Công cụ tài chính MODULE 3 bond market

MODULE 3: BOND MARKET Content Bond securities Bond pricing Bond yield Term structure of interest rate Bond securities ¨  Bond is an obligation that the issuer (the borrower) must repay to the owners of bond (the lender) the principal amount at maturity and a certain amount of money (interest) in a certain period of time Bond securities A bond with a face value of $1,000, coupon rate of 8%, maturity of 10 years will have cash flows as following: Characteristics of bond ¨  ¨  ¨  ¨  ¨  Fixed – income securities Long – term debt instrument Bondholder: ¤  Coupon Interest ¤  Face value ¤  Maturity ¤  Free sell, transfer, convert, pledge, for donation Market value Risk Classified bond IN TERM OF ISSUER Government bonds Some government agencies issue their own securities to finance their activities - Treasury notes - Treasury bonds Municipal bonds Are issued by state and local government - Industrial development bond - Tax anticipation notes … Corporate bonds Are means by which private firm borrow money directly from public (1)Government bonds ¨  Coupon securities: pay interest every months, plus principle at maturity ¤  Treasury notes: 2-10 years ¤  Treasury bonds: more than 10 years Discount securities: pay only a contractually fixed amount at maturity ¨  Treasury Inflation protection securities (TIPS) ¨  ¤  Coupon rate (real rate) on an issue is set at a fixed rate ¤  The principal is adjusted semiannually for inflation (2) Municipal securities ¨  ¨  ¨  ¨  Issued by state and local government (cities and counties) Most municipal securities are tax exempt (applies to interest income, not capital gains) Tax risk? Some issues are taxable at the federal level Municipal issue long – term bond as the principal means for financing: ¤  Long-term capital projects such as the construction of schools, bridges, roads, and airport ¤  Long – term budget deficits arise from current operations (3) Corporate bonds Utilities - Electric power Companies -gas distribution -water companies -communication companies Transportation industrials Airlines Railroads Trucking Manufacturing Merchandising Service companies Banks & Finance companies Commercial banks Life insurance companies Basic features of a corporate bond issue Maturity of bonds ¨  Security for bonds ¤  Debenture bonds ¤  Guaranteed bonds ¨  Provisions for paying off bonds ¤  Sinking fund ¤  refunding ¨  10 Factors Affecting the Shape of Yield Curve: Expectations Hypothesis Suppose that investors have money to invest in years They can buy a two-year security Alternatively, they can buy a one-year security and when that matures, buy another one-year security ¨  Assume that the yield curve is stable, meaning investors are happy with current situation (if they were not happy, they will shift among securities with different terms) Investors will only be indifferent among the two strategies if there is no difference in the rate of return: (1+is)(1+îs) = (1+iL)2 => + îs = (1+iL)2/(1+is) is: one-year rate, iL: two-year rate, îs one-year future rate predicted by investors ¨  Factors Affecting the Shape of Yield Curve: Expectations Hypothesis Investors know about is and iL but they have to guess îs ¨  The yield curve is upward-sloping if long-dated rates are higher than shortdated rates: is < iL => (1+is)2 < (1+iL)2 = (1+is)(1+îs) ⇒  is < îs ⇒  market expects short-term future interest rates îs to rise and be higher than current short-term interest rates is ¨  Factors Affecting the Shape of Yield Curve: Expectations Hypothesis ¨  According to expectations hypothesis: The yield curve is upward-sloping if the market expects short rate to raise in the future ¤  The yield curve is downward-sloping if the market expects short rate to decrease in the future ¤  The yield curve is flat if the market expects short rate to remain unchanged in the future ¤  ¨  This hypothesis CANNOT explain the fact that the yield curve is usually upwardsloping Factors Affecting the Shape of Yield: Market Segmentation Assumes investors have maturity preference boundaries, e.g., short-term vs long-term maturities ¨  If there are strong liquidity preference, then interest rates at any part of the maturity spectrum will depend upon the strength of supply and demand in that particular part of spectrum ¨  Explains why rates and prices vary significantly between certain maturities ¨  Factors Affecting the Shape of Yield: Duration and Interest Rate Risk Assume that the bond market is dominated by investors who are capital risk adverse (who sell bonds before maturity date and dislike price changes) ⇒  Investors will demand a premium for interest rate risk ⇒  longer-dated bonds with higher exposure to interest rate risk usually have higher yields ⇒  Duration helps explain why the yield curve should normally be upward-sloping ¨  The Term Structure of Interest Rates The various explanations are not mutually exclusive ¨  Combine the hypotheses to explain the shape of the yield curve ¨  The Term Structure of Interest Rates DownwardSloping Yield Curve UpwardSloping Yield Curve ¨  ¨  ¨  ¨  Normal circumstances Expected higher interest rate levels Tight monetary policy Expanding economy ¨  ¨  ¨  Strongly expected lower interest rate levels Expansive monetary policy Recession soon? 74 6-75 Bond Markets ¨  ¨  Stock exchange: An entity that provides physical location for stock brokers and dealers to trade stocks, bonds and other securities Most financial markets consist of traders linked together only by high speed broadband, sharing the same software that displays the bid – ask prices (buying – selling prices) of the market makers for all securities they deal in and for various sizes of transactions Bond Markets Market makers (dealers): Institutions that are a member of an exchange and holds securities which it offers to buy and sell at bid – ask prices Income of dealers is from difference between bid – ask prices ¨  Brokers: Institutions that place buy and sell orders on behalf of their clients Income of brokers are commission fees ¨  Large investment banks consist of both dealers and brokers ¨  Bond Markets ¨  ¨  Transaction volume of secondary market is much bigger than that of primary market Turnover is very much larger than the outstanding stock of debt London Stock Exchange – Bond Markets Turnover Bond markets, 2009 8,599.00 Govt bond markets, 2008-2009 4,077.42 Market value of outstanding bonds Turnover ratio New issues 518.00 525.94 7.75 208.50 Pricing Instruments in a Supply and Demand Framework Market for existing three year treasury bond - secondary market (similar for primary market and markets for other fixed income instruments) ¨  Supply of the bond is fixed so supply curve is vertical ¨  Demand curve is downward-sloping because a lower price means a higher yield and the demand increase with its yield ¨  Pricing Instruments in a Supply and Demand Framework Initially, the equilibrium price is £102.81 at YTM of 4% ¨  Suppose that market interest rates fall by 100 basis points (1%) to 3% ¨  Demand for the existing three year bond increases as demand switches from other assets offering market rate of 3% ¨  Increased demand pushes up the bond’s price (and lower yield) ¨  Pricing Instruments in a Supply and Demand Framework The switches (and thus increase in demand for the bond) will cease when the bond’s yield equals to 3% as that of other instruments ¨  New equilibrium price of the bond is 105.66 at YTM of 3% => A change in market interest rates leads to change in asset prices in the opposite direction ¨  Pricing Instruments in a Supply and Demand Framework Market price £ Yield, % = 105.66 3% 102.81 4% D’ D = Quantity of bonds ... corporate bond issue Maturity of bonds ¨  Security for bonds ¤  Debenture bonds ¤  Guaranteed bonds ¨  Provisions for paying off bonds ¤  Sinking fund ¤  refunding ¨  10 Types of Bonds ¤ ... 2.92 A 109.10 2. 53 -0. 03 -1.19 1.81 Citigroup 01/11 6.50 A A3 A+ 1 03. 62 3. 16 Morgan Stanley 04/12 6.60 A A2 (1) Name of the bond issuer (2) Maturity or redemption date month/year (3) Coupon (4)...Content Bond securities Bond pricing Bond yield Term structure of interest rate Bond securities ¨  Bond is an obligation that the issuer (the borrower) must repay to the owners of bond (the