global captial market #2

defining risk

-is a measure that can be quantified.
• arises from uncertainty about the future.
• has to do with the future payoff of an
investment or group of investments.
• must be assessed over some time horizon.
• must be measured relative to some benchmark - not in isolation.

bond

A bond is a promise to make a series of payments
on specific future dates.
• The most common type of bond is a coupon
bond

coupon payments

Issuer is required to make annual payments

coupon rate

The annual interest the borrower pays

maturity date

The date on which the payments stop and the loan is
repaid

final payment

principal, face value or par value

bond prices vs interst rate

Bonds promise fixed payments on future dates, so
the higher the interest rate, the lower their
present value, The value of a bond varies inversely with the
interest rate used to calculate the present
value of the promised payment

coupon bond

The market value of a coupon bond is the
present value of the coupon payments, as well
as the face value at maturity

valuing bonds

We calculate the present value of the annual
coupon payments and repayment of principal

current yield

• measure of the proceeds the bondholder receives for making a loan

• The current yield measures that part of the
  return from buying the bond that arises
  solely from the coupon payments

yeild to maturity

• The most useful measure of the return on
  holding a bond

• The yield bondholders receive if they hold the
  bond to its maturity when the final principal
  payment is made

default risk

• Short term U.S. Treasury bonds are generally considered “risk-free”; Long term bonds, municipal bonds and corporate bonds all have some default and duration risk.
  • In determining what happens to bond prices when we consider default risk, we can look at an example of a corporate bond

bond rating

• The best--known bond rating services are
  – Moody’s
  – Standard & Poor’s
  • They monitor the status of individual bond issuers and assess the likelihood a lender will be repaid by the bond issuer.
  • A high rating suggests that a bond issuer will have little problem meeting a bond’s payment obligations

• firms or governments with an exceptionally string financial postion carry the highest ratings and are able to issue the highest-rated bonds, Triple A

investment-grade bonds

top 4 categories are considered…

• These bonds have a very low risk of default.

• Reserved for most government issuers and
  corporations that are among the most financially
  sound

The distinction between investment-grade and
high yield is importan

A number of regulated institutional investors are not
allowed to invest in bonds rated below investment
grade, which is Baa on Moody’s scale or BBB on
Standard and Poor’s scale.

high yield

• bonds issued by companies and countries that may have difficulty meeting their bond payments but are not at risk of immediate default

• highly speculative bonds consist of debts that are in serious risk of default.
  • All bonds with grades below investment grade are often referred to as junk bonds or
  high-yield bonds

Junk Bonds : Fallen angles

bonds that were once investment- grade, but their issuers fell on hard times.
– Bonds issued by issuers about which there is little known

• Material changes in a firm’s or government’s
  financial conditions precipitate changes in its
  debt rating

ratings downgrade

lower on issuer bond rating

ratings upgrades

upgrade an issuer bond ratings

the impact of ratings on yeild

• Bond ratings are designed to reflect default risk.
  • The lower the rating
  – The higher the risk of default.
  – The lower its price and the higher its yield.
  • To understand quantitative ratings, it is easier to compare them to a benchmark

• If bond ratings properly reflect risk, then the lower the rating if the issuer, the higher the default-risk premium.
  • When Treasury yields move, all other yields move with them

benchmark bonds

U.S. Treasury issues are viewed as having little default risk, so they are used as

spread over treasuries

Yields on other bonds are measured in terms
of the…

bond yield is the sum of 2 parts

U.S. Treasury yield + Default risk premium

long term bonds

• Long-term bonds are like a composite of a series

of short-term bonds.

• Their yield depends on what people expect to

happen in the future

term structure of interest rates

The relationship among bonds with the same risk characteristics but different maturities is called

compare 3-month and 10 year treasury yeild

1. Interest rates of different maturities tend to move together.

2. Yields on short-term bonds are more volatile than yields on long-term bonds.

3. Long-term yields tend to be higher than short- term yields.

term structure of interest rates : NORMAL

the yield curve usually slopes upward

term structure of interest rates : INVERTED

short-term interest rates exceed long- term yields leading to an inverted yield curve.

• Can predict a general economic slowdown.

• Indicates policy is tight because policymakers are
  attempting to slow economic growth and inflation.

Municipal Bonds

• Taxes are also an important factor affecting
  the yield on a bond.
  • Bondholders must pay income tax on the
  interest income they receive from owning
  privately issued bonds - taxable bonds.
  • The coupon payments on bonds issued by
  state and local governments, municipal or
  tax-exempt bonds, are specifically exempt
  from taxation

investors base their decisions on the after-tax yeild

after-tax yeild