Module 4 - Fixed Income PDF

Module 4 - Fixed Income RBA are a central bank. They oversee monetary policy and regulate banks and ensure financial stability. Money Market Identify and Explain the Contributions of the Money Market to the Financial System Part A. The Role of the Money Market The money market is the market for Shor...

Module 4 - Fixed Income RBA are a central bank. They oversee monetary policy and regulate banks and ensure financial stability. Money Market Identify and Explain the Contributions of the Money Market to the Financial System Part A. The Role of the Money Market The money market is the market for Short Term Debt Securities. Money market is the smallest of the markets we consider, but important due to it;s relationship with the banking system, with the RBA and as the market where Short Term Interest Rate Benchmarks are determined Biggest participants in the money market is the RBA. - RBA participates due to this being one of the ways they can control monetary policy.. - Through this they can manage the Australian dollar and our credit system It is not a retail market, meaning it does not serve household, but is mainly used by banks, the RBA and fund managers APRA regulates and supervises the financial markets and institutions financing moneymarketiation financing -Through direct Indirect - - The Role of the Money Market 1 Contribution to the Flow of Funds; Arranges direct financing through the issue of short term debt securities and is a low risk asset class for investors. - The money market enables direct financing in wholesale amounts through the issue of low risk, ST, tradable debt securities. 1 The largest issuers are the banks, who issue negotiable certificates of deposits (NCDs) 2 Banks also help companies borrow from the market through their acceptance of bills (Bank Accepted Bills - BABs) - Banks don’t issue these, they endorse the companies who issue them. Banks endorsing increases credit worthiness 3 State and Commonwealth governments also use the market. Aus Government issues short term securities called Treasury Notes. - Government issue these to help manage their short term cash flow needs specifically to fund government expenditure in the short term. - We have three different short term money market instruments as they are unique in that thy are issued by three different Instructions. - As these ST term instruments are expire over 30, 60, 90 day time periods, they are then rolled over and so financing can be provided for longer periods of time. Wouldn’t need to issue a new one, this is important for institutions that finance themselves - Fund managers have investment portfolios on behalf of clients and they invest in the ST term instruments in the money market to access Short Term gains and to add liquidity t the portfolio in addition to shares and long term bonds as these are illiquid. - The GFC highlighted how the financial markets have a need for risk assessment and regulation due to market stability and this is done through the money market. 2 Contributions to the Banking System; Provides the banking systems with a source of wholesale funds and a low risk market for their liquid reserves. - The money market holds the banking system’s liquid reserves including loans to the inter-bank overnight market and securities that can be used in repos with the RBA. Enables banks to meet their reserve requirements. Reserves can be fulfilled by participating in the money market - Banks use repurpose agreements where they sell securities to mainly RBA with an agreement to repurchase them later to provide ST funding. - The money market is a source of funds for banks. They raise funds through the issue of NCDs and it enables banks to sell the bills they accept to investors. 3 Benchmark Rates; Performs price discovery by identifying short term benchmark rates - A benchmark rate is important as in the financial market, its important for us to have a single rate to which we can anchor other rates from - A base rate is taken and this is used as an anchor any rates from - Money market assigned this anchor rate through The Bank Bill Swap rate (BBSW) which is a key financial rate over the short term. - BBSW is relatively new in Aus as a benchmark and is trustworthy and more accurate. We used to have LIBOR (London Inter Bank Offered Rate) but there was too much manipulation by dealers causing 9b$ worth of fines. LIBOR revealed vulnerability in global financial markets and highlighted the need for Aus to have top quality oversight and regulatory such as ASIC. They ensure we have fair practice in financial markets. - BBSW is the rate at which BABs and NCDs are transacted in the market. They are calculated for 1-6 month tenor - BBSW is administered by ASC Benchmarks LTD - BBSW is designed to measure the price at which Prime Bank eligible securities trade in the open market between 8:30 and 10am on a Sydney business day. Top NCDs would trade at these rates. 4 Relationship with the RBA; Enables the RBA to implement monetary policy and so influence the economy. - The money market is the main channel through which the RBA’s monetary policy is transmitted Part B. Money Market Securities - Less than 1 year, single FV PMT at end. Different between PV and FV is INT. Involves Short Term securities with maturity term less than a year and make a single face value payment at maturity They are issued at a discount to their face value - Investors earn a return by purchasing them and later reselling for a higher price, or by holding them until they mature and receiving their face value. Money market securities have low credit risk even though they are mostly unsecured. Issued by institutions that are very credit worthy, trustworthy e.g. government and banks 1) Bank Securities a) NCDs - Issued predominantly by financial institutions; mostly banks. - By banks issuing NCDs, it helps diversify their funding sources meaning they dont rely just on deposits - APRA participate and monitor the NCDs to ensure the safety and stability of the financial institutions along with the banks that issue the NCDs. - Funds deposited for fixed time - Tradeable certificate issued stating amount to be repaid on maturity date. Info - NCDs represent over 80% of money market securities. Weight demonstrates importance of facilitating ST financing and managing liquidity - Wholesale buyers of NCDs are then enabled to sell or trade the NCDs in 2nd market to enhance liquidity - They become a source of bank funds b) Bank Accepted Bills (BABs) - A legal commitment by a third party to stand behind a borrower’s obligation to pay the bill’s face value at the specified future date - Alternative source of funds for borrowers to a bank loan - Bank guarantee the bills (issued by commercial borrowers and accepted by banks) will be redeemed at maturity. - Not a source of bank funds. - BAB issues by company but company has lack of credibility and instrument is not as liquid as an NCD, therefore bank guarantees the BAB will be paid when it matures. As the bank guarantees this, this then becomes lower risk and more liquid meaning it can then be traded in the money market. - Serve as way for borrowers to access ST funds with benefit of endorsement from established bank for a commission - If payment cant be honoured, bank will step in and accept it - Attractive for borrowers looking for ST term financing, looking for lower cost loans - Reduces credit risk for investors of BABs and new credit risk depends on credit standing of accepting bank - Borrowers pay acceptance fee normally as an add no yield Info - Like loans, BAB process exposes bank’s to borrower’s credit risk but differs as accept can sell bills to investors in the money market so that the borrower’s funds are supplied by investors. - Bill acceptance numbers and BABs sold has fallen since GFC - BAB trades as an unsecured instrument but acceptor usually requires security for the borrower. Bill Facilities - Borrowers use bills to raise funds for longer periods than the bill term by using a bill facility; An agreement by acceptor to rollover bills on maturity date for an agreed period. - New bills are issued to raise funds to repay the maturing bills - Int PMTs are required at each rollover date, equal to FV less proceeds from replacement bill or FV of previous bill. - Useful for cash flow - People rollover instead of borrowing for the total period as borrowers may not know the total amount of money they’ll need for 270 days and can therefore only estimate for 90. 2) Treasury Notes - ST Securities issued by the Treasury on behalf of Cmwlth Gov - Help Gov meet ST finance needs - Issued through competitive tender where bids invited form money market dealers - Lowest bidders are successful given bids are expressed as yields - T-Notes are considered risk free and so trade below the Bank Bill Swap Rate. - Risk free as its highly unlikely that Aus gov will fail on debt obligations Procedure - As a registered market participant like a financial institution, they would go online submit a bid and whichever bid that pays the highest yield will be successful. 3) Other Non-Gov Issues Securities a) Commercial Paper; Raise ST funds for working capital, to finance debtors/inventory - Promissory notes issued by low risk, non financial companies - Trade at yields around or above BBSW, depending on issuer risk - Bank acceptance Bills are guaranteed by bank but commercial paper is not - Higher yield and can effect credit worthiness of issuing company b) Asset Backed Commercial Paper - Promissory notes issued by SPVs and secured by specified assets, mainly residential mortgages. - Issued by company - Can buy it form financial institution and if the company defaults, there will be a security linked to it 4) Repurchase Agreements - Repos are an arrangement to sell securities on the basis that they are repurchased at a later date at a higher agreed price - Provides short term finance for seller (the security issuer) from the buyer (cash provider) - Periods vary from intra-day, 1/2/3 day, to a number of months - MST repos use Commonwealth Gov bonds - They are used extensively by RBA but also by fund managers and bond dealers. - RBA involvement enables them to infer short term interest rates and manage stability in financial system. - Contract where deficit/seller/securities provider will sell asset like government bonds as collateral to surplus/buyer/cash provider, with the intention of buying it back from them the following day or over a short time period. The seller will repay buyer the funds for the bonds returned plus the interest for holding them. - Repo rate is interest paid - Ability for banks to use gov bonds as collateral in repos enhances market liquidity and supports efficient trading in these securities. - Diversity in participants use of repos identifies importance of having financial stability and liquidity - E.g. April 2027 Aus Treasury bonds used as the repo collateral to borrow 1 mil for 5 days -> Cost of funds or int rate is 2.25% Money Market - Retail Investments (ETFs) Where individual retail deposits are pooled so that they can take part in investing in higher return money market instruments like; - AAA - Australian High interest cash - BILL - iShares Core Cash ETF - ISEC - ishares Enhanced Cash ETF They offer advantages go like liquidity, diversification, ease of trading Describe the Money Market’s Trading and Settlement Arrangements Part C. Trading and Settlement Arrangements An OTC market is where money market instruments trade in OTC is where dealers trade on their own behalf in making a market for wholesale clients - The main dealers are the majors, foreign-owned banks, specialist investment and merchant banks - They trade from their own dealing rooms mostly by phone OTC markets provide flexibility, but provide risk including counter party risk form transacting with someone else. Trading protocols specified by AFMA Dealers hold an inventory of securities (and so can provide immediacy) and earn interest and trading income. Dealer s quote their bid and offer yields as a simple interest yield. - Usually spread is only a few basis points - Yields and prices are inversely related, they bid high and offer low - The yield is then used to calculate the settlement price, helps know efficiency of market - Buy at a higher yield = low price, sell at a lower yield - higher price Austraclear is the market’s clearinghouse and arranges settlement on a same day (T + 0) basis. They ensure we have smooth functioning of financial markets by management settlement clearing and transitioning Calculate and Analyse the Returns from Investments in Short Term Securities Part D. Investment Yields Main component of investment returns is the interest earned - this is implicit, since security prices trend up over time to their FV - If securities are held to maturity, interest is only return; Therefore, they earn the yield at which securities were purchased. Fixed income - income received in form of interest If security was held for full maturity, investor receives interest earned along with final face value of instrument. Becomes predictable stream of income for investors. Fin Maths Yield to Maturity (YTM); Analysing Holding Period Investment Yields - When securities are sold before maturity, the return to investors will conclude interest but may also include capital gains or losses. - Risk of capital loss is price risk - Capital gains and losses rise form changes in the market yield - If a security is sold at a lower yield (than purchased), a capital gain is achieved and vice versa - Sold at lower yield than purchased = Capital gain. OR Sold at higher yield than purchased = Capital Loss - Actual yield achieved is holding period yield and is usually different from the YTM at commencement Price Risk in Holding Period Yields - Price risk arises from random movements in int rates, it’s impact is reflect in security’s tick value - Tick Value is the change in price caused by a one basis point change in yield - it is the smallest change that can arise in the market value or a security. - Observe; Tick values and price risk ate greater for longer term securities * price risk can be avoided by holding security until maturity - Yield of 5% changing to 5.01% will cause a price decrease Explain the Influence of Monetary Policy on Shot Term Interest Rates Part E. Short-Term Interest rates and Monetary Policy Monetary Policy The main objective of monetary policy is low inflation with a target range of 2%-3% on average, over the medium term - Other objectives are low unemployment and stable economic growth - The RBA’s tool is the target cash rate; which it reviews at it’s monthly meeting and adjusts; - Upwards if inflationary pressures exceed it’s target - Downwards when the economy could grow faster without posing an inflation problem - Aus gov and RBA work together in mission to achieve economic and monetary policy objectives that benefit Australia 3 Objectives of Monetary Policy and the Principal Objective The RBA aims in the implementation of monetary policy are; - Low inflation, low unemployment, level of economic growth that is consistent with low finlation Its principal objective is low inflation, specifically to maintain an inflation rate of between 2-3% on average over the medium term. Relationship with the RBA Monetary policy exerts considerable influence on the economy through a complex transmission process. - First Phase; - Cash rate setting impacts Interest rates generally - Second Phase; - Interest rates generally impacts Economic activity and inflation setting Implementing Monetary-Policy Decisions RBA announces at 2:30pm on the 1st Tuesday of every month, except January, the board’s decision on the cash rate. If the cash rate is changed, the next day, it conducts market operations to ensure the new target is reached - To increase the cash rate, the RBA uses repos “sell securities” to withdraw funds from the interbank market and similarly, repos “buy securities” to decrease the cash rate. The Relationship Between the Cash Rate and the Main Short Term Interest Rates The main interest rates influenced by the cash rate are; 1 Bank Bill Swap Rate 2 Variable Rates on Housing Loans 3 Variable rates on Business Loans Influence of Monetary Policy on Short Term Interest Rates Business cycle and risk premiums impact short term rates but monetary policy has greatest influence The aim of monetary policy is to keep inflation within a zone of 2-3% over medium term. RBA is responsible for implementing this and does so by changing its cash rate target and by conducting market operations like repos buy and sell agreements to reinforce the movement in the cash rate to align with the new target rate. Changes to the cash rate influence interest rates general over a short time period, these impact the economy and inflation over a longer time period. Workshop Notes Part B. Money Market Securities Bank Securities 1) Negotiable Certificates of Deposits - Funds are deposited for a fixed time and a tradeable certificate is issued stating the amount to be repaid and maturity date - NCDs represent over 80% of securities in money market - Wholesale deposits become tradeable securities - They are a source of banks funding. - Formula - Example 1) 90 Day NCD with FV of $100 at yield of 6% p.a P 100 = 1 p = (6 86 99/365) + x. $98 54. 2) 90 Day NCD with FV of $100 at yield 3% p.a p 18 G = (0 83x 90/365) $99 27 1 P = +.. 2) Bank Accepted Bills - Alternative source of funds to borrowers apart from a bank loan - Bank guarantees the bills but are issued by commercial borrowers and accepted by banks\ - Redeemed at maturity - Not a source of bank funding as the money doesn’t come from them. - Formula; Price Paid (P) by an investor for BABs is calculated as; - Example ↑ 1 3% 1) A bank accepts a company’s 90 day bill with FV of $10mil for an acceptance fee of 130bps and sells it in the money market at 3%. What is the Price paid by buyer? What is amount received by borrower?. Ppaidby bUyer = D =10000000/365) $9 : , 926 5: , Methodand - Amount received by : p 18600000 = borrower : Bank acceptance fee (10 1 = -. $9 03 + 0 , =. 813) x 98/365) 926, 571 $31. 00 -$9 486 00 ,. $9 , 895 , 085 2) 3) 895 085 88 ,. , amount F/1 + paid by buyer of bl ol diny) (Mrate Amount received by borrower is forfee fund Acceptor = /1 ((Mrace DP) : + PV+accep = lang) He= Borrower PV-buyer P 3 90 days - Bill Facility Example 1) NAB agrees to establish a 270 day bill facility for a company using 90 day bank bills - FV is $5 mil ad company is charged acceptance fee of 95 basis points (0.95%) - First parcel is issued at market yield of 3%, second at 3.25% and third at 3.50% - What are the bill proceeds? What are the net cash flows for the company over the 270 days? x Bill proceeds 8- 98d P Pl * remember 5008 888 - , 7+ (0 03. 44 = , : 0 0895) 98/365] +. ↳ 951 , 771 88. bill rollover usee Initial #) as borrowed amount Pz 5006 088 = 1 P3 + (8 8323 x , 8 8845 98/365 x.. $4 - 948 , 758 88. 5000000 : -" ,888350. 0095 x 97 e difference Net Cash HOWS are all Int. PMTs The risk -Pay $5M-P2 = Pal $5M-P3 $54,268 $51 , 168 / f Receive P, u Rose new interest rate at each rollover as intial rate Pay $5M during no longer currenta feasible.' With P1U growing Intrakes the borrowers will lose more in Int us I ( 277 188 9f financing strategy that borrowers must = ( in this opposed bill to just borrowing a. longer period Part C. Trading and Settlement Arrangements Demonstration of the Dealer’s Spread - Example 1) Suppose a dealer buys a parcel of $50 million 90 day NCDs at their bid of 3.89% and sells the parcel a short time alter at their offer of 3.85%. The dealer’s buying price is? Their selling price is? How much have they made? I bod what they're willing1 Duy bills for 50000000 p = , bid 16 $49 ↓ ~ Potter · Round 6389 + 98/365 574 967 37 ,. , 50000 806 : -. ↓ /3. 8385 x 98/365) $49 , 529 , 886 Trip Profit : ~ =. 09 (sell) Offer $49 $4 , 529 886 89. , 838 7. , bid - (bub) price - $49 574 967 37 , ,. What is a Security’s Tick Value and how Does it Reflect the Price Risk of an Investment in the Security? The tick value is the change in a security’s price that arises from a one basis point change in the yield. It is an indication of price risk, with greater tick values (price changes) reflecting greater risk. Greater tick value means it is subject to grater price changes Tick values and price risk are positively related to the security’s term - Example: Tick Value 1) Compare the Tick Value of a $100million Parcel of 180 day BABs with that of a $100 Million parcel of 30 day BABs given the interest rate increased from 3.50% to 3.51% Part D. Yield Investments Yield to Maturity - Formula - Example #F 1) Demonstrate that a purchase of a $10million parcel of 90 day NCDs at 6.5% and held until maturity, will earn a YTM of 6.5% him rearranged) P, = roo 365) - > = $9 872 , 154 28. , (400000 2g 1) x -. - 0 865. 6 5%. Holding Period Yield (HPY) - Example 1) Suppose the 90 day security purchased at 6.5% for $9,842,254.28 was sold 20 days later at 6%. The holding period yield would be calculated as? How much has the investment earned? What are its components? Psell: , 1000000/305) $9 - = HPV V = 886 240 52 ,. , 18888888 I 9886240 54 1) 365 = 0 0816 or 8 16% :. -.. Investment has earned 8 16% 80 $43, 986 In => This has interest a capitul gain component... 2) Calculate the holding period yield, the accrued interest and the capital gains or loss form an investment in a 90 day bill with a face value of $50 million purchased at 3.20% and sold 30 days later at 3.30% Puy a) 50000000 = 1 +0 032. ↑ sell HPV(r) b) : 98/366) 50000000 = 30 nays/ er1 + + 0. 833 (1 + - = 60/362) P sell-Pbuy or = 738, 230 53 , 688 , 568 81.. 53 in 2. 98 % price of 30 over 30 day investment sry price days , 49688568 81. - = 832 assuming $179 market. We know interest accumulated was gain) Profit loss is : or Loss = 49 738 , 230 53 ,. price of beig in of 30 as interest. 58 accumulated - , - - - $179 , 794 121 , 662 52 119 , 744 58 $8 , 132 86 - Loss :. , Therefore capital Bell-Pany = - b) al in 794 58 we know investment made profit of 49738230 53 44608568 81 $121 662 52. yield remained. , lossi one a) FROM Cap Gain s 1) -. /$50680688 18 x68/365) ↓.. 49688568 81 - 1+ Cap Gain $49 , as 2) , ) 35 149738730 earned is change price end purchase yield = $49 = int interest = - ($5010 1.. mil. 032 x60/365) = - $8 , 132 06. (los) price a end of 38 ds 3) Suppose that the 90 day base bill swap rate just increased from 3.80% to 4.1%.What does this imply for the prospective investors, and the investors holding money market securities? - A rate rise is good for prospective investors since it increases the interest return from future investments. - It is bad for existing investors because it lowers their selling price (due to inverse relationship between prices and interest rates) if they choose to sell before maturity Module 5 - Fixed Income Bond Market Part 1 Part A. Introduction to the Bond Market Money Market = ST Bond Market = LT - Cash Rate = ST Int rate determined by RBA - A spread graph show s the difference of between the rate of the given investments. Fixed Income - Form of fixed income as they pay regular interest payments Introduction to the Bond market Long term Coupon Rate is dependent on market conditions and Fixed interest/coupon payments cash rates are at the time of the issue of the bond. Pay FV at maturity Many types but focus on Treasury Bonds Other issuers are state governments, companies (financial institutions), foreign entities. Bond issuing of non-government bonds and Australian bonds in Aus, increased after GFC - Gov bonds most popularly bought due to low risk and quality. These are safer investments for banks and investors - Majority of Aus bonds at AAA, AA and A fairly safe overall Non financial corporate bonds = Non banks = Qantas, BHP, Netflix etc. Contribution of the Bond Market Contribution to the flow of funds: enables wholesale borrowers to raise large sums for long periods and by being a defensive asset class for wholesale investors. - BILLIONS OF DOLLARS OVER 20-30 YEARS - Defensive asset they pay fixed interest which is safe and secure for investor. Lower risk lower return - Most Aus bonds are low credit risk (high ratings) due to being issued by stable, secure institutions. - Risk for institution to default on coupon payments of bonds - Market risks arise from changes in yields. Contribution to Price Discovery: revealing level of long term default free interest rates and credit spreads. Rather than discovering cost we discover the default interest rates. - Informs borrowers of cost and investors of return of long term funds. - Generally Aus Treasury Bonds have higher yields than US Gov bonds due to higher risk. Shouldn’t be much difference as both rated AAA, differences today are due to exchanged rates, imports, exports, economic conditions etc. 1 Default Free Interest rates; Revealed by trading Treasury Bonds, with the 3 year and 1 year yields being the benchmark rates - Market for Treasury Bonds is very liquid which enhances the quality of price discovery - Treasury Bonds are issued by gov and therefore assumed gov will not default on coupon int and FV of bonds. - Default free term is the risk free interest rate (CAPM) also used in Black Scholls Martin Model 2 Credit Risk Premium; Trading in semi-government and non-government bonds reveals the size of credit risk premiums which trade at higher yields than Treasury Bonds. - Credit Spreads (Yield Spreads) show margin above the default free rate a borrower has to pay because of their credit rating. - Credit spread narrow before GFC and increased durin - Risk premium is added to the default risk free rate Part B. Trading and Settlement Trading and Settlement A wholesale, over the counter market where dealers are market makers that operate according to the Australian Financial Markets Association protocols due to the large size, amount of bonds. Dealers; - Have their own supply of bonds - Trade by telephone or increasingly using system called Yieldbroker - clients trade with each other - Quote or post bid-offer yields on a semi annual compound basis - Trade with wholesale clients and each other Transaction occurs and then Settlement (incl. payment) is arranged by Austraclear on a T + 2 basis (transaction plus 2 days) Part C. Market Segments Australian Bond Issues GOV mayority state Qantas 1) Treasury Bonds - Gov issues bonds regardless of whether funding is required as it benefits financial system including price discovery - Main security is a fixed rate bond. Means coupon rate is fixed not the YTM. - Investors can choose from range of bond series If yield is greater than the coupon payment, the - Series is identified by its coupon rate and maturity date bond will be trading at a discount AKA less than - Series can be added and more bonds can be issued of existing series face value - Bond pays series of coupons and has fixed maturity date and face value. If yield is less than coupon, bond will trade at a - Gov issues bond to investors and they buy and sell in the market. premium AKA more than FV through term - The Issuing Process - Treasury bonds issued by the Gov/Australian Office for Financial Management (AOFM) via a tender process on Yieldbroker - Step 1; Announcement of bond series on offer, the coupon rate, amount to be sold and closing date and time for bids - Step 2; Bids are submitted electronically and successful bids (lowest yield/highest price) are notified shortly after close. 2) Semi-Government Bonds - Bonds issued by state borrowing authorities (NSW T-Corp) for the state or territory government or agencies - Bonds are medium or long term - Fixed or floating coupon rates - Yields exceeds Treasury bonds and vary between issuers depending on credit risk and liquidity - Issued through dealer panels often as a closed auction and these dealers make the secondary market. Can buy through auction or directly form dealer in secondary market 3) Non-Government Bonds - Mostly non resident and financial a) Financials; Mainly bonds issued by major banks - Most floating rate - Medium term av. 5 years - Were largest non gov issuer 2008-2012, then decline due to greater reliance by ADIs on deposits. b) Non Resident - Kangaroo Bonds; Bonds issued by highly rated foreign, international institutions in the Aus market. E.g. World Bank to raise only for purpose outside of their home country - Largest category of non-gov bonds - E.g. Emirates $450mil Kangaroo bonds in Aus, 10 year term, - Issues are driver by investor demand for highly rated and relatively high yielding AUD bonds - Issuers want to diversify funding sources, expand in new markets - Issuers mostly swap their AUD payments for USD c) Mortgage Backed Securities; Fund property loans, mostly residential - Impacted by GFC but increased since 2010 - Issued in Tranches were each tranche has a different payment structure, payment priority and credit rating - Most common are floating rate bonds based on the Bank Bill Swap rate and nominal maturity of 25 years - Payments form borrowers flow through to investors and so include principal and Interest d) Bonds Issued by Non Financial Companies; Issued by companies other than banks of FinIns like Qantas, Telstra, Woolworths - As it is expensive issue bonds, these issues are only done by firms who need relatively large amounts - Some lower rated issuers have their credit standing improved by credit wrapping such as guarantees by a third party - Like banks, Aus companies raise more funds from overseas than in domestic market. Rating Agencies Informed opinion on credit risk of a security from a ratings agency e.g. S&P Bonds are rated in order to be issued with the cost of the rating paid by issuer. - Ratings are revised and influence the yield at which the securities trade. Some ratings unreliable incentive problem due to issuer paying the rating agency AAA -> CC, C, D (Default) Grades; - Best quality - High quality - Upper Medium Grade - Investment Grade - Speculative Can also rate countries. Aus is AAA Sovereign ceiling is Country rating is the ceiling of the country’s issued bond rate Part F. Determinants of Long Term Interest Yields Determinants of Movements in Long Term Yields Gradual decrease in long term rates for past 20 years Due to increase in inflation rates The 10 year bond yield is the reference long term rate The Greatest influence on demand for bonds, and therefore bond yields if inflation rate An increase in expected inflation, erodes the expected purchasing power of a bond’s fixed payments as yields increase too. Government is participating in manipulation of short term interest rate by increasing the short term interest rates which has an impact on the long term interest rate The Fisher Effect Relationship between bond yields and the expected inflation rate represented by the Fisher Equation Nominal interest rate = real interest rate plus an expectation of the longer term inflation rate - r = market yield for long term rates - r real = the real interest rate (risk free rate) - P e = the expected long term inflation rate Given the real rate is stable, then changes in market yields reflect changes in the expected inflation rate. Other Influences of Bond Yield GFC saw investors shift demand away from riskier securities in a flight to quality resulting in decrease in Treasury Bond yields Changes in volatility and liquidity within markets will also influence risk premiums embedded in the real interest rate. Part D. Calculating Bond Prices Bond Pricing Basics Treasury bonds are priced using the AOFM formula and the Australian Financial Market Association’s pricing conventions. - They are quoted and sold at a percentage or YTM basis. Therefore bid yield is higher than the offer yield - Bid for high yield sell at low yield. Australian Office of Financial Management (AOFM) manages the Australian Government’s debt portfolio - being short term and long term debt. - Yield is a semi annual compound rate - Coupons paid twice a year, on dates/ months determined by bond’s maturity date - Prices are per $100 of face value to 3 dec. Bonds settle T+2 with the settlement price calculated using the yield agreed on the trade date. Can have maturity of 1 year or more Treasury bonds are still exposed to interest rate risk If I want price 6 months by Calculating a Bond’s Price on a Coupon Date maturity n 1 Price of a bond is the present value of its remaining payments discounted at the current market yield. < & 21 Bec Formula: This formula is only valid on two dates throughout the year, when the coupon paayments are made. , Coupons = ~ (M in (1 10023) 26 + 2B26 $64 0 75 - CV = 91 75(1 (823) - 6) -. P = P2 $69 92 = 0 + 180 (1 + 0. 823) FV- PMT -. 75(123) 16) + Price -. - ( 823) 1 24 -.. 4 6% =. 13 = $108 -. n (use Excel) Mi OV , - , Need Pl to be & 21 December 2024 later.. 25 penode par cr = 1 5 %. = 134. FV = $108 PMT + Example: Bond Prices and Movement in Yield premium p = 0 75. /1-(B3)26) P $185 - =. 33 + 100 (1 0153. remaining X2 to , 5)20) to 26 75 = P-05 =.. /Period, FI) negative & get annual rate = P(EXIe)) PV (Rate Maturity upon PMT-FV) will return neg and (f if want Example: Bond Prices and Movement in Yield HTM Yeld-(#) ". 100 (0 0875) $0 period I ! (V = 0 0075 = 0 023 1 5% n(t) 0 O. YTM(r) = remaining -.. 2) semi-annual Example: Bond Pricing P always periods - - = PMT e Price = "rgt $8 75. e value to be pss. FRA Contracts We define FRA by its starting and finishing months. - E.g. a 1:4 FRA @ 5.00%, sets a rate of 5% for 3 months starting in one month. —> 1:4 with 1 being 1 month from today and 4 being the security maturing 4 months from today meaning the term is 3 months —> Company goes to bank and asks to agree on fixed forward rate through a FRA - A strip of FRAs (e.g. 1:4, 4:7, 7:10) hedges a series of exposures such as from a bill facility. FRAs use standard documentation that specify: a) Their Settlement date b) The term of the rate c) The amount of which the rate applies d) Whether it is a borrowing or lending rate e) The cash settlement equation — The equation used with discount securities —> Settlement = V agreed=[]’/ - V market (SCREENSHOT FORMULA) The FRA Market A primary, wholesale market conducted on an OTC basis The main dealers are the Big 4 and some international banks The main advantages of FRA are they: a) Meet each client’s requirements (made to measure) b) Are convenient to arrange because of standard documentation c) Pose low default risk (on the settlement payment) d) BUT they do not have a secondary market Calculations for I year Example - a for I year maturity ↑ maturity or2 -O 1 p * use TUM can invest for F2 1(1 = +0. full 2 always indicates spot rate I always indicates forward rate year term 865)2 Body ~ rate * can also invest a yo spot rate & add lur forward #, = 1(1 + 0 864). Both methods of calculating 2 yr rate or 1 yr rate and finding the second forward rate, should give you the same answer or FV. Calculating this is beneficial because we can calculate the expected forward rate. 2) Example ↓% 5. 4 % 5% I I I - 2 ins or 1 = - 2 , , Goss 5 8824 - 2ts = 3 1000 7 21 Y.. Denominator 23 - , Numerator=2 - 1 = year spot I year spok