Lecture 9: Trade-off theory - Zafer Yuksel

Lecture 9: Trade-off theory - Zafer Yuksel

Bond Features and Markets A Bond Issued by Macys Term Amount of issue Date of issue Maturity Face value Annual coupon Offer price (%) Coupon payment dates Security Sinking fund

Call provision Call price Rating $550 million 01/15/2012 01/15/2022 $2,000 3.875 99.189 01/15, 07/15 None None

At any time Treasure rate plus 0.35% Moodys Baa3, S&P BBB- A Bond Issued by Macys Annual coupon: 3.875 The coupon rate is 3.875% Each bondholder will receive per bond per year Offer price: 99.189 The price offered to the public is Coupon payment dates: 01/15, 07/15

This is semiannual coupon bond $38.75 (=$77.5/2) is paid to investor on Jan, 15 and July, 15 Security The issuer may pledge some of their assets for the bond. With these assets, the bondholders are secured when the company cannot repay its obligations Collateral: Financial securities that are pledged as security for payment of bond Mortgage: Real property (real estate, like land or buildings)

Debentures: Unsecured bond for which no specific pledge of property is made Notes: Unsecured debt with original maturity less than 10 year Macys bond Security: None The bonds are not secured by specified assets Sinking Fund Usually, the bondholders receive the face value at maturity, but sometimes they may be repaid in part or in entirely before maturity Early repayment is often handled through a sinking fund

A sinking fund is an account managed by the bond trustee for the purpose of repaying the bond The company makes annual payment to the trustee The trustee uses the funds to retire a portion of the bonds: Buying up some of the bonds or calling in a fraction of the outstanding bonds Macys bond Sinking Fund: None The bonds have no sinking fund Call Provision A call provision allows the company to repurchase part or

all of the bond issue at stated price over specified time Deferred call provision: the company can be prohibited from calling its bonds for the first part of a bonds life (say the first 10 years) During this period of prohibition, the bond is said to be call protected Macys bond Call Provision: At any time The bonds can be called at any time before maturity The bond do not have deferred call Call Price

Stated price in call provision Price the company used to call the bonds from the market Call price > face value, why? The company would like to call the bond when the market interest rate is lower than the bonds coupon When the company calls the bond, it hurts bondholders benefit, so the bond has to be called at a price greater than face value Call premium = Call price face value Macys Call Price: Treasury rate plus 0.35% The discount rate (YTM) used to compute Macys call price is

treasury rate at calling time + 0.35% Protective Covenants Negative covenants Limit certain actions a company might otherwise wish to take during the term of the loan Example: The firm cannot pledge any assets to other lenders Positive covenants Specify an action that the company agree to take or a

condition the company must abide by Example: The firm must maintain any collateral or security in good condition Bond Indenture (Deed of Trust) Contract between issuing company and bondholders Includes: Basic terms of the bonds Total amount of bonds issued Secured versus Unsecured Sinking fund Call provisions

Deferred call Call premium Details of protective covenants Bond Ratings Investment-Quality Measure bond default risk High Grade Moodys Aaa and S&P AAA: Capacity to pay is extremely strong Moodys Aa and S&P AA: Capacity to pay is very strong Medium Grade Moodys A and S&P A: Capacity to pay is strong, but

more susceptible to changes in circumstances Moodys Baa and S&P BBB: Capacity to pay is adequate, adverse conditions will have more impact on the firms ability to pay Macys bond Credit Rating: Baa3 BBB This bond has moderate credit risk at the bottom of investment grade Bond Ratings Low Quality Low and Very Low Grade Moodys: Ba, B, Caa, Ca, C S&P: BB, B, CCC, CC, C

Considered speculative with respect to capacity to pay. The BB and Ba ratings are the lowest degree of speculation Although such bond is likely to have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions Default Moodys D and S&P D in default with principal and interest in arrears Primary vs. Secondary Market

Primary Market Original sale of securities by governments or corporations Public offerings Private placements Secondary Market Securities are bought and sold after the original sale Provide the means for transferring ownership of corporate securities Dealer markets and auction markets Dealer and Dealer Market

Dealers Maintains an inventory Buy and sell for themselves, at their own risk Used car dealer; local college bookstore Dealer Market Most of buying and selling is done by dealers No central location Most trading in debt securities takes place over the counter (OTC) in old days Many dealers are connected electronically now

Bond Market Dealer market Extremely large number of bond issues A corporation typically has only 1 common stock, but could have a dozen or more bond issues Federal, state, and local governments can have a wide variety of bonds outstanding Little or no transparency Getting up-to-date prices difficult, particularly on small company issues

Little centralized reporting of transactions, which are privately negotiated between parties Corporate Bond Quotations Corporate bond dealers are now required to report trade information through Trade Reporting and Compliance Engine (TRACE) One site that provides bond information is www.finra.org/industry/trace/corporate-bond-data Database that provides bond information is Bloomberg Treasury Quotations

Treasury Quotations Maturity Coupon 5/15/2030 6.250 Bid Asked

150.7188 150.7500 Chg .8906 Asked Yield 2.713 This bond will mature on May 15, 2030 The coupon rate on this bond is 6.250% If this bond par value is $1,000, investors can receive from

selling it to dealers If this bond par value is $1,000, investors must pay to buy it from deals Treasury Quotations Maturity Coupon 5/15/2030 6.250

Bid Asked 150.7188 150.7500 Chg .8906 Asked Yield 2.713

Ask price goes up by 0.8906% since the previous day Two bond prices correspond to two YTM. Asked Yield is the YTM (=2.713%) used to compute Asked Price (=$1,507.5) Problem 6-13 Use Treasury Quotes Locate the Treasury issue in Figure 6.3 maturing in August 2021. Assume a par value of $1,000. What is its coupon rate? What is its bid price in dollars? What was the previous days asked price in dollars? Maturity Coupon

8/15/2021 8.125 Bid Asked 155.1094 155.1563 Chg .7969

Asked Yield 2.713 Clean Price You have decided to purchase an bond with a face value of $1,000 and a market quote of 105 The market quoted bond price (in dollars) is clean price Clean price:

Dirty (Invoice) Price This bond pays a 12% semiannual coupon on 6/30 and 12/31 of each year If you are going to purchase the bond on 5/31/2017, the price you need to pay is clean price plus accrued interests. We call this price dirty (invoice) price On 6/30/2017, coupon will be paid to you (current owner). The previous bond owner will ask you a fraction of this coupon on the date you buy the bond. How much will he ask for? Accrued interests: $50 Dirty price:

Problem 6-21 Accrued Interest You purchase a bond with an invoice price of $1,095. The bond has a coupon rate of 9.9%, semiannual coupons, and there are two months to the next coupon date. What is the clean price of the bond? Problem 6-22 Accrued Interest You purchase a bond with a coupon rate of 9 percent, semiannual coupons, and a clean price of $840. If the next coupon payment is due in three months, what is the invoice price? Real and Nominal Rates

Nominal rate on an investment is the % change in the number of $ Real rate on an investment is the % change in purchasing power Difference between nominal and real rate is inflation Example: Pizzas Pizzas cost $5 per piece today and will cost $5.25 in a year $100 buys 20 pieces of pizza today If the interest rate is 15.5%, we can withdraw $115.50 in a year after depositing $100 today

$115.50 in a year can buy 22 pieces of pizza Our buying power goes up by 10% , which is the real interest rate Inflation is 5% per year Fisher Effect Fisher effect is the relationship between real rates, nominal rates, and inflation : Nominal rate : Real rate : Inflation rate Approximation:

Problem 6-11 Nominal and Real Returns An investment offers a total return of 14 percent over the coming year. Bill Bernanke thinks the total real return on this investment will be only 8.1 percent. What does Bill believe the inflation rate will be over the next year? Term Structure of Interest Rates The graphical representation of the relationship between YTM and maturity of default-free, pure discount bonds is called the time structure of interest rates Tells the pure time value of money for different

length of time Three components determine the shape of term structure Real rate of interest Inflation Interest rate risk Normal Case: Upward-Sloping Inverted Case: Downward-Sloping Treasury Yield Curve

Risk and Reward for holding Bonds Anything else that affects the risk of the cash flows (bond payments) to the bondholders will affect the bond yield to maturity (YTM) Bond YTM is the return required in the market to compensate those risks of investing in bond

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