O-MSF-FIN-521-Bonds-Fundamentals-and-Valuation-Part-2-transcription

Investment Analysis: Bonds Fundamentals and Valuation – Part 2

Slide 1: Introduction

• Lecture Title: Bond Fundamentals and Valuation Part 2

• Lecturer: David Zynda, Eller College of Management, University of ArizonaThis lecture delves into the intricacies of bond investments, essential for understanding the fixed-income market's structure and dynamics.

Slide 2: Bond Valuation Part 2

• U.S. Treasury Obligations:

  • Significance: These instruments represent a cornerstone in the U.S. dollar fixed-income market, reflecting the government's credit reliability.

  • Taxation: Subject to federal taxation, providing interest income that fuels government spending, while being exempt from state and local taxes.

  • Categories:

    • T-Bills: Short-term instruments with maturities of less than 1 year, issued at a discount to par value.

    • Treasury Notes: Medium-term securities with maturities ranging upward to 10 years, offering semiannual interest payments.

    • Treasury Bonds: Long-term securities with maturities exceeding 10 years, providing regular interest payments until maturity.

• TIPS (Treasury Inflation-Protected Securities):

  • Inflation Protection: Principal and interest payments are adjusted based on the Consumer Price Index (CPI), providing a hedge against inflation.

  • Adjustment Lag: Comes with a three-month lag on indexing values, which can affect cash flow timing.

  • Use Case: Ideal for investors seeking to lock in real rates of return, particularly in inflationary environments, helping to preserve purchasing power.

Slide 3: Understanding TIPS

• Example Analysis: If inflation rises by 1.5%,

  • Face Value Adjustment: Original face value of $1,000 increases to $1,015.

  • Coupon Payment Change: Original coupon payment adjusts from $17.50 (3.5% of $1,000) to $17.76, reflecting the increased principal.

  • Real Rate of Return: Maintains a real rate of return of 3.5% post-inflation adjustment, enhancing investment security.

Slide 4: Japanese Government Bonds (JGBs)

• Market Size: JGBs represent the second largest government bond market globally, showcasing Japan's economic strength.

• Quality: Highly rated in terms of credit quality, comparable to U.S. Treasuries, and known for high liquidity, making them attractive to investors.

• Maturity Segments:

  • Medium-term: Ranging from 2 to 4 years, appealing for investors seeking moderate risk and return.

  • Long-term: Typically maturing after 10 years, suitable for those seeking long-lasting investments.

  • Super-long: Offering maturities from 15 to 20 years, often in private placements to manage specific institutional investment strategies.

Slide 5: U.K. Government Bonds

• Sovereign Bonds: Commonly referred to as "gilts," these bonds are essential to financing U.K. government activities.

• Maturity Types:

  • Short Gilts: Maturities of less than 5 years, appealing for short-term investments.

  • Medium Gilts: Maturing between 5 to 15 years, balancing yield and risk.

  • Long Gilts: Exceeding 15 years, providing stable interest income over an extended period.

• Market Characteristics: Known for their high liquidity and guaranteed payment by the British government, these securities trade on the London Stock Exchange with semiannual interest payments, making them a popular choice among conservative investors.

Slide 6: Eurozone Bonds

• Market Composition: Bonds issued by significant economies such as Germany, France, and Italy, contributing to a robust collective market.

• Currency: All bonds are denominated in euros, reflecting the economic ties within the Eurozone and allowing diversified investment options across member countries.

Slide 7: Government Agency Issues

• Included Agencies:

  • Fannie Mae and Freddie Mac: Important for maintaining a liquid secondary market for residential mortgages, aiding in housing market stability.

  • Ginnie Mae: A government agency that guarantees mortgage-backed securities issued to promote affordable housing.

  • Other Agencies: Support initiatives in agriculture and education (e.g., Farmer Mac and Sallie Mae) fostering economic growth and accessibility.

• Perception: These bonds are regarded for their high safety, similar to Treasuries, yet subject to varying state/local taxes, depending on jurisdiction.

Slide 8: Municipal Bonds

• Types: Composed of General Obligation (GO) bonds and revenue bonds, each serving different funding needs and investor profiles.

• Tax Status: Interest payments are typically exempt from federal income tax, enhancing their attractiveness to investors in higher tax brackets.

• Equivalent Taxable Yield (ETY):

  • Formula: ETY = ( \frac{i}{1 - t} ), where ( i ) is the yield of municipal obligations and ( t ) is the marginal tax rate.

  • Importance: This calculation helps investors compare tax-exempt municipal yields to taxable investments effectively.

Slide 9: Corporate Bond Market

• Maturities: Corporate bonds generally range from 5 to 40 years, catering to various investor time horizons.

• Callable Bonds: Often feature deferred call protection, allowing issuers to refinance under favorable conditions without penalizing investors before a set period.

• Example Comparison:

  • Oracle's bond: 3.95% coupon, maturing 2051, trades at 73.88% of par (indicating a discount).

  • Amgen's bond: 5.25% coupon, maturing 2030, trades at 101% of par (indicating a premium).

• Yield Relation:

  • Yield > Coupon Rate: Indicates a discount bond, appealing for investors looking for lower purchase prices.

  • Yield < Coupon Rate: Classifies as a premium bond, generally preferable for safety seekers.

Slide 10: Asset-Backed Securities

• Types Include:

  • Collateralized Mortgage Obligations (CMOs)

  • Mortgage-Backed Securities (MBS)

  • Asset-Backed Securities (ABS)

  • Certificates for Automobile Receivables (CARs)

  • Collateralized Debt Obligations (CDOs)

• Structure: These securities are typically packaged loans sold to investors, where payments are passed through from borrowers, adding layers of complexity and risk assessment.

Slide 11: Nontraditional Bond Coupon Structures

• Variable-rate Notes: Feature coupon rates that adjust periodically based on referenced market indexes like LIBOR or SOFR, adapting to market conditions.

• Redemption Features: Often redeemable at par after predetermined periods boosting liquidity and attractiveness for investors looking for flexible investment options.

Slide 12: Zero-Coupon Bonds

• Characteristics: Provide no interim interest payments, instead promising a single principal payment at maturity, appealing for long-term investment strategies.

• Pricing Mechanism: The valuation is based on the present value of the principal, with tax implications on implied interest accrued over the investment period.

Slide 13: High-Yield Bonds

• Alternate Names: Commonly referred to as junk bonds or speculative bonds, these securities are rated below BBB, reflecting higher risk.

• Emergence in the 1980s: Fueled by firms needing alternative avenues for financing, introducing a new realm of investment opportunities.

• Institutional Investors: Often held by mutual funds and pension funds seeking higher returns despite increased risk, diversifying their portfolios accordingly.

Slide 14: International Bonds

• Types Include:

  • Yankee Bonds: U.S. dollar-denominated securities issued by foreign firms within the U.S. market.

  • Samurai Bonds: Yen-denominated securities issued by non-Japanese firms within Japan, catering to local investor appetites.

  • Bulldog Bonds: British Pound-denominated securities issued by non-UK firms, allowing access to the UK capital market.

  • Eurobonds: Denominated in one currency (usually that of the issuer), sold in multiple international markets, facilitating cross-border investment strategies.