1 Unit 7 (Chapter 10) Bond Prices and Yields MBA 536 Spring 2012

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Unit 7 (Chapter 10)Bond Prices and Yields

MBA 536Spring 2012

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Characteristics Of All Debt Instruments

A. Interest (coupons) and maturity value ($1000 for corporate bonds).

B. Indenture Agreement,

1. Loan contract between lender and borrower.

2. Appoints the trustee; a fiduciary responsible for guarding the lenders' interests.

3. Terms and conditions, legal remedies.

C. Sources of risk

1. Default = probability of not getting all of the promised interest and principal.

2. Price fluctuations = changes in prices as interest rates change over time.

3. Loss of purchasing power = effects on inflation on coupon income.

4. Reinvestment rate risk

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Principal Categories of Bonds

A. Corporate1. Mortgage (collateralized)2. Debentures (uncollateralized)3. Convertibles4. Commercial Paper, Notes, Bonds

B. US Treasury1. Bills, Notes, Bonds2. Interest exempt from state taxation

C. Municipals1. Revenue, Development, Tax Anticipation2. Interest exempt from Federal taxes

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Bond Values And Bond Yields

A. Valuation Model Vb = Coupon * PVIFA + Face Value * PVIF

B. Coupon Yield

C. Current yield = coupon ÷ price (PV)

D. Yield to maturity (YTM)

E. Yield to First Call (YTC)

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Five Bond Pricing Theorems

A. Bond prices move inversely to changes in interest rates

B. The longer the maturity of a bond, the more price sensitive the bond

C. The price sensitivity of bonds to changes in interest rates increases as maturity increases, but at a decreasing rate

D. Bonds with lower coupons are more price sensitiveE. Yield decreases have a greater impact on bond

prices than similar yield increases

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FINANCIAL CALCULATORS & BOND PRICESA. The value of a bond (VB) is a combination of

a present value of an annuity (the present value of the coupons to be received) and the present value of the face value of the bond.

B. VB = $Coupon * PVIFA + $Face * PVIF

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General Observations on Bonds

A. When bonds sell at prices greater than their maturity or Face values, the are said to be selling at a premium.

B. When bonds sell at prices less than their maturity or Face values, the are said to be selling at a discount.

C. When bonds sell at prices equal to their maturity or Face values, the are said to be selling at a par.

TERM STRUCTURE OF INTEREST RATES

I. Factors Influencing Interest rates.A. Federal Reserve Monetary Policy.

B. Investor expectations about economy.

C. Inflation expectations.

D. Business Decisions.

Unit 7: Chapter 11Managing Bond Portfolios

MBA 536Spring 2012

Student Learning Objectives

A. Sources of Risk

B. Managing risk: Duration

C. Passive bond portfolio management

D. Active bond management strategies

SOURCES OF RISKS FOR BONDS

A. Interest Rate Risk1. Bond prices move inversely with interest rates,

rates riska. The value of the bond declines

b. Opportunity cost

2. All bonds expose investors to interest rate risk, but some have more than others

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SOURCES OF RISKS FOR BONDS

B. Reinvestment Risk1. Most bonds pay coupon interest

a Must reinvest these coupons

b If interest rates decline, the actual return will be less than the promised return

2. Interest rate risk and reinvestment risk tend to offset one another

3. Immunization techniques attempt to strike a balance between the two

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SOURCES OF RISKS FOR BONDS

C. Purchasing Power Risk1. Impact on cash flows of inflation

2. Must earn at least the rate of inflation to stay “even”

3. What if actual inflation exceeds the expected inflation?

4. Rising inflation means higher interest rates

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DURATION

A Duration measures the relative price sensitivity of bonds to interest rate changes.

B Duration is a function of a bond’s coupon rate, time to maturity and yield to maturity; duration:

1 Duration increases as the coupon rate decreases2 Duration increases as the time to maturity increases3 Duration decreases as yield to maturity increases

C The longer the duration of a bond, the more sensitive its price to a given change in interest rates.

C Adjustments to duration of a portfolio based on expectations of interest rate trends.

1. Swapping high-coupon short-maturity onds for low-coupon long-maturity bonds.

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Actively Managed Bond Portfolios

A Actively managed bond portfolios require the investor to estimate:

1. interest rate trends (rising, falling)

2. interest rate volatility

3. yield spreads

4. foreign exchange rates (for transactions denominated in a foreign currency)

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Actively Managed Bond Portfolios

A Actively managed bond portfolios require the investor to estimate:

1. interest rate trends (rising, falling)

2. interest rate volatility

3. yield spreads

4. foreign exchange rates (for transactions denominated in a foreign currency)

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Actively Managed Bond Portfolios

B. Interest Rate Expectations Strategies1. As interest rate rise, bond prices fall

a. short maturity bonds (or bills) are preferred.

2. As interest rate fall, bond prices risea. long maturity bonds preferred.

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Actively Managed Bond Portfolios

C. Riding the Yield Curve1. Strategy based on interest rate expectations

a. Upward-sloping yield curve not expected to change in shape nor slope.

b. Yields will fall as bonds “ride the yield curve” downward, increasing the return.i. Return = coupon yield plus capital gain

ii. Change in bond prices induce positive returns.

iii. Magnitude of gains a function of convexity.

c. Changes in shape and slope over time provides profit opportunities if correctly anticipated. Changes in slope: curve gets flatter or steeper (convexity).

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Actively Managed Bond Portfolios

D. Yield Spread Strategies1. Risk premiums vary between quality levels of bonds over

time2. Change the composition of a bond portfolio based on

expected changes in yield spreadsE. Foreign Exchange Strategies

1. Based on expected changes in foreign interest and/or exchange rates

2. If no change is expected, may switch to foreign bonds for higher yields

3. Strategies are complex since interest rates are major determinant of foreign exchange rates

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Actively Managed Bond Portfolios

F. Bond Swaps1. Technique for managing bond portfolio by selling

some bonds and buying others

2. Possible benefits achieved:a. tax treatment

b. yields

c. maturity structure

d. trading profits

Passively Managed Bond Portfolios

A. Passive Strategies Seek To Control The Risk Of A Bond Portfolio:

1. Indexing strategies to replicate the performance of broad market indexes.

2. Immunization strategies to reduce the risks from fluctuations in interest rates.

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Passively Managed Bond Portfolios

B. Indexing Bond Portfolios1. Recognize the difficulty of an actively managed

portfolio consistently outperforming the overall market

2. Indexing reduces transaction costs and management expenses

3. Indexing does not guarantee funds availability at specific times

4. Tracking error is a way of assessing how well an index fund replicates the benchmark

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Passively Managed Bond Portfolios

C. Immunization Strategies1. Seek to reduce interest rate risk and reinvestment

risk

2. Selection of strategy based on the risk requiring protection

a. Horizon date immunization [HD = Du]

b. Cash flow matching [HDt = Dut]

c. Net worth immunization [Du A = Du L]

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Break Time

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GLOBALIZATION & INTERNATIONAL INVESTING

CHAPTER 19

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GLOBAL MARKETS

A. Developed Countries1. OECD (34)

2. Market Cap – GDP per capita

B. Emerging Markets1. BRIC

2. FTSE: advanced, secondary

3. TIMBI (Turkey, India, Mexico, Brazil, Indonesia)

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RISK FACTORS IN INTERNATIONAL INVESTINGA. Exchange Rate Risk

1. Differential rates of return local currency vs. translation into USD.

2. Solving the Interest Rate Parity problem (or Covered Interest Arbitrage)

3. Inability to form perfect hedges.

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RISK FACTORS IN INTERNATIONAL INVESTINGB. Country Risk

1. Political Risk: stability of government, local ethnic conflicts, legal structures

2. Financial Risk: convertibility of currency, ability to repatriate profits, exchange controls

3. Economic Risk: GDP per capita levels, domestic inflation rates, current account balance

4. Emerging markets riskier than developed markets.

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RISK FACTORS IN INTERNATIONAL INVESTINGC. COVERED INTEREST ARBITRAGE

1. How can we take advantage of differences in interest rates to earn risk free returns?

2. Examine the relationship between spot rates, forward rates, and nominal rates between 2 countries

a. Again, the formulas will assume that the exchange rates are quoted in terms of foreign currency per U.S. dollar

b. The U.S. risk-free rate is assumed to be the T-bill rate

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COVERED INTEREST ARBITRAGEEXAMPLE

1. Consider the following informationa. S0 = .8 Euro / $ RUS = 4%

b. F1 = .7 Euro / $ RE = 2%

2. What is the arbitrage opportunity?a. Borrow $100 at 4%

b. Buy $100 (.8 Euro/$) = 80 Euro and invest at 2% for 1 year

c. In 1 year, receive 80(1.02) = 81.6 Euro and convert back to dollars

d. 81.6 Euro / (.7 Euro / $) = $116.57 and repay loan

e. Profit = 116.57 – 100(1.04) = $12.57 risk free

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RISK FACTORS IN INTERNATIONAL INVESTINGA. INTEREST RATE PARITY

1. Based on the previous example, there must be a forward rate that would prevent the arbitrage opportunity.

a. Interest rate parity defines what that forward rate should beb. Short-Run Exposurec. Risk from day-to-day fluctuations in exchange rates and the fact

that companies have contracts to buy and sell goods in the short-run at fixed prices

d. Managing riske. Enter into a forward agreement to guarantee the exchange rate

2. Use foreign currency options to lock in exchange rates if they move against you, but benefit from rates if they move in your favor

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EVALUATING OPPORTUNITIES TO INVEST/DIVERSIFY

A. Level of infrastructure development

B. Investment Opportunity Set: Natural resources, consumer goods, capital goods/services

C. Emerging markets offer higher returns and more risk.

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INTERNATIONAL INVESTMENT PERFORMANCEA Active investors more likely to do well than

passive investors

B Additional competencies required: e.g., Currency exchange, key source of risk.

C Importance of Benchmarks1 How do we know when we are doing well?2 Identify best opportunities by country.

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INTERNATIONAL INVESTMENT PERFORMANCED Key Consideration Factors

1 Currency: convertibility and exchange rate stability

2 Country: political stability, transparent legal structure

3 Investment Selection: company performance versus relevant index.

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