Untitled Quiz

Canadian Securities

• Mohammad Safavi
• Date: November 13, 2024
• Website: safavim.com
• Figure: 289.33

Chapter 14: Bond Prices and Yields

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

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 at maturity
• 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 1,000bondwitha41,000 bond with a 4% coupon rate might sell for 1,000bondwitha41,000
• The bondholder is entitled to a 40annualpayment(or40 annual payment (or 40annualpayment(or20 semi-annually) for 30 years
• At the end of 30 years, the issuer pays the $1,000 par value

Treasury Bonds and Notes

• Bonds issued and guaranteed by the federal government are called Government of Canada bonds or Canadas.
• Treasury notes: 1 to 10 years
• Treasury bonds: 10 to 30 years
• Both 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 publications are not the actual prices investors pay
• If purchased between coupon payment dates, the buyer must pay accrued interest
• Accrued interest is the prorated share of the upcoming coupon payment
• In a semi-annual coupon bond, accrued interest = (Annual coupon payment / 2) × (Days since last coupon payment / Days separating coupon payments)

Example (Accrued Interest)

• If the coupon rate is 8%, annual coupon is 80andsemi−annualpaymentis80 and semi-annual payment is 80andsemi−annualpaymentis40
• 30 days have passed since the last coupon payment, accrued interest = 40×(30/182.5)=40 × (30/182.5) = 40×(30/182.5)=6.58
• If the quoted price is 990,invoiceprice/dirtyprice=990, invoice price/dirty price = 990,invoiceprice/dirtyprice=990 + 6.58=6.58 = 6.58=996.58

Corporate Bonds

• Callable bonds allow the issuer to repurchase the bond before maturity at a specified price

Question

• Telus issues two bonds with identical coupon rates and maturity dates. One is callable, the other isn't. Which sells at a higher price?
• The non-callable bond sells at a higher price. Investors will not pay as much for the callable bond because the issuer can repurchase at a lower price if interest rates fall.

Convertible Bonds

• Convertible bonds give holders the option to exchange each bond for a specified number of shares of the firm's stock

Floating-Rate Bonds

• Floating-rate bonds have interest rates reset periodically based on a specified market rate

Preferred Stock

• Considered equity but often in fixed-income
• Like bonds, preferred stock promises a specified cash flow stream
• Unlike bonds, failure to pay preferred dividends does not lead to bankruptcy
• Preferred stock commonly pays a fixed dividend
• Rarely gives holders full voting privileges

International Bonds

• Foreign bonds are issued by a borrower in one country, but sold in another, denominated in the currency of the market
• Examples: Maple bonds in Canada, Yankee bonds in the U.S., Samurai bonds in Japan, and Bulldog bonds in the U.K.
• Eurobonds are denominated in one currency, sold in other national markets, and not regulated by U.S. federal agencies

Innovation in the Bond Market

• Inverse floaters are like floating-rate bonds, but their coupon rate drops when interest rates rise
• Asset-backed bonds use specific asset income to service the debt
• Catastrophe bonds' final payment depends on whether a catastrophe occurs
• Indexed bonds make payments tied to a general price index or commodity price (e.g., TIPS, RRBs)

Principal and Interest Payments for an Inflation-Indexed Bond or TIPS

• Table shows example payments for an inflation-indexed bond showing increase due to inflation.

Bond Pricing

• Bond value = Σ (Coupon / (1+r)^t) + (Par Value / (1+r)^T)
• The first term is the present value of an annuity
• The second term is the present value of a single amount (final payment)
• Coupons are generally paid semi-annually in the U.S. and Canada, and annually in Europe

Bond Pricing: Example

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

Bond Prices and Yields

• Inverse relationship between bond price and yield: higher yield leads to lower price
• Interest rate fluctuations are the main risk in fixed-income markets
• Price curve is convex, becoming flatter at higher interest rates. The maturity of a bond affects its sensitivity to changes in interest rates

The Inverse Relationship Between Bond Prices and Yields

• Graph shows the inverse relationship between interest rate and the price of a bond

Table 14.2: Bond Prices at Different Interest Rates

• Shows how bond price changes with different maturity and interest rates.

Bond Yields: Yield to Maturity

• Yield to maturity (YTM) is the interest rate that makes PV of bond = Current Price
• Interpreted as average return if held to maturity
• Calculated by solving the bond price equation for the rate

Yield to Maturity Example

• Suppose an 8% coupon, 30-year bond is selling for $1,276.76. What is the YTM?
• YTM= 3% per half year
• Bond equivalent yield = 6%
• EAR = 6.09%

Bond Yields: YTM vs Current Yield

• Yield to maturity (YTM): Bond's internal rate of return, reflects expected compound return over the bond's life, assuming reinvestment of coupons at the same rate
• Current yield: Bond's annual coupon payment divided by its price; a proxy for the average return
• Premium bonds: Coupon rate > current yield > YTM
• Discount bonds: Coupon rate < current yield < YTM

Bond Yields: Yield to Call

• Lower interest rates: The price of a callable bond stays flat or low as the risk of a call is high.
• Higher interest rates: The price of a callable bond converges to that of a normal bond, as the risk of a call is low

Bond Prices: Callable and Straight Bond

• Graph illustrating how the price of a callable bond is typically lower than a straight bond at any given interest rate.

Bond Yields: Realized Compound Return vs YTM

• YTM equals the realized rate of return if all coupons are reinvested at that rate
• Realized compound return is the compound rate of return if coupons are reinvested at variable rates, or until maturity
• Horizon analysis is forecasting realized compound yield over various holding periods.

Figure 14.5 Growth of Invested Funds

• Simple example of a future value calculation, emphasizing the effect of different reinvestment rates.

Prices Path of Two 30-Year Maturity Bonds

• Graph showing the price path of two 30-year bonds (4%, 12%) over time; the price approaches par value as the maturity date nears.

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
• HPR: rate of return over a particular investment period, depends on the bond's price at end of holding period; can only be forecasted

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

• Chart of zero-coupon bond prices over time. Price rises to the par value at time T

Default Risk and Bond Pricing

• Credit risk (default risk): Risk that the bond issuer will not make all promised payments
• Rating companies: Moody's, Standard & Poor's, and Fitch
• Rating categories: Highest is AAA (or Aaa), others rated BBB/Baa (investment grade), those rated below are speculative/junk

Default Risk and Bond Pricing (continued)

• Bond safety determinants: Coverage ratios, leverage ratios (debt-to-equity), liquidity, profitability, and cash flow-to-debt ratio

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

• Table of financial ratios for different bond ratings (Aaa, Aa, A, Baa, Ba, B, C)

Discriminant Analysis

• Financial ratios can predict default risk (Altman used discriminant analysis to predict bankruptcy)
• Firms are assigned a score based on financial characteristics; if scores are above an established cut-off, they are considered more creditworthy.

Altman Z-Score

• Formula for calculating the Z-score
• Z-scores below 1.2 indicate bankruptcy vulnerability
• Z scores between 1.23 and 2.90 are in a gray area.
• Z-scores above 2.90 indicate safety

Bond Indentures

• Sinking fund: Issuer periodically repurchases some proportion of outstanding bonds prior to maturity.
• Subordination clauses limit additional borrowing.
• Dividend restrictions limit dividends paid by a firm.
• Collateral is a particular asset that bondholders receive if the firm defaults.

YTM and Default Risk

• The YTM only considers the bond's promise to repay in the future.
• The expected YTM considers the default risk; this is found by adding a default premium
• A default premium compensates the investor for the risk of default.

Yield Spreads

• Graph showing the spread between high yield, Baa-rated, and Aaa-rated bonds over time

Default Risk and CDS

• Credit default swaps (CDS) act like insurance against bond default risk
• Allows lenders to protect against default risk
• Risk structure of rates and prices are closely tied for CDS contracts

Summary

• Fixed-income securities are distinguished by their promise to pay a fixed stream of income.
• Bonds are issued at or near their face value. Callable bonds offer higher promised yield to maturity.
• Extendable and retractable bonds give the bondholder option over the bond duration.
• Convertible bonds can be traded for equity shares.

Summary (part two)

• Floating-rate bonds pay a coupon rate linked to a short-term interest rate.
• Bond prices and yields have inverse relationships. Bond safety is evaluated using financial ratio analysis.
• Credit default swaps provide risk protection against bond defaults.
• Collateralized debt obligations (CDOs) allocate credit risk from a pool of loans.