1、Chapter 1 - IntroductionLiping ChuSchool of FinanceContents2Sectors of the U.S. Bond MarketOverview of Bond FeaturesRisks Associated with Investing in BondsOverview of Our ObjectivesExamplesQ1Q2Q3Q4Q51.1 Sectors of the U.S. Bond Market31.1.1 What is A Bond?A debt instrument requiring the issuer (deb

2、tor) to repay to lender/investor the amount borrowed plus interest over a specified period of time Plain vanilla bonds Advanced debt contract mortgage pass-through securities4Most Generic ClassificationGovernment bonds low/no risk, low yield, low expected returns - return is high when yield goes dow

3、nRisky bonds non-government bonds, including corporate bonds, municipal bonds, mortgage securities (subprime market securities)Sectors of US Bond MarketTreasury Sector Have you heard of saving bonds?Agency SectorMunicipal SectorCorporate SectorAsset-Backed Security SectorMortgage SectorSee: 1.1.1 Se

4、ctors of the U.S. Bond MarketTreasury sector securities issued by the U.S. governmentChapter 6Agency sector securities issued by federally related institutions and government-sponsored enterprisesChapter 6Municipal sector securities issued by state and local governments bondsChapter 871.1.1 Sectors

5、of the U.S. Bond Market(contd)Corporate sector securities issued in the U.S. by U.S. corporations and foreign corporationsChapter 7Asset-backed sectorsecurities backed by a pool of assetsChapter 15Mortgage sector securities backed by mortgage loansChapter 10-148Federal Reserve: Flow of Funds Account

6、1.2 Overview of Bond Features11Stocks vs. Bonds 1. Different Characteristics 2. Different Markets Stocks: traded on exchanges and OTC markets: NYSE, AMEX, NASDAQ Bonds: traded on OTC markets 3. Similarity: Buy stocks and bonds through online traders Overview of Bond FeaturesTerm to maturityCoupon ra

7、teFixed rate bondsFloating rate bondsReference rate + quoted marginPrincipal/Face ValueInterest rate/yield to maturityPrice1.2.1 Bond IndentureThe terms under which money is borrowed are set forth in an agreement known as the indenture.The indenture lays down the obligations of and restrictions on t

8、he borrower and forms the basis for all future transactions between the lender and the issuer.141.2.2 Term to MaturityMaturity the date on which the principal is required to be repaidTerm to Maturity - the length of time until the loan contract or agreement expiresIt defines the (remaining) life of

9、the bond.The borrower is committed to meet its obligations over this period.Short term, intermediate term, and long termThere may be provisions in the indenture that allow either the issuer or bondholder to alter a bonds term to maturity.151.2.2 Term to Maturity(contd)Why the Maturity of a Bond is I

10、mportant?It defines the period over which the interest and principal payments will be received by the bondholder.The return (yield) earned by the bondholder will be affected by the maturity.The fluctuation in the price of the bond (price volatility) will depend to a large extent on the maturity of t

11、he bond. 161.2.3 PrincipalPrincipal the amount that the issuer agrees to repay the bondholder at the maturity dateAlso referred to as redemption value, maturity value, par value, or face valueDepending on market interest rates, a bond may sell for more or less than its par value.Bond prices are quot

12、ed as percent of its par value.At par: 100Above par: 100 At premiumBelow par: 100 At discount17Coupon (Nominal) Rate the interest rate that the issuer agrees to pay each yearCoupon the annual amount of the interest payment made to bondholdersCoupon Frequency how often the interest is paid each yearI

13、f the coupon rate is c percent (per year) and F is the face or par value of the bond,1.2.4 Coupon Rate181.2.4 Coupon Rate(contd)Floating-Rate SecuritiesFloating-rate securities are bonds that pay a fluctuating rate of interest.Instead of being set for the life of the issue, the coupons on these bond

14、s will vary period by period, depending on interest rate conditions in the market.If market interest rate goes up, the coupons on these securities will go up too.The formula for computing the coupon rate is pre-specified in the indenture.19Coupon Formula for Floating-Rate SecuritiesThe most common p

15、rocedure for setting the coupon rates on floaters is one which starts with a reference rate (such as the rate on certain U.S. Treasury securities or the London Inter-Bank Offered Rate, LIBOR) and then adds, or subtracts, a stated margin to, or from, that reference rate.The formula is often referred

16、to as the coupon reset formula.To find the new coupon rate: New coupon rate = reference rate +/- quoted margin201.2.4 Coupon Rate(contd)Example for Floating-Rate CouponThe coupon of a floating-rate bond will be reset every six months and be calculated with reference to the 6-month LIBOR and a quoted

17、 margin of 150 basis points. (A basis point is 1/100 of 1%, or 0.01%).If the current 6-month LIBOR is 4.75%, what is the relevant coupon rate for the next interest payment period?New coupon rate = 4.75% + 1.50% = 6.25%211.2.4 Coupon Rate(contd)Cap, Floor & Collar for FloatersAs the coupon rate for a

18、 floater varies over time, it may become very high or very low, depending upon the range of values for the reference rate.The two parties to the bond contract sometimes want to limit their exposure to such extreme fluctuations in the coupon rate, and can do so by placing upper and lower limits on th

19、e adjusted coupon rate.221.2.4 Coupon Rate(contd)The upper limit, called the cap, limits the maximum interest paid by the borrower.The lower limit, called the floor, limits the minimum interest received by the lender.When both limits are present simultaneously, the combination is called a collar.231

20、.2.4 Coupon Rate(contd)Inverse FloatersAn inverse or reverse floater is another class of floater where the coupon rate moves in a direction opposite to that of the reference rate.Coupon rate = constant rate (K) L * reference rateWhere K, the constant, and L, the multiplier, are specified in the pros

21、pectus at the time of the issue and remain fixed for the life of the bond.241.2.4 Coupon Rate(contd)1.2.5 Embedded Options Call ProvisionCall provision gives the issuer the right (but not the obligation) to retire all or a part of an issue prior to maturity.If the bonds are “called”, the bondholder

22、has no choice but to turn in his bonds.Call features give the issuer the opportunity to get rid of expensive (high coupon) bond and replace it with lower coupon issue if market interest rates decline during the life of the issue (i.e., refinancing).A call provision is detrimental to the bondholders

23、interests.251.2.6 Embedded Options Put ProvisionBondholders may have the right to sell the bond to the issuer at what is known as the “put price” at certain dates prior to maturity.The put price is generally close to par if the bond is originally issued at or close to par.If interest rates have rise

24、n and the market price of the bond has fallen below par, the bondholder can invoke the put right and force the issuer to buy back the bond at a higher price, i.e. the put price or the par value. The put option benefits the bondholder.261.2.7 Embedded Options Conversion ProvisionA convertible bond is

25、 an issue giving the bondholder the right to exchange the bond for a specified number of shares of common stock.An exchangeable bond allows the bondholder to exchange the issue for a specified number of common stock shares of a corporation different from the issuer of the bond.271.2.8 Bond Features

26、and VariationsFeatures10-year Treasury NoteVariationsTerm to MaturityFixedCallable / Putable / PerpetualRedemptionParCall price / Put price / Index-linkedCoupon RateFixedZero / Floating / Inverse floating / Variable / Step-upCoupon FrequencySemi-annualAnnual / QuarterlyEmbedded OptionsNoneCallable /

27、 Putable / Convertible281.3 Risks Associated with Investing in Bonds29 1.3.1 Interest Rate Risk (Market Risk)The price of a typical bond will change in the opposite direction from a change in interest rates.Interest Rate Risk risk of capital loss due to interest rate increase301.3.2 Reinvestment Ris

28、kTotal return on holding a bond includes additional income from reinvestment of interim cash flows, i.e. interest on interest.Reinvestment Risk variability in the reinvestment rate because of changes in market interest rates311.3.3 Call Risk The cash flow pattern of a callable bond is not known with

29、 certainty.Because the issuer will call the bonds when interest rates have dropped, the investor is exposed to reinvestment risk.The capital appreciation potential of a bond will be reduced, because the price of a callable bond may not rise much above the call price.321.3.4 Credit Risks Default Risk

30、 risk of the bond issuer failing to make timely payment of interest and principalCredit Spread Risk risk of bond price declining due to widening credit spreadDowngrade Risk risk of unanticipated downgrading of an issue or issuer331.3.5 Inflation Risk (Purchasing Power Risk)Inflation Risk variation i

31、n the value of cash flows from a security due to inflation, as measured in terms of purchasing power341.3.6 Exchange-Rate Risk (Currency Risk)Exchange-Rate Risk uncertainty of the value of dollar cash flows from a non-dollar-denominated bond due to fluctuations in exchange rate351.3.7 Liquidity Risk

32、 (Marketability Risk)Liquidity Risk the ease with which an issue can be sold at or near its valueMeasured by the bid-ask spread36 1.3.8 Volatility RiskVolatility Risk risk that a change in volatility of interest rates will affect the price of a bond adverselyAffecting the price of the embedded optio

33、ns371.3.9 Risk RiskRisk risk refers to not knowing the risk of a security.Two ways to mitigate or eliminate risk risk are: Keep up with the literature on the state-of-the-art methodologies for analyzing securitiesavoid securities that are not clearly understood381.3.10 Risks of 10-Year U.S. Treasury

34、 NoteDimension of RiskLevel of Risk Present in the SecurityFuture Cash FlowsKnown in advanceCredit RiskNot presentInterest Rate RiskHighReinvestment RiskHighLiquidity RiskGenerally very liquid, bid-offer spreads are narrowCall RiskNo uncertainty of timing of cash flowsExchange Rate RiskNone for dome

35、stic investorInflation RiskPresentVolatility RiskNot present391.4 Overview of Our Objectives4041Basic Knowledge on BondChapter 2 Pricing Chapter 3 Measuring Yield Chapter 4 Bond Price VolatilityChapter 5 Factors Affecting Bond Yields and the Term Structure of Interest RatesSectors of the U.S. BondCh

36、apter 6 Treasury and Agency SecuritiesChapter 7 Corporate Debt InstrumentsChapter 8 Municipal SecuritiesChapter 9 Non-U.S. Bonds Chapter 10 Residential Mortgage LoansChapter 11 Agency Mortgage Pass-Through SecuritiesChapter 12 Agency Collateralized Mortgage Obligations and Stripped Mortgage-Backed S

37、ecuritiesChapter 15 Asset-Back Securities Bond InvestmentsChapter 22 Bond Portfolio Management StrategiesChapter 23 Bond Portfolio ConstructionChapter 24 Liability-Driven StrategiesChapter 25* Bond Performance Measurement and Evaluation1.4.1 Overview1.5 Questions42Example 1-1 How to calculate coupon

38、 interest?A bond has a par value of $5,000 and a coupon rate of 8.5% payable semi-annually. The bond is currently trading at 112 5/32. What is the dollar amount of the semi-annual coupon payment?$212.50$238.33$425.00$476.6643Answer to Example 1-1AThe dollar amount of the coupon payment is computed a

39、s follows:Coupon in $ = $5,000 x 0.0425 (1/2 of 8.5%) = $212.5044Example 1-2 How to calculate the settlement proceed?A bond has a par value of $50,000 and is currently offered at a quoted price of 98 5/32. What is the dollar amount that an investor must pay in order to purchase the bond?$98.16$49,07

40、8.15$50,000.00$4,907,812.5045Answer to Example 1-2BIf the quoted price is 98 5/32 this means that the dollar amount is 0.981563 x $50,000 = $49,078.1546Example 1-3 Concept of Discount, Par & PremiumGiven that the coupon rate on a bond is higher than the market interest rate on bonds with similar mat

41、urities and payment structures, the bond will be trading at:Par valueA discountA premiumIts call price47Answer to Example 1-3CIf the bond provides investor with a higher coupon rate than the market interest rate, the bond has to be trading at a premium relative to its par value.48Example 1-4 To calc

42、ulate a floating rate issues coupon?Consider a floating-rate issue that carries a coupon rate that is reset on January 1 of each year. The coupon rate is defined as the one-year London interbank offered rate (LIBOR) + 125 basis points and the coupons are paid semi-annually. If the one-year LIBOR is

43、6.5 percent on January 1, what will the semi-annual coupon be on this issue?3.250%3.875%6.500%7.750% 49Answer to Example 1-4BThe value is computed as follows:Semi-annual coupon = (LIBOR + 125 basis point)/2 = (6.5 + 1.25)/2 = 3.875%50Example 1-5 Are caps & floors in floating-rate securities benefici

44、al to investors?Which of the following statements is TRUE with regarding to a floating-rate issues that have caps and floors?A cap is an advantage to the bondholder while a floor is an advantage to the issuer.A cap is an disadvantage to the bondholder while a floor is an disadvantage to the issuer.A

45、 floor is an disadvantage to both the issuer and the bondholder while a cap is an advantage to both the issuer and the bondholder.A floor is an advantage to both the issuer and the bondholder while a cap is an disadvantage to the issuer and the bondholder.51Answer to Example 1-5BA cap limits the upside potential of the coupon rate paid on the floating-rate bond and is therefore a disadvantage to the bondholder.A floor limits the downside potent