Fixed Income Course Transcript
This is the transcript from our popular fixed income fundamentals course at the Corporate Finance Institute
This is the transcript from our popular fixed income fundamentals course at the Corporate Finance Institute
Part 1 (video course)
Slide 1 – Introduction
As we go through the course we be looking to understand yield curves, pricing simple bonds, and finally, we will look at bond duration. In this first section we will start by answer some fundamental questions.
What is a bond?
Who issues bonds?
And, who buys bonds?
When a company wants to raise money, it has two main sources; It can look at the equity capital markets, also known as the stock market, or it can look at the debt capital market, also known as the fixed income market. Unlike the stock market, investing in bonds does not give the investor an ownership interest in the company. Instead, the investor lends money to the company. So a bond is a debt instrument requiring the issuer, also called a debtor or borrower, to repay the lender or investor the amount borrowed plus interest over some specified period of time.
Companies used to issue bond certificates. Here is a bond certificate issued by the State of Hawaii for a nominal value of five thousand dollars. This is the amount borrowed by the State of Hawaii and the amount that needs to be repaid once the bond matures. –
Here is a bond issued by the West Shore Railway Company. Its nominal value is a thousand dollars. The different nominal values cause a problem when we price the bonds. The bond on the left is five times larger than the bond on the right. We therefore price all bonds per one hundred of nominal value.
MDA Training has issued this bond. The nominal value (also known as the face value or par value) is 1000 – this is the amount that MDA Training has to return to the investor or owner of this bond when it matures. The maturity date is 30 September 2022 and the coupon rate is 10% semi-annual. This means every six months, the owner of this bond receives a coupon of 50.
Slide 6 Pop Quiz
Slide 7 – demonstration – US Treasury 10 year
This is a screen shoot from Bloomberg showing the key features of a particular bond.
When analysing any bond the first three things to look for are the issuer, the maturity and the coupon interest.
For this bond the issuer is the US Government, the coupon interest is 2% per year on a semi-annual basis and the bond matures on Feb 15, 2023.
The owner of the bond will receive 1% of the nominal value in interest every six months. Here the nominal value is $100. Therefore 1% is $1. On the maturity date they will also receive the nominal value of $100.
We can also see how much the US Government raised by issuing this particular bond. It is 45,000 MM, which is 45 billion dollars.
The price of the bond is at the top of the screen. It has two prices called the bid and the offer. The bid price of 100-12+ is what you would receive if you sold the bond to a trader. The offer price of 100-13 is what you would pay to buy a bond from a trader. The trader makes money from the difference between the bid and offer prices.
In the US Government bond market the prices are quoted in a rather unusual way. 100-13 does not mean $100 and 13 cents. It means $100 + $13/32. This is peculiar to the US Government market and you won’t see it in other markets.
Finally we see the yield at the top of the screen next to the price. 1.956% is the bid yield and 1.955% is the offer yield. This is the overall return that an investor will expect to earn if they buy the bond and hold it to maturity. It is less than the 2% coupon rate as the investor has to pay more than $100 for the bond. We explore the relationship between price and yield in a later section in detail.
Slide 8 – US Treasury yield graph
This Bloomberg screen shot shows how the yield of the bond is changing as the price changes over time. We can see that is has been trading in a range of between 1.85% and 2.05%. The return that an investor earns for lending to the US Government is very low as it is a very low risk investment.
Slide 9 Demonstration Ford DES
Having seen an example of a bond issued by a government , we now look at a bond issued by a company, in this example it is Ford. Remember the first three features to look for are the issuer, the coupon interest and the maturity date.
By reading the Bloomberg screen, you will see that Ford is the issuer, the coupon interest is 8.875% per year on a semi annual basis and the bond matures on Jan 15, 2022. Notice that the Ford has to pay a much higher rate of interest than the US government. This is because Ford is a more risky investment.
For corporate bonds we will see that they will often have a credit rating. There are a number of credit ratings agencies including Moody’s, Standard and Poors, Fitch and Dunbar and Bradstreet. The strongest rating is AAA and the worst is D.
Slide 10 Demonstration Ford versus Treasury
This final Bloomberg screen shot compares the two bonds that we have just looked at. It has a lot of detail including the duration of the bonds which we will cover in detail in a later section.
The key figure is the spread of 307.9bp, which is 3.079%. The additional yield that an investor expects to earn for taking on the risk of lending to Ford rather than the US Government.
Slide 11 EXERCISE The Bond is right
Now it’s your turn. Click on the attachment link entitled – The Bond is right exercise. It’s an opportunity to read and analyze some Bloomberg screens for yourself. Once you are finished check your answers against the bond is right solution.
We have seen that the US Government raises money in the bond market. Many other governments do the same. They borrow money when they have a budget deficit. That is when they have spent more than they have raised in taxes.
Many large companies raise money in the bond markets to fund their operations and growth. We have seen one example which is Ford.
Regions and municipalities also raise money in the bond markets f or example the State of California, the City of New York or Transport for London.
The last issuer we have listed are the supranationals, for example the World Bank whose members include the US, Japan, China, Germany and UK governments. It raises money for reconstruction and development projects in various countries around the world. It is the banking arm of the International Monetary Fund.
Finally, let’s address the question of who invests in bonds.
Firstly individuals can invest either directly or via mutual funds
Pension funds invest in bonds to help them with their asset and liability management. The coupons from the bonds can be used to pay the peoples pensions in their retirement.
Charities can also invest in bonds as a less risky alternative to the stock market.
Insurance companies are large investors and buy both bonds and shares. They invest their policy holders’ premiums so that they can satisfy future claims.
Some countries have budget surpluses. They raise more money than they spend. These countries will often have sovereign wealth funds to invest the surpluses.
Pension funds, charities, insurance companies and sovereign wealth funds make up what we would called Institutional Investors.
Next we are going to explore yield curves.
A yield curve is a graph. It shows the return an investor will expect to earn by lending their money for a given period of time. This curve is similar to the ones that we see for the developed economies through most of the economic cycle.
So for example if an investor lends long term to the US Government they expect to earn a higher return per year than on a short term investment.
In this session we will explore the various shapes that we see for the yield curve is different economies and how it changes over time.
US Treasury Yield Curve from Bloomberg
Here we have a yield curve for US treasury bonds as at March, 2013. This yield curve is determined by the current market price of US treasuries. For example, 10 year treasuries are yielding 1.9%. In other words, investors lending money to the US government for 10 years require a return of 1.9%. Another way of looking at this is that the cost of debt for the US government over a 10 year time period is 1.9%. We can see that the yield curve is upward sloping, reflecting that it is riskier to lend money to the US government for 30 years rather than 10 years. Yield curves are normally upward sloping so we refer to this shaped yield curve as the normal yield curve.
Yield curves are determined by current interest rates and the credit risk of those borrowing money. The higher the level of credit risk, the greater the cost of borrowing. Here we have the yield curve for US treasuries. They have minimal credit risk, and hence a low yield curve. Triple A rated companies have a slightly higher level of credit risk than US government treasuries. Therefore investors expect a slightly higher return when lending money to triple A companies rather than the US government. This is reflected in a slightly higher yield curve. The gap between the yield on a bond and the government yield curve is called the credit spread. As the credit risk of companies increase, the yield curve for those companies gets higher and higher. Once a company loses investment grade status, the cost of borrowing increases significantly. Companies that have lost investment grade status are called high yield or junk bonds. Credit spreads change as economic conditions change. When the economy is deteriorating as we saw in late 2007 and 2008, credit spreads widen. This reflects the added risk in lending to these companies. As economic conditions improve, credit spreads narrow because of an improvement in the credit quality of the companies. As credit spreads narrow, yields of the bonds fall which means the prices of those bonds are increasing.
The major rating agencies include Standard and Poor’s and Moody’s
The agencies are paid by the issuers to rate their debt. The rating helps the issuers sell their debt in the market place.
Debt with a rating of BBB- or higher is known as investment grade. Debt with a rating of BB+ or lower is known as high yield or junk.
Slide 18 Pop Quiz
The first stage in the economic cycle is a steepening of the yield curve.
As the economy grows, the market expects central banks to raise interest rates in the future. As this expectation becomes more predominant, the yield curve steepens.
The next stage of the economic cycle is a flattening of the yield curve. In diagram B, you can see the short end of the curve rise. This happens when central banks raise interest rates. The official central bank interest rates are always short term rates. Raising them affects the short end of the curve.
The third stage of the economic cycle, is when interest rates are raised to such a level the market expects future interest rates to be lower than they are today. Remember, central banks are raising interest rates to manage growth and inflation. If the demand in the economy weakens then the central will lower interest rates. In graph C the market is predicting these future lower rates and the curve inverts.
The final stage of the economic cycle is when central banks actually lower short term interest rates. This hopefully has the effect of stimulating growth in the economy. Once the economy is growing again, market expectations return to expecting future interest rates to be higher than what they are today.
Historically this economic cycle has repeated itself every 5 to 9 years.
Slide 20 Pop Quiz
Slide 21 Demonstration – Theory of yield curve shapes
As we have just seen, the yield curve takes different shapes. Typically the yield curve is upward sloping. This is the normal yield curve.
The yield curve can also become inverted. This is a reliable leading indicator that growth in the economy is slowing.
Yield curves can also be humped. This occurs when there is strong demand for long term bonds. Pension funds in particular buy long term bonds to match their long term liabilities.
There is no one unifying theory that adequately explains all yield curve shapes and movements. Several theories have been developed; the main ones are as follows: liquidity preference, pure expectations and market segmentation. Let’s look at these one by one.
The liquidity preference theory says that investors have a preference for ready access to cash. They therefore like to invest short term and borrow long term, which has the effect of lowering short term interest rates and raising long term interest rates. This preference is particular strong when they have concerns about inflation. The liquidity preference theory explains why the yield curve is normally upwardly sloping.
The pure expectations theory states that long term interest rates predict what short term rates will do in the future. So when the market expects short term rates to fall, then we see low long term interests. The pure expectations theory explains why the yield curve sometimes inverts when demand is slowing. The market will predict that the central bank will cut short terms to stimulate demand at some point in the future.
The final theory is the market segmentation. This theory states that investors have different investment goals, and therefore invest in fixed income products with different terms. For example corporate treasures may invest in short term bonds and pension funds may invest in long term bonds. The price of bonds at different points along the curve reflects the different levels of demand from each type of investor. The market segmentation theory explains why the yield curve is sometime humped reflecting strong demand at a particular point on the curve.
Slide 22 – Yield Curve Mix and Match exercise
Now it’s your turn. Click on the attachment link entitled “yield curve mix and match exercise”. Once you’ve had a go, check your attempt with the attached “yield curve mix and match solution.” Good Luck!
Slide 23 – Summary
That concludes the first module, introducing the fixed income products and markets. Be sure to check out list of investing books for more reading.
The key points to take away are: