1. 1 Business F723 Fixed Income Analysis

2. 2 Plain Vanilla Bond Issuer Maturity Date Face Value ($1,000) Coupon Rate (paid 1/2 every six months) Financial engineering has made things much more complicated

3. 3 US Bond Market Segments Treasury Agency (smallest sector) Municipal (tax exempt) Corporate, including Yankee bonds Asset backed securities Mortgage securities; –residential or commercial

4. 4 The Indenture Legal document that spells out all details of the particular issue. Maturity, face value, coupon rate Special features Redemption provisions Collateral & Covenants Embedded options

5. 5 Term to Maturity Different types of markets –Money market; less than 1 year –Short term; 1 - 5 years –Intermediate term; 5 - 12 years –Long term; greater than 12 years

6. 6 Importance of Maturity Time period for promised cash flows Influences the required yield on the bond based on the yield curve Price volatility; all else being equal, the longer the term to maturity, the greater the price volatility

7. 7 Principal & Coupons Principal: aka; redemption value, par value, face value, maturity value –Amount to be paid at maturity Coupon Rate: aka; nominal rate –stated annual rate –principal x coupon rate paid every year –typically 1/2 of that paid every 6 months –some European markets pay annually

8. 8 Odd Coupons Zero coupon or pure discount bonds Floating rate bonds –reference rate + quoted margin –usually an interest rate, but not always Inverse floating rate bonds Deferred coupon bonds; deferred, step-up or payment in kind. Usually junk bonds.

9. 9 Amortization Principal paid off over the life of the bond, not just at maturity Amortization schedule is the required payments of principal Mortgage and asset backed securities Term to maturity is much less meaningful –weighted average life or average life

10. 10 Embedded Options Call; issuer can buy back bond at a predetermined price. Put; buyer can sell bond back to issuer Convertible; buyer can trade bond for a fixed number of common shares of issuer Exchangeable; trade for other securities Currency; coupon payments in different currencies, issuer or buyer chooses

11. 11 Risk Bonds are considered lower risk than equity Even treasury bonds have risk Nine types of risk identified

12. 12 Interest Rate Risk When interest rates change, market prices of bonds change Called interest rate risk or market risk Amount of risk dependent on; –term to maturity –coupon rate –embedded options

13. 13 Reinvestment Risk How much will an investment be worth in 5 years? Highly dependent on interest-on-interest Reinvestment risk increases as coupon rate increases Zero coupon = no reinvestment risk, but much more interest rate risk

14. 14 Call Risk Three problems for buyer; –cash flow pattern not certain –if called for refinancing, high reinvestment risk –capital appreciation limited Callable bonds are priced to give a higher yield than non-callable bonds Spread dependant on call parameters

15. 15 Credit Risk Possibility of default Credit spread risk –risk premium over treasury –change in credit rating can affect prices –upgrade reduces spread, increases prices –downgrade increases spread, decreases prices

16. 16 Inflation Risk Also known as purchasing power risk Interest rates include a provision for expected inflation Unexpected changes in inflation could mean that the proceeds of the investment is not sufficient for the planned use of funds Floating rate bonds somewhat protected

17. 17 Exchange Rate Risk Also called currency risk Affects any bond with cash flows denominated in foreign currency

18. 18 Liquidity Risk How easy is it to sell your bond? High bid/ask spread for bonds with low liquidity Important to institutional investors since they need to “mark to market” periodically, so the bond must trade with some frequency to determine a market price

19. 19 Volatility Risk Important for bonds with embedded options Option prices increase with an increase in the volatility of the underlying asset If interest rates become more volatile, the value of the embedded option will increase

20. 20 Risk Not knowing what the risk of a security is. Many new types of securities lead to some misunderstanding of the risk/return characteristics of securities Complex securities can offer opportunities and return enhancement

21. 21 Financial Innovation Economic Council of Canada classifications –market broadening instruments; increase the liquidity of the market –risk management instruments –arbitrage instruments and processes; take advantage of differences between markets including; risk perception, information, taxation, and regulation

22. 22 Financial Innovation Bank for International Settlements –Price-risk-transferring instruments –Credit-risk-transferring instruments –Liquidity-generating innovations –Credit-generating innovations –Equity-generating innovations

23. 23 Pricing a Bond Consider the following bond; $1,000 face value6% coupon rate 10 years to maturity7% required return Coupons are an ordinary annuity. PVIFA(0.035, 20) Face value returned at year 10 (t = 20) FV = PV x (1 + r) t

24. 24 Pricing a Bond Price = $928.94 The bond trades at a discount because the coupon rate is below required return. Return = coupons + capital gain.

25. 25 A Premium Bond Consider the following bond; $1,000 face value12% coupon rate 7 years to maturity7% required return Coupons are an ordinary annuity. PVIFA(0.035, 14) = $655.23 Face value returned at year 7 (t = 14) FV = PV x (1 + r) t = $617.78 Price = $1,273.01, a premium of over 27%.

26. 26 In General If the YTM of a bond is equal to the coupon rate, the bond sells at par. If the yield exceeds the coupon rate the bond sells at a discount. If the coupon rate is greater than the required rate of return, the bond will trade at a premium.

27. 27 Price/Yield Relationship

28. 28 Price/Time Relationship

29. 29 Reasons for Price Changes Change in credit quality of issuer causes required return to change non-Par bond, yield doesn’t change, but time passes Market interest rates change causing required return to change

30. 30 Closer Payments What is the price of bond if the next coupon payment date is less than 6 months away? Value as 6 months away and future value the price for the extra days at the required return e.g. if purchased 22 days after previous coupon payment multiply by (1+r)^(22/181)

31. 31 Other Complications Cash flows uncertain: for bonds with an embedded option or mortgage backed. Single discount rate for all cash flows: –could view bond as package of pure discount payments and price that way Price of floater; near par unless credit spread has changed or it has a cap or floor

32. 32 Quotes and Accrued Interest Prices are typically quoted as a percent of face value; a price of 107.5 would mean a $5,000 face value bond sells for $5,375 If the bond is not in default, the buyer must also pay the seller the interest that has accrued since the last coupon payment, this total price is called the dirty price or full price, the quoted price is the clean price