Document Sample

Chapter 1: Introduction Text: Bond Markets, Analysis and Strategies, by Frank J. Fabbozi, Fifth Edition, Prentice Hall, 2004. “A bond is a debt instrument requiring the issuer (also called the debtor or borrower) to repay to the lender/investor the amount borrowed plus interest over a specified period of time. A typical (“plain vanilla”) bond issued in the United States specifies (1) a fixed date when the amount borrowed (the principal) is due, and (2) the contractual amount of interest, which typically is paid every six months. The date on which the principal is required to be repaid is called the maturity date. Assuming that the issuer does not default or redeem the issue prior to the maturity date, an investor holding this bond until the maturity date is assured of a known cash flow pattern.” Sectors of the bond market are identified by the bond issuer, U.S. Treasury (largest single issuer), Agency, Corporates, Municipals, Mortgage Backed, Asset Backed securities. How are the mortgage backed and asset backed sectors fundamentally different than the other bond market sectors listed above? Bond Features: The bond market can be subdivided according to features of the bonds that trade in that sector of the market. Short term – maturity 1-5 years, medium term 5-12 years, long term maturity greater than 12 years. fixed coupon, zero coupon, floating rate, inverse floater Synonyms: principal = face value = par value = maturity value = redemption value Synonyms: coupon rate = nominal rate Importance: Multiplying the principal times the coupon rate determines the annual income paid by the bond issuer to the bondholder. The bond indenture is the contract specifying all contractual terms of the relationship between the bond issuer and the bond owner. The bond trustee is typically a commercial bank identified to monitor the bond issuer’s performance per the terms of the indenture. Security Status – Some bond are secured by claims on specific assets of the issuer, so that in the event of default (failure to make payment as scheduled) the bondholders have a claim on specified assets or the proceeds from liquidation of the assets. Bonds of this type are often referred to as mortgage bonds, collateralized bonds or collateralized trust bonds. 1 Bonds which represent a general (unsecured) obligation of the issuer are often times referred to as debentures. Claims represented by more junior bonds (subordinated debentures) rank behind the claims of secured bondholders, general obligation bondholders, and other unsecured creditors. Call Provision (Option) – Issuer’s option to payoff bond before scheduled maturity date as specified in call provision terms. Callable for purpose of refinancing, Callable for general business purposes (financial reorganizations, sinking fund purposes, etc.) Sinking Fund - Retirement of a portion of a bond issue at regularly scheduled intervals. Conversion Option – Some bonds are convertible to equity or other assets at the option of the bond holder. Put Option – Some bonds can be sold back to the issuer on dates prior to the maturity date. Options: Call provision, Put provision, Convertible bond: for these common embedded options which party to the bond contract has the right, which party grants the right, does the option make the bond contract more or less valuable? Risks (investor viewpoint): 1. interest-rate (market risk) 2. reinvestment risk 3. call risk 4. default risk 5. inflation risk 6. exchange-rate risk 7. liquidity risk 8. volatility risk 9. risk risk 10. yield curve risk 11. event risk 12. tax risk 1. A bond’s price and its yield to maturity are inversely related. 2. A component of the total return from owning a bond is the interest earned from reinvesting coupon payments over the remaining time till maturity. 3. Low rates may induce a bond issuer to call the bond if the indenture contains a call provision. 2 4. Cash flow difficulties may force the issuer to delay or omit regularly scheduled coupon payments. 5. The real purchasing power of dollars received at future dates is inversely related to the inflation rate. 6. The purchasing power of payments denominated in foreign currency is inversely related to the value of the domestic currency. 7. Every transaction has at least two participants. 8. The price of an option (calls and puts) is directly related to the volatility of the price of the asset on which the option is written. 9. Occurs when there is no frame of reference within which to assess the degree of uncertainty concerning the possible outcomes. 10. The shape of the term structure changes with economic conditions. The change in a bond’s value due to term structure fluctuations is greatly affected by the time pattern of the bond’s promised cash flows. 11. The interest earned on municipal securities is exempt from federal income tax, or so you thought? Recent bond issuance patterns: (Assignment #1 due 8 http://www.bondmarkets.com/assets/files/ResearchQuarterly0804.pdf Chapter 2: Pricing Bonds When interest is paid more than one time per year, both the interest rate and the number of periods used to compute the future value must be adjusted as follows: r = (annual interest rate) / ( number of times interest is paid per year) n = (number of times interest is paid per year) x (number of years) What will be the total future dollars realized by the maturity date for $25,000,000 face value of a 7.25% coupon, semi-annual pay bond with 22 years till maturity, if the assumed reinvestment rate of 5.5%? Semi annual coupon payment = 0.5* .0725*$25,000,000 = $906,250 Future value of semi-annual coupon payments @ 5.5% = (1 .0275 ) 44 1 $906 ,250 $75,767 ,063 .0275 Face value = $25,000,000 Total future dollars = $75,767,063 + $25,000,000 = $100,767,063 What will be the total future dollars if the reinvestment rate is 5.25%? 3 How important is the reinvestment rate in determining the total future dollars from a bond investment? The value of a financial asset is the present value of the expected cash flows discounted at the required rate of return appropriate for the risk(s) associated with the expected cash flows. Bond pricing relationship: 1 (1 r ) n P C M (1 r ) n r P = Value (Price) of coupon bond C = Coupon payment in dollars r = required yield adjusted for frequency of coupon payments n = number of remaining coupon payments M = face value Bond value is an inverse function of the required return. The relationship between bond value and required yield is convex. Bonds with different characteristics i.e. maturity, coupon rate, etc., have different degrees of convexity. Convexity is a desirable property. Bond price and time to maturity: Use the calculator you will use on exams to find the value of $1,000 face value of a 7.75% coupon, semi-annual pay bond with 5 years till maturity as the time to maturity decreases to zero. Assume the required return remains constant at 5.5%. Use ½ year increments, i.e. reduce the number of future payments by one for each successive calculation. Use the calculator you will use on exams to find the value of $1,000 face value of a 3.75% coupon, semi-annual pay bond with 5 years till maturity as the time to maturity decreases to zero. Assume the required return remains constant at 5.5%. Use ½ year increments, i.e. reduce the number of future payments by one for each successive calculation. Compare bond values 5 years prior to maturity. Which bond has the greatest value? Why? Compare bond values on the maturity date. Which bond has the greatest value? Why? Notice how the values of both bonds converge to their face value; the first bond from above, the second from below. 4 Change the required yield from 5.5% to 7.75%. Comparing bond values 5 years prior to maturity, what happens to the value of both bonds? Change the required yield from 7.75% to 3.0%. Comparing bond values 5 years prior to maturity, what happens to the value of both bonds? Accrued Interest – In the United States the buyer of a coupon bond owes the seller accrued interest through the settlement date of the transaction. Each marketplace i.e. Treasury, corporate, municipal, has a specific set of conventions that are used to calculate accrued interest. clean price + accrued interest invoice price In an efficient market, the present value of the remaining bond payments is equivalent to the invoice price. 5

DOCUMENT INFO

Shared By:

Categories:

Tags:

Stats:

views: | 0 |

posted: | 5/18/2012 |

language: | |

pages: | 5 |

How are you planning on using Docstoc?
BUSINESS
PERSONAL

By registering with docstoc.com you agree to our
privacy policy and
terms of service, and to receive content and offer notifications.

Docstoc is the premier online destination to start and grow small businesses. It hosts the best quality and widest selection of professional documents (over 20 million) and resources including expert videos, articles and productivity tools to make every small business better.

Search or Browse for any specific document or resource you need for your business. Or explore our curated resources for Starting a Business, Growing a Business or for Professional Development.

Feel free to Contact Us with any questions you might have.