only if sufficient revenues are generated from the projects
will the issuers be obligated to make the payments on these bonds. Investors in
revenue bonds are exposed to more credit risk so they require higher yields
compared to general obligation bonds. You have to analyze them like corporate
bonds.
Special Bond Structures
·
Insured Bonds are insured by a
third party.
·
Pre-refunded bonds are collateralized by U.S. treasuries that
have been purchased and placed in an escrow account. Pre-refunded bonds have
little or no credit risk. Bonds that have their principle cash amount already
held aside by the original issuer of the debt. A subset of the municipal and
corporate bond classes, the funds required to pay off refunded bonds are held
in escrow until the maturity date, usually by purchasing Treasury or agency
paper.
Corporate Bonds
·
Secured debt is backed by some
form of collateral like personal property (e.g. machinery and vehicles), real
property (e.g. land and buildings) and financial assets (e.g. stocks and bonds)
·
Debentures or unsecured bonds
is not backed by the pledge of any specific collateral. Subordinated debentures
are bonds whose claims are met after those of holders of senior debt.
·
Credit enhancements (Third
party guarantees, Letters of credit, bond insurance) refer to guarantees made
by third parties that the obligations of a loan agreement will be fulfilled.
Medium term notes versus
commercial papers
·
Medium-term notes are
shelf-registered securities that do not be issued all at once. They are issued
by companies because they enable them to obtain cash flows as financing needs
rise. Structured MTNs are investment instruments that are geared towards
satisfying the needs of institutional investors who are prohibited from using
swaps and other derivatives for hedging or speculating.
·
Commercial paper is a short
term, unsecured debt instrument that is issued by companies in the open market
at rates lower than bank rates. It’s usually issued as a zero-coupon instrument
with a maturity of 270 days or less. It has very little secondary market
trading in these securities. Commercial paper is usually rolled over (to pay
off the original loan).
Bank obligations
·
Certificate of deposit (CD) is
issued by a bank to its clients when they deposit money. A CD bears an interest
rate and a maturity date, and can be issued in any denomination. In the U.S.,
CDs are insured by the FDIC (Federal Deposit Insurance Corporation) for amounts
up to $100,000. Nonnegotiable CD is one in which an early withdrawal penalty is
imposed if the depositor withdraws funds before the maturity date. Negotiable
CDs provide depositors with the option to sell the CD in the market if they
wish to liquidate it before maturity. Eurodollar CDs are U.S. dollar
denominated CDs that are issued outside the U.S.
·
Banker’s Acceptances are
basically guarantees by banks that a loan will be repaid. They expose investors
to credit and liquidity risk.
Asset Backed Securities
ABS securities are backed by pools of loans
and receivables (e.g. auto loans and leases, consumer loans, commercial assets,
credit cards, home-equity loans and manufactured housing loans). ABS are meant
to minimize cost of borrowing and receive a higher credit ratings on the issue.
Internal credit enhancements include reserve funds, over collateralization and
senior/subordinate structures. Credit enhancements are only as good as the quality
of the party providing them. A downgrading of the guarantor can result in
downgrade of the ABS.
Collateralized Debt Obligation
(CDO)
A investment product that is backed by a
diversified pool of assets which can include investment grade bonds, high-yield
corporate bonds, emerging market bonds, ABS and even other CDOs. Arbitrage CDOs
are formed with the purpose of earning a spread between the return on the
portfolio and payments to the note-holders in the CDO. Balance sheet CDOs are
instruments that effectively remove debt obligations from an issuer’s balance
sheet.
Primary Markets
Primary markets deal with securities that
are newly issued to investors by central governments, agencies and
corporations.
Secondary Markets
Secondary markets include exchanges and
over-the-counter (OTC) markets. Secondary markets offer bond investors
liquidity, provide information about fair values of securities and reduce costs
of search for bond market participants.
• The municipality takes a 2% haircut, lending 98% of the market value, or $30,604,140.70 at a repo rate of 5.25%.
• After 51 days, the municipality returns the $30
million bonds, and the dealer repays $30,604,140.70 (1+0.0525 x 51/360) = $30,831,759.
• Note that repo rates are simple interest rates that use an actual/360 calendar (in the U.S.--some other countries use actual/365).
• if the dealer lends money, it's a reverse repo
If the duration of the loan is one day, the agreement is called an overnight repo.
* Approximately 50% of the market.
Otherwise the agreement is a term repo
* The term can be as long as one year.
* The vast majority of repos have maturities of three months or less.
Open repo is an overnight repo whose term is renegotiated on an ongoing basis.
Bonds trading ‘on special’ in the repo market will also be subject to exceptional specific demand in the cash market. Indeed, demand in the cash market is usually the reason why bonds trade on special in the repo market. Market-makers and other dealers will use the repo market to borrow bonds that are in strong demand in the cash market (and therefore sometimes scarce) in order to fulfill delivery commitments on sales of those bonds in the cash market. One of the most common reasons for a bond to go special is when it becomes the cheapest-to-deliver in the futures market for that bond. Some futures sellers will have difficulty buying what they need to deliver to the futures clearing house. As failure to deliver to a clearing house would have serious consequences, these parties will be forced to borrow the bond in the repo market and they may have to bid aggressively to secure it.
Where a bond is on special in the repo market, it will be more expensive to buy in the cash market compared to comparable issues.
Yield Curve
The yield curve illustrates the relationship
between the yield to maturity and term to maturity of on-the-run treasury
securities. Investments in on-the-run securities can be financed at lower rates
than investments in off-the-run issues. This results in greater demand for
on-the-run securities, which increases their prices, and artificially lower
their YTMs.
Theories of the term structure and interest rates
1.
Pure (unbiased) expectations
theory: It asserts that long-term yields are simply the geometric means of
short term yields. An upward sloping yield curve implies that short-term rates
are expected to rise in the future. A flat curve indicates that short-term
yields are expected to remain constant. A downward sloping yield curve suggests
that short-term rates are expected to fall in the future. A humped yield curve
can be explained by investors expecting short-term yields to rise for a number
of years before falling eventually. This theory doesn’t account for the higher
interest rate risk borne by long-term investors.
2.
Liquidity preference or biased
expectations theory: It accounts for the fact that investors in long-term
securities require compensation for taking higher interest rate risk. Yields
are determined by two factors: Expected future short-term rates and a yield
premium for taking greater interest rate risk.
3.
Market segmentation theory:
asserts that the yield for each maturity along the yield curve is determined
independently by the supply and demand of funds over the particular horizon.
The market for bonds is divided into segments and each segment determines its
own equilibrium yield. This theory fails to explain the observed fact that
yields for different maturities tend to move together.
4.
Preferred habitat theory: it
states that in addition to interest rate expectations, investors have distinct
investment horizons and require a meaningful premium to purchase bonds with
maturities outside their “preferred” maturity, or “habitat”. Match the duration
of your liabilities with the duration of your assets. If you are a pension fund
and you have long time to return money to retirees, you can purchase long –term
assets.
Treasury Spot Rates
The yield to maturity on any zero-coupon
bond is known as a spot rate and is distinguished as the yield that has no
reinvestment risk (because there is no interim cash flows).
Bond Price
A bond's dollar price represents a percentage
of the bond's principal balance, otherwise known as par value. In its simplest form, a bond is a loan, and the principal balance, or
par value, is the loan amount. So, if a bond is quoted at 99-29, and you were
to buy a $100,000 two-year Treasury bond, you would pay $99,906.25.
Let's look at how we calculated this number. A bond's price consists of a
"handle" and "32nds". The two-year Treasury's handle
is 99, and the 32nds are 29. We must convert those values into a
percentage to determine the dollar amount we will pay for the bond. To do so,
we first divide 29 by 32. This equals .90625. We then add that amount to 99
(the handle), which equals 99.90625. So, 99-29 equals 99.90625% of the par
value of $100,000, which equals $99,906.25.
Whereas many corporate bonds pay principals of $1,000, this is not the case for many non-corporate bonds and other fixed-income securities. As a result, many traders quote bond prices as a percentage of their par value. For example, if a bond is selling at par, it would be quoted at 100 (100 percent of par); thus, a bond with a face value of $10,000 and quoted at 80 1/8 would be selling at (.80125)($10,000) = $8,012.50. When a bond's price is quoted as a percentage of its par, the quote is usually expressed in points and fractions of a point, with each point equal to $1. Thus, a quote of 97 points means that the bond is selling for $97 for each $100 of par. The fractions of points differ among bonds. Fractions are either in thirds, eighths, quarters, halves, or 64ths. On a $100 basis, a 1/2 point is $0.50 and a 1/32 point is $0.03125. A price quote of 97 4/32 (97 – 4) is 97.125 for a bond with a 100 face value. It should also be noted that when the yield on a bond or other security changes over a short period, such as a day, the yield and subsequent price changes are usually quite small. As a result, fractions on yields are often quoted in terms of basis points (bps). A bp is equal to 1/100 of a percentage point, or phrased differently, 100 bps = 1 percent. Thus, 6.5 percent may be quoted as 6 percent plus 50 bps, or 650 bps, and an increase in yield from 6.5 percent to 6.55 percent would represent an increase of 5 bps.
Bloomberg FIT screen shows the prices and yields of U.S. Treasury bonds, Treasury notes, and Treasury bills that were recently issued and actively traded. The Bloomberg description screen (DES) for the Treasury provides more details; for example, the bond was issued on 2/15/12, matures on 2/15/22, pays a 2 percent coupon semiannually, its quoted bid and ask prices from one dealer (BVAL) (ALLQ screen) are 99-15 1/4 and 99-18 3/4. The Bloomberg yield analysis (YA) screen shows, for an investment period from the settlement date of 4/19/12 to 2/15/22, the yield or total return on the bond (with semiannual compounding) is 2.054441 percent.
Like the value of any asset,
the value of a bond is equal to the sum of the present values of its future
cash flows.
Example: A 5 year semiannual pay bond
carries a coupon rate of 8.5% and has 4 years remaining to maturity. If the
yield to maturity on this bond falls from 9% to 8.75%, the quoted price of this
bond is:
FV= 100
PMT= 8.5/2= 4.25
r= 8.75/2= 4.375
n=4*2=8
n=4*2=8
PV=99.17
The longer a coupon paying
bond’s term to maturity, the greater its price sensitivity to changes in
interest rates.
If Bond Price < Future
value è Bond is selling at a discount (interest rate > coupon rate)
If Bond Price > Future
value è Bond is selling at a premium (interest rate < coupon rate)
The inverse relation between a
bond's price and rate of return is illustrated by the negatively sloped price-yield
curve shown below. The curve shows the different values of a 10-year, 9 percent
annual coupon bond given different rates. As shown, the 10-year bond has a
value of $938.55 when R = 10 percent and $1,000 when R = 9
percent.
Bloomberg PT screen shows the price and yields for the 5 3/8 percent, 2020 Kraft. In addition to showing a negative relation between price and yield, the price-yield curve is also convex from below (bowed shape). This convexity implies that for equal increases in yields, the value of the bond dasing rate). The bow-shapedness of a bond's price-yield curve is referred to as the bond's convexity.
Example: Which of the
following bonds is least likely accurately priced
Bond Coupon Rate(%) yield(%) Maturity(Years) Price
A 7.5 8 11 102.25
à Premium
B 0 10 5 62.09
à discount
C 12.5 12 2 100.85
à premium
Bond A is Not accurately priced. Coupon
< Yield, therefore Price < Parvalue à
discount and not premium
Duration
Example 1: In response to a change in
yields from 11% to 13%, a bond’s market price falls by 7% . The duration of the
bond is:
Duration = -7%/2%= - 3.5%
Example 2. In response to a decrease in yields
from 12% to 10.5%, a bond’s market price moves by 3.5% to 897.55. The dollar
duration of the bond is:
Dollar
Duration = price change for 100 bps in rate change
Duration = 3.5%/-1.5%= - 2.33%
Old price * (1.035) = New Price = 897.55 è Old
Price = 867.20
897.55 – 867.20 = 30.35 à price
change for 150 bps in rate change
30.35/1.5 = 20.23 à price
change for 100 bps in rate change
Callable and Putable bonds
Disadvantage faced by investors in a callable security:
1.
There is uncertainty of the
timing and pattern of future cash flows.
2.
The security carries high
reinvestment risk.
3.
The security suffers from price
compression at low interest rates
Price
compression: The limitation of the price appreciation potential for a callable bond in a declining interest rate environment, based on the expectation that the bond will be redeemed at the call price.
Price of a callable/putable bond
Price of a callable bond = price of option
free bond – price of embedded call option
Price of a putable bond = price of option
free bond + price of embedded put option
Risks
Interest rate risk
Bonds with different coupon rates have
different exposures to interest rate and reinvestment risk. For example, a bond
with a 5.35% has a higher interest rate risk (duration) and a lower
reinvestment risk than 5.75% coupon bond with a similar term to maturity.
Factors to interest rate risk:
1.
Higher term to maturity
increases the interest rate risk.
2.
Low coupons
3.
Premium means high price and
therefore low yield.
Example: Which of the following bonds most likely has the greatest
interest rate risk given that they are all option free:
Bond Coupon Rate(%) yield required by market(%) Maturity(Years)
A 5.5 6.8 11
B 7 6.9 12
C 5.5 6.4 11
Term to maturity are relatively close for
the bonds. A and B has low coupons and C has a lower yield. Therefore C has the
greatest interest rate risk.
An increase in interest rate volatility
will most likely
1.
Increase the value of the call
option embedded in a callable bond.
2.
Decrease the value of callable
bond.
3.
Increase the value of a putable
bond.
4.
Increase the value of the put
option embedded in a putable bond.
Prepayment Risk: Contraction Risk,
Extension Risk, CMO
A mortgage pass-through security is one in
which homeowners’ payments pass through the government agency on to investors.
The prepayment risk faced by each individual investor in the pass-though is
spread across all the loans in the pool. The motivation for creating a CMO –
Collateralized Mortgage Obligation is to redistribute prepayment risk among
different classes of securities issued. A CMO has different tranches, each of
which is exposed to a different level of prepayment risk. CMO provides greater
certainty about the expected maturity of each tranche as compared to mortgage
pass-throughs
·
Tranche A (Short term)
o
Most contraction risk when the
rate goes down
o
Least extension risk when the
rate goes up
·
Tranche B (long term)
o
Most extension risk when the
rate goes up
o
Least contraction risk when the
rate goes down
·
If rate is
going up, you want to avoid extension risk and if rate is going down, you want
to avoid contraction risk.
