Chapter 9: Debt Securities
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Bond Basics: What Are Bonds?
Bond Basics: What Are Bonds? Have you ever borrowed money? Of course you have! Whether we hit our parents up for a few bucks to buy candy as children or asked the bank for a mortgage, most of us have borrowed money at some point in our lives. Just as people need money, so do companies and governments. A company needs funds to expand into new markets, while governments need money for everything from infrastructure to social programs. The problem large organizations run into is that they typically need far more money than the average bank can provide. The solution is to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor). Of course, nobody would loan his or her hard-earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed- income securities because you know the exact amount of cash you'll get back if you hold the security until maturity. -
Principal Investment Strategy Main Risks
Class Investor I Y PORTFOLIO TURNOVER Ticker DHRAX DHRIX DHRYX The fund pays transaction costs, such as commissions, when it Before you invest, you may want to review the fund’s Prospectus, which buys and sells securities (or “turns over” its portfolio). A higher contains information about the fund and its risks. The fund’s Prospectus and portfolio turnover rate may indicate higher transaction costs and Statement of Additional Information, both dated February 28, 2021, are may result in higher taxes when fund shares are held in a taxable incorporated by reference into this Summary Prospectus. For free paper or account. These costs, which are not reflected in annual fund electronic copies of the fund’s Prospectus and other information about the operating expenses or in the Example, affect the fund’s fund, go to http://www.diamond-hill.com/mutual-funds/documents.fs, email a performance. During the most recent fiscal year, the fund’s request to [email protected], call 888-226-5595, or ask any financial portfolio turnover rate was 28% of the average value of advisor, bank, or broker-dealer who offers shares of the fund. its portfolio. Investment Objective Principal Investment Strategy The investment objective of the Diamond Hill Core Bond Fund is to maximize total return consistent with the preservation of Under normal market conditions, the fund intends to provide capital. total return by investing at least 80% of its net assets (plus any amounts borrowed for investment purposes) in a diversified Fees and Expenses of the Fund portfolio of investment grade, fixed income securities, including This table describes the fees and expenses that you may pay if bonds, debt securities and other similar U.S. -
3. VALUATION of BONDS and STOCK Investors Corporation
3. VALUATION OF BONDS AND STOCK Objectives: After reading this chapter, you should be able to: 1. Understand the role of stocks and bonds in the financial markets. 2. Calculate value of a bond and a share of stock using proper formulas. 3.1 Acquisition of Capital Corporations, big and small, need capital to do their business. The investors provide the capital to a corporation. A company may need a new factory to manufacture its products, or an airline a few more planes to expand into new territory. The firm acquires the money needed to build the factory or to buy the new planes from investors. The investors, of course, want a return on their investment. Therefore, we may visualize the relationship between the corporation and the investors as follows: Capital Investors Corporation Return on investment Fig. 3.1: The relationship between the investors and a corporation. Capital comes in two forms: debt capital and equity capital. To raise debt capital the companies sell bonds to the public, and to raise equity capital the corporation sells the stock of the company. Both stock and bonds are financial instruments and they have a certain intrinsic value. Instead of selling directly to the public, a corporation usually sells its stock and bonds through an intermediary. An investment bank acts as an agent between the corporation and the public. Also known as underwriters, they raise the capital for a firm and charge a fee for their services. The underwriters may sell $100 million worth of bonds to the public, but deliver only $95 million to the issuing corporation. -
Understanding the Z-Spread Moorad Choudhry*
Learning Curve September 2005 Understanding the Z-Spread Moorad Choudhry* © YieldCurve.com 2005 A key measure of relative value of a corporate bond is its swap spread. This is the basis point spread over the interest-rate swap curve, and is a measure of the credit risk of the bond. In its simplest form, the swap spread can be measured as the difference between the yield-to-maturity of the bond and the interest rate given by a straight-line interpolation of the swap curve. In practice traders use the asset-swap spread and the Z- spread as the main measures of relative value. The government bond spread is also considered. We consider the two main spread measures in this paper. Asset-swap spread An asset swap is a package that combines an interest-rate swap with a cash bond, the effect of the combined package being to transform the interest-rate basis of the bond. Typically, a fixed-rate bond will be combined with an interest-rate swap in which the bond holder pays fixed coupon and received floating coupon. The floating-coupon will be a spread over Libor (see Choudhry et al 2001). This spread is the asset-swap spread and is a function of the credit risk of the bond over and above interbank credit risk.1 Asset swaps may be transacted at par or at the bond’s market price, usually par. This means that the asset swap value is made up of the difference between the bond’s market price and par, as well as the difference between the bond coupon and the swap fixed rate. -
Structured Notes, Which Have Embedded Derivatives, Some of Them Very Complex
Structured note markets: products, participants and links to wholesale derivatives markets David Rule and Adrian Garratt, Sterling Markets Division, and Ole Rummel, Foreign Exchange Division, Bank of England Hedging and taking risk are the essence of financial markets. A relatively little known mechanism through which this occurs is the market in structured notes, which have embedded derivatives, some of them very complex. Understanding these instruments can be integral to understanding the underlying derivative markets. In some cases, dealers have used structured notes to bring greater balance to their market risk exposures, by transferring risk elsewhere, including to households, where the risk may be well diversified. But the positions arising from structured notes can sometimes leave dealers ‘the same way around’, potentially giving rise to ‘crowded trades’. In the past that has sometimes been associated with episodes of market stress if the markets proved less liquid than normal when faced with lots of traders exiting at the same time. FOR CENTRAL BANKS, understanding how the modern For issuers, structured notes can be a way of buying financial system fits together is a necessary options to hedge risks in their business. Most, foundation for making sense of market developments, however, swap the cash flows due on the notes with a for understanding how to interpret changes in asset dealer for a more straightforward set of obligations. prices and, therefore, for identifying possible threats In economic terms, the dealer then holds the to stability and comprehending the dynamics of embedded options. Sometimes they may hedge crises. Derivatives are an integral part of this, used existing exposures taken elsewhere in a dealer’s widely for the management of market, credit and business. -
Auction Rate Securities Issue Brief
C ALIFORNIA DEBT AND ISSUE BRIEF INVESTMENT ADVISORY California Debt and Investment Advisory Commission August 2004 C OMMISSION AUCTION RATE SECURITIES Douglas Skarr CDIAC Policy Research Unit The Auction Rate Securities market has Securities must carefully evaluate the current expanded significantly in the public finance environment, their objectives, and consider how sector since 2001. Nationwide, issuance of this debt will be managed over the long term. auction rate securities, including the public finance area, grew from $100 billion in the This Issue Brief provides an overview of the first quarter of 2002 to $200 billion by the end market, mechanics, costs, benefits and risks of the fourth quarter of 2003. Public finance associated with Auction Rate Securities. has become the fastest-growing sector to use auction rate securities, with total issuance I. DEFINITION AND PURPOSE projected to grow at double-digit rates in the Auction Rate Securities (ARS) are long term, future (see Figure 1). variable rate bonds tied to short term interest rates. ARS have a long term nominal maturity Figure 1 – ARS Issues Outstanding with interest rates reset through a modified ARS Outstanding 2002-2003 Dutch auction, at predetermined short term 250 intervals, usually 7, 28, or 35 days. They trade 200 at par and are callable at par on any interest payment date at the option of the issuer. 150 Interest is paid at the current period based on 100 the interest rate determined in the prior auction ($)In Billions period. 50 0 Although ARS are issued and rated as long term Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- 2002 2002 2002 2002 2003 2003 2003 2003 bonds (20 to 30 years), they are priced and Total Municipal traded as short term instruments because of the liquidity provided through the interest rate reset The use of auction rate financing is becoming mechanism. -
Convertible Bond Investing Brochure (PDF)
Convertible bond investing Invesco’s Convertible Securities Strategy 1 Introduction to convertible bonds A primer Convertible securities provide investors the opportunity to participate in the upside of stock markets while also offering potential downside protection. Because convertibles possess both stock- and bond-like attributes, they may be particularly useful in minimizing risk in a portfolio. The following is an introduction to convertibles, how they exhibit characteristics of both stocks and bonds, and where convertibles may fit in a diversified portfolio. Reasons for investing in convertibles Through their combination of stock and bond characteristics, convertibles may offer the following potential advantages over traditional stock and bond instruments: • Yield advantage over stocks • More exposure to market gains than market losses • Historically attractive risk-adjusted returns • Better risk-return profile • Lower interest rate risk Introduction to convertibles A convertible bond is a corporate bond that has the added feature of being convertible into a fixed number of shares of common stock. As a hybrid security, convertibles have the potential to offer equity-like returns due to their stock component with potentially less volatility due to their bond-like features. Convertibles are also higher in the capital structure than common stock, which means that companies must fulfill their obligations to convertible bondholders before stockholders. It is important to note that convertibles are subject to interest rate and credit risks that are applicable to traditional bonds. Simplified convertible structure Bond Call option Convertible Source: BofA Merrill Lynch Convertible Research. The bond feature of these securities comes from their stated interest rate and claim to principal. -
Bonds and Their Valuation
Chapter 7 Bonds and Their Valuation Key Features of Bonds Bond Valuation Measuring Yield Assessing Risk 7‐1 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is a bond? • A long‐term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond. 7‐2 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Bond Markets • Primarily traded in the over‐the‐counter (OTC) market. • Most bonds are owned by and traded among large financial institutions. • The Wall Street Journal reports key developments in the Treasury, corporate, and municipal markets. Online edition lists trading for each day the most actively‐traded investment‐grade, high‐yield, and convertible bonds. 7‐3 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Key Features of a Bond • Par value: face amount of the bond, which is paid at maturity (assume $1,000). • Coupon interest rate: stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest. • Maturity date: years until the bond must be repaid. • Issue date: when the bond was issued. • Yield to maturity: rate of return earned on a bond held until maturity (also called the “promised yield”). 7‐4 © 2012 Cengage Learning. -
VALUATION of CALLABLE BONDS: the SALOMON BROTHERS APPROACH Fernando Daniel Rubio Fernández
VALUATION OF CALLABLE BONDS: THE SALOMON BROTHERS APPROACH Fernando Daniel Rubio Fernández VALUATION OF CALLABLE BONDS: THE SALOMON BROTHERS APPROACH FERNANDO RUBIO1 Director FERNCAPITAL S.A. and Invited Professor at the Graduated Business School Universidad de Valparaíso, Chile. Pasaje La Paz 1302, Viña del Mar, Chile. Phone (56) (32) 507507 EXTRACT This paper explain, analyze and apply in an example the original paper developed by Kopprasch, Boyce, Koenigsberg, Tatevossian, and Yampol (1987) from The Salomon Brothers Inc. Bond Portfolio Analysis Group. Please, be aware. This paper is for educational issues only. There is a Spanish version in EconWPA. JEL Classification: G10, G15, G21, G32. Keywords: Salomon Brothers, bond portfolio, duration and convexity, effective duration, valuation, callable and non callable bond. Originally developed January, 1999 Originally published October, 2004 This update July, 2005 1 This paper was made while I was assisting to the Doctoral Programme in Financial Economics, Universidad Autónoma de Madrid, Spain. Comments and suggestions will be appreciated. Please, send them by e-mail to [email protected] [email protected] 1 VALUATION OF CALLABLE BONDS: THE SALOMON BROTHERS APPROACH Fernando Daniel Rubio Fernández VALUATION OF CALLABLE BONDS: THE SALOMON BROTHERS APPROACH By Professor Dr. © Fernando Rubio 1 DURATION AND CONVEXITY FOR NORMAL (NO CALLABLE) BONDS Bonds are fixed income investments that have a fixed interest rate or coupon, payable on the principal amount. All fixed income investments are evidence of indebtedness which represent a loan or debt between the issuer and the owner or holder of the security. The value of any bond is the present value of its expected cash flows. -
Bond Valuation Reading
Bond valuation A reading prepared by Pamela Peterson Drake ___________________________________________________________ O U T L I N E 1. Valuation of long-term debt securities 2. Issues 3. Summary ___________________________________________________________ 1. Valuation of long-term debt securities Debt securities are obligations to repay an amount borrowed, along with some compensation for the time value of money and risk. The borrowers may be corporations, the government, or governmental agencies. The lenders may be corporations, governments, pension funds, mutual funds, or individual investors. Long-term debt securities, such as notes and bonds, are promises by the borrower to repay the principal amount. Notes and bonds may also require the borrower to pay interest periodically, typically semi- annually or annually, and generally stated as a percentage of the face value of the bond or note. We refer to the interest payments as coupon payments or coupons and the percentage rate as the coupon rate. If these coupons are a constant amount, paid at regular intervals, we refer to the security paying them as having a straight coupon. A debt security that does not have a promise to pay interest we refer to as a zero-coupon note or bond. The value of a debt security today is the present value of the promised future cash flows -- the interest and the maturity value.1 Therefore, the present value of a debt is the sum of the present value of the interest payments and the present value of the maturity value: Present value of a bond = present value of interest payments + present value of maturity value To calculate the value of a debt security, we discount the future cash flows -- the interest and maturity value -- at some rate that reflects both the time value of money and the uncertainty of receiving these future cash flows. -
The Use of Credit Default Swaps by U.S. Fixed-Income Mutual Funds
Sanjiv R. Das FDIC Center for Financial Research Darrell Duffie Working Paper Nikunj Kapadia No. 2011-01 Empirical Comparisons and Implied Recovery Rates The Use of Credit Default Swaps by U.S Fixed-Income Mutual Funds Risk-Based Capital Standards, kkk Deposit Insurance and Procyclicality November 19, 2010 Risk-Based Capital Standards, Deposit Insurance and Procyclicality An Empirical September 2005 An Empirical Analysis Federal Dposit Insurance Corporation •Center for Financial Researchh State- May, 2005 Efraim Benmel Efraim Benmelech June 20 May , 2005 Asset S2005-14 The Use of Credit Default Swaps by U.S. Fixed-Income Mutual Funds Tim Adam, Humboldt University* and Risk Management Institute (Singapore) Andre Guettler, University of Texas at Austin and EBS Business School† November 19, 2010 Abstract We examine the use of credit default swaps (CDS) in the U.S. mutual fund industry. We find that among the largest 100 corporate bond funds the use of CDS has increased from 20% in 2004 to 60% in 2008. Among CDS users, the average size of CDS positions (measured by their notional values) increased from 2% to almost 14% of a fund’s net asset value. Some funds exceed this level by a wide margin. CDS are predominantly used to increase a fund’s exposure to credit risks rather than to hedge credit risk. Consistent with fund tournaments, underperforming funds use multi-name CDS to increase their credit risk exposures. Finally, funds that use CDS underperform funds that do not use CDS. Part of this underperformance is caused by poor market timing. JEL-Classification: G11, G15, G23 Keywords: Corporate bond fund, credit default swap, credit risk, fund performance, hedging, speculation, tournaments * Humboldt University, Institute of Corporate Finance, Dorotheenstr. -
Default & Returns on High Yield Corporate Bonds
Soluzioni Innovative: (Private) & Public Debt Crediamo nella supremazia della Conoscenza. Dr. Edward Altman Crediamo nelle forza delle Idee. Co-Founder & Senior Advisor Classis Capital Sim SpA Crediamo nell’Ispirazione. 1 Turin, April 12, 2017 Agenda . Current Conditions and Outlook in Global Credit Markets . Assessing the Credit Health of the Italian SME Sector . Minibond Issuers 2 Major Agencies Bond Rating Categories Moody's S&P/Fitch Aaa AAA Aa1 AA+ Aa2 AA Aa3 AA- A1 A+ A2 A A3 A- Baa1 BBB+ Baa2 Investment BBB Baa3 Grade BBB- Ba1 High Yield BB+ Ba2 ("Junk") BB Ba3 BB- B1 B+ B2 B B3 B- High Yield Caa1 CCC+ Market Caa CCC Caa3 CCC- Ca CC C C D 3 Size Of High-Yield Bond Market 1978 – 2017 (Mid-year US$ billions) $1.800 $1,624 $1.600 Source: NYU $1.400 Salomon Center $1.200 estimates US Market using Credit $1.000 Suisse, S&P $800 and Citi data $ (Billions)$ $600 $400 $200 $- 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 1994 – 2016 (Mid-year € billions)* 500 468€ 471 Western Europe Market 418 400 370 ) 300 283 Source: Credit 200 194 Suisse Billions ( 154 € 108 100 81 61 70 89 84 81 79 80 77 0 2 5 9 14 27 45 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 *Includes non-investment grade straight corporate debt of issuers with assets located in or revenues derived from Western Europe, or the bond is denominated in a Western European currency.