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Reinvestment Risk
Bond Price
Bond Price
This bond was issued near par value of 100 in the middle of January 2007. price quoted here is for the year 2009 (January to December). Fluctuation in bond price may be due to: (a) An increase in interest rate in the market. (b) An increase in unanticipated inflation rate. (c) A fall in risk premium that causes investors to prefer riskier securities than treasury securities.
Credit Risk
Treasury securities do not carry credit risk. However there are corporate bonds that carry significant amount of credit risk: that the issuer may be unable to service all or some of the promised obligations due to financial distress, reorganization, workouts, or bankruptcy.
Liquidity Risk
Some debt securities may trade in illiquid markets (few dealers, wide bid-offer spreads, low depth, and so on). Emerging market debt and some high yield debt fall into this category. Liquidity refers to the ease with which a reasonable size of a security can be transacted in the market within a short notice, without adverse price reaction.
Liquidity Risk
The seller or the buyer will face following: 1. High Transaction costs such as fees and commissions, 2. Bid-offer spreads 3. Market impact costs, which refer to the possibility that following the placement of a buy (Sell) order the market makers may increase (Decrease) the prices at which they are willing to trade.
Contractual Risk
Debt securities may be callable by the issuer at the issuers option. Holders of mortgage loans have the right to prepay their old mortgages if they can refinance them at a cheaper rate. This implies that prepayment should increase when mortgage rates in market drop. The lender will want to charge a higher interest rate to account for the fact that he or she is giving the borrower a valuation option to call away the loans when interest rate fall in the market. This is call risk in the mortgages. Hence mortgages must trade at a yield higher than similar non callable treasury debt securities.
Inflation Risk
Inflation risk is the risk that money obtained in the future will be worth less than when it is invested, which is almost always the case. The real risk is how much this risk will be. On the other hand, it is possible, in some cases, to take advantage of deflation that occurs when interest rates rise. A good example is when interest rates are rising, newly issued fixedincome securities start to pay more, while prices of things that generally require borrowing, such as real estate, start declining. Thus, for instance, one could buy 4 week T-bills as a way to save for a house or for a down payment. As the T-bills expire, they can be re-invested at progressively higher rates (while rates are rising). In the meantime, real estate prices are falling because it is becoming more expensive to borrow the money to pay for it. So the money earned on the T-bills becomes even more valuable than the interest rate itself suggests when used to purchase real estate.
Event Risk
Some debt securities may be sensitive to events such as hostile reorganizations or leveraged buyouts (LBOs). Such events can lead to a significant price loss. In October 1988 RJR Nabisco was taken over through an LBO. The resulting company took on heavy debt to finance the takeover. As a result Moodys rating for RJR Nabiscos debt from A1 to B3. The prices of RJR Nabisco dropped about 15%, and yield spread went from about 100 BPS above treasury to 350 BPS above treasury. In corporate debt market this risk is called event risk.
Tax Risk
If debt securities were originally issued with certain tax exemption features and subsequently there developed an uncertainty regarding their tax status, it could to lead to a price loss.
Cost of Debt..
Debt may be in the form of Debentures, Bonds, Term Loans from financial institutions and Banks etc. Debt carries a fixed rate of interest payable, to them irrespective of the profitability of the firm. Payment of interest will reduce profit and will result into tax saving. Use of debt keep EPS high. If company makes loss, the tax shield goes down and cost of borrowing increases.
Cost of Debt
Cost of perpetual Debt: KDt= I * (1-T) / D Where: I = Annual interest payable. D = net proceed of issue of debentures. T= Tax rate.
Example:
Aries limited has issued 30,000 irredeemable 14% debentures of Rs.150 each. The cost of floatation of debentures is 5% of the total issued amount. The companys Tax rate is 40%. Calculate Cost of Debt?
Example:
Surya limited has raised funds through issue of Rs.10,000 debentures of Rs.150 each at a discount of Rs. 10 per debenture with 10year maturity. The coupon rate is 16%. The floatation cost is Rs. 5 per debenture. The debentures are redeemable with 10% premium. Applicable tax rate is 40%. Calculate cost of debt.
Bond Pricing
Bond Characteristics
Face or par value Coupon rate Zero coupon bond Compounding and payments Accrued Interest Indenture
Bond Pricing
The price of any financial instrument is equal to the present value of the expected cash flows from financial instrument. Determining the price require: 1. An estimate of the expected cash flows. 2. An estimate of the appropriate required yield.
Bond Pricing
The required yield refers to the yield for financial instruments with comparable risk, or alternative (or substitute) investments. The first step in determining the price of a bond is to determine its cash flows. The cash flows of a bond that the issuer can not retire prior to its stated maturity date. (a non callable bond) consist of: 1. Periodic coupon payments to the maturity date. 2. The Par (or maturity) value at maturity.
Bond Pricing
C ParValue PB T t (1 r ) t 1 (1 r )
T
PB = Price of the bond Ct = interest or coupon payments T = number of periods to maturity y = semi-annual discount rate or the semi-annual yield to maturity
Bond Pricing
You may recall that PV of an annuity was: PV = c/y [ 1 1/(1+y)N ] Where 1/y [ 1 1/(1+y)N ] is called an annuity factor. And also PV of Terminal Value is: Par Value * 1/(1+r)N Where 1/(1+r)N is called PV factor. So Price = Coupon* Annuity factor (r, T) + Par Value* PV factor (r, T)
Bond Prices at Different Interest Rates (8% Coupon Bond, Coupons Paid Semiannually)
Premium
Relationship Between Bond Price and Time if Interest Rates are Unchanged
If the required yield does not change between the time the bond is purchased and the maturity date, what will happen to the price of the bond? For a Bond Selling at Par: as the bond moves towards maturity it will continue to sell at par value. Its price will remain constant as the bond moves towards the maturity date. Bond Selling at Discount: ? Bond Selling at Premium: ?
Measuring Yields
Current Yield Yield to Maturity Yield to Call Yield to Put Yield to Worst
Current Yield
Limitations?
Yield to Maturity
In practice, an investor considering the purchase of a bond is not quoted a promised rate of return. Instead the investor must use Bond Price, Maturity Date, Coupon Payments, to infer the return offered by the bond over its life. YTM is often interpreted as a measure of true average rate of return that will be earned if it is bought now and held until maturity. Bond price used in the function should be the reported flat price, without accrued interest.
Yield to Maturity
Interest rate that makes the present value of the bonds payments equal to its price Solve the bond formula for r
C ParValue PB T t (1 r ) t 1 (1 r )
T
Yield to Maturity
15 year 7%- Semiannual pay bond with par value of $1000 selling at $769.42. Coupon = 7% of $1000 = $70 annual Cash flow 1. $35 semiannual payments for 30 periods. Cash flow 2. $1000 principal amount to be received 30 periods from now.
Yield to Call
What if the bond is callable, and may be retired prior to the maturity? (YTM is not Relevant). The price at which a bond may be called back is referred to as the call price. For some issues, the call price is the same regardless of when the issue is called. For other callable issues, there is a call schedule that specifies a call price for each call date.
Yield to Put
When bondholders can force the issuer to buy the issue at a specified price. As with callable issue, putable issue can have a put schedule. The schedule specifies when the issue can be put and the price, called the put price. The YTP (yield to put) is the interest rate that makes the present value of cash flows to the assumed put date plus the put price on that date equal to the bond price. PV of Cash Flows to put date + PV of Put Price = Bond Price
Yield to Worst..
A Practice in the industry is for an investor to calculate the yield to maturity, yield to every possible call date, and the yield to every possible put date. The minimum of all of these is called Yield to Worst.