SECTION I

Bond prices and yields

Asset Classes and Financial Instruments
Learning outcomes
• Understand money market instruments
• Understand capital market instruments
 Money markets are made up of short-term, marketable, liquid, low-
risk debt securities

Treasury Bills (that is, T-bills- discount instrument)

• Simplest form of borrowing wherein the government raises money by selling bills to

Money
the public
• Ask price is the price you would have to pay to buy a T-bill from a securities dealer
• Bid price is the slightly lower price you would receive if you wanted to sell a bill to
a dealer

Market • Bid-ask spread is the difference in these prices, which is the dealer’s source of
profit

Securities Certificates of Deposit (CD)

Bank pays interest and principal to the depositor only at maturity

Time deposit cannot be withdrawn on demand

 Commercial paper

• Short-term unsecured debt notes, often

issued by large, well-known companies and
backed by a bank line of credit. Asset-
backed CP is not too common.

Money Bankers’ acceptance

Market • An order to a bank by a customer to pay a
Securities sum of money at a future date

Eurodollars

• Dollar-denominated deposits at foreign

banks or foreign branches of American
banks
 Repurchase agreements

• Short-term, often over-night, sales of

securities with an agreement to repurchase
them at a slightly higher price
Money Federal funds

Market • Funds in a bank’s reserve account at the

Federal Reserve Bank
Securities Brokers’ calls

• Investors may buy stocks on margin and

brokers, in turn, may borrow the funds from a
bank
Task

• https://www.resbank.co.za/content/dam/sarb/publications/jibar/202
1/Jibar_Revised%20Code_of_Conduct-April2021.pdf

• Task 2- draw a figure showing (i) spread between repo rate and at-bill
rate; (ii) JIBAR and t-bill rate
The Bond Market

• Capital markets include longer-term and riskier securities

• Divided into four segments – longer-term bond markets, equity
markets, and the derivative markets for options and futures
• Bond market is composed of longer-term borrowing or debt instruments than
those that trade in the money market
• Treasury notes and bonds
• Corporate bonds
• Municipal bonds
• Mortgage securities
• Federal agency debt
Debt Instruments

Treasury notes and treasury bonds

• U.S. government borrows funds in large part by selling T-notes and T-bonds
• Notes – maturities range up to 10 years
• Bonds – maturities range from 10 to 30 years
• Inflation-protected treasury bonds
• Many countries’ governments issue bonds linked to an index of the cost of
living in order to provide their citizens with an effective way to hedge
inflation risk

• In the U.S., inflation-protected T-bonds are called TIPS

Debt Instruments

Municipal Bonds
• Tax-exempt bonds issued by state and local governments
• General obligation – backed by general taxing power of issuer
• Revenue – backed by proceeds from the project or agency
they are issued to finance
• Typically issued by airports, hospitals, etc.
• Industrial development – revenue bond issued to finance
commercial enterprises
• Vary widely in maturity
Debt Instruments

Corporate bonds
• Means by which private firms borrow money directly from the public
• Secured bonds
• Unsecured bonds (that is, debentures)
• Subordinated debentures
• Similar to Treasury issued securities in that they usually pay
semiannual coupons and return face value to bondholder at maturity
• Larger default risk than Treasury issued securities
• May come with options attached
• Callable or convertible options
Debt Instruments

Mortgage- and asset-backed securities

• Ownership claim in a pool of mortgages or an obligation that is
secured by such a pool
• Conforming mortgages
• Loans must satisfy certain underwriting guidelines before they
may be purchased by Fannie Mae or Freddie Mac
• Subprime mortgages
• Riskier loans made to financially weaker borrowers
Bond Prices and Yields
Learning outcomes

1 2 3
Understand Identify Understand various
evaluation determinants of portfolio strategies
principles risk and return
A bond is a security that is Issuer agrees to make
specified payments to the
issued in connecting with a bondholder on specified
borrowing arrangement dates

Par value (in essence., face value) is the payment

to the bondholder on the bond’s maturity date
Bond
Coupon rate is a bond’s interest payments per
Characteristics
dollar of par value

Bond indenture is the contract between the

issuer and the bondholder
 • Treasury notes – 1 to
10 years
Maturity
• Treasury bonds – 10
to 30 years Treasury
Bonds and
Both bonds
and notes
Notes
may be
purchased
directly from
the Treasury
Callable bonds typically come with a period of
call protection

Convertible bonds give holders option to

exchange each bond for a specified number of
shares of the firm’s stock Corporate
Put bond gives holder option to exchange for Bonds
par value at some date or to extend for a given
number of years

Floating-rate bond has interest rate that is reset

periodically according to a specified market rate
 • Considered to be equity, but often included in
the fixed-income universe
• Like bonds, preferred stock promises to pay a
specified cash flow stream
• Unlike bonds, failure to pay the promised
dividend does not result in corporate
Preferred bankruptcy
Stock • Dividends owed simply cumulate
• Preferred stock commonly pays a fixed
dividend
• Rarely gives holders full voting privileges in
firm
International Bonds

Foreign bonds Eurobonds

Issued by a borrower from a country other than Denominated in one currency, usually that of
the one in which the bond is sold the issuer, but sold in other national markets

Denominated in the currency of the country in Euroyen bonds

which it is marketed Eurosterling bonds
Samurai bonds
Bulldog bonds
Inverse floaters are like floating-rate bonds, except
coupon rate falls when the general level of interest
rates rises

Asset-backed bonds use income from a specified group

Innovation
of assets to service the debt
in the
Catastrophe bonds’ final payment depends on whether
there has been a catastrophe Bond
Indexed bonds make payments that are tied to a
Market
general price index or the price of a commodity

• Treasury Inflation Protected Securities (TIPS)

Principal and Interest Payments for TIPS
Bond Pricing
•
T
Coupon ParValue
Bond
= value ∑ +
t =1 (1 + r ) t
(1 + r )T

• the First term of the right-hand side of the equation is the present
value of an annuity
• the Second term is the present value of a single amount, the final
payment of the bond’s par value
•
example
• Example 14.2 Bond Pricing
An 8% coupon, 30-year maturity bond with par value of $1,000 paying 60
semiannual coupon payments of $40 each. Suppose that the interest rate is
8% annually or r = 4% per six-month period. Then the value of the bond can
be written as $40 $1,000
60

Price = ∑ +
t =1 (1.04) t
(1.04) 60
$40 × Annuity factor ( 4%,60 ) + $1,000 × PV factor ( 4%, 60 )

• It is easy to confirm that the present value of the bond’s 60 semiannual

coupon payments of $40 each is $904.94 and that the $1,000 final payment
of par value has a present value of $95.06, for a total bond value of $1,000.
You can calculate this value directly from Equation 14.2, perform these
calculations on any financial calculator (see Example 14.3), use a
spreadsheet program
Inverse relationship between price and
yield is a central feature of fixed-income
securities

Interest rate fluctuations represent the

main source of risk in the fixed-income
market
Bond Prices
The price curve is convex and becomes
and Yields
flatter at higher interest rates

The longer the maturity of the bond, the

more sensitive the bond’s price to changes
in market interest rates
The Inverse
Relationship
Between
Bond Prices
and Yields
Bond Prices at Different Interest Rates
Bond Yields: Yield to Maturity

• Yield to maturity (YTM) is the interest rate that makes the present value of
a bond’s payments equal to its price
• Interpreted as a measure of the average rate of return that will be
earned on a bond if it is bought now and held until maturity
• To calculate YTM, solve the bond price equation for the interest rate given
the bond’s price
Yield to Maturity Example

• Suppose an 8% coupon, 30-year

bond is selling for 1,276.76.
What is the YTM?

60
$40 1000
= ∑
$1276.76 + 60
t =1 (1 + r ) t
(1 + r )
r = 3% per half year
Bond equivalent yield = 6%
EAR = ((1.03)2) – 1 = 6.09%
Bond Yields: YTM versus Current Yield

Current yield is the bond’s

Yield to maturity annual coupon payment divided
by its price
• Bond’s internal rate of return • Premium bonds: Coupon rate >
• Interpreted as compound rate Current yield > YTM
of return over life of the bond • Discount bonds: Coupon rate <
assuming all coupons can be Current yield < YTM
reinvested at that yield
• Proxy for average return
Bond Yields: Yield to Call

Low interest rates High interest rates

The price of the callable bond is flat since the risk The price of the callable bond converges to that
of repurchase or call is high of a normal bond since the risk of call is
negligible
Bond Yields: Realized Compound Return versus
YTM

YTM will equal the rate of return realized over the life of the
bond if all coupons are reinvested to earn the bond’s YTM

Realized compound return is the compound rate of return

assuming that coupon payments are reinvested until maturity

Forecasting the realized compound yield over various holding

periods or investment horizons is horizon analysis
Growth of Invested Funds
Prices Path of
Two 30-Year
Maturity
Bonds
Bond Prices Over Time: YTM versus HPR

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

• Rate of return over a particular investment period

HPR • Depends on the bond’s price at the end of the

holding period, an unknown future value
• Can only be forecasted
Default Risk and Bond Pricing

• Credit risk, or default risk, is the risk the bond will not make all promised
payments
• Rating companies
• Moody’s Investor Service, Standard & Poor’s, and Fitch Investor Service
• Rating categories
• Highest rating is AAA (or Aaa)
• Investment grade bonds are rated BBB/Baa or above
• Speculative-grade/junk bonds are rated below BBB/Baa
Default Risk • Determinants of bond safety
• Coverage ratios
and Bond • Leverage (for example, debt-to-equity)
Pricing ratios
• Liquidity ratios
• Profitability ratios
• Cash flow-to-debt ratio
 • Note: EBITA is earnings before interest, taxes, and amortization. EBITDA
Financial Ratios by is earnings before interest, taxes, depreciation, and amortization.
Rating Class Source: Moody’s Financial Metrics, Key Ratios by Rating and Industry for
Global Non-Financial Corporations, December 2016.
 Sinking fund calls for the issuer to periodically
repurchase some proportion of the outstanding
bonds prior to maturity

Subordination clauses restrict the amount of

Bond additional borrowing by the firm

Indentures Dividend restrictions limit the payment of

dividends by firms

Collateral is a particular asset that the

bondholders receive if the firm defaults
 • Must distinguish between the bond’s promised
YTM and its expected YTM
• Promised YTM will be realized only if the firm
meets the obligations of the bond issue
YTM and • Expected YTM must consider the possibility
of a default
Default Risk • Default premium is a differential in promised
yield that compensates the investor for the risk
inherent in purchasing a corporate bond that
entails some risk of default
Yield Spreads

• Yield spreads between corporate and 10-year Treasury bonds

 • Natural buyers of CDSs would be large
bondholders or banks that wish to enhance the
creditworthiness of their outstanding loans
Credit • But, CDSs can also be used to speculate on the
financial health of particular issuers
Default • An example of this behavior would be an
Swaps (CDSs) investor in early 2008 who predicted the
imminent financial crisis and purchased CDS
contracts on mortgage bonds
 • Collateralized debt obligations (CDOs)
Credit Risk and • Major mechanism to reallocate credit risk in
the fixed-income markets
Collateralized • To create a CDO, a legally distinct entity to
buy/resell a portfolio of bonds must be
Debt established
Obligations • Structured Investment Vehicle (SIV)
• Loans are pooled together and split into
(CDOs) tranches, where each tranche is given a
different level of seniority in terms of its
claims on the underlying loan pool
• Mortgage-backed CDOs were an investment
disaster in 2007 to 2009