Introduction to Debt Markets
Bonds vs. StocksIn the Rearview Mirror
Sources of RisksDebt Classes
Investments 14 2
Bonds vs. Stocks Sizing Bond (2009) and Stock Markets (Q3 2008)
$-
$5.0
$10.0
$15.0
$20.0
$25.0
$30.0
$35.0
Bond Market Stock Market
$34.3 T $14.1 T
Investments 14 3
Rearview MirrorS&P 500
30.47%
10.07%
21.04%
-11.89%
-22.10%
28.69%
10.88%
4.91%
15.79%
5.49%2.79%
7.62%
37.58%
22.96%
33.36%
28.58%
1.32% -9.10%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
1990 1992 1994 1996 1998 2000 2002 2004 2006
Investments 14 4
Rearview MirrorU.S. Bond Aggregate Index
8.95%
16.00%
7.40%
9.75%
3.63%
11.63%10.26%
4.10%2.43%
4.33%
6.97%
18.47%
8.69%
-2.92% -0.82%
9.65%8.44%
4.34%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
1990 1992 1994 1996 1998 2000 2002 2004 2006
Investments 14 5
Why Bonds? Bonds form an important asset class
Sources of risk and return in bonds Interest rate risk Reinvestment risk Default risk
When liabilities are fixed in nominal terms, investing in suitably chosen bond portfolios may lead to lower risk May not be necessary to consider all asset classes
and use mean variance optimization methods
Bond mispricing may arbitrage opportunities for an active portfolio manager
Investments 14 6
Issuers of Bonds U.S. Treasury
Notes and Bonds Municipalities
Tax-Exempt Bonds Corporations
Corporate Bonds, Preferred Stock International Governments and Corporations
Innovative Bonds• Indexed Bonds• Floaters and Reverse Floaters
Investments 14 7
Source of Risks Interest Rate Risk (Market Risk)
The major factor affecting bond prices The price of bond changes in the opposite
direction of interest change All bonds are exposed
Inflation Risk Inflation reduces purchasing power Yield changes to reflect the expected inflation
Reinvestment Risk No guarantees that coupon payments could be
reinvested at the same rate
Investments 14 8
Source of Risks Credit Risk
Inability of issuer to pay coupon and/or principal Corporate, Emerging market and high-yield bonds Credit linked debt securities, credit derivatives
Liquidity Risk Inability to unload position without substantial loss Municipal, Corporate, and Emerging market bond
FX Risk The risk of exchange rate fluctuation in reducing
the return on a foreign bond
Investments 14 9
Debt Classes: Definition Bond (Fixed Income Security)
A security obligating issuer to pay interest and principal to the holder on specified dates.
Coupon Interest rate, e.g. 4%, 5 3/4%, etc. Face/par value or Principal amount, e.g. $100 MM, $3B. Maturity, e.g. 3 month, 1 year, 30 years, etc.
Bond can be classified according to its attributes Payment type, e.g. semi-annual coupon, amortizing, etc. Issuer, e.g. government, agency, corporate, etc. Maturity, e.g. short, medium, long, etc. Security, e.g. secured, unsecured debenture, etc.
Investments 14 10
Debt Classes: Payment Type Pure Discount or Zero-Coupon Bond
No coupon payments prior to maturity. Bond’s face value paid at maturity.
Coupon Bond A stated coupon paid periodically prior to maturity. Bond’s face value paid at maturity.
Perpetual (Consol) Bond A stated coupon paid at periodic intervals.
Self-Amortizing Bond Certain amount paid at each payment period. No balloon payment at maturity.
Investments 14 11
Debt Classes: U.S.Treasuries Treasury Bills
maturity 1 year when issued typically 3 months and 6 months pure discount bond, no coupon
Treasury Notes Maturity: 1 year maturity 10 years when
issued Typically, 2, 3, 5, and 10 year
Coupon: semi-annual Treasury Bonds
Maturity: >10 years when issued Typically, 20, 30 (last issued Feb 15, 2001)
Coupon: semi-annual
Investments 14 12
Debt Classes: U.S.Treasuries Treasury STRIPS are zero-coupon securities
that are made by “stripping” coupons or principals from Government Notes and Bonds.
Treasury Strips are issued under the U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) program.
Prices of Notes, Bonds, and STRIPS are quoted as prices per $100 of face value. Prices of Bills are quoted in terms of rate of discount.
Investments 14 13
Debt Classes: Corporate Bonds Secured Debt (backed by collateral assets)
Secured by real property Property reverts to bondholder upon default
Subordinate Debenture General creditors subordinate to secured debt Higher priority over stockholders
Other Features of corporate bonds Convertible bonds: convertible to equity Callable bonds: issuer’s right to buys back bond Putable bonds: holder’s right to sell bond to issuer Sinking funds: reduced face amount over time
Investments 14 14
Corporate Bonds – Default Risk
One of the biggest differences between Corporate Bonds and U.S. Treasury Bonds is the default risk on corporate bonds
Corporate bonds are rated on the basis of their default risk by a few rating companies
Investments 14 15
Factors Used by Rating Companies
Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt Effects of bond covenants
Moody’s acquired KMV to use option pricing theory to rate corporate bonds
Investments 14 16
Corporate Bonds – Default RatingsRating Companies Moody’s Investor Service Standard & Poor’s Fitch
Rating Categories Investment grade
Aaa, Aa, A, Baa by Moody’s ratings AAA, AA, A, BBB by S&P ratings
Speculative grade or “Junk” bonds Rated below Baa by Moody’s and BBB by S&P
Investments 14 17
Debt Classes: Corporate Bonds Credit Rating
Moody S&P Quality of Issue Aaa AAA Highest quality. Very small risk of default.
Aa AA High quality. Small risk of default.
A A High-Medium quality. Strong attributes, but potentially vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially unreliable.
Ba BB Some speculative element. Long-run prospects questionable.
B B Able to pay currently, but at risk of default in the future.
Caa CCC Poor quality. Clear danger of default .
Ca CC High specullative quality. May be in default.
C C Lowest rated. Poor prospects of repayment.
- D In default.
Investments 14 18
Average One-Year Credit Loss Rates
0.0% 0.0% 0.1% 0.1%
0.9%
2.7%
6.1%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
Aaa Aa A Baa Ba B Caa - C
Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006
Investments 14 19
Ratings and Average Time to Default
Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006
Original RatingAverage # of Years from Original Rating to Default
AAA 8.0
AA 9.5
A 8.5
BBB 6.5
BB 4.8
B 3.6
CCC 3.3
Investments 14 20
Mean and Median Recovery Rates
70%
44%39%
29%
16%
83%
40%35%
21%
6%
0%
20%
40%
60%
80%
100%
Ba and Up B Caa Ca C
Mean
Median
Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006
Investments 14 21
Protection Against Default
Sinking funds
Subordination of future debt
Dividend restrictions
Collateral
Investments 14 22
Bond Provisions Call Provision allows the issuer to repurchase the bond
at a specified call price before the maturity date Put Provision allows a bondholder to reclaim a
principal, or to extend bond’s life Convertible Provision allows a bondholder to
exchange a bond for common stock Typically are callable as well
Secured Bonds have specific collaterals for bonds Sinking Funds guarantee gradual repurchase of
corporate bonds by the issuer Floating Rate Bonds have interest payments tied to
some measure of current market rates
Investments 14 23
Comparing Bonds – On the Importance of Fine Print
Yield is useful for comparing similar bonds to see if which bond may be cheaper
Detailed analysis focuses on bonds identified this way: “Similar” Cash flows Duration Credit risk Call, Put, Conversion and other provisions
Investments 14 24
“Similar” Bonds ExampleTwo U.S. Treasury bonds of same maturity from July 1, 2004 WSJ:
The first bond has a coupon rate of 4.75%, and yields 4.56%The second bond has a coupon rate of 13.25%, and yields only 3.71% (!!!)
The difference is that the second bond is CALLABLE!!! It was issued as a 30yr bond in May of 1984, and is callable at par value in 25 years, i.e. in May of 2009Now it is almost 100% certain that it will be called, hence it now trades as bond maturing in 2009:
RateMaturity
Bid Asked ChgAsked
Mo/Yr Yield
4 3/4 May 14 n 101:15 101:16 +10 4.56
13 1/4 May 14 142:03 142:04 +11 3.71
RateMaturity
Bid Asked ChgAsked
Mo/Yr Yield
3 7/8 May 09 n 100:22 100:23 +9 3.71
5 1/2 May 09 n 108:02 108:03 +10 3.67
Investments 14 25
Bond Provisions Bond provisions may alter the structure of
cash flows, affecting bond prices and yields Call Provision allows the issuer to repurchase
the bond at a specified call price before the maturity date
Relationship between
Interest Rate and
Callable Bond Price
Callable Bond Price vs. Interest Rate
0
1000
2000
3000
4000
5000
0 5 10 15Interest Rate
Bond Price
Investments 14 26
Yield to Call Bonds are most likely to be called when their price exceeds
the call price It implies that premium bonds will be called at the earliest date when
the bond becomes callable Hence yield quoted in WSJ for callable premium bonds is in fact
yield to call (recall previous example)!!! Example of cash flows difference for a callable bond:
A 30yr bond with 8% coupon sells for $115, and is callable in 10 years at par Cash Flow to Call Cash Flow to Maturity
Coupon payment $4 $4
Number of semi-annual periods 20 periods 60 periods
Final payment (principal) $100 $100
Price $115 $115
Yield to Call Yield to Maturity
5.98% 6.82%
Investments 14 27
Debt Classes: Municipal Bonds Municipal Bonds
Maturity varies from one month to 40 years Exempt from federal taxes and state taxes (for
residents of issuing state) Generally two types:
Revenue bonds backed by the revenue of a particular project e.g. water bond
General Obligation bonds backed by the tax revenue of local government e.g. school bond
Riskier than U.S. Government bonds
Investments 14 28
Source of Risks – Foreign Bonds
0
20
40
60
80
100
120
140
1/1/1997 8/29/1997 4/26/1998 12/22/1998 8/19/1999 4/15/2000 12/11/2000 8/8/2001
Date
Bo
nd
Pri
ces Russian MinFin 10yr 3%
T-Note 10yr 6.5%
Investments 14 29
Bond Resources WSJ - Bonds Yahoo – Bonds Bloomberg - Bonds Lehman Brothers Bond Indices
(what’s left of them…) www.investinginbonds.com PIMCO - Everything You Need to Know
About Bonds
Top Related