Recommended
More Related Content
Similar to Lecture # 8 _Advanced .pdf
Similar to Lecture # 8 _Advanced .pdf (20)
Recently uploaded
Recently uploaded (20)
Lecture # 8 _Advanced .pdf
- 1. cisi.org CISI – Financial Products, Markets & Services
- 2. cisi.org Learning Objectives 1. Know the advantages and disadvantages of investing in different types of bonds 1. Understand the role of credit rating agencies and the differences between investment and non-investment grades 1. Be able to calculate the flat yield of a bond
- 3. cisi.org Activity – Bonds presentation Based on everything we have covered about bonds, In groups you are to prepare and make a 3-minute presentation on one of either: 1. The advantages of investing in bonds 1. The advantages for a company of issuing bonds as opposed to issuing shares 1. The disadvantages and risks of investing in bonds
- 4. cisi.org Investing in bonds - advantages Advantages of investing in bonds A regular and certain flow of income (bonds with a fixed coupon) For many bonds (not all!) they have a fixed maturity date A range of income yields to suit different investment and tax situations Relative security of capital for more highly rated bonds
- 5. cisi.org Investing in bonds – Disadvantages/Risks Disadvantages and risks of investing in bonds Inflation risk If inflation rises, the ‘real’ value of the bond’s coupon and redemption payment are eroded Default risk There is a possibility that the issuer will not be able to pay the coupon or capital back Price risk/Market risk Fluctuations in interest rates cause bond prices to change accordingly when they are traded Seniority Risk Some bonds may rank behind more recently issued bonds in terms of being repaid if the issuer is unable to pay the bond back (company may go into liquidation) Liquidity Risk The ease with which a security can be converted into cash. Some bonds are more easily sold at a fair market price than others. Exchange rate risk Bonds denominated in a currency different from that of the investor’s home currency are potentially subject to adverse exchange rate movements.
- 6. cisi.org Price Risk/Market Risk – A closer look There is an inverse relationship between interest rates and bond prices: Why? Its 5% coupon is no longer attractive, so its resale price will fall to compensate and make the return the bond offers more competitive. Why? Its 5% coupon is very attractive, so its resale price will rise to compensate and make the return it offers fall to more realistic levels. If interest rates increase, bond prices will decrease If interest rates decrease, bond prices will increase
- 7. cisi.org Highly rated government bonds are said to have only price risk, as there is little or no risk that the government will fail to pay the coupons or repay the capital on the bonds. Price Risk/Market Risk – A closer look However, recent turmoil in government bond markets has resulted from fears that certain European governments (such as Greece, Ireland and Portugal) may be unable to meet their obligations on these loans. The prices of their bonds fell significantly as a result.
- 8. cisi.org Bond yields Yields are measures of the return that can be earned on bonds. 1888 US railway company issues a 30-year bond certificate ‘4.4% Pennsylvania Railroad Company 1931’ An investor buys US$1,000 nominal of this bond How much in coupons does the investor receive annually? US$44 What is the yield of the bond (at par)? 4.4% Remember that the coupon reflects the interest rate payable on the nominal or principal amount
- 9. cisi.org Bond yields – Flat Yields An investor may not have paid the par value – they may have paid a different amount to purchase the bond, so a method of calculating the true return to him or her is needed. Flat yield The most straightforward yield is to look at the coupon paid on a bond as a percentage of its market price – known as the flat or running yield Annual coupon (£) Bonds market price (Price paid to purchase £100 nominal) X 100 Flat yield (%) = When a bond is kept by the holder from when it is purchased at the nominal value until the maturity date: Coupon rate = The yield
- 10. cisi.org Activity – Calculating bond yields Using the worksheets provided, calculate the bond yields for each example given. 1. A bond with a coupon of 5%, issued by XYZ plc, redeemable in 2025, is currently trading at £100 per £100 nominal. Flat yield = (£5/£100) x 100 Flat yield = 5% 2. A bond with a coupon of 4%, issued by ABC plc, redeemable in 2025, is currently trading at £78 per £100 nominal Flat yield = (£4/£78) x 100 Flat yield = 5.13% 3. 5% Treasury stock 2028 is currently priced at £104 per £100 nominal. Flat yield = 4.81% Flat yield = (£5/£104) x 100 4. A company issues a bond priced £65 per £100 nominal, paying 2% coupons half-yearly with redemption in 2024. 5. A bond priced at £110 per £100 nominal, with a variable coupon of 1.5% above LIBOR has a redemption date of 2016. LIBOR is averaging 1.2%. Flat yield = (2/65) x 100 Flat yield = 3.08% Flat yield = (£2.7/£110) x 100 Flat yield = 2.45%
- 11. cisi.org Activity – Calculating bond yields Using the worksheets provided, calculate the bond yields for each example given. 6. a) 2.75% Apple Loan 2030 is trading at £130 per £100 nominal. What is the flat yield? Flat yield = (£2.75/£130) x 100 Flat yield = 2.16% b) Interest rates fall to 2.25% and the same bond is now trading at £140 per £100 nominal. What is the flat yield? Flat yield = (£2.75/£140) x 100 Flat yield = 1.96% c) Interest rates rise to 3.15% and the same bond is now trading for £85 per £100 nominal. What is the flat yield? Flat yield = 3.24% Flat yield = (£2.75/£85) x 100 Relationship between bond prices and bond yields If the price of the bond goes up from the nominal value, the yield decreases. If the price of the bond goes down from the nominal value, the yield increases Remember….. Bond price when issued = £100 per £100 nominal. If bond price when traded is below £100 per £100 nominal, the bond price has decreased, therefore the yield will be higher than the coupon rate If bond price when traded is above £100 per £100 nominal, the bond price has increased, therefore the yield will be lower than the coupon rate
- 12. cisi.org Rating Agencies We’ve seen examples where security in the form of a fixed charge, floating charge or third party guarantee over a bond does not exist. The three most prominent credit rating agencies that provide these ratings are Standard & Poor’s; Moody’s; and Fitch Ratings. The credit risk for most bond issues can be assessed by looking at independent credit ratings Bonds will be assessed and given a credit rating when they are first issued and then re-assessed if circumstances change, so that their rating can be upgraded or downgraded with a consequent effect on their price.
- 13. cisi.org Ratings Agencies Bond Credit Ratings Credit Risk Moody’s Standard & Poor’s Fitch Ratings Highest quality High quality Very strong Strong Upper medium grade Lower medium grade Somewhat speculative Low grade Speculative Medium grade Poor quality May default Most speculative No interest being paid or bankruptcy petition filed In default Aaa AAA AAA Aa AA AA A A A Baa BBB BBB Ba BB BB B B B Caa CCC CCC C CC CC C D C C D D INVESTMENT GRADE Offer the greatest liquidity and certainty of repayment NON-INVESTMENT GRADE Also known as ‘High Yield’ The worst rated are also known as ‘Junk’
- 14. cisi.org Grading bonds Exercise 1. Moody’s rates a bond ‘Baa’. What grade would it be rated as? INVESTMENT GRADE 2. Standard & Poor’s rates a bond ‘BBB’. What grade would it be rated as? INVESTMENT GRADE 3. Fitch Ratings rates a bond ‘BB’ What grade would it be rated as? NON-INVESTMENT GRADE 4. An issuer is ‘in default’. What rating would Moody’s give to their bonds? ‘C’ rating 5. What is the highest rating Fitch Ratings will offer on bonds? ‘AAA’ rating 6. What rating does Standard & Poor’s offer for a bond considered to be ‘low grade’? ‘B’ rating 7. What rating does Moody’s offer for a bond considered to be ‘high quality’? ‘Aa’ rating 8. What rating does Fitch Ratings offer for a bond considered to be ‘Poor quality’? ‘CCC’ rating