IAD Securities ED5 (print)...• Callable/Putable bonds - Callable – can be redeemed early at the discretion of the issuer - Putable – can be redeemed early at the discretion of

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Chapter 2Fixed-income Securities

20 questions

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www.fitchlearning.com

Debt: Types and FeaturesDebt types: summary

Capital

Debt

(companies and governments)

Equity

(companies only)

Bank Loan

(companies only)

Debt Securities

(companies and governments)

Bills

maturities < 1 year

Bond

maturities > 1 year

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1. Sovereign and Government BondsGovernment debt• Supranational

- E.g. World Bank, European Investment Bank, Asian Development Bank

• Governments

• Government sponsored Entities (GSEs) or Agencies- Government sponsored agencies, e.g.:

• Federal Home Loan Mortgage Corporation (Freddie Mac) in the US• Public corporation bonds in UK

• Local government bonds (UK)- Constrained by central government

• Transport for London raised £600m in 2006

• Municipal bonds (US)- Issued by states and local authorities

• Tax benefits to local residents

Further informationCharacteristicsAgency bonds (US) – Federal Home Loan Banks (FHLB), the Federal National Mortgage Association (‘Fannie Mae’), the Federal Home Loan Mortgage Corporation (FHLMC, ‘Freddie Mac’) and the Student Loan Marketing Association (‘Sallie Mae’). Municipal bonds – are usually guaranteed by a third party, known as a monoline insurer to enhance credit quality which enables municipality tosecure funds on more advantageous terms.

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Government debt (cont.)• Features of gilts COUPON

Expressed as an annual percentage of the nominal value

NAMEThe name given at issue

NOMINAL VALUEThe capital payment the holder receives at redemption

REDEMPTIONThe year when the gilt is repaid

6½ PER CENT TREASURY STOCK 2018Principal and interest charged on the National Loan Fund, with recourse to the Consolidated Fund of the United Kingdom

Repayable at par on the 7 December 2018

Interest payable half-yearly on 7 June and 7 December

GBX00001144KK00Security Code

HOLDING NUMBER

555-XZ333333

122

CERTIFICATE NUMBER 555-XZ333333

£100.00******

MR FREDERICK BLOGGS24a ACACIA AVENUE ARBINGER SURREY SSY 345

THIS IS TO CERTIFY THAT THE ABOVE-NAMED IS/ARE THE REGISTERED HOLDER(S) OF ONE HUNDRED POUNDS 61/2 PER CENT TREASURY STOCK 201817 JUNE 2002

IMPORTANT: The Bank of England should be notified immediately ofany change of address of any of the above stockholdersNo transfer in whole or part of this holding represented by thiscertificate will be registered until this certificate has been delivered to the Bank of England

The stock is transferable in multiples of 1p

CHIEF REGISTRARBANK OF ENGLAND

S P E C I M E N

S P E C I M E N

COUPONExpressed as an annual percentage of the nominal value

NAMEThe name given at issue

NOMINAL VALUEThe capital payment the holder receives at redemption

REDEMPTIONThe year when the gilt is repaid





HOLDING NUMBER

555-XZ333333

122


£100.00******






S P E C I M E N

S P E C I M E N





HOLDING NUMBER

555-XZ333333

122


£100.00******






S P E C I M E N

S P E C I M E N





S P E C I M E N

S P E C I M E N

Further informationCharacteristicsName – to act as an identifier.Coupon – generally paid semi-annually and the quoted coupon of a gilt represents the annual amount of interest paid per nominal value.Coupons are received gross (before tax) but are taxable (subject to income tax for individuals).Redemption – the specified date on which the capital is repaid by the DMO. Normally, redemption is at par: i.e. £100 for each £100 nominal value held. Benchmarking – the yield available on UK gilts is considered the risk-free rate for sterling denominated bonds – UK gilts are effectively credit risk-free.

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Government debt (cont.)• Categories of gilt

• Conventional- Shorts- Mediums- Longs- Undated

• Index-linked- Coupon- Redemption

Further informationThe Debt Management Office (DMO) – ensures that the government can borrow the money it requires to fund the Public Sector Net Cash Requirement (PSNCR). Issues by the DMO may be for a new gilt with a coupon/maturity dissimilar to any existing issues.

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Government debt (cont.)• Categories of bond

- Other non-conventional bonds• Double-dated (dual-dated)

- Redeemed at the discretion of the DMO between two dates• Convertible

- Into other gilts at the discretion of the holder• Floating rate

- Coupon reset in line with short-term rates (LIBOR)- Capital protection

• Zero coupon

• Risk considerations- Sovereign debt

• Not all default risk-free• Portugal, Ireland, Italy, Greece, Spain (PIIGS)

Further informationDouble-dated gilts – have two dates, e.g. Treasury 3 3/4% 2015-2018. The Government has the option of redeeming after the first date, but no later than the last date. Double-dated gilts are categorised as shorts, mediums and longs by using the latter date.Convertible gilts – give the owner the right to convert the gilt into pre-defined amounts of a different gilt at some time in the future. Convertibles are usually short- to medium-term bonds which may be converted into a longer issue at the discretion of the investor.Floating rate bonds – are adjusted in line with published market interest rates. At present there are no floating rate gilts in existence.

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Index-linked debt• Inflation indices

- Representing average household consumption

RPI300 goods and servicesArithmetic average price

RPIXRPI minus:Mortgage

repayments

CPIHarmonised indexGeometric average

Excludes housing costsUsed by MPC

RPIYRPI minus:Mortgage

repayments andIndirect tax (VAT)

Further informationInflation indices – there are significant differences between the CPI and the RPI. The CPI excludes a number of items, mainly related to housing. In addition to the differing items contained within the RPI and CPI, the methods of calculation are different. This tends to result in a lower figure for the CPI than RPI – something called the formula effect.

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Index-linked debt (cont.)• Index-linked issues

- RPI used as inflation measure for index-linked gilts- Inflation proof - Both coupon and final redemption value adjusted

• Since June 2005 reference date for coupon and redemption is three months prior

- Zero inflation will pay coupon with no uplift redemption will be nominal value

Dec 08Issue date

Sep 08RPI = 126

3 months

Jun 10Coupon

date

March10RPI = 142

3 months

Coupon=1.12698 x £5 x 0.5

= £2.82Inflation uplift = 142 / 126 = 1.12698

Example: 5% £100 nominal value ILG with semi-annual coupon

Further informationIndex-linked debt – the base index figure is the one three months prior to the issue date, and the final reference rate is the index value three months prior to redemption. The holder is compensated for inflation for the three months prior to the issue, but exposed to inflation for the last three months. An investor is not guaranteed a real rate of return in any period due to the time lag involved.

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2. Corporate DebtSecured debt

Corporate Bonds

DebenturesSecured debt securities

Loan StockUnsecured debt securities

Fixed charge over assets

Floating charge over assets

Further informationDebenturesFixed charge over assets – a fixed charge is security over a certain specific company asset, e.g. a building or land, and is the most common form of security for debentures. A mortgage charge is a type of fixed charge.Floating charge over assets – a floating charge is security over a class of assets, e.g. plant and machinery, fixtures and fittings, trade debtors.Fixed and floating charges need to be registered and this is usually done through a debenture trustee.

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Secured debt (cont.)• Asset-backed securities

- Secured by a pool of assets, e.g. property, loans, credit card receivables - Underlying assets securitised- ‘Off balance sheet’ finance

Pool of mortgages

£250K

£monthly+ %

£monthly+ % ABS

£ £Mortgagee Lender Special purpose vehicle

(SPV)Investment company

Summary• The mortgagee agrees to a monthly payment reflecting capital plus interest for a fixed time period, e.g. 25 years• The lender sells the repayments on to a SPV• The SPV pools the mortgage with others and securitises them by producing an ABS• The ABS is sold on to an investment company• The money raised is passed on to the lender as payment for the mortgage repayments

Further information Asset-backed securitiesThe assets provide the bondholders’ security. Such arrangements are often referred to as the ‘securitisation of assets’. The name ‘securitisation’reflects the fact that the resulting financial instruments is a bond (a security).Financial institutions issue bonds to finance borrowing. Where a bank uses a special purpose vehicles (SPVs), the loan does not appear within the accounts of the bank. This type of finance is often described as ‘off balance sheet finance’.

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Unsecured debt• Impact of security

• Junior vs. senior

1. Liquidator

2. Fixed charge holders

3. Preferential creditors (e.g. employees)

4. Floating charge holders

5. Unsecured creditors (e.g. trade creditors and the Government)

6. Subordinated loan stock

7. Preference shareholders (nominal value only except

participating shares)

8. Ordinary shareholders

CRED

ITO

RS

OW

NER

S

Mezzanine Finance

Further information Unsecured debt – other termsIncome bonds – junior bonds. Only the face value bond is paid to the investor; coupon payments being paid only if the issuing company has enough income.High yield bonds – bonds rated below BBB-.Subordinated loan stock – loan stock issued by a company that ranks above its preference shares but below its unsecured creditors in the event of the company’s liquidation.Permanent interest bearing securities – issued by mutual building societies; semi-annual coupons paid gross. Classified as perpetual subordinated bonds (PSBs). When a building society is demutualised.Mezzanine debt – will rank below other forms of debt, but above the equity in a liquidation. As the riskiest debt, the mezzanine debt will offer a greater rate of interest and can be raised in a variety of ways; for example: Payment in kind notes (PIK notes) – are zero coupon bonds that are issued at a substantial discount to their face value. When they are repaid, the difference between the redemption value and the purchase cost will provide the investor’s return.

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Unsecured debt (cont.)• Credit ratings

- Prime vs. sub-prime Standard & Poor’s

AAAAAABBBBBBCCCCCCD

Moody’s

AaaAaABaaBaBCaaCaC

Investment grade

Speculative grade

Bond in default

Bond in default

Further information The three most prominent credit rating agencies that provide these ratings are Standard & Poor’s, Moody’s and Fitch.Fitch ratings are not shown in this table as they use a similar system to Standard & Poor’s.

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Bonds with embedded options• Callable/Putable bonds

- Callable – can be redeemed early at the discretion of the issuer- Putable – can be redeemed early at the discretion of the holder

• Convertible bonds- Convertible loan stock – convertible into new ordinary shares in issuer- Contingent convertible bonds – strike to convert shares and strike they must reach to

be convertible

• Exchangeable bonds- Exchangeable loan stock – convertible into existing ordinary shares in another

company

• Contingent Convertible bonds (CoCos)- Conversion takes places on a pre-specified event for example:

• Share price• Level of capital

Further information Callable bonds – double-dated bonds may be considered as a subset of callable bonds.From the issuer’s perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. However, in exchange for the benefit of reduced interest payments, the value of shareholders’ equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares. Issuing contingent bonds is more advantageous to companies than issuing regular convertibles. Until an investor exercises the option, the company does not need to count shares in its calculation of diluted earnings.

LinksThe pricing of an exchangeable bond is similar to that of convertible bond, splitting it in to a straight debt part and an embedded option part and valuing the two separately.Price of exchangeable bond = price of straight bond + price of option to exchange.

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3. EurobondsTypes of eurobonds• Definition

- International bonds• Issued through international placing

- Bearer documents- Issued in a eurocurrency

• Any currency other than the currency of the market on which it is issued

• Versions - As varied as any corporate bond

• Straight/Plain vanilla• Floating/Variable rate• Subordinated• Asset-backed• Convertible

Further information Listing eurobonds – a London listing of a eurobond consists of admission to listing by the United Kingdom Listing Authority (UKLA) – a division of the Financial Conduct Authority (FCA), and admission to trading on arecognised investment exchange such as the London Stock Exchange.Straight or plain vanilla – fixed coupon eurobonds or bullet bonds normally pay the coupons once a year. Additionally, there are some straight zero-coupon eurobonds.Floating rate eurobonds (FRN/VRN) – bonds where the coupon rate varies. The rate is adjusted in line with published market interest rates. The published interest rates that are normally used are LIBOR and Euribor.

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Hints Accrued interest – eurobonds are bearer documents which do not have a registration lag from an issuer’s point of view. However the examiner describes an ex-coupon period where the buyer of the bond is not entitled to a portion of the coupon. We have to assume that, due to immobilisation, the depositary imposes this ex-interest period.


Dealing and settlement• Typically OTC but some exchange-traded

• Regulated by International Capital Markets Association (ICMA) - Trades reported and matched through TRAX- Settlement: T+2

• Gross annual coupon

• Day-count convention for accrued interest- 30/360

Immobilisation• As bearer documents, eurobonds are often held in depositaries (immobilised)

- Euroclear/Clearstream

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4. Fixed-income SecuritiesUK Debt Management Office (DMO)• Role of the DMO

- Executive agency of the Treasury- Prime responsibility

• To ensure the government can borrow funds to cover the Public Sector Net Cash Requirement (PSNCR)

- Issues gilts through auctions and T-bills through ‘T-bill tenders’- Operates the Public Works Loans Board

• Lends money to local authorities

Further information The Debt Management Office (DMO) makes new issues of UK Government securities (gilt-edged securities or gilts). Once issued, the secondary market for dealing in gilts is overseen by two bodies: the DMO and the LSE.The DMO applies to the UKLA for a listing of its gilts. Even though most gilts trades take place OTC, the LSE defines the rules to which they are traded.The DMO is the body that enables certain LSE member firms to act as primary dealers, known as gilt-edged market makers (GEMMs).

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UK Debt Management Office (DMO) (cont.)• Participants

- GEMMs (primary dealers)• Vetted by DMO, registered with LSE, supervised by FCA• Provide liquidity in the gilt market

- Obligations:• Quote two-way prices to customers

- Exceptions to two-way pricing – other GEMMS, fixed interest market makers and gilt inter-dealer brokers

• Minimum volume set by DMO• Participate in DMO auctions• Provide closing price to DMO

- Privileges:• Executive rights to competitive telephone bidding• Exclusive facility to trade as counterparty of DMO• Exclusive access to inter-dealer broker screens

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UK Debt Management Office (DMO) (cont.)• Other participants

- Gilt inter-dealer brokers

- Broker dealers

• Standing repo facility- Allows GEMMs to enter into a reverse repo with DMO

I.D.B.

GEMM 1GEMM 2

Buys Sells Buys Sells

Acting as a central counterparty in a ‘riskless principal transaction’

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UK Debt Management Office (DMO) (cont.)• Gilt auctions

Further information To judge the ‘success’ of a government auction, the bid to cover ratio can be used. It is computed in two ways: the number of bids received divided by the number of bids accepted, or the total amount of the bids.A ratio above 2.0 indicates a successful auction comprised of aggressive bids. A low ratio is an indication of a disappointing auction, marked by a wide spread in the yield’s bid.

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UK Debt Management Office (DMO) (cont.)• Auctions

- Competitive • Minimum bid: £1,000,000 of nominal value• Price bid• Pay price bid

- Non-competitive• Maximum bid: £500,000 of nominal value• No price bid• Pay volume weighted average price of successful competitive bids

- Tranches• DMO issues more of an existing gilt

• Interim funding/TAPS- Issued in to the secondary market via GEMMS

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Bond pricing benchmarks• Spreads and benchmarks

- Difference between the yield on one investment and the yield on another• Measured in basis points (0.01%)

• Example- A corporate bond yields 100bp above the benchmark gilt. The benchmark gilt is

currently yielding 3.8% and LIBOR is 4.1%. What is the corporate bond’s spread to LIBOR?

Further information Spread over/under LIBOR – at times of financial stress, such as during the banking crisis in the autumn of 2008, the spread between LIBOR and the applicable base rates can widen dramatically which, in this instance, reflected the incapacity or unwillingness of banks to engage in normal money market activities.Spread over/under swap rates – the swap spread is the difference between the ten-year Treasury and the swap rate, which is the fixed rate on a LIBOR-based interest rate swap. Under normal market conditions, the ten-year Treasury yield would be lower than the swap rate.Swap spread inversion – perhaps a fleeting phenomenon, and some suggest the inversion might signal concerns over increased government debt issuance and deteriorating credit quality.

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Issuance of fixed-income securities• Scheduled funding and opportunistic finance

- Shelf registration• Single registration covers several issues

- Typically used for medium-term notes (MTNs)• Issued on an ongoing basis with coupons in line with the prevailing rates• Reverse enquiry

- Similar to a commercial paper programme

Further information Shelf registration – has been heavily used in the medium-term note (MTN) market (bonds with generally 2 to 10 years). Shelf registration allows flexibility to issue smaller batches of bonds with the coupons and maturity varying according to market demand at the time.Those listed on the Official List need only produce, on an annual basis, a document (‘shelf document’) which contains most of the information required in listing particulars. The shelf document must be formally approved by the UK Listing Authority before publication and registration.

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5. Fixed-income Markets and Trade Execution Government bond market• Participants (UK)

- GEMMs- Inter-dealer brokers- Broker dealers

• Participants (US)- Primary dealers (designated and investment banks)

• ‘Risk-free’ and credit ratings- Assumption that government debt is default risk-free- Interest rate risk- Inflation risk

• Regulated markets- Government bond market subject to same regulation as any other security

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Issuance of fixed-income securities• Difference between auction and tender:

- Auction• Pay the price bid

- UK Government bonds (non-indexed-linked)- UK T-bills

- Tender• Pay the lowest successful price

- UK index-linked Government bonds- Corporate bonds- US Government bonds

Keeping on targetAn auction is offered to raise £100m nominal value at a market price of £101 per £100 nominal.ABC offers £102.50 for £50m nominalDCF offers £101.75 for £50m nominalGHI offers £101.50 for £50m nominal

Who would be successful and what is the price they will pay?

Keeping on targetA tender is offered to raise £100m nominal value at a market price of £101 per £100 nominal.ABC offers £102.50 for £50m nominalDCF offers £101.75 for £50m nominalGHI offers £101.50 for £50m nominal

Who would be successful and what is the price they will pay?

LinksTreasury bills are issued at weekly auctions, known as ‘tenders’. The bids are tendered competitively – only those bidding a high enough price will be allocated any Treasury bills and they will pay the price that they bid.

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Summary of major government bondsGilt Japan US T-Bond Bund Germany China

Coupon Semi-annual Semi-annual Semi-annual Annual Annual

Legal Form Registered Registered or Bearer

Registered Bearer Bearer

Life Variable up to 50 years

10 years20 years

Up to 30 years 10 to 30 years Variable

Quotation 1/1001/100

1/321/100

1/100

Medium-term Debt T-note 2-10 years Schatz 2 yearsBOBL up to 5 years

Settlement T+1 T+3 T+1 T+2 T+3

Settlement agency CREST Tokyo Stock Exchange

FICC Euroclear and Clearstream

Interest Convention

Actual/ActualActual/365

Actual/ActualActual/Actual

Actual/Actual

Keeping on targetAn investor wishes to buy US Treasury bonds. He is quoted 105 13/32. The investor considers the price, during which time the price rises by 14/32. At what price will the investor buy the bond? A. 105.27B. 105.44C. 105.64

D. 105.84

Answers to questions on previous slide

Auction = ABC is successful and pays £102.50; DCF is successful and pays £101.75 and GHI is unsuccessful.

Tender = ABC is successful and pays £101.75; DCF is successful and pays £101.75 and GHI is unsuccessful.

Further information Only Japanese are subject to withholding tax.The French Government’s bond issues are known as Obligations Assimilables du Trésor (OATs), which are longer-term bonds; they are bearer and settle T+2.

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Global strip market• STRIPS – Separate Trading of Registered Interest and Principal of Securities –

UK and US

• Permitted parties (UK)- GEMMs- Treasury- Bank of England

• Strippable gilts- Gilts designated as strippable by the DMO

• Minimum units for stripping- Based on multiples of a penny- Example: the nominal of a 4.25% bond could never be stripped into smaller portions

than £8• Semi-annual coupon strip would be £8 x 2.125% = 17p

• Main benefits – match liabilities precisely, removing any reinvestment risk

Keeping on targetAn investor wishes to invest in gilts. Which of the following bonds would allow an investment in a nominal no less than £16?A. 2 year gilt with a 2 1/4% couponB. 5 year gilt with a 3 1/2% couponC. 8 year gilt with a 4 1/8% couponD. 10 year gilt with a 6% coupon

Answer to the question on the previous slide = DUS Treasury bonds are quoted in fractions down to 1/32. The original price quoted is not a bid/offer spread, but a fraction; effectively 105.40625. The price move is also a fraction 14/32 (or 0.4375). 105.40625 + 0.4375 = 105.84.

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Global corporate bond markets• Global corporate bond markets

- Decentralised dealer market• Liquidity provided by market makers

- In UK some trading on LSE via market makers- In US some trading on NYSE

• Regulation in UK- Financial Conduct Authority (FCA)- Prudential Regulation Authority (PRA)- London Stock Exchange (LSE)- International Capital Markets Association (ICMA)

Answer to the question on the previous slide = CThe minimum denomination that the DMO will allow is 1p. At £16 NV all semi-annual coupon payments would be in whole pennies.2 1/4% bond would pay out £16 x 2.25% / 2 = 18p3 1/2% bond would pay out £16 x 3.5% / 2 = 28p4 1/8% bond would pay out £16 x 4.125% / 2 = 33p6% bond would pay out £16 x 6% / 2 = 48pHowever, all the other bonds can be sold to lower nominal values and still pay out coupons in whole pence.The 2 1/4% bond could pay out on an £8 NV: £8 x 2.25% / 2 = 9pThe 3 1/2% bond could pay out on a £4 NV. £4 x 3.5% / 2 = 7pThe 6% bond could pay out on a £2 NV. £1 x 6% / 2 = 3p

Further information Regulation of the UK bond market – the complete rules and conditions for listing securities in London are set out in the Listing Rules, commonly known as the Rule Book, and in the Admission and Disclosure Standards. The Listing Rules are maintained by the UK Listing Authority – a division of the Financial Conduct Authority; whereas the Admission and Disclosure Standards are maintained by the London Stock Exchange.

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Global bond markets and trading methods• Historically

- Inter-dealer markets- Voice trading systems

• In general a move towards electronic over-the-counter trading platforms- Business to business (B2B)- Business to client (B2C)- Request for quote (RFQ)

Emerging economies bond markets• Considered higher risk

• Lower rated bonds

• Less efficient markets

Further information Emerging economies bond marketsBonds from such countries are generally regarded as much higher risk, some reasons:• Greater likelihood of economic swings• Common political upheaval• Government interference• Taxation on foreign investment• Less liquidity• Less stable political systems• More market volatility

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6. Present Value, Yield and Conversion CalculationsFactors influencing price• Credit ratings

- Credit enhancements• E.g. over-collateralisation

• Seniority of debt- Senior- Subordinated- Mezzanine

• Interest and inflation rate risk

• Market liquidity

• Fiscal risk- Withholding tax on overseas bonds can be increased

Further informationCredit enhancements Excess spread – the excess spread is the difference between the interest rate received on the underlying collateral and the coupon on the issued security. If some of the underlying loan payments are late or default, the coupon payment can still be made.Over-collateralisation – The face value of the underlying loan portfolio is larger than the security it backs. If some of the payments from the underlying loans are late or default, principal and interest payments on the asset-backed security (ABS) can still be made. Reserve account – a reserve account is created to reimburse the issuing trust for losses up to the amount allocated for the reserve. Surety bonds – insurance policies that reimburse the ABS for any losses. Letter of credit – a financial institution is paid a fee to provide a specified cash amount to reimburse the ABS-issuing trust for any cash shortfalls from the collateral, up to the required credit support amount. Wrapped security – is insured or guaranteed by a third party. The third-party guarantees are typically provided by AAA- rated financial guarantors or monoline insurance companies.

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%100priceMarket

couponannualGrossyieldFlat X

Valuation of fixed-income securities• Flat yield

- Uses:• Income-seeking non-taxpayers• Irredeemable bonds

HintsThe examiner can also use the following terms for the flat yield:• Income yield• Coupon yield• Current yield• Running yield• Simple yield

Further informationThe two major elements of a quote for a bond: the price and, as a result of the price, the yield. Most investment managers will be looking for bonds with particular yields and maturity dates.When dealing in corporate bonds, the quotation method is usually a yield bid/offer spread rather than a price bid/offer spread.

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Bond yield calculations• Gross redemption yield / yield to maturity

Example:

An investor purchases an 8-year 7% coupon bond at a market price of £95.00 (per £100 nominal). The gross redemption yield is calculated as follows:

• Net redemption yield

8.1%

++

Gross redemption yield

Profit / Loss at redemption

Flat yield (coupon income)

%.% 70100£95

(£5 Profit / 8 years) =x

7.4%100%£95£7 =x

Keeping on targetWhich one of the following is the best approximation of the gross redemption yield of an 8% two-year gilt with a current price of £103?A. 6.3%B. 7.8%C. 8.2%D. 9.7%

Further informationThe yield to maturity (YTM) is also known as the gross redemption yield(GRY); it represents the internal rate of return (IRR), expressed as an annualised percentage rate, if one was to hold on to the bond until maturity. One key assumption of the YTM calculation is that one is able to reinvest all the interest payments received at the same yield throughout. The net redemption yield can be calculated as the internal rate of return(IRR) of: • The dirty price paid to buy the bond• The net coupons received to redemption (net of the appropriate rate of tax)• The final redemption proceeds which are paid gross

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Bond yield calculations (cont.)• Discounting

Example• The value of a two-year 6.5% coupon bond using 4.5% interest rates:

£103.74

0.045)(1£106.50

0.045)(1£6.50

r1val£red£coupon

r1£couponbondofValue

2

n

Answer to the question on the previous slide = A

As the gilt is trading above par, the investor would make a loss on redemption – therefore the GRY will be less than the flat yield.The flat yield on this gilt is 7.8% – therefore the GRY must be less than 7.8% – so A is the only possible answer.

Keeping on targetThe present value of the following gilt with a 4% annual coupon with two years to maturity and a prevailing discount rate of 2.75% is:A. £98.51B. £100.28C. £102.40D. £104.28

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Valuation of fixed-income securities• Clean and dirty prices

Price

Coupon paid date

Time

Dirty Price

Clean Price

Ex-coupon date

Cum coupon period

6 MONTHS

Ex

coup

on p

erio

d

Cum coupon period

Answer to the question on the previous slide = CYear one will have a cash flow of £4 and a discount factor of 1/1.0275. The present value at the end of year one is £3.89.Year two will have a cash flow of £104 and a discount factor of 1 / (1.02752). The present value at the end of year two is £98.51.The price of the bond is the sum of the present values.

HintsThe ex-coupon period for gilt is typically seven business days.Bearer bonds generally do not have ex-coupon periods.

59


Valuation of fixed-income securities (cont.)

Example:

You buy £10,000 nominal of an 8% gilt on 5 July for a clean price of £105. Coupon dates are 1 April and 1 October. Calculate the dirty price payable on settlement:

A. £10,690

B. £10,700

C. £10,710

D. £10,720

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Valuation of fixed-income securities (cont.)• Factors affecting bond prices

- Interest rates determine the return required from the bond. Bond prices have an inverse relationship with interest rates. A rise in interest rates will lead to a rise in the bond’s required yield (YTM) and its price will fall. The sensitivity of the bond’s reaction to an interest rate move is determined by:• Remaining life

- Longer- Shorter

• Coupon size- Larger- Smaller

Further informationInterest rate sensitivity – if the required yield from a bond rises, its price will fall. If the required yield from a bond falls, its price will rise.Bond prices have an inverse relationship with their yields:

Inflation risk – is linked to interest rate risk, as interest rates have to rise to compensate bondholders for declines in the purchasing power of money.

Price = Par Coupon Yield

Price < Par

Yield > CouponPrice > Par

Yield < Coupon

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HintsConvexityAn adjustment to modified duration

At low yields modified duration underestimates the price increase when yields fall, and over estimates the price decrease when the yield rises.


Valuation of fixed-income securities (cont.)• Macaulay Duration:

- A relative measure of a bond’s sensitivity:- Used for immunisation – constructing a bond portfolio with the same initial value as

the present value of the liability it is designed to meet and with the same duration as the liability

• Modified Duration- The approximate percentage change in a bond’s price for a 1% change in yield:

r1DDurationModified

Where D is the bond’s duration and r is its present yield.

62


Simple interest • Calculate simple interest income on corporate debt:

- Corporate bond paying 6% coupon maturing in 20 years- Market price is £108 per £100 nominal- Investor buys bonds at a market price of £4,320

Convertible loan stock• Calculate the conversion premium:

- Convertible trading at £125 per £100NV- Conversion ratio = 50- Current share price £2.30

HintsWe would assume that the examiner wishes us to calculate the interest on the next coupon payment and not over 20 years.

Keeping on target – Question 1A company has issued convertible loan stock which can convert into 80 ordinary shares per £100 nominal. The convertible is trading at £160 and the ordinary shares at 180p per share. What is the conversion premium as a percentage?A. 10%B. 11.1%C. 20%

D. 22.2%

Keeping on target – Question 2Your client holds loan stock in company ADY plc, redeemable in five years. The stock has conversion rights set at 40 shares per £100nv and has just moved into a conversion window. The stock is currently trading at £121.50 per £100nv, and ADY plc share price is currently £3.15. Which of the following statements, if true, would be most helpful to the investor?A. Conversion cannot occur until redemption so sell the loan stock and

use the funds to buy a direct holding in the shares B. Conversion can occur so convert the bond into shares and sell the

shares at a profit C. Conversion cannot occur until redemption so hold on to the loan stock D. Although conversion can occur, the investor will profit from selling the

loan stock and use the funds to buy a direct holding in theshares

63

Chapter 3Equities

15 questions

Answer to the questions on the previous slideQuestion 1 – B - Effective price of share via convertible debt (£160/80 shares) £2.Actual share price £1.80.Conversion premium is 20p, or expressed as a percentage of share price, (£0.20/£1.80) 11.1%.Question 2 – B -The bond is trading in a conversion window. It can be converted.The bond is trading at a discount to the share price. Share price = 3.15, number of shares per £100nv = 40. So theoretical price of the bond = 3.15 x 40 = £126.This is £4.50 above the bond price. This has created an arbitrage opportunity.The investor could in theory convert each £100nv into £126 of shares, sell these shares and repurchase the bond at £121.50 to make a profit.

Documents

IAD Securities ED5 (print)...• Callable/Putable bonds - Callable – can be redeemed early at the discretion of the issuer - Putable – can be redeemed early at the discretion of