Default & Returns on High Yield Corporate Bonds
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Treasury Yields and Corporate Bond Yield Spreads
Treasury yields and corp orate b ond yield spreads: An empirical analysis Gregory R. Du ee Federal Reserve Board Mail Stop 91 Washington, DC 20551 202-452-3055 gdu [email protected] First version January 1995 Currentversion May 1996 previously circulated under the title The variation of default risk with Treasury yields Abstract This pap er empirically examines the relation b etween the Treasury term structure and spreads of investment grade corp orate b ond yields over Treasuries. I nd that noncallable b ond yield spreads fall when the level of the Treasury term structure rises. The extentof this decline dep ends on the initial credit quality of the b ond; the decline is small for Aaa- rated b onds and large for Baa-rated b onds. The role of the business cycle in generating this pattern is explored, as is the link b etween yield spreads and default risk. I also argue that yield spreads based on commonly-used b ond yield indexes are contaminated in two imp ortant ways. The rst is that they are \refreshed" indexes, which hold credit ratings constantover time; the second is that they usually are constructed with b oth callable and noncallable b onds. The impact of b oth of these problems is examined. JEL Classi cation: G13 I thank Fischer Black, Ken Singleton and seminar participants at the Federal Reserve Board's Conference on Risk Measurement and Systemic Risk for helpful comments. Nidal Abu-Saba provided valuable research assistance. All errors are myown. The analysis and conclusions of this pap er are those of the author and do not indicate concurrence by other memb ers of the research sta , by the Board of Governors, or by the Federal Reserve Banks. -
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. -
Bond Risk, Bond Return Volatility, and the Term Structure of Interest Rates
Bond Risk, Bond Return Volatility, and the Term Structure of Interest Rates Luis M. Viceira1 Forthcoming International Journal of Forecasting This draft: January 2010 Abstract This paper explores time variation in bond risk, as measured by the covariation of bond returns with stock returns and with consumption growth, and in the volatility of bond returns. A robust stylized fact in empirical finance is that the spread between the yield on long-term bonds and short-term bonds forecasts positively future excess returns on bonds at varying horizons, and that the short-term nominal interest rate forecasts positively stock return volatility and exchange rate volatility. This paper presents evidence that movements in both the short-term nominal interest rate and the yield spread are positively related to changes in subsequent realized bond risk and bond return volatility. The yield spread appears to proxy for business conditions, while the short rate appears to proxy for inflation and economic uncertainty. A decomposition of bond betas into a real cash flow risk component, and a discount rate risk component shows that yield spreads have offsetting effects in each component. A widening yield spread is correlated with reduced cash-flow (or inflationary) risk for bonds, but it is also correlated with larger discount rate risk for bonds. The short rate forecasts only the discount rate component of bond beta. JEL classification:G12. 1Graduate School of Business Administration, Baker Libray 367, Harvard Univer- sity, Boston MA 02163, USA, CEPR, and NBER. Email [email protected]. Website http://www.people.hbs.edu/lviceira/. I am grateful to John Campbell, Jakub Jurek, André Per- old, participants in the Lisbon International Workshop on the Predictability of Financial Markets, and especially to two anonymous referees and Andréas Heinen for helpful comments and suggestions. -
1 Bond Valuation
Structure of fixed income securities • A Fixed Income Security promises to pay fixed coupon payments at a prespecified dates and a fixed principal amount Bond Valuation (the face value) at the maturity date. • When there are no coupon payments then the bond is called a •The Structure of fixed income securities zero coupon bond or a pure discount bond. •Price & yield to maturity (ytm) •Term structure of interest rates Payments of a “N” year bond with annual coupon C and face value F •Treasury STRIPS •No-arbitrage pricing of coupon bonds payments: C C …………… C C+F Time: 0 1 2 ………….. N-1 N Coupon Bonds The U.S. government issues bonds • The coupon payments on coupon bonds are typically stated as a Default free bonds issued by the government: percentage of the principal (or face value) paid per year. Treasury bills have an initial maturity less than one year and are all • If coupon payments are made n times per year, then the coupon discount bonds amount is (c x F)/n, where c is the coupon rate and F is the face Treasure notes have initial maturities between one and ten years and value. pay coupons Treasury bonds have initial maturities longer than ten years and pay Understanding the terms: U.S. Treasury Notes and Bonds are coupons typically issued with face value of $10,000, and pay semi-annual coupons. Assume a 30 year coupon rate of 7.5%. What payments Default free bonds issued by government sponsored agencies do you receive from buying this bond? Fannie Mae: Federal National Mortgage Association Ginnie Mae: Government National Mortgage Association You receive a coupon payment of (0.075 x $10,000)/2 = $375 twice a Freddie Mac: Federal Home Loan Mortgage Corporation year and on the maturity date you will receive the coupon of $375 Federal Home Loan Bank plus the principal of $10,000. -
Chapter 10 Bond Prices and Yields Questions and Problems
CHAPTER 10 Bond Prices and Yields Interest rates go up and bond prices go down. But which bonds go up the most and which go up the least? Interest rates go down and bond prices go up. But which bonds go down the most and which go down the least? For bond portfolio managers, these are very important questions about interest rate risk. An understanding of interest rate risk rests on an understanding of the relationship between bond prices and yields In the preceding chapter on interest rates, we introduced the subject of bond yields. As we promised there, we now return to this subject and discuss bond prices and yields in some detail. We first describe how bond yields are determined and how they are interpreted. We then go on to examine what happens to bond prices as yields change. Finally, once we have a good understanding of the relation between bond prices and yields, we examine some of the fundamental tools of bond risk analysis used by fixed-income portfolio managers. 10.1 Bond Basics A bond essentially is a security that offers the investor a series of fixed interest payments during its life, along with a fixed payment of principal when it matures. So long as the bond issuer does not default, the schedule of payments does not change. When originally issued, bonds normally have maturities ranging from 2 years to 30 years, but bonds with maturities of 50 or 100 years also exist. Bonds issued with maturities of less than 10 years are usually called notes. -
Glossary of Bond Terms
Glossary of Bond Terms Accreted value- The current value of your zero-coupon municipal bond, taking into account interest that has been accumulating and automatically reinvested in the bond. Accrual bond- Often the last tranche in a CMO, the accrual bond or Z-tranche receives no cash payments for an extended period of time until the previous tranches are retired. While the other tranches are outstanding, the Z-tranche receives credit for periodic interest payments that increase its face value but are not paid out. When the other tranches are retired, the Z-tranche begins to receive cash payments that include both principal and continuing interest. Accrued interest- (1) The dollar amount of interest accrued on an issue, based on the stated interest rate on that issue, from its date to the date of delivery to the original purchaser. This is usually paid by the original purchaser to the issuer as part of the purchase price of the issue; (2) Interest deemed to be earned on a security but not yet paid to the investor. Active tranche- A CMO tranche that is currently paying principal payments to investors. Adjustable-rate mortgage (ARM)- A mortgage loan on which interest rates are adjusted at regular intervals according to predetermined criteria. An ARM's interest rate is tied to an objective, published interest rate index. Amortization- Liquidation of a debt through installment payments. Arbitrage- In the municipal market, the difference in interest earned on funds borrowed at a lower tax-exempt rate and interest on funds that are invested at a higher-yielding taxable rate. -
The Relation Between Treasury Yields and Corporate Bond Yield Spreads
THE JOURNAL OF FINANCE • VOL. LIII, NO. 6 • DECEMBER 1998 The Relation Between Treasury Yields and Corporate Bond Yield Spreads GREGORY R. DUFFEE* ABSTRACT Because the option to call a corporate bond should rise in value when bond yields fall, the relation between noncallable Treasury yields and spreads of corporate bond yields over Treasury yields should depend on the callability of the corporate bond. I confirm this hypothesis for investment-grade corporate bonds. Although yield spreads on both callable and noncallable corporate bonds fall when Treasury yields rise, this relation is much stronger for callable bonds. This result has im- portant implications for interpreting the behavior of yields on commonly used cor- porate bond indexes, which are composed primarily of callable bonds. COMMONLY USED INDEXES OF CORPORATE bond yields, such as those produced by Moody’s or Lehman Brothers, are constructed using both callable and non- callable bonds. Because the objective of those producing the indexes is to track the universe of corporate bonds, this methodology is sensible. Until the mid-1980s, few corporations issued noncallable bonds, hence an index de- signed to measure the yield on a typical corporate bond would have to be constructed primarily with callable bonds. However, any empirical analysis of these yields needs to recognize that the presence of the bonds’ call options affects their behavior in potentially important ways. Variations over time in yields on callable bonds will reflect, in part, variations in their option values. If, say, noncallable bond prices rise ~i.e., their yields fall!, prices of callable bonds should not rise as much be- cause the values of their embedded short call options also rise. -
Bonds and Yield to Maturity
Bonds and Yield to Maturity Bonds A bond is a debt instrument requiring the issuer to repay to the lender/investor the amount borrowed (par or face value) plus interest over a specified period of time. Specify (i) maturity date when the principal is repaid; (ii) coupon payments over the life of the bond. P stream of coupon payments maturity date Cash flows in bonds 1. Coupon rate offered by the bond issuer represents the cost of raising capital (reflection of the creditworthiness of the bond issuer). 2. Assume the bond issuer does not default or redeem the bond prior to maturity date, an investor holding this bond until maturity is assured of a known cash flow pattern. Other features in bond indenture 1. Floating rate bond – coupon rates are reset periodically according to some predetermined financial benchmark. 2. Amortization feature – principal repaid over the life of the bond. 3. Callable feature (callable bonds) The issuer has the right to buy back the bond at a specified price. Usually this call price falls with time, and often there is an initial call protection period wherein the bond cannot be called. 4. Put provision – grants the bondholder the right to sell back to the issuer at par value on designated dates. 5. Convertible bond – giving the bondholder the right to exchange the bond for a specified number of shares. * Bondholder can take advantage of the future growth of the issuer’s company. * Issuer can raise capital at a lower cost. 6. Exchangeable bond – allows bondholder to exchange the issue for a specified number of common stocks of another corporation. -
The Informational Role of the Yield Spread and Stock Returns for Predicting Future GDP in Emerging Countries
The informational role of the yield spread and stock returns for predicting future GDP in Emerging countries Daaliya Aafiya Maria Headlie* Masters in Finance Dissertation Advisor: Julio Fernando Seara Sequeira da Mota Labão, Ph.D 2016 *[email protected] Bibliographical Statement Daaliya Aafiya Maria Headlie was born on October 14th 1988. She completed her undergraduate studies in Economics with a minor in Finance at the University of the West Indies in Trinidad before joining the Masters of Finance programme at the Faculty of Economics at the University of Porto. As an Erasmus student studying in Portugal, aside from pursuing her Masters in Finance, Daaliya has actively been involved in the FEP Finance Club, where she has been a member of the Career Development, Corporate Finance and Portfolio Management team. Daaliya has also developed a strong passion for professional photography during her stay in Portugal. Upon completion of her Masters programme, Daaliya shall return to her home country to offer her services to the Trinidad and Tobago government as a means of fulfilling her undergraduate scholarship agreement as a scholarship holder. i Acknowledgements My sincerest appreciation and gratitude for the time and effort my supervisor, Professor Julio Labão has extended throughout this journey. Professor Natercia for all of her efforts. My family and friends for their continued love, support and prayers. The FEP librarian staff for assisting and teaching me how to collect and gather the necessary data for this study. Lastly, to Erasmus Mundus and the European Commission for grating me this amazing opportunity that I would forever hold close to my heart. -
Equity Friendly Or Noteholder Friendly? the Role of Collateral Asset Managers in the Col- Lapse of the Market for ABS-Cdos
Equity friendly or noteholder friendly? The role of collateral asset managers in the col- lapse of the market for ABS-CDOs Thomas Mählmann Chair of Banking and Finance, Catholic University of Eichstaett-Ingolstadt, Auf der Schanz 49, 85049 Ingolstadt, Germany This version: April 2012 Abstract This paper shows that ABS-CDOs (i.e., collateralized debt obligations backed by asset- backed securities) managed by large market share managers have higher ex post collateral default rates. The paper also finds that (1) large manager deals, while having higher realized default rates, do not carry more default risk ex ante (at origination), as measured by the deal fraction rated AAA or the size of the equity tranche, (2) ex post, these deals have higher per- centages of home-equity loans, subprime RMBS and synthetic assets in their collateral pools, and larger asset-specific default rates and issuer concentration levels, (3) compared to smaller managers, large market share manager deals pay out higher cash flows to equity tranche in- vestors prior to the start of the subprime crisis (July 2007) but significantly lower cash flows afterwards, and (4) investors demand a (price) discount on non-equity tranches sold by large manager deals. In sum, this evidence is consistent with a conflict of interest/risk shifting ar- gument: some managers boost their market share by catering to the interests of the deals’ eq- uity sponsors. JEL classification: G21, G28 Keywords: Conflict of interest, Credit Rating, Collateralized Debt Obligation, Yield Spread Tel.: +49 841 937 1883; fax: +49 841 937 2883. E-mail address: [email protected] 1. -
FUNDAMENTALS of the BOND MARKET Bonds Are an Important Component of Any Balanced Portfolio
FUNDAMENTALS OF THE BOND MARKET Bonds are an important component of any balanced portfolio. To most they represent a conservative investment vehicle. However, investors purchase bonds for a variety of reasons, including regular income, reducing portfolio volatility, and potential for capital gains. This publication describes bonds and the factors determining bond prices. THE BASICS A bond is an obligation or loan made by an investor to an issuer (e.g. a government or a company). The issuer promises: ■ To repay the principal (or face value) of the bond on a fixed maturity date; and ■ To make regularly scheduled interest payments (usually every six months). The major issuers of bonds are governments and corporations. Investors in the bond market range from individuals to many different types of institutions, including banks, life insurance companies, pension funds and mutual funds. 2 RBC Dominion Securities Fundamentals of the Bond Market WHY INVEST IN BONDS? Preservation of capital Although the day-to-day value of a bond will Bonds offer investors a number of benefits. fluctuate according to market conditions, high A few of the more popular ones are outlined below: quality bonds can be expected to mature at par (100). Therefore, an investor knows the exact Income amount to be received at maturity. If a capital return Bonds typically pay semi-annual interest. They is required prior to maturity, interim fluctuations provide the investor with regular and predictable will be an important consideration. income. This is a contractual obligation and must be paid unless the issuer is under bankruptcy protection. Predictability The regular interest payments provide investors Portfolio diversification with predictability in their portfolios.