Management 183Financial Markets

Investments 1(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

Projected 10 year cumulative real return stock return 8%; bond return 4.5%

inflation 3%

80% / 20% bond 52%

70% / 30% bond 47%

60% / 40% bond 42%

50% / 50% bond 38%

40% / 60% bond 33%

30% / 70% bond 29%

20% / 80% bond 24%

Stock are riskier than Bonds

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

Denominated in basis points (bps). Historically 10 to 50 bps – average 30 bps

A rising TED spread indicates shrinking liquidity –an indicator of perceived credit risk:

T-bills are considered risk-freeLIBOR reflects the credit risk of lending banks.

Widening TED spread is a sign that lenders believe default risk on interbank (counterparty) loans is increasing.]

2007 average 150 – 200 bpsSeptember 2008 > 300 bps10/10/2008 465 bps

TED Spread

Pick the Federal Reserve Bank Chairmen

Click Glenn Hubbard for the parody

a c

d e

b

What’s the problem with the Fed balance sheet?

Not it’s size. But the quality of the assets.

The largest piece of the pie is pass-thru-securities (pass thrus from sub-prime mortgages) CDO’s.

No one knows the real value of this balance sheet.

Did the Fed break the law? (Federal Reserve Act of 1913) by taking less than Federal government backed securities?

Inflation? Or Deflation?

The problem is losing dollar strength.

Most people get this wrong.

The effects are similar: Prices go up – but the cause is subtly different.

The weakening dollar due to the extreme moves by the Fed undermine Americans buying power.

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– Sinking Funds?– 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

                        

106.85-0.12 (-0.11%) Apr 9, 2014

•52 Wk. High111.10•52 Wk. Low103.14

BOND News

Why the market may be underpricing fear

Bond investors take note: This could be trouble

Pressure rises on Gross as investors pull $3.1 billion from Pimco's flagship fund

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

Bond Yields

• Current or Annual Yield:Current or Annual Yield: Annual coupon divided by bond price.

– Different from YTM

• Accrued Interest– Interest is earned for each day that a bond is held, although

interest payments are generally made twice a year only.– A bond buyer must pay the accrued interest to the seller of the

bond.• dirty price = bond price + accrued interest• clean price = bond price

– By convention, accrued interest is calculated using a 360-day year.

Bond Pricing: Accrued Interest

• Example– Consider a bond that is paying a six percent annual

coupon rate in semiannual payments with a yield to maturity of 10 percent and two years and ten months until its maturity.

• What is the quoted price or clean price?

• What is the dirty price?

Bond Pricing: Accrued Interest

• What is the quoted price or clean price?Step One: Calculate the present value of a bond that has 2.5 years until it matures and pays semiannual interest coupons.

Step Two: The $30 coupon is added to $913.39. The sum is $943.19.

Step Three: The value $943.19 is discounted back 4 months to the purchase date.

39.913

2/10.01

000,1

2/10.01

305

5

10

tt

p

16.913

2/10.01

39.9436/40

p

Bond Pricing: Accrued Interest

• What is the dirty price?

Calculate the accrued interest for two months. There are 180 days between semiannual coupon payments and 30 days in a month. Therefore 60/180 is the fraction of the coupon payment earned by the seller. In other words the accrued interest is $10 and the dirty price is $923.16.

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