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Lecture8IntroductiontoBondMarket,2,Whatisbond,Bondsaregivenbyaissuertoinvestors(debtholders)usuallyinordertoraisemoneyforthefirmHowdobondscomparewithloans?,PrivatefinancingClosemonitoringofcreditor,Bilateralloan,Bondsissuedinprivateplacement,,,,,,PublicfinancingAccesstomorecapitalAbilitytospreadrisks,Multilateralloan,Bondsissuedtothepublic,Securitization(e.g.,CLOs,MBSs),3,BasicFeaturesofbonds,FixedfeaturesofbondsPrincipal(facevalue/parvalue):amountbondstatesisowedtoDHsBondsusuallyhavefacevalueof$1,000Maturity:thedatetheprincipalneedstoberepaidCoupon:annualinterestthatthebondstatesissuerwillpayInterestisusuallypaidsemiannually.Thecouponratecanbezero.Interestpaymentsarecalled“couponpayments”.,U.S.TreasuryBonds,BondsandnotesmaybepurchaseddirectlyfromtheTreasury.Denominationcanbeassmallas$100,but$1,000ismorecommon.Bidpriceof100:08means1008/32or$1002.50,Notematurityis1-10yearsBondmaturityis10-30years,Otherfeatures,OptionalfeaturesSecuredbond:certainassetsserveascollateralGuaranteedbond:someoneotherthanissuerguaranteespaymentCallable(redeemable)bond:issuermayredeem(pay)bondbeforematurity,oftenrequirespayingcallpremium(e.g.,oneyear’sworthofextrainterest).Whywouldissuerwanttoredeembonds?Convertiblebond:DHscanconvertbondintosharesOthercovenants:issuerobligations,breachofwhich=default,InnovationintheBondMarket,InverseFloatersAsset-BackedBondsCatastropheBondsIndexedBondsTreasuryInflationProtectedSecurities(TIPS).,Table14.1PrincipalandInterestPaymentsforaTreasuryInflationProtectedSecurity,PB=PriceofthebondCt=interestorcouponpaymentsT=numberofperiodstomaturityr=semi-annualdiscountrateorthesemi-annualyieldtomaturity,BondPricing,Priceofa30year,8%couponbond.Marketrateofinterestis10%.,,,,,Example14.2:BondPricing,Pricesandyields(requiredratesofreturn)haveaninverserelationshipThebondpricecurve(Figure14.3)isconvex.Thelongerthematurity,themoresensitivethebond’spricetochangesinmarketinterestrates.,BondPricesandYields,Figure14.3TheInverseRelationshipBetweenBondPricesandYields,Table14.2BondPricesatDifferentInterestRates,,YieldtoMaturity,Interestratethatmakesthepresentvalueofthebond’spaymentsequaltoitspriceistheYTM.Solvethebondformulaforr,YieldtoMaturityExample,Supposean8%coupon,30yearbondissellingfor$1276.76.Whatisitsaveragerateofreturn?,r=3%perhalfyearBondequivalentyield=6%EAR=((1.03)2)-1=6.09%,YTMvs.CurrentYield,YTM,TheYTMisthebond’sinternalrateofreturn.YTMistheinterestratethatmakesthepresentvalueofabond’spaymentsequaltoitsprice.YTMassumesthatallbondcouponscanbereinvestedattheYTMrate.,CurrentYield,Thecurrentyieldisthebond’sannualcouponpaymentdividedbythebondprice.Forbondssellingatapremium,couponrate>currentyield>YTM.Fordiscountbonds,relationshipsarereversed.,Figure14.4BondPrices:CallableandStraightDebt,YieldtoCall,Yieldtocallistheyieldassumingbondwillberepurchasedonitscallabledate.Ifinterestratesfall,priceofstraightbondcanriseconsiderably.Thepriceofthecallablebondisflatoverarangeoflowinterestratesbecausetheriskofrepurchaseorcallishigh.Wheninterestratesarehigh,theriskofcallisnegligibleandthevaluesofthestraightandthecallablebondconverge.,RealizedYieldversusYTM,ReinvestmentAssumptionsHoldingPeriodReturnChangesinratesaffectreturnsReinvestmentofcouponpaymentsChangeinpriceofthebond,Figure14.5GrowthofInvestedFunds,Figure14.6PricesoverTimeof30-YearMaturity,6.5%CouponBonds,YTMvs.HPR,YTM,YTMistheaveragereturnifthebondisheldtomaturity.YTMdependsoncouponrate,maturity,andparvalue.Allofthesearereadilyobservable.,HPR,HPRistherateofreturnoveraparticularinvestmentperiod.HPRdependsonthebond’spriceattheendoftheholdingperiod,anunknownfuturevalue.HPRcanonlybeforecasted.,Figure14.7ThePriceofa30-YearZero-CouponBondoverTime,Ratingcompanies:Moody’sInvestorService,Standard&Poor’s,FitchRatingCategoriesHighestratingisAAAorAaaInvestmentgradebondsareratedBBBorBaaandaboveSpeculativegrade/junkbondshaveratingsbelowBBBorBaa.,DefaultRiskandBondPricing,CoverageratiosLeverageratiosLiquidityratiosProfitabilityratiosCashflowtodebt,FactorsUsedbyRatingCompanies,Table14.3FinancialRatiosandDefaultRiskbyRatingClass,Long-TermDebt,Figure14.9DiscriminantAnalysis,DefaultRiskandYield,Theriskstructureofinterestratesreferstothepatternofdefaultpremiums.Thereisadifferencebetweentheyieldbasedonexpectedcashflowsandyieldbasedonpromisedcashflows.ThedifferencebetweentheexpectedYTMandthepromisedYTMisthedefaultriskpremium.,Figure14.11YieldSpreads,CreditDefaultSwaps,Acreditdefaultswap(CDS)actslikeaninsurancepolicyonthedefaultriskofacorporatebondorloan.CDSbuyerpaysannualpremiums.CDSissueragreestobuythebondinadefaultorpaythedifferencebetweenparandmarketvaluestotheCDSbuyer.,CreditDefaultSwaps,Institutionalbondholders,e.g.banks,usedCDStoenhancecreditworthinessoftheirloanportfolios,tomanufactureAAAdebt.CDScanalsobeusedtospeculatethatbondpriceswillfall.ThismeanstherecanbemoreCDSoutstandingthantherearebondstoinsure!,Figure14.12PricesofCreditDefaultSwaps,CreditRiskandCollateralizedDebtObligations(CDOs),Majormechanismtoreallocatecreditriskinthefixed-incomemarketsStructuredInvestmentVehicle(SIV)oftenusedtocreatetheCDOLoansarepooledtogetherandsplitintotrancheswithdifferentlevelsofdefaultrisk.Mortgage-backedCDOswereaninvestmentdisasterin2007,Figure14.13CollateralizedDebtObligations,InformationonexpectedfutureshorttermratescanbeimpliedfromtheyieldcurveTheyieldcurveisagraphthatdisplaystherelationshipbetweenyieldandmaturityThreemajortheoriesareproposedtoexplaintheobservedyieldcurve,OverviewofTermStructure,Figure15.1TreasuryYieldCurves,BondPricing,YieldsondifferentmaturitybondsarenotallequalNeedtoconsidereachbondcashflowasastand-alonezero-couponbondwhenvaluingcouponbonds,Table15.1YieldsandPricestoMaturitiesonZero-CouponBonds($1,000FaceValue),YieldCurveUnderCertainty,Anupwardslopingyieldcurveisevidencethatshort-termratesaregoingtobehighernextyearWhennextyear’sshortrateisgreaterthanthisyear’sshortrate,theaverageofthetworatesishigherthantoday’srate,Figure15.2Two2-YearInvestmentPrograms,Figure15.3ShortRatesversusSpotRates,DeterminingSpotRates(example),Z1=3.62%,Z2=3.949%,Z3=4.007%Thecashflowtimelinefromthestrippedcashflowsisasfollows:,,,,,,0,1,2,3,1-yearbond,2-yearbond,3-yearbond,-96.6463,-100.000,-100.000,+4,+3.8,+100,+104,+4,+103.8,fn=one-yearforwardrateforperiodnyn=yieldforasecuritywithamaturityofn,ForwardRatesfromObservedRates,Example15.4ForwardRates,,4yr=8.00%3yr=7.00%fn=?(1.08)4=(1.07)3(1+fn)(1.3605)/(1.2250)=(1+fn)fn=.1106or11.06%,DownwardSlopingSpotYieldCurveExample,Zero-CouponRatesBondMaturity12%111.75%211.25%310.00%49.25%5,ForwardRatesforDownwardSlopingYCExample,1yrForwardRates1yr[(1.1175)2/1.12]-1=0.1150062yrs[(1.1125)3/(1.1175)2]-1=0.1025673yrs[(1.1)4/(1.1125)3]-1=0.0633364yrs[(1.0925)5/(1.1)4]-1=0.063008,InterestRateUncertainty,WhatcanwesaywhenfutureinterestratesarenotknowntodaySupposethattoday’srateis5%andtheexpectedshortrateforthefollowingyearisE(r2)=6%then:Therateofreturnonthe2-yearbondisriskyforifnextyear’sinterestrateturnsouttobeaboveexpectations,thepricewilllowerandviceversa,InterestRateUncertaintyContinued,Investorsrequireariskpremiumtoholdalonger-termbondThisliquiditypremiumcompensatesshort-terminvestorsfortheuncertaintyaboutfutureprices,ExpectationsLiquidityPreferenceUpwardbiasoverexpectations,TheoriesofTermStructure,ExpectationsTheory,Observedlong-termrateisafunctionoftoday’sshort-termrateandexpectedfutureshort-termratesLong-termandshort-termsecuritiesareperfectsubstitutesForwardratesthatarecalculatedfromtheyieldonlong-termsecuritiesaremarketconsensusexpectedfutureshort-termrates,Long-termbondsaremoreriskyInvestorswilldemandapremiumfortheriskassociatedwithlong-termbondsTheyieldcurvehasanupwardbiasbuiltintothelong-termratesbecauseoftheriskpremiumForwardratescontainaliquiditypremiumandarenotequaltoexpectedfutureshort-termrates,LiquidityPremiumTheory,Figure15.4YieldCurves,Figure15.4YieldCurves(Concluded),InterpretingtheTermStructure,IftheyieldcurveistoriseasonemovestolongermaturitiesAlongermaturityresultsintheinclusionofanewforwardratethatishigherthantheaverageofthepreviouslyobservedratesReason:HigherexpectationsforforwardratesorLiquiditypremium,Figure15.5PriceVolatilityofLong-TermTreasuryBonds,Figure15.6TermSpread:Yieldson10-YearVersus90-DayTreasurySecurities,