Bond Types and Features Quiz

Canadian Securities

• Mohammad Safavi
• November 13, 2024
• safavim.com
• 289.33

Chapter 14: Bond Prices and Yields

• Tenth Canadian Edition
• Investments
• Bodie et al. 10th CE
• © 2022 McGraw-Hill Education Limited
• Dinesh Gajurel, Ph.D., University of New Brunswick

Chapter Overview

• Bond Characteristics
• Bond Pricing
• Bond Yields
• Bond Prices Over Time
• Default Risk and Bond Pricing

Bond Characteristics

• A bond is a security issued in connection with a borrowing arrangement.
• The issuer agrees to make specified payments to the bondholder on specified dates.
• Par value (face value) is the payment to the bondholder on the bond's maturity date.
• Coupon rate is the bond's interest payments per dollar of par value.
• Bond indenture is the contract between the issuer and the bondholder.

Example

• A bond with a 1,000parvalueanda41,000 par value and a 4% coupon rate might sell for 1,000parvalueanda41,000.
• The bondholder receives $40 per year for 30 years.
• Payments are typically made in two semi-annual installments of $20 each.
• At the end of the 30-year period, the issuer pays the $1,000 par value to the bondholder.

Treasury Bonds and Notes

• Government of Canada bonds or Canadas
• Maturity: Treasury notes (1-10 yrs), Treasury bonds (10-30 yrs)
• Bonds and notes can be purchased directly from the Treasury.
• Denominations as small as 100,but100, but 100,but1,000 is more common.

Accrued Interest and Quoted Bond Prices

• Quoted bond prices in financial pages are not the prices investors pay.
• If a bond is purchased between coupon payment dates, the buyer pays accrued interest.
• This is a prorated share of the upcoming coupon payment.
• In a semi-annual coupon bond, accrued interest is calculated as: (Annual coupon payment / 2) * (Days since last coupon payment / Days separating coupon payments)

Example (Accrued Interest)

• Suppose a bond has an 8% coupon rate, $40 semi-annual payment.
• 30 days have passed since last coupon payment.
• Accrued interest = 40x(30/182.5)=40 x (30/182.5) = 40x(30/182.5)=6.58
• If the quoted price is 990,theinvoicepriceis990, the invoice price is 990,theinvoicepriceis996.58

Corporate Bonds

• Callable bonds allow the issuer to repurchase the bond before maturity at a specified price.
• This is called refunding. A callable bond typically comes with a call protection period.
• Example: If a company issues a bond with a high coupon rate during high interest rates and interest rates fall later, the company might want to retire the high-coupon debt to issue new bonds at a lower coupon rate to reduce interest payments.

Question

• Suppose Telus issues two identical bonds. One is callable, the other is not.
• The callable bond will sell at a lower price, as investors know the firm can reclaim the bond if interest rates fall.

Convertible Bonds

• Give holders the option to exchange the bond for a specified number of shares of the firm's stock.

Floating-Rate Bonds

• Have interest rates that are reset periodically according to a specified market rate.

Preferred Stock

• Considered equity but often in the fixed-income universe.
• Like bonds, it promises a specified cash flow stream.
• Unlike bonds, its failure to pay the promised dividend doesn't lead to bankruptcy.
• Preferred stock commonly pays a fixed dividend and rarely gives holders full voting privileges in the firm.

Foreign Bonds

• Issued by a borrower from a different country than where the bond is sold.
• Denominated in the currency of the country where it's marketed.
• Called "Maples," "Yankees," "Samurai," or "Bulldogs" in respective countries.

Eurobonds

• Denominated in a currency, usually of the issuer, but sold in other markets.
• Examples include Eurodollars, Euroyen, Eurosterling, EuroCanadian bonds.
• Not regulated by US federal agencies.

Innovation in the Bond Market

• Inverse floaters are like floating-rate bonds, but the coupon rate falls when interest rates rise.
• Asset-backed bonds use proceeds from a specified group of assets to service the debt.
• Catastrophe bonds' payments depend upon whether a catastrophe occurred.
• Indexed bonds tie payments to a general price index or commodity price.
• Examples: TIPS (Treasury Inflation Protected Securities), Canada Real Return Bonds (RRBs).

Principal and Interest Payments for an Inflation-Indexed Bond (TIPS)

• Table showing inflation and corresponding par value, coupon, principal, and total payment over time.

Bond Pricing

• Bond value is the sum of the present values of all future coupon payments and the par value.
  • Note: Coupons are generally paid semi-annually in the US and Canada, annually in Europe.

Bond Pricing: Example

• Price of a 30-year 8% coupon bond (market rate 8%) = $1,000
• Price of a 30-year 8% coupon bond (market rate 10%) = $810.71

Bond Prices and Yields

• Inverse relationship between bond price and yield.
• Interest rate fluctuations are the main risk in the fixed-income market.
• Price curve is convex and becomes flatter at higher interest rates.
• The longer the bond's maturity, the more sensitive its price is to changes in interest rates.

The Inverse Relationship Between Bond Prices and Yields

• Graph showing the inverse relationship between bond prices and interest rates.
• Price of a 30-year 8% coupon bond with semi-annual payments at varying interest rates (8%, 10%, 2%)

Table 14.2: Bond Prices at Different Interest Rates

• Table showing bond prices at different interest rates for various maturity periods. The bond has an 8% coupon with semi-annual payments.

Bond Yields: Yield-to-Maturity (YTM)

• YTM is the interest rate that makes the present value of a bond's payments equal to its price.
• Interpreted as an average return over the bond's life, assuming all coupons are reinvested.

Yield-to-Maturity Example

• 8% coupon 30-year bond selling for $1,276.76
• YTM is 3% per half year (6% bond equivalent yield)
• EAR is 6.09%

Bond Yields: YTM versus Current Yield

• Yield to maturity is a bond's internal rate of return, compound rate.
• Current yield is the bond's annual coupon payment divided by its price.
• Premium bonds (coupon rate > current yield > YTM)
• Discount bonds (coupon rate < current yield < YTM)

Bond Yields: Yield to Call

• Low interest rates: Callable bond price is flat, high risk of repurchase or call.
• High interest rates: Callable bond price converges to a normal bond price, negligible call risk.

Bond Prices: Callable and Straight Bond

• Graph showing the difference in price of callable versus straight bonds over time, with varying interest rates

Bond Yields: Realized Compound Return vs YTM

• YTM equals the realized rate of return if all coupons are reinvested.
• Realized compound return considers the reinvestment of coupon payments.
• Horizon analysis forecasts realized compound yield over various holding periods (time).

Figure 14.5 Growth of Invested Funds

• Graph illustrating the growth of invested funds at different rates.

Prices Path of Two 30-Year Maturity Bonds

• Graph showing how the price of bonds with 12% and 4% coupons, with 30-year maturity, differs over time.

Bond Prices Over Time: YTM versus HPR

• YTM equals average return if bonds are held to maturity; depends on coupon rate, maturity, and par value. All are easily calculated.
• HPR equals the rate of return over a particular investment period; depends on the bond's price at the end of the holding period. This is an unknown future value, and can only be forecasted.

The Price of a 30-Year Zero-Coupon Bond Over Time

• Graph illustrating the price of a 30-year zero-coupon bond over time at a 10% yield to maturity (YTM).

Default Risk and Bond Pricing

• Credit risk (default risk): Risk that a bond issuer will not make all promised payments.
• Rating companies: Moody's, Standard & Poor's, and Fitch.
• Rating categories: AAA (or Aaa) is highest; investment-grade bonds (BBB/Baa and above), speculative-grade/junk bonds (below BBB/Baa)

Default Risk and Bond Pricing (continued)

• Determinants of bond safety:
  • Coverage ratios
  • Leverage ratios (debt-to-equity ratio)
  • Liquidity ratios
  • Profitability ratios
  • Cash flow-to-debt ratio.

Financial Ratios and Default Risk by Rating Class, Long-Term Debt

• Table detailing financial ratios (e.g., EBITDA/Assets, Operating profit margin, Debt/EBITDA) and their relationship to default risk, by rating class (Aaa-C).

Discriminant Analysis

• Financial ratios can be used to predict default risk.
• Edward Altman used discriminant analysis to predict bankruptcy.
• Firms are assigned a score based on financial characteristics. If the score exceeds a cut-off value, the firm is deemed creditworthy.

Altman Z-Score

• Formula: Z = [3.1(EBIT/Assets)] + [1.0(Sales/Assets)] + [0.42(Equity/Assets)] + [1.2(Retained Earnings/Assets)] + [0.72(Working Capital/Assets)]
• Z-scores below 1.2 indicate vulnerability to bankruptcy.
• Scores between 1.23 and 2.90 are a gray area.
• Scores above 2.90 are considered safe.

Bond Indentures

• Sinking fund: Periodically repurchase some proportion of outstanding bonds before maturity.
• Subordination clauses: Restrict the amount of additional borrowing by the firm.
• Dividend restrictions: Limit dividend payments by firms.
• Collateral: Particular asset given to bondholders if the firm defaults.

YTM and Default Risk

• Distinguish between promised yield-to-maturity (YTM) and the expected YTM.
• Promised YTM is realized if the firm meets obligations; expected YTM considers the possibility of default.
• Default premium: Differential in promised yield that compensates the investor for the risk of default.

Yield Spreads

• Graph showing the yield spreads between corporate and 10-year Treasury bonds over time.

Default Risk and CDS

• Credit default swaps (CDSs) act like insurance against default risk for bonds or loans.
• CDSs can be used to speculate on the financial health of entities. This can be seen in the 2008 mortgage crisis.

Default Risk and CDS (continued)

• Natural buyers of CDSs would be large bondholders or banks.
• Speculation may occur on the financial health of entities (e.g., the 2008 mortgage crisis).

Credit Risk and Collateralized Debt Obligations (CDOs)

• CDOs reallocate credit risk within fixed-income markets.
• Bonds are pooled and divided into tranches with different seniority, reflecting relative risk levels.
• Mortgage-backed CDOs were a significant factor in the 2007-2009 financial crisis.

Collateralized Debt Obligations (CDOs) (Table)

• Table detailing typical terms for different tranches in a CDO structure.

Summary

• Fixed-income securities are defined by their promise to pay a fixed or variable stream of income.
• Bonds are usually issued at or close to par value with prices quoted net of accrued interest.
• Callable bonds generally offer higher promised yields than extendable/retractable bonds.
• Convertible bonds often include an option to exchange for shares of stock.

Summary (second page)

• Floating-rate bonds adjust coupon rates based on a short-term interest rate.
• Bond prices and yields have an inverse relationship.
• For bonds with default risk, the stated yield-to-maturity is a maximum possible return.
• Financial ratio analysis is often used to assess bond safety.
• Credit default swaps, or CDSs, provide insurance against bond defaults.
• Collateralized debt obligations (CDOs).