Introduction to Debt Markets

Bonds vs. StocksIn the Rearview Mirror

Sources of RisksDebt Classes

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Bonds vs. Stocks Sizing Bond (2009) and Stock Markets (Q3 2008)

$-

$5.0

$10.0

$15.0

$20.0

$25.0

$30.0

$35.0

Bond Market Stock Market

$34.3 T $14.1 T

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Rearview MirrorS&P 500

30.47%

10.07%

21.04%

-11.89%

-22.10%

28.69%

10.88%

4.91%

15.79%

5.49%2.79%

7.62%

37.58%

22.96%

33.36%

28.58%

1.32% -9.10%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

1990 1992 1994 1996 1998 2000 2002 2004 2006

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Rearview MirrorU.S. Bond Aggregate Index

8.95%

16.00%

7.40%

9.75%

3.63%

11.63%10.26%

4.10%2.43%

4.33%

6.97%

18.47%

8.69%

-2.92% -0.82%

9.65%8.44%

4.34%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

1990 1992 1994 1996 1998 2000 2002 2004 2006

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Why Bonds? Bonds form an important asset class

Sources of risk and return in bonds Interest rate risk Reinvestment risk Default risk

When liabilities are fixed in nominal terms, investing in suitably chosen bond portfolios may lead to lower risk May not be necessary to consider all asset classes

and use mean variance optimization methods

Bond mispricing may arbitrage opportunities for an active portfolio manager

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Issuers of Bonds U.S. Treasury

Notes and Bonds Municipalities

Tax-Exempt Bonds Corporations

Corporate Bonds, Preferred Stock International Governments and Corporations

Innovative Bonds• Indexed Bonds• Floaters and Reverse Floaters

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Source of Risks Interest Rate Risk (Market Risk)

The major factor affecting bond prices The price of bond changes in the opposite

direction of interest change All bonds are exposed

Inflation Risk Inflation reduces purchasing power Yield changes to reflect the expected inflation

Reinvestment Risk No guarantees that coupon payments could be

reinvested at the same rate

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Source of Risks Credit Risk

Inability of issuer to pay coupon and/or principal Corporate, Emerging market and high-yield bonds Credit linked debt securities, credit derivatives

Liquidity Risk Inability to unload position without substantial loss Municipal, Corporate, and Emerging market bond

FX Risk The risk of exchange rate fluctuation in reducing

the return on a foreign bond

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Debt Classes: Definition Bond (Fixed Income Security)

A security obligating issuer to pay interest and principal to the holder on specified dates.

Coupon Interest rate, e.g. 4%, 5 3/4%, etc. Face/par value or Principal amount, e.g. $100 MM, $3B. Maturity, e.g. 3 month, 1 year, 30 years, etc.

Bond can be classified according to its attributes Payment type, e.g. semi-annual coupon, amortizing, etc. Issuer, e.g. government, agency, corporate, etc. Maturity, e.g. short, medium, long, etc. Security, e.g. secured, unsecured debenture, etc.

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Debt Classes: Payment Type Pure Discount or Zero-Coupon Bond

No coupon payments prior to maturity. Bond’s face value paid at maturity.

Coupon Bond A stated coupon paid periodically prior to maturity. Bond’s face value paid at maturity.

Perpetual (Consol) Bond A stated coupon paid at periodic intervals.

Self-Amortizing Bond Certain amount paid at each payment period. No balloon payment at maturity.

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Debt Classes: U.S.Treasuries Treasury Bills

maturity 1 year when issued typically 3 months and 6 months pure discount bond, no coupon

Treasury Notes Maturity: 1 year maturity 10 years when

issued Typically, 2, 3, 5, and 10 year

Coupon: semi-annual Treasury Bonds

Maturity: >10 years when issued Typically, 20, 30 (last issued Feb 15, 2001)

Coupon: semi-annual

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Debt Classes: U.S.Treasuries Treasury STRIPS are zero-coupon securities

that are made by “stripping” coupons or principals from Government Notes and Bonds.

Treasury Strips are issued under the U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) program.

Prices of Notes, Bonds, and STRIPS are quoted as prices per $100 of face value. Prices of Bills are quoted in terms of rate of discount.

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Debt Classes: Corporate Bonds Secured Debt (backed by collateral assets)

Secured by real property Property reverts to bondholder upon default

Subordinate Debenture General creditors subordinate to secured debt Higher priority over stockholders

Other Features of corporate bonds Convertible bonds: convertible to equity Callable bonds: issuer’s right to buys back bond Putable bonds: holder’s right to sell bond to issuer Sinking funds: reduced face amount over time

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Corporate Bonds – Default Risk

One of the biggest differences between Corporate Bonds and U.S. Treasury Bonds is the default risk on corporate bonds

Corporate bonds are rated on the basis of their default risk by a few rating companies

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Factors Used by Rating Companies

Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt Effects of bond covenants

Moody’s acquired KMV to use option pricing theory to rate corporate bonds

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Corporate Bonds – Default RatingsRating Companies Moody’s Investor Service Standard & Poor’s Fitch

Rating Categories Investment grade

Aaa, Aa, A, Baa by Moody’s ratings AAA, AA, A, BBB by S&P ratings

Speculative grade or “Junk” bonds Rated below Baa by Moody’s and BBB by S&P

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Debt Classes: Corporate Bonds Credit Rating

Moody S&P Quality of Issue Aaa AAA Highest quality. Very small risk of default.

Aa AA High quality. Small risk of default.

A A High-Medium quality. Strong attributes, but potentially vulnerable.

Baa BBB Medium quality. Currently adequate, but potentially unreliable.

Ba BB Some speculative element. Long-run prospects questionable.

B B Able to pay currently, but at risk of default in the future.

Caa CCC Poor quality. Clear danger of default .

Ca CC High specullative quality. May be in default.

C C Lowest rated. Poor prospects of repayment.

- D In default.

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Average One-Year Credit Loss Rates

0.0% 0.0% 0.1% 0.1%

0.9%

2.7%

6.1%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

Aaa Aa A Baa Ba B Caa - C

Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006

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Ratings and Average Time to Default

Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006

Original RatingAverage # of Years from Original Rating to Default

AAA 8.0

AA 9.5

A 8.5

BBB 6.5

BB 4.8

B 3.6

CCC 3.3

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Mean and Median Recovery Rates

70%

44%39%

29%

16%

83%

40%35%

21%

6%

0%

20%

40%

60%

80%

100%

Ba and Up B Caa Ca C

Mean

Median

Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006

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Protection Against Default

Sinking funds

Subordination of future debt

Dividend restrictions

Collateral

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Bond Provisions Call Provision allows the issuer to repurchase the bond

at a specified call price before the maturity date Put Provision allows a bondholder to reclaim a

principal, or to extend bond’s life Convertible Provision allows a bondholder to

exchange a bond for common stock Typically are callable as well

Secured Bonds have specific collaterals for bonds Sinking Funds guarantee gradual repurchase of

corporate bonds by the issuer Floating Rate Bonds have interest payments tied to

some measure of current market rates

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Comparing Bonds – On the Importance of Fine Print

Yield is useful for comparing similar bonds to see if which bond may be cheaper

Detailed analysis focuses on bonds identified this way: “Similar” Cash flows Duration Credit risk Call, Put, Conversion and other provisions

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“Similar” Bonds ExampleTwo U.S. Treasury bonds of same maturity from July 1, 2004 WSJ:

The first bond has a coupon rate of 4.75%, and yields 4.56%The second bond has a coupon rate of 13.25%, and yields only 3.71% (!!!)

The difference is that the second bond is CALLABLE!!! It was issued as a 30yr bond in May of 1984, and is callable at par value in 25 years, i.e. in May of 2009Now it is almost 100% certain that it will be called, hence it now trades as bond maturing in 2009:

RateMaturity

Bid Asked ChgAsked

Mo/Yr Yield

4 3/4  May 14 n   101:15  101:16  +10  4.56 

13 1/4  May 14   142:03  142:04  +11  3.71 

RateMaturity

Bid Asked ChgAsked

Mo/Yr Yield

3 7/8  May 09 n   100:22  100:23  +9  3.71 

5 1/2  May 09 n   108:02  108:03  +10  3.67 

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Bond Provisions Bond provisions may alter the structure of

cash flows, affecting bond prices and yields Call Provision allows the issuer to repurchase

the bond at a specified call price before the maturity date

Relationship between

Interest Rate and

Callable Bond Price

Callable Bond Price vs. Interest Rate

0

1000

2000

3000

4000

5000

0 5 10 15Interest Rate

Bond Price

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Yield to Call Bonds are most likely to be called when their price exceeds

the call price It implies that premium bonds will be called at the earliest date when

the bond becomes callable Hence yield quoted in WSJ for callable premium bonds is in fact

yield to call (recall previous example)!!! Example of cash flows difference for a callable bond:

A 30yr bond with 8% coupon sells for $115, and is callable in 10 years at par  Cash Flow to Call Cash Flow to Maturity

Coupon payment $4 $4

Number of semi-annual periods 20 periods 60 periods

Final payment (principal) $100 $100

Price $115 $115

Yield to Call Yield to Maturity

5.98% 6.82%

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Debt Classes: Municipal Bonds Municipal Bonds

Maturity varies from one month to 40 years Exempt from federal taxes and state taxes (for

residents of issuing state) Generally two types:

Revenue bonds backed by the revenue of a particular project e.g. water bond

General Obligation bonds backed by the tax revenue of local government e.g. school bond

Riskier than U.S. Government bonds

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Source of Risks – Foreign Bonds

0

20

40

60

80

100

120

140

1/1/1997 8/29/1997 4/26/1998 12/22/1998 8/19/1999 4/15/2000 12/11/2000 8/8/2001

Date

Bo

nd

Pri

ces Russian MinFin 10yr 3%

T-Note 10yr 6.5%

Investments 14 29

Bond Resources WSJ - Bonds Yahoo – Bonds Bloomberg - Bonds Lehman Brothers Bond Indices

(what’s left of them…) www.investinginbonds.com PIMCO - Everything You Need to Know

About Bonds