Week 4 Flashcards
Bonds
bonds are like money market instruments (debt security where an investor loans money to an entity in exchange for periodic interest payments and the return of the principal amount (the face value) at maturity) However, they have maturities that exceeds one year
Why do people borrow long term
To reduce the risk that interest rates will rise before individuals or firms can pay off their debt.
What is the capital market used for?
Capital markets are used for long-term investments, such as financing and raising funds for investments beyond one year
What are the primary issuers of capital market securities?
Federal and local governments: Debt issuers (long-term notes and bonds)
Corporations: Equity and debt issuers (stocks and bonds)
What are the two types of capital market trading?
Primary market: For the initial sale of securities (e.g., IPO)
Secondary market: Where securities are traded after the initial sale (e.g., over-the-counter or organized exchanges like the NYSE
What is the main difference between Treasury bills, notes, and bonds?
Treasury bill: Maturity of less than 1 year
Treasury note: Maturity of 1 to 10 years
Treasury bond: Maturity of 10 to 30 years
How do short-term Treasury bills compare to long-term Treasury bonds in terms of interest rates?
Short-term rates of returns (on bills) are typically lower than long-term rates (on bonds).
Short-term rates are more volatile and are heavily influenced by the current rate of inflation.
What are Treasury Inflation-Protected Securities (TIPS)?
TIPS are bonds that protect against inflation by adjusting the principal value according to inflation. At maturity, they are redeemed at the greater of inflation-adjusted principal or par amount.
What is Treasury STRIPS?
STRIPS (Separate Trading of Registered Interest and Principal Securities) separate a Treasury bond’s coupon payments from the principal repayment and sell them as zero-coupon bonds.
Characteristics of Municipal Bonds
Issued by local, county and state government
Used to finance public interest projects
Tax-free
Types of Municipal Bonds
General obligation bonds: do not have specific assets pledged as security or a specific source of revenue allocated for their payment. They are backed by the “full faith and credit” of the issuing government. (e.g. taxes collected can be used to pay to the bondholders)
Revenue bonds: are backed by the cash flow of a particular revenue generating project. (generated revenues of projects are used to pay to the bondholders)
Corporate Bonds
It has different face values: $1000,$5000 or $10000.
Cannot be redeemed anytime the issuer wishes, unless specific clause is stated
Degree of risk varies with each bond, even from the same issuer, and the required interest rate varies alongside it.
Characteristics of Coporate Bonds
Register bonds: are bonds that are tracked by the issuer and the IRS (IRS tracks the income interest)
Restrictive Covenant: rules designed to protect bondholders’ interests. —- May limit dividends, new debt, rations, etc.
- Usually includes a cross-default clause
- Typically lower interest when more restrictions are placed
Call provision: A call provision gives the issuer the right to force the bondholder to sell the bond back.
Conversion: Some debt may be converted to equity, in other words, bonds can be converted into shares of common stock
What are secured bonds?
Secured bonds are bonds backed by collateral (e.g., property or assets). For example, mortgage bonds are secured by real estate, and equipment trust certificates are secured by tangible property such as heavy equipment or airplanes
What are unsecured bonds?
Unsecured bonds are not backed by collateral and are instead backed by the issuer’s general creditworthines
Examples include:
Debentures: Long-term unsecured bonds.
Subordinated debentures: Bonds with a lower priority claim on assets in case of default.
What are variable-rate bonds?
Variable-rate bonds have interest rates tied to another market interest rate (e.g., Treasury bonds) and are periodically adjusted based on market conditions.
What are junk bonds?
Junk bonds are bonds rated below BBB. They are high-risk investments with high yields and are typically avoided by trusts and insurance companies. They became popular in the 1980s with the development of the junk bond market by Michael Milken.
Agency Problems and Ratings
Ratings are nowadays paid by issuers instead of the investors. Thus, rating agencies might overestimate the ratings in order to attract business (more issuers will be attracted because it is benefitial for them to have better rated bonds).
Financial guarantees for bonds
Issuer pay for the guarantee, it lowers the risk of bonds, and ensures that bondholders are paid within promised dates. The reduction in the risk, lowers the interest rate as well because it becomes a safe investment. The reduction in the interest payment to the bondholders is compensated by the payment made from issuer to the insurance company.
Credit default swap
financial derivative that functions like insurance against the risk of a borrower defaulting on its debt obligations (both principal and interest). It is an agreement between two parties where one party (the protection buyer) pays periodic fees to another party (the protection seller) in exchange for compensation if a credit event (such as a default) occurs on a specified credit instrument (e.g., a bond or loan).
Problems with CDS
- CDS are like buying your neighbor’s house -> might result in ethical problems
- Creditors with CDS might be better off with a default than a non-default -> might result in unnecessary
defaults
current yield calculation that is commonly used for long-term debt
Page 28
What is the current yield for a bond
CurrentYield=
AnnualCouponPayment/CurrentBondPrice
Annuities and Perpetuities
Find the PV of bonds–> Page 28
Find the value of coupon bonds –> Page 28
Adjustments made for SEMIannual bond
- Divide coupon payment by 2
- Market interest rate dived by 2
- Double number of periods
What is Duration?
Duration is a measure that helps assess the interest rate risk of a bond or debt security. It gives the average time it takes for a bondholder to receive the present value of all the bond’s future cash flows (coupon payments and principal repayment).
What drives bond prices?
There are three main things that determine the price of the bond: market conditions (changes in interest rates, stock market development), ratings and the age of the bond.
Duration changes as follows
- the longer the term to maturity of a bond, the longer its duration
- Al else equal, when interest rates rise, the duration of a coupon bond falls.
- The higher the coupon rate on the bond, the shorter the duration of the bond
- Duration is additive: the duration of a portfolio of securities is the weighted-average of the durations
of the individual securities, with the weights equaling the proportion of the portfolio invested in each
security
How do length of duration affect sensitivity to interest rate risk
Longer duration bonds are more sensitive to interest rate risk and vice versa
when interest rates rise, the duration of a coupon bond falls.
the weight of distant cash flows in the duration calculation is reduced, shifting the focus to earlier cash flows and reducing duration.
Interest rates increase → Bond price decreases → Distant cash flows contribute less to the bond’s value → Weighted average time to recover cash flows shortens → Duration decreases.
The higher the coupon rate on the bond, the shorter the duration of the bond
the bond’s duration (the weighted average time to receive cash flows) is shorter, since the bondholder recovers a significant portion of the bond’s value earlier.
