Canadian Securities Ch14 PDF

CANADIAN SECURITIES MOHAMMAD SAFAVI Date: November 13, 2024| Website: safavim.com 1  Chapter 14 Bond Prices...

CANADIAN SECURITIES MOHAMMAD SAFAVI Date: November 13, 2024| Website: safavim.com 1  Chapter 14 Bond Prices Chapter Title and Yields INVESTMENTS | BODIE, KANE, MARCUS, SWITZER, BOYKO, PANASIAN, STAPLETON Slides 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 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-3  Bond Characteristics A bond is a security that is issued in connecting with a borrowing arrangement – Issuer agrees to make specified payments to the bondholder on specified dates Par value (i.e., face value) is the payment to the bondholder on the bond’s maturity date Coupon rate is a bond’s interest payments per dollar of par value Bond indenture is the contract between the issuer and the bondholder INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-4 Example To illustrate, a bond with par value of $1,000 and coupon rate of 4% might be sold to a buyer for $1,000. The bondholder is then entitled to a payment of 4% of $1,000, or $40 per year, for the stated life of the bond, say, 30 years. The $40 payment typically comes in two semi-annual installments of $20 each. At the end of the 30-year life of the bond, the issuer also pays the $1,000 par value to the bondholder. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-5  Treasury Bonds and Notes Bonds issued and guaranteed by the federal government are called Government of Canada bonds or Canadas. Maturity – Treasury notes – 1 to 10 years – Treasury bonds – 10 to 30 years Both bonds and notes may be purchased directly from the Treasury Denominations – As small as $100, but $1,000 is more common INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-6  Accrued Interest and Quoted Bond Prices The bond prices that are quoted in the financial pages are not actually the prices that investors pay for the bond. If a bond is purchased between coupon payment dates, the buyer must pay the seller for accrued interest which is the prorated share of the upcoming coupon payment. In a semi-annual coupon bond, accured interest: INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-7 Example Suppose that the coupon rate is 8%. Then the annual coupon is $80 and the semi-annual coupon payment is $40. Because 30 days have passed since the last coupon payment, the accrued interest on the bond is $40 x (30/182.5) = $6.58. Alternatively, using the annual coupon amount, we can calculate $80 x 30/365 = $6.58. If the quoted price of the bond is $990, then the invoice price or dirty price will be $990 + $6.58 = $996.58. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-8  Accrued Interest and Quoted Bond Prices (continued) The quoted price is also called flat price. The invoice or total price paid is also called the dirty price. Example: A semi-annual coupon bond with 8% coupon rate. – Days passed since last coupon payment is 30 days – Accrued interest = $80/2 * (30/182.5) = $6.58. – If the quoted price is $990, then the invoice price will be $990+$6.58 = $993.58. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-9  Corporate Bonds Callable bonds Some corporate bonds are issued with call provisions that allow the issuer (borrower) to repurchase the bond at a specified call price before its maturity date. For example, if a company issues a bond with a high coupon rate when market interest rates are high, and interest rates later fall, it might like to retire the high-coupon debt and issue new bonds at a lower coupon rate to reduce its interest payments. This is called refunding. A callable bond typically comes with a period of call protection, an initial time during which the bond is not callable. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-10 Question Suppose that Telus issues two bonds with identical coupon rates and maturity dates. One bond iscallable, whereas the other is not. Which bond will sell at a higher price? The callable bond will sell at a lower price. Investors will not be willing to pay as much if they know that the firm retains a valuable option to reclaim the bond for the call price if interest rates fall. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-11  Corporate Bonds Convertible bonds give holders option to exchange each bond for a specified number of shares of the firm’s stock Floating-rate bond has interest rate that is reset periodically according to a specified market rate INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-12  Preferred Stock 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 bankruptcy ▪ Dividends owed simply cumulate – Preferred stock commonly pays a fixed dividend – Rarely gives holders full voting privileges in firm INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-13  International Bonds Foreign Bonds – Issued by a borrower from a country other than the one in which the bond is sold – Denominated in the currency of the country in which it is marketed – Called Maples in Canada, Yankees in the U.S. , Samurai bonds in Japan, or Bulldog bonds in the U.K. Eurobonds – Denominated in one currency, usually that of the issuer, but sold in other national markets; e.g., Eurodollar bonds, Euroyen bonds, Eurosterling bonds, EuroCanadian bonds – Not regulated by U.S. federal agencies INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-14  Innovation in the Bond Market 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 of assets to service the debt Catastrophe bonds’ final payment depends on whether there has been a catastrophe Indexed bonds make payments that are tied to a general price index or the price of a commodity – Treasury Inflation Protected Securities (TIPS) Indexed Bonds – Canada Real Return Bonds (RRBs) INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-15 Principal and interest payments for an inflation-indexed bond or TIPS INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-16  Bond Pricing First term of right-hand side of equation is the present value of an annuity Second term is the present value of a single amount, the final payment of the bond’s par value Note: In general, coupons are paid semi-annually in the U.S. and Canada and annually in the Europe. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-17  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% 60 $40 $1000 Price =  + t =1 (1.05) (1.05) t 60 Price = $810.71 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-18  Bond Prices and Yields 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 The price curve is convex and becomes 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 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-19 The Inverse Relationship Between Bond Prices and Yields Figure 14.3 The inverse relationship bond prices and yields. Price of an 8% coupon bond with 30-year maturity making semiannual payments INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-20  Table 14.2: Bond Prices at Different Interest Rates Bond Price at Given Market Interest Rate: Time to Maturity 2% 4% 6% 8% 10% 1 year 1,059.11 1,038.83 1,019.13 1,000.00 981.41 10 years 1,541.37 1,327.03 1,148.77 1,000.00 875.35 20 years 1,985.04 1,547.11 1,231.15 1,000.00 828.41 30 years 2,348.65 1,695.22 1,276.76 1,000.00 810.71 Bond prices at different interest rates (8 % coupon bond, Coupon paid semiannually) INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-21  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 T C Par Value PB =  + t =1 (1 + r )t (1 + r )T INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-22  Yield to Maturity Example Suppose an 8% coupon, 30-year bond is selling for $1,276.76. What is the YTM? T C Par Value PB =  + t =1 (1 + r ) t (1 + r ) T $1276.76 =  60 $40 1000 + t =1 (1+ r ) (1+ r ) t 60 ▪ r = 3% per half year; ▪ Bond equivalent yield = 6% ▪ EAR = ((1.03)2) - 1 = 6.09% INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-23  Bond Yields: YTM vs Current Yield Yield to maturity – Bond’s internal rate of return – Interpreted as compound rate of return over life of the bond assuming all coupons can be reinvested at that yield – Proxy for average return 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 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-24  Bond Yields: Yield to Call Low Interest Rates: The price of the callable bond is flat since the risk of repurchase or call is high High Interest Rates: The price of the callable bond converges to that of a normal bond since the risk of call is negligible INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-25 Bond Prices: Callable and Straight Bond INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-26  Bond Yields: Realized Compound Return vs 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 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-27 Figure 14.5 Growth of Invested Funds INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-28 Prices Path of Two 30-Year Maturity Bonds INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-29 Bond Prices Over Time: YTM versus HPR YTM HPR It is the average It is the rate of return return if the bond is over a particular held to maturity investment period Depends on coupon Depends on the bond’s rate, maturity, and par price at the end of the value holding period, an unknown future value All of these are readily Can only be forecasted observable INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-30 The Price of a 30-Year Zero-Coupon Bond Over Time INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-31  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 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-32  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 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-33 Financial Ratios and Default Risk by Rating Class, Long-Term Debt INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-34  Financial Ratios and Default Risk by Rating Class, Long-Term Debt (1 of 2) Aaa Aa A Baa Ba B C EBITA/Assets (%) 20.9% 15.6% 13.8% 10.9% 9.1% 7.1% 4.0% Operating profit margin 22.0% 17.1% 17.6% 14.1% 11.2% 8.9% 4.1% (%) EBITA to interest 28.9% 15.1% 9.7 5.9 3.5 1.7 0.6 coverage (multiple) Debt/EBITDA (multiple) 0.58 2.03 1.83 2.58 3.41 5.26 8.35 Debt/(Debt + Equity) 19.3% 50.2% 38.6% 46.2% 51.7% 72.0% 98.0% Funds from operations/Total debt 1.335 0.385 0.425 0.296 0.206 0.120 0.031 (multiple) Retained cash flow/Net 1.3 0.3 0.4 0.3 0.2 0.1 0.0 debt (multiple) INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-35  Discriminant Analysis Can financial ratios can be used to predict default risk? Edward Altman used discriminant analysis to predict bankruptcy – Firm is assigned a score based on its financial characteristics – If score exceeds cut- off value, the firm is deemed creditworthy INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-36  Altman Z-Score 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 𝑍 = 3.1 + 1.0 + 0.42 𝐴𝑠𝑠𝑒𝑡𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑅𝑒𝑡. 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 0.85 + 0.72 𝐴𝑠𝑠𝑒𝑡𝑠 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 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-37  Bond Indentures Sinking fund calls for the issuer to periodically repurchase some proportion of the outstanding bonds prior to maturity Subordination clauses restrict the amount of additional borrowing by the firm Dividend restrictions limit the payment of dividends by firms Collateral is a particular asset that the bondholders receive if the firm defaults INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-38  YTM and Default Risk 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 – Expected YTM must consider the possibility of a default 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 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-39  Yield Spreads INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-40  Default Risk and CDS Credit default swap (CDS) – Acts like an insurance policy on the default risk of a bond or loan – Allows lenders to buy protection against default risk – Risk structure of interest rates and CDS prices ought to be tightly aligned – CDS contracts trade on corporate as well as sovereign debt INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-41  Default Risk and CDS (continued) Natural buyers of CDSs would be large bondholders or banks that wish to enhance the creditworthiness of their outstanding loans But, CDSs can also be used to speculate on the financial health of particular issuers – An example of this behavior would be an investor in early 2008 who predicted the imminent financial crisis and purchased CDS contracts on mortgage bonds INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-42  Credit Risk and Collateralized Debt Obligations (CDOs) Collateralized debt obligations (CDOs) – Major mechanism to reallocate credit risk in the fixed-income markets – To create a CDO, a legally distinct entity to buy/resell a portfolio of bonds must be established; Structured Investment Vehicle (SIV) – Loans are pooled together and split into 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 2007-2009 INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-43 Collateralized Debt Obligations INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-44  Summary Fixed-income securities are distinguished by their promise to pay a fixed or specified stream of income to their holders. Bonds are issued at or near par value, with their prices quoted net of accrued interest. Callable bonds should offer higher promised yields to maturity Extendable and retractable bonds give the bondholder rather than the issuer the option to extend or reduce the life of the bond. Convertible bonds may be exchanged, at the bond- holder’s discretion, for a specified number of shares of stock. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-45  Summary Floating-rate bonds pay a coupon rate with reference to a short-term interest rate. Bond prices and yields are inversely related. When bonds have default risk, the stated yield to maturity is the maximum possible yield to maturity that can be realized by the bondholder. Bond safety is often measured using financial ratio analysis. Credit default swaps provide insurance against the de- fault of a bond or loan. Collateralized debt obligations are used to reallocate the credit risk of a pool of loans. INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited 14-46