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Business School

ACTL4303 AND ACTL5303


ASSET LIABILITY MANAGEMENT

Week 6
Fixed Income Securities
Greg Vaughan

Review of Equity Pricing and Revision

b is earnings retention (1 payout ratio)


E is next years earnings
k is the equity discount rate eg Rf + B(Rm-Rf)
ROE is return on newly invested equity
Given b, E and ROE you can determine P if you have k, or determine k if
you have P (market implied returns, consistent with assumptions)
2

Review of Equity Pricing (2)

If the price accurately reflects stock characteristics (eg ROE) then


investment return equals discount rate
High PE and high growth do not mean high return

Disequilibrium Example
E(r)
SML
15%
Rm=11%

rf=3%
1.0 1.25
4

The security characteristic line

RHP (t ) = HP + HP RS &P500 (t ) + eHP (t )


5

Portfolio Construction and the Single-Index Model

Managers are assessed on their information ratios: (e )


These relate to their active portfolios. A stocks weight in the active
portfolio is the difference between its portfolio weight and its weight in
the index
A

A
i

= wi wi

Key result: If not for the long only constraint (


index model implies

A
i

P
i

>0

) the single-

(e )
i

..we are concerned only with the aggregate beta of the active
portfolio, rather than the beta of each individual security.
Normally this is zero by design, so that portfolio beta is one.
Active weights are scaled based on target tracking error
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Arithmetic and geometric returns


E(Geometric Average) = E(Arithmetic average)

1 2
2

IF we were observing a stationary return distribution:


The sample arithmetic average (eg over 55 years) is an unbiased
estimate of the true mean
However compounding at this rate results in an upwardly biased
forecast for a given horizon (eg over ten years)
The unbiased estimator for a projection of H years, based on a data
sample of T years is
(H/T) x Geometric + (1-H/T) x Arithmetic
For a short projection horizon, the Arithmetic mean is appropriate, but
where the horizon is longer, or the data span is shorter, the geometric
mean becomes increasingly relevant

Australian Equity Log Returns 1980-2012

Frequency

Skewness

Excess
Kurtosis

Probability
of Normality

Monthly

-3.1

30.3

0%

Quarterly

-1.8

8.8

0%

Annual

-0.5

0.8

56%

Random Walk and the EMH


Volatility of log returns can be calculated at different
data frequencies (eg annual, quarterly, monthly)
If there is true independence from one period to the
next the results should be consistent (ie variance ratios
of 1)
There is some mild statistical contradiction of the
random walk in Australia (1980-2012)

Dividend Imputation (2)


A company makes a profit of $100, and pays
company tax at 30% leaving $70 for distribution as
dividend
A $30 imputation credit is attached to the $70
dividend in respect of the company tax paid
The superannuation fund pays 15% tax on the
aggregate of the dividend ($70) and the franking
credit ($30). Tax = 15%x($70 + $30) =$15
The superannuation fund receives a credit from the
tax office of $30 against that tax liability, with the net
effect that the superannuation fund receives $15
The dividend is worth $85 to the superannuation fund
10

This weeks coverage


Bodie et al
Chapter 14
Chapter 15
Chapter 16

11

Bond Prices and Yields


The Term Structure of Interest Rates
Managing Bond Portfolios

Interest Rate Uncertainty and


Forward Rates
Investors require a risk premium to hold a
longer-term bond
This liquidity premium compensates short-
term investors for the uncertainty about
future prices

12

INVESTMENTS | BODIE, KANE, MARCUS

Theories of Term Structure


The Expecta=ons Hypothesis Theory
Observed long-term rate is a func=on of todays
short-term rate and expected future short-term
rates
fn = E(rn) and liquidity premiums are zero

13

INVESTMENTS | BODIE, KANE, MARCUS

Theories of Term Structure


Liquidity Preference Theory
Long-term bonds are more risky; therefore, fn
generally exceeds E(rn)
The excess of fn over E(rn) is the liquidity premium
The yield curve has an upward bias built into the
long-term rates because of the liquidity premium

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INVESTMENTS | BODIE, KANE, MARCUS

Interpreting the Term Structure


The yield curve reects expecta=ons of future
interest rates
The forecasts of future rates are clouded by
other factors, such as liquidity premiums
An upward sloping curve could indicate:
Rates are expected to rise
and/or
Investors require large liquidity premiums to hold
long term bonds
15

INVESTMENTS | BODIE, KANE, MARCUS

Bond Pricing:
Two Types of Yield Curves

16

Pure Yield Curve

On-the-Run Yield Curve

Uses stripped or zero


coupon Treasuries
May dier signicantly
from the on-the-run
yield curve

Uses recently-issued
coupon bonds selling at
or near par
The one typically
published by the
nancial press

INVESTMENTS | BODIE, KANE, MARCUS

Bond Yields: YTM vs. Current Yield


Yield to Maturity

Bonds internal rate of return


The interest rate that makes the PV of a bonds
payments equal to its price; assumes that all bond
coupons can be reinvested at the YTM

Current Yield

Bonds annual coupon payment divided by the bond


price

For premium bonds

Coupon rate > Current yield > YTM

For discount bonds, rela=onships are reversed


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INVESTMENTS | BODIE, KANE, MARCUS

Bond Yields: Yield to Call


If interest rates fall, price of straight bond can
rise considerably
The price of the callable bond is at over a
range of low interest rates because the risk of
repurchase or call is high
When interest rates are high, the risk of call is
negligible and the values of the straight and
the callable bond converge
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INVESTMENTS | BODIE, KANE, MARCUS

Figure 14.4 Bond Prices: Callable and


Straight Debt

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INVESTMENTS | BODIE, KANE, MARCUS

Bond Yields:
Realized Yield versus YTM
Reinvestment Assump=ons
Holding Period Return
Changes in rates aect returns
Reinvestment of coupon payments
Change in price of the bond

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INVESTMENTS | BODIE, KANE, MARCUS

Bond Prices Over Time:


YTM vs. HPR

21

YTM

HPR

It is the average return


if the bond is held to
maturity
Depends on coupon
rate, maturity, and par
value
All of these are readily
observable

It is the rate of return


over a par=cular
investment period
Depends on the bonds
price at the end of the
holding period, an
unknown future value
Can only be forecasted
INVESTMENTS | BODIE, KANE, MARCUS

Yield components
Real risk-free interest rate +
Expected inflation rate +
Maturity Premium
=Sovereign Bond Yield
Liquidity Premium +
Credit spread
= Corporate Bond Spread
Corporate Bond Yield = Sovereign Yield + Corporate Spread
Corporate Bond Spreads increase with maturity.

22

Yields spreads and economic sensitivity


Post-GFC era

Credit spreads have narrowed


with reach for yield
Relaxed investors because
default rates have been low

Conventional soft economy

Credit spreads deteriorate

Investors require wider risk


premium because of rising default
risk

Issuance drives spreads wider


when investors are reluctant
holders

Secondary market liquidity


deteriorates so liquidity premiums
expand

Significant issuance has had little


effect on spreads
Secondary market has been
reasonable healthy

23

Australian bond pricing

P = the price per $100 face value (rounded to 3 decimal places)


v = 1/(1+i) where i is half yearly yield = y/200 where y is %pa
f = number of days from settlement to next interest payment date
d = number of days in the half year ending on the next interest
payment data (181-184)
g = the half-yearly rate of coupon payment per 100
n = the term in half years from the next interest-payment date to
maturity
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Bond pricing and accrued interest


Accrued interest = gx(1-f/d)
Bond prices may be quoted including accrued interest
(Australian practice ) or net of accrued interest (clean US
practice)
The Australian formula naturally calculates the price including
accrued interest
US based software (excel, financial calculators) are based
around the clean price convention

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Table 14.1 Principal and Interest Payments


for a Treasury Ination Protected Security

There are only $5b Australian Government Indexed


Bonds on issue compared to $350b conventional
Australian Government Bonds
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INVESTMENTS | BODIE, KANE, MARCUS

Bank bills

27

Bond pricing and yield sensitivity

Bond pricing is based on yields convertible half yearly

If we measure time in years then the pricing formula is effectively:


2t

# y&
P = Ct %1+ (
$ 2'
2t1

$ y'
dP
= Ct (2t ) &1+ )
% 2(
dy
! dP $
# &
! 1 $
" dy %
= #
& t wt
P
" 1+ y / 2 %

28

2t
$1' $ 1 '
$ y'
& ) = &
) Ct t &1+ )
% 2 ( % 1+ y / 2 (
% 2(

where

2t

" y%
wt = Ct $1+ '
# 2&

/P

Bond pricing and yield sensitivity

The duration is the weighted average term of cash flows with weights
determined as the proportion of valuation at that point in time

This is commonly referred to as Macaulay duration (1938)

MacaulayDuration = t wt

2t

where

" y%
wt = Ct $1+ '
# 2&

Modified Duration is the first derivative relative to price :

" dP %
$ '
1
# dy &
ModifiedDuration =
=
MacaulayDuration
P
(1+ y / 2)

29

/P

Bond pricing and yield sensitivity

Because this is a first derivative we can estimate modified duration by


pricing the bond at yields either side of the current yield and estimating by
difference
P P
ModifiedDuration

2 P y

Consider a ten year 4% coupon bond with the market yield at 3%.

P at 3% = 108.584, P at 3.2%=106.800, P at 2.8% = 110.403

Modified Duration = (110.403 106.800)/(2x108.584x0.002) = 8.30 years

Because of the relation to Macaulay duration it is quoted in years rather than


as a percentage (which would be more logical)

For every 1% change in yields, price changes inversely by 8.30%

The corresponding Macaulay duration is 8.42 years

30

Interest Rate Risk


What Determines Dura=on?
Rule 1
The dura=on of a zero-coupon bond equals its =me
to maturity

Rule 2
Holding maturity constant, a bonds dura=on is
higher when the coupon rate is lower

Rule 3
Holding the coupon rate constant, a bonds dura=on
generally increases with its =me to maturity
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Interest Rate Risk


What Determines Dura=on?
Rule 4
Holding other factors constant, the dura=on of a
coupon bond is higher when the bonds yield to
maturity is lower

Rules 5



32

The dura=on of a level perpetuity is equal to:


(1 + y) / y

INVESTMENTS | BODIE, KANE, MARCUS

Bond pricing and yield sensitivity

The relationship between price and yield is non-linear

Recall Taylors theorem

h2
f (x + h) = f (x) + h f "(x) +
f ""(x) +....
2!

Estimating change in price is improved by taking account of the second


derivative, referred to as Convexity

Convexity is related to the spread of cash flows around the duration

P+ + P 2 P
Convexity
2 P (y)2

Convexity = (106.800+110.403-2x108.584)/(2 x 108.584 x 0.002^2) = 40.3


using previous example

33

Bond pricing and yield sensitivity


P
2
ModDur y + 1 Convexity ( y )
2
P

( )

If we wanted to estimate the change in price for an increase in yield from 3%


to 3.50%, based on our example

P
= 8.30 0.0050 + 0.5 40.3 0.0050 2 = 4.10%
P

The actual price is 104.188 at 3.5% yield, a change of -4.05%

In practice portfolios can be priced directly without any approximation


formula

However these concepts are relevant in risk management (eg what is the
duration of the fixed interest portfolio)

34

Frank Redington (greatest British actuary ever)


Redingtons 1952 paper on immunization
Set duration of assets equal to duration of liabilities
Have convexity of assets greater than convexity of liabilities
If assets and liabilities have the same duration, the the assetliability hedge can be improved by increasing the convexity of
the assets.
( A L)
2
1
= (DurA DurL ) y +
(ConvA ConvL ) ( y)
2
L

( )

The convexity contribution will always be positive, and the


duration contribution will be zero

Immunization issues
To achieve greater convexity than liabilities, the asset
portfolio will have a wider spread of maturities eg maturity
barbell
This is OK if the yield curve experiences a parallel shift
However if the yield curve steepens for example at the
same time as shifting, the high convexity portfolio will
underperform a matched convexity portfolio
Need to model the risks of asset/liability mismatch more
thoroughly

Default Risk and Bond Pricing


Credit Default Swaps (CDS)
Acts like an insurance policy on the default risk of
a corporate bond or loan
Buyer pays annual premiums
Issuer agrees to buy the bond in a default or pay
the dierence between par and market values to
the CDS buyer

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INVESTMENTS | BODIE, KANE, MARCUS

Default Risk and Bond Pricing


Credit Default Swaps
Ins=tu=onal bondholders, e.g. banks, used CDS to
enhance creditworthiness of their loan por_olios,
to manufacture AAA debt
Can also be used to speculate that bond prices will
fall
This means there can be more CDS outstanding
than there are bonds to insure

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INVESTMENTS | BODIE, KANE, MARCUS

Figure 14.12 Prices of Credit Default Swaps

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INVESTMENTS | BODIE, KANE, MARCUS

Credit Risk (1)


The risk of loss resulting from the borrower (issuer of
debt) failing to make full and timely payments of interest
and/or principal
Expected loss=Default Probability x Loss given default
For investment grade credits the focus is on default
probability, which is very low
For speculative grade credit, loss given default becomes
very important
Recovery rates vary widely by industry
They also depend on the credit cycle

Credit Risk (2)


Corporate yield spreads depend on credit worthiness
and market liquidity
Credit rating can migrate with atendency for speculative
grade credits to become even lower rated

Recovery Rating

Average 3 Year Corporate Transition Rates


(1981-2014)

Source: Standard & Poors 2015

Note for speculative grade the tendency is for ratings to deteriorate


rather than improve

Investment Grade and Speculative Grade


Investment grade is rated BBB- and above
Risk of default is very low for investment grade (circa 2%
over 5 years) so covenants and collateral matter much
less
However for speculative grade (BB+ and below) default
risk is significantly higher and lending tends to be
secured
Secured needs to be interpreted carefully
A significant number of secured loans ultimately realise
losses on default
For speculative grade the investor needs to consider
both risk of default and loss in the event of default

First Lien, Second Lien, subordination


Lien refers to the security of loan
First lien ranks ahead of second lien in regard to specific
collateral
Ideally collateral is enough to satisfy both first and
second lien with some left over for general unsecured
creditors
If collateral is not enough to satisfy claim of first lien, they
both rank equally from there on
Subordinated debt ranks after senior creditors which may
be secured and unsecured (eg general obligation bonds)
Investment grade borrowers typically dont need to offer
security via specific collateral

Ratings Agencies and Credit Ratings


The common credit rating refers to risk of default
A separate rating addresses loss severity
Ratings agencies were guilty of over-rating structured
credit leading up to GFC
Standard corporate credit ratings have been reliable
The market will usually anticipate downgrades so beware
discrepancies between yield and rating
Issuer rating refers usually to senior unsecured debt
Specific issues may be notched (eg subordinate debt will
be rated lower)

Credit Rating (S&P)

Credit Rating (S&P)


US Industrial companies 3 year average

Source: Standard & Poors 2011

Ratings and default by time horizon

Ratings and default by time horizon

Default rates and investment grade (2)

Default rates and investment grade (1)

Default rates are cyclical, especially for speculative grade

Default rates vary significantly by industry

Surges in speculative grade issuance have


tended to lead the default cycle

Recovery Rating Distribution

Loan covenants (1)


Two types incurrence (light) and maintenance(restrictive)
covenants
At the investment grade level (bonds) where default risk is
remote incurrence covenants are common
Incurrence covenants are triggered where the issuer takes
an action (paying a dividend, making an acquisition, issuing
more debt)
For example more debt may not be able to be issued if the
multiple of debt to cash flow falls below a threshold (eg 5
times)

Loan covenants (2)


Maintenance covenants (high yield credit) require the
issuer to have ongoing satisfactory financial health, even if
there is no intention to issue more debt
For example if cash flow declines and debt to cash flow
increases a maintenance covenant might be breached
Maintenance covenants allow lenders to take action earlier
with the onset of financial distress
They may increase the spread or seek additional collateral
Covenants on new issues tend to be stronger during weak
economic conditions

Loan covenants (3)


Maintenance covenants are typically more detailed and may
include:
Coverage minimum level of cash flow or earnings relative
to interest, debt service (interest plus repayments), fixed
charges (debt service plus capex and rent)
Leverage debt to equity or cash flow (eg total debt to
EBITDA)
Current-ratio current assets (cash, securities, receivables,
inventories) to current liabilities (accounts apyable, short
term debt). Quick ratio excludes inventories.
Tangible-net-worth minimum level of book value less
intangibles)
Maximum-capital-expenditures

High Yield Credit and Liquidity Risk


High yield companies can have fragile liquidity
They may have a slow cash conversion cycle (eg high
inventory and receivables)
No access to commercial paper market so rely on banks
which may impose tight restrictions
Private companies cannot easily issue equity
Rollover risk - new loans or bond issues are required to pay
maturing debt
Secured loans in a debt structure make unsecured loans
less attractive

High yield credit is susceptible to a perfect storm


Profitability of companies with high operational leverage is
adversely affected by an economic downturn
Liquidity can tighten as banks become more cautious with
short-term funding, further crimping profitability
Debt becomes difficult to roll over investors are reluctant
The default cycle awakens and spreads widen, reducing the
market value of these loans
Companies that can only afford cheap debt are in trouble
even if they can roll over loans
Collateral is worth less so loss given default increases
Investors get stuck as the secondary market dries up, and
there bonds/loans fall in value

Floating rate mischief on the ASX (1)


There are a range of interest bearing securities traded on the
ASX:
Australian Government Bonds (for retail investors
Unsecured notes sometimes issued by insurers as
regulatory capital
Convertible notes debt with an option over equity
Corporate preference shares conversion or redemption
may be at companys option, with risk of security becoming
perpetual
Bank capital notes similar to a converting preference
shares
The Australian corporate bond market is largely traded overthe-counter (ie not through an exchange)

Floating rate mischief on the ASX (2)


Floating rate securities are of no standard form and need to
be analysed thoroughly
Typically pay a margin above Bank Bill Swap Rate
Although they have zero yield curve duration they still have
spread duration because of term to maturity
Bank capital notes are every bit as vulnerable as equity in
the event of financial stress (thats why theyre Tier 1
capital)
Where an issuer has options (eg to redeem early), the
investor should be compensated by a yield premium
Interest is not always cumulative, and may be deferred (eg
if APRA says so!)

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