Treasury STRIPS Program (Separate Trading of Registered Interest and Principal Securities)
The U.S. government does not issue zero coupon notes and bonds and there is a strong demand for an instrument with no credit risk and a maturity of greater than one year.
These securities come in two different forms:
Coupon Strips
Coupon strips come from the coupon payment part of the security.
Principal Strips
Principal strips come from the principal payment.
Coupon strips accrue interest and are taxed each year even though interest is not paid until maturity. This causes negative cash flows for a taxable entity. Foreign investors often like principal strips because of the preferred tax treatments they can receive in their home countries.
Showing posts with label Features of Debt Securities. Show all posts
Showing posts with label Features of Debt Securities. Show all posts
Monday, December 22
On-the-run vs. Off-the-run Government Securities
On-the-run Securities
· most current security issued by the U.S.Treasury Department, tend to be more liquid in the marketplace.
Off-the-run Securities
· the securities that are replaced by the on-the-run securities,tend to be less liquid in the marketplace
Note:
· Price quotes as a percent of par value. The quotes are in fraction of 1/32.
· most current security issued by the U.S.Treasury Department, tend to be more liquid in the marketplace.
Off-the-run Securities
· the securities that are replaced by the on-the-run securities,tend to be less liquid in the marketplace
Note:
· Price quotes as a percent of par value. The quotes are in fraction of 1/32.
US Treasury securities
T-bills
· maturity of less than 12 months, no coupon rate, issued at a discount to par value, mature at par value.
T-notes
· maturity of 1 to 10 years, semi-annual coupon
T-bonds
· maturity of greater than 10 years, semi-annual coupon.
Treasury Inflation Protected Securities (TIPS)
· Issued as notes or bonds and help to protect the investor against inflation risk
· The inflation reflected through upward adjustments to the principal value of the bond. At maturity, get greater of initial par or the inflation adjusted principal. But due to the IRS taxes, TIPS fail to povide perfect inflation protection
Adjusted principal = Principal x (1 + Annual inflation / 2)
Coupon = Adjusted principal at end of period x Coupon rate / 2
· maturity of less than 12 months, no coupon rate, issued at a discount to par value, mature at par value.
T-notes
· maturity of 1 to 10 years, semi-annual coupon
T-bonds
· maturity of greater than 10 years, semi-annual coupon.
Treasury Inflation Protected Securities (TIPS)
· Issued as notes or bonds and help to protect the investor against inflation risk
· The inflation reflected through upward adjustments to the principal value of the bond. At maturity, get greater of initial par or the inflation adjusted principal. But due to the IRS taxes, TIPS fail to povide perfect inflation protection
Adjusted principal = Principal x (1 + Annual inflation / 2)
Coupon = Adjusted principal at end of period x Coupon rate / 2
Political risk
With governments and municipalities, investors must evaluate the willingness(desire) of the issuer to pay as well as the ability to pay.
Event risk
Natural and corporate events can affect the issuer’s ability to pay. For example: disasters, corporate restructurings
Event risk
Natural and corporate events can affect the issuer’s ability to pay. For example: disasters, corporate restructurings
Inflation risk
Yield volatility risk
· Rise in yield volatility increases value of embedded options
· When expected yeild volatility increase, the value of call option increase-> decrease value of callable bond;
· If yield volatility increase ,value of put option increase -> increse value of putable bond. They move in opposite ways
· When expected yeild volatility increase, the value of call option increase-> decrease value of callable bond;
· If yield volatility increase ,value of put option increase -> increse value of putable bond. They move in opposite ways
Liquidity risk
· Investors will not be able to realize the true value of their investments due to a widening of the bid-ask spread and a lack of buyers or sellers.
· Estimate through bid-ask spread which is also considered be a type of transaction cost.
· Increases in extreme events or if one or more dealers leave the market.
· Instintutional investors need to mark their holdings to market (using bid price or use evaluation model if no active bids-> if illiquid, prevailing market price not true
Bid-ask spread: Highest Bid - Lowest Ask
· Estimate through bid-ask spread which is also considered be a type of transaction cost.
· Increases in extreme events or if one or more dealers leave the market.
· Instintutional investors need to mark their holdings to market (using bid price or use evaluation model if no active bids-> if illiquid, prevailing market price not true
Bid-ask spread: Highest Bid - Lowest Ask
Credit risk, Downgrade risk, Default risk
Credit risk
The loss due to a debtor’s inability to meet its bond obligations. Credit spread risk {aka risk premium, widening of bond spread over the benchmark - happens before ratings downgrade, yield on a risky bond = yield on a defalut free bond + risk premiun, increase risk-> increase spread->decrease price}.
Downgrade risk
Fall in the bond price due to a ratings downgrade.
Default risk
Issuer fails to make interest and principal payments
The highest – prime grade, below BBB- or Baa3-noninvestment grade (junk bonds)
Examples:
Moody’s: Aaa, Aa2 etc
Standard & Poor’s: AAA, AA+ etc
Fitch: use similar system to S&P
The loss due to a debtor’s inability to meet its bond obligations. Credit spread risk {aka risk premium, widening of bond spread over the benchmark - happens before ratings downgrade, yield on a risky bond = yield on a defalut free bond + risk premiun, increase risk-> increase spread->decrease price}.
Downgrade risk
Fall in the bond price due to a ratings downgrade.
Default risk
Issuer fails to make interest and principal payments
The highest – prime grade, below BBB- or Baa3-noninvestment grade (junk bonds)
Examples:
Moody’s: Aaa, Aa2 etc
Standard & Poor’s: AAA, AA+ etc
Fitch: use similar system to S&P
Reinvestment risk
The proceeds from an investment may have to be reinvested at a lower rate than the rate available from the investment itself.
The reinvestment risk for callable bonds and amortizing bonds is higher than bullet bonds. Zero coupon bonds have no reinvestment risk.
It is required to balance reivestment risk against price risk - if interest rate decline, price rise which helps to offset the losses in reinvesting coupon payments at lower market int rate.
The reinvestment risk for callable bonds and amortizing bonds is higher than bullet bonds. Zero coupon bonds have no reinvestment risk.
It is required to balance reivestment risk against price risk - if interest rate decline, price rise which helps to offset the losses in reinvesting coupon payments at lower market int rate.
Yield curve risk
The graph showing the relationship between term to maturity and yield to maturity is Yield Curve. Bonds with different maturity change by different amount due to the change in the shape of yield curve.
As Economic circumstance change, curve shift up or down, either in
Parallel shift
· interest rate change by same no. of basis points for all maturities
Non-parallel shift
· different maturities undergo different changes in yield. Bond with shorter maturity will not be affected to the same extent as the one with longer maturity when interest rise.
· If LT rate rise, bond value rapidly drop due to the compounding effect on distant cash flows.
· Longer-term bond has greater price sensitivity and higher bond duration.
As Economic circumstance change, curve shift up or down, either in
Parallel shift
· interest rate change by same no. of basis points for all maturities
Non-parallel shift
· different maturities undergo different changes in yield. Bond with shorter maturity will not be affected to the same extent as the one with longer maturity when interest rise.
· If LT rate rise, bond value rapidly drop due to the compounding effect on distant cash flows.
· Longer-term bond has greater price sensitivity and higher bond duration.
Sunday, December 21
Call and prepayment risk:
Call provision makes the bond’s cash flows unpredictable, increases reinvestment risk, and limits the potential for price appreciation. Prepayment risk is similar.
Measurement of interest rate risk
Duration of a bond (D)
· Percentage change in price for a 100 basis point change in yield
· aka bond’s effective duration, go down or up by same no. of basis points
· Duration of zero coupon rate equals its maturity
· Duration of a floater coupon bond equals the time to the next reset date
D = (V_- V+) / (2 x Vo x dy in decimal)
Approximate bond price change = -1 x Duration x Price x dy
Dollar duration = -1 x Duration x Price / 100
Effect of yield level :
· Price volatility inversely related to the level of market yields. As yields increase, bond prices fall
· The price curve gets flatter and is referred to as positive convexity. The bond prices go up faster than they go down.
· Percentage change in price for a 100 basis point change in yield
· aka bond’s effective duration, go down or up by same no. of basis points
· Duration of zero coupon rate equals its maturity
· Duration of a floater coupon bond equals the time to the next reset date
D = (V_- V+) / (2 x Vo x dy in decimal)
Approximate bond price change = -1 x Duration x Price x dy
Dollar duration = -1 x Duration x Price / 100
Effect of yield level :
· Price volatility inversely related to the level of market yields. As yields increase, bond prices fall
· The price curve gets flatter and is referred to as positive convexity. The bond prices go up faster than they go down.
Factors affect bond price sensitivity
Maturity - bond with longer maturity is more sensitive to interest rate movements as more cash flows will be affected over a longer period of time.
Coupon Rate - bond with lower coupon rate is more sensitive to interest rate movement. Zero bond has the greatest interest rate risk
Yield - bond with higher yield is less sensitive to interest rate movement due to the nature of positive convexity
Embedded options -can increase or decrease sensitivity depending on the features of the options
Eixstence of embedded options make future cash flows of the bond harder to predict and thus affect the sensitivity
Callable bond value = value of the straight bond components – value of the ebedded call option
In the formula, negative sign is used because call option is of value to the issuer not the bondholder.
Straight bond has inverse relationship between yield and prices. However, if with call options, investors will be unwilling to pay more than the call price or at least not much more so that call price acts as a ceiling on the callable bond value. When yield fall, the call option becomes more valuable to the issurer up to the ceiling value; When yields rise, the value of a callable bond may not fall as much as that of a similar straight bond
Note:
Interest rate risk of FRN is lower than that of a fixed-coupon bond. Still, it exists due to: fixed coupon until the next reset period( time lag), fixed margin, change in credit quality, or the presence of a cap on the floating rate.
Interest rate risk
Refer to how the bond price changes in response to the interest rate movement. The risk not only depends on direction of change in market interest rate but also its magnitude. When interest rates go up, investors’ bond prices fall. When interest rates go down, bond prices rise
Coupon rate < yield =""> Price < Par value {bond trades at a discount}
Coupon rate = Yield => Price = Par value {bond trades at par}
Coupon rate > Yield => Price > Par value {bond trades at a premium}
Coupon rate < yield =""> Price < Par value {bond trades at a discount}
Coupon rate = Yield => Price = Par value {bond trades at par}
Coupon rate > Yield => Price > Par value {bond trades at a premium}
Financing the purchase of the bonds
Repurchase agreements (a.k.a. repo):
One party (seller or security lender) sells a security to another (buyer or security borrower) with an agreement to buy it back at a specified price on a later date. Security lender does a repo, security borrower does a reverse repo.
Reverse repo:
Used by institutional investors in bond markets where it allows to finance a larger portion of the purchase price than margin buying.
If 1 day =>overnight repo
If >1 day => term repo
Margin buying:
· As a collateral loan by buying stock partly with cash and partly with a loan. It is more common for individual than institution.
· The Fed sets the cash component, or the margin, at 50%.
In equity markets, it is used by individual and institutional borrowers.
Cost of loan = Call money rate + service charge
where:
Call money rate is the rate the broker borrowed from bank & investor borrow from broker in turn at call money rate plus service charge
One party (seller or security lender) sells a security to another (buyer or security borrower) with an agreement to buy it back at a specified price on a later date. Security lender does a repo, security borrower does a reverse repo.
Reverse repo:
Used by institutional investors in bond markets where it allows to finance a larger portion of the purchase price than margin buying.
If 1 day =>overnight repo
If >1 day => term repo
Margin buying:
· As a collateral loan by buying stock partly with cash and partly with a loan. It is more common for individual than institution.
· The Fed sets the cash component, or the margin, at 50%.
In equity markets, it is used by individual and institutional borrowers.
Cost of loan = Call money rate + service charge
where:
Call money rate is the rate the broker borrowed from bank & investor borrow from broker in turn at call money rate plus service charge
Embedded options
Give the issuer or bondholder rights to dispose of or redeem a bond and can have a dramatic effect on the price of a security’s cash flow as well as its total return.
Options that Benefit the Issuer
Call options - allows the issuer to call the bonds prior to maturity if prevailing rates decrease enough to replace the existing issue with lower coupon bonds.
Prepayments - similar to call features and gives the issuer the right to repay principal ahead of scheduled repayment, in whole or in part.
Caps – A cap puts a maximum amount that an issuer has to pay in the face of rising interest rates for bond with floating interest rate.
Options that Benefit the Holder
Puts - give the bond bolder the right to receive principal repayment before maturity and help them dump their holdings and reinvest their proceeds at a higher rate as rates rise.
Floor - set a limit on the interest payment at a certain level even as market rates decline below the floor level.
Conversion option - give the right to bondholder to exchange for the issuer’s stock when the equity of the firm is outperforming the bonds.
Notes:
· If the option benefit the issuer, the yield increase.
· If the option benefit the bondhodler, the yield decrease.
Options that Benefit the Issuer
Call options - allows the issuer to call the bonds prior to maturity if prevailing rates decrease enough to replace the existing issue with lower coupon bonds.
Prepayments - similar to call features and gives the issuer the right to repay principal ahead of scheduled repayment, in whole or in part.
Caps – A cap puts a maximum amount that an issuer has to pay in the face of rising interest rates for bond with floating interest rate.
Options that Benefit the Holder
Puts - give the bond bolder the right to receive principal repayment before maturity and help them dump their holdings and reinvest their proceeds at a higher rate as rates rise.
Floor - set a limit on the interest payment at a certain level even as market rates decline below the floor level.
Conversion option - give the right to bondholder to exchange for the issuer’s stock when the equity of the firm is outperforming the bonds.
Notes:
· If the option benefit the issuer, the yield increase.
· If the option benefit the bondhodler, the yield decrease.
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