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1

Corporate bonds can:

 Be callable

allow the issuer to buy them back from the holder at a pre-determined call price prior to maturity

  • If they buy bond at high coupon rate and later interest rates fall, the firm can retire the high-coupon debt and issue new bonds as a lower coupon rate to reduce interest payments

2

puttable corporate bonds

allow the holder to extend or sell them to the issuer at the call date if they so choose

  • if bond's coupon rate> current market yields, bondholder will choose to extend bond's life

3

convertible corp bonds

bondholders the right to swap them for a pre-determined number of shares in the firm

4

 Bonds receiving relatively high ratings (eg an S&P rating of at least BBB or a Moody’s rating of at least Baa) are classed as

investment-grade bonds;

5

Bonds receiving below  (n S&P rating of at least BBB or a Moody’s rating of at least Baa) 

 

speculative-grade or junk bonds

6

Bonds are issued with indentures designed to

protect the purchaser against the risk of default, and can involve the issuer agreeing to:

 Establish a sinking fund;
 Subordinate further debt;
 Restrict dividend payments;
 Include collateral as part of the issue; and / or,

Maintain financial ratios such as leverage at pre- determined levels.

7

YTM

YTM is the average rate of return if the bond is held to maturity. The measure implicitly assumes all coupon payments are reinvested at the YTM.

 

8

When interest rate is constant over the life of the bond

YTM = interest rate

9

relationship between bond price and YTM

inverse

10

the realized yield is based on 

the actual reinvestment rate in each period and the total cash received at maturity

11

If interest rates fall, the price of a straight bond

the price of a callable blond

can rise considerably. However:

▪ The price of the callable bond is flat when interest rates are low as the risk of repurchase or call is high; and,

▪ If the bond is called, the bondholder will only receive the call price, not the market price.

12

When interest rates are high,

the risk of call is small and the values of the straight and the callable bond converge.

13

what do we calculate for callable bonds

calculate a yield to call rather than YTM for callable bonds; and,

The yield to call replaces time until maturity with time until call and par value with call price in the YTM calculation.

14

The pure yield curve

describes the relationship between YTM and time to maturity for stripped or zero-coupon treasuries; and,

15

on-the-run yield curve

describes the relationship between YTM and time to maturity for newly issued coupon-paying bonds selling at / close to par.

16

17

Theories of Term Structure

The Expectation Hypothesis

the yield curve reflects the market’s expectations of future interest rates. In particular, it asserts that:

Investors are risk neutral, or there are equal numbers of short- and long-term investors;

The forward rate is an unbiased estimate of the future short rate, that is, E(rn) = fn; and,

An upward-sloping yield curve implies that the market believes interest rates will rise.

18

Theories of Term Structure

Liquidity Preference Hypothesis

  • There are more short-term investors than long-term investors, meaning long term bonds have lower liquidity than short-term bonds;

 To compensate buyers of long-term bonds for the lower liquidity, long-term bonds must offer a higher return; and,

 The forward rate is the expected future short rate plus a liquidity premium, or fn = E(rn) + liquidity premium.

19

Theories of Term Structure

Market Segmentation Hypothesis

  • Borrowers and lenders have strong preferences for particular maturities. Consequently, they do not hold or issue bonds at other maturities;

  Debt markets at different maturities are not linked, that is, they are segmented; and,

  The yield at a particular maturity is determined purely by supply and demand for bonds at that maturity.

20

Shortcomings of current yield

 

does not account for capital gains or losses on bonds bought at prices other than par value. It also does not account for reinvestment income on coupon payments.

21

shortcomings of yield to maturity

assumes the bond is held until maturity and that all coupon income can be reinvested at a rate equal to the yield to maturity.

22

Realized compound yield 

shortcomings

is affected by the forecast of reinvestment rates, holding period, and yield of the bond at the end of the investor's holding period

23

Under expectation hypothesis, if yield curive is upward sloping

the market must expect an increase in short-term interest rates b/c 

there are no risk premia built into bond prices. The only reason for long-term yields to exceed short-term yields is an expectation of higher short-term rates in the future

24

25

Segmentation hypothesis.

 

An upward sloping yield curve is

evidence of supply pressure in the long-term market and demand pressure in the short-term market.

26

According to the segmentation hypothesis, expectations of future rates

have little to do with the shape of the yield curve

27

liquidity preference hypothesis

Yields on long-term bonds are

Yields on long-term bonds are greater than the expected return from rolling-over short-term bonds in order to compensate investors in long-term bonds for bearing interest rate risk.

Thus bonds of different maturities can have different yields even if expected future short rates are all equal to the current short rate.

28

liquidity preference hypothesis

Yields on long-term bonds are

Yields on long-term bonds are greater than the expected return from rolling-over short-term bonds in order to compensate investors in long-term bonds for bearing interest rate risk.

Thus bonds of different maturities can have different yields even if expected future short rates are all equal to the current short rate.

29

Expectations hypothesis.

An upward sloping curve is explained by

expected future short rates being higher than the current short rate.

30

Expectations hypothesis.

A downward-sloping yield curve implies

expected future short rates are lower than the current short rate.

Thus bonds of different maturities have different yields if expectations of future short rates are different from the current short rate.