Module 5 - Fixed Income Bond Market Part 1 PDF

Module 5 - Fixed Income Bond Market Part 1 Part A. Introduction to the Bond Market Money M Bond M - Cash Rate = ST Int rate determin - A spread graph show s the difference of be rate of the given inv Fixed Income - Form of fixed income as they pay regular interest payments Introduction to the Bond...

Module 5 - Fixed Income Bond Market Part 1 Part A. Introduction to the Bond Market Money M Bond M - Cash Rate = ST Int rate determin - A spread graph show s the difference of be rate of the given inv 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 GoU 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 I Price of a bond is the present value of its remaining payments discounted at the current market yield. @ 21 Rec Formula: This formula is only valid on two dates throughout the year, when the coupon paayments are made. , un a ra P = Mr = - 0. (i) Cr. (1 11.823) 6) p = P2 $69 92 = 0 - + 100(1 + 0 02. % 75 (2) (use Excel) YTM = /period, -. 823) OMT OV , , Price 26 - #1) Need All to be p(EX(e)) PV(Rate "maturity Cupon " = Example: Bond Prices and Movement in Yield PMT = negative (1) = & will return neg = , add 5Y FV = $100 Example: Bond Prices and Movement in Yield premium p = 0 75(1 (3) 26) -. P $105 =. 33 + 100(1 J %. ) =... n = Yeld = 26 5) 75 later : 2014 25 penode remaining annual rate get. 52. 08+ (r = 0 2075 r = 0 023 @ 21 December par P 100(0 $0 Cr = 1 5 % PMT. 13 = period I x2 to 1 6% = $108 PMT = 1 ". FV = 0.. remaining 91. 1 5% = n(t) 0 75 always periods 15(1-023326 $69 uTM (r) = 2) semi-annual Example: Bond Pricing P price () If want NO $8 75. value to be pos. (  Example: Settlement Prices 9) Cr = 0 0575 - 0. r 3 80 = = $188 PMT b) &r 0 015 -. FX 01815. : At. 6 n= are 2) (r equal par =. = $187 a)3 year Pinitially. = n= : (premium P2(a 0 +5 (r = 5 00. Cr = 5X)8. 015 PMT = $1 58 r = 5 08 => 0 :.. = = 0. $2 5 = , A = 20 (r r = 0 015. 0 015 =. : (a+ par.. % 5/ $98 634 $96 aso change 188 n 38 W = 8 025 r = 8 825 P2 =.. P = - Change = $103(a+ par) =. 2. (discount) 678 = 1. 37% a a.... 5 5% 1) 15 year 2 5% ↑ 5 51 875(135). PS b) 10 year o 5%4.. P2 015 = 0 8275. 08 8 035 P= 2 / 834 $150... =. r= 1 $2 875 :. P = 2 815 V. 0 87875 PMT = $2 875 100(8 82815) = = 5 75 = - 188 = - 3 81 %. 5/02553 Mage = Iff $94. 938 = - 5 86%. Part E. Bond Investments Assumption that coupon payments get invested at same yield but they dont due to market rates at that time Reinvestment risk; The risk of reinvesting the coupons at a lower yield than the purchase yield Example: Held to Maturity First calculate FV of coupons using the 3% rate and calculate relevant semi annual rate to use. F In Excel = Cr = 1 5% = 0 0075 r = 4 6 % - 0 023.... n = 13 26 = Fl = $108 100 (0.. PMT = $0 =.. PV. 00 75) 75 69 92 = * coupon. FI). reinvestment we use coupons reinvested@ Coupon : i = = In this lase 0. 3% annuity formula 1 015 =. 75/ $23. 635 semi rupy= - Thpy (EXCEL) = annually = c upon reinvest r, re = 12% = 8% 4 43%. RATE (maturity = = 100 Pony "Psell) coupon FY , , * I frannuali (0 05). $5 10 % Ex $108 Pouy $92 64 F1) A + 18 % = period ((23635 100-a. PMT coupon rate 2 x investment curon = = = 5/11.05 $34. 98956 =. RTOtal Nur = 5 Psel 5/1 : 3 = : HP4 = = $103 (134.. 62989 88956 a 2 64 13 642 %. +. 103. 62909)" 1) - x2 - FY (rate , period upon , PMT)