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Finance (Fach) / Fixed Assets (Lektion)
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- Downward sloping Yield Curve When the Economy goes down, the interest rate usually goes up
- Kind of Bonds Sovereign bonds—issued by governments– Treasury Bonds (US), Gilts (UK)– Emerging Market Debt (e.g. Brazilian Treasuries) Corporate bonds—issued by corporations– Investment grade / Speculative Grade (“Junk”) International bonds– The Eurodollar market refers to $-denominated bonds sold outside the US (not just in Europe) Bonds with special features– Option features (Callable bonds/Puttable Bonds/Convertible Bonds)– Indexed bonds make payments that are tied to a general price index (e.g. inflation, TIPS) or the price of a particular commodity
- Default Risk & Bond Rating US debt is conventionally treated as being free of default risk Recent congressional budget disputes have raised questions about whether it is really free from default risk. Corporate bonds treated as risky Rating agencies provide measures (ratings) of the risk of default by the company (or credit risk)In order for most public companies to be able to issue bonds their debt must be rated. – A rating with respect to a specific financial obligation – A rating for a corporation/obligor as a whole The two largest rating agencies are:– Standard and Poor's Corporation – Moody's Investors Service
- Why are Credit Rating important? Significantly affects the Cost of Debt Affects types of securities it can issue : direct link to covenants of financial contract to rating Investors will be able to lend money to company - many mutual funds and pensions funds place limits on amount of portfolio by junk bonds Impact of an increase in debt level on the credit rataing is important for the decision issue Debt vs. Equity re-purchase outstanding debt
- US Treasuries Easiest to value– Only fixed coupons– No default risk Three types:– T-bills (maturities up to 1 year) - ZCB– T-notes (1-10 year maturities)– T-bonds (more than 10 years) Coupons:– T-bills have no coupons (zero coupons)– T-notes and T-bonds: semi-annual coupons
- Rules in Bond Valuation The higher the interest rate, the smaller the PV of the payments to be received by bondholder is Market interest rate ↑ Bond price ↓ will fall (1) Negate slope of the Yield Curve: negative relationship between prices and interest rates general feature of fixed-income securities. Rationale: If you buy a bond at par for 8%, and then market rates subsequentlyrise, then you suffer a loss: You have tied up your money earning 8% when alternative investments earn higher returns. (2) Convexity - Convex shape of the Bond Price Curve increase in interest rates results in a smaller price decline than the price gain that results from an interest rate decrease of equal magnitude
- Yield to Maturity interest rate that makes the present value of a bond’s payments equal to its price. The yield to maturity is the rate of return earned by an investor purchasing the bond and holding the bond to maturity.
- Zero-Coupon Bonds (ZCB) Arbitrage-free relationship: if this relation were not satisfied itwould be possible to replicate the coupon bond with a portfolio of ZCBs and generate risk-free profits - STRIPS in the US: Give a Coupon Bond to the US Treasury and get ZCBs in return 1 ZCB for each coupon payment and final face value payment You can also “unstrip” (reconstitute) the ZCBs and put them back into a coupon-bond
- Interest Rate Risk and Duration We already saw that the price of a bond depends on interest rates.The returns of all fixed income securities are highly correlated, because they all depend on the interest rate. Portfolio managers and firms need to know how the value of their bond portfolio responds to changes in interest rates and then manage this sensitivity. Other things equal, the longer the time to maturity, the more sensitive is the price of a bond to changes in the interest rate. The duration of a bond provides a measure of the sensitivity of a bond to interest rate changes. Duration (D) is a measure of the average maturity of the bond’s promised cash flows. Because of differences in coupon rates, maturity is an ambiguous measure for bonds making many payments. Macaulay (1938) suggested that duration be computed as the weighted average of the times to each coupon or principal payment made by the bond. The weight applied to each payment is the proportion of the total value of the bond accounted for by that payment. The weight wtassociated with the cash flow made at time t (denoted CFt) would be:
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