Basics Bond issuers Javier Estrada Federal/state/local - - PDF document

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Basics Bond issuers Javier Estrada Federal/state/local - - PDF document

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Corporate Finance Bond Pricing Javier Estrada Spring, 2014 1. Basics Bond issuers and bond types 2. Bond Pricing The general case Specific cases The yield to maturity 3. Risk Default risk Interestrate risk and duration

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  • 1. Basics
  • Bond issuers and bond types
  • 2. Bond Pricing
  • The general case
  • Specific cases
  • The yield to maturity
  • 3. Risk
  • Default risk
  • Interest‐rate risk and duration
  • Other sources of risk

Corporate Finance

Bond Pricing

Javier Estrada Spring, 2014

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Basics

  • Bond issuers
  • Federal/state/local governments
  • Corporations
  • Others

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  • Bond types
  • Coupon bonds
  • Zero‐coupon bonds
  • Consols

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  • Inflation‐protected bonds (TIPS)
  • Convertible bonds
  • Asset‐backed securities
  • …
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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Pricing – The General DCF Model

  • Beginning from the general DCF model
  • Expected cash flows
  • ‘Certain’ cash flows (Coupons and principal)
  • Typically with finite maturity (T)
  • Discount rate
  • R = Rf + RP

 Rf : Compensates the expected loss of purchasing power  RP: Compensates risk bearing → RP = f (Default risk, Interest‐rate risk, …) → There may be many other sources of risk

Go Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Pricing – General and Special Cases

  • Coupon bond
  • Zero‐coupon bond

Zeros always trade at a discount

  • Consols
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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

What Is the ‘Current’ Situation?

GoXls Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

The Yield to Maturity (YTM)

  • Definition
  • Annualized return from buying the bond at the

market price (p0) and holding it until maturity (T)

  • The bond’s internal rate of return
  • ‘Causality’ of the expression
  • Note what are the inputs and outputs in each case
  • Pricing: C, P, and R are inputs / p0 is the output
  • YTM: C, P, and p0 are inputs / y is the output
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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

The Yield to Maturity

  • Elaborating …
  • YTM v. interest rate
  • Annual YTM v. Effective annual YTM
  • Yield curve
  • Relationship between YTM and maturity
  • Typically refers to (risk‐free) government bonds

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  • Current yield
  • ‘Quick and dirty’ YTM
  • Similar to the dividend yield for stocks
  • Back to YTMs in the case, a critical question:
  • What do the differences in yields reflect?

Go Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Default (Credit) Risk

  • Issues
  • How is default risk typically assessed?
  • Credit ratings
  • Investment‐grade bonds v. High‐yield (junk) bonds
  • Key drivers
  • AAA status
  • Reliability

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Interest‐Rate (Market) Risk

  • Issues
  • Definition
  • Estimation

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  • A basic but critical point
  • The negative relationship between interest rates and

bond prices

 Hence about inflation and prices

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  • Two questions
  • What is the main determinant of interest‐rate risk?

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  • Any way to assess it simpler than what we did?

 Is there any variable that an individual, unsophisticated investor could use to quickly assess this risk?

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Interest‐Rate Risk – Duration

  • Two definitions
  • 1. Related to when CFs are received

(Expressed in years)

  • Weighted‐average time to receive a bond’s cash flows

 Weights: Proportion of PV received in each period

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  • 2. Related to interest‐rate risk

(Expressed in percent)

  • Sensitivity of a bond’s price to a 1% change in the

interest rate

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Appendix

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Bond Issuers

Back

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Consols

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Very Long‐Term Bonds

Back

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Liquidity Risk

Back Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Even the Safest Bonds Are Risky!

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Even the Safest Bonds Are Risky!

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

YTMs and Risk

Back

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – Scales

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – Key Drivers

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – AAA Status

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – AAA Status

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – AAA Status

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – AAA Status

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – Reliability

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – Reliability

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – Reliability

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – Reliability

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – Reliability

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Ratings – Reliability

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Interest Rates and Bond Prices

Back Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Maturity and Interest‐Rate Risk

$1,102.7 $913.1 $1,038.9 $1,064.2 $963.0 $941.1

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Maturity and Interest‐Rate Risk

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Duration and Interest‐Rate Risk

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Duration and Interest‐Rate Risk

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