Slide 8.22 Pure Discount Bonds Example
Zero coupon bonds are bonds that are offered at deep discounts because there
are no periodic coupon payments. Although no cash interest is
paid, firms deduct the implicit interest, while holders report it as
income. Interest expense equals the periodic change in the
amortized value of the bond.
Lecture Tip: Most students are familiar with Series EE savings bonds. Point
out that these are actually zero coupon bonds. The investor pays
one-half of the face value and must hold the bond for a given
number of years before the face value is realized. As with any
other zero-coupon bond, reinvestment risk is eliminated, but an
additional benefit of EE bonds is that, unlike corporate zeroes, the
investor need not pay taxes on the accrued interest until the bond
is redeemed. Further, it should be noted that interest on these
bonds is exempt from state income taxes.
Lecture Tip: A popular financial innovation is Treasury “STRIPS.” You might
want to take a few minutes to describe these instruments and use
them as a springboard for a discussion of value additivity and/or
an example of cash flow valuation in practice.
Treasury strips are created when a coupon-bearing Treasury
issue is purchased, placed in escrow, and the coupon payments are
“stripped away” from the principal portion. Each component is
then sold separately to investors with different objectives: the
coupon portion is purchased by those desirous of safe current
income, while the principal portion is purchased by those with
cash needs in the future. (The latter portion is, in essence, a
synthetically created zero-coupon bond.) Merrill Lynch was the
first to offer these instruments, calling them “TIGRs” (Treasury
Investment Growth Receipts), soon to be followed by Salomon
Brothers’ CATs (Certificates of Accrual of Treasury securities).
Slide 8.23 Bond Pricing with a Spreadsheet
8.1. Government and Corporate Bonds
.A Government Bonds
Slide 8.24 Government Bonds
Long-term debt instruments issued by a governmental entity. Treasury bonds
are bonds issued by a federal government; a state or local
government issues municipal bonds. In the U.S., Treasuries are
exempt from state taxation and “munis” are exempt from federal
taxation.
Lecture Tip: The government of Russia issued bonds in 1996 for the first time
since the 1917 revolution. Demand was so great that the amount of
the issue was raised from $200 million to $1 billion. The prime
minister of Russia stated that the market’s reaction “reflected the
trust international investors have in Russia.” It should be noted,
however, that the yield required by investors in the five-year bonds
was 9.36%, nearly 3.5% higher than similar U.S. Treasury issues.
Russia’s borrowing spree ended in a financial meltdown and
unilateral default on much of its debt.
Lecture Tip: In June, 1996, The Wall Street Journal reported that officials in
New York City were considering the issuance of municipal bonds
backed by the assets of “deadbeat parents.” The plan was to work
like this: investors would buy the high-yield bonds, funds would go
to some of the families to whom back child-support payments are
owed, and the city would go after the assets of those with payments
in arrears in order to make the interest payments on the bonds.
What makes the deal so attractive to the city is that, besides
addressing the “deadbeat parents” issue, the city is not backing
the financial obligation; rather, the city simply promises to enforce
the child-support laws. According to
Finance Commissioner Fred Cerullo, “We find this proposal interesting … it’s
very consistent with the city’s position of helping the families of
deadbeat dads, and our position on [asset] securitization.” And,
as the Journal points out, if this proposal sounds strange, “who
would have thought 20 years ago that credit cards and other so-
called receivables would be securitized and sold on a regular
basis?”
Lecture Tip: A Wall Street Journal article described how an American with
the Agency for International Development has helped introduce
municipal bonds to India. As the article notes, “The concept is to
use dwindling funds to offer government the most rudimentary
tools of capitalism, such as the mundane but beneficial muni bond.
The idea is to help poor nations tap vast new sources for vital
infrastructure development while developing goodwill, and
investment opportunities, for U.S. investors.” And the key to this
exercise? The ability to get the bonds rated by a credit-rating
agency.
Slide 8.25 After-tax Yields
To properly compare bond yields, taxes must be included. For
example, is an investor better off investing in a corporate bond
with a yield of 6% or a tax free bond with a yield of 4%? It
depends on the investor’s tax rate. At a rate of 25%, the taxable
bond yields:
6% * (1 – .25) = 4.5%
So, the investor is still better off with the taxable bond. But, at
what tax rate does he breakeven?
6% * (1 – t) = 4%
t = 33%
At any tax rate above 33%, the investor would choose the tax free
bond.
.B Corporate Bonds
Slide 8.26 Corporate Bonds
Corporate bonds present greater default risk relative to government
bonds, thus there is an underlying difference between the bond’s
promised yield (or, yield to maturity) and its expected return.
.C Bond Ratings
Given the importance of understanding the risk of default, bond
ratings play a key role in the pricing and analysis of corporate debt.
Slide 8.27 Bond Ratings – Investment Quality
Slide 8.28 Bond Ratings – Speculative
Lecture Tip: The question sometimes arises as to why a potential issuer
would be willing to pay rating agencies tens of thousands of
dollars in order to receive a rating, especially given the possibility
that the resulting rating could be less favorable than expected.
This is a good place to remind students about the pervasive nature
of agency costs and point out a real-world example of their effects
on firm value. You may also wish to use this issue to discuss some
of the consequences of information asymmetries in financial
markets.
Lecture Tip: A “new” player entered the debt rating arena in the 1990s.
According to the November 2, 1998 issue of Forbes Magazine, a
small, relatively young firm in San Francisco, KMV Corp.,
provides clients with “access to a software package that translates
publicly available data into probabilities that a particular
borrower will default on its obligations.” The article suggests that,
by translating stock volatility into estimates of business risk, the
firm is able to forecast defaults ahead of the more traditional
rating agencies. The key is the now-familiar notion in finance that
equity in a levered firm is equivalent to a call option on the firm’s
assets. By estimating the probability that the value of the firm will
fall below its liabilities, KMV is effectively estimating the
probability that the equityholders will not “exercise their option,”
thus defaulting on the debt obligations.
The firm was “successful” enough, that they were acquired by
Moody’s. For more information, see www.moodyskmv.com.
Lecture Tip: Ask your students which is riskier – junk bonds or IBM common
stock? If they guess the former, they would get an argument from
those IBM shareholders who lost billions of dollars as prices fell
from the $120’s to $42. More value was lost by IBM shareholders
in 1991 – 92 than in the junk bond market from the 1980’s to that
point!
Lecture Tip: A major scandal broke in 1996 when allegations were made that
Moody’s Investors Service, Inc. was issuing ratings on bonds it
had not been hired to rate, in order to pressure issuers to pay for
their service. In a Wall Street Journal story dated May 2, 1996, it
was reported that, after choosing to use rating services other than
Moody’s, officials in Chippewa County, Michigan received a letter
from the Executive Vice President warning that the “absence of a
rating … might imply that we believe that there exist deficiencies”
in the financing arrangements. Further, Moody’s billed the county
anyway, “as part of a long-standing policy.” Moody’s actions
resulted in an antitrust inquiry by the U.S. Justice Department,
and resulted in the departure of several of the firm’s senior
management.
It should be noted that Standard and Poor’s is also in the practice of
issuing unsolicited ratings. In November of 1996, the Financial
Times reported that S&P was “moving closer to formalizing the
issuance of unsolicited ratings, which are issued
without cooperation from the rated entity. Before the end of the year, it will
have issued such ratings on emerging market banks in Singapore,
Malaysia, Mexico, Colombia, Slovakia, as well as Japanese
regional banks.”
However, in March 1999, the U.S. Justice Department announced that they
were dropping the antitrust investigation into Moody’s without
taking any action.
Lecture Tip: In the wake of the sub-prime debt issue in late 2007
and 2008, many ratings agencies came under fire for rating
collateralized debt based on underlying mortgages as triple AAA,
even when many of the mortgages in the pool were highly
speculative. In fact, many bond insurers were pushed to the edge of
bankruptcy as a result of these investments.
8.2. Bond Markets
Slide 8.29 Bond Markets
.A How Bonds Are Bought and Sold
Most transactions are OTC (over-the-counter).
Daily bond trading volume (by dollar value) exceeds stock trading volume,
but trading in individual issues tends to be very thin.
.B Bond Price Reporting
Slide 8.30 Treasury Quotations
.C A Note on Bond Price Quotes
Slide 8.31 Clean versus Dirty Prices
Bonds are quoted without accrued interest, and this is called the “clean price.”
The “dirty price” is the quoted price plus accrued interest and is the
price that is actually paid. The accrued interest is computed by
taking a pro rata share of the coupon payment.
Example: Suppose the last coupon was paid 50 days ago and there are 182
days in the current coupon period. If the semiannual coupon
payment is $40, then the accrued interest would be (50/182)*40 =
$10.99, and this would be added to the quoted price to determine
the “dirty price.”
8.3. Inflation and Interest Rates
Slide 8.32 Inflation and Interest Rates
.A Real versus Nominal Rates
Slide 8.33 Real versus Nominal Rates
Nominal rates – rates that have not been adjusted for inflation
Real rates – rates that have been adjusted for inflation
Let R be the nominal rate, r the real rate and h the expected
inflation rate; then,
(1 + R) = (1 + r)(1 + h)
A reasonable approximation, when expected inflation is relatively
low, is R = r + h.
A definition whereby the real rate can be found by deflating the nominal rate
by the inflation rate: r = [(1 + R) / (1 + h)] – 1.
.B Inflation Risk and Inflation-Linked Bonds
Slide 8.34 Inflation-Linked Bonds
Even with default-free government bonds, there is still inherent
risk. Specifically, inflation risk suggests that inflation can
deteriorate the value of money over the time it is invested. Thus,
the real return is less than the nominal return.
TIPS (treasury inflation-protected securities) enable investors to
offset inflation risk by providing promised payments specified in
real terms.
.C The Fisher Effect
Slide 8.35 The Fisher Effect: Example
The Fisher Effect is a theoretical relationship between nominal returns, real
returns and the expected inflation rate. Essentially, the effect can
be stated as:
“A rise in the rate of inflation causes the nominal
rate to rise just enough so that the real rate of
interest is unaffected. In other words, the real rate is
invariant to the rate of inflation.”
Lecture Tip: In late 1997 and early 1998 there was a great deal of
talk about the effects of deflation among financial pundits, due in
large part to the combined effects of continuing decreases in
energy prices, as well as the upheaval in Asian economies and the
subsequent devaluation of several currencies. How might this
affect observed yields? According to the Fisher Effect, we should
observe lower nominal rates and higher real rates, and that is
roughly what happened.
8.4. Determinants of Bond Yields
Slide 8.36 Determinants of Bond Yields
.A The Term Structure of Interest Rates
Term structure of interest rates –relationship between nominal interest rates on
default-free, pure discount bonds and time to maturity
Inflation premium – portion of the nominal rate that is compensation for
expected inflation
Interest rate risk premium – reward for bearing interest rate risk
.B Bond Yields and the Yield Curve: Putting It All Together
Treasury yield curve – plot of yields on Treasury notes and bonds relative to
maturity
Slide 8.37 Factors Affecting Required Return
Default risk premium – the portion of a nominal rate that represents
compensation for the possibility of default
Taxability premium – the portion of a nominal rate that represents
compensation for unfavorable tax status
Liquidity premium – the portion of a nominal rate that represents
compensation for lack of liquidity
.C Conclusion
The bond yields that we observe are influenced by six factors:
(1) the real rate of interest
(2) expected future inflation
(3) interest rate risk
(4) default risk,
(5) taxability
(6) liquidity
Slide 8.38 Quick Quiz