Fixed Income Securities and Debt Markets

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Presentation transcript:

Fixed Income Securities and Debt Markets Chapter 7

Debt vs. Equity Debt: Equity: Contractual , obligation Fixed term Interest The Issuer can be sued for default of payments Equity: Right to eliminate dividends, even on preferred shares Can’t be sued for reduction or elimination of dividends

Bonds A Bond - is a publicly traded debt Different types of Bonds: Treasury Zero coupon Corporate In US - Municipal In Canada: Provincial City

Bonds Rating agencies: Principal borrowers: Payments on a Bond: Fitch Moody Principal borrowers: Governments Corporations Payments on a Bond: Income payment is called – Coupon Principal is called – Par Value

Bonds Notations: The coupon rate is fixed over maturity rc – coupon rate, usually paid semi-annually YTM – y - expected rate of return for a Bond investor (per annum, compounded semi-annually) M – Par Value (principal) n - # of 6-months periods to maturity n/2 – # of years to maturity C - coupon The coupon rate is fixed over maturity Yield to maturity (YTM or y) is market determined

Bonds Coupon: Value of Bond:

Bonds There are 3 rates in the bond market: Coupon rate Yield to maturity (YTM , y) Current yield

YTM ≤ Current Yield ≤ Coupon rate (OTE) Bonds Premium bond: Price > Par Value YTM ≤ Current Yield ≤ Coupon rate (OTE)

Bonds Other Things Equal (OTE): Interest rates in the economy don’t change Credit worthiness of borrower doesn’t change Flat term structure of yields Can’t “ride down” the yield curve Coupon reinvestment at yield rate

YTM ≥ Current Yield ≥ Coupon Rate Bonds Discount bond: Price < Par Value YTM ≥ Current Yield ≥ Coupon Rate

Bonds Bond Pricing: Invoice Price = Bond Value = = Quoted Price + Accrued Interest Notations: IP – Invoice Price = Total expenditure to buy a bond QP – Quoted Price = Price used for trading AI = Accrued Interest = the buyer of a bond must pay the seller “fraction” of a coupon period since last coupon times the amount of the upcoming coupon IP = QP + AI

Bonds Risks: Price Risk Reinvestment Risk Default Risk Inflation Fisher’s Relationship: (1 + y) = (1 + r*)*(1 + ∏) r* - real rate of interest per annum ∏ - expected rate of inflation per annum

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