Lecture 5 Flashcards
Face Value
Indenture
Nominal Value / Par Value = 1000
(Written in 100 notional amount)
Indenture: Actual contract (agreement)
US Treasuries
Reference for “risk-free Asset”
Maturity < 1Y = Bills
Maturity < 10Y = Notes
Maturity < 10 or 30Y = Bonds
Bond types
- Callable Bonds: Can be repurchased before maturity date
- Convertible bonds: can be exchanged for shares
- Putable bonds: Gives the holder in the option to retire or extend the bond
- Floating rate bonds: adjustable coupon rate (LIBOR)
- preferred stocks: Shares with characteristics of both equity and fixed income (dividends paid before common)
Bond innovations
Inverse floaters: coupon falls when reference rate rises
Asset-backed bonds: MBS
Catastrophe bonds
TIPS
Relationship Bondprice and yield
Yields are equivalent to required rates of return • Prices and yields have an inverse relationship • The bond price curve is convex • The longer the maturity, the more sensitive the bond’s price to changes in market interest rates
Yield to maturity
Interest rate that makes the present value of the bond’s payments equal to its price is the yield to maturity
• Solve the bond formula for r
• r is the internal rate of return (IRR)
Current Yield
Bond’s annual coupon payment divided by the bond price
• For premium bonds (that sell above face value)
Coupon rate > Current yield > YTM
Yield to call
Yield to call is the yield of callable bonds, adjusted for the built-in call option
The price of the callable bond is flat over a range of low interest rates because the risk of repurchase (call) is high
• When interest rates are high, the risk of call is negligible and the values of the straight and the callable bonds converge
YTM vs HPR
YTM:
It is the average return if the bond is held to maturity
• Depends on coupon rate, maturity, and par value
• All of these are readily observable
HPR:
It is the rate of return over a particular investment period
• Depends on the bond’s price at the end of the holding period, an unknown future value
• Can only be forecasted by horizon analysis
Strips
STRIPS: Separate Trading of Registered Interest and Principal of Securities program by the Treasury
Longer term bonds,where the coupons and the principal are traded separately
At maturity zeros sell at par, thus their discount decreases with age
Name 5 determinants of Bond safety
Coverage ratios •Leverage ratios, debt-to-equity ratio • Liquidity ratios •Profitability ratios • Cash flow-to-debt ratio
What are the Bond Indentures
Sinking funds: is a way to call bonds early to smooth the payout of the issuer firm
Subordination of future debt: restricts additional borrowing and creates seniority between “bond classes”
• Dividend restrictions: a covenant that forces the firm to retain assets rather than paying them out to shareholders
• Collateral: a particular asset bondholders receive if the firm defaults
The difference in YTM and default risk
There is a difference between the yield based on expected cash flows and yield based on promised cash flows
CDS
Insurance on a loan (hedging)
Institutional bondholders,e.g. banks, use CDS to enhance creditworthiness of their loan portfolios (Regulatory loophole: Lower Buffer rate: Arbitrage)
Can be used to speculate that bond
prices will fall (Naked CDS Ban)
Collateralized debt obligation (CDO)
Reallocate credit risk in the fixed income markets
Loans are pooled together and split into tranches with different levels of default risk (and those prices)
Yield curves
Flat yield curve
Rising yield curve
Inverted yield curve
Hump shaped yield curve
Bond pricing through yield curve
- Yields on different maturity bonds are not all equal
- We need to consider each bond cash flow as a stand-alone zero-coupon bond
- Bond stripping and bond reconstitution offer opportunities for arbitrage
- The value of the bond should be the sum of the values of its parts
Two types of yield curves
Pure Yield Curve
• Uses stripped or zero coupon Treasuries
• May differ significantly from the on-the-run yield curve
• This is typically provided by central banks
On-the-run (most recent) Yield
• Uses recently-issued coupon bonds selling at/or near par value
Yield curve with certain interest rates
Holding a 2 year zero bond or 2 1 year bonds should be the same
Spot rate: The rate that prevails today for a given maturity
Short rate: The rate for a given maturity at different points in time
The spot rate is the geometric average of its components short rates
If the next years short rate is greater than this year’s short rate, the yield curve slopes up: rates are expected to rise (or large liquidity premium wanted)
Theories of term structure
- The Expectations hypothesis theory
• Observed long-term rate is a function of today’s short-term rate and expected future short-term rates - Liquidity preference theory
• The yield curve has an upward bias built into the long-term rates because of the liquidity premium
The yield curve reflects expectations of future interest rates
The yield curve is a good predictor of the business cycle (Inverted yield curve may indicate that interest rates are expected to fall and signal a recession)
