Economics 173AFinancial Markets

Bonds

Capital Markets

• To help to finance CompaniesCirca 2010-11

1. Annual Working Capital increases = $ 150 Billion2. Annual Capital Expenditures = $ 900 Billion

= $ 1,050 Billion

• Source of funds:1. Annual Earnings = ($ 800 Billion)

GAP $ 250 Billion2. New Debt Issued = ($ 300 Billion)

Repurchases of Equity = $ 50 Billion

Assets & Investing

The Assets• Fixed Income Bonds Real Estate

• Equity Shares Units

• Derivatives Options Futures

The Process• Asset Allocation

Equity/Fixed• 40/60• 80/20• 120/20 ?

• Security Selection • Security Analysis

Risk Return Trade-off

Return

Risk

Risk and expected Return

Intermediation and Innovation

• Banks– Commercial Banks– Investment Banks

• Funds– Mutual– Hedge– Pension– Private Equity (“PIPES”)– Foreign Exchange– Commodity

• Securitization– GNMA– CMOs, CDOs

• Bundling (Un)– STRIPS

• Engineering– Custom-tailored

Risk/Return– Synthetics – derivative

hedges – mimic something

Financial Instruments

• Money Market– Certificates of Deposit– U.S. Treasury Bills– Money Market Funds

• Bond Market– U.S Treasury Notes and

Bonds– U.K. Gilts and Consols– Municipal Bonds– Corporate Bonds

• Equity Market– Common Stock– Preferred Stock

• Derivative Market– Options– Futures

• Other– Swaps– Pass-throughs

Fixed Income Securities & Rates

• Fixed– CDs – bank time-deposits– Paper – unsecured, trade-able company debt– Acceptances – bank promises– Eurodollars - $ denominated foreign bonds– Repos, Reverse Repos – of treasury debt– Treasuries – bills, notes, bonds

• Rates– Prime– Fed Funds– LIBOR– TED Spread : the 3-month Treasury less LIBOR

Bonds

• Debt Security – corporate or government borrowing• Also called a Fixed Income security• Covenants or Indenture define the contract (this can be

complex)• 2 types of Payments:

interestprincipal

• Interest payments are the Coupon• Principal payment is the Face

Bond Basics

• Fixed Income Securities:Fixed Income Securities: A security such as a bond that pays a specified cash flow over a specific period.

Fixed ClaimHigh Priority on cash flowsTax DeductibleFixed MaturityNo Management Control

Residual ClaimLowest Priority on cash flowsNot Tax DeductibleInfinite life Management Control

Bonds Common StockHybrids (Combinationsof debt and equity)

Fixed Income Securities vs. Common StockFixed Income Securities vs. Common Stock

• Characteristics –– Types: mortgage/asset-backed, callable or puttable?,

convertible?, senior or subordinated, floating rate, zero coupon or stripped

– Denomination (Par value) Face– Coupon, Dates of Coupon Payments– Rating

• Pricing – present value of future cash flows• Yields:

– Coupon yield– YTM– RCYTM

• Sensitivity to Time, i.e. maturity• Sensitivity to changes in interest rates

Bond Analysis

Treasury Bills, Notes, & Bonds

• Bills – 90 days to 6 months • Notes – 1 year up to 10 years• Bonds – to 30 years• Face (denomination) of $1,000; quotes in $100’s• Coupon (rate) paid semi-annually• Prices quoted in points (of face) + 1/32

• No default / credit risk

US Treasury Bonds Rates April 9, 2014

Maturity Yield Yesterday Last Week Last Month

3 Month 0.02 0.02 0.01 0.04

6 Month 0.04 0.03 0.04 0.06

2 Year 0.40 0.39 0.45 0.36

3 Year 0.87 0.85 0.92 0.77

5 Year 1.69 1.66 1.79 1.62

10 Year 2.71 2.68 2.80 2.77

30 Year 3.56 3.54 3.65 3.72

Corporate Bonds April 9, 2014

Maturity Yield Yesterday Last Week Last Month

2yr AA 0.50 0.49 0.55 0.51

2yr A 0.70 0.69 0.75 0.72

5yr AAA 1.80 1.76 1.98 1.84

5yr AA 2.05 2.01 2.14 2.04

5yr A 2.18 2.15 2.31 2.20

10yr AAA 3.10 3.06 3.21 3.35

10yr AA 3.33 3.30 3.44 3.51

10yr A 3.59 3.56 3.70 3.74

20yr AAA 3.99 3.97 4.06 4.05

20yr AA 4.32 4.30 4.38 4.42

20yr A 4.64 4.63 4.71 4.70

Bond Pricing

As with all Financial Assets

The price is a Present Value of the expected cash flows discounted at the appropriate (relative to risk) discount (interest) rate.

Coupon Payments

• Relative to other types of securities, bonds produce cash flows that an analyst can predict with a high degree of precision.

– Fixed rate– Variable rate– Zero coupons– Consols – consolidated annuities - perpetuities

introduced in 1751.

Rates

Risk-adjusted Discount Rate (RADR)

Annual Percentage Rate (APR)

Annual Percentage Yield (APY)

Bond Pricing

• DCF Technique

PB = Price of the bond

Ct = interest or coupon payments

T = number of periods to maturity

r = discount rate

1 (1 )(1 )

T

TtTt

t

BFaceCP

rr

Bond Pricing

CCtt = 40 (SA), F = 1000, = 40 (SA), F = 1000,

T = 20 periods, r = 3% (SA)T = 20 periods, r = 3% (SA)

PB = $1,148.77

tt=1=1++

2020

== PPBB4040

(1+.03)) t 1000 1(1+.03) 20

Insert Figure 4-6 here.

Three Bonds in a 10 percent world …

Bond Pricing

• Zero Coupon Bonds

• Consols – Zero Face Bonds

nr 1

par value al)PV(princip price bondcurrent

r

t

r

t

tt

at time flowcash

1

at time flowcash price bondcurrent

1

Bond Yields

• Yield to Maturity:Yield to Maturity: The discount rate that makes the present value of a bond’s payments equal to its price.– Internal rate of return from holding bond till

maturity.– Example

3 year bond with interest payment of $100, principal of $1,000 and current price of $900

– Assume coupon proceeds are reinvested at the YTM.

Bond Pricing

• Example (annual coupon paid SA) in a 6 percent world.Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000

CCtt = 40 (SA), P = 1000, = 40 (SA), P = 1000,

T = 20 periods, r = 3% (SA)T = 20 periods, r = 3% (SA)

PB = $1,148.77

tt=1=1++

2020

== PP BB4040

(1+.03)) t 1000 1(1+.03) 20

Approximate Yield to Maturity

• Approximating YTMUsing the earlier example

Avg. Income = 80 + (1000-1149)/10 = 65.10

Avg. Price = (1000 + 1149)/2 = 1074.50

Approx. YTM = 65.10/1074.50 = 0.0606

Actual YTM = 6.00%

• Prices and Yields (required rates of return) have an inverse relationship

– When yields get very high the value of the bond will be very low

– When yields approach zero, the value of the bond approaches the sum of the cash flows

Bond Yields

Price

Yield

Bond Risks

• Price Risks– Default risk– Interest rate risk

• Convenience Risks– Call risk– Reinvestment rate risk– Marketability risk

Default Risk

• The income stream from bonds is not riskless unless the investor can be sure the issuer will not default on the obligation.

• Rating companies – Moody’s Investor Service– Standard & Poor’s– Duff and Phelps– Fitch– Kroll

Default Risk

• Rating Categories– Investment Grade Bonds– Speculative Grade Bonds

S&PMoody’sVery High Quality AAA, AA Aaa, AaHigh Quality A, BBB A, BaaSpeculative BB, B Ba, BVery Poor CCC, CC, C, D Caa, Ca, C, D

2 1 12 0 1 0 1 1

2 1 12 0 1 0 1 1

(1 ) (1 ) (1 )

(1 ) / (1 ) (1 )

r r r

r r r

Forward Rates term years r at year

3 2 13 0 2 0 1 2

3 2 13 0 2 0 1 2

(1 ) (1 ) (1 )

(1 ) / (1 ) (1 )

r r r

r r r

One-year rate one year from now

One-year rate two years from now