Essentials of Investments
Chapter 10.
Bond Prices and
Yields (C)
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.5 Default Risk and Bond Pricing
Bond Indentures
• Indenture: the document defining the contract
between the bond issuer and bondholder
- specifies a set of restrictions that protect the rights of the
bondholders
- Issuing firm agrees to these protective covenants
• Sinking funds: A bond indenture that calls for the
issuer to periodically repurchase some proportion
of the outstanding bonds prior to maturity
2
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.5 Default Risk and Bond Pricing
Bond Indentures
• Sinking funds:
- Sinking fund call differs from a conventional call provision
1. the firm can repurchase only a limited fraction of the bond issue
at the sinking fund call price
2. while callable bonds generally have call prices above par value,
the sinking fund call price usually is set at the bond’s par value
3
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.5 Default Risk and Bond Pricing
Bond Indentures
• Serial bonds
- Firm sells bonds with staggered maturity dates
- As bonds mature sequentially, the principal repayment burden is
spread over time
- Unlike sinking fund bonds, serial bonds do not confront security
holders with the risk that a particular bond may be called for the
sinking fund
- Disadvantage: Bonds of each maturity date are different bonds,
which reduces the liquidity of the issue
4
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.5 Default Risk and Bond Pricing
Bond Indentures
• Subordination of further debt: me-first rule
- Senior debt holders must be paid in full before junior debt holders
- In the event of bankruptcy, subordinated or junior debt holders will
not be paid unless and until the prior senior debt is fully paid off
• Dividend restrictions
- Covenants limit the dividends firms may pay
5
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.5 Default Risk and Bond Pricing
Bond Indentures
• Collateral:
- A particular asset of the firm the bondholders receive
if the firm defaults
- Because of the collateral that backs them, collateralized bonds
generally are safer
- Collateralized bonds generally offer lower yields than general
debenture
6
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.5 Default Risk and Bond Pricing
Yield to Maturity and Default Risk
Bond’s promised yield to maturity & expected yield
- Corporate bonds are subject to default => distinguish between
bond’s promised yield to maturity and its expected yield
- Promised yield will be realized only if the firm meets
the obligations of the bond
- Expected yield to maturity must take into account the possibility
of a default
7
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.5 Default Risk and Bond Pricing
Yield to Maturity and Default Risk
• To compensate for the possibility of default, corporate bonds
must offer a default premium
• Default premium: Difference between the promised yield
on a corporate bond and the yield of an otherwise identical
government bond
• Pattern of default premiums is called the risk structure of
interest rates; the greater the default risk, the higher the
default premium
8
Figure 10.9 Callable Bond: Apple
Comment
Description of Bond
1. Interest of 3.45% will be payable on February 9 and August 9 of ea
ch year. Thus, every 6 months each note will pay interest of (.0345/
2) × $1,000 = $17.25.
ISSUE: Apple Inc. 3.45% Notes
2. Investors will be repaid the $1,000 face value in 2045.
DUE: February 9, 2045
3. Moody’s bond rating is Aa, the second-highest-quality rating.
RATING: Aa
4. A trustee is appointed to look after investors’ interest.
TRUSTEE: Issued under an indenture between Apple and The Bank
of New York Mellon Trust Company
5. The bonds are registered. The registrar keeps a record of who owns
the bonds.
REGISTERED: Issued in registered, book - entry form
6. The company is not obliged to repay any of the bonds on a regular
basis before maturity.
SINKING FUND: None
7. The company has the option to buy back the notes. The redemptio
n price is the greater of $1,000 or a price that is determined by the
value of an equivalent Treasury bond.
CALLABLE: In whole or in part at any time
8. The notes are senior debt, ranking equally with all Apple’s other un
secured senior debt.
SENIORITY
9. The notes are not secured; that is, no assets have been set aside to
protect the noteholders in the event of default. However, if Apple s
ets aside assets to protect any other bondholders, the notes will als
o be secured by these assets. This is termed a negative pledge clau
se.
SECURITY: The notes are unsecured. However, “if Apple shall incur
, assume or guarantee any Debt, … it will secure … the debt securi
ties then outstanding equally and ratably with … such Debt.”
10. The principal amount of the issue was $2 billion. The notes were s
old at 99.11% of their principal value.
OFFERED: $2,000,000,000 at 99.11%
11. The book runners are the managing underwriters to the issue and
maintain the book of securities sold.
JOINT BOOK - RUNNING MANAGERS: Goldman, Sachs; Deutsche
Bank Securities
9
Figure 10.10 Yield Spreads among Corporate Bonds
10
aaaaaaaa
Chapter 10. Bond Prices and Yields
Credit Default Swaps
✓ Credit default swap (CDS): Insurance policy on the
default risk of a bond or loan
– Buyer pays the seller an annual premium (and
sometimes an upfront fee)
– Seller collects the annual premium but must
compensate the buyer for the loss of bond value
in the event of a default
11
aaaaaaaa
Chapter 10. Bond Prices and Yields
Credit Default Swaps
• In the event of a default, compensation can take two
forms
- CDS buyer may deliver a defaulted bond to
the seller in return for the bond’s par value
: physical settlement
- The seller may pay the buyer the difference between
the par value of the bond and its market price
: cash settlement
12
aaaaaaaa
Chapter 10. Bond Prices and Yields
Credit Default Swaps
• Even if the borrowing firm had shaky credit standing, the
insured debt would be as safe as the issuer of the CDS
• An investor holding a bond with a BB rating could in
principle raise the effective quality of the debt to AAA by
buying a CDS on the issuer
• If a BB-rated bond bundled with insurance via a CDS is
effectively equivalent to a AAA-rated bond, then the fair
price of the swap ought to approximate the yield spread
between AAA-rated and BB-rated bonds
13
aaaaaaaa
Chapter 10. Bond Prices and Yields
Figure 10.11
Prices of five-year credit default swaps, Greece
Source: Bloomberg, August 1, 2012, www.bloomberg.com/quote/ CDBR1U5:IND/chart
14
Prices of CDSs, German Sovereign Debt
Prices of CDSs, U.S. Banks
CDS Prices
17
aaaaaaaa
Chapter 10. Bond Prices and Yields
Credit Default Swaps
• CDSs can be used to speculate on financial health of
firms
– Swap buyers need not hold the underlying bond or loan
– At their peak, $63 trillion worth of CDS outstanding; US
GDP is about $14 trillion.
– What is the implication of the size of this market if the
economy experiences greater than expected defaults?
– Did this contribute to the Financial Crisis of 2008?
18
aaaaaaaa
Chapter 10. Bond Prices and Yields
Credit Default Swaps
• New regulations on CDS will be implemented
– CDS contracts will be required to be traded on an
exchange with collateral requirements to limit risk
– Exchange trading will also increase transparency of
positions of institutions
10-19
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.6 THE YIELD CURVE
10-20
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.6 Yield Curve
• Generally bonds with shorter maturities offer lower yields to
maturity than longer-term bonds
• Yield curve: a graphical representation between the yield
to maturity and the term to maturity
• Called “Term structure of interest rates”: It relates yield
to maturity to the term (maturity) of each bond
21
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.6 Yield Curve
Figure 10.12 Treasury yield Curves
Source: Various editions of The Wall Street Journal.
22
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.6 Yield Curve
• Why should bonds of differing maturity offer
different yields?
• Two most plausible possibilities have to do with
expectations of future rates and risk premium
23
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.6 Yield Curve
Theories of Term Structure
• Expectations Theory
– Long term rates are a function of expected future short
term rates
– Upward slope means that the market is expecting
higher future short term rates
– Downward slope means that the market is expecting
lower future short term rates
24
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.6 Yield Curve
Expectations hypothesis:
Yields to maturity are determined solely by
expectations of future short-term interest rates
Figure 10.13 Returns to Two 2-year Investment Strategies
10-25
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.6 Yield Curve
Theories of Term Structure
• Forward Rates Implied in the Yield Curve
(1+yn)n = (1+yn-1)n-1(1+fn)
→ Forward rate: fn = (1+yn)n / (1+yn-1)n-1 – 1
26
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.6 Yield Curve
Theories of Term Structure
• Liquidity Preference Theory
– Investors demand a risk premium on long-term bonds.
– Upward bias over expectations
– The observed long-term rate includes a risk premium
– fn = E(rn) + Liquidity premium
Extra expected return demanded by investors as
compensation for the greater risk of longer term bonds
27
aaaaaaaa
Chapter 10. Bond Prices and Yields
10.6 Yield Curve
Theories of Term Structure
• Liquidity Preference Theory
– In the absence of a liquidity premium, forward rate
would equal the expectation of the future short rate
– But generally, we expect forward rate to be higher to
compensate investors for the lower liquidity of longer
term bonds
28
aaaaaaaa
Chapter 10. Bond Prices and Yields
Figure 10.14 Illustrative Yield Curves
• Rates are expected to rise over time
• Together with a liquidity premium, this fact makes
the yield curve steeply upward-sloping
aaaaaaaa
Chapter 10. Bond Prices and Yields
Figure 10.14 Illustrative Yield Curves
• Rates are expected to fall, which would make the yield
curve slope downward
• However, the liquidity premium lends something of an
upward slope
• Net effect of these two opposing factors is a humpshaped curve
Figure 10.15 Term Spread: Yields on 10-Year versus
90-day Treasuries
31