Chapter 2 Fixed-income Securities. 20 questions

Transcription

1 Chapter 2 Fixed-income Securities 20 questions 25

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3 Debt: Types and Features Debt types: summary Capital Debt (companies and governments) Equity (companies only) Bank Loan (companies only) Debt Securities (companies and governments) Bills maturities < 1 year Bond maturities > 1 year 27

4 1. Sovereign and Government Bonds Government debt Supranational - E.g. World Bank, European Investment Bank, Asian Development Bank Governments Government sponsored Entities (GSEs) or Agencies - Government sponsored agencies, e.g.: Federal Home Loan Mortgage Corporation (Freddie Mac) in the US Public corporation bonds in UK Local government bonds (UK) - Constrained by central government Transport for London raised 600m in 2006 Municipal bonds (US) - Issued by states and local authorities Tax benefits to local residents Characteristics Agency bonds (US) Federal Home Loan Banks (FHLB), the Federal National Mortgage Association ( Fannie Mae ), the Federal Home Loan Mortgage Corporation (FHLMC, Freddie Mac ) and the Student Loan Marketing Association ( Sallie Mae ). Municipal bonds are usually guaranteed by a third party, known as a monoline insurer to enhance credit quality which enables municipality to secure funds on more advantageous terms. 28

5 Government debt (cont.) Features of gilts COUPON Expressed as an annual percentage of the nominal value NAME The name given at issue NOMINAL VALUE The capital payment the holder receives at redemption REDEMPTION The year when the gilt is repaid Security Code 122 GBX KK00 6½ PER CENT TREASURY STOCK 2018 Principal and interest charged on the National Loan Fund, with ecourse r to the Consolidated Fund of the United Kingdom Repayable at par on the 7 December 2018 HOLDING NUMBER Interest payable half -yearly on 7 June and 7 December CERTIFICATE NUMBER 555-XZ XZ MR FREDERICK BLOGGS 24a ACACIA AVENUE ARBINGER SURREY SSY 345 S P E C I M E N ****** S P E C I M E N Characteristics Name to act as an identifier. Coupon generally paid semi-annually and the quoted coupon of a gilt represents the annual amount of interest paid per nominal value. Coupons are received gross (before tax) but are taxable (subject to income tax for individuals). Redemption the specified date on which the capital is repaid by the DMO. Normally, redemption is at par: i.e. 100 for each 100 nominal value held. Benchmarking the yield available on UK gilts is considered the risk-free rate for sterling denominated bonds UK gilts are effectively credit riskfree. THIS IS TO CERTIFY THAT THE ABOVE -NAMED IS/ARE THE REGISTERED HOLDER(S) OF ONE HUNDRED POUNDS 61/2 PER CENT TREASURY STOCK JUNE 2002 CHIEF REGISTRAR BANK OF ENGLAND IMPORTANT: The Bank of England should be notified immediately any of change of address of any of the above stockholders No transfer in whole or part of this holding represented by certificate this will be registered until this certificate has been delivered to the Bank of England The stock is transferable in multiples of 1p 29

6 Government debt (cont.) Categories of gilt Conventional - Shorts - Mediums - Longs - Undated Index-linked - Coupon - Redemption The Debt Management Office (DMO) ensures that the government can borrow the money it requires to fund the Public Sector Net Cash Requirement (PSNCR). Issues by the DMO may be for a new gilt with a coupon/maturity dissimilar to any existing issues. 30

7 Government debt (cont.) Categories of bond - Other non-conventional bonds Double-dated (dual-dated) - Redeemed at the discretion of the DMO between two dates Convertible - Into other gilts at the discretion of the holder Floating rate - Coupon reset in line with short-term rates (LIBOR) - Capital protection Zero coupon Double-dated gilts have two dates, e.g. Treasury 3 3 / 4 % The Government has the option of redeeming after the first date, but no later than the last date. Double-dated gilts are categorised as shorts, mediums and longs by using the latter date. Convertible gilts give the owner the right to convert the gilt into predefined amounts of a different gilt at some time in the future. Convertibles are usually short- to medium-term bonds which may be converted into a longer issue at the discretion of the investor. Floating rate bonds are adjusted in line with published market interest rates. At present there are no floating rate gilts in existence. Risk considerations - Sovereign debt Not all default risk-free Portugal, Ireland, Italy, Greece, Spain (PIIGS) 31

8 Index-linked debt Inflation indices - Representing average household consumption Inflation indices there are significant differences between the CPI and the RPI. The CPI excludes a number of items, mainly related to housing. In addition to the differing items contained within the RPI and CPI, the methods of calculation are different. This tends to result in a lower figure for the CPI than RPI something called the formula effect. RPI 300 goods and services Arithmetic average price CPI Harmonised index Geometric average Excludes housing costs Used by MPC RPIX RPI minus: Mortgage repayments RPIY RPI minus: Mortgage repayments and Indirect tax (VAT) 32

9 Index-linked debt (cont.) Index-linked issues - RPI used as inflation measure for index-linked gilts - Inflation proof - Both coupon and final redemption value adjusted Since June 2005 reference date for coupon and redemption is three months prior Index-linked debt the base index figure is the one three months prior to the issue date, and the final reference rate is the index value three months prior to redemption. The holder is compensated for inflation for the three months prior to the issue, but exposed to inflation for the last three months. An investor is not guaranteed a real rate of return in any period due to the time lag involved. Example: 5% 100 nominal value ILG with semi-annual coupon Coupon= x 5 x 0.5 Inflation uplift = 142 / 126 = = 2.82 Sep 08 RPI = 126 Dec 08 Issue date March10 RPI = 142 Jun 10 Coupon date 3 months 3 months - Zero inflation will pay coupon with no uplift redemption will be nominal value 33

10 2. Corporate Debt Secured debt Corporate Bonds Debentures Loan Stock Secured debt securities Unsecured debt securities Debentures Fixed charge over assets a fixed charge is security over a certain specific company asset, e.g. a building or land, and is the most common form of security for debentures. A mortgage charge is a type of fixed charge. Floating charge over assets a floating charge is security over a class of assets, e.g. plant and machinery, fixtures and fittings, trade debtors. Fixed and floating charges need to be registered and this is usually done through a debenture trustee. Fixed charge over assets Floating charge over assets 34

11 Secured debt (cont.) Asset-backed securities - Secured by a pool of assets, e.g. property, loans, credit card receivables - Underlying assets securitised - Off balance sheet finance monthly + % 250K monthly + % ABS Pool of mortgages Mortgagee Lender Special purpose vehicle Investment company (SPV) Summary The mortgagee agrees to a monthly payment reflecting capital plus interest for a fixed time period, e.g. 25 years The lender sells the repayments on to a SPV The SPV pools the mortgage with others and securitises them by producing an ABS The ABS is sold on to an investment company The money raised is passed on to the lender as payment for the mortgage repayments Asset-backed securities The assets provide the bondholders security. Such arrangements are often referred to as the securitisation of assets. The name securitisation reflects the fact that the resulting financial instruments is a bond (a security). Financial institutions issue bonds to finance borrowing. Where a bank uses a special purpose vehicles (SPVs), the loan does not appear within the accounts of the bank. This type of finance is often described as off balance sheet finance. 35

12 Unsecured debt other terms Unsecured debt Impact of security Junior vs. senior 1. Liquidator 2. Fixed charge holders 3. Preferential creditors (e.g. employees) 4. Floating charge holders 5. Unsecured creditors (e.g. trade creditors and the Government) 6. Subordinated loan stock 7. Preference shareholders (nominal value only except participating shares) 8. Ordinary shareholders CREDITORS OWNERS Mezzanine Finance Income bonds junior bonds. Only the face value bond is paid to the investor; coupon payments being paid only if the issuing company has enough income. High yield bonds bonds rated below BBB-. Subordinated loan stock loan stock issued by a company that ranks above its preference shares but below its unsecured creditors in the event of the company s liquidation. Permanent interest bearing securities issued by mutual building societies; semi-annual coupons paid gross. Classified as perpetual subordinated bonds (PSBs). When a building society is demutualised. Mezzanine debt will rank below other forms of debt, but above the equity in a liquidation. As the riskiest debt, the mezzanine debt will offer a greater rate of interest and can be raised in a variety of ways; for example: Payment in kind notes (PIK notes) are zero coupon bonds that are issued at a substantial discount to their face value. When they are repaid, the difference between the redemption value and the purchase cost will provide the investor s return. 36

13 Unsecured debt (cont.) Credit ratings - Prime vs. sub-prime Standard & Poor s Moody s The three most prominent credit rating agencies that provide these ratings are Standard & Poor s, Moody s and Fitch. Fitch ratings are not shown in this table as they use a similar system to Standard & Poor s. AAA Aaa Investment grade AA A Aa A BBB Baa BB Ba Speculative grade B CCC B Caa CC Ca C C Bond in default Bond in default D 37

14 Bonds with embedded options Callable/Putable bonds - Callable can be redeemed early at the discretion of the issuer - Putable can be redeemed early at the discretion of the holder Convertible bonds - Convertible loan stock convertible into new ordinary shares in issuer - Contingent convertible bonds strike to convert shares and strike they must reach to be convertible Exchangeable bonds - Exchangeable loan stock convertible into existing ordinary shares in another company Callable bonds double-dated bonds may be considered as a subset of callable bonds. From the issuer s perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. However, in exchange for the benefit of reduced interest payments, the value of shareholders equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares. Issuing contingent bonds is more advantageous to companies than issuing regular convertibles. Until an investor exercises the option, the company does not need to count shares in its calculation of diluted earnings. Contingent Convertible bonds (CoCos) - Conversion takes places on a pre-specified event for example: Share price Level of capital Links The pricing of an exchangeable bond is similar to that of convertible bond, splitting it in to a straight debt part and an embedded option part and valuing the two separately. Price of exchangeable bond = price of straight bond + price of option to exchange. 38

15 3. Eurobonds Types of eurobonds Definition - International bonds Issued through international placing - Bearer documents - Issued in a eurocurrency Any currency other than the currency of the market on which it is issued Versions - As varied as any corporate bond Straight/Plain vanilla Floating/Variable rate Subordinated Asset-backed Convertible Listing eurobonds a London listing of a eurobond consists of admission to listing by the United Kingdom Listing Authority (UKLA) a division of the Financial Conduct Authority (FCA), and admission to trading on a recognised investment exchange such as the London Stock Exchange. Straight or plain vanilla fixed coupon eurobonds or bullet bonds normally pay the coupons once a year. Additionally, there are some straight zero-coupon eurobonds. Floating rate eurobonds (FRN/VRN) bonds where the coupon rate varies. The rate is adjusted in line with published market interest rates. The published interest rates that are normally used are LIBOR and Euribor. 39

16 Hints Dealing and settlement Typically OTC but some exchange-traded Regulated by International Capital Markets Association (ICMA) - Trades reported and matched through TRAX - Settlement: T+2 Gross annual coupon Day-count convention for accrued interest - 30/360 Accrued interest eurobonds are bearer documents which do not have a registration lag from an issuer s point of view. However the examiner describes an ex-coupon period where the buyer of the bond is not entitled to a portion of the coupon. We have to assume that, due to immobilisation, the depositary imposes this ex-interest period. Immobilisation As bearer documents, eurobonds are often held in depositaries (immobilised) - Euroclear/Clearstream 40

17 4. Fixed-income Securities UK Debt Management Office (DMO) Role of the DMO - Executive agency of the Treasury - Prime responsibility To ensure the government can borrow funds to cover the Public Sector Net Cash Requirement (PSNCR) - Issues gilts through auctions and T-bills through T-bill tenders - Operates the Public Works Loans Board Lends money to local authorities The Debt Management Office (DMO) makes new issues of UK Government securities (gilt-edged securities or gilts). Once issued, the secondary market for dealing in gilts is overseen by two bodies: the DMO and the LSE. The DMO applies to the UKLA for a listing of its gilts. Even though most gilts trades take place OTC, the LSE defines the rules to which they are traded. The DMO is the body that enables certain LSE member firms to act as primary dealers, known as gilt-edged market makers (GEMMs). 41

18 UK Debt Management Office (DMO) (cont.) Participants - GEMMs (primary dealers) Vetted by DMO, registered with LSE, supervised by FCA Provide liquidity in the gilt market - Obligations: Quote two-way prices to customers - Exceptions to two-way pricing other GEMMS, fixed interest market makers and gilt inter-dealer brokers Minimum volume set by DMO Participate in DMO auctions Provide closing price to DMO - Privileges: Executive rights to competitive telephone bidding Exclusive facility to trade as counterparty of DMO Exclusive access to inter-dealer broker screens 42

19 UK Debt Management Office (DMO) (cont.) Other participants - Gilt inter-dealer brokers Acting as a central counterparty in a riskless principal transaction I.D.B. GEMM 2 GEMM 1 Buys Sells Buys Sells - Broker dealers Standing repo facility - Allows GEMMs to enter into a reverse repo with DMO 43

20 UK Debt Management Office (DMO) (cont.) Gilt auctions To judge the success of a government auction, the bid to cover ratio can be used. It is computed in two ways: the number of bids received divided by the number of bids accepted, or the total amount of the bids. A ratio above 2.0 indicates a successful auction comprised of aggressive bids. A low ratio is an indication of a disappointing auction, marked by a wide spread in the yield s bid. 44

21 UK Debt Management Office (DMO) (cont.) Auctions - Competitive Minimum bid: 1,000,000 of nominal value Price bid Pay price bid - Non-competitive Maximum bid: 500,000 of nominal value No price bid Pay volume weighted average price of successful competitive bids - Tranches DMO issues more of an existing gilt Interim funding/taps - Issued in to the secondary market via GEMMS 45

22 Bond pricing benchmarks Spreads and benchmarks - Difference between the yield on one investment and the yield on another Measured in basis points (0.01%) Example - A corporate bond yields 100bp above the benchmark gilt. The benchmark gilt is currently yielding 3.8% and LIBOR is 4.1%. What is the corporate bond s spread to LIBOR? Spread over/under LIBOR at times of financial stress, such as during the banking crisis in the autumn of 2008, the spread between LIBOR and the applicable base rates can widen dramatically which, in this instance, reflected the incapacity or unwillingness of banks to engage in normal money market activities. Spread over/under swap rates the swap spread is the difference between the ten-year Treasury and the swap rate, which is the fixed rate on a LIBOR-based interest rate swap. Under normal market conditions, the ten-year Treasury yield would be lower than the swap rate. Swap spread inversion perhaps a fleeting phenomenon, and some suggest the inversion might signal concerns over increased government debt issuance and deteriorating credit quality. 46

23 Issuance of fixed-income securities Scheduled funding and opportunistic finance - Shelf registration Single registration covers several issues - Typically used for medium-term notes (MTNs) Issued on an ongoing basis with coupons in line with the prevailing rates Reverse enquiry - Similar to a commercial paper programme Shelf registration has been heavily used in the medium-term note (MTN) market (bonds with generally 2 to 10 years). Shelf registration allows flexibility to issue smaller batches of bonds with the coupons and maturity varying according to market demand at the time. Those listed on the Official List need only produce, on an annual basis, a document ( shelf document ) which contains most of the information required in listing particulars. The shelf document must be formally approved by the UK Listing Authority before publication and registration. 47

24 5. Fixed-income Markets and Trade Execution Government bond market Participants (UK) - GEMMs - Inter-dealer brokers - Broker dealers Participants (US) - Primary dealers (designated and investment banks) Risk-free and credit ratings - Assumption that government debt is default risk-free - Interest rate risk - Inflation risk Regulated markets - Government bond market subject to same regulation as any other security 48

25 Issuance of fixed-income securities Difference between auction and tender: - Auction Pay the price bid - UK Government bonds (non-indexed-linked) - UK T-bills - Tender Pay the lowest successful price - UK index-linked Government bonds - Corporate bonds - US Government bonds Keeping on target An auction is offered to raise 100m nominal value at a market price of 101 per 100 nominal. ABC offers for 50m nominal DCF offers for 50m nominal GHI offers for 50m nominal Who would be successful and what is the price they will pay? Keeping on target A tender is offered to raise 100m nominal value at a market price of 101 per 100 nominal. ABC offers for 50m nominal DCF offers for 50m nominal GHI offers for 50m nominal Who would be successful and what is the price they will pay? Links Treasury bills are issued at weekly auctions, known as tenders. The bids are tendered competitively only those bidding a high enough price will be allocated any Treasury bills and they will pay the price that they bid. 49

26 Summary of major government bonds Gilt Japan US T-Bond Bund Germany China Coupon Semi-annual Semi-annual Semi-annual Annual Annual Legal Form Registered Registered or Bearer Life Variable up to 50 years 10 years 20 years Registered Bearer Bearer Up to 30 years 10 to 30 years Variable Keeping on target An investor wishes to buy US Treasury bonds. He is quoted /32. The investor considers the price, during which time the price rises by 14/32. At what price will the investor buy the bond? A B C D Quotation 1 / / / 32 1 / / 100 Medium-term Debt T-note 2-10 years Schatz 2 years BOBL up to 5 years Settlement T+1 T+3 T+1 T+2 T+3 Settlement agency CREST Tokyo Stock Exchange Interest Convention FICC Euroclear and Clearstream Actual / Actual Actual / 365 Actual / Actual Actual / Actual Actual / Actual Only Japanese are subject to withholding tax. The French Government s bond issues are known as Obligations Assimilables du Trésor (OATs), which are longer-term bonds; they are bearer and settle T+2. Answers to questions on previous slide Auction = ABC is successful and pays ; DCF is successful and pays and GHI is unsuccessful. Tender = ABC is successful and pays ; DCF is successful and pays and GHI is unsuccessful. 50

27 Global strip market STRIPS Separate Trading of Registered Interest and Principal of Securities UK and US Permitted parties (UK) - GEMMs - Treasury - Bank of England Strippable gilts - Gilts designated as strippable by the DMO Minimum units for stripping - Based on multiples of a penny - Example: the nominal of a 4.25% bond could never be stripped into smaller portions than 8 Semi-annual coupon strip would be 8 x 2.125% = 17p Main benefits match liabilities precisely, removing any reinvestment risk Keeping on target An investor wishes to invest in gilts. Which of the following bonds would allow an investment in a nominal no less than 16? A. 2 year gilt with a 2 1 / 4 % coupon B. 5 year gilt with a 3 1 / 2 % coupon C. 8 year gilt with a 4 1 / 8 % coupon D. 10 year gilt with a 6% coupon Answer to the question on the previous slide = D US Treasury bonds are quoted in fractions down to 1 / 32. The original price quoted is not a bid/offer spread, but a fraction; effectively The price move is also a fraction 14 / 32 (or ) =

28 Global corporate bond markets Global corporate bond markets - Decentralised dealer market Liquidity provided by market makers - In UK some trading on LSE via market makers - In US some trading on NYSE Regulation in UK - Financial Conduct Authority (FCA) - Prudential Regulation Authority (PRA) - London Stock Exchange (LSE) - International Capital Markets Association (ICMA) Regulation of the UK bond market the complete rules and conditions for listing securities in London are set out in the Listing Rules, commonly known as the Rule Book, and in the Admission and Disclosure Standards. The Listing Rules are maintained by the UK Listing Authority a division of the Financial Conduct Authority; whereas the Admission and Disclosure Standards are maintained by the London Stock Exchange. Answer to the question on the previous slide = C The minimum denomination that the DMO will allow is 1p. At 16 NV all semi-annual coupon payments would be in whole pennies. 2 1 / 4 % bond would pay out 16 x 2.25% / 2 = 18p 3 1 / 2 % bond would pay out 16 x 3.5% / 2 = 28p 4 1 / 8 % bond would pay out 16 x 4.125% / 2 = 33p 6% bond would pay out 16 x 6% / 2 = 48p However, all the other bonds can be sold to lower nominal values and still pay out coupons in whole pence. The 2 1 / 4 % bond could pay out on an 8 NV: 8 x 2.25% / 2 = 9p The 3 1 / 2 % bond could pay out on a 4 NV. 4 x 3.5% / 2 = 7p The 6% bond could pay out on a 2 NV. 1 x 6% / 2 = 3p 52

29 Global bond markets and trading methods Historically - Inter-dealer markets - Voice trading systems In general a move towards electronic over-the-counter trading platforms - Business to business (B2B) - Business to client (B2C) - Request for quote (RFQ) Emerging economies bond markets Considered higher risk Lower rated bonds Less efficient markets Emerging economies bond markets Bonds from such countries are generally regarded as much higher risk, some reasons: Greater likelihood of economic swings Common political upheaval Government interference Taxation on foreign investment Less liquidity Less stable political systems More market volatility 53

30 6. Present Value, Yield and Conversion Calculations Factors influencing price Credit ratings - Credit enhancements E.g. over-collateralisation Seniority of debt - Senior - Subordinated - Mezzanine Interest and inflation rate risk Market liquidity Fiscal risk - Withholding tax on overseas bonds can be increased Credit enhancements Excess spread the excess spread is the difference between the interest rate received on the underlying collateral and the coupon on the issued security. If some of the underlying loan payments are late or default, the coupon payment can still be made. Over-collateralisation The face value of the underlying loan portfolio is larger than the security it backs. If some of the payments from the underlying loans are late or default, principal and interest payments on the asset-backed security (ABS) can still be made. Reserve account a reserve account is created to reimburse the issuing trust for losses up to the amount allocated for the reserve. Surety bonds insurance policies that reimburse the ABS for any losses. Letter of credit a financial institution is paid a fee to provide a specified cash amount to reimburse the ABS-issuing trust for any cash shortfalls from the collateral, up to the required credit support amount. Wrapped security is insured or guaranteed by a third party. The thirdparty guarantees are typically provided by AAA- rated financial guarantors or monoline insurance companies. 54

31 Valuation of fixed-income securities Flat yield - Uses: Income-seeking non-taxpayers Irredeemable bonds Hints The examiner can also use the following terms for the flat yield: Income yield Coupon yield Current yield Running yield Simple yield Flat yield Gross annual coupon Market price X 100 % The two major elements of a quote for a bond: the price and, as a result of the price, the yield. Most investment managers will be looking for bonds with particular yields and maturity dates. When dealing in corporate bonds, the quotation method is usually a yield bid/offer spread rather than a price bid/offer spread. 55

32 Bond yield calculations Gross redemption yield / yield to maturity Example: An investor purchases an 8-year 7% coupon bond at a market price of (per 100 nominal). The gross redemption yield is calculated as follows: Keeping on target Which one of the following is the best approximation of the gross redemption yield of an 8% two-year gilt with a current price of 103? A. 6.3% B. 7.8% C. 8.2% D. 9.7% Flat yield (coupon income) + Profit / Loss at redemption Gross redemption yield Net redemption yield 7 x100% = 7.4% 95 + ( 5 Profit / 8 years) x100% = 0. 7% % The yield to maturity (YTM) is also known as the gross redemption yield (GRY); it represents the internal rate of return (IRR), expressed as an annualised percentage rate, if one was to hold on to the bond until maturity. One key assumption of the YTM calculation is that one is able to reinvest all the interest payments received at the same yield throughout. The net redemption yield can be calculated as the internal rate of return (IRR) of: The dirty price paid to buy the bond The net coupons received to redemption (net of the appropriate rate of tax) The final redemption proceeds which are paid gross 56

33 Bond yield calculations (cont.) Discounting Example The value of a two-year 6.5% coupon bond using 4.5% interest rates: Keeping on target The present value of the following gilt with a 4% annual coupon with two years to maturity and a prevailing discount rate of 2.75% is: A B C D Value of bond coupon coupon red val n 1 r 1 r ( ) ( ) Answer to the question on the previous slide = A As the gilt is trading above par, the investor would make a loss on redemption therefore the GRY will be less than the flat yield. The flat yield on this gilt is 7.8% therefore the GRY must be less than 7.8% so A is the only possible answer. 57

34 Valuation of fixed-income securities Clean and dirty prices Hints The ex-coupon period for gilt is typically seven business days. Bearer bonds generally do not have ex-coupon periods. Price Cum coupon period Ex coupon period Cum coupon period Dirty Price Clean Price Time 6 MONTHS Coupon paid date Ex-coupon date Answer to the question on the previous slide = C Year one will have a cash flow of 4 and a discount factor of 1/ The present value at the end of year one is Year two will have a cash flow of 104 and a discount factor of 1 / ( ). The present value at the end of year two is The price of the bond is the sum of the present values. 58

35 Valuation of fixed-income securities (cont.) Example: You buy 10,000 nominal of an 8% gilt on 5 July for a clean price of 105. Coupon dates are 1 April and 1 October. Calculate the dirty price payable on settlement: A. 10,690 B. 10,700 C. 10,710 D. 10,720 59

36 Valuation of fixed-income securities (cont.) Factors affecting bond prices - Interest rates determine the return required from the bond. Bond prices have an inverse relationship with interest rates. A rise in interest rates will lead to a rise in the bond s required yield (YTM) and its price will fall. The sensitivity of the bond s reaction to an interest rate move is determined by: Remaining life - Longer - Shorter Coupon size - Larger - Smaller Interest rate sensitivity if the required yield from a bond rises, its price will fall. If the required yield from a bond falls, its price will rise. Bond prices have an inverse relationship with their yields: Price > Par Yield < Coupon Price = Par Price < Par Coupon Yield > Coupon Yield Inflation risk is linked to interest rate risk, as interest rates have to rise to compensate bondholders for declines in the purchasing power of money. 60

37 Valuation of fixed-income securities (cont.) Macaulay Duration: - A relative measure of a bond s sensitivity: - Used for immunisation constructing a bond portfolio with the same initial value as the present value of the liability it is designed to meet and with the same duration as the liability Hints Convexity An adjustment to modified duration Modified Duration - The approximate percentage change in a bond s price for a 1% change in yield: Modified Duration D 1 r Where D is the bond s duration and r is its present yield. At low yields modified duration underestimates the price increase when yields fall, and over estimates the price decrease when the yield rises. 61

38 Simple interest Calculate simple interest income on corporate debt: - Corporate bond paying 6% coupon maturing in 20 years - Market price is 108 per 100 nominal - Investor buys bonds at a market price of 4,320 Convertible loan stock Calculate the conversion premium: - Convertible trading at 125 per 100NV - Conversion ratio = 50 - Current share price 2.30 Hints We would assume that the examiner wishes us to calculate the interest on the next coupon payment and not over 20 years. Keeping on target Question 1 A company has issued convertible loan stock which can convert into 80 ordinary shares per 100 nominal. The convertible is trading at 160 and the ordinary shares at 180p per share. What is the conversion premium as a percentage? A. 10% B. 11.1% C. 20% D. 22.2% Keeping on target Question 2 Your client holds loan stock in company ADY plc, redeemable in five years. The stock has conversion rights set at 40 shares per 100nv and has just moved into a conversion window. The stock is currently trading at per 100nv, and ADY plc share price is currently Which of the following statements, if true, would be most helpful to the investor? A. Conversion cannot occur until redemption so sell the loan stock and use the funds to buy a direct holding in the shares B. Conversion can occur so convert the bond into shares and sell the shares at a profit C. Conversion cannot occur until redemption so hold on to the loan stock D. Although conversion can occur, the investor will profit from selling the loan stock and use the funds to buy a direct holding in the shares 62

39 Chapter 3 Equities 15 questions Answer to the questions on the previous slide Question 1 B - Effective price of share via convertible debt ( 160/80 shares) 2. Actual share price Conversion premium is 20p, or expressed as a percentage of share price, ( 0.20/ 1.80) 11.1%. Question 2 B -The bond is trading in a conversion window. It can be converted. The bond is trading at a discount to the share price. Share price = 3.15, number of shares per 100nv = 40. So theoretical price of the bond = 3.15 x 40 = 126. This is 4.50 above the bond price. This has created an arbitrage opportunity. The investor could in theory convert each 100nv into 126 of shares, sell these shares and repurchase the bond at to make a profit. 63