4 - Bonds (fin) Flashcards

1
Q

Bond characteristics

A

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

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2
Q

what is a bond

A

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

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3
Q

bond yield

A

= 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

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4
Q

bond features: maturity date

A

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

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5
Q

Coupons

A

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

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6
Q

Credit ratings

A

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

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7
Q

Credit ratings - Moody, fitch, s&p

A
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8
Q

spreads

A

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

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9
Q

bond covenants

A

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

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10
Q

Susuk

A

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

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11
Q

Ijarah Susuk

A

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

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12
Q

Intifa susuk

A

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

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13
Q

salam susuk

A

similar to forward contract
issuer issues susuk and promises to delivery commodity on future date
price paid in advance via susuk
usually ST finance

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14
Q

perpetual susuk

A

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

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15
Q

convertible susuk

A

gives holder right to convert into shares of issuer at future date

price of susuk cannot be below par val of shares

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16
Q

green bonds?
GBP?

A

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

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17
Q

green bonds?
GBP?

A

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

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18
Q

what is greenwashing

A

practise of comps making misleading environmental claims for marketing purposes - with aim of improving rep, to attract environmentally aware customers and increase profits

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19
Q

social bonds

A

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

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20
Q

sustainability bonds

A

funds used to finance or refinance combo of green and social project - ICMA has issued SBG - sustainability bond guidelines - promoting integrity etc, voluntary

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21
Q

sustainability linked bonds (SLBs)

A

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

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22
Q

blue bonds

A

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

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23
Q

social impact bonds

A

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.

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24
Q

factors affecting bond price

A

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

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25
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
26
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
27
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
28
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
29
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
30
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
31
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
32
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
33
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
34
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
35
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 )
36
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
37
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
38
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
39
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
40
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
41
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
42
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
43
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
44
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
45
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
46
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
47
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
48
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
49
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
50
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
51
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
52
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
53
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
54
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
55
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
56
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
57
equity sweeteners
either by issuing convertible or by attaching a warrant might allow issuance w/ lower coupon
58
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
59
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
60
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
61
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)
62
conversion ratio
no. of shares the bond can be converted into e.g. x shares per £100 NV ratio = NV/conversion price
63
conversion price
convertible price/no. of shares can use NV if converting at maturity
64
conversion value
current share price x conversion ratio conversion ratio = NV/conversion price
65
conversion premium
conversion price - share price /share price
66
eurobond issuance
via syndicate of international banks eurobond issuers dont keep record of holders - bearer docs IB who originate issues have develeoped various types
67
corp bond issuance
most common method in primary, domestic bond market is via placement
68
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
69
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
70
PV of bond long hand (semi annual)
for semi annual bond HALVE COUPOUNS HALVE DISCOUNT RATES DOUBLE TIME PERIODS (TO WHOLE NUMBERS)
71
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
72
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
73
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
74
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
75
pricing ZCB/strips
price = PV of redemption amount = FV/(1+r)^n for strips value each CF individually
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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
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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
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ex div date for gilts
when holder register is taken 7 bis days before payment date
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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
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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
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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
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dirty price ILB
New style gilts quoted excluding inflation calc accrued interest + to clean price uplift both by inflation
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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
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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
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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
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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
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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
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net redemption yield simple
JGRY using net coupon as no CGT on gain convention is to assume 40% rate
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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
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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
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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
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GRY of FRNs
can use this formula to work out r = yield
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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)
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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
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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
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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
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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
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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
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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
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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
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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
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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
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calculating forward rates formula
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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
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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
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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
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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
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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
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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
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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
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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)
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currency risk
exposure to losses/gains in the value of currency when converting CFs can be mitigated by buying bonds in investors home currency
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issue specific risk
risk arising due to specific bond issue e.g. call rights
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fiscal risk
risk that witholding tax will increase or risk of capital controls locking money into market with foreign bonds
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yield sensitivity to interest rates
longer dated more sensitive than shorter dates lower coup/lower yield more sensitive both as CFs futher away
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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
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mac D formula
cannot use annuity formula as it's the sum of PVxt
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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
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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
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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
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convexity adjustment
amount to add to price to account for convexity (always pos)
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convexity trends
longer maturity = higher convexity lower coupon = higher convexity lower yield = higher convexity if same mod duration - higher coup = greater convexity
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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
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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