4 - Bonds (fin) Flashcards
Bond characteristics
NV - far value/face value - amount issue will pay back @ redemption. coupon expressed as % of this
£100, $1000, 100 yuan, 1000 rand
price - quoted as amount investor would have to pay to buy NV
redemption date/maturity date - when issue will repay NV
coupon - interest that issuer pays to holder (usually semi annual, can be quarterly or annual)
can be 0 for ZCB
fixed for vanilla bonds
index (inflation) linked for ILB - linked to RPI with 8 (issued before jul 2005) or 3 month lag - inflation uplift = RPI now/RPI @ issue
maturity
<7yrs = short 7-15 = med >15 = long
yield - measures return on bond incl coupon and principal
what is a bond
a form of debt whereby borrower issues bond and receives price of bond, over the lifetime of bond pays interest in form of coupons and then at maturity repays lender the principal value of the bond
rank ahead of equity in cases of liquidation - so relatively low risk - so generally lower expected returns
traditionally low correlation to equities
bond yield
= return an investor expects to receive each year over its term to maturitY
In financial media - will see flat yield and GRY (aka YTM)
figure shown = annual
markt val of straight will vary as rates vary - because fixe dcoupon will seem more/less attractive relative to rates
yields can be neg = capital loss (cannot be offset as no CGT on gains)
higher yield = higher risk
risk built up of
risk free rate + credit risk + liquidity risk + currency risk (if in another currency) +maturity
for most govis - yield is just risk free rate + maturity as no credit risk/currency risk
currency risk can be taken on by issuer by denominating bond in another currency
bond features: maturity date
single dated/bullet bonds - vast majority of bonds - single redemption date
irredeemable/perpetual/undated
issuer has no obligation to redeem but may have right to do so after particular date
coupon paid in perpetuity
e.g. war bonds UK 5% war loan 1917
no undated UK gilts in issue
also issued by corps - AT1 bonds are perpetual bonds issued by banks to help fulfil cap reqs
most corp perpetuals are convertible
callable bonds - can be redeemed by issuer between call date and maturity date
- if rates fall - call back and refinance at lower rate
higher coupons for investor
e.g. UK double dated gilt - last one redeemed in 2013
putable bonds
can be redeemed early by holder
- if rates rising - redeem and buy new bond @ higher rate
lower coupon
both call and put bonds hard to analyse price - dissuades investors
Coupons
most bonds = fixed rate coupon = ‘straights’
frequency = market driven
semi annual usually- UK, US, Japan, Italy
annual - Germany, France
ILB - coupon and redemption linked to inflation index (currently RPI) via uplift (or down if no deflation floor)
FRN - coupons linked to ref interest rate e.g. SONIA, ESTR, SARON, SOFR
ZCB - no coupon. issued at discount to face val and the gain provides the required GRY - will be subject to income tax as yield is considered to have accrued over life of bond
- UK govs dont issue these but can be created via STRIPS
step up coupons - % increases annually
Credit ratings
Credit rating agencies provide a benchmarking system for government and corporate bonds.
-Moody’s, Fitch, S&P
IG - least likley to default, highest liquidity
speculative/high yield/junk/non IG - more likely to default, compensated for with higher coupons and higher YTM
PostGFC scrutiny - competitive pressure to lower standards, bias towards clients with more issues with ratings agencies
Credit ratings - Moody, fitch, s&p
spreads
difference between yield avail on 1 instrument vs another - usually as bps
e.g.
same instrument different maturities
2yr gilt vs 10 yr gilt
corp vs gov
- 10 yr appl vs 10 year treasury
different countries
10yr gilt vs 10 year treasury
used as indicators of risk sentiment - wider spread vs govi = greater perceived risk
can also be vs rate benchmarks eg SONIA, ESTR, SOFR etc
als bond yields vs equity yields - observed as indicators of changing sentiments and relative val
bond covenants
baso just conditions that protect holders
covenants limiting further debt and priority -
negative pledge clause
- prevent issuer from reducing val of bond by issuing additional debt @ higher priority or
pari passu clause
- only allowing debt to be issued at higher priority is existing bonds are upgraded to have equal priority
covenants restricting divi payment
- excessive divis could negatively impact bond value - covenants frequently restrict payment of cash divi based on earnings and cash
- can also restrict buyback facility
covenants restricting sale of assets
- to prevent val falling due to asset sale - often assets only permitted for sale if proceeds used to buy new fixed assets or retire debt
- can prohibit transfer of whol bis or require new owner to assume all obligations of bond
breach of covenants is a default event - if no solution is found afer engagment period post default - bond becomes immediately repayable
Susuk
Islamic financial instruments - similar to bond s- compliant with Shariah law (interest forbidden)
works on basis of risk sharing -customer and bank share risk of investment and divide profit between them
susuk = instruments of equal val representing common share in ownership of UL
baso - issuer sells investor group a certificate (susuk) and uses proceeds to buy asset -investor group has direct partial ownership in asset
issuer must also promise to buy back certificate at future date @ par
severaldifferent structures
Ijarah Susuk
Ijarah = lease
company owns asset
SPV issues susuk and uses proceeds to buy asset from company
leases asset back to company
lease payments passed back through to investors
@end - comp buys back assets and SPV buys back susuks from investors
Intifa susuk
similar to Ijarah but investors have right to use,own, develop asset over period
issuer divides right sof assets into units and transfers to investors
investors have right to benefit like a time share
salam susuk
similar to forward contract
issuer issues susuk and promises to delivery commodity on future date
price paid in advance via susuk
usually ST finance
perpetual susuk
susuk without specific maturity date
may be redeemed or amortised wholly or partially @ any time @ issuer discretion or within specific period
gov, ministries, instiution and public authorities can issue perpetual susuk
convertible susuk
gives holder right to convert into shares of issuer at future date
price of susuk cannot be below par val of shares
green bonds?
GBP?
conventional debt where proceeds used to finance/refinance new/existing green projects
- w/ positive environmental or climate benefits e.g. energy efficiency, transportation
additional transaction costs - issuer must track, monitor and report on funds
- issuers think this is offset by benefits (diversifying investor base, highlighting greenness etc)
lack of standardization as to what makes a green bond - can lead to greenwashing, green label can confer pricing advantage
GBP - green bonds principal dev by ICMA - completely voluntary recommendation of guidelines + transparency and disclosure, promoting integrity etc
fall from green grace - bonds losing green status -reputational and price damage - could put cap at risk due to downward pressure.
canlead to ‘green default’ - investors seeking penalties for breaking green clauses even if bond is paid in full
green bonds?
GBP?
conventional debt where proceeds used to finance/refinance new/existing green projects
- w/ positive environmental or climate benefits e.g. energy efficiency, transportation
additional transaction costs - issuer must track, monitor and report on funds
- issuers think this is offset by benefits (diversifying investor base, highlighting greenness etc)
lack of standardization as to what makes a green bond - can lead to greenwashing, green label can confer pricing advantage
GBP - green bonds principal dev by ICMA - completely voluntary recommendation of guidelines + transparency and disclosure, promoting integrity etc
fall from green grace - bonds losing green status -reputational and price damage - could put cap at risk due to downward pressure.
canlead to ‘green default’ - investors seeking penalties for breaking green clauses even if bond is paid in full
what is greenwashing
practise of comps making misleading environmental claims for marketing purposes - with aim of improving rep, to attract environmentally aware customers and increase profits
social bonds
bond with proceeds used to fund projects with non environmental but beneficial theme - typically with social objectives in mind
e.g. basic infrastructure, affordable housing, health services - particularly to benefit those livign below poverty line
first ever - Asia 2018 - to provide stable LT housing in Korea
like green bonds - ICMA has issues SBP (social bond principles) - voluntary guidelines where issuers may align framework to market expectations = market confidence
sustainability bonds
funds used to finance or refinance combo of green and social project - ICMA has issued SBG - sustainability bond guidelines - promoting integrity etc, voluntary
sustainability linked bonds (SLBs)
any bond instrument where financial and structural characteristics vary depending on whether issuer has achieved ESG/sustainability objectives
more flexi than green/social/sustainability bonds which can only be used to finance specific projects
- no specific use of proceeds - but issuer must define/commit to sustainability path over years
ICMA has vol SLBP guidelines = sets out best practise for launching credible slb
SLBs are complimentary financing to green/social/sustainability bonds
blue bonds
proceeds used for protection and conservation of marine ecosystems
generally issued by low-income countries that are heavily reliant on oceans and their resources
first sovereign blue bond: 2018 Republic of Seychelles - $15mn to support expansion of marine protected areas, fisherie governance
coupons partically guaranteed by world bank and concessional loan from GEF
social impact bonds
main goal is to achieve social objectives not investmentreturns
very diff from conventional bonds - focus is on social benefit > investment potential
payouts based on specific social criterias being met
dont offer fixed return
used by govt to address issues e.g. homelessness, youth unemployment, children in care etc
BASO
contract with GOV/pub sector issue, whereby it pays for better social outcomes + passes on part of the savings achieved to investors.
factors affecting bond price
rates (up P down) - investors need higher ROR as rates rise
inflation (up price down) - investors need higher ROR as inflation rises, for ILB price tends to rise as higher inflation expected - both prevailing and expected rates impact
liquidity - more liquid = more expensive
exchange rates
issuer specific factors
- credit rating - higher = higher price - lower yield
- structure and seniority of bond - higher = higher price
bond derivs
loan based crowdfunding+ risks?
crowfunding = popularized following GFC - way of financing debt through raising via from a large no. of people
loan based aka P2P
- consumers lend to bis directly for interest payment and repayment of capital over time
- bypasses traditional banks
- returns are financial
-primarily for profitable SMEs, not really suitable for startups
Risks
- no FSCS recourse
- may have difficulty cashing in (some platforms do have 2ndary market tho)
- capital at risk
investment based crowdfunding+ risks
consumers invest in comp by buying shares or debentures
- can also refer to mini/crowd bonds which is a way investors lend directly to bis
Risk
- high risk - potential for loss of capital funding entrepreneurial endeavours
- may have little recourse in case of default/fraud
- dilution risk as likely multiple rounds of funding
- long investment periods
- risk platform could fail or become insolvent
- secs not transferable, most platforms have no 2ndary market - difficult to cash in early
lending platforms for debt crowdfunding
UK = FundingCircle— US=Lending Club
Fudingcircle - 2010
- P2P crowdfunding platform , listed in 2018 on lse
- enables investors to lend to small comps - mechs have changed over time
- used to allow retail investors to pick who they lent to - suspended this in 2017 citing lack of diversification and risk to retail investors
FCA reg of lending platforms
FCA regs both loan and investment based crowdfunding
- banned sale on mini bonds to retail investors in 2020 - substantially decreasing popularity of investment based crowdfunding
- they did this after many mini bond scandals
- e.g. collapse of mini bon dprovider london capital finance - promised 8% interest and risked >£200mili invested by 11k people
bond fintech
capexmove?
bondevalue?
fintech has potential to transform bond markets - large fin instit are experimenting w/ issues on blockchains
capexmove - bond tokenisation platform - digitises tradition debt instruments into smart legal contracts and issues tradable units
bond evalue - breaks down large denomination bonds into smaller denominations suitable for retail investors
approved in 2020 by monetary authority of Singapore as a recognized market operator
gov bonds
govs issue bonds to raise money to cover deficits, fund projects etc - easy for govs like UK with high credit rating
low risk as as government backed - though govs can default
Argentine has defaulted 9 times in history - May 2020 - failed to make $500mn interest payment on foreign debt
dev market gov debt
UK - issued by DMO (executive agency of treasury), also servies and manages gilts
US - US treasury handles secs issued by US gov in form of T bonds, notes and bills, also issues gov sponsored entities which involve ABSs
EU - countries retain control over its own debt - even eurozone
EM debt
historically only a small fraction of global bond market due to
limited issuance, poor data qual, market illiquidity, regular economic crises
Brady bonds - US treasury sec nicholas brady issued first EM gov bond by converting many latin american defaulted bank loans to collateralized ZCBs.
issued in USD to reduce currency risk (political instability etc)
now - improved credit ratings, stronger gov balance sheets, much sovereign debt considered IG
types of gilt
conventional
75% - fixed, semi annual coupon. receive principal + final coupon @ redemption
ILG - approx 1/4 of UK debt
coupon payments and principal adjusted in line with RPI (8 month lag before sep 05, 3 month lag after)
will have no uplift in period of zero deflation
during deflation - depends on if gilt has deflationary floor
STRIPS
practise of stripping coupon and bond apart, so CFs and principal are separated
holder of prin basically has ZCB, which trades at discount to NV
holder of coupons analogous to annuity (if coupons split up they are also baso ZCB)
good for liability matching - no reinvestment risk as usual with coupon paying gilts
only some gilts are designated ‘strippable’ by DMO and stripped by GEMMs
dual dated - none in issue rn
foreign currency debt issues
- issued to finance foreign currency reserves. USD and euro outstanding rn. trade like eurobonds with same conventions for accrued interest
green gilts
first issued in 2020 to mean green obj
Green Gilts issued in Sep 2021. Plan to raise £15bn to fund clean transport, climate change adaption, renewable energy,
energy efficiency, pollution prevention and control and living and natural resources
NSI green savings bonds
fixed term investments where saving contribute to green projects - rate fixed for 3 yrs, taxable but paid gross.
no floating rate or convertible in issue since 01
bid- cover ratio
no. of bids received / no. of bids accepted (or can use £ amount / £ amount)
> 2 = successful auction - strong demand
<1 = failure - amount bid < amount offered
low ratio = disappointing auction - marked by higher yield
gilt issuance
competitive auction - pay the amount bid up to the amount the DMO wishest to raise highest to lowest
non-competitive tender - up to 500k NV where applicants revieve NV they applied for @ weighted avg price of successful competitive bids
PAOF - post auction option facility
successful bidders have option to acquire additional 10% of gilt allocation @ average accepted price
Interim funding/TAPS
issuance of smaller quant of stock to improve liquidity or market efficiency - DMO sells to GEMMs (often tranche of existing stock or result of failed auction )
GEMMs
obligations and privileges
must be vetted by DMO and LSE - then become primary dealers
obligations
- to make effective 2 way prices to customers on demand up to size agree with DMO = provide liquidity (excluding other GEMMS, fixed interest MM or gilt IDB)
- to participate in gilt issuance programme, bidding competitively - baso underwriting gilt auctions
- provide DMO with closing prices, market conditions and GEMMs positions/turnover
privileges
- executive rights to competitive telephone bidding @ gilt auctions and other DMO ops
- exclusive facility to trade as counterparty to DMO
-exclusive access to gilt IDB screen
firm can register to be a GEMM on
- all gilt edged secs
-IL gilts only
- gilts excluding IL
Broker dealers
non GEMM LSE members that can buy/sell gilts as agent (broker) or as principal (dealer)
- as broker - bound by LSEs best ex rules
- must identify with GEMM if deal is a small one from outset i.e. <1mili
Gilt IDB (inter dealer brokers)
arrange deals anonymously between GEMMs
cannot take principal positions
IDB acts as angel - but settles transaction as in it were the principle
can only act as principal between GEMMs
secondary gilt market
supported by GEMMs who must ensure two way quote exists @ all times
secondary market for ILG may be less liquid than straights
relationship between interest rates and gilt price
inverse
rates increase - fixed val of coupon less attractive vs rate on deposited funds - price down
rates decrease - fixed val of coupon more attractive vs rate on deposited funds - price up
gilt repos
repo = sale and repurchase - legally binding
borrower - sells gilts and agrees to buy back @ future date @ set price with interest @ repo rate inferred in the repurchase price
baso ST lending w/ gilt as collateral
If coupon due during repo must be paid back to orig owner - stated in repo agreement
buyer/lender has entered into a reverse repo
borrower = able to raise finance against security of gilts - potentially @ cheaper rate
lender = if lender is bank - benefit of repo is security of gilt vs conventional finance
if lender = GEMM - repo enables GEMM to access gilts it requires to meet settlement obligations
Standing repo facility (SRF)
ensures smooth running of gov bond market
enables GEMMS to enter into reverse repo with DMO to e.g. cover short position in bonds
must first sign the relevant documentation provided by CB
above £5mn NV
next day settlement
can be rolled forward for up to two weeks
other countries also have SRF
in UK DMO charge higher than normal repo rate
Reverse repo and sale
creation of short position in debt instrument - where buyer/lender immediately sells security provided by borrower/seller on open market
on settlement date - buyer acquires gilt in market (hoping to profit from fallen price) and delivers to seller
stock borrowing and lending intermediaries (SBLI)
- pool large blocks of secs from instit investors (pension funds, insurance brokers)
- secs then loaned out to borrowers to cover their short position
- once short position is closed out (borrowers purchased secs elsewhere), bonds returned to instit
- SBLI charges fee 0.5% split between themselves and lenders of secs
- minimal activity in UK since 96 due to intro of repo market
instit investors dont have to do anything - just receive fee
with repo - they would have to invest money paid to make return
gilt settlement
UK - settle T+1 in CREST (certificates registry for electronic share registration) - part of Euroclear UK and Ireland
CREST is the CSD, regulated by the BoE with RCH status
CREST
same day clearing system
allows shareholders/bondholders to hold assets in dematerialized form
clears trades by matching settlement details of buyers and sellers
UPDATES SHAREHOLDER REGISTER - settles when CREST updates the register of relevant company to transfer shares to buyer
ISSUES PAYMENT OBLIGATION - bank to transfer £ to seller
ISSUES RECEIPT NOTIFICATION - to sellers bank to expect payment
ETC (electronic trade confirmation system) - both parties to transaction required to confirm sides of transac via file transfer - submit confirmation details to CREST - if they dont match CREST highlights this
LCH - clearing house for OTC trades (CREST/Euroclear) which is responsible for settling transaction with each CP
other functions
- custodianship
-assisting w/ divi payments
-handing corp actions on behalf of clients it reps
- collects SDRT
CREST members are either
- members - large instits used by sponsored members to provide access
- sponsored members
bond prices and futures
IR and inflation expectations are explicit in bond derivs - these are a driver of bond prices
10 yr treasury note contract - one of most activity traded futures contracts - trades of CBOT
- v good liquidity
- vehicle to hedge exposure to variety of fixed income instruments
- speculation opp (on IR spread between IG and HY bonds vs UST)
bond futures = cash or physically settled (cheapest to deliver bonds)
arbitrage opps will quickly eliminate price discrepancies regarding cheapest to deliver bonds
debenture vs loan stock
debenture = loan with some specified security
loan stock/unsecured loan stock = loan with no security provided
- in UK market tends to be comps with high credit rating or status
loans w/out security have higher coup to compensate for risk
eurobonds
bonds issued outsideof the country whose currency they are denominated in
- allows orgs to issue debt w/out being restricted to domestic market
bearer form (comp doest keep record of holders) - safekeeping is important - so often held in depositories/ CH - ‘immobilisation’
unsecured debt (highly rated comps)
OTC trading
no WH tax (CH keeps register but not avail to gov)
coupons taxable but paid gross + annual
vanilla (annual coupon) or ZCB, FRN, stepped coupon
trades matched through TRAX
ICMA self regulatory system
t+2 settlement
accrued interest 30/360
foreign bonds
aka overseas bonds - bonds issued in a domestic market by a foreign comp in domestic market’s currency
eurobond - currency is different from the domestic market currency
regulated by domestic market authorities
useful for investors as can add foreign credit without fx exposure
fixed charge
2 types of legal charge a comp can issue over its assets - fixed or floating
fixed - over definable asset of company identified in deed of debenture
- usually asset whose val wont decrease over term of debenture
-comp cannot sell asset w/out lender’s permission (debenture holder wont do this unless they are offered equally good asset as replacement)
if comp fails coupon or principal payment - holder can
- appoint receiver + get income from assets under charge
- take possession of asset and sell - using income to repay debentures
- return excess proceeds to comp
- any shortfall will be unsecured liability of comp
floating charge debenture
2 types of legal charge a comp can issue over its assets - fixed or floating
floating charge =equitable charge on all comps assets, both present and future - so comp can use assets in normal course of bis
- e.g. stock, works in progress, plant and machinery, vehicles, premises
good for comp as bis can continue as ussual - charge floats over asset until debenture ‘crystallizes’
- failure to meet terms of cap or income payments
-liquidation
- cessation of trading
cystallisation -charge fixes on assets currently owned by comp
corp bond redemption
bullet, serial, optional
bullet - most bonds - principal val paid all @ once on maturity date
non-callable
serial
- principal amort redeemed in installments @ regular intervals til maturity
optional
issuer (sometimes holder) has option to redeem bond
e.g. double dated - can redeem @ either date but must redeem at later one
discounted bonds
either w/ no or low coupon (substantially lower than current IR)
issued at discount to NV - reflecting prevailing IR
longer maturity = greater discount
deeply discounted if bond sold >20% below par
earnings treating as income rather than cap gain - considered to be accrued over lifetime of bond
adv - issuer not burdened by full interest cost in early years
corporate FRN
bonds where coup fluctuates with a market rate of interest
e.g. SONIA, ESTR, SOFR, SARON, TONAR
coupon =
reference rate + quoted spread above ref rate (bps)
possible additions :
drop lock - IR becoming fixed if it falls to specific level
cap- ceiling on rate to protect issuer
collared/mini max - floor and ceiling
floors - floor or rates - wont fall below this level (can rise back up unlike drop lock)
inverse floaters - pay variable coup that changes in op direction to ST IR
subtracts benchmark from set coupon rate e.g. 6% - SONIA
dual currency bonds
coupon and redemption in different currencies
rate could be determined @ outset ot spot rate @ time of transaction
can also be designed w/ an option to use a mixture of currencies
equity sweeteners
either by issuing convertible or by attaching a warrant
might allow issuance w/ lower coupon
convertible bonds
gives holder right not obligation to conert bond into predetermined no. of ordinary shares of issuer @ fixed price @ set time @predetermined conversion ratio e.g. (25 shares per 100 NV)
holders only exercise if share price more attractive than prevailing market price
exposes holder to growth potential in rquity while retaining safety of bonds - trade at prem to shares they can convert into
characteristics of convertibles
until converted or maturity - react to changes in yield and IR like other bonds
employed as deferred shares - issuers expect conversion @ conversion date/period
predefined conversion ratio - e.g 25 per 100 NV (maybe with price per convert too)
conversion right may only be on maturity or may exist for period of time
lower coup than straight corp
subordinated debt instruments
poss additions
- put rights - to force early redemption normally at premium to par
- call rights - under certain conditions @ certain price
adv and disadv of convertibles to issuer
Advantages
- lower coupon issuance
- no immediate dilution of shareholder control
- no assets required to secure straight finance
- good for finance projects with LT payback
- less EPS dilution than normal share/bond issue
- interest payments tax deductable unlike equity finance
Disadvantages
- coupon payments required even if comp makes no profit unlike divi payments
- if poor performance - would have to redeem for cash if holder chooses not to convert
- cannot be sure firm is issuing deferred share cap as may not convert
- future dilution of shareholders
advantages and disadvantages to investor of convertibles
advantages
- security of fixed income with downside protection if shares fall with option to participate in uplift from + share price performance
- higher coupon vs divi yield (lower than straight corp)
- very liquid vs straight corp
- above shares in liquidation
disadv
- unsecured, lower ranking debt - lower repayment piroiry
-often callable
-dilution of existing shareholding on conversion
-if cshares go down - yield sacrified vs corp with no benefit
- lower yield than corp (higher than corresponding eq)
conversion ratio
no. of shares the bond can be converted into
e.g. x shares per £100 NV
ratio = NV/conversion price
conversion price
convertible price/no. of shares
can use NV if converting at maturity
conversion value
current share price x conversion ratio
conversion ratio = NV/conversion price
conversion premium
conversion price - share price /share price
eurobond issuance
via syndicate of international banks
eurobond issuers dont keep record of holders - bearer docs
IB who originate issues have develeoped various types
corp bond issuance
most common method in primary, domestic bond market is via placement
corp bond issuance
most common method in primary, domestic bond market is via placement
issuer appoints lead manager - awards them w/ mandate
LM empowered + obligated to issue bond on behalf of issuer +ensure issue is taken up
- failed placement does reputational damage to LM and issuer
- agrees bond terms with issuer (can change as market conditions dictate)
-Best efforts or Bought deal (commitment of LM to purchase entire issue - puts risk on LM balance sheet)
LM can create management group of other issuing houses
- each house receives % of deal and places with clients
-Or LM can run entire book and omit management group
variation - fixed price re-offer
-members of management group not permitted to sell below issue price in 2ndary market unit syndicate terminates
- this happens when LM believes most of issue has been placed
secondary market for corp bonds
limited secondary market both in domestic and euromarket
most issues not actively traded - market therefore not well structured with little involvement from MM
mostly - away from major XC in decentralized market - dealer provide liquidity
either between dealers or between dealers and customers
D2D =
- phone call
- indirect with IDB broking deal
- via electronic market - electronic trading platform eg MTS
PV of bond long hand (semi annual)
for semi annual bond
HALVE COUPOUNS
HALVE DISCOUNT RATES
DOUBLE TIME PERIODS (TO WHOLE NUMBERS)
PV of bond long hand (NPV)
PV = discounting future values of CF back to today in accordance w/ prevailing IR
(coupons and redemption)
NPV = PV of cash flows - current price
For semi annual = Halve coupons and discount rate. Use FULL NUMBER time periods
relationship between bond price and desired yield/prevailing rate when calculating
inverse relationship between yield and price
when coupon rate = interest rate/desired yield - PV = NV
annuity discount formula - pricing bonds
r = rate/desired yield
n= no. of period
Use formula to work out PV of coupons and ADD
PV of redemption payment
pricing irredeemables
PV = A/r
A= amount of periodic payment
r = yield/discount rate/interest rate
baso a perpetuity of CFs = irredeemables
value is baso finite as CFs very far in future will have negligible PV
pricing ZCB/strips
price = PV of redemption amount
= FV/(1+r)^n
for strips value each CF individually
ILB pricing
CFs change w/ inflation relative to reference date (3M prior for bonds issues since Sep05, 8 months for bonds before)
uplift CF by inflation
price bond using uplifted CF
UPLIFT FINAL PRICE BY RPI TODAY/RPI @ ISSUE
clean and dirty bond prices
value of bond/quoted price is clean price - but they settle on dirty price (clean price+ accrued interest)
dirty price increases up to ex div date then falls
ex div date gilts -7 bis days before payment
ex div date for gilts
when holder register is taken
7 bis days before payment date
accrued interest
period coupon x accrued days/days in period
accrued days= last coup date up to and including day before settlement date
days in period - last coupn date to and including day before next coupon
ex coupon bargains cum div
accrued interest subtracted from buyers costs as purchase does not include next coup
dirty price = clean price - accrued interest (PERIOD coupon x accrued days/days in period)
accrued days = days from settlement to next coup
ex coupon bargains
accrued interest subtracted from buyers costs as purchase does not include next coup
dirty price = clean price - accrued interest (PERIOD coupon x accrued days/days in period)
accrued days = days from settlement to next coup
dirty price ILB
New style gilts quoted excluding inflation
calc accrued interest
+ to clean price
uplift both by inflation
flat yield
cash return as % of cash price
- ignores cap gain/loss @ redemption = better for ST investors who wont hold to maturity
- good for irredeemables or ST cash returns
- ignores timing of cash flows and time val of $
- useless if coupon isn’t constant
uses clean price
Japanese GRY
good way to estimate GRY -considers returns, income and cap
better than flat yield
useful for non taxpayer who will hold to maturity
ignores timing of CFs and time val of $
assumes linear growth not compoind growth - can overstate effects of cap gain/loss
uses clean price
worse if bond is further from maturity
GRY
basically IRR of the bonds cash flows
more appropriate for LT investors than FY as takes coupons and gain/loss @ maturity into account
- best for LT, non taxpaying investors - pension funds and charities
1) calculate JGRY to give indication of yield
(coupon + gain/loss@maturity / years to maturity) / clean price
2) calculate NPV (N1) using R1 (rate below JGRY) - should be pos
3) calculate NPV2 (N2) using R2 (rate above JGRY) - should be neg
4) calculate GRY by interpolation
comparing yields @, above and below par
JGRY will overstate GRY if gain @ redemption and understate if loss
@par - flat yield = JGRY = GRY
above par (loss to redemption) = JGCRY<GRY<flat yield
below par (gain to redemption) = flat yield<GRY<JGRY
uses and limitation of GRY
GRY is best - even though interpolation isnt exact as relationships non linear - considers timing of CF, time val of $, coup and redemption
limitations
GRY based on IRR assumes interest rates remain same throughout lifetime - and so coupons revinvested@same rate as yield
if bond not held to maturity - return will be a function of price of the bond
GRY baso ignores that ROR will vary with rates over lifetime of bond
net redemption yield simple
JGRY using net coupon as no CGT on gain
convention is to assume 40% rate
net redemption yield using IRR
same as GRY but net coupon down using marginal rate
1) calculate JGRY to give indication of yield (with netted coup)
(coupon + gain/loss@maturity / years to maturity) / clean price
2) calculate NPV (N1) using R1 (rate below JGRY) - should be pos
3) calculate NPV2 (N2) using R2 (rate above JGRY) - should be neg
4) calculate GRY by interpolation
uses and limitations of NRY
using IRR - surmounts issues of FY and JGRY (includes times val of $, timing of CFs, gain/loss@ redemption)
limitations - same as GRY - only represents return received if rates remained stable through lifetime
GRY for semi annual coupon bonds
half rates and half coupons
do GRY as normal then double @ end
- approximation as it ignores compounding effect of rates within a year
GRY of FRNs
can use this formula to work out r = yield
GRY for ILB
will usually be asked for ‘real and nominal GRY’
1) divide inflation adjusted price by index ratio to get clean real price
2) use interpolation to calc real GRY using real price
3) calc nominal yield using fisher relationship
(1+i)= (1+r)(1+R)
i = nominal
r=real
R= infatlion
(1+nom)=(1+real)(1+inflation)
8m lag bonds quoted inflation adj
3m lag quoted clean (but exam may give infl adjusted)
yield curve
normally upward sloping - longer dated bonds giving higher yield vs shorted to reflect additional risk or variability in pricing + lack of liquidity
curve flattens in long end due to demand from pension companies
inverted - market thinks rates are falling
yield curve theories
liquidity pref theory
- longer term commitment = higher compensation required - explains upward sloping curve
- people desire liquidity so must be compensated more if they are lending for longer(3 motives)
- spot rates are the egg - forward rtaes and yields derived from them
pure expectations theory
- shape varies according to rate expectations
-steep upwards = expecting rate rising, increased demand for ST bonds
-downward = rates expected to fall, want to lock current rates in now
-flat curve - no expected change in rates
- argues that curve is reflection of spot rates which are reflection of forward rates (yield = weighted avg of spot rates which are geometric mean of forward rates)
- yield curve reflection of spot rates and spot rates reflection of forward rates (egg)
preferred habitat/segmentation - different investors in different segments of maturity spectrum
- pensions/insurance companies at long end
- banks in short end
- 2 nds of curve have life of their own since they react differently to same data
3 motives for desiring liquidity
Keynes
transactions motive - need for cash for current transactions of personal/investment bis
precautionary motive - desire for security to meet unexpected costs
speculative motive- cash to speculate on market movements
decrease in rates = icrease in quant of money demanded by people
what are spot rates
= rate of interest demanded for deposit/borrowing from today to a specific point in time (i.e. 1 yr)
AKA zero coupon rate
DCF uses same rate to discount CF - better method to value fixed income is to view as composite investment made up of several discrete CFs with different discount rates
where can you find spot rates
ST avail in money markets - widely available is UST market
Longer maturities - avail in ZCB or STRIPS market
less developed market - derived from series of straight bond prices if GRY, coupon are also known
deriving spot rate from bond price
bootstrapping
use 1 yr bond to find 1 yr spot rate (will be same as yield as only 1 CF)
then use 1 yr rate to find 2 year rate - as 2 yr bond is a DCF of 2 CFs - so discount 1yr coupon by 1 year spot rate
what are forward rates
rate of interest agreed today for deposit/borrowing from 1 future date to another
allows you to lock in rate today for future deposit/borrowing to avoid adverse interest rate movements in future
way of hedging exposure to IR risk - as prevailing rate may be better/worse than forward rate you lock into
e.g. 1D2 = starts in 1 year, ends in 2 years
how to calculate forward rates
arbitrage - should be no difference between investing for 2 years vs investing for 1 year and rolling over @end
SO calc 1 yr spot rate then 2 year sport rate then rearrange for forward rate
what came 1st chicken or egg (forward or spot rates)
are spot rates determined by consensus for required rets for periods from now - and forward rates derived from this?
OR
are forward rates established by consensus on future dates from which spot rates are deduced
calculating forward rates formula
relationship between yield, spot and forward rates
spot rates are geometric mean of forward rates - smoother curve than forward rates
yield is weighted avg of spot rates - less vol that spot rates, forward rates most vol
supply side factors of the yield curve
stock availability could lead to excess/shortage of stock - leading to an irregular yield of some maturities
- bigger problem @ long end where govs may be priced out of market
some argue QE (CB buying gov bonds to inject CF into bank reserves) has muddied curves predictive powers - QE = longer end purchases, reducing stock, pushing up prices, decreasing yield and flattening curve
theoretical yield curve
all 3 explanations prob influence (pref habitat, liq pref theory, pure expectation theory)
short end - dominated by future rate expectations
med/long - more influences by inflation expectations and liq premium
risk management of bond investments
interest rate risk
Inflation risk
Credit/Default risk
Liquidity/Marketability risk
Issue specific risk
Fiscal risk
Currency risk
Macro-economic factors
interest rate risk
= potential that a change rates will reduce the value of a bond
prob most important risk factor - due to relationship between rates and bond prices
can be mitigated by matching macaulay duration with liability
or with FRNs or step up bonds to mitigate effect of rate changes or ILBs
inflation risk
risk that inflation will undermine the performance of an investment
linked to IR risk as rates will rise to compensate bondholders for decline in purchasing power
may be reduced with ILBs
credit/default risk
risk of issuer defaulting on obligations to pay coupons and repay principal
ratings help to assess this risk - though reputational damage caused during financial crisis due to ratings of MBS
mitigated by investing in highly rated bonds
liquidity/marketability risk
loss incurred when a market participant wants to execute a trade or to liquidate a position immediately while not hitting the best price - i.e. ease with which asset can be sold for best price
- worse for smaller issues and off the run stocks (not most recent issue)
currency risk
exposure to losses/gains in the value of currency when converting CFs
can be mitigated by buying bonds in investors home currency
issue specific risk
risk arising due to specific bond issue e.g. call rights
fiscal risk
risk that witholding tax will increase
or risk of capital controls locking money into market with foreign bonds
yield sensitivity to interest rates
longer dated more sensitive than shorter dates
lower coup/lower yield more sensitive
both as CFs futher away
Macauly duration
weighted average PV of bond’s payments (yrs)
i.e. how long it takes for cost of bond to be repayed by CFs
essentially - calc of sensitivity of bond to changes in yields
low coup, low yield, long time to duration = higher mac d
do this in a table w/ headings,
period, CF, PV CF, PV xt
mac D formula
cannot use annuity formula as it’s the sum of PVxt
modified duration
y = rate
aprox change in price for 1% change in yield
if yield goes up price will go down obvi
only an approximation due to convexity because mod duration implies linear price yield relationship
mod dur and convexity
only an approximation due to convexity because mod duration implies linear price yield relationship
actual relationship isnt linear - increases in yields results in prices dropping at reducing rate
mod dur - will overstate fall in price and understate rise
convexity
measure of curvature in relationship between bond price and yield
- change in mod dur with respect to yields
higher convexity = more curvature
lower coup = lower convexity
mod duration good aprox for small movements in yield - diminishes as yield vol increases
convexity adjustment
amount to add to price to account for convexity (always pos)
convexity trends
longer maturity = higher convexity
lower coupon = higher convexity
lower yield = higher convexity
if same mod duration - higher coup = greater convexity
duration and convexity for semi annual bonds
half coupon and yield - double periods when pricing
calc duration as usual then half
calc convexity as usual then /4
BPV - basis point value
finer measure of sensitivity AKA price/dollar value of basis point
represents how much price will change if yield changes by a bp
more sensitive bonds obvs have higher bpv
