1. Fall-02 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html Investments Zvi Wiener tel: 02-588-3049 mswiener@mscc.huji.ac.il Bond Prices and Yields BKM Ch 14

2. Zvi WienerBKM Ch 14 slide 2 Face or par value Coupon rate Zero coupon bond Compounding and payments Accrued Interest Indenture Bond Characteristics Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Zvi WienerBKM Ch 14 slide 3 Different Issuers of Bonds U.S. Treasury Bills, Notes and Bonds Corporations Municipalities International Governments and Corporations Innovative Bonds Indexed Bonds Floaters and Reverse Floaters Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

4. Zvi WienerBKM Ch 14 slide 4 Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Sinking funds Preferred Stock Provisions of Bonds Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

5. Zvi WienerBKM Ch 14 slide 5 P B =Price of the bond C t = interest or coupon payments T = number of periods to maturity r = yield to maturity Bond Pricing Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Fixed coupon only!

6. Zvi WienerBKM Ch 14 slide 6 C t = 40 (SA) P= 1000 T= 20 periods r= 3% (SA) Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

7. Zvi WienerBKM Ch 14 slide 7 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 Prices and Yields Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

8. Zvi WienerBKM Ch 14 slide 8 Price Yield Prices and Coupon Rates Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

9. Zvi WienerBKM Ch 14 slide 9 Yield to Maturity Interest rate that makes the present value of the bond’s payments equal to its price. Solve the bond formula for r Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

10. Zvi WienerBKM Ch 14 slide 10 Yield to Maturity Example 10 yr MaturityCoupon Rate = 7% Price = $950 Solve for r = semiannual rate r = 3.8635% Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

11. Zvi WienerBKM Ch 14 slide 11 Yield Measures Bond Equivalent Yield 7.72% = 3.86% x 2 Effective Annual Yield (1.0386) 2 - 1 = 7.88% Current Yield Annual Interest / Market Price $70 / $950 = 7.37 % Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

12. Zvi WienerBKM Ch 14 slide 12 Callable bond The buyer of a callable bond has written an option to the issuer to call the bond back. Rationally this should be done when … Interest rate fall and the debt issuer can refinance at a lower rate.

13. Zvi WienerBKM Ch 14 slide 13 Embedded Call Option r regular bond callable bond strike

14. Zvi WienerBKM Ch 14 slide 14 Puttable bond The buyer of a such a bond can request the loan to be returned. The rational strategy is to exercise this option when interest rates are high enough to provide an interesting alternative.

15. Zvi WienerBKM Ch 14 slide 15 Embedded Put Option r regular bond puttable bond

16. Zvi WienerBKM Ch 14 slide 16 Convertible Bond Payoff Stock Convertible Bond Straight Bond

17. Zvi WienerBKM Ch 14 slide 17 Timing of exercise European American Bermudian Lock up time

18. Zvi WienerBKM Ch 14 slide 18 Example Cost: 101 Promised cashflow: After 1 year6 After 2 years7 After 3 years8 After 4 years9 After 5 years110

19. Zvi WienerBKM Ch 14 slide 19 Yield calculation y = 7.6%

20. Zvi WienerBKM Ch 14 slide 20 Example 2 Cost: 101 Promised cashflow: After 1 year6 After 2 years7, callable at 100 After 3 years8 After 4 years9 After 5 years110

21. Zvi WienerBKM Ch 14 slide 21 Yield to Call calculation y = 5.94%

22. Zvi WienerBKM Ch 14 slide 22 Realized Yield versus YTM Reinvestment Assumptions Holding Period Return Changes in rates affects returns Reinvestment of coupon payments Change in price of the bond Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

23. Zvi WienerBKM Ch 14 slide 23 Holding-Period Return: Single Period HPR = [ I + ( P 0 - P 1 )] / P 0 where I = interest payment P 1 = price in one period P 0 = purchase price Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

24. Zvi WienerBKM Ch 14 slide 24 Holding-Period Example CR = 8% YTM = 8%N=10 years Semiannual CompoundingP 0 = $1000 In six months the rate falls to 7% P 1 = $1068.55 HPR = [40 + ( 1068.55 - 1000)] / 1000 HPR = 10.85% (semiannual) Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

25. Zvi WienerBKM Ch 14 slide 25 Holding-Period Return: Multiperiod Requires actual calculation of reinvestment income Solve for the Internal Rate of Return using the following: Future Value: sales price + future value of coupons Investment: purchase price Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

26. Zvi WienerBKM Ch 14 slide 26 Yield to Call Yield to Put Yield to Worst Spread for a floater Total return for a bond

27. Zvi WienerBKM Ch 14 slide 27 IRR of a portfolio Aggregation of all cashflows and using the same formula.

28. Zvi WienerBKM Ch 14 slide 28 Problems with yield Many equivalent ways to measure? Assumes reinvestment. Does not reflect risk. What if investment is very leveraged? Options, Forwards, Swaps

29. Zvi WienerBKM Ch 14 slide 29 Rating companies Moody’s Investor Service Standard & Poor’s Duff and Phelps Fitch Rating Categories Investment grade Speculative grade Default Risk and Ratings Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

30. Zvi WienerBKM Ch 14 slide 30 Moody’sS&P=F=D&P AaaAAA Aa1AA+ Aa2AA Aa3AA- A1A+ A2A A3A- Baa1BBB+ Baa2BBB Baa3BBB- Investment Grade

31. Zvi WienerBKM Ch 14 slide 31 Moody’sS&P=F=D&P Ba1BB+ Ba2BB Ba3BB- B1B+ B2B B3B- CCC+ CaaCCC CCC- CaCCC Speculative Grade

32. Zvi WienerBKM Ch 14 slide 32 High Yield Bonds LBO, downgrading, refinancing fallen angels deferred interest bonds Step-up bonds pay initially low interest which increases with time Spreads as a measure of risk and premium.

33. Zvi WienerBKM Ch 14 slide 33 Transition Matrix One year transition matrix (very old) Start\endAaaAaABaaBaBC&D Aaa91.97.380.720.000.000.000.00 Aa1.1391.267.090.310.210.000.00 A0.102.5691.205.330.610.200.00 Baa0.000.215.3687.945.460.820.21

34. Zvi WienerBKM Ch 14 slide 34 Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt Factors Used by Rating Companies Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

35. Zvi WienerBKM Ch 14 slide 35 Sinking funds Subordination of future debt Dividend restrictions Collateral Protection Against Default Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

36. Zvi WienerBKM Ch 14 slide 36 Default Risk and Yield Risk structure of interest rates Default premiums Yields compared to ratings Yield spreads over business cycles Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

37. Zvi WienerBKM Ch 14 slide 37 Important Rates Treasuries Libor Swap Spread Euribor Telbor

38. Zvi WienerBKM Ch 14 slide 38 How to treat Floaters Floater is similar to a constantly renewed loan with fixed spread (!). Thus the yield of a floater is equal to the yield on the basis plus the spread. Note that some of the Israeli government bonds have funny linkage to other bonds.

39. Zvi WienerBKM Ch 14 slide 39 Reverse (Inverse) Floater USD 5 year interest rates are 5%, however short term interest rates are Libor =2%. Libor = London Interbank offered rate on Bloomberg see FWCV + currency One can construct so-called reverse floater:

40. Zvi WienerBKM Ch 14 slide 40 Reverse Floater Years 0 1 2 3 4 5 bond -100 5 105 loan +100 -L 0 -L 1 -L 2 -L 3 -100- L 4 Reverse Fl. -100 8 10-L 1 10-L 2 10-L 3 110- L 4 bond -100 5 105

41. Zvi WienerBKM Ch 14 slide 41 Chapter 14 Weblinks http://www.bloomberg.com/marketshttp://www.bloomberg.com/markets General price information http://cnnfn.cnn.com/markets/bondcenter/rates.html http://cnnfn.cnn.com/markets/bondcenter/rates.html General price information http://www.bondresources.comhttp://www.bondresources.com Detailed information on bonds can be found at this site. It is comprehensive and has many related links. http://www.investinginbonds.com/http://www.investinginbonds.com/ Detailed information on bonds can be found at this site. It is comprehensive and has many related links. http://www.bondsonline.com/docs/bondprofessor-glossary.html http://www.bondsonline.com/docs/bondprofessor-glossary.html Detailed information on bonds can be found at this site. It is comprehensive and has many related links.

42. Zvi WienerBKM Ch 14 slide 42 Chapter 14 Weblinks http://www.standardandpoors.com/ratings/corporates/index.htm http://www.standardandpoors.com/ratings/corporates/index.htm Information on bond ratings can be found here. http://www.moodys.com http://www.moodys.com Information on bond ratings can be found here. http://www.fitchinv.com http://www.fitchinv.com Information on bond ratings can be found here. http://www.publicdebt.treas.govhttp://www.publicdebt.treas.gov USA public debt. http://www.maalot.co.il/http://www.maalot.co.il/ Raing of Israeli bonds. http://www.bba.org.uk/ http://www.bba.org.uk/ Libor rates worldwide.

43. Zvi WienerBKM Ch 14 slide 43 Home Assignment Required: problems 1, 2, 5, 7, 16 (3 rd ed). problems 1, 2, 5, 8, 21 (5 th ed). visit the web site and know Israeli bonds closely follow financial news! know yields on major classes of bonds: US government NIS linked NIS unlinked

44. Zvi WienerBKM Ch 14 slide 44 Features of Corporate Bonds (indentures) Corporate trustee – represents bondholders Term bonds – maturity Under 10 years – notes Some bonds have specific collateral Others are debentures Guaranteed bonds (third party’s guarantees)

45. Zvi WienerBKM Ch 14 slide 45 SEC rule 144A Allows to trade private placements among qualified institutions.

46. Zvi WienerBKM Ch 14 slide 46 Medium Term Notes (MTN) Notes are registered with the SEC under Rule 415 (the shelf registration) and are offered continuously to investors by an agent of the issuer. Maturities vary from 9 months to 30 years. Can be either fixed or floating. Very flexible way to raise debt!

47. Zvi WienerBKM Ch 14 slide 47 Primary Market (MTN) Issuer posts spreads over Treasuries for a variety of maturities. Then an agent tries to find an investor. Minimal size is between $1M and $25M. The schedule can be changed at any time! Often structured MTNs are used (caps, floors, etc.) = structured notes.

48. Zvi WienerBKM Ch 14 slide 48 Structured Notes Many institutional investors can use swaps and structured notes to participate in markets that were prohibited. Another use of structured notes is in risk management. Financial Engineering is used to create securities satisfying the needs of investors.

49. Zvi WienerBKM Ch 14 slide 49 Commercial Papers Short term debt issued with less documentation typically by large and stable corporations for up to 270 days. Much cheaper borrowing than banks. Bridge financing. Rollover Risk An alternative to CD.

50. Zvi WienerBKM Ch 14 slide 50 Commercial Papers Short term unsecured promissory note An alternative to short term bank borrowing A typical round-lot transaction is $100,000 In the USA maturity is up to 270 days Requires less paperwork Those with maturity up to 90 days can be used as collateral for FED discount window.

51. Zvi WienerBKM Ch 14 slide 51 Commercial Papers Typically rolled over Rollover risk is backed by an unused bank credit line In order to issue CP one need either a high rating or good collateral Sometimes credit enhancement is used (LOC) CP issued in the USA by foreigners are called Yankee CP

52. Zvi WienerBKM Ch 14 slide 52 Commercial Papers Between 71 an 89 there was one default on CP. 3 defaults occurred in 89 and 4 in 90 Direct paper is sold without an agent Secondary market is thin There is a special rating for CP, P-1,3, A-1,3 discount instruments, used by money market

53. Zvi WienerBKM Ch 14 slide 53 Bankruptcy and Creditor rights Liquidation (Chapter 7) Reorganization (Chapter 11)

54. Zvi WienerBKM Ch 14 slide 54 Bankruptcy and Credit Rights liquidation - all assets will be distributed reorganization - a new corporate entity will result a company that files for protection becomes a debtor in possession and continues to operate under the supervision of the court

55. Zvi WienerBKM Ch 14 slide 55 Bankruptcy and Credit Rights Absolute priority rule - senior creditors are paid in full before junior creditors are paid anything. Works in liquidation but often does not work in reorganization.

56. Zvi WienerBKM Ch 14 slide 56 Merton’s model DVDV $ equity debt firm

57. Zvi WienerBKM Ch 14 slide 57 Price quotation of bonds In units of 1/32, for example 92-14 means that the price is 92+14/32% of par (plus accrued interest) + means 1/64

58. Zvi WienerBKM Ch 14 slide 58 Accrued Interest Additional payment for part of the coupon time $

59. Zvi WienerBKM Ch 14 slide 59 Price Quotes and Accrued Interest Assume that the par value of a bond is $1,000. Price quote is in % of par + accrued interest the accrued interest must compensate the seller for the next coupon.

60. Zvi WienerBKM Ch 14 slide 60 STRIPS Separate Trading of Registered Interest and Principal of Securities. Reconstitution of a bond.

61. Zvi WienerBKM Ch 14 slide 61 Government Sponsored Enterprises Federal Home Loan Bank System Federal National Mortgage Association Federal Home Loan Mortgage Corporation Federal Farm Credit Bank System

62. Zvi WienerBKM Ch 14 slide 62 TIIS = TIPS Treasury Inflation Indexed (Protected) Securities. Since 97, $92B were issued, based on the non- seasonally adjusted CPI lagged 2.5 months. The quoted price do not reflect the accumulated inflation compensation. Real price = quoted*index ratio + accrued interest I-bonds saving bonds that are also CPI indexed.

63. Zvi WienerBKM Ch 14 slide 63 UST example 8.75 UST 11/08 Security was purchased 06-Jun-01 @ 110-31 Security was sold 06-Sep-01 @ 109-27+ Calculate the loss (10,000 units) …