RISKS ASSOCIATED WITH INVESTING IN BONDS

RISKS ASSOCIATED WITH INVESTING IN BONDS - Under sovereign risk: the quality of debt obligation depends on both the borrower’s ability AND willingness to repay. - Interest rate risk = interest rate sensitivity = duration - yield is the required rate of return on a bond  as yields increase bond prices fall  inverse relationship - longer maturity = greater duration - lower coupon = greater duration If market yields decrease, interest risk will increase since the duration or the sensitivity of the bond to interest rate fluctuation will increase. The price sensitivity is lower when the level of interest rates is higher. Bond issue 2 has the highest market yield and therefore is least susceptible to larger price swings as interest rates change. Put another way, Bond issue 2 has the lowest duration and is therefore the least sensitive to changes in interest rates. Zero-coupon bonds have the highest interest rate risk because they deliver all their cash flows at maturity. Another way to think about this: A zero-coupon bond has the lowest coupon (0.00%), so it has the highest price volatility, since the coupon rate is inversely related to price volatility. A lower-coupon bond is more sensitive to interest rate movements than a higher-coupon bond (all else equal). Bond price sensitivity is lowest when yields are high. Callable Bond - Will be less-senstive than a similar option-free bond to interest rate changes This is because the bond price will not rise above it’s call price. - Limits the upside price movement Putable Bond - Will be less-senstive than a similar option-free bond to interest rate changes This is because the bond price will not fall below its price. - Limits the downside price movement Maturity Up Coupon UP Call Put Interest risk UP Interest risk DOWN Interest risk DOWN Interest risk DOWN Duration UP Duration DOWN Duration DOWN Duration DOWN Only maturity increased interest rate risk and duration all other factors reduce both interest rate risk and duration (See yield curve risk below. Note that Yield curve risk looks at yields and maturity). Callable Bond - Price (Value) of Callable Bond = Option-free bond minus the call option value - The value of a call option is higher at lower yields (higher prices). - With higher prices, the likelihood that the call will be excercised increases as price approaches the call price which is set above par value. - As interest rates decrease, the issuer values the call option more because the company has the potential to call the bond and replace existing debt with lower-coupon (and thus lower cost) debt. Also, it is more likely that the bond will be called 63. e. Floating Rate Security - Purpose of the floating rate is to allow the bond to sell at or near it’s par value with no adjustment to price - The purpose is to reduce interest rate risk - The longer the “reset period” the higher the interest rate risk - The price of the bond should return to par on the reset date – the closer to the reset date, the lower the interest rate risk. - Exception: if there is a “cap” then as the reference rate is above the cap rate then the bond will trade at a discount. This is known as “cap risk” - Because of the fixed margin (reference rate + ) an increase in the creditworthiness will cause for the bond to trade at a premium. 63. f. Duration and Dollar Duration - Duration = % Change in Bond Price / % Change in yield - Duration of a bond is equal to approx. time to maturity - The duration of a floating rate bond is equal to the time until the next coupon payment takes place - A bond's percentage change in price and dollar change in price are both tied to the underlying price volatility - For coupon paying bonds, duration is less than maturity - Duration is inversely related to yield to maturity (YTM). The higher the YTM, the lower the duration. This is because the change in the bond's price (or present value) is inversely related to changes in interest rates. When market yields rise, the value (or cash flow) of a bond decreases without decreasing the time to maturity. - For a zero-coupon bond duration is approximately equal to the number of years to maturity. Dollar Duration = 63. g. Yield Curve Risk for a Portfolio of Bonds - Yield cuve: Yield vs. maturity - Duration of portfolio of bonds is the market-weighted average of the individual bond’s durations. - When yields on bonds in the portfolio change by different amounts resulting in a change in the shape of the yield curve (non-parallel shifts in the yield curve). This is known as yield curve risk. - The yield curve plots term to maturity and yield to maturity. - viewing each bond coupon payment as a separate zero coupon bond. - viewing a bond's cash flows as having maturities ranging from the next coupon payment to the final payment at maturity - assuming that individual discount rates do not change by the same amount. - nonparallel shift is more common than a parallel shift. 63. h. Disadvantages of a callable or prepayable security to an investor - uncertainty of timing of cashflows - reinvestment risk – bonds are called or prepaid when rates are low – investor must reinvest principal at lower rates - Limited price appreciation as market yields fall (when market yields fall, coupon rate is higher than market yield so the price rises). 63. i. Factors that affect reinvestment risk - a lower coupon increases duration (interest rate risk) and decreases reinvestment risk (** a market yield would increase reinvestment risk. Don’t confuse “coupon” and yield definitions here) More investment risk when: - Higher coupon (because lower yields the issuer may call the debt forcing investor to reinvest at lower rates) - Call feature - Prepayment option - Amortizing security - Zero coupon bonds have no reinvestment risk over their term. - All else equal, reinvestment risk and price risk move in opposite directions. For example, when interest rates rise, bond prices decrease, but the loss is at least partially offset by decreased reinvestment risk (it is less likely that a bond will be called and bondholders can invest coupon payments at higher yields). 63. j. Credit Risk - Bond rating: probability of default - AA is greater than A - Lower rated bonds have more default risk - Lower rated bonds offer higher yields - Credit spread - Credit spread risk - Downgrade risk - Different bonds can have different ratings - AAA – BBB  investment grade - BB and below  speculative junk bonds - CCC  highly speculate - When a rating agency downgrades a security, the bond's price usually falls. - The credit risk spread is measured in relation to a default-free security. The security with the least chance of default is the Treasury bond. - YieldRisky = YieldRF + Risk Premium, where RF = default -free rate. Suppose that a corporate bond and a government bond have equivalent characteristics. They both have a coupon rate of 6% paid annually and have two years remaining to maturity. Assuming a flat government term structure of 7% which of the following is a possible price of the corporate bond? - Government Bond Price = 6 / 1.07 + 106 / 1.07 = 98.19 - Since it is a Treasury bond, downgrade and default risk are not relevant. Interest rate risk is not important because the investor plans to hold the bond until maturity. Reinvestment risk is the most important. The investor will have to worry about the rates at which he/she will be able to reinvest the coupons over the life of the bond and the principal upon maturity. 2 63. k. Liquidity risk - higher yield for less-liquid securities - bid-ask spread – indication of liquidity - wider spread = less liquidity - Even if the security is held to maturity prices can fall due to lack of liquidity - Marking to market – periodic valuation to assess current value - Institutional investors may need to do this to value their portfolios - Also necessary for repurchase agreements 63. l. Exchange rate risk - If the foreign currency depreciates, bond investors lose, all else equal. This occurs because the bond’s coupon payments and principal will convert to fewer U.S. dollars. 63. j. Inflation risk - purchasing power risk - A 15-year bond with a coupon formula equal to the U.S. prime rate plus 3.25% is an example of a floating rate bond. The holder of an adjustable rate asset is impacted less by inflation than the holder of a fixed-rate asset because the increased cash flow (from the higher coupon payments when the base rate increases) at least partially offsets the decreased purchasing power caused by inflation. - The inflation premium is less in the short term because investors are better able to predict inflation in the short term – inflation risk increases as time increases. (Investors want to be compensated for this uncertainty.) - An investor’s real return is not fixed- even though an investor may hold a fixed-rate coupon bond, the real return depends on a variable – inflation. Higher inflation rates result in a reduction of the purchasing power of bond payments. - Inflation risk is of more concern to the long-term investor because it is more difficult to predict inflation long-term and there is more chance for purchasing power erosion. - Empirical evidence shows that equity securities, or stocks, have the least inflation risk of the investments 63. k. Yield volatility - an increase in yield volatility increases the value of the call option and decreases the market value of the callable bond. Value of a callable bond = value of option-free bond – value fo the call Value of a putable bond = value of option-free bond + value of the put - Volatility risk for callable bond = the risk that volatility will increase (from perspective of investor – don’t want prices up) - Volatility risk for a putable bond = the risk that volatility will decrease (if rates increase, prices fall, and can’t put). - callable bond’s value is its straight bond value minus the value of the embedded call option. Since the bondholder is effectively short a call option, the value of the option is subtracted from the bond price. This is why the value of callable bonds decreases when yield volatility rises. - To calculate the value of a putable bond, it is correct to add the option value to the value of a similar straight bond. However, to calculate the callable bond value, subtract the option value from that of a similar straight bond. As a result, when yield volatility increases (thus increasing the option value), the value of a callable bond decreases and the value of a putable bond increases. A call option does benefit the issuer, but a put option benefits the holder. - As yield volatility decreases, the value of the embedded option decreases. The formula above shows that for a putable bond, a decrease in the option value results in a decreased bond value. *** the reason why call option is deducted from the value of the bond with call is that it is for the benefit of the issuer and bad for the investor. As interest rate volatility would increase the chance that the price of the bond will increase above the call price, thereby having it called by the issuer for a profit. 63. o. Event Risk - Disasters - Corporate restructurings - Regulatory issues - As interest rates become more volatile, accurate pricing of bonds becomes more difficult, and thus some bonds are likely to be priced incorrectly. This pricing discrepancy will allow for short-term profit opportunities by buying a bond that is priced too low and selling it at the market rate. OVERVIEW OF BOND SECTORS AND INSTRUMENTS A. Features, characteristics, and government securities sovereign bonds – issued by central government In U.S.,  treasury securities Essentially free of default risk Can be issued in either home or foreign country Local issuance gets higher credit rating Methods of governments to issue sovereign debt: 1. 2. 3. 4. Regular cycle auction –single price - where highest price is awarded – as used by U.S. Treasury Regular cycle auction – multiple price – based on bids Ad hoc –arbitrary Tap system –same as a previous cycle – not a regular cycle. All T-bills are auctioned using the single-price method  refers to #1 B. Types of securities issued by Treasury - Treasury securities issued by the U.S. Treasury - Still subject to interest risk - bills, notes and bonds, and inflation-protected securities T-bills - maturities less than one year - no interest payments - sold at discount (like zero-coupon bonds) - implicit interest - aka pure discount bonds - 3 maturity cycles: 4 week, 3 month, 6 month - periodically issue “cash management” bills to help overcome temporary cash shortages prior to collection of tax. T-Notes and Bonds - semiannual coupon interest (A 20-year Treasury bond can be used as the basis for 40 coupon strips and 1 principal strip.) - Notes: maturities of 2,3,5,10 years - Bonds: maturities of 20 or 30 years - Treasury has not issued callable bonds since 1984. - T-bonds: 102-5 = (102 + 5/32)% X 100,000 (denomination is $100,000) this is for bonds Return = (Pend − Pbeg + Interest) / Pbeg TIPS (Treasury Inflation Protected Securities) - 5, 10-year notes, and 20-year bonds - semi annual payments - par value is adjusted semi-annually for inflation based on the CPI - Interest is not taxed but gain on par is taxed. TIPS coupon payment = adjusted par X (stated coupon /2) -- as par increases so does coupon. Semi annual /2 - The coupon rate is set at a fixed rate determined via auction. This is called the real rate. The principal that serves as the basis of the coupon payment and the maturity value is adjusted semiannually. Because of the possibility of deflation, the adjusted principal value may be less than par (however, at maturity the Treasury redeems the bonds at the greater of the inflation-adjusted principal and the initial par value). The coupon payments are not tax-free. On the run issues – most actively traded (liquid) Off the run issues Well of the run issues c. Treasury Strips - notes and bonds are separated into coupon and principal into coupon and zero-coupon bonds. - taxed on their implicit interest - U.S. Treasury Notes are issued quarterly. All of the other statements are true. It is possible that taxable investors will have negative cash flows from holding zero-coupon securities, since there is no cash income, but taxes must be paid at least annually on the implicit interest. d. Federal Agencies - Agency bonds – U.S. government agencies and not the government directly - Federally related institutions – owned by government - Government sponsored enterprises – privately owned - Debentures – not backed by collateral Mortgage-back Securities (prepayment risk) - secured by pool of mortgages (collateral) - collateral and cashflows - Mortagage loans are amortizing different from coupon bonds - Federal agencies issue MBS’ - Mortgage passthrough securities - Collateralized mortgage obligations - Stripped mortgage-backed securities - Purpose is to increase attractiveness to investors Types of cashflows: 1) periodic interest 2) principal 3) prepayment - With prepayment there is prepayment risk - Mortgage holder is subject to prepayment risk - Curtailment is when the prepayment is not for the entire amount. Mortgage passthrough security - payments (cashflows) from mortgages are passed through to security holders pro rata - there is some prepayment risk when interest rates fall - some diversification benefits due to 100,000s of mortgages in the pool Collateralized mortgage obligations (CMOs) - derivative securities deriving value from MBS’. - tranches (3) E.g. Simple sequential CMO structure: Tranche 1: short term segment of the issue – received interest and principal Tranche 2: intermediate – receive interest and starts receiving principal after Tranche 1 has been completely paid off. Tranche 3: long term – receives montly interest and receives principal repayments after 1 and 3 have been paid. Prior to that it only receives interst payments f. CMOs explained - redistributes prepayment risk - and creates different maturities - more options for investors ***Tranche III has the least amount of prepayment risk since it receives the prepayments last. Tranche III has the least amount of prepayment risk; therefore, there is a greater chance that the investor will be able to hold on to the investment for a longer time horizon. Municipal Bonds (tax-back and revenue bonds) - often called tax-exempt or tax-free - some are taxable: within one’s state – tax free - taxable: federal standars must be met. Most munis are tax free Tax-backed and Revenue Bonds Tax-backed (aka General Obligation Bonds “GOs”) - Limited tax GO Debt - Unlimited tax GO debt – most common - Double barreled bonds – additional resources of gov’t - Appropriation-backed bonds – state will appropriate funds if necessary - The vast majority of municipal bonds sell at lower yields because their bond interest is exempt from federal income tax. - After-tax yields are highest for individuals in the highest tax bracket who benefit the most from the municipal bond’s taxexempt status. Before tax yields on municipal bonds are lower due to their tax shield. - Coupon or interest income is exempt from federal income taxes. Capital gains taxes associated with municipal bonds are not exempt from federal taxes. - A moral obligation bond has no legally binding requirement to be repaid. Revenue Bonds - revenues from projects - issuer only pays a portion out of revenues of a certain project unlike GOs - more risk and higher yields Insured and prefunded bonds rd - 3 party guarantee - prerefunded bonds – treasury securities have been purchased and placed in escrow h. Rating agencies and credit ratings - firm-specific factors: - past repayment history - Quality of management - Industry outlook and firm strategy - Overall debt level - Operating cashflow and ability to service debt - Other sources of liquidity - Competitive position, regulatory environment, union contracts - Financial management and controls - Susceptibility of event and political risk Particular to debt issue: - Priority of claims - Value of collateral pledged - covenants - Guarantees of parent Secured debt - personal property - financial assets - real property - Lien held by bondholder - unsecured debt – debentures - subordinated debentures Credit enhancements - third party guarantees - letters of credit - bond insurance Corporate Bonds - Corporate bonds usually have a face value of $1,000 and mature between 5 and 10 years. Medium Term Notes (MTNs) - differ from corporate bond issues (sold at once, firms commitment, single coupon) - self registration – doesn’t have to be sold at once - various maturities 9 months to 100 years - best-efforts basis - fixed or floating coupons - denominated in any currency - calls, caps, non-interest indexed, structured securities Structured Notes - bond with a derivative - to cater to investor - lower borrowing rate - structure in order to allow investor to get around restrictions Commercial paper, directly placed and dealer placed Commercial paper - short term, unsecured used by corps at lower than bank rate - less than 270 days - SEC registration not required - usually sold at discount with no coupon payments - No secondary market – no trading of CP - used by companies with strong credit ratings - finance credit to a company’s customers or to finance inventories - usually issued by finance company subsidiary of a corporation - dealer placed - directly placed Certificates of Deposit and Banker’s Acceptances - like bank deposits but issued in specific denominations - insured by the Federal Deposit Insurance Corporation for up to $100K - penalty if withdrawn early - Negotiable CDs permit the owner to sell the CD in the secondary market at any time - Domestic CDs and Eurodollar CDs Banker’s Acceptances - bank guarantees payment - usually done in international trade - payment is discounted due to time gap - some credit risk Asset Backed Securities - any type of assets including mortgages, david bowie, credit card debt, etc. - - The asset-backed pool may be overcollateralized to provide a credit enhancement SPV - transfer assets to entity - shields the assets from claims fo the corporations’ general creditors - spv gets higher credit rating from clean company - bankruptcy remote entity - reduces borrowing costs - higher credit rating External credit enhancements - According to the “weak link” philosophy adopted by rating agencies, the credit quality of an issue can not be higher than the credit rating of the third-party guarantor. Along these lines, if the guarantor is downgraded, the issue itself could be subject to downgrade even if the structure is performing as expected. j. Collateralized debt obligations - other debt obligations is the underlying collateral - A CDO (collaterized debt obligation) issued to profit on the spread between the return on the underlying assets and the return paid to investors is referred to as an arbitrage CDO. - A balance sheet CDO is created by a bank or insurance company wishing to reduce their loan exposure on the balance sheet. k. Primary and Secondary Markets - When bonds are sold in a bought deal, the transaction takes place on the primary markets - bought deal (deal) ; firm commitment (arrangement) - When bonds are sold in a Rule 144A offering, they are sold privately to a small number of investors or institutions. This offering does not require registration with the SEC and this is valuable to the issuer. The investor will require a slightly higher yield because the bonds cannot be resold to the public unless they are registered with the SEC. The other sales transactions in the responses represent secondary market offerings. 65. UNDERSTANDING YIELD SPREADS See Schweser Key Concepts summary notes + markups. - The U.S. Federal Reserve can encourage or persuade banks as a whole to tighten or loosen their credit policies, but it cannot compel them to do so. - The two most important tools available to the Fed are changing the discount rate, the rate at which banks can borrow from the Fed’s discount window, and open market operations, the Fed’s activity of buying and selling Treasury securities. - Since the yield curve depicts the yield on securities with different maturities, the slope of the curve between two maturities is a function of the maturity spread. - The pure expectations theory purports that forward rates are solely a function of expected future spot rates. - spot rates have to do with expectations about future rates - The market segmentation theory, pure expectations theory, preferred habitat theory, and liquidity preference theory are all consistent with any shape of the yield curve. - The expectations hypothesis holds that the shape of the yield curve reflects investor expectations about the future behavior of inflation and market interest rates. Thus, if investors believe inflation will be slowing down in the future, they will require lower long-term rates today and, therefore, the yield curve will be downward-sloping. - Bond prices fall with a rise in interest rates. If realized rates rise more than the associated forward rate implied, then a bearish bond position will be the most beneficial. (because the bond holder receives the fixed interest rate as prices of his bonds fall). - If given spot rates for years 1,2,3 and current coupon: First determine the current price of the corporate bond: 2 3 = 6 / 1.05 + 6 / (1.06) + 106 / (1.07) = 5.71 + 5.34 + 86.53 = 97.58 Then compute the yield of the bond: N = 3; PMT = 6; FV = 100; PV = -97.58; CPT → I/Y = 6.92% - During periods of economic expansion corporate yield spreads generally narrow, reflecting corporate bonds decreased credit risk. If yield spreads narrow, the price of corporate bonds increases relative to the price of treasuries. If given a two-bond portfolio – after tax yield calculation on munis: To calculate the portfolio yield, take the average after-tax yields of both bonds