Economics 173A and Management 183 Financial Markets Fixed Income Securities: Bonds

Financial Instruments Money Market –Certificates of Deposit –U.S. Treasury Bills –Money Market Funds Bond Market –U.S Treasury Notes and Bonds –U.K. Gilts and Consols –Municipal Bonds –Corporate Bonds Equity Market –Common Stock –Preferred Stock Derivative Market –Options –Futures Other –Swaps –Pass-throughs

Fixed Income Securities & Rates Fixed –CDs – bank time-deposits –Paper – unsecured, trade-able company debt –Acceptances – bank promises –Eurodollars - $ denominated foreign bonds –Repos, Reverse Repos – of treasury debt –Treasuries – bills, notes, bonds Rates –Prime –Fed Funds –LIBOR, HIBOR –TED Spread : LIBOR less the 3-month Treasury yield

Denominated in basis points (bps). Historically 10 to 50 bps – average 30 bps A rising TED spread indicates shrinking liquidity –an indicator of perceived credit risk: T-bills are considered risk-free LIBOR reflects the credit risk of lending banks. Widening TED spread is a sign that lenders believe default risk on interbank (counterparty) loans is increasing. ] ] 2007average150 – 200 bps September 2008> 300 bps 10/10/ bps TED Spread

Pick the Federal Reserve Bank Chairmen Click Glenn Hubbard for the parody a c de b

What’s the problem with the Fed balance sheet? Not it’s size. But the quality of the assets. The largest piece of the pie is pass-thru-securities (pass thrus from sub-prime mortgages) CDO’s. No one knows the real value of this balance sheet. Did the Fed violate the Federal Reserve Act of 1913 by adding lower than Federal government backed securities?

Inflation? Or Deflation? The problem is losing dollar strength. Most people get this wrong. The effects are similar: Prices go up – but the cause is subtly different. The weakening dollar due to the extreme moves by the Fed undermine American’s buying power.

Bonds Debt Security – corporate or government borrowing Also called a Fixed Income Security Covenants or Indenture define the contract (this can be complex) 2 types of Payments: interest principal Interest payments are the Coupon Principal payment is the Face

Bond Basics Fixed Income Securities:Fixed Income Securities: A security such as a bond that pays a specified cash flow over a specific period. Fixed Claim High Priority on cash flows Tax Deductible Fixed Maturity No Management Control Residual Claim Lowest Priority on cash flows Not Tax Deductible Infinite life Management Control BondsCommon Stock Hybrids (Combinations of debt and equity) Fixed Income Securities vs. Common Stock

Characteristics – –Types: mortgage, callable, convertible, senior or subordinated, floating rate, zero coupon. –Denomination (Par value) Face –Coupon, Dates of Coupon Payments –Sinking Funds? –Credit Rating Pricing – present value of future cash flows Yields: –Coupon yield = C / Price –YTM = the DR that makes the NPV of CF’s = 0 – RCYTM = Compound all CFs to Term and do CAGR Sensitivity to Time, i.e. maturity Sensitivity to changes in interest rates Bond Analysis

Treasury Bills, Notes, & Bonds Bills – 90 days to 6 months Notes – 1 year up to 10 years Bonds – to 30 years Bond & Note: Face (denomination) of $1,000; quotes in $100’s Bills: Face = $10,000. Discounted and quoted at Yield. Bond & Note: Coupon (rate) paid semi-annually Prices quoted in points (of face) + 1 / 32 No default / credit risk

US Treasury Bonds Rates Maturity Month 3.36 % 8.08 % 0.02 % 2 bps 6 Month 3.23 % 8.14 % 0.04 % 9 bps 2 Year 3.53 % 8.32 % 0.40 % 55.7 bps 3 Year 3.82 % 8.41 % 0.87 % 95 bps 5 Year 4.41 % 8.44 % 1.69 % bps 10 Year 4.84 % 8.51 % 2.71 % bps 30 Year 5.43 % 8.51 % 3.56 % bps rates/Pages/TextView.aspx?data=yield

Corporate Bonds April 9, 2014 Maturity4/9/2014 2yr AA0.50 2yr A0.70 5yr AAA1.80 5yr AA2.05 5yr A yr AAA yr AA yr A yr AAA yr AA yr A4.64

Bond Pricing As with all Financial Assets The price is a Present Value of the expected cash flows discounted at the appropriate (relative to risk) discount (interest) rate.

Coupon Payments Relative to other types of securities, bonds produce cash flows that an analyst can predict with a high degree of precision. –Fixed rate –Variable rate –Zero coupons –Consols – consolidated annuities - perpetuities introduced in 1751.

Rates, Returns Total Return (TR) Holding Period Return (HPR) Compound Average Growth Rate (CAGR) Risk-adjusted Discount Rate (RADR) Annual Percentage Rate (APR) Annual Percentage Yield (APY)

Example We invest $ year later we have $130 and, a year later, we have $150. Calculate the following: Total Return HPR Annualized HPR CAGR APR APY

Bond Pricing DCF Technique P B =Price of the bond C t = interest or coupon payments T = number of periods to maturity r = discount rate

Bond Pricing an 8% 10 year bond at 6%. C t = 80 (A), F = 1000, T = 10 periods, r = 6% (A) P B = $1, t=1 + 10= P B 80 ) ( 1+.06) t ( ) 10

Insert Figure 4-6 here. Three Bonds in a 10 percent world …

Bond Pricing Zero Coupon Bonds Consols – Zero Face Bonds this is “capitalizing” a cash flow

Bond Yields Yield to Maturity:Yield to Maturity: The discount rate that makes the present value of a bond’s payments equal to its price, or NPV = 0 –Internal rate of return from holding bond till maturity. –Example 3 year bond with interest payment of $100, principal of $1,000 and current price of $900 –Assume coupon proceeds are reinvested at the YTM.

Prices and Yields (required rates of return) have an inverse relationship –When yields get very high the value of the bond will be very low –When yields approach zero, the value of the bond approaches the sum of the cash flows Bond Yields

Price Yield

Bond Risks Price Risks –Default risk –Interest rate risk Convenience Risks –Call risk –Reinvestment rate risk –Marketability risk

Default Risk The income stream from bonds is not riskless unless the investor can be sure the issuer will not default on the obligation. Rating companies –Moody’s Investor Service –Standard & Poor’s –Duff and Phelps –Fitch –Kroll

Default Risk Rating Categories –Investment Grade Bonds –Speculative Grade Bonds S&P Moody’s Very High QualityAAA, AAAaa, Aa High QualityA, BBBA, Baa SpeculativeBB, BBa, B Very PoorCCC, CC, C, DCaa, Ca, C, D

Bond Yields Current or Annual Yield:Current or Annual Yield: Annual coupon divided by bond price. –Different from YTM Accrued Interest –Interest is earned for each day that a bond is held, although interest payments are generally made twice a year only. – A bond buyer must pay the accrued interest to the seller of the bond. dirty price = bond price + accrued interest clean price = bond price –By convention, accrued interest is calculated using a 360-day year.

Bond Pricing: Accrued Interest Example –Consider a bond that is paying a six percent annual coupon rate in semiannual payments with a yield to maturity of 10 percent and two years and ten months until its maturity. What is the quoted price or clean price? What is the dirty price?

Bond Pricing: Accrued Interest What is the quoted price or clean price? Step One: Calculate the present value of a bond that has 2.5 years until it matures and pays semiannual interest coupons. Step Two: The $30 coupon is added to $ The sum is $ Step Three: The value $ is discounted back 4 months to the purchase date.

Bond Pricing: Accrued Interest What is the dirty price? Calculate the accrued interest for two months. There are 180 days between semiannual coupon payments and 30 days in a month. Therefore 60/180 is the fraction of the coupon payment earned by the seller. In other words the accrued interest is $10 and the dirty price is $

Forward Rates term years r at year One-year rate one year from now One-year rate two years from now