Investment
Analysis II
MGMT-6330 Investment Analysis II
International Fixed Income
Gold as an investment
Investment Analysis II - © 2012 Houman Younessi
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Investment
Analysis II
The World-wide Bond Market
Domestic Bonds
Issued locally by a domestic borrower usually in local denomination
Foreign Bonds
Issued on local markets by a foreign borrower and usually
denominated in local currency
International Bonds
Underwritten by a multinational syndicate of banks and usually
placed in countries other than the ones whose currency the bond
denominates
Investment
Analysis II
Foreign Bonds
Expanding the pool of potential investors, many borrowers
issue bonds in foreign markets. These bonds are in the local
denomination of that foreign market and subject to the laws
and regulations of the local market authorities.
There is no direct exchange rate exposure.
Investment
Analysis II
International Bonds
In 1963 the US government imposed an interest equalization tax (IET) on
foreign securities held by US investors
Later the Federal Reserve restricted the financing of FDI by US
corporations
Additionally all borrowers wishing to issue bonds in the US market must
abide by the generally more stringent US regulations.
Due to these measures and restrictions, the US bond markets became
less attractive to foreign borrowers and simultaneously created a need for
offshore financing of US corporate foreign activities.
The Glass-Steagall Act prevented US commercial banks from issuing and
dealing in bonds. Such restrictions did not apply to their offshore activities
and foreign subsidiaries.
This gave momentum to the International Bond (Eurobond) market a
momentum that the later repeal of the IET and the relaxation of the GlassSteagall acts did not slow.
Investment
Analysis II
World Market Size
Total world bond market size: USD67 Trillion
Total International bond market size: USD18 Trillion
Total Domestic bond market size: USD49 Trillion (I too can subtract )
Market Capitalization of Bond Markets - In
Local Currency (Domestic Bond Markets)
Marker Capitalization of Bond Markets International Bonds
Other, 5%
Yen, 3%
Other, 15%
GBP, 8%
USD, 36%
USD, 45%
Yen, 17%
GBP, 2%
Euro, 48%
Euro, 21%
Source: bank of International settlements, 2007
Investment
Analysis II
Types of Instruments
Straight Fixed-Rate Issues (66%):
As the name implies they are straight (regular)
bonds with a set maturity date and fixed
coupons.
Structured Notes and Floating-Rate Notes (32%):
A structured note is a bond with some unusual
clause or provision. Floating-Rate Notes may
be deemed as one such type. FRNs have
coupons that adjust to interest rates
Equity Related Issues (2%):
Covers convertible bonds and warrant
backed bonds. They are exchangeable for
equity
Investment
Analysis II
Floating-Rate Notes (FRNs)
Generally indexed to the London Interbank Offer Rate (LIBOR)
At Time of Issue
At Coupon Date
Dates
Set Coupon Dates
Set Spread
LIBOR
Rate
Spread
Amounts
Determine Applicable LIBOR
Set next coupon to
LIBOR+Spread
LIBOR
Quote
Major Banks
Investment
Analysis II
Valuing (FRNs)
To simplify, let us assume no default risk
With no default risk and coupon values being reset at each coupon time, the
price P of the FRN itself must be 100% of the face value at each coupon date.
Between coupon dates:
There is no reason for the price to stay constant between coupon (reset) dates.
Between two coupon dates the bond behaves like a short term fixed-coupon
bond.
So the price P can be estimated as P = 100%+reset coupon value at the next
coupon date, all discounted by the LIBOR rate pro-rata to number of days
remaining to next coupon
Investment
Analysis II
Valuing (FRNs)
Example:
A very secure company (no risk of
default) has issued a 10-year FRN at
LIBOR. The coupon is paid and reset
semi-annually. The FRN was issued at
t0 when the six-month LIBOR was at
5%. Exactly six months later at t1,
LIBOR is at 5.5%
1. What is the coupon paid at t1 per
$1000 bond?
2. What is the new value of the coupon
set on the bond?
3. Three days after t1 the six month
LIBOR has dropped to 5.4%. What is
the new value of the FRN?
1. The coupon at t1 was set at t0 at
5%, so it earns $25 per $1000
2. The coupon to be paid at t2 will
earn $27.5 per $1000
3. We discount the known future
value of the bond on t2 at the new
LIBOR and adjust for the three
days passed:
P
1000  27.5
1000  27.5

180  3
3
(1  (5.4)%)  (
) (1  (5.5)%)  (
)
180
180
Investment
Analysis II
Valuing (FRNs) with Default Risk
The market will demand a risk
premium (spread) of m set under
market conditions reflecting the
fundamentals of the issuer and time
to maturity (longer term bonds have
more time to default and as such are
riskier)
However
The risk premium or spread for a
given FRN is set at issue time n
The price volatility of the FRN then
will be proportional to the ratio of
LIBOR+m and LIBOR+n
Investment
Analysis II
Dual Currency Bonds
A bond issued with coupons in one currency and the principal
redemption in another
The motivation for the issuer is to borrow in the desired currency but at a
lower cost than directly issuing straight bonds in that currency
As the coupon is paid in a low interest rate currency (e.g. CHF) and
reimbursed in a high interest rate currency (USD), local investors (say Swiss
investors buying dual currency bonds to receive coupon payments in CHF) are
attracted to this type of bond because it pays a high coupon rate in their own
currency.
Local investors are also attracted to the opportunity for limited currency
speculation only on the principal. Our Swiss investors are betting on an
appreciation of the USD.
Also as for regulatory purposes the issues are considered CHF bonds
although they are USD linked. They allow Swiss institutional investors to
increase their fixed income investment in higher-yield currencies
Investment
Analysis II
Dual Currency Bonds- Valuation
The bond can be dismantled into two parts:
A sequence of fixed coupons in CHF. The current value of this stream of
cash flow is determined by discounting at the CHF yield curve
A USD zero-coupon bond for the principal. The current value of this
investment is determined by discounting at the USD yield curve.
The valuation is trivial
Investment
Analysis II
Currency-Option Bonds
Please: These are not options, these are bonds
In a currency-option bond the coupon and/or the principal can be paid in
two or more currencies as chosen by the bond-holder.
The choice must be made a priori and not at the payment time.
This gives investors a longer term currency play with limited risk. Of
course the investor could purchase an option in a currency for the
same play but the durations with currency-option bonds are usually
much longer than afforded by options (only a few months).
Valuation is done by breaking down the bond into a straight bond in currency
X and an option to swap a bond in currency X for another of same rate in
currency Y at an a priori set exchange rate of X:Y
Investment
Analysis II
Collateralized Debt Obligations (CDOs)
Tranche 1
A structured note or set of
notes backed by some
assets usually a portfolio of
bonds or loans.
Bond 1
1st 5% of loss
Bond 2
Y=30%
Bond 3
Tranche 2
It allows for creation of
securities with widely
different credit risk
characteristics (called
Tranches or slices)
:::::::::::
2nd 10% of loss
Valuation is difficult and will
not be discussed
:::::::::::
CDO
Trust
Y=15%
:::::::::::
Bond 120
::::::::::::
Tranche n
Average
yield 7.5%
Residual loss
Y=5.5%
Investment
Analysis II
Emerging Markets
When investing in debt securities from the emerging markets, investors
have several options:
• Domestic bonds issued by the emerging countries
(government or corporate)
• Foreign bonds issued by the emerging countries (government or
corporate)
• International bonds issued by emerging countries or corporations
in those countries. These may be denominated in USD or some
other currency (e.g. GBP)
• Brady bonds issued by the government of some emerging
countries as a form of debt restructuring according to the Brady
Plan (1990)
Investment
Analysis II
Brady Bonds
Emerging countries in need of debt restructuring
can work with the IMF and upon presentation of a
credible economic reform plan, to re-package
their debt (or part thereof) into tradable bonds the
sum total of the market value of which is less than
the original debt. However, Brady bonds are
made more attractive than the original debt as
they carry an array of guarantees. These bonds
are then offered through international commercial
banks.
Brady bonds are complex to understand,
analyze and value as they come with a
plethora of options, risks and guarantees
Investment
Analysis II
Brady Bonds
Three basic types of guarantees can be instated:
• Principal collateral: The US treasury issues
long-term zero-coupon bonds to back the
principal of the Brady bond.
• Rolling-interest guarantee: The first few
(generally three) semi-annual coupons are
guaranteed by securities deposited in
escrow with the NY Federal Reserve Bank.
• Value recovery rights: Some nations (e.g.
Mexico and Venezuela) link the interest
paid on the bond to their economic success,
for example a rise in price of oil.
Investment
Analysis II
Bond Indices
Bond indices are gaining in popularity. They are most often a total-return index.
The index cumulates the total return on a bond portfolio (i.e. price movement
and the accrued interest).
A bond index calculated daily can allow quick assessment of
the direction and magnitude of the movement of the market.
Unlike a stock index, bond indices must be based on a small
but representative sample (as not all bonds trade every day).
Sometimes a single actively traded bond called a benchmark
bond is used.
A total-bond index is also used to measure the performance
of a bond portfolio in a domestic or multi-currency setting.
Indices computed by Barclay’s (taken over from the former Lehman
Brothers), J.P. Morgan,, Bank of America Merrill Lynch and Bloomberg
are most commonly used.
Investment
Analysis II
Multi-currency Bond Analysis
There is an inverse relationship between the price of a bond and changes in
interest rate
If the cash flow is fixed, the price is solely a function of the market yield
Interest rate differences and movement are a primary concern when dealing
globally
But first, let us deal with bond returns in general
It is useful to define interest rate sensitivity (aka duration) as the approximate
percentage price change for 100 basis points change in the market yield
As such, one can view duration D as
the derivative of the price wrt yield.
The minus sign signifies that the
price drops when yield goes up.
dP
dr
  DP
Investment
Analysis II
Multi-currency Bond Analysis
Another way of saying the same thing is that duration or sensitivity is the
ratio of the percentage price difference to the change in the yield
P
P
r
 D
rearranging
P
P
  D  r
The return on a bond is equal to the yield over the holding period plus any
capital gain or loss due to movement in the market yield
return  r  PP  r  D  r
Investment
Analysis II
Multi-currency Bond Analysis
Over a short holding period, the risk-free rate is the short-term interest rate. The
return on a bond can then be expressed as the sum of:
- The risk-free rate
- The spread of the bond yield over the risk-free rate, and
- The percentage capital gain/loss
return  r  (r  r )  PP  r  (r  r )  D  r
Where r is the interest free rate
The EXPACTED return therefore is the risk-free rate plus a risk premium.
The risk premium is therefore:
rˆ  (r  r )  D  r
Investment
Analysis II
Multi-currency Bond Analysis
Break-even Analysis
What is the implication for exchange rates, of yield differentials on bonds
denominated in different currencies but with similar maturities?
Higher yield in one currency is usually compensated for with pressure on
the currency and in turn a currency loss on the bond.
We need to know how much currency movement will compensate for the
yield differential. Let us consider a one year bond with an interest rate r
in the domestic currency and a similar bond with the foreign currency
interest rate r*. The exchange rate is S0 now. We have learned that due
to interest rate parity, in one year we will have:S  S
r  r*
1
0
S0
Assuming the forward rate F0 for S1

(1  r )
F0  S0 r  r *

S0
(1  r )
Investment
Analysis II
Multi-currency Bond Analysis
Rearranging, we get:
(1  r * )
F0  S0
(1  r )
The multi-period equation is:
(1  r * )t
Ft 1  S0
(1  r )t
The implied forward exchange rate is not a forecast but a break-even
point. The investor can then compare their own FX forecast with the
implied figure.
Investment
Analysis II
Multi-currency Bond Analysis
Risk-Return Analysis
It goes without saying that the return from investing in a non-domestic bond has
three components:
- During the investment period, the holder receives the foreign yield
- A change in the foreign yield induces a % capital loss/or gain
- A currency movement induces a currency gain or loss
so:
return  r  D  r  m
where m is % currency movement
Investment
Analysis II
Multi-currency Bond Analysis
The risk on a foreign bond has two major sources:
- Interest rate risk: that the foreign yield will rise
- Currency risk: that the foreign currency will depreciate
Of course the risks could be somewhat correlated.
As for any investment, the expected return is the risk-free rate plus the risk
premium. The risk premium is of course:
rˆ  (r  r )  D  r  m
Investment
Analysis II
Multi-currency Bond Analysis
Currency-Hedging Strategies
By selling forward contracts, we can hedge against currency risk.
Hence the return on a hedged bond will be:
Return  Foreign _ Yield  D  Foreign _ Yield  ( Domestic _ Cash _ rate  Foreign _ Cash _ rate)
Which is what we have had all along
Investment
Analysis II
International Bond Portfolio Strategies
International bond portfolio management includes several steps:
•
Select benchmark
•
Select market
•
Select sector
•
Manage currency
•
Manage duration/yield curve
•
Optimize; Use yield enhancement techniques
Investment
Analysis II
International Bond Portfolio Strategies
Selecting a Benchmark
This must be an appropriate bond index
• What types of issues are included?
•
Has there been a floor put under credit quality (e.g. no junk bond)?
•
Which countries are included?
•
Have they allowed all maturities or are there restrictions (e.g. on long-term)
•
Is the benchmark hedged or not?
And most importantly: Do the components and the mix resemble my
investment?
Investment
Analysis II
International Bond Portfolio Strategies
Selecting a Market
• Monetary and fiscal policy
• Public spending
• Current and forecast public debt
• Inflation and inflationary pressure
• Balance of payments
• International comparison of the real yield
• National productivity and competitiveness
• Cyclical factors
• Political factors
Investment
Analysis II
International Bond Portfolio Strategies
Selecting a Sector
Choices include:
• Government securities
• Regional and municipal bonds
• Mortgage backed and public-loan-backed bonds (e.g. German Pfandbrief)
• Investment grade corporate bonds
• Junk bonds
• Inflation-indexed bonds
• Emerging markets debt (Brady)
Investment
Analysis II
Gold as Investment
Gold is a non-consumed commodity. It is estimated that
only three Kg of gold “disappears” each year.
There is a very small amount of annual production in
comparison to the amount of metal already mined.
It is estimated that 60% of the gold
available on the planet is already
mined and in use and is constantly
recycled.
Gold from King Solomon’s
crown may be in your wedding
ring
So, it is annual demand and supply rules and not production rates
that dominate the price of gold.
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Investment
Analysis II
Gold prices :
 generally decline when interest rates go up
 generally rise with rising inflation, along with other commodities.
This is called (moving to tangibility)
 move in opposition with stock prices
 are sensitive to international macro-economic and global
government economic and fiscal policies
Gold is a hedge against inflation and currency devaluation (perceived store of value)
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Investment
Analysis II
Forms of investing in gold
Metal:
Antique coins, jewelry and
wrought gold
Bullion coins, bars and ingots
Accounts and certificates:
Claim documents for delivery of gold (to be
tendered upon presentation) or based on the
provisions of the document.
Ownership of the underlying gold may be
direct (allocated) or virtual (unallocated, that is
% of a pool).
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Investment
Analysis II
Forms of investing in gold
Exchange-traded gold securities
Gold ETFs:
The SPDR Gold Trust (NYSE: GLD)
the Australian Gold Bullion Security (NYSE: GOLD)
Claymore Gold ETF (TSX: CGL)
iShare Gold Trust (NYSE: IAU)
Gold ETNs:
These are the exchange-traded versions of bank gold certificates.
UBS E-TRACS Long Gold ETN (UBG)
RBS Gold ETN (TBAR)
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Investment
Analysis II
Forms of investing in gold
Exchange-traded gold securities
Gold CEF (Closed-end funds):
Central Fund of Canada NYSE:CEF
Claymore Gold CEF
Gold Derivatives:
New York Commodities Exchange (COMEX) Gold futures. For instance the
CME Group GC index
Options:
Options on gold futures CME (OG) an option on GC
Options on gold ETFs, for instance a July call option on the GLD ETF (GLDCJ)
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