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Factors Affecting bond Yields and the Term structure of interest Rates

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Presentation on theme: "Factors Affecting bond Yields and the Term structure of interest Rates"— Presentation transcript:

1 Factors Affecting bond Yields and the Term structure of interest Rates
Base interest rate., benchmark interest rate or the minimum interest rate investors demand in the US treasury market. This yield is refereed to “on the run” yield. Risk premium Market sectors (types of issuers) Default risk Imbedded options Taxability of the interest Liquidity and term to maturity of the issue

2 Yield Curves Why we should not use the yield curve to price a bond?
The yield curve is a snap shot of yields for various maturities, cetris paribus, however other things does not remain the same. Just look at the treasury market. Treasury spot definition and derivation Forward rate Coupon stripping an arbitrage example: Forward rate as a hedgeable rate

3 Behavior of spot, forward rates

4 Price yield relation

5 Term structure of spot/forward

6 Inverted yield curve

7 Determinants of the Shape of the Term structure
Expectation theory: the forward rates is the market best unbiased expectation of future interest rates. For example, expectation of falling short term future rate would affect the responsiveness of the various market participants, thus creating an inverted yield curve. Suppose that subsequent economic news leads market participants to expect interest rate to fall in the near future assuming initial flat term structure. Speculators expecting fall in interest rate would anticipate a rise in price of long term bonds and would want to buy long term bonds, bidding their price higher and their yield down.

8 Expectation Theory 1: Borrower wishing to borrow now , may be induced to wait and postpone their borrowing at a later date when it will be less expensive. 2: Those market participant interested in the long end of the market would want to buy long term bond now for expectation of capital gain in near future as rates start to fall. 3: All these responses would tend to derive the price of long term bond higher and their yield lower

9 4: The actions of borrower, speculators and investors tend to derive short term rates higher and long term rates lower. Expectation theory fails to recognize that bonds of different maturities are not perfect substitute. The future interest rate is unknown and price is unpredictable over differing horizon resulting in unknown future return. 5: There are price risk and reinvestment rate risk, which expectation theory ignores.

10 Liquidity theory Forward rate should embody a premium for risk ( liquidity) premium for long term bond which has greater price volatility as compared to short term bond. Preferred habitat Theory: The term structure reflect future interest rate as well as risk premium which is not expected to uniformly rise over maturity horizon Market segmentation Theory: supply and demand in each sector will determine the shape of the yield curve.

11 Quotes on treasury Bills
Quotes on Bank Discount Basis: bids and offer quotes are different for T/bills and treasury securities. The yield on bank discount basis is as follows: Y=D/F * 360/t, where D is discount, F is face value and t is the time to expiration. CD equivalent yield=360Y/360-t.Y Dealers profit in treasury market: Bid/ask spread, appreciation(Dep) on long and short position and cost of carry ( the difference Between the interest earned in the long position and interest paid on the short position.

12 Stripped treasury securities
Synthetic treasury receipt TIGRs , CATS and LIONs Treasury Receipts STRIPS

13 PRISM PRISM, core credit risk management model used in the banking system. Perspective, Repayment, Intention, Safeguard, Management

14 The PRISM looks at the big picture of what the borrower is all about, including history and prospect
Management, is like contours of decision tree: solution in one sector leads to solutions further along… Intention, what is the purpose of the loan? The purpose serves the basis for repayment. Repayment, focuses on external and internal sources of fund. Conversion of short term assets in the balance sheet provides the means for repayment of short term debts, while long term debts are serviced from internally generated cash flow. Safeguard, internal safeguard originates from the soundness of financial statements, while collateral and guarantees provide external safeguards.. Perspective, provides the deal’s risk and reward and operating and financial strategies to create value for the shareholders, while enabling the borrower to repay the loans.

15 PRISM: Management Business operation Management Bank relationship Financial reporting Number of years the firm has been in business The firm reputation and performance record, The firm ability and willingness to pay, business longevity

16 Company information: Changes in capital structure, any predecessor company, Present capitalization, any insolvency Description of products: markets, principal customers, subsidiaries, and line of business. Technological innovation and recent product change. Customers growth, ecological problems, availability of supplies. List of principal suppliers, any delinquencies Market segmentation by customer types, geography, distribution channel, pricing policy, and degree of integration. Strategic goals and company’s track record for meeting and or missing goals. Number and types of customers broken down in percentage of the sale/profit. Government contracts Capital equipments requirements and commitments

17 Industry information Industry composition and any recent changes
# of firms in the industry Products and services compared to industry Borrower’s market share and trend Recent merger and acquisitions Recent foreign entrants Rate of business failure in the industry Industry’s average bond rating Degree of operating leverage/financial leverage Adverse conditions reported by analyst for the industry If publicly traded, which exchange the borrower’s stock traded The effect of government regulation on the industry

18 Management Information
Banks need to know to whom they are granting credit Ratio of management salaries to net revenue The reputation of management in mitigating various problems Management basic philosophy List of directors, their longevity # of people employed and extent of their activities Mission statement Adequacy of information system, control, and risk management.

19 Financial reporting Secure tax return for the last five years
Secure audited financial statements Secure un-audited quarterly statement Ask client to submit projected financial and operating statements Check bank records for the client.

20 Accounting watch list Obsolete inventories, or contingent liabilities, hiding operating cost to increase earnings per share (Worldcom) Product liability Unfunded pension liabilities Expenses being paid by stockholders through bargain pricing Stockholders-managers drawing excessive compensation Adoption of less conservative accounting policies Sales subject to guarantee and warranty Check out that subsidiaries have different accounting

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