BONDS

Proponents of the liquidity preference theory believe that, in general: ◦ Investors prefer to invest short term rather than

long term◦ Borrowers must entice lenders to lengthen their

investment horizon by paying a premium for long-term money (the liquidity premium)

Under this theory, forward rates are higher than the expected interest rate in a year

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Liquidity Preference Theory

The inflation premium theory states that risk comes from the uncertainty associated with future inflation rates

Investors who commit funds for long periods are bearing more purchasing power risk than short-term investors◦ More inflation risk means longer-term investment

will carry a higher yield

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Inflation Premium Theory

Price risks Malkiel’s interest rate theories Duration as a measure of interest rate risk

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Bond Risk

Interest rate riskPrice riskReinvestment risk

Default risk

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Risks

Interest rate risk is the chance of loss because of changing interest rates

The uncertainty concerning bond values/prices due to interest rate fluctuations are called interest rate risk

Examples 1. zerocoupon 2. coupon bonds

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Interest Rate Risk

Interest rate risk Bond prices are sensitive to the

market interest rate

If interest rates rise, the market value of bonds fall in order to compete with newly issued bonds with higher coupon rates.

Sensitivity to the interest rate chance become more severe for longer term bonds

Percentage rise in price is not symmetric with percentage decline.

Reinvestment rate risk refers to the uncertainty surrounding the rate at which coupon proceeds can be invested

The higher the coupon rate on a bond, the higher its reinvestment rate risk

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Reinvestment Rate Risk

They almost always pay coupons

Like Government bomds, they are exposed to interest rate risk

But they also subject to default risk

Corporate Bonds

Default risk measures the likelihood that a firm will be unable to pay the principal and interest on a bond

CRISIL. ICRA and CARE are the leading advisory services in monitoring default risk

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Default Risk

Investment grade bonds are bonds rated BBB or above

Junk bonds are rated below BBB

The lower the grade of a bond, the higher its yield to maturity

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Default Risk (cont’d)

Suppose you have two bonds with same maturities and same coupon rates, but one is a government bond and other is a corporate bond,

which will sell for less?why?

Pricing of corporate bonds

Bond prices move inversely with yields:◦ If interest rates rise, the price of an existing bond

declines

◦ If interest rates decline, the price of an existing bond increases

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Theorem 1

Bonds with longer maturities will fluctuate more if interest rates change

Long-term bonds have more interest rate risk

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Theorem 2

Higher coupon bonds have less interest rate risk

Money in hand is a sure thing while the present value of an anticipated future receipt is risky

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Theorem 3

TYPES

Issuer Maturity Coupon Option Redemption

Govt Short term Zero put single

Banks/PSU/Local bodies Medium

Fixed coupon call multiple

Corporations LongFloating coupon

perpetual

Type of Bonds

The concept of duration Calculating duration

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Duration as A Measure of Interest Rate Risk

For a noncallable security:◦ Duration is the weighted average number of

years necessary to recover the initial cost of the bond

◦ Where the weights reflect the time value of money

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The Concept of Duration

Duration is a direct measure of interest rate risk:◦ The higher the duration, the higher the interest

rate risk

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The Concept of Duration (cont’d)

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Inflation and Interest Rates

Real rate of interest – change in purchasing power

Nominal rate of interest – quoted rate of interest, change in purchasing power, and inflation

The ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation

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The Fisher Effect The Fisher Effect defines the relationship

between real rates, nominal rates, and inflation

(1 + R) = (1 + r)(1 + h), where◦ R = nominal rate◦ r = real rate◦ h = expected inflation rate

Approximation◦ R = r + h

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The Bond Indenture Contract between the company and the

bondholders and includes◦ The basic terms of the bonds◦ The total amount of bonds issued◦ A description of property used as security, if

applicable◦ Sinking fund provisions◦ Call provisions◦ Details of protective covenants

Priority of claims in liquidation

1. Secured creditors from sales of secured assets.

2. Wages, subject to limits3. Taxes4. Unfunded pension liabilities5. Unsecured creditors6. Preferred stock7. Common stock