Chapter 12 Flashcards
What are treasury bills
Short term government securities with maturities of less than 1 year that are issued at discount
Why are treasury bills issued and what is a characteristic of them
In order to manage amount of cash in banking system and deemed as default risk free
T bill yield formula (quoted)
(Par value - purchase price)/purchase price x 365/D x 100%
D is number of days before redemption
Compounded annualised return for t bills
[1 + (par-purchase price)/purchase price]^(365/D) -1
What market do banks traditionally balance customer deposits and loan demand
Inter bank market
Maturities in interbank market
From overnight to up to 1 year
Minimum deposit in interbank market
500k
Most important rates quoted by banks until GFC and what they are
Libor - London interbank offered rate - rate at which banks lend to one another short term
Libid - London interbank bid - rate at which banks prepared to accept short term deposits
What happened to interbank market in GFC
Banks didn’t want to lend as banks were hoarding liquidity in response to disruptions in other market and due to uncertainty about credit risk
Libor spreads increased
How was libor calculated and how did GFC affect it
Banks report on what they think they can borrow at but in times of market illiquidity, these rates were becoming less accurate
Most common ice libor rate
3 month is dollar rate
What currencies and maturities are involved for international exchange libor
Dollar, sterling , Japan yen, euro, Swiss franc
Overnight, one week, one, 2,3,6 and 12 month
What is SOFR and when released
April 2018
Secured overnight financing rate - cost of interbank borrowing secured by is treasuries
Consolidated appropriations act 2022
Libor act is meant to address concerns to cease the use of libor by replacing libor in existing contracts
When does FCA intend to cease requiring synthetic libor
End of September 2024
What is synthetic libor
Temporary bridge to risk free reference rates
SONIA, what is it and when introduced
Sterling overnight index average - preferred sterling risk free rate benchmark in bond, loan and derivatives market
2018
How is Sonia calculated
Reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions
When did libor spreads to exits for 5 main currencies
Dec 2021 - sterling, euro, Swiss franc, Japanese yen
June 2023 US dollar
Certificates of deposit
Tradeable time deposits issued by depositing institutions such as commercial banks
What is usual maturity range for uk CDs and minimum value
1 month to 1 year - can be longer
100k
What Is price of CD based on
Based on future value of deposit paid to the investor when the deposit matures
Like zero coupon bond
Commercial paper, issued by who, what price issued at and maturity
Is a short term unsecured promissory note issued by both financial firms and creditworthy corporations, issued at discount to par value, maturity between 7 days and 1 year
Floating rate notes characteristics
Issued at par but have coupon that is linked to pre specified market rate eg Sonia
Why would a floating rate note trade close to par
If there is no change in credit risk by the issuer
What is a drop lock for a floating rate note
If coupon rate falls below a certain level then the issue is converted into a fixed rate issue for the rest of it life
What is uk largerest fixed income market
Gilt edged security market
What is a gilt
Uk Government liability, listed by the HM treasury on the LSE
How are gilts issued
Through an auction process
What occurs just before the sale of gilts
Debt management office issues a formal notice that spells out how much they want to raise, maturity and interest rates
Conventional gilt and how quoted
Pay coupon every 6 months and then plus principal at maturity
Quoted in terms of £100 nominal
8% treasury stock 2021 meaning for investor holding £1000
Coupon payments of 40 pounds every 6 months and maturity in 2021
What do Index link gilts coupons reflect
The real borrowing rate of the government and not the nominal, much smaller variation in real yields over time
Maturity lengths for gilts
Long - more than 15 years
Medium - 7-15 years
Short - less than seven years
Ultra short - less than 3 years
Formula for valuing an undated stock
= coupon payment / R
R= required yield
What type of bond is a 2.5% consols
Undated bond uk government bond issue with no maturity date
What happens when Bond is quoted as 5.5% treasury 2008-12
Gov can redeem at any point between those dates so if I rates fall below 5.5% in that period, Gov would redeem and and refinance at a lower rate
Characteristics of a 12% exchequer stock 2013-17
Can redeem in full or in part any day between the first and final maturity dates
What is a strip
Breaking a gilt down into its individual cash,flows which can be traded separately as a zero coupon gilts
Ho many cash flows does a 3 year girl have
7
6 coupon payments + 1 principle payment
When can issues of gilts be stripped
Not strippable until sufficient amount of issuance has occurred to maintain liquidity in both formats
Who can strip and reconstitute gilts
Gilt edged market makers, BofE, HM treasury
What is the repo market
Sale and repurchase of a security (gilt)
What is a repo contract
Contract to Sell securities for cash and then to buy them back in the future for an agreed price and date
Agreed price will be original price plus interest rate at the repo rate
What is a repo like for the initial seller of the security
Effectively acts as a loan with the securities as collateral
Low risk of capital means interest charge is low compared to other borrowing
What is it like for the counterparty of a repo contract
Way or borrowing securities to perhaps settle a short position
Repo rate
Rate of interest charge on cash extended under the agreement
What returns better and why?
T bills or repos
Repos as there is higher chance that the rebuying of the bond may fail and price of bond may have fallen in the mean time
Clean prices?
And what is quoted as clean
Ie. Excluding accrued interest, so that reported price refekcts changes in market conditions and not accrued interest
Gilts quoted as clean
What price is paid for bonds
Dirty price = clean price plus accrued interest
Yield to maturity
Represent Heidi investor would get if they held the gilt until maturity ( assuming all coupons reinvested at the same rate)
How is ytm (gross redemption yield) calculated
Bond price = C/1+r + (C+P)/(1+r)^n
R is the ytm
GRY/YTM is only accurate measure of future return if 2 things are met
Gilt is held to maturity
All coupons received at reinvested at the GRY rate
Index linked bonds and why are they used
Coupon and the principle is related to a specific price index,
Protection provided to investors form changes in underlying index
What are index linked bonds also known as
TIPS
Treasury inflation protected securities
What do index linked gilts (ILG) offer
Attempt to offer investors a fixed real return
How do inflation affect ILGs and when do changes get implemented
Th timing of the uplift to coupon and principle payments usually refer to a recent past value eg lag of three months
When were ILGs made available to all investors
1982
For three month lagged index linked gilts what is the reference RPI rate for 1 September
Reference rate is the rpi in June
ILG COUPON FORMULA
= quoted coupon x index ratio
Index ratio = three month lag rpi/issue date rpi
8 month lag ILG coupon formula
= semi annular coupon x (rpi 8 month prior to coupon/rpi eight month prior to issuance)
What do ILGs prevent governments from doing
Inflating debt away as the securities move in line with inflation
When do index linked bonds offer a better return than nominal bond
Above the break even point of 2% inflation
Bond indenture
Corporate bonds are not standardised investment vehicles, each issue has an accompanying legal doc known as an indenture
What do firms issue to raise long term capital
Corporate bonds
Sinking fund provision?
Requires the firm to buy back (retire) a certain promotion of the bond issue throughout the life of the bond each year
What does a sinking Bond provision do for other investors and where is it outlined
Reduces credit risk for th remaining bond holders and is outlined in the indenture
What are the limitation described in the bond indenture known as and what do they ensure
Protective covenants
Ensure steady stream of income needed to pay off debt is not subject to undue risk
Example so covenants restrictions
Dividend policy
Additional debt raises
Ranking of debt
Amount executives vacant pay themselves
Call provision? And why used?
Allows firm to redeem the issue at its discretion a pre determined price and date
If I rates lower, they can repay debt and refinance at lower rate
How and why are investors of callable bonds compensated
Investors exposed to greater risk due to being repaid in low rate environment and having to reinvest in low rate market
Firms pay par value of the debt plus the call premium
Put provision
Allows investor to sell the bond back to the issuer at a pre determined price
Why a put provisions used
Allows investor to sell the bond back in high rate market and reinvest at higher rates to get greater return
H
Secured bonds
Secured against specific collateral
What are debentures usually secured by and explain what it is
Not secured by physical assets but Secured by Floating charge (general creditworthiness and reputation of issuer)
Floating charge is a legal right over a class of asset such as a stock
Zero coupon bonds benefit for investor of them
No reinvestment rate risk for the investor.
What risk for investor of zero coupon bond s
Substantial price risk, risk relating to price changes as I rate changes
Euro bonds
Bonds issued in a foreign currency within the home market
(COCOS) Contingent convertible bond, what is it and example
Debt that is converted into equity if a pre specified trigger event occurs, such as capitalisation falling below a certain level
What characteristic do cocos need to fullfill their function
Mechanism by which losses are absorbed and trigger that activates the loss absorbing
mechanism
Mechanical trigger example
Capital of coco issuing bank falls below a specified percentage of risk weighted assets
What are discretionary triggers and what are they also known as
Point of non viability triggers
Based on bank supervisors judgement on the issuers solvency. Conditions for loss absorption mechanism must be set out in advance
Coco can raise equity in two ways
Conversion to equity coco raises capital by converting bond into equity at predetermined rate (either market price of stock or stock price at time of issuance)
Principal write down coco
Conversion to equity problem
Leads to large dilution of equity for existing shareholders, provides shareholders incentive to avoid activating trigger
What does. A principle write down coco involve
Principle wrote down cocos involve a mixture of principle wrote down (75%) and cash compensation (25%)
Issuer of cocos would have to fund cash payout while in distress
What is main driver of coco supply
Pressure from regulators on banks to raise capital
Coco trigger rlevel trade off
Trade off between the regulatory capital eligibility criteria and cost of issuance
Low triggers equal lower loss absorbing capacity but cheaper to issue
What is a key capital definition for cocos
Minimum trigger level of 5.125% of risk weighted assets and debt is perpetual
Main investor groups purchasing cocos are
Private banks due to their relative high nominal yields
Us institutional investors and European non bank financial institutions which see them as an alternative asset class
Why has investor base for cocos struggled to grow
Lack of consistent credit ratings
Due to different regs treatment in different jurisdictions
Key determinants of pricing a coco
Position in the banks capital structure
Loss absorbing mechanism itself
When in cap structure are they and why (cocos)
Subordinated to other debt instruments as they incur losses first and hence their yield at issuance is greater
Why is low trigger level of coco more preferred
More favourable to holders than equity holders bc trigger less likely to be breached and holders are less likely to suffer
Should a low trigger level or high trigger level have a greater yield and why
High trigger level has higher yield bc more likely to lead to early loss absorption by the holder
Why do issuing banks prefer Point of no viability triggers
They are necarssay condition for regulatory capital eligibility under Basel 3
Why do holders of cocos not prefer ponv cocos
Because they increase prob of loss absorption
What cocos do equity holders like and why
Prefer principle wrote downs as equity is not diluted and transfer the cost of financial distress to coco holders
For holders, what type of coco is preferred
Conversion to equity coco preferred as if triggered, equity provides some partial compensation whereas as write down does not
Rules for if bond trading at premium or discount
Premium - coupon greater than GRY
Discount - coupon less than GRY
What is the present value of the bond
Discounted sum of coupon payments plus principle
Two factors that affect sensitivity of a change in price when required rate of return changes
Time to maturity - longer the term to maturity, the greater the percentage change in price of bond
Size of coupon - the smaller the coupon, the greater the affect of the ROR on bond price
If a bond portfolio manager thinks I rates will rise, what type of bond will they hold
To ensure the value of bond doesn’t fall too much ,
They will hold shorter dates bonds with higher coupons
What is a measure of bond price sensitivity
Macaulay duration - weighted average duration of a bond, where weights are relative discounted cash flows in each period
When a bond pays zero coupons,, what is the duration of the bond
Bond duration equals time to maturity for zero coupon bonds
As apthe maturity of a fixed income increases, what happens to duration
Duration increases
As coupon of fixed income decreases, what happens to duration
It’s duration increases
What happens if investor switches from short duration to long duration bond
Interest rate risk will increase as long duration bonds have longer maturity dates and small coupon payments so more sensitive to I rate changes
What is modified duration
Approx change in bonds price given a 100 basis point (1%) change in yields
MD=D/1+R
D is duration
Limitation of duration
Assumes coupons reinvested at current redemption yield
What is reinvestment risk
Risk that coupons cannot be reinvested at redemption yield
What is the shape of the relationship between yield and prices for bonds
Convex
What can the slope of the yield price curve be considered as
Modified duration
Modified duration for a 1 year bond with coupon rate of 6% and yield rate of 6%?
1/1.06 = 0.94%
If the MD is 0.94% at 6% yield, and price of 100, if yields rise to 7%, the new price would be…
100 - (100x0.0094) = 99.06
Where does convex line lie compared to straight line
Above so price of bond for linear line is always lower than price for convex line
Two elements of interest rate risk
Price risk - I rates increase, price falls
Reinvestment risk - I rate increases return from reinvesting coupons prior to maturity rises
Other bond risks
Default risk
Credit risk - risk that ratings falls
Inflation risk
Currency risk
Call risk
Firms that rate credit and characteristic of them
Moody
S and p
Fitch
Independents
A average spread between AAA and us gov bonds
0.35%, this difference gets larger as the rating gets worse
What is investment grade bonds
BBB- or Baa- and above = investment grade
BBB- or Baa- below is known as what
High yield , junk or below investment grade
What are foreign currency bonds attract
Low credit rating but if they are issued in local currency attract higher rating due to less exchange risk
Seniority of debt order and how ratings change through the levels
Senior secured - on underlying assets of firm
Senior unsecured
Subordinated
As you get lower in cap structure - ratings get worse
Pari passu
When two or more securities are equal in hierarchy of claims
What affects credit rating
Financial statement
Forecasts
Trends
Regs environment
Management quality
Bonds covenants
Ratio for ability to make payments
Ebit/ interest payable
Ratio for ability to make payments
Ebit/ interest payable
Indebtness ratio
Interest bearing debt/ ordinary shareholders funds
Profitability ratio
Operating income/ sales
Interest yield formula for bonds
Coupon / current price of bond
Gross redemption yield (GRY)
Measure of total return to an investor
When does GRY hold
If these two assumptions met
Bond held to maturity
Coupons reinvested at GrY rate up to maturity
What is net redemption yield
Coupons received after tax Is used in the PV of bonds cash flows formula
What is the relationship between the maturity and yield known as
Yield curve
What is pure expectations theory
The long term rate is is the the expected short term rate in the future
What does pure expectations theory imply
Implicit relationship between current fixed income yields and forward rates
With pure expectations theory, an investor who invests 1000 can …
Return the same from either investing in a two year bond or a one year bond that subsequently reinvests the proceeds into another 1 year bond
Pure expectations theory formula
(1+R)^2 = (1+r1) (1+r2)
What does upward yield curve mean for pure expectations
Current short rate expected to rise in the future
Liquidity preference theory
In uncertainty, lenders and investors wants to hike assets that can be converted into cash, therefore they demand liquidity premium for holding long term assets
What do borrowers do bc they don’t like uncertainty in LPT
Borrow for longer periods at a rate that is certain now, so they pay a liquidity premium on longer term debt
Market segmentation theory
Bond market made up of from a number of separate markets distinguished by time to maturity, each with their own supply and demand, different types of investors have different preferences first different parts of the yield. So yield curve changes depending on the investors behaviour
Forward rates
Implied future interest rates
If the 3 month Sonia rate is currently 4 percent
And the 3 month Sonia rate in 3 months time is expected to be 5%
What is the current six month spot rate
4.5%
What is the yield o f a zero coupon bond
Spot rate for that particular Time horizon
What order or rates creates an upward sloping yield curve
Forward rate greater than spot rate which is greater than yield
What creates a downward sloping yield curve
Yield is greater than spot rate which is greater than forwards rate
What creates a downward sloping yield curve
Yield is greater than spot rate which is greater than forwards rate
What does the duration method assume about relationship between yield and bond prices
Assumes linear whereas actually convex
What is the duration of a floating rate note
Close to zero due to Renault resetting of the coupon rates to market rates
Duration formula
D = (PV1/B) + 2 (PV2/B) + 3(PV3/B)
When using bond duration to estimate sensitivity to change in yields, what is the case
Whether rates rise or fall, duration will underestimate the price
What is the measure of return that only measures interest income
Flat yield
