Credit & Fixed Income Instruments

School of Business
Trinity College Dublin
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Today
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Introduction to the course & review of the

syllabus
Bonds: a refresher
Bond pricing
Different types of yield
Term structure of the interest rates

Housekeeping
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Schedule
Exam
Interaction
Electronic devices

Companies Financing Choices

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Shares or Bonds ?
WACC = E/(E+D)xRe+D/(E+D)xRd x(1-Tc)
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Re = cost of equity
Rd = cost of debt
E = the market value of the firm's equity
D = the market value of the firm's debt
E/(E+D) = % of financing that is equity
D/(E+D) = % of financing that is debt
Tc = the corporate tax rate

No free lunch! Higher risk means higher

expected return.
But Debt to Equity and other ratios!
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Bond Characteristics
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Face or par value

Coupon rate
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Compounding and payments

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Zero coupon bond

Accrued Interest

Indenture

Provisions of Bonds
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Secured or unsecured
Call provision
Convertible provision
Put provision (putable bonds)
Floating rate bonds

LIBOR
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London Interbank Offered Rate

The benchmark
Formerly published by the
British Bankers Association
Taken over in 2014 by ICE
Panel of at least 11 banks
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Calculation

Available for: GBP, USD, EUR, JPY et CHF

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But no more for CAD, AUD, NZD, SEK et DKK

Euribor
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Euro Interbank Offered Rate

Published by the European Banking Federation
Rate at which euro interbank term deposits are
offered by one prime bank to another prime
bank and is published at 11.00 a.m. CET for
spot value (T+2)

Prime rate vs. LIBOR on USD deposits

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Different Issuers of Bonds

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Governments
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U.S. Treasury
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France
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Municipalities

Corporations
International Agencies (Supranational)
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O.A.T.

Other state entities

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Notes and Bonds

World Bank

Mortgages and Mortgage-Backed Securities

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Treasury Notes and Bonds

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Maturities
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Notes maturities up to 10 years

Bonds maturities in excess of 10 years

Par Value - $1,000

Quotes percentage of par

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Treasury Notes, Bonds & Bills

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Federal Agency Debt

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Major issuers
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Federal Home Loan Bank

Federal National Mortgage Association
Government National Mortgage Association
Federal Home Loan Mortgage Corporation

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Government Agency Issues

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Municipal Bonds
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Issued by state and local governments

Types
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General obligation bonds

Revenue bonds
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Industrial revenue bonds

Maturities range up to 30 years

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Municipal Bond Yields

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Interest income on municipal bonds is not

subject to federal and sometimes state and
local tax
To compare yields on taxable securities a
Taxable Equivalent Yield is constructed

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Equivalent Taxable Yields

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Corporate Bonds
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Issued by private firms

Semi-annual interest payments
Subject to larger default risk than government
securities
Options in corporate bonds
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Callable
Convertible

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Corporate Bond Prices

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Euromarket
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Not linked to the EUR

Dominated by the USD
Standard conditions
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Annual coupon
30/360
No restriction
No tax

Issuer from all around the world

ICMA

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Day Count Conventions

Actual/360

Eurozone
USA

Actual/365

30/360

UK

Switzerland

Several
commonwealth
countries

Euromarket

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Terminology review

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Catastrophe bond
Eurobond
Zero-coupon bond
Samurai bond
Junk bond
Convertible bond

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Serial bond
Equipment
obligation bond
Indexed bond
Callable bond
Puttable bond

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The basics
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Interest rates
Inflation
Risk and return

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Investments & Financial Assets

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Essential nature of investment

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Real Assets
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Reduced current consumption

Planned later consumption
Assets used to produce goods and services

Financial Assets
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Claims on real assets

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Treasury Inflation Protected Security

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Bond Pricing

PB =
Ct =
T =
r =

Price of the bond

interest or coupon payments
number of periods to maturity
semi-annual discount rate or the semi-annual
yield to maturity

Price: 10-yr, 8% Coupon

Ct = 40 (SA)
P = 1000
T = 20 periods
r
= 3% (SA)
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Bond Prices and Yields

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Prices and Yields (required rates of return)

have an inverse relationship
When yields get very high the value of the
bond will be very low.
When yields approach zero, the value of the
bond approaches the sum of the cash flows.

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The Inverse Relationship

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8% Coupon Bond, Semiannual

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Yield to Maturity
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Interest rate that makes the present value of

the bonds payments equal to its price.

Solve the bond formula for r

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Yield to Maturity Example

10 yr Maturity Coupon Rate = 7%

Price = $950
Solve for r = semiannual rate
r = 3.8635%
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Yield Measures
Bond Equivalent Yield
7.72% = 3.86% x 2
Effective Annual Yield
(1.0386)2 - 1 = 7.88%
Current Yield
Annual Interest / Market Price
$70 / $950 = 7.37 %
Yield to Call

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Callable and Straight Debt

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Yield to Call

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Realized Yield versus YTM

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Reinvestment Assumptions
Holding Period Return
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Changes in rates affects returns

Reinvestment of coupon payments
Change in price of the bond

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Growth of Invested Funds

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Prices over Time of a 6-5%, 30-Year Bond

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Holding-Period Return: Single Period

HPR = [ I + ( P0 - P1 )]

P0

where
I = interest payment
P1 = price in one period
P0 = purchase price

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Holding-Period Example
CR = 8%
YTM = 8% N=10 years
Semiannual Compounding P0 = $1000
In six months the rate falls to 7%
P1 = $1068.55
HPR = [40 + ( 1068.55 - 1000)] / 1000
HPR = 10.85% (semiannual)

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Price of a 30-Year 0 coupon Bond

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Default Risk and Ratings

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Rating companies
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Moodys Investor Service

Standard & Poors
Fitch

Rating Categories
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Investment grade
Speculative grade

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Bond Rating Class

Factors Used by Rating Companies

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Coverage ratios
Leverage ratios
Liquidity ratios
Profitability ratios
Cash flow to debt

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Financial Ratios and Default Risk by Rating

Class, Long-Term Debt

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Protection Against Default

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Sinking funds
Subordination of future debt
Dividend restrictions
Collateral

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Callable Bond Issue

by Mobil

The Basics of Pricing a Corporate Bond

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The pricing of a corporate bond is based on comparable

issues outstanding in the market based on
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credit rating
market sector
term to maturity

If a borrower is a frequent issuer in the market, such as

Nestl , the comparable issues used will largely
comprise their own issues in that currency
e.g. Nestl in Euro
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Nestl 3.25% due 2017 is trading at: 38bps over mid-swaps

Nestl 3.00% due 2021 is trading at: 59bps over mid-swaps
Nestl 3.00% due 2025 is trading at: 85bps over mid-swaps
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The Basics of Pricing a Corporate Bond

Setting the coupon rate
Example: a new Nestl 10-year in Euro:
10-year Mid-swaps yield:
1.70%
+10-year Nestl credit spread to mid-swaps: 0.85% (85bps)
Re-offer yield:
2.55%
Coupon (reduce yield to nearest 0.125%)

2.50%

NB: The rounding will of course impact the offering price

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The Basics of Pricing a Corporate Bond

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But investors required 2.55% yield to buy 10 year

Nestl Eurobonds, but only receive 2.50%

From the bond valuation formula, we can see that

an increased required yield implies a discounted
cash price. The investors now buy the bond for
EUR99.59 and receive EUR100 at maturity
This 41 cents over 10 years provides the remaining
0.05% annual yield required by investors

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Default Risk and Yield

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Risk structure of interest rates

Default premiums
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Yields compared to ratings

Yield spreads over business cycles

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Yields on L-T Bonds, 1954 2006

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Yields on L-T Bonds, 1984 - 2010

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Overview of Term Structure

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The relationship between yield to maturity and

maturity.
Information on expected future short term
rates can be implied from yield curve.
The yield curve is a graph that displays the
relationship between yield and maturity.
Three major theories are proposed to explain
the observed yield curve.

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Treasury Yield Curves

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Spreads
Yield curve is about government bonds

Yield (%)
Single-A Rated Corporate
Spread vs Swaps
Swap curve - Double-A Rated Financial Institution Risk

Spread vs Govt
Swap Spread

Governments - Triple-A Rated Risk

Maturity

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YTM & Prices on 0-Coupon Bonds

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Two 2-Year Investment Programs

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Short Rates versus Spot Rates

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Forward Rates

fn = one-year forward rate for period n

yn = yield for a security with a maturity of n

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Example of Forward Rates

4 yr = 8.00% 3yr = 7.00%

fn = ?

(1.08)4 = (1.07)3 (1+fn)

(1.3605) / (1.2250) = (1+fn)
fn = .1106 or 11.06%
Note: this is expected rate that was used in
the prior example.
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Downward Sloping Yield Curve

Zero-Coupon Rates
12%
11.75%
11.25%
12%
9.25%

Bond Maturity
1
2
3
4
5

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Forward Rates Downward Curve

1yr Forward Rates
1yr

[(1.1175)2 / 1.12] - 1

= 0.115006

2yrs [(1.1125)3 / (1.1175)2] 1

= 0.102567

3yrs [(1.1)4 / (1.1125)3] 1 = 0.063336

4yrs [(1.0925)5 / (1.1)4] 1 = 0.063008

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Theories of Term Structure

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Expectations
Liquidity Preference
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Upward bias over expectations

Habitat

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Expectations Theory
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Observed long-term rate is a function of

todays short-term rate and expected future
short-term rates.
Long-term and short-term securities are
perfect substitutes.
Forward rates that are calculated from the
yield on long-term securities are market
consensus expected future short-term rates.

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Liquidity Premium Theory

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Long-term bonds are more risky.

Investors will demand a premium for the risk
associated with long-term bonds.
The yield curve has an upward bias built into
the long-term rates because of the risk
premium.
Forward rates contain a liquidity premium and
are not equal to expected future short-term
rates.

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Yield Curves (with Liquidity Premiums)

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Price Volatility of L-T T-Bonds

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Yields on 10-Year versus 90-Day Treasury

Securities: Term Spread

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Group Exercise - Bonds

What will happen to the price of a corporate bond in the
following scenarios, and why
1. Stock indices begin to fall
2. Inflation starts to climb
3. Credit rating of the company is up-graded
4. Interest rates are lowered
5. General increase in demand for bonds by pension funds
6. Co. announces profits in line with market expectations
7. Co. announces it intends to repay the bond early
8. Credit rating of the country is down-graded
9. Co. announces a large cash surplus in its accounts
10. Co. becomes a takeover subject of a higher rated corp.
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Group Exercise - Bonds

What will happen to the price of a corporate bond in the following
scenarios, and why:
1. Stock indices begin to fall
(L)
2. Inflation starts to climb (L)
3. Credit rating of the company is up-graded (H)
4. Interest rates are lowered (H)
5. General increase in demand for bonds by pension funds (H)
6. Company announces profits in line with market expectations (U)
7. Company announces that it intends to repay the bond early (L)
8. Credit rating of the country is down-graded (L)
9. Company announces it has a large cash surplus in its accounts
(H)
10. Company becomes a takeover subject of a higher rated corp (H)

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Thats all for today

Before you leave

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