Essay About Price Of The Bond And Coupon Rate

Cfa Level II Fixed Income Readings Outline
FIXED INCOMESECTION I: GENERAL PRINCIPLES OF CREDIT ANALYSISCredit RiskThere are three distinct types of risks associated with credit riskDefault Risk – Borrow wont repay obligationCredit Spread Risk – Risk that credit spread will increase which causes the issue’s value to decrease or underperform compared to benchmarkDowngrade Risk – Issue will be downgraded by rating agency, which causes the price of the bond to fallRating agencies release 3 sources of information that help assess the likelihood of downgrade riskCredit Rating – Reflects probability of defaultRating Watch – Agencies typically announce that they are reviewing a particular issue in advance of ST up/down gradeRating Outlook – LT projectionMoody’s Scale for assessing default risk of an issue:Downgrade Watch: 2 notch reductionNegative Outlook: 1 notch reductionStable Outlook: Maintain Current RatingPositive Outlook: 1 notch increaseUpgrade Watch: 2 notch increaseKey Components of Credit Analysis – The 4 C’sCharacter: Management Integrity & Commitment to RepayFocuses on Firm’s corporate governance structure/best practicesLarge board, separate committees (audit, comp, etc.), majority are independent, committees entirely ind., nominating committee should be the onces identifying new board members, CEO is NOT the chairmanCovenants: terms/conditions of borrowingAffirmative require a company to do somethingNegative prohibit company from doing somethingCollateral: Quality of underlying if debt is an ABSCapacity to Pay: There are 3 specific aspects that should be analyzedSources of Liquidity: Must assess Industry Trends (5-forces), Regulatory Environment, Operating & Competitive Position, Financial Position, & Sources of LiquidityFinancial Position & Liquidity Sources looks at a variety of things:Firm’s Working CapitalDependable Cash Flows (Annuity)Can the firm Securitize AssetsDoes the firm have access to 3rd party guarantees (e.g. parent)Ratio Analysis: There are 4 types of Financial Ratios applicable to assessing a firm’s capacity to payProfitability Ratios can the firm generate funds to pay int. & princ.ROE = [pic 1]ST Solvency Ratios can the firm pay it ST obligationsCurrent, Acid-Test (Quick) = [pic 2]Capitalization (Fin Leverage) Ratios firms ability to take on additional risk  →  with these the LOWER the betterLT Debt-to-Cap = [pic 3]Total Debt-to-Cap = [pic 4]Coverage Ratios ability to pay debt & lease obligations using their CFOInt Coverage = TIE =    also there’s   [pic 5][pic 6]*When you analyze these ratios for a firm compared to industry averages, you can make a good assessment of whether or not the firm is likely to be upgraded/downgradedCash Flow Analysis: How CFO is used to assess issuers ability to service debtRating agencies use CF measures slightly difference than that of the CF Statement, which then affects the ratios they incorporateSEE PAGE 115 for the rundownHigh Yield Corporate BondsAnalysis is required of BOTH the Debt Structure & Corporate StructureDebt Structure of a HY Issuers →Typically have MORE BANK DEBT than a corporation that is investment gradeSenior Bank Debt – has special characteristics that set it apart from regular debtIt is floating rate → CF analysis must be a scenario analysisIts ST debt → Analyze ability to pay off immediate obligationIt has seniority → over other issued debtReset Notes – have a specific premium to the par val because the coupon rate on the note is reset periodicallyThe effect of changing credit spreads must be incorporated into scenario analysis, and the firm may sell assets to avoid higher interest costs in the futureZero Coupon Bonds – Held by subordinated debtholdersThe interest accruing over time can be negatively impacted by the increased amounts of senior debtCorporate Structure of HY Issuers → Typically structured as a holding companyThis means that the parent borrows and passes $ to subordinateTherefore analysis must be of BOTH parent and subordinatesShould Consider if debt covenants restrict:Dividend payments to the parentRestrictions on asset salesIntercompany loansMunicipal Bond Credit Analysis – 2 general typesTax Backed Debt: secured by tax revenuesMust consider the debt per capita? Is the municipality’s budget balanced? What is the State’s ability to help the municipality? What are the employment trendsRevenue Bonds: revenue from a specific projectAnalyze the Cash Inflows (amount & reliability), also whether the debt repayment will be the primary use of the CFs of the project, also analyze any covenants that may be in placeSovereign Bond Analysis – This is broken into two types of riskEconomic Risk – Ability to PayPoints that must be considered are:Living StandardsEconomic GrowthFiscal & Monetary Policy → BOP FlexabilityBOP = 0 = Current Acct + Fin Acct – Δ Reserves AcctPublic Debt BurdenAmount of composition of external debt & liquidityPolitical Risk – Willingness to PayPoints that must be considered are:Subject gov’ts participation in the global economyThe political stabilityForm of gov’tInternal & external security risksRating the currency risk of sovereign debt – Each country has 2 ratingsLocal Currency – (debt service depr.) Subject gov’t has more control of thisLooking at the political stability, income base/growth, country’s economic infrastructure, tax & budgetary discipline, monetary policyForeign Currency – The main concern here is economic & fiscal policiesLooking at its BOP along with the external Balance Sheet compared to its debt (foreign currency) obligationsABS vs CorporatesWith an ABS, there is no business or operating risksThe ABS servicer plays an important roleSECTION II: TERM STRUCTURE VOLATILITY OF INTEREST RATESYield Curve ShiftsParallel Shift – the yield on all maturities change by the same amount in the same directionNonParallel Shift – refers to anyrtime the slope of the yield curve changes. There are 2 kinds of nonparallel shiftsTwists[pic 7]With the steepened curve, spreads between LT & ST rates have widenedWith the flattened curve, spreads between LT & ST rates have narrowedButterfly shifts[pic 8]Positive Butterfly Shift becomes less curvedNegative Butterfly Shift becomes more curvedThe 3 factors that drive Treasury security returnsΔ in level of interest rates – 90% of variation →Δ in slope of the Yield Curve – 8.5% of variation → TwistsΔ in curvature of Yield Curve – 1.5% or variation → Butterfly ShiftsBootstrapping & the Treasury Spot Rate curveBootstrapping – sequentially calculating the spot rates from securities with different maturities → using the yields on T-bonds from the yield curve Price = [pic 9]There are 4 combinations of securities that can be used to construct the Treasury spot rate curve:On-the-run treasuries onlyOn-the-run treasuries and some off the runALL treasury bonds, notes, and billsTreasury stripsThe appeal is that you want to use securities with high trade volumes, which are always the on the run issues, BUT since there are large gaps in the issuance timeline of bonds & notes, using off the run securities are often addedIssue is that off the run can have stale prices (low vol)Treasury Strips – BIG PICTURE, we are trying to determine the accurate spot rate for all maturities. Treasury coupon strips are zero-coupon securities  created by “stripping out” the coupons from normal T-bonds → i.e. since they are zero-coupon, their rates are expressed as spot ratesUnfortunately, this does not necessarily work because the strips market is not very liquid, causing a liquidity premium to be priced into their rate. Also, they reflect a tax disadvantage bc accrued interest on strips are taxed even though there are no CFs realizedSwap Rate Curve – LIBOR CurveThis is an alternative to creating the treasury spot rate curveUses a series of swap rates quoted by swap dealers over a period of 2 – 30 yearsHold preference over Treasury Spot Rate curve for multiple reasons:Swap Market is not regulated by any governmentMakes swap rates in different countries more comparableSwaps pricing are purely results of supply and demandNot affected by technical factors that affect gov’t bondsDo not contain sovereign riskHas many more maturitiesPure (Unbiased) Expectations Theory, Liquidity Preference Theory, & Preferred Habitat TheoryPure (Unbiased) Expectations TheoryForward rates are purely a function of expected future spot ratesEverything is in equilibrium, so the forward rate can be impliedLiquidity Preference TheoryInvestors demand a rate premium to compensate for their exposure to interest rate risk → higher premium for longer the maturityPreferred Habitat TheoryInvestors and borrowers trade bonds that match their future CF obligationse.g. Banks ST security demand. Endowment LT security demandKey Rate Duration – Assessing nonparallel shiftsThis is the %Δ in the value of a bond portfolio in response to a 100bps Δ in the corresponding key rate (holding all else constant)Key Rate Duration Matrix & Calculation[pic 10]        [pic 11]        [pic 12][pic 13]*NOTE that a bond KR Duration = the bond portfolio’s effective durationKey Rate Duration is typically applied to 3 kinds of bond portfolios:Barbell – Large % & LT & ST maturity bondsLadder – Even distribution among all maturitiesBullet – Large % in Intermediate maturity bondsYield Volatility – useful for valuing callable bonds and IR derivatives, or measuring IR riskYield Volatility Measure – Std. Dev. Of yield changesσ2 = [pic 14]Xt = 100 * ln)[pic 15]yt = yield on day t = avg yield change over period t = 1 to t = T[pic 16]Commonly the std. dev. is annualized:σannual = σdaily * (# of trading days in the year)0.5Yield Volatility Forecast – Estimated using int. rate derivatives & option pricing modelsσ2 =    ……but needs to be done for each observation in port.[pic 17]σ2 =    [pic 18]SECTION III: VALUING BONDS WITH EMBEDDED OPTIONSRelative Value Analysis – Comparing the bond’s spread over the same benchmark, to the required spreadThis determines if a bond is over/under valued compared to benchmarkUndervalued → Bond Spread > Required Spread → “Cheap”Overvalued → Bond Spread < Required Spread → “Rich”Constructing an Arbitrage-Free Interest Rate Tree – Binomial TreeNOT LIKELY TO SHOW UP on pages 164-165Builds to constructing a Binomial TreeBackward Induction Valuation MethodologyProcess of valuing using a binomial interest rate tree, but going from period n (maturity) to node 0, and compounding at each possible valueSpread Masures → REFRESHER3 common measuresNominal Spread: YTMbond - YTMTreasuryThe Bond and Treasury security must have the same maturityZ-Spread: Spread over the ENTIRE spot rate curve[pic 19]This is versus the Benchmark spot rate curveOAS: z-spread – option costCalc using the binomial interest rate modeCommon benchmark interest rates used to calculate spreadsTreasury securitiesSpecific sector of the bond market with a credit rating higher than the issue being valuedA specific issuerValue of callable/putable bondsCalculationVcall = Vnoncallable - VcallableVput = Vputable - VnonputableEffect of volatility on the arbitrage-free value of an optionAs interest rate volatility increases, the value of a callable bond decreases, this is because the upside price a callable bond can rise to is basically capped at its call priceEffective Duration & Effective ConvexityDE =         AND        CE = [pic 20][pic 21]Convertible BondsKeep in mind that the fact that its convertible means that the bond has an embedded call optionConversion Ratio – The number of common shares for which a convertible bond can be exchangedCalculationConversion Ratio = [pic 22]Conversion Value – the value of the common stock into which the bond is converted intoConversion Val. = Market$ * Conversion RatioThe minimum value of the convertible bond must be GREATER than the conversion value or straight valueIf not, then arbitrage opportunities would existMarket Conversion Price (and price per share)Aka the conversion parity price – the price the convertible bondholder would pay for the stock if they bought the bond and immediately converted it = [pic 23]Per Share:Market conversion premium per share should = the market conversion price - the market priceRatio: = [pic 24]Premium Payback Period time it takes to recoup the per-share premium (Breakeven point)Ratio:=[pic 25]Favorable Income Difference Per Share:= [pic 26]Premium Over Straight ValueDownside risk is limited for investor, because its convertible means that the bond will not fall below the bond’s underlying straight-valueRatio:=) – 1[pic 27]SECTION IV: MORTGAGE-BACKED SECTOR OF THE BOND MARKET