Lecture 1 Overview of Fixed Income Markets and Valuing Bonds

Question 1

Give three reasons why the maturity of a bond is important

Answer 1

1. Gives the time period over which the holder can expect to receive the coupon payments and the principal
2. Maturity is important because the yield of a bonds depends on it - the shape of the yield curve determines how the maturity affects the yield
3. The price of a bond will fluctuate over its life as yields in the market change. The volatility of a bond’s price is dependent on its maturity

Question 2

Explain whether or not an investor can determine today what the cash flow of a floating rate bond will be

Answer 2

An investor cannot determine today what the future cash flows of a floating-rate bond will be since part of the cash flows are based on an index that changes over time (i.e. LIBOR)

Question 3

What is a deferred coupon bond?

Answer 3

Deferred coupon bonds are bonds that let the issuer avoid using cash to make interest payments for a specified number of years. There are three types of deferred-coupon structures:

1. Deferred-interest bonds (makes one payment at a later date)
2. Step-up bonds (pays a lower initial interest rate but permits periodic rate increases)
3. Payment-in-kind bonds (pas in the form of a new bonds instead of cash)

Question 4

What is meant by a linker?

Answer 4

A linker is a bond whose interest rate is tied to the rate of inflation - U.S. TIPS

Question 5

What is meant by an amortizing security?

Answer 5

An amortizing security is a type of security where a part of the principal is pad to the security’s owner along with the periodic interest payment - most common type is a mortgage-backed security. For an amortizing security, there is a schedule of principal repayments

Question 6

Why is the maturity of an amortizing security not a useful measure?

Answer 6

For amortizing securities, investors do not talk in terms of a bond’s maturity. This is because the stated maturity of such bonds or securities only identifies when the final principal payment will be made. For an amortized security, the repayment of the principal is made through multiple payments over its maturity.

Question 7

What is a bond with an embedded option?

Answer 7

A bond with an embedded option is a bond that contains a provision in the indenture that gives either the bondholder and/or the issuer an option to take some action against the other party. For example, the borrower may be given the right to alter the amortization schedule for amortizing securities.

Question 8

What does the call provision for a bond entitle the issuer to do?

Answer 8

A call provision grants the issuer the right to retire the debt, fully, or partially, before the scheduled maturity date.

Question 9

Advantages of a call provision for an issuer

Answer 9

Benefits bond issuers by allowing them to replace an old bond issue with a lower-interest cost issue if interest rates in the market decline. A call provision effectively allows the issuer to alter the maturity of a bond. The right to call an obligation is included in most loans and this in all securities creates from such loans.

Question 10

Disadvantages of a call provision for the bondholder

Answer 10

1. Cash flow pattern of a callable bond is not known with certainty and so the investment value is hard to estimate
2. Because the issuer will call the bonds when interest rates have dropped, the investor is exposed to reinvestment risk
3. The capital appreciation potential of a bond will be reduced because the price of a callable bonds may not increase much above the price at which the issuer will call the bonds

Question 11

What does the put provision for a bond entitle the bondholder to do?

Answer 11

An issue with a put provision entitles the bondholder to sell the issue back to the issuer at par value on designated dates

Question 12

Advantage of Put Provision

Answer 12

The advantage to the put provision is related to the possibility that if interest rates rise after the issue date the bondholder can force the issuer to redeem the bond at par value

Question 13

How do market participants gauge default risk of a bond issue?

Answer 13

Market participants gauge the default risk of an issue by looking at the default rating or credit rating assigned to a bond issue by one of the three rating companies—Standard & Poor’s, Moody’s, and Fitch

Default risk is a form of credit risk. Credit risk refers to the risk that a borrower will default on any type of debt by failing to make required payments. The risk is chiefly that of the lender and includes lost principal and interest, disruption in payments, and increased collection expenses.

Question 14

Comment on the following statement: Credit risk is more than the risk that an issuer will default.

Answer 14

There are risks other than default that are associated with investment bonds that are also components of credit risk. Even in the absence of default, an investor is concerned that the market value of a bond issue will decline in value and/or the relative price performance of a bond issue will be worse than that of other bond issues.

The yield on a bond issue is made up of two components: (1) the yield on a similar maturity Treasury issue and (2) a premium to compensate for the risks associated with the bond issue that do not exist in a Treasury issue—referred to as a spread. The part of the risk premium or spread attributable to default risk is called the credit spread.

The price performance of a non-Treasury debt obligation and its return over some investment horizon will depend on how the credit spread of a bond issue changes. If the credit spread increases—investors say that the spread has “widened”—the market price of the bond issue will decline. The risk that a bond issue will decline due to an increase in the credit spread is called credit spread risk. This risk exists for an individual bond issue, bond issues in a particular industry or economic sector, and for all bond issues in the economy not issued by the U.S. Treasury.

Question 15

3 types of Credit Risk

Answer 15

• Credit Spread Risk: credit spread risk is typically caused by the changeability between interest rates and the risk-free return rate
• Default Risk: when borrowers are unable to make contractual payments, default risk can occur
• Downgrade Risk: risk ratings of issuers can be downgraded, thus resulting in downgrade risk

Question 16

Explain whether you agree or disagree with the following statement: “Because my bond is guaranteed by an insurance company, I have eliminated credit risk.”

Answer 16

Disagree - a bond’s guarantee is only as good as the insurance company guarenteeing it and an insurance company itself can experience a downgrade increasing its credit risk

Question 17

What is counterparty risk?

Answer 17

Form of credit risk that involves transactions between two parties in a trade. The risk to each party of a contract is that the counterparty will not be able to live up to its contractual obligations

Question 18

Does an Investor who Purchases a ZCB face reinvestment risk?

Answer 18

Unlike bonds that pay a stream of coupon payment over time, the payment is reinvested at the same rate as the coupon rate. This eliminates any risk associated with the possibility that coupon payments will be reinvested at a lower rate

Question 19

Reinvestment Risk

Answer 19

Calculation of the yield of a bond assumes that the cash flows received are reinvested. The additional income from such reinvestment depends on the prevailing interest-rate levels at the time of reinvestment. The variability in the reinvestment rate of a given strategy because of changes of the prevailing market interest rate

Question 20

Who issues bonds?

Answer 20

1. Governments
2. States, provinces and municipalities
3. Commercial Banks
4. Companies
5. Special-purpose vehicles or trusts
6. Foreign Institutions

Question 21

Why Issue Bonds?

Answer 21

• general corporate purposes
• capex
• M&A
• LBO
• Return of Shareholder Capital; issuing bonds to fund share buy-backs
• Refinancing; as existing bonds mature, companies issue new ones to repay principal amounts

Question 22

Who buys bonds?

Answer 22

1. Government, foreign institutions, sovereign wealth funds
2. Pension funds
3. Insurance companies
4. Mutual funds, hedge funds, and asset management firms
5. Commercial banks
6. Retail investors

Question 23

Treasury Bills

Answer 23

• ZCB through auction

- maturity: 13,26,52 weeks

Question 24

Treasury Notes and Bonds

Answer 24

• semi-annual coupons

- maturity 2,3,5,7,10, and 30 years

Question 25

Agency Securities in the US

Answer 25

• Federal National Mortgage Association (Fannie Mae)
• Federal Home Loan Mortgage Corporation (Freddie Mac)
• Student Loan Marketing Association (Sallie Mae)

Question 26

Agency Securities in Canada

Answer 26

CMHC

Question 27

Municipal Bonds

Answer 27

• issued by state and local governments, exempt from federal income tax and exempt from (issuing) state local tax
• market virtually non-existent in Canada because of no preferential tax treatment for the coupons
• types municipals include:
  (1) general obligation bonds –> back by the “full faith and credit” of the issuer (taxing power)
  (2) revenue bonds –> issued to finance specific projects

Question 28

Corporate Bonds

Answer 28

• typically pays semi-annual coupons
• subject to default risk
• different “seniority” classes - senior secured, unsecured, subordinated debentures

Question 29

Bonds Structures - 3 Structures of Principal Repayment

Answer 29

1. Bullet Bond Offering: issuer repays entire principal at maturity date - highest amount of refinancing risk
2. Sinking fund: requires the issuer to set money in an amount to retire the principal amount at maturity or repurchase the bonds in the open market - lower refinancing risk and often seen in bridge or toll road bonds
3. Amortizing bonds: requires the issuer to repay the principal along with the coupon payments in equal instalments

Question 30

What is CDOR?

Answer 30

CDOR (canadian dollar offer rate) is simply the average of all Bankers’ Acceptances (“BA”) rates offered by the main banks operating in Canda

Question 31

What is LIBOR?

Answer 31

The rate of interest at which banks can borrow funds from each other in the interbank market

Question 32

YTM

Answer 32

to find the YTM we must first determine the expected cash flows and then search by trial and error for the interest rate that will make the PV of cash flows equal to the market price
–> major limitation of the YTM is that it assumes that the coupons can be reinvested at YTM

Question 33

Bond Equivalent Yield

Answer 33

• if a bond’s cash flows are semi-annual, then solving for the YTM yields a 6M rate
• the BEY is the calculation for stating semi-annual, quarterly, or monthly bond yields into a simple (non-compounding) annualized yield

Question 34

Coupon = YTM

Answer 34

Par

Question 35

Coupon > YTM

Answer 35

Premium

Question 36

Coupon < YTM

Answer 36

Discount

Question 37

Relationship between coupon rate, YTM and price

Answer 37

• when the yields in the marketplace rise above the coupon rate at a given point in time, the price of the bond adjusts so that an investor contemplating the purchase of the bond can realize some additional interest. If it did not, investors wouldn’t buy the issue because it offers a below-market yield; the resulting lack of demand would cause the price to fall
• when the required yield (YTM) in the market is below the coupon rate, the bond must sell above its par value. This is because investors who have the opportunity to buy the bond at par value would be getting a coupon rate excess of what the market requires, as a result, investors would bid up the price of the bond because its yields are attractive

Question 38

Reasons for the Change in Price of a Bond

Answer 38

1. There is a change in the required yield owing to changes in the credit quality of the issuer
2. There is a change in the price of a bond selling at a premium/discount without any change in yield, moving towards maturity
3. There is a change in the required yield owing to a change in the yield on comparable bonds

Question 39

Bond Valuation - Uneven Payment Dates

Answer 39

• bond formula assumed that the settlement date falls on the coupon date
• in trading, the settlement date is the date on which payment is due in exchange for the bond and is used to compute accrued interest

Question 40

Accrued Interest

Answer 40

• when an investor buys a bond between coupon payment dates, the investor must compensate the seller of the bond for the coupon interest earned from the time of the last coupon payment to the settlement date
• market conventions for settlement date:
• -> in the U.S., treasury bonds are T+1
• -> in the Euro Zone, treasury bonds are equal to T+2
• -> In Canada, government bonds settle in T+2 or T+3 days, corporate bonds in T+2 days

Question 41

Full or Dirty Price

Answer 41

Price of the bond with accrued interest

Question 42

Clean Price

Answer 42

Price of the bond without accrued interest

Question 43

Sources of a Bond’s Returns

Answer 43

• returns from a bond can be generated from:
• -> periodic coupon payments
• -> capital gain or loss
• -> reinvestment of coupon payments