Economics 173A Financial Markets Bonds

Capital Markets To help to finance Companies Circa Annual Working Capital increases = $ 150 Billion 2.Annual Capital Expenditures = $ 900 Billion = $ 1,050 Billion Source of funds: 1.Annual Earnings = ($ 800 Billion) GAP $ 250 Billion 2.New DebtIssued = ($ 300 Billion) Repurchases of Equity= $ 50 Billion

Assets & Investing The Assets Fixed Income Bonds Real Estate Equity Shares Units Derivatives Options Futures The Process Asset Allocation Equity/Fixed 40/60 80/20 120/20 ? Security Selection Security Analysis Risk Return Trade-off

Return Risk Risk and expected Return

Intermediation and Innovation Banks –Commercial Banks –Investment Banks Funds –Mutual –Hedge –Pension –Private Equity (“PIPES”) –Foreign Exchange –Commodity Securitization –GNMA –CMOs, CDOs Bundling (Un) –STRIPS Engineering –Custom-tailored Risk/Return –Synthetics – derivative hedges – mimic something

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 –TED Spread : the 3-month Treasury less LIBOR

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/asset-backed, callable or puttable?, convertible?, senior or subordinated, floating rate, zero coupon or stripped –Denomination (Par value) Face –Coupon, Dates of Coupon Payments –Rating Pricing – present value of future cash flows Yields: –Coupon yield –YTM – RCYTM 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 Face (denomination) of $1,000; quotes in $100’s Coupon (rate) paid semi-annually Prices quoted in points (of face) + 1 / 32 No default / credit risk

US Treasury Bonds Rates April 9, 2014 MaturityYieldYesterdayLast WeekLast Month 3 Month Month Year Year Year Year Year

Corporate Bonds April 9, 2014 MaturityYieldYesterdayLast WeekLast Month 2yr AA yr A yr AAA yr AA yr A yr AAA yr AA yr A yr AAA yr AA yr A

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 Risk-adjusted Discount Rate (RADR) Annual Percentage Rate (APR) Annual Percentage Yield (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 C t = 40 (SA), F = 1000, T = 20 periods, r = 3% (SA) P B = $1, t=1 + 20= P B 40 ) ( 1+.03) t ( ) 20

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

Bond Pricing Zero Coupon Bonds Consols – Zero Face Bonds

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. –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.

Bond Pricing Example (annual coupon paid SA) in a 6 percent world. Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000 C t = 40 (SA), P = 1000, T = 20 periods, r = 3% (SA) P B = $1, t=1 + 20= P B 40 ) ( 1+.03) t ( ) 20

Approximate Yield to Maturity Approximating YTM Using the earlier example Avg. Income = 80 + ( )/10 = Avg. Price = ( )/2 = Approx. YTM = 65.10/ = Actual YTM = 6.00%

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

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