Bond Markets Chapter Objectives I qprovide a background on bonds qdescribe the different types of bonds and their characteristics qdescribe other types of long-term debt securities q q n Chapter Objectives II nexplain how bonds are priced, nidentify the factors that affect bond prices, nexplain how the sensitivity of bond prices to interest rates is dependent on particular bond characteristics, Background on Bonds nBonds represent long-term debt securities qContractual qPromise to pay future cash flows to investors nThe issuer of the bond is obligated to pay: qInterest (or coupon) payments periodically usually semiannually qPar or face value (principal) at maturity nAccording to ownership structure: qBearer bonds qRegistered bonds n How Bond Markets Facilitate the Flow of Funds nSource: Madura, J.: Financial Markets and Institutions, 9th Edition nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Bond Yields nYield from the Issuer’s Perspective qCost of financing nYield to maturity qannualized yield that is paid by the issuer over the life of bond qAnnualized discount rate that equates the future coupon and principal payments qBased on assumption that coupon can be reinvested at the same yield Bond Yields qAn investor can purchase a ten-year, $1000 par value bond with an 8 percent annualized coupon rate for $936. Determine the yield to maturity for this bond. n N I PV PMT FV 10 –936 80 1000 Bond Yield nYield from the Investor’s Perspective qA: Investor holds it until maturity nYield to maturity Bond Yield qB: Investor does not hold until maturity nHolding period return HPR qLess than one year – HPR = coupons + difference between selling and purchasing price qOver one year – HPR = annualized discount rate that equates payments received to the initial investments §Yield consists of two components: (1)a set of coupon payments and (2)the difference between the par value that the issuer must pay to investors at maturity and the price it received when selling the bonds. qSelling price of the bond is uncertain if the bond is not hold to maturity qAn investment on bond is subject to the risk that the holding period return will be less than expected U. S. Treasury Bonds nIssued by the U.S. Treasury to finance federal government expenditures nMaturity qNotes < 10 Years qBonds > 10 to 30 Years nActive OTC Secondary Market nSemiannual Interest Payments nBenchmark Debt Security for Any Maturity U. S. Treasury Bonds 1.Treasury bond auctions §Normally held in the middle of each quarter. §Financial institutions submit bids for their own accounts or for their clients. §Bids are submitted on a competitive or a noncompetitive basis. §Competitive bids specify a price and a dollar amount of securities to be purchased. §Noncompetitive bids specify only a dollar amount of securities to be purchased. n Kinds of Treasury Bonds nCoupon Bonds qInterest paid semiannually qTo registered bondholders n nStripped Treasury Bonds – STRIPS (Separate Trading of Registered Interest and Principal of Securities) qSTRIPS are not issued by the Treasury but instead are created and sold by various financial institutions. nOne security represents the principal payment (PO) at maturity nOther securities represents the interest payments (IO) at interest paying dates nInflation-Indexed Treasury Bonds – TIPS (Treasury Inflation-Protected Securities) qIntended for investors who seek inflation protection with their investments qCoupon rates less than other Treasuries qPrincipal value adjusted for the U.S. inflation rate (CPI) every 6 months qCoupon income increases with inflation q Municipal Bonds nState and local government obligations nRevenue bonds vs. general obligation Bonds nInvestor interest income exempt from federal income tax §Typically promise semiannual interest payments. §Minimum denomination of municipal bonds is usually $5,000. §Most municipal bonds contain a call provision. Corporate Bonds nWhen corporations want to borrow for long-term periods they issue corporate bonds qUsually pay semiannual interest qMost have maturities between 10-30 years qPublic offering vs. private placement qLimited exchange, larger OTC secondary market qInvestors seek safety of principal and steady income n Corporate Bond Offerings nPublic Offering qInvestment bank to underwrite the bonds nSyndicate of investment banks nDetermine selling price nProspectus of bond issuance qRegistration of SEC qUsed by institutional investors nPrivate Placement qNot registered by SEC qFor small amounts of funds ($30 million) easy to find an institutional investor qDisclosure of financial date qSecurity firms qNo active secondary market nInstitutional investor can trade bonds with each other Corporate Bond Terminology nIndenture qLegal document specifying rights and obligations of issuer and bondholder nTrustee qRepresents bondholders to assure compliance with indenture nSinking Fund Provision qRequirement that the firm retire a certain amount or number of bonds each year qProtects investors with principal reduction nProtective Covenants qPlaces restrictions on the firm to protect bondholders qExamples: limits dividends and officer salaries, restricts additional debt n Corporate Bond Terminology nCall provisions: Ability to pay bonds off early qCall premium qAdvantage to issuers; disadvantage to investor nBond collateral qUsually consists of a mortgage on real property qUnsecured bonds are called debentures and are backed only by the general credit of the issuing firm n Corporate Bond Terminology nLow-coupon and zero-coupon bonds nVariable-rate bonds nConvertible bonds nJunk bonds Junk Bonds nJunk Bonds qJunk bonds are also called high-yield bonds or noninvestment rated bonds qPopularized in the direct finance boom of the 1980s qThe risk premium is between three and seven percent above Treasury bonds and susceptible to contagion effects qSecondary market supported by dealer market Risk Premiums of Junk Bonds versus Other Corporate Bonds over Time Risk Premiums on Debt Issued by Governments of Eurozone Countries Other Types of Long-Term Debt Securities nStructured notes nExchange Traded Notes nAuction-Rate Securities Bond Valuation and Risk Bond Valuation and Risk nThe price of a bond is the present value of the cash flows that will be generated by the bond, namely periodic interest or coupon payments and the principal at maturity. n Impact of the Discount Rate on Bond Valuation nCritical for accurate valuation nThe appropriate discount rate qYield that could be earned on alternative investments with similar risk and maturity qHigher return on riskier securities -> higher discount rates qA high-risk securities have a lower value than a low risk securities even though both have the same expected cash flow nHigher risk nHigher discount rates nLower bond prices n nLower risk nLower discount rates nHigher bond prices Note Inverse Relationship Between Risk, required returns and Bond Prices Bond Risks and Prices Relation between Discount Rate and Present Value of Payment - $10,000 Payment to Be Received in 10 Years (EXCEL sheet yield) nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Bond Valuation Process nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Valuation of Bonds with Semiannual Payments (EXCEL sheet Price) Impact of the Timing of Payments on Bond Valuation nThe market price is affected by the timing of the payments made to bondholders qSooner can be reinvested to earn additional returns qDollar received sooner has a higher present value than one to be received later Relation between Time of Payment and Present Value of Payment nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Relations between Coupon Rate, Required Return and Bond Price, y = 0,1, FV 1000, n=1 q1. Discount bonds: Bonds Selling below Par (1.000) nCoupon rate is below required rate, the price of the bond is below par (P < 1,000) n q2. Par Bonds: Bonds Selling at Par (1.000) nCoupon rate equals the required rate, the price of the bond is equal to par value (P = 1,000) n qPremium Bonds: Bonds Selling above Par (1.000) nCoupon rate is above the required rate, the price of the bond is above the par (P > 1,000) q Explaining Bond Price Movements nThe price of a bond should reflect the present value of future cash flows discounted at a required rate of return nThe required return on a bond is primarily determined by qPrevailing risk-free rate qRisk premium n Factors that affect the risk-free rate qChanges in returns on real investment nFinancial investment an alternative to real investment nOpportunity cost of financial investment is the returns available from real investment nFederal Government deficits/surplus position qInflationary expectations nConsumer price index nFederal Reserve monetary policy position nOil prices and other commodity prices nExchange rate movements n Factors that affect the credit or default risk premium qStrong economic growth nHigh level of cash flows nInvestors bid up bond prices; lower default premium qWeak economic growth nLower profits and cash flows nImpact on specific industries varied nInvestors flee from risky bonds to Treasury bonds nBond prices fall; default premiums increase n Bond Risk Premium over Time nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Framework for Explaining Changes in Bond Prices over Time Sensitivity of Bond Prices to Interest Rate Movements nDepends on the bond’s characteristics nIndicates the potential damage to bond holdings in response to and increase in interest rates qBOND PRICE ELASTICITY qDURATION q Bond Price Elasticity nBond Price Elasticity = Bond price sensitivity for any % change in market interest rates nBond Price Elasticity = q(% Change In Price)/(% Change In Interest Rates) nIncreased elasticity means greater price risk Sensitivity of Bond Prices to Interest Rate Movements a.Influence of Coupon Rate on Bond Price Sensitivity i.A zero-coupon bond is most sensitive to changes in the required rate of return. ii.The price of a bond that pays all of its yield in the form of coupon payments is less sensitive to changes in the required rate of return. b.Influence of Maturity on Bond Price Sensitivity - As interest rates decrease, long-term bond prices increase by a greater degree than short-term bond prices. n Sensitivity of Bonds with Different Coupon Rates to Interest Rate Changes (EXCEL sheet elasticity) nSource: Madura, J.: Financial Markets and Institutions, 9th Edition Duration qMeasure of bond price sensitivity qMeasures the life of bond on a PV basis qDuration = Sum of discounted, time-weighted cash flows divided by price qThe longer a bond’s duration, the greater its sensitivity to interest rate changes qThe duration of a zero-coupon bond = bond’s term to maturity qThe duration of any coupon bond is always less than the bond’s term to maturity n Duration Modified duration (EXCEL sheet duration) nModified Duration (DUR*): Can be used to estimate the percentage change in the bond’s price in response to a change in bond yields n Sensitivity of Bond Prices to Interest Rate Movements nBond Convexity - The actual response of the bond’s price to a change in bond yields is convex and is represented by the red curve in Exhibit 8.8 nConvexity is more pronounced for bonds with long maturities nConvexity is more pronounced for bonds with low (or no) coupons. n Relationship between Bond Yields and Prices Bond Convexity (EXCEL sheet convexity) nDeterminants of bond convexity n © Oltheten & Waspi 2012 Volatility nTaylor Expansion: n Modified Duration effect Convexity effect