Fixed Income SecuritiesFixed Income Securities

Bonds & Its Diversified

Dimensions

11

Real vs. Financial AssetsReal vs. Financial Assets

Real Assets have physical characteristics that determine the value of the asset– Size, Shape, Material, Color, etc.

– Price based on the benefits of the physical characteristics

Financial Assets physical characteristics are inconsequential– Value based on claim to promised or anticipated

cash flows

– TVM concepts used to price financial assets

33

The U.S. Bond MarketThe U.S. Bond Market

U.S. Treasury is the world’s single largest

borrower—also has the most liquid market—an informal OTC market.

44

Corporate Bonds in the U.S.Corporate Bonds in the U.S.

Market for corporate bonds is less liquid than market for U.S. Treasuries– IPOs for bonds are underwritten by investment

banking firms

Largest organized secondary bond market is NYSE– Uses matrix prices for most of the bonds listed on

its Automated Bond System (ABS)• Based on price quotes for similar bonds (in terms of

coupon rate, maturity, quality rating, call provisions)

55

Bond Markets Bond Markets

Debt Issuers Underwriter Investors

U.S. government U.S. Treasury Governments, pensions, commercial banks, insurance companies, mutual funds, foreigners, households

Federal government agencies Investment banks Governments, pensions, commercial banks, insurance companies, mutual funds, foreigners, households

Municipalities Commercial and investment banks

Governments, commercial banks, insurance companies, mutual funds, foreigners, households

Corporations Investment banks Pensions, commercial banks, insurance companies, mutual funds, foreigners, households

Home buyers, commercial real estate developers

Mortgage banks & pool operators

Pensions, commercial banks, insurance companies, REITs

Foreign governments Investment banks Pensions, mutual funds, foreigners, households

Foreign corporations Investment banks Pensions, commercial banks, insurance companies, mutual funds, foreigners, households

U.S. government

conducts regularly scheduled

auctions for Treasury securities.

66

Sectors of the Industrialized Sectors of the Industrialized World’s Bond MarketsWorld’s Bond Markets

In almost every country, the federal government is that country’s largest debt issuer

Corporate sector for Japan, Italy and Germany is relatively small compared to their overall bond markets– Due to custom of borrowing from a bank

vs. issuing bonds

77

International BondsInternational Bonds

Represent a rapidly growing category– Reflects willingness of borrowers to borrow

across borders

International bond investors face two types of political risk– Repatriation-of-funds risk

• A government may block payments of principal or interest

– Sovereign risk• A government may refuse to honor its debts

88

International BondsInternational Bonds

Can be organized into the following categories– Domestic bonds

• Issued by a local borrower and denominated in local currency

– Foreign bonds• Issued in one country and denominated in that

country’s currency by a bond issuer from another country

– Eurobonds• Any bond not issued in a domestic market regardless of

its currency denomination and the issuer’s nationality

99

Bearer Bonds Vs. Registered BondsBearer Bonds Vs. Registered Bonds

Registered bonds—send coupon checks to registered bond owners

Bearer bonds—have no list of registered owners– Investor must submit a dated coupon to a

bank to receive coupon payments• Many Eurodollar bonds are of this type

• Owner’s identity is unknown

1010

Accrued InterestAccrued Interest

Market price of bond (or its clean price) is:

1 2 T T

1 2 T Tbond

Present Value of Coupon Payments Present Value of Par

Coupon Coupon Coupon ParPrice1 k 1 k 1 k 1 k

Bonds pay coupon payments periodically Annually, semi-annually, quarterly, etc.

When a bond is purchased on a day between its scheduled interest payment, buyer must pay seller for accrued interest Interest that has been earned but not yet paid by

issuer

1111

Compounding ConventionsCompounding Conventions

The length of time between coupon payments impacts bonds’ yields and prices

Bonds PricingBonds Pricing

Bond Price = Coupon X PVIFA

+

Par Value X PVIF

1212

1313

Yield-to-Maturity (YTM): A First LookYield-to-Maturity (YTM): A First Look

A simple approximation of yield-to-maturity is:

Rate of Cash FlowRate of price appreciation or depreciation

Par - Current Price

Years until maturityNon compounded YTM Coupon Rate

Current Price

Bond Basics, II.Bond Basics, II.

Two basic yield measures for a bond are its coupon rate and its current yield.

value Par

coupon Annualrate Coupon

price Bond

coupon Annual yieldCurrent

1515

Compounded YTMCompounded YTM

YTM defined as the discount rate equating the present value of a bond’s future cash flows to its current market price– For bonds paying coupon payments semi-

annually, the correct formula is:

1 2 2T

1 2 T 2T

Present 2 2 2Coupon Coupon Coupon ParValue 1 YTM 2 1 YTM 2 1 YTM 2 1 YTM 2

•The YTM is identical to IRR

1616

Example: Comparing a Bond’s Example: Comparing a Bond’s Conventional and Effective YTMConventional and Effective YTM

Given information– Par value: $100

– Coupon rate: 10% (semi-annual)

– Time to maturity: 10 years

– Purchase price: $106.59

Using the conventional YTM formula, we calculate a YTM of 8.89%

1 2 20

$10 2 $10 2 $10 2 $100$106.59

1 0.089873 2 1 0.089873 2 1 0.089873 2

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Conditions Required to Earn a Conditions Required to Earn a Bond’s Expected YTMBond’s Expected YTM

A bond’s computed YTM will only actually be earned if:– The bond is held to maturity– The bond issuer does not default in the

timing or amount of scheduled payments– All the cash flows are immediately

reinvested to earn the bond’s YTM

1818

Inverse Relationship Between a Inverse Relationship Between a Bond’s Price and YTMBond’s Price and YTM

The price and YTM of a bond move inversely

NOTE: Price-yield curves are convex to the origin.

Interest Rate RiskInterest Rate Risk

The value of the 5% bond falls as interest rates rise

700

800

900

1,000

1,100

1,200

0 2 4 6 8 10 12 14 16

Interest rate (%)

Bo

nd

pri

ce (

$)

Interest Rate Risk and Time to Interest Rate Risk and Time to Maturity Maturity

Bond values ($)

Interest rates (%)

1-year bond

30-year bond$1,768.62

$916.67

$1,047.62

$502.11

5 10 15 20

2,000

1,500

1,000

500

Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities

Interest rate 1 year 30 years

5% $1,047.62 $1,768.62

10 1,000.00 1,000.00

15 956.52 671.70

20 916.67 502.11

Time to Maturity

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Other Measures of Bonds’ YieldsOther Measures of Bonds’ Yields

Yield-to-call (YTC)– A bond issuer may call a bond before its

original maturity date• Need to calculate the bond’s YTC

– Similar to YTM, except replace T as the time-to-call rather than time-to-maturity

2222

International Bond Index StatisticsInternational Bond Index Statistics

U.S. $ U.K. Pound Hong Kong $ German Mark

Return SD Return SD Return SD Return SD

Australia 8.5% 15.5% 9.9% 18.3% 9.5% 16.4% 5.0% 20.2%

Belgium 11.6 17.2 13.0 14.7 12.7 16.2 8.1 8.6

Canada 9.3 10.4 10.7 19.3 10.3 13.2 5.8 17.0

France 10.8 15.6 12.2 15.3 11.8 15.6 7.2 12.2

Germany 12.0 14.9 13.4 16.7 13.0 13.4 8.4 8.4

Japan 12.2 17.5 13.7 18.4 13.3 18.3 8.7 17.3

Netherlands 11.7 14.2 13.1 15.8 12.7 14.0 8.1 8.2

Switzerland 10.2 17.1 11.6 16.8 11.2 16.0 6.7 9.8

U.K. 10.2 22.3 11.6 17.2 11.6 17.2 11.3 23.4

U.S. 9.3 12.2 10.6 21.3 10.3 14.7 5.8 16.8

No single bond

investment appears to be the most or least risky.

2323

Actively Managing International Actively Managing International Bond InvestmentsBond Investments

Active international bond investors can use different approaches:– Political analysts begin with a top-down approach and

analyze sovereign risks, etc.– Macro-economists study macro factors (income,

employment, etc.) to determine which nations are economically strong

– Monetary economists forecast a nation’s level and structure of market interest rates by analyzing central bank and their policies, etc.

– Industry analysts analyze financial data from different industries

– Security analysts have a bottom-up approach—focus on bond issuer’s financial conditions, protective provisions, etc.

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The Bottom LineThe Bottom Line

Governments are the largest borrowers in the world Most rapid growth occurring in Eurobond market

– Unregulated and untaxed

Some countries publish clean bond prices while others publish dirty prices which includes accrued interest

Day counting conventions differ across countries YTM calculations methods also differ across

countries

2525

Bond Risk HierarchyBond Risk Hierarchy

1st Mortgage Bonds

2nd Mortgage BondsSenior Debentures

Subordinated Debentures

Preferred StockCommon StockMore

Risk

LessRisk

Priority of Claim Higher Lower

2626

The Bottom LineThe Bottom Line

If a bond’s cash flows are not invested at the bond’s YTM the investor will not earn the YTM

Other yield measures exist– Holding period return– Current yield– Yield to call