Financial Institutions and Markets

Financial Institutions Financial Institutions and Marketsand Markets

Dr. Andrew L. H. ParkesDr. Andrew L. H. Parkes

Day 7Day 7““How do financial markets work?”How do financial markets work?”

卜安吉卜安吉

April 10, 2014April 10, 2014 Fin Institutions & Markets, Day 6Fin Institutions & Markets, Day 6 22

Chapter 10: BondsChapter 10: Bonds

What is Yield to a Call?What is Yield to a Call?

Remember what Call means?Remember what Call means? Higher yield Higher yield –– potential early potential early

maturity datematurity date Only if favorable to the Only if favorable to the

issuer!issuer!

Only done in Excel and with a Only done in Excel and with a FINANCIAL calculator =>FINANCIAL calculator =>

The U.S. Budget


Callable BondCallable Bond


A 10-year, 10% semiannual coupon,$1,000 par value bond is selling for$1,135.90 with an 8% yield to maturity.It can be called after 5 years at $1,050.

What’s the bond’s nominal yield tocall (YTC)?



10 -1135.9 50 1050 N I/YR PV PMT FV

3.765 x 2 = 7.53%

A 10-year, 10% semiannual coupon,$1,000 par value bond is selling for$1,135.90 with an 8% yield to maturity.It can be called after 5 years at $1,050.

What’s the bond’s nominal yield tocall (YTC)?

INPUTS

OUTPUT



rNom = 7.53% is the rate brokers would quote. Could also calculate EAR (Equivalent Annual Rate) to call:

EAR =

This rate could be compared to monthly mortgages.

Callable Bond Continued - EARCallable Bond Continued - EAR


rNom = 7.53% is the rate brokers would quote. Could also calculate EAR (Equivalent Annual Rate) to call:

EAR = (1.03765)2 - 1 = 7.672%.

This rate could be compared to monthly mortgages.

Callable Bond Continued - EARCallable Bond Continued - EAR


If you bought bonds, would If you bought bonds, would you be more likely to earn YTM you be more likely to earn YTM

or YTC?or YTC? The Coupon rate = 10% The Coupon rate = 10% YTC = r YTC = rdd = 7.53%. = 7.53%.

Could raise money by selling new bonds which Could raise money by selling new bonds which pay 7.53%.pay 7.53%.

Then replace bonds which pay $100/year with Then replace bonds which pay $100/year with bonds that pay only $75.30/year.bonds that pay only $75.30/year.

Investors will expect a call, hence YTC = 7.5%, Investors will expect a call, hence YTC = 7.5%, not YTM = 8% will be the return for investors.not YTM = 8% will be the return for investors.


If a bond sells at a If a bond sells at a premiumpremium, , then (1) then (1) coupon > rcoupon > rdd, so (2) , so (2) a a call is likelycall is likely..

So, expect to earn:So, expect to earn:– YTCYTC on premium bonds. on premium bonds.– YTMYTM on par & discount bonds. on par & discount bonds.

In General:In General:


Disney recently issued 100-year Disney recently issued 100-year bonds with a YTM of 7.5%--this bonds with a YTM of 7.5%--this represents the promised return. represents the promised return. The expected return was less than The expected return was less than 7.5% when the bonds were issued.7.5% when the bonds were issued.

If issuer defaults, investors receive If issuer defaults, investors receive less than the promised return. less than the promised return. Therefore, the expected return on Therefore, the expected return on corporate and municipal bonds is corporate and municipal bonds is less than the promised return.less than the promised return.

Disney BondsDisney Bonds


Bond Ratings Provide One Bond Ratings Provide One MeasureMeasure

of Default Riskof Default Risk

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C

S&P AAA AA A BBB BB B CCC D


What factors affect default What factors affect default risk and bond ratings?risk and bond ratings?

Financial performanceFinancial performance– Debt ratioDebt ratio– Coverage ratios, such as Coverage ratios, such as

interest coverage ratio or interest coverage ratio or EBITDA coverage ratioEBITDA coverage ratio

– Current ratiosCurrent ratios

(More…)


BankruptcyBankruptcy

Two main chapters of Federal Two main chapters of Federal Bankruptcy Act:Bankruptcy Act:– Chapter 11, ReorganizationChapter 11, Reorganization– Chapter 7, LiquidationChapter 7, Liquidation

Typically, company wants Chapter Typically, company wants Chapter 11, creditors may prefer Chapter 7.11, creditors may prefer Chapter 7.


If company can’t meet its If company can’t meet its obligations, it files under Chapter 11. obligations, it files under Chapter 11. That stops creditors from That stops creditors from foreclosingforeclosing, taking assets, and , taking assets, and shutting down the business.shutting down the business.

Company has Company has 120 days120 days to file a to file a reorganization plan.reorganization plan.– Court appoints a “trustee” to supervise Court appoints a “trustee” to supervise

reorganization. reorganization. – Management usually stays in controlManagement usually stays in control..

Bankruptcy continuedBankruptcy continued


Very SimplyVery Simply::

A company must demonstrate A company must demonstrate in its reorganization plan that it in its reorganization plan that it is “is “worth more alive than deadworth more alive than dead.” .”

Otherwise, judge will order Otherwise, judge will order liquidation under Chapter 7.liquidation under Chapter 7.



If the company is liquidated, here’s the If the company is liquidated, here’s the payment priority:payment priority:

1.1. Secured creditors from sales of secured Secured creditors from sales of secured assets.assets.

2.2. Trustee’s costsTrustee’s costs3.3. Wages, subject to limitsWages, subject to limits4.4. TaxesTaxes5.5. Unfunded pension liabilitiesUnfunded pension liabilities6.6. Unsecured creditorsUnsecured creditors7.7. Preferred stockPreferred stock8.8. Common stockCommon stock



In a liquidation, In a liquidation, unsecured creditorsunsecured creditors generally get generally get zerozero. This makes them more . This makes them more willing to participate in reorganization even willing to participate in reorganization even though their claims are greatly scaled back.though their claims are greatly scaled back.

Various groups of creditors vote on the Various groups of creditors vote on the reorganization plan. If both the majority of reorganization plan. If both the majority of the creditors and the judge approve, the creditors and the judge approve, company “emerges” from bankruptcy with company “emerges” from bankruptcy with lower debts, reduced interest charges, and lower debts, reduced interest charges, and a chance for success.a chance for success.


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Financial Institutions and Markets