Real vs. Financial AssetsReal vs. Financial Assets
Real Assets have physical characteristics that determine the value of the asset– Size, Shape, Material, Color, etc.
– Price based on the benefits of the physical characteristics
Financial Assets physical characteristics are inconsequential– Value based on claim to promised or anticipated
cash flows
– TVM concepts used to price financial assets
33
The U.S. Bond MarketThe U.S. Bond Market
U.S. Treasury is the world’s single largest
borrower—also has the most liquid market—an informal OTC market.
44
Corporate Bonds in the U.S.Corporate Bonds in the U.S.
Market for corporate bonds is less liquid than market for U.S. Treasuries– IPOs for bonds are underwritten by investment
banking firms
Largest organized secondary bond market is NYSE– Uses matrix prices for most of the bonds listed on
its Automated Bond System (ABS)• Based on price quotes for similar bonds (in terms of
coupon rate, maturity, quality rating, call provisions)
55
Bond Markets Bond Markets
Debt Issuers Underwriter Investors
U.S. government U.S. Treasury Governments, pensions, commercial banks, insurance companies, mutual funds, foreigners, households
Federal government agencies Investment banks Governments, pensions, commercial banks, insurance companies, mutual funds, foreigners, households
Municipalities Commercial and investment banks
Governments, commercial banks, insurance companies, mutual funds, foreigners, households
Corporations Investment banks Pensions, commercial banks, insurance companies, mutual funds, foreigners, households
Home buyers, commercial real estate developers
Mortgage banks & pool operators
Pensions, commercial banks, insurance companies, REITs
Foreign governments Investment banks Pensions, mutual funds, foreigners, households
Foreign corporations Investment banks Pensions, commercial banks, insurance companies, mutual funds, foreigners, households
U.S. government
conducts regularly scheduled
auctions for Treasury securities.
66
Sectors of the Industrialized Sectors of the Industrialized World’s Bond MarketsWorld’s Bond Markets
In almost every country, the federal government is that country’s largest debt issuer
Corporate sector for Japan, Italy and Germany is relatively small compared to their overall bond markets– Due to custom of borrowing from a bank
vs. issuing bonds
77
International BondsInternational Bonds
Represent a rapidly growing category– Reflects willingness of borrowers to borrow
across borders
International bond investors face two types of political risk– Repatriation-of-funds risk
• A government may block payments of principal or interest
– Sovereign risk• A government may refuse to honor its debts
88
International BondsInternational Bonds
Can be organized into the following categories– Domestic bonds
• Issued by a local borrower and denominated in local currency
– Foreign bonds• Issued in one country and denominated in that
country’s currency by a bond issuer from another country
– Eurobonds• Any bond not issued in a domestic market regardless of
its currency denomination and the issuer’s nationality
99
Bearer Bonds Vs. Registered BondsBearer Bonds Vs. Registered Bonds
Registered bonds—send coupon checks to registered bond owners
Bearer bonds—have no list of registered owners– Investor must submit a dated coupon to a
bank to receive coupon payments• Many Eurodollar bonds are of this type
• Owner’s identity is unknown
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Accrued InterestAccrued Interest
Market price of bond (or its clean price) is:
1 2 T T
1 2 T Tbond
Present Value of Coupon Payments Present Value of Par
Coupon Coupon Coupon ParPrice1 k 1 k 1 k 1 k
Bonds pay coupon payments periodically Annually, semi-annually, quarterly, etc.
When a bond is purchased on a day between its scheduled interest payment, buyer must pay seller for accrued interest Interest that has been earned but not yet paid by
issuer
1111
Compounding ConventionsCompounding Conventions
The length of time between coupon payments impacts bonds’ yields and prices
1313
Yield-to-Maturity (YTM): A First LookYield-to-Maturity (YTM): A First Look
A simple approximation of yield-to-maturity is:
Rate of Cash FlowRate of price appreciation or depreciation
Par - Current Price
Years until maturityNon compounded YTM Coupon Rate
Current Price
Bond Basics, II.Bond Basics, II.
Two basic yield measures for a bond are its coupon rate and its current yield.
value Par
coupon Annualrate Coupon
price Bond
coupon Annual yieldCurrent
1515
Compounded YTMCompounded YTM
YTM defined as the discount rate equating the present value of a bond’s future cash flows to its current market price– For bonds paying coupon payments semi-
annually, the correct formula is:
1 2 2T
1 2 T 2T
Present 2 2 2Coupon Coupon Coupon ParValue 1 YTM 2 1 YTM 2 1 YTM 2 1 YTM 2
•The YTM is identical to IRR
1616
Example: Comparing a Bond’s Example: Comparing a Bond’s Conventional and Effective YTMConventional and Effective YTM
Given information– Par value: $100
– Coupon rate: 10% (semi-annual)
– Time to maturity: 10 years
– Purchase price: $106.59
Using the conventional YTM formula, we calculate a YTM of 8.89%
1 2 20
$10 2 $10 2 $10 2 $100$106.59
1 0.089873 2 1 0.089873 2 1 0.089873 2
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Conditions Required to Earn a Conditions Required to Earn a Bond’s Expected YTMBond’s Expected YTM
A bond’s computed YTM will only actually be earned if:– The bond is held to maturity– The bond issuer does not default in the
timing or amount of scheduled payments– All the cash flows are immediately
reinvested to earn the bond’s YTM
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Inverse Relationship Between a Inverse Relationship Between a Bond’s Price and YTMBond’s Price and YTM
The price and YTM of a bond move inversely
NOTE: Price-yield curves are convex to the origin.
Interest Rate RiskInterest Rate Risk
The value of the 5% bond falls as interest rates rise
700
800
900
1,000
1,100
1,200
0 2 4 6 8 10 12 14 16
Interest rate (%)
Bo
nd
pri
ce (
$)
Interest Rate Risk and Time to Interest Rate Risk and Time to Maturity Maturity
Bond values ($)
Interest rates (%)
1-year bond
30-year bond$1,768.62
$916.67
$1,047.62
$502.11
5 10 15 20
2,000
1,500
1,000
500
Value of a Bond with a 10% Coupon Rate for Different Interest Rates and Maturities
Interest rate 1 year 30 years
5% $1,047.62 $1,768.62
10 1,000.00 1,000.00
15 956.52 671.70
20 916.67 502.11
Time to Maturity
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Other Measures of Bonds’ YieldsOther Measures of Bonds’ Yields
Yield-to-call (YTC)– A bond issuer may call a bond before its
original maturity date• Need to calculate the bond’s YTC
– Similar to YTM, except replace T as the time-to-call rather than time-to-maturity
2222
International Bond Index StatisticsInternational Bond Index Statistics
U.S. $ U.K. Pound Hong Kong $ German Mark
Return SD Return SD Return SD Return SD
Australia 8.5% 15.5% 9.9% 18.3% 9.5% 16.4% 5.0% 20.2%
Belgium 11.6 17.2 13.0 14.7 12.7 16.2 8.1 8.6
Canada 9.3 10.4 10.7 19.3 10.3 13.2 5.8 17.0
France 10.8 15.6 12.2 15.3 11.8 15.6 7.2 12.2
Germany 12.0 14.9 13.4 16.7 13.0 13.4 8.4 8.4
Japan 12.2 17.5 13.7 18.4 13.3 18.3 8.7 17.3
Netherlands 11.7 14.2 13.1 15.8 12.7 14.0 8.1 8.2
Switzerland 10.2 17.1 11.6 16.8 11.2 16.0 6.7 9.8
U.K. 10.2 22.3 11.6 17.2 11.6 17.2 11.3 23.4
U.S. 9.3 12.2 10.6 21.3 10.3 14.7 5.8 16.8
No single bond
investment appears to be the most or least risky.
2323
Actively Managing International Actively Managing International Bond InvestmentsBond Investments
Active international bond investors can use different approaches:– Political analysts begin with a top-down approach and
analyze sovereign risks, etc.– Macro-economists study macro factors (income,
employment, etc.) to determine which nations are economically strong
– Monetary economists forecast a nation’s level and structure of market interest rates by analyzing central bank and their policies, etc.
– Industry analysts analyze financial data from different industries
– Security analysts have a bottom-up approach—focus on bond issuer’s financial conditions, protective provisions, etc.
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The Bottom LineThe Bottom Line
Governments are the largest borrowers in the world Most rapid growth occurring in Eurobond market
– Unregulated and untaxed
Some countries publish clean bond prices while others publish dirty prices which includes accrued interest
Day counting conventions differ across countries YTM calculations methods also differ across
countries
2525
Bond Risk HierarchyBond Risk Hierarchy
1st Mortgage Bonds
2nd Mortgage BondsSenior Debentures
Subordinated Debentures
Preferred StockCommon StockMore
Risk
LessRisk
Priority of Claim Higher Lower
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