Week 5 - Interest bearing securities

Question 1

Why are interest rates so low globally? [List 6 factors]

Answer 1

1) Subdued post-GFC growth and stagnation
2) Low levels of corporate investment
3) Subdued wages growth
4) Low inflation
5) Concerns over trade frictions
6) Neutral interest rate decline, important for bond modelling

Question 2

What is the Fisher effect? What is the embedded inflation assumption?

Answer 2

Connects inflation and interest rates, suggesting that they move closely together.
Approximation: R = r + i (R=nominal, r=real)
Exact: r = (R - i)/(1+i)

Question 3

What is the Taylor rule? Explain the formula.

Answer 3

i = pi + r* + a(pi)[pi - pi] + a(y)[y - y]

Where r* is the equilibrium real interest rate, pi is the current inflation rate, pi* is the desired inflation (2%-3%), y is the current GDP growth rate, y* is the potential GDP growth and a(pi) and a(y) are positive coefficients at around 0.5.

The key learning is that for an increase in inflation, the central bank will have to adjust rates by more than one-to-one to control for the change. Further, if growth is above potential GDP growth then we have that the interest rate will increase.

Question 4

How does the currency affect growth and inflation in Australia?

Answer 4

1) Import inflation, upward pressure on costs, although this depends on the industry of the firm and its bargaining power. Typically it has a much lesser impact than anticipated.
2) Strong dollar is good for importers, but not good for exporters or import-competitors

Question 5

Should you take an average of MP rates over the last 10 years to determine the rate used for analysis?

Answer 5

If the changes that have been perceived in the last 10 years are cyclical then yes! If changes are structural then best not to do so as you cannot compare across different environments and make a fair judgement.

Question 6

What is the neutral interest rate? What is the recent trend?

Answer 6

The neutral real interest rate aligns savings and investment at a level consistent with full employment and stable inflation. Increase in savings causes decrease in neutral rate. Increase in investment causes increase in neutral rate.

Recently the neutral rate has decreased from 2-3% to 1%, caused by

1) Slower potential growth (0.5%)
2) Risk aversion causes hurdles to investment rates and increased savings
3) Similar changes across the world passed into Australia

Question 7

What is a liquidity premium? How does this affect the shape of yield curves?

Answer 7

A liquidity premium is a measure of compensation given to investors to accommodate for the uncertainty in future prices. This has decreased recently as we have seen few interest rate movements.

The liquidity premium means there is an upward bias to the yield curve (yield increases with time - due to this liquidity premium and/or expected increase in rates)

Question 8

What does the slope of the yield curve indicate about the market?

Answer 8

Positive slope predicts economic growth in the future, while a negative slope indicates a softening of the economy and a recession. Typically yield curve is around 1%. The Australian yield curve has historically fluctuated as we are a cyclical economy.

Question 9

Distinguish between pure yields and on-the-run yields.

Answer 9

Pure yield uses stripped/zero-coupon Treasuries

On-the-run yield uses recently issued bonds selling at near par (though not all are liquid)

Question 10

Distinguish between YTM and current yield.

Answer 10

YTM is the bond’s internal rate of return (that makes NPV equate to price).
Current (running) yield is coupon/bond value

If the bond trades at a premium then coupon rate > current yield > YTM and vice versa

Question 11

What is unique about a callable bond?

Answer 11

Callable bonds give the issuer the right to pay out the bond earlier if it is in their best interest. If there is a decline in IR, then a straight bond value can rise significantly, while price of a flat bond is flat over low IR as the risk of “call” is quite high. When IR increases, callable and straight bond values converge.

Question 12

Distinguish between realised yield and YTM.

Answer 12

Holding period return includes reinvestment of coupons at a certain rate of return, where changes in rates affect returns and price of bond. It depends on the price at the end of future period and is hence forecasted.
YTM is the average return if the bond is held to maturity, depends on coupon rate, maturity and face value - hence it is observable.

Question 13

What are the components of:

1) Sovereign bond yield
2) Corporate bond spread
3) Corporate bond yield

Answer 13

1) Sovereign bond yield = 
   Real risk free IR (neutral rate around 1%) + 
   Expected inflation (around 2%)
   Maturity premium (around 1%)
2) Corporate bond spread = 
   Liquidity premium + 
   Credit spread
3) Corporate bond yield = 
   Sovereign bond yield + 
   Corporate bond spread

Question 14

Compare the post-GFC environment to a conventional softening economy (CSO).

Answer 14

1) Credit spreads suppressed (vs. deteriorate in CSO)
2) Investors ignore the risk of more defaults (vs. require wider risk premiums in CSO)
3) Issuance has little impact on spreads (vs. issuance drives wider spreads in CSO)
4) Secondary markets healthy (vs. deteriorate in CSO)

Question 15

What are credit default swaps?

Answer 15

CDS act like an insurance policy on the default risk of a corporate bond. Buyer pays annual premiums and the issuer agrees to buy back bond in a default/pay difference between market and par values.

Question 16

What is credit risk? Comment on any differences between investment and speculative grade credit.

Answer 16

Credit risk is the risk of loss resulting from the borrower failing to make timely and full payments of interest/loan principal.

Expected loss = P(default) * E(loss | default). This is only relevant for speculative grade credit (as investment grade credit has a very low probability of default). Credit risk can migrate, typically investment grade stays the same, but speculative grade credit tends to deteriorate.

Question 17

What are secured loans and the lien of a loan?

Answer 17

Secured loans are those where investors receive some return on default, dependent on lien (ranking). First lien get priority regarding specific collateral, if first lien not covered, they are considered equal with second lien. Ideally collateral covers all lien.

Question 18

Should you refrain from purchasing a bond if there is no collateral?

Answer 18

Depends on quality of the bond - if investment grade then still purchase, if speculative grade then do not purchase at all.

Question 19

What are some of the general trends relating to defaults?

[List 5]

Answer 19

1) Good ROA > 9%, EBITDA/Interest > 6, Debt/Book Cap. < 50%
2) P(default) rapidly increases as quality worsens in speculative bonds
3) Slippery slope of deterioration once you hit B grade credit
4) Default rates are cyclical, especially for speculative grade credit
5) Surges in speculative grade issuance tend to lead the default cycle. Over 50% of issued bonds are now speculative grade credit, suggesting defaults are about to spike

Question 20

What are the two different loan covenants?

Answer 20

1) Incurrence covenants (light), covenants are triggered when issuer takes actions, e.g. cannot issue more debt if debt/cash flow falls below a certain level
2) Maintenance covenants (restrictive), require issuer to have ongoing satisfactory financial health even with no intention to issue further debt. Allows lenders to take further action quicker, e.g. increase spread/collateral

Question 21

What is the high-yield credit and liquidity risk relationship/spiral?

Answer 21

High yield risk has fragile liquidity, slow cash conversion cycle, quality credit and high operational leverage.

• They are then adversely affected by downturn
• In a downturn, banks liquidity tightens as they approach the short-term market with more caution
• Diminished profits for banks and companies
• Debt becomes harder to rollover as investors are reluctant to hold
• Spreads widen as companies begin to default
• Collateral is worth less and the secondary market dries up
• Loans fail leaving investors with nothing and no way to get out

Question 22

Why might secured loans, low credit spreads and low defaults not always be a good environment to invest in?

Answer 22

Defaults are cyclical, secured loans are often from poor quality companies, who respond poorly to changes in the business cycle. In these scenarios, investors are left with very little and cannot escape due to dried up secondary markets. (See high-yield and liquidity risk cycle)

Question 23

What is Additional Tier 1 Capital (AT1)?

Answer 23

Interest-bearing securities that pay a margin about the BBSW including franking (!). They have spread duration and risk attached to the possibility that they become perpetual, and are non-cumulative (interest payments can be foregone). They are meant to be loss-absorbing if the bank is under going concern. APRA and the bank have the power to convert these to ordinary shares, redeem for cash or to write off if deemed beneficial to the bank.

Question 24

What is Additional Tier 2 Capital (AT2)?

Answer 24

Subordinated capital, behind depositors and senior debt-holders but ahead of AT1. Income is not discretionary. Payment at maturity, bank has option to pay early and can also be converted to equity/written off if APRA desires (loss-absorbing).

Question 25

What are some of the risks with AT1 Capital?

Answer 25

APRA has a large amount of control over what happens with AT1 capital. The bank has an option to convert to ordinary shares, though this may not happen if the ordinary shares pay higher dividends. Further, APRA can decide to have them written off if in the interests of the bank. They are illiquid and no-one will purchase them in the event of a forced conversion, leaving little benefit for the lender.