Professional Documents
Culture Documents
The bond indenture is a three party contract (a trust deed) between the bond issuer, the bondholder, and Right to put - the right to sell the issue back to the issuer at a specified price on designated dates (Putable
the trustee bonds)
- Details the promises of the issuer and the rights of the bondholder. The trustee protects the Floor on a floater
bondholders interests. Sectors of the Bond Market
Collateral: Assets (or financial guarantees) underlying the debt obligation above and beyond issuers Domestic Market: Issuers domiciled in country where bond is issued and traded.
promise to pay. Foreign Market: Issuers of the bond are not domiciled in the country where the bonds are issued and
Credit enhancements: Provisions used to reduce credit risk. traded. e.g. Samurai Bond, Yankee Bond, Bulldog Bond.
Covenants: Clauses that specify the rights of bondholders. Eurobond Market: Issuer not domiciled in country of issue, and currency is different. e.g. Euro yen bond
- Affirmative Covenants: Activities the issuer has promised to do. issued in London and denominated in JPY. Typically bearer bonds.
- Negative Covenants: Restrictions on the issuers activities. Classification of bond markets
Structure of Cash Flows: Principal Repayment Type of Issuer
Bullet: Entire payment of principal occurs at maturity Credit Quality
Amortised: Periodic payment of interest and principal repayment. Maturity
- Partially amortised - only a portion of principal is repaid by the maturity date, so a balloon Currency Denomination
payment is required. Coupon
- Fully amortised - outstanding principal amounts reduced to zero by maturity date. Geography
Sinking fund: Issuers plan to set aside funds over time to retire the bond. Primary Markets
- Amount to be retired each year is specified in contract. Primary markets are markets in which issuers
Call provision: Grants the issuer an option to retire all or part of the issue prior to the stated maturity date. first sell bonds to investors to raise capital.
Structure of Cash Flows: Coupon Payment Structures Public Offering
Zero-Coupon Bonds - Underwritten
No periodic coupon payments - Shelf-registration - Allows certain issuers to offer additional bonds without having to prepare new
Holder realizes interest by buying the bond at a substantial discount. Interest then paid at maturity. documents.
How does risk compare to coupon-paying bond? Auctions - Investors bid for bonds to be allocated.
Deferred Coupon Bonds Private Placements -Non-underwritten, unregistered offering, sold to single/few investors.
No interest payments during a specified period, and then periodic payments made until bond matures. Auctions: Distributing New Government Securities
Are the payments higher or lower than with no deferral? Regular auction cycle / multiple price: Allocated at individual bid price.
Why might an issuer use such bonds? Regular auction cycle /single-price: All allocated at highest yield / lowest price.
Step-Up Notes Ad hoc auction: Announced when market conditions are favourable.
Bonds that have a coupon rate that increases over time. Tap method: Additional bonds of previously outstanding issue are auctioned.
Credit Linked Coupon Bonds Most recently auctioned bonds are referred to on-the-run. Off-the-run issues trade at a discount.
Coupon changes when the bonds credit rating changes. Secondary Markets
Which direction do coupons change if credit improves (declines)? Markets in which existing securities are traded among investors.
Payment-in-Kind Bonds Large institutional investors and central banks are the major participants.
Allow issuer to pay interest in the form of additional amounts of the bond issue rather than in cash. Few retail investors (unlike equity markets).
Index-Linked Bonds Liquidity: Ability to trade securities quickly and easily at prices close to their fair market value.
Coupon payments and/or principal linked to a specific index. - Demands have evolved as active traders have replaced buy-and-hold investors.
Structure of Cash Flows: Floating Rate Notes Sovereign Bonds
Floating-rate securities have coupon payments that reset periodically on predetermined dates. Issued by central / federal government.
Coupon Rate = Reference Rate + Quoted Margin All bonds are subject to credit risk
BBSW & LIBOR are typical reference rates. Two types of default risk ratings: Local Currency and Foreign Currency
Governments often issue Inflation linked bonds (TIPS) Non-Sovereign, Quasi-Government & Supranational Bonds
FRNs may have additional features:
In Australia, the U.S. and other industrialised countries, numerous braces or agencies of the federal
Cap: Sets maximum coupon that will be paid (Issuer will benefit) government are able to issue bonds.
Floor: Sets minimum coupon that will be paid (Owner will benefit) Such bonds may be implicitly or explicitly backed by the central government.
Bonds with Contingency Provisions (Embedded Options)
In the U.S., government sponsored enterprises (GSEs) are privately owned entities that were created to
Bond indentures can contain provisions that allow both the issuer and bondholder to take some course of reduce the cost of capital for certain sectors of the economy. e.g. Fannie/Sallie Mae, Freddie Mac
action against the other party. These are known as embedded options Corporate Debt
Embedded options are important and add to the complexity of bond valuation and analysis. Corporations have two sources of debt financing: bank borrowing and the issuance of debt securities
Bonds with embedded options affect the return (or cost) of the issue. The exercise of options will depend Even a company in a country that does not have a well-developed bond market can issue debt by issuing
on changes in market interest rates. securities in foreign markets
Necessary to model the impact of embedded options in different scenarios (sub-prime crisis). In Australia, many corporate debt securities are transacted through the ASX
Embedded Options Money Market Securities
Granted to Issuers: Short-term, zero-coupon securities
Right to call (Callable bonds)
Bankers Acceptances
Prepayment by borrowers in pool of loans - Usually issued by companies to fund (international) trade
Sinking fund provisions - Bank endorses (guarantees) security
Cap on a floater Commercial Paper
Granted to Bondholders: - No bank endorsement so generally only issued by well-known companies with high credit quality
Conversion privilege - allows the investor to convert the bond into a specified number of shares of - Issued in open market by firm in need of short-term funding.
common stock (Convertible bonds)
- Commonly rolled-over PMT PMT PMT FV
Flat Price, Accrued Interest, and the Full Price PV FULL ... (1 r)t/T
Negotiable Certificates of Deposit General formula for pricing bonds (in red) (1 r) (1 r)
1 2
(1 r)N
- Issued by banks. Indicates a specific amount of money has been deposited. Can be traded in the Yield Measures for Fixed-Rate Bonds
PV (1 r)t/T
secondary market. There are many ways to measure the rate of
Short-Term Funding Alternatives for Banks return on a fixed-rate bond investment.
Financial institutions typically have larger financing needs than non-financial firms. Investors want a yield measure that is standardised to allow for comparison between bonds that have
Retail Deposits different times-to-maturity.
Wholesale Funds Yield measures are typically annualised, then:
- Central Bank Funds: Many countries require deposit-taking banks to place a reserve balance with - compounded if maturity > 1-year; not-compounded if maturity < 1-year
the central bank to ensure liquidity. Current yield: Commonly used (simplicity).
- Interbank Funds: Market of loans and deposits between banks. Coupon payments in 1-year divided by flat-price
- Negotiable Certificates of Deposit: >$1m = Large denomination Alternate measures need to be used if the bond has embedded options
- Repurchase (Repo) agreements: Sale of a security with simultaneous agreement to buy back at Yield Measures for Floating-Rate Notes
an agreed-on price and future date. A type of collateralised loan. Quoted Margin: specified yield spread over the reference rate that reflects credit risk.
Credit Ratings Required Margin: Yield spread over, or under, the reference rate such that the FRN is priced at par value
Based on prospects of default, organisations with outstanding debt are issued credit ratings. on a rate reset date.
Credit rating agencies (e.g. Standard & Poors) conduct detailed examinations based on character, On each coupon date the floater will be priced at par.
capacity, collateral and covenants Between coupon dates the flat price will be at a premium / discount to par if Libor changes.
Ratings are based on individual debt offerings. It is possible for an organization to have multiple credit Discount Margin: Difference between quoted margin and required margin (Used in pricing model)
rating scores. Yield Measures for Money Market Instruments
Module 8 - Debt Security Valuation and Monetary Policy Several important differences from bond market:
Valuation is the process of determining the fair value of a financial asset. Annualized but not compounded. Stated on a simple interest basis.
Three steps in valuation: Money market instruments are often quoted using non-standard interest rates and require different pricing
1. Estimate expected cash-flows PMT PMT PMT FV
PV ... equations than those used for bonds.
(1 r) (1 r) (1 r)
2. Determine appropriate discount rates 1 1 N
Money market instruments having different times-to-maturity have different periodicities for the annual rate.
3. Use 1 & 2 to calculate PV of expected CFs Yield Measures for Money Market Instruments
Yield-to-Maturity
Money market rates are either discount rates (CP, T-Bills, BAs) or add-on rates (CDs, Repos, Libor).
If the market price of a bond is known, we can calculate its yield-to-maturity
Pricing formula for money market instruments quoted on a discount rate basis:
(YTM) - essentially this is the IRR of the CFs.
Pricing formula for money market instruments quoted on an add-on rate basis:
This is the rate of return on the bond to an investor given three critical assumptions:
A bond equivalent yield (BEY) is a money market rate stated on a 365-day add-on rate basis.
1. Investor holds the bond to maturity, 2. All coupons and principal payments are made as scheduled (no
Days Days
default), 3. Investor is able to reinvest coupon payments at the same yield. PV FV (1 DR), PV FV (1 AOR)
Relationship between bond price and bond characteristics Year Year
Value of bond = PV(Coupon Payments) + PV(Principal) Maturity Structure of Interest Rates
Bond price is inversely related to the discount rate (inverse effect) There are many reasons why the yields-to-maturity on any two bonds are different:
Percentage change is greater when the discount rate goes down Currency, Credit risk, Liquidity, Tax status, Periodicity of coupon payments, Term-to-maturity
than when it goes up (convexity effect) Yield Spreads
Lower-coupon bonds have a > response to changes in the discount Important to understand why bond prices and yields-to-maturity change. To facilitate this, we can separate
rate than do higher-coupon bonds (coupon effect) into two components: 1. Benchmark - government bond yield 2. Spread - difference between YTM on
Longer-term bonds have a > response to changes in the discount security and benchmark
rate than do shorter-term bonds (maturity effect) This helps distinguish between macro- and micro-economic factors. Spread measures include:
Change in Value as Bond Moves Toward Maturity -At maturity, a bond is worth par value, so there is a (Absolute) Yield Spread = YieldNon-Treasury - YieldTreasury
pull-to-par value over time Relative Yield Spread = Yield Spread / YieldTreasury
Spot Rates Z-Spread: Constant yield spread over a government spot curve.
For a basic valuation, a single interest rate is used to discount all cash-flows. However, a proper approach Option-Adjusted Spread (OAS): Used to calculate spreads when bonds have embedded options. e.g.
to valuation uses multiple interest rates, each specific to a particular cash-flow and time period. callable bonds.
Spot rates are yields-to-maturity on zero-coupon bonds maturing at the date of each cash flow. Treasury Yield Curve
Pricing bonds using spot rates is referred to as the no-arbitrage value. The Treasury yield curve shows the relationship b/n yield and maturity of on-the-run Treasury securities.
Yield-to-Maturity vs. Expected Return Since Treasury securities have no credit risk, the yield they offer is the minimum interest rate required on a
The yield-to-maturity is a weighted average of spot rates used in the valuation of a bond. non-Treasury security with same maturity.
It only reflects the expected return on a bond under very restrictive assumptions. The Treasury yield curve can be: Normal (upward sloping), Flat, Inverted (downward sloping) and Humped
Bond held to maturity, assuming all coupon and principal payments are made in full when due and that
coupons are reinvested at the original YTM.
Provides a poor estimate of expected return if:
- Interest rates are volatile, the yield curve is steeply sloped (upward or downward), there is
significant risk of default, or the bond has one or more embedded options
Flat Price, Accrued Interest, and the Full Price
Accrued interest is the amount of interest accrued since the last coupon date. t
The bond buyer must pay the bond seller the accrued interest at time of transaction. AI PMT
T Term Structure of Interest Rates
Dirty Price (full price) = Agreed price + Accrued Interest Relationship between maturity and Treasury spot rates. 3 theories to explain the shape of the yield curve:
Clean Price (flat price) = Agreed price (no accrued interest) Pure Expectations Theory: market sets yields based on expectations for future interest rates.
Liquidity Preference Theory: participants want to be compensated for the interest rate risk associated
with holding longer-term bonds.
Market Segmentation Theory: Different maturity sectors of the yield curve and each sector is
independent from the other sectors. Within each sector the interest rate is determined by the supply and
demand for funds. Also called Preferred Habitat Theory
*Left out Monetary Policy for now
Module 9 - The Term Structure and Interest Rate Dynamics
Spot rate: Rate of interest on a security that makes a single payment at a future point in time.
Forward rate: Rate of interest set today for a single-payment security to be issues at a future date.
Spot rates
At any point in time, the price of a risk-free single-unit payment (e.g. $1) at time T is called the discount
factor with maturity T, denoted by P(T).
The yield to maturity of the payment is called a spot rate, denoted by r(T). We have equation (1):
The spot (yield) curve is simply the spot rate for range of maturities.
- Represents the term structure of interest rates at any point in time.
- Shows the annualised return on an option-free and default -risk-free zero-coupon bond with a
single payment of principal at maturity.
- Shape and level of the yield curve are dynamic.
Forward Rates
Forward rate: Interest rate that is determined today for a loan that will be initiated in a future time period.
The term structure of forward rates is called the forward curve.
Forward rate of a loan initiated T* years from today with tenor of T years = f(T*+T)
Forward contract in which one party commits to pay the other party a forward contract price, at Time T*
years from today for a zero-coupon bond with maturity T years and unit principal ($1).
No money exchanged at start of contract - future promise.
At time T*, the buyer will pay the seller the contracted forward price value and will receive from the seller
(at time T*+T) the principal payment of the bond.
Then, following the no-arbitrage principle we have equation (2): P(T*+T)= (T*)F(T*,T)
Where P(T*) and P(T*+T) are the prices of zero coupon bonds maturing in given period.
The forward rate f(T*+T) is the discount rate for a risk-free unit-principal payment T*+T years from today,
valued at time T*, such that the present value equals the contract price, F(T*,T)
1
Then, by definition, we have equation (3): F(T * T)
1 f (T*,T)
By substituting equations 1 and 3 into equation 2, we have the forward rate model:
T
[1 r(T * T)(T* T) [1 r(T*)]T* 1 f (T*,T)
Forward rates relationship with spot rates
When the yield curve is upward sloping, the forward rate is higher than the long-term (T*+T) spot rate.
What the yield curve is downward sloping, the forward rate is lower than the long-term (T*+T) spot rate.
When the yield curve is flat, the forward rate is equal to the long-term (T*+T) spot rate.
Bootstrapping
The par curve represents the yields to maturity on coupon-paying government bonds, priced at par, over a
range of maturities. Typically use on-the-run issuesas they have greater liquidity and priced close to par
Can be used to construct a zero-coupon yield curve, in a process called bootstrapping.
Coupon-paying bonds can be viewed as a portfolio of zero-coupon paying bonds.
Theoretical Spot Rates - Bootstrapping
Value of Treasury coupon bond = Value of package of zero-coupon Treasuries that duplicate cash flows
Start w/ the par yield curve, we want to know how to derive the spot rates shown in the last column