Lecture 4. The Bond Market. Mingzhu Wang SKKU ISS 2017

Transcription

1 Lecture 4 The Bond Market Mingzhu Wang SKKU ISS 2017

2 Bond Terminologies 2

3 Agenda Types of Bonds 1. Treasury Notes and Bonds 2. Municipal Bonds 3. Corporate Bonds Financial Guarantees for Bonds Current Yield Calculation Finding the Value of Coupon Bonds Investing in Bonds 3

4 Types of Bonds Bonds are securities that represent debt owed by the issuer to the investor, and typically have specified payments on specific dates. Types of bonds we will examine include long-term government bonds (T-bonds), municipal bonds, and corporate bonds. 4

5 Sample Corporate Bond 5

6 1. Treasury Notes and Bonds The U.S. Treasury issues notes and bonds to finance its operations. The maturity differences among the various Treasury securities: Type Maturity Treasury Bill Treasury Note Treasury Bond Less than 1 year 1 to 10 years years 6

7 Treasury Bond Interest Rates No default risk since the Treasury can print money to payoff the debt Very low interest rates, often considered the risk-free rate (although inflation risk is still present) 7

8 Treasury Bond Interest Rates Interest Rate on Treasury Bonds and the Inflation Rate, (January of each year) 8

9 Treasury Bond Interest Rates: T-Bills vs. T-Bonds Interest Rate on Treasury Bills and Treasury Bonds, (January of each year) 9

10 Treasury Bonds: Recent Innovation Treasury Inflation-Indexed Securities: the principal amount is tied to the current rate of inflation to protect investor purchasing power Treasury STRIPS: the coupon and principal payments are stripped from a T-Bond and sold as individual zero-coupon bonds. 10

11 Treasury Bonds: Agency Debt Although not technically Treasury securities, agency bonds are issued by government-sponsored entities, such as Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA), and Federal Home Loan Mortgage Corporation (FHLMC). The debt has an implicit guarantee that the U.S. government will not let the debt default. 11

12 2. Municipal Bonds Issued by local, county, and state governments Used to finance public interest projects Interests are tax free Tax-free municipal interest rate = taxable interest rate (1 marginal tax rate) 12

13 Municipal Bonds: Example Suppose the rate on a corporate bond is 9% and the rate on a municipal bond is 6.75%. Which should you choose? Answer: Find the marginal tax rate: 6.75% = 9% x (1 MTR), or MTR = 25% If you are in a marginal tax rate above 25%, the municipal bond offers a higher after-tax cash flow. 13

14 Municipal Bonds Two types General obligation bonds Revenue bonds NOT default-free (e.g., Orange County California) Defaults in 1990 amounted to $1.4 billion in this market 14

15 Municipal Bonds: Comparing Revenue and General Obligation Bonds Issuance of Revenue and General Obligation Bonds, (End of year) 15

16 3. Corporate Bonds Typically have a face value of $1,000, although some have a face value of $5,000 or $10,000 Pay interest semi-annually Cannot be redeemed anytime the issuer wishes, unless a specific clause states this (call option). Degree of risk varies with each bond, even from the same issuer. Following suite, the required interest rate varies with level of risk. 16

17 Corporate Bonds: Interest Rates 17

18 Corporate Bonds: Characteristics of Corporate Bonds Registered Bonds Replaced bearer bonds The tax authority can track interest income this way Restrictive Covenants Mitigates conflicts with shareholder interests May limit dividends, new debt, ratios, etc. Usually includes a cross-default clause 18

19 Corporate Bonds: Characteristics of Corporate Bonds (1) Call Provisions Higher yield Sinking fund Interest of the stockholders Alternative opportunities Conversion Some debt may be converted to equity Similar to a stock option, but usually more limited 19

20 Corporate Bonds: Characteristics of Corporate Bonds (2) Secured Bonds Mortgage bonds Equipment trust certificates Unsecured Bonds Debentures Subordinated debentures Variable-rate bonds 20

21 Corporate Bonds: Characteristics of Corporate Bonds (3) Junk Bonds Debt that is rated below BBB Often, trusts and insurance companies are not permitted to invest in junk debt Michael Milken developed this market in the mid-1980s, although he was convicted of insider trading 21

22 Investing in Bonds Bonds and Stocks Issued,

23 Investing in Bonds Bonds are the most popular alternative to stocks for long-term investing. Even though the bonds of a corporation are less risky than its equity, investors still have risk. 23

24 Financial Guarantees for Bonds Some debt issuers purchase financial guarantees to lower the risk of their debt. The guarantee provides for timely payment of interest and principal, and are usually backed by large insurance companies. 24

25 Bond Yield Calculations Bond yields are quoted using a variety of conventions, depending on both the type of issue and the market. We will examine the current yield calculation that is commonly used for longterm debt. 25

26 Bond Current Yield Calculation What is the current yield for a bond with a face value of $1,000, a current price of $921.01, and a coupon rate of 10.95%? Answer: i c = C / P = $ / $ = 11.89% Note: C ( coupon) = 10.95% x $1,000 = $

27 Bond Pricing Bond pricing is, in theory, no different than pricing any set of known cash flows. Once the cash flows have been identified, they should be discounted to time zero at an appropriate discount rate. 27

28 2 8 Interest rates (YTM) are inversely related to present (i.e., bond) values Primary Principle: How to Value Bonds Value of financial securities = PV of expected future cash flows Bond value is, therefore, determined by the present value of the coupon payments and par value

29 2 9 The Bond Pricing Equation Coupon payments Principal repayment Bond Value C r 1 (1 1 FV r) T (1 r T ) This is the formula for the present value of an annuity

30 3 0 Three types of bonds Zero-coupon (pure discount) bonds Coupon bonds Consols

31 3 1 Pure Discount Bonds Make no periodic interest payments (coupon rate = 0%) The entire yield to maturity comes from the difference between the purchase price and the par value Cannot sell for more than par value Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs) Treasury Bills and principal-only Treasury strips are good examples of zeroes

32 3 2 Pure Discount Bonds Information needed for valuing pure discount bonds: Time to maturity (T) = Maturity date - today s date Face value (F) Discount rate (r) $0 $0 $0 $F T 1 T Present value of a pure discount bond at time 0: PV FV ( 1 r) T

33 $0 $1,000 $ Pure Discount Bond: Example Find the value of a 30-year zero-coupon bond with a $1,000 par value and a YTM of 6%. 0 $0 1 $0 2 $0 29 $1, PV FV (1 r) T $1,000 (1.06) 30 $174.11

34 Coupon Bonds Make periodic coupon payments in addition to the maturity value The payments are equal each period. Therefore, the bond is just a combination of an annuity and a terminal (maturity) value Coupon payments are typically semiannual 34

35 3 5 Level Coupon Bond: Practical Example Consider a U.S. government bond with a 6 3/8% coupon, acquired in January 2006 that expires in December The Par (Face) Value of the bond is $1, Coupon payments are made semi-annually (June 30 and December 31 for this particular bond). Since the coupon rate is 6 3/8%, the payment is (1000*6.375%)/2=$ On January 1, 2006 the size and timing of cash flows are: 1/1/ 06 $ / 30 / 06 $ / 31/ 06 $ / 30 /10 $1, / 31/10

36 3 6 Level Coupon Bond: Practical Example On January 1, 2010, the required annual yield is 5%. PV $ (1.025) $1,000 (1.025) Too difficult? No worries, there is an financial calculator solution: N = 10, FV = 1000, PMT = , I = 2.5 Computer the PV. PV = $ $1,060.17

37 Consols Not all bonds have a final maturity British consols pay a set amount (i.e., coupon) every period forever These are examples of a perpetuity PV C R 37

38 3 8 Key Bond Concepts Two key characteristics: Coupon rate & Maturity Bond prices and market interest rates move in opposite directions When coupon rate = YTM, price = par value (par bond) When coupon rate > YTM, price > par value (premium bond) When coupon rate < YTM, price < par value (discount bond) 38

39 Bond Value YTM and Bond Value 1300 When the YTM < coupon, the bond trades at a premium When the YTM = coupon, the bond trades at par /8 (YTM) Discount Rate When the YTM > coupon, the bond trades at a discount. 39

40 4 0 Coupon Bond Example Revisited Using our previous example, now assume that the required yield is 11%. How does this change the bond s price? 1/1/ 06 $ /30/ 06 $ /31/ 06 $ /30/10 $1, /31/10 PV $ (1.055) $1,000 (1.055) $825.69

41 4 1 Computing Yield to Maturity Yield to maturity is the rate implied by the current bond price Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding R with an annuity

42 4 2 YTM with Annual Coupons Consider a bond with a 10% annual coupon rate, 15 years to maturity, and a par value of 1,000. The current price is Will the yield be more or less than 10%? N = 15; PV = ; FV = 1,000; PMT = 100 CPT I/Y = 11%

43 4 3 YTM with Semiannual Coupons Suppose a bond with a 10% coupon rate and semiannual coupons has a face value of 1,000, 20 years to maturity, and is selling for 1, Is the YTM more or less than 10%? What is the semiannual coupon payment? How many periods are there? N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y = 4% (Is this the YTM?) YTM = 4%*2 = 8%

44 4 4 Bond Market Reporting Primarily OTC transactions with dealers connected electronically Extremely large number of bond issues, but generally low daily volume in single issues Makes getting up-to-date prices difficult, particularly on a small company or municipal issues National government securities are an exception

45 Next Topic The Stock Market Mishkin and Eakins (2015) chapter