1. The Capital Markets: Bonds Prof. Ian Giddy New York University New York University/ING Barings

2. Copyright ©1998 Ian H. Giddy Bonds 2 The Bond Markets l Treasuries l Corporates l International Bonds l Market Risk l Credit risk

3. Copyright ©1998 Ian H. Giddy Bonds 3 Fixed-Income Benchmarks 02/13/97 - 11:06 PM ET Money rates Treasury securities Thu. 6-mos. ago Yr. ago 3-mo. T-bill discount 4.98% -0.02 5.05% 4.77% 6-mo. T-bill discount 4.99% -0.05 5.12% 4.71% 10-yr. note 6.31% -0.10 6.60% 5.70% 30-yr. bond 6.62% -0.08 6.80% 6.16% Savings rates, latest 7-day averages Thu. 6-mos. ago Yr. ago Money mut. funds 4.81% 4.79% 4.84% Tax-free money funds 2.83% 2.96% 2.82% Bank money market 2.60% 2.64% 2.74% 6-mo. CDs 4.76% 4.73% 4.59% 1-yr. CDs 5.05% 5.07% 4.69% 5-yr. CDs 5.57% 5.67% 5.02% Mortgage rates Thu. 6-mos. ago Yr. ago 30-yr. fixed (FHLMC) 7.65% 7.88% 6.94% 15-yr. fixed (FHLMC) 7.14% 7.39% 6.44% Adj. rate (FHLMC) 5.52% 5.81% 5.19% 1-yr. Treas. ARM index(*) 5.53% 5.60% 4.85% 11th dist. ARM index 4.842% 4.809% 5.059% Fannie Mae 30 year commitments 30 days, 7.77 60 days, 7.84 Other rates Thu. 6-mos. ago Yr. ago Prime lending 8.25% 8.25% 8.25% Fed. discount 5.00% 5.00% 5.00% Federal funds 5.06% 5.63% 5.38%

4. Copyright ©1998 Ian H. Giddy Bonds 4 Money Market Instruments l Treasury bills l Certificates of deposit l Commercial Paper l Bankers Acceptances l Eurodollars l Repurchase Agreements (RPs) and Reverse RPs l Federal Funds

5. Copyright ©1998 Ian H. Giddy Bonds 5 The Eurocurrency Market and its Linkages US Domestic German Market EUR0CURRENCY MARKET Domestic Market Euro-Deutsche Mark Eurodollar Market Market Foreign Exchange Market Japanese Euro-Yen Domestic Market Market Euro-CommercialEuro-Floating Rate Straight Paper Market Note Market Eurobond Market

6. Copyright ©1998 Ian H. Giddy Bonds 6 Instruments and Markets Bonds Governments Corporates

7. Copyright ©1998 Ian H. Giddy Bonds 7 Instruments and Markets Governments Treasuries Agencies, Mortgage-backed Securities

8. Copyright ©1998 Ian H. Giddy Bonds 8 Benchmark Bonds

9. Copyright ©1998 Ian H. Giddy Bonds 9 The Yield l Yield to maturity combines coupons and capital gains - all cash flows. l The yield to maturity on any bond, is the rate that will make the present value of the cash flows from the investment equal to the price of the investment.

10. Copyright ©1998 Ian H. Giddy Bonds 10 Prices and Yields in the Wall Street Journal Monday, May 16, 1994

11. Copyright ©1998 Ian H. Giddy Bonds 11 Yield To Maturity (YTM) l YTM is the rate of return investors earn if they buy a bond at a specific price and hold it until maturity l YTM is also the discount rate that causes the bond’s current price to just equal the present value of its interest payments and par value. l Find y such that LHS=RHS:

12. Copyright ©1998 Ian H. Giddy Bonds 12 The Yield Curve

13. Copyright ©1998 Ian H. Giddy Bonds 13 Yield Curves Yields Maturity Upward Sloping Downward Sloping

14. Copyright ©1998 Ian H. Giddy Bonds 14 Theories of Term Structure l Expectations l Liquidity Preference  Upward bias over expectations l Market Segmentation  Preferred Habitat

15. Copyright ©1998 Ian H. Giddy Bonds 15 Yield Has Problems l Reinvestment assumption: YTM assumes we reinvest at the same yield. l Coupon effect: different bonds with the same maturity, all fairly priced, have different yields. l Callable bonds have no defined maturity.

16. Copyright ©1998 Ian H. Giddy Bonds 16 Yield of a Zero l Zero-coupon bonds simply pay the principal at maturity, no interest, so find k such that: l Example: 10-year US Treasury zero with face value $1,000 priced at $399.85: k=9.60%

17. Copyright ©1998 Ian H. Giddy Bonds 17 Better Bond Pricing The method used previously discounts all the bond's cash flows at a single rate, the yield to maturity. But as the yield curve shows, different yields apply to different maturities. The best way to look at the yield for a particular maturity is to find out the yield on a zero-coupon bond for that maturity. Then we can find the PV of each cash flow (coupons & principal) by discounting each cash flow at the corresponding zero-coupon rate. (Or, equivalently, by multiplying by the corresponding discount factor.)

18. Copyright ©1998 Ian H. Giddy Bonds 18 Better Bond Pricing So we need to find out the z's: the zero- coupon bond yields. There are two ways of doing this. Let us call the zero-coupon rate for each maturity z t. Then the value of a bond should be the sum of the PVs of each of the cash flows.

19. Copyright ©1998 Ian H. Giddy Bonds 19 The Zero Approach l Use zero-coupon rates to value each cash flow - then add them! l Where can we get the z’s? One place is from the Treasury strip market.

20. Copyright ©1998 Ian H. Giddy Bonds 20 Treasury Strips in the Wall Street Journal Monday, May 16, 1994

21. Copyright ©1998 Ian H. Giddy Bonds 21 Bond Lego u To value this bond, break it up into its component cash flows - e.g. 1st coupon of (5 3/4)/2 in Feb 1996, and so on... u Then use zero’s to see what each is worth, and add the total. In general, breaking up a security into its component parts is an excellent path to valuation.

22. Copyright ©1998 Ian H. Giddy Bonds 22 Identifying Undervalued Securities Bonds Spot Rates Spot Rates “Correct” pricing “Correct” pricing Compare with actual Compare with actual

23. Copyright ©1998 Ian H. Giddy Bonds 23 Instruments and Markets Bonds Governments Corporates

24. Copyright ©1998 Ian H. Giddy Bonds 24 Corporate Bonds: Spread over Benchmark

25. Copyright ©1998 Ian H. Giddy Bonds 25 Corporate Bonds Legal Aspects Of Corporate Bonds  A Bond Indenture is a contract between the borrowing corporation and the bondholders, stating the conditions under which a bond has been issued  Common features of bond indentures include: q Sinking-Fund Requirements q Security Interest  A Trustee is a third party paid to protect the bondholders' interest

26. Copyright ©1998 Ian H. Giddy Bonds 26 Provisions of Bonds l Secured or unsecured l Call provision l Convertible provision l Put provision (putable bonds) l Floating rate bonds l Sinking funds

27. Copyright ©1998 Ian H. Giddy Bonds 27 Default Risk and Ratings l Rating companies  Moody’s Investor Service  Standard & Poor’s  Duff and Phelps  Fitch l Rating Categories  Investment grade  Speculative grade

28. Copyright ©1998 Ian H. Giddy Bonds 28 Bond Credit Ratings

29. Copyright ©1998 Ian H. Giddy Bonds 29 Factors Used by Rating Companies l Coverage ratios l Leverage ratios l Liquidity ratios l Profitability ratios l Cash flow to debt

30. Copyright ©1998 Ian H. Giddy Bonds 30 Protection Against Default l Sinking funds l Subordination of future debt l Dividend restrictions l Collateral

31. Copyright ©1998 Ian H. Giddy Bonds 31 AT&T’s Cost of Debt l After the divestiture of AT&T analysts lowered the corporation's bond rating due to the uncertainty of the outcome of the massive breakup. While AT&T eventually regained its former top rating, for the interim period AT&T bond prices fell... and its cost of debt was higher as a result of investors increasing their required rates of return on AT&T bonds.

32. Copyright ©1998 Ian H. Giddy Bonds 32 Instruments and Markets Corporate Bonds Domestic International

33. Copyright ©1998 Ian H. Giddy Bonds 33 International Capital Markets l The Eurobond Market is the market for bonds issued outside the country of the currency l The Foreign Bond Market is one in which a foreign corporation or government issues bonds in a domestic market in the local currency l An International Equity Market has emerged that allows corporations to sell large blocks of shares simultaneously to investors in several different countries Major Securities Markets

34. Copyright ©1998 Ian H. Giddy Bonds 34 International Bond Markets are Linked l Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps BOND MARKETS WITHIN COUNTRY OF CURRENCY BOND MARKETS OUTSIDE COUNTRY OF CURRENCY Currency Swaps Long-dated Forward Exchange Domestic US -Gov't -Corporate Foreign Bonds "Yankee" Domestic Japanese -Gov't -Corporate Foreign Bonds "Samurai" Eurodollar Bond Market Euroyen Bond Market

35. Copyright ©1998 Ian H. Giddy Bonds 35 Foreign Bonds l A foreign bond is a bond issued in a host country's financial market, in the host country's currency, by a foreign borrower l The three largest foreign bond markets are Japan, Switzerland, and the U.S., representing issuance of about $40 billion in bonds annually

36. Copyright ©1998 Ian H. Giddy Bonds 36 Private Placements and Rule 144A The private placement exemption from registration and disclosure is extended to Eurobonds as long as the U.S. investors meet the following requirements:  They are large and sophisticated  There are only a few investors  They have access to information and analysis similar to that which would ordinarily be contained in a registered offering prospectus  They are capable of sustaining the risk of losses, and  They intend to purchase the bonds for their own investment portfolios, and not for resale.

37. Copyright ©1998 Ian H. Giddy Bonds 37 Characteristics of Eurobonds l Issued outside country of currency l Not subject to domestic registration or disclosure requirements l In most cases take form of private placements l Placed through syndicates in many countries who sell principally to nonresidents l Bonds are structured so as to be free of withholding tax l Bearer form But... l Eurobonds usually influenced de facto by government and banks of country of currency

38. Copyright ©1998 Ian H. Giddy Bonds 38 Key Dates in the Issuance of a Eurobond

39. Copyright ©1998 Ian H. Giddy Bonds 39 Key Players in the Issuance of a Eurobond MANAGERS UNDER- WRITERS SELLING GROUP

40. Copyright ©1998 Ian H. Giddy Bonds 40 A Day in the Life...

41. The Bond Markets: Risk Prof. Ian Giddy New York University New York University/ING Barings

42. Copyright ©1998 Ian H. Giddy Bonds 42 Risk and Return  A positive relationship exists between risk and nominal or expected return  The actual return earned on a security will affect the subsequent actions of investors  Investors must be compensated for accepting greater risk with the expectation of greater return Return Risk Interest Rates and Required Returns

43. Copyright ©1998 Ian H. Giddy Bonds 43 l FEMSA, the Mexican brewing company, recently borrowed 5-year US$ funds at 16% from American International Insurance Co. l On the same day, Heineken was able to issue a 3-year Eurobond at 8%. l Meanwhile, US government securities were paying the following interest rates:  1-year bills: 5%  3-year notes: 5.5%  30-year bonds: 6.5% To what do you attribute these differences? Why do Interest Rates Differ?

44. Copyright ©1998 Ian H. Giddy Bonds 44 Risk Bond Risk Market Risk Credit Risk

45. Copyright ©1998 Ian H. Giddy Bonds 45 A $1 Investment in Different Types of Portfolios: 1926-1996 Index ($) $4,495.99 $33.73 $13.54 $8.85 $1,370.95 Small Company Stocks Large Company Stocks Long-Term Government Bonds Treasury Bills Inflation Year-End

46. Copyright ©1998 Ian H. Giddy Bonds 46 Average Annual Returns and Risk Premiums: 1926-1996 Investment Average Return Risk Premium Large company stocks12.7% 8.9% Small company stocks17.7 13.9 Long-term corporate bonds6.0 2.2 Long-term government bonds5.4 1.6 U.S. Treasury bills3.8 0.0 Source: © Stocks, Bonds, Bills and Inflation 1997 Yearbook™, Ibbotson Associates, Inc. Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved

47. Copyright ©1998 Ian H. Giddy Bonds 47 Price Risk of Treasuries Treasuries differ: l Liquidity - traders quote wider bid-ask spreads for illiquid bonds l Duration - sensitivity of price to a change in interest rates - is based on the bond’s coupon levels and maturity date (low duration means less risky) l Convexity - measures how duration changes with a change in rates (high convexity is desirable)

48. Copyright ©1998 Ian H. Giddy Bonds 48 The Price-Yield Relationship Bond prices and interest rates have an inverse relationship: PRICE YIELD(RATE)9% 100

49. Copyright ©1998 Ian H. Giddy Bonds 49 The Price-Yield Relationship But plotting price vs yield shows that the relationship is non-linear: 100 9% Price of a 9% bond

50. Copyright ©1998 Ian H. Giddy Bonds 50 Maturity In general, the longer the maturity, the more sensitive is a bond’s price to interest-rate changes, other things being equal:

51. Copyright ©1998 Ian H. Giddy Bonds 51 The Coupon Effect... But three bonds with the same maturity can have very different sensitivities, depending on their coupon levels:

52. Copyright ©1998 Ian H. Giddy Bonds 52 Duration as a Measure of Price Sensitivity Duration measures the % price change for a given change in yield: PRICE YIELD9% 100 The steeper the line, the more the price falls for a given rise in yield

53. Copyright ©1998 Ian H. Giddy Bonds 53 Uses of Duration l Summary measure of length or effective maturity for a portfolio l Immunization of interest rate risk (passive management)  Net worth immunization  Target date immunization l Measure of price sensitivity for changes in interest rate

54. Copyright ©1998 Ian H. Giddy Bonds 54 Managing Fixed Income Securities: Basic Strategies l Active strategy  Trade on interest rate predictions  Trade on market inefficiencies l Passive strategy  Control risk  Balance risk and return

55. Copyright ©1998 Ian H. Giddy Bonds 55 Active Bond Management: Swapping Strategies l Substitution swap l Intermarket swap l Rate anticipation swap l Pure yield pickup l Tax swap

56. Copyright ©1998 Ian H. Giddy Bonds 56 Frequency Distribution of Returns on Common Stocks, 1926-1996 2 16 1 8 11 6 10 13 13 Number of Years Return (%)

57. Copyright ©1998 Ian H. Giddy Bonds 57 Returns, Standard Deviations, and Frequency Distributions: 1926-1996 Source: © Stocks, Bonds, Bills, and Inflation 1997 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved. – 90% + 90% 0% Average Standard Series Annual Return DeviationDistribution Large Company Stocks12.7%20.3% Small Company Stocks17.734.1 Long-Term Corporate Bonds6.08.7 Long-Term Government Bonds5.49.2 U.S. Treasury Bills3.83.3 Inflation3.24.5

58. Copyright ©1998 Ian H. Giddy Bonds 58 The Normal Distribution Probability Return on large company stocks 68% 95% > 99% – 3 – 48.2% – 2 – 27.9% – 1 – 7.6% 0 12.7% + 1 33.0% + 2 53.3% + 3 73.6%

59. Copyright ©1998 Ian H. Giddy Bonds 59 Risk and Return of Stocks, Bonds and a Diversified Portfolio

60. Copyright ©1998 Ian H. Giddy Bonds 60 The Correlation Between Stock and Bond Returns l Covariance = 0.3333(-7-11)(17-7) + 0.3333(12-11)(7-7) +0.3333(28-11)(-3-7) = -116.67 l Correlation = -116.66 / 14.3(8.2) = -0.99

61. Copyright ©1998 Ian H. Giddy Bonds 61 Portfolio Return and Standard Deviation

62. Copyright ©1998 Ian H. Giddy Bonds 62 Portfolio Risk/Return Two Securities: Correlation Effects l Relationship depends on correlation coefficient -1.0 <  < +1.0 l The smaller the correlation, the greater the risk reduction potential If  = +1.0, no risk reduction is possible

63. Copyright ©1998 Ian H. Giddy Bonds 63 Case Study: A Portfolio

64. Copyright ©1998 Ian H. Giddy Bonds 64 Portfolio Return Computation

65. Copyright ©1998 Ian H. Giddy Bonds 65 Portfolio Risk Computation

66. Copyright ©1998 Ian H. Giddy Bonds 66 To Find the Risk-Return Possibilities, Vary the Proportions A E(r) B

67. Copyright ©1998 Ian H. Giddy Bonds 67 The Minimum-Variance Frontier of Risky Assets “Efficient frontier” Individual assets Global minimum- variance portfolio E(r)

68. Copyright ©1998 Ian H. Giddy Bonds 68 Risk Bond Risk Market Risk Credit Risk

69. Copyright ©1998 Ian H. Giddy Bonds 69 Bond Credit Ratings

70. Copyright ©1998 Ian H. Giddy Bonds 70 Credit Risk versus Market Risk

71. Copyright ©1998 Ian H. Giddy Bonds 71 CreditMetrics Methodology l Establishes the exposure profile of each obligor in a portfolio. l Computes the volatility in value of each instrument caused by possible upgrades, downgrades, and defaults. l Taking into account correlations between each of these events, it combines the volatility of the individual instruments to give an aggregate portfolio volatility.

72. Copyright ©1998 Ian H. Giddy Bonds 72 CreditMetrics Roadmap Compute exposure profile of each asset Compute the volatility of value caused by upgrades/downgrades and defaults Compute correlations Portfolio value-at-risk due to credit ExposuresValue-at-risk due to creditCorrelations

73. Copyright ©1998 Ian H. Giddy Bonds 73 Volatilities from “Transition Matrix”

74. Copyright ©1998 Ian H. Giddy Bonds 74 Construction of Volatility Across Credit Horizons

75. Copyright ©1998 Ian H. Giddy Bonds 75 Defaults and Recovery Rates

76. Copyright ©1998 Ian H. Giddy Bonds 76 A Picture of a BBB Bond’s Value Distribution

77. Copyright ©1998 Ian H. Giddy Bonds 77 Calculating Mean and Standard Deviation

78. Copyright ©1998 Ian H. Giddy Bonds 78 CreditMetrics www.jpmorgan.com

79. Copyright ©1998 Ian H. Giddy Bonds 79 The Bond Markets l Treasuries l Corporates l International Bonds l Market Risk l Credit risk

80. Copyright ©1998 Ian H. Giddy Bonds 80

81. Copyright ©1998 Ian H. Giddy Bonds 81 www.giddy.org

82. Copyright ©1998 Ian H. Giddy Bonds 82

83. Copyright ©1998 Ian H. Giddy Bonds 83 www.giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://www.giddy.org