You are on page 1of 62

Business School

ACTL4303 AND ACTL5303
ASSET LIABILITY MANAGEMENT

Week 6
Fixed Income Securities
Greg Vaughan

Review of Equity Pricing and Revision

b is earnings retention (1 – payout ratio)
E is next year’s earnings
k is the equity discount rate eg Rf + B(Rm-Rf)
ROE is return on newly invested equity
Given b, E and ROE you can determine P if you have k, or determine k if
you have P (market implied returns, consistent with assumptions)
2

Review of Equity Pricing (2)

§  If the price accurately reflects stock characteristics (eg ROE) then
investment return equals discount rate
§  High PE and high growth do not mean high return

3

Disequilibrium Example E(r) SML 15% Rm=11% rf=3% 1.25 4 β .0 1.

The security characteristic line RHP (t ) = α HP + β HP RS &P500 (t ) + eHP (t ) 5 .

•  Active weights are scaled based on target tracking error 6 . A stocks weight in the active portfolio is the difference between its portfolio weight and its weight in the index A w A i P I = wi − wi •  Key result: If not for the long only constraint ( index model implies w A i ∝ w P i >0 ) the single- α σ (e ) i 2 i •  ‘. so that portfolio beta is one. rather than the beta of each individual security’.Portfolio Construction and the Single-Index Model α A •  Managers are assessed on their information ratios: σ (e ) •  These relate to their active portfolios.we are concerned only with the aggregate beta of the active portfolio. Normally this is zero by design..

or the data span is shorter.Arithmetic and geometric returns E(Geometric Average) = E(Arithmetic average) – 1 2 2σ IF we were observing a stationary return distribution: •  The sample arithmetic average (eg over 55 years) is an unbiased estimate of the true mean •  However compounding at this rate results in an upwardly biased forecast for a given horizon (eg over ten years) •  The unbiased estimator for a projection of H years. the geometric mean becomes increasingly relevant 7 . the Arithmetic mean is appropriate. based on a data sample of T years is (H/T) x Geometric + (1-H/T) x Arithmetic •  For a short projection horizon. but where the horizon is longer.

3 0% Quarterly -1.5 0.8 0% Annual -0.1 30.8 8.8 56% 8 .Australian Equity Log Returns 1980-2012 Frequency Skewness Excess Kurtosis Probability of Normality Monthly -3.

monthly) •  If there is true independence from one period to the next the results should be consistent (ie variance ratios of 1) •  There is some mild statistical contradiction of the random walk in Australia (1980-2012) 9 . quarterly.Random Walk and the EMH •  Volatility of log returns can be calculated at different data frequencies (eg annual.

Dividend Imputation (2) •  A company makes a profit of $100. with the net effect that the superannuation fund receives $15 •  The dividend is worth $85 to the superannuation fund 10 . Tax = 15%x($70 + $30) =$15 •  The superannuation fund receives a credit from the tax office of $30 against that tax liability. and pays company tax at 30% leaving $70 for distribution as dividend •  A $30 imputation credit is attached to the $70 dividend in respect of the company tax paid •  The superannuation fund pays 15% tax on the aggregate of the dividend ($70) and the franking credit ($30).

This week’s coverage Bodie et al Chapter 14 Chapter 15 Chapter 16 11 Bond Prices and Yields The Term Structure of Interest Rates Managing Bond Portfolios .

 MARCUS   .Interest  Rate  Uncertainty  and     Forward  Rates   •  Investors  require  a  risk  premium  to  hold  a   longer-­‐term  bond   •  This  liquidity  premium  compensates  short-­‐ term  investors  for  the  uncertainty  about   future  prices   12 INVESTMENTS  |  BODIE.  KANE.

Theories  of  Term  Structure   •  The  Expecta=ons  Hypothesis  Theory   •  Observed  long-­‐term  rate  is  a  func=on  of  today’s   short-­‐term  rate  and  expected  future  short-­‐term   rates   •  fn  =  E(rn)  and  liquidity  premiums  are  zero   13 INVESTMENTS  |  BODIE.  KANE.  MARCUS   .

 MARCUS   .  fn   generally  exceeds  E(rn)   •  The  excess  of  fn  over  E(rn)  is  the  liquidity  premium   •  The  yield  curve  has  an  upward  bias  built  into  the   long-­‐term  rates  because  of  the  liquidity  premium     14 INVESTMENTS  |  BODIE.  therefore.  KANE.Theories  of  Term  Structure   •  Liquidity  Preference  Theory     •  Long-­‐term  bonds  are  more  risky.

 KANE.  such  as  liquidity  premiums   •  An  upward  sloping  curve  could  indicate:   •  Rates  are  expected  to  rise   and/or   •  Investors  require  large  liquidity  premiums  to  hold   long  term  bonds   15 INVESTMENTS  |  BODIE.Interpreting  the  Term  Structure   •  The  yield  curve  reflects  expecta=ons  of  future   interest  rates   •  The  forecasts  of  future  rates  are  clouded  by   other  factors.  MARCUS   .

 MARCUS   .  KANE.Bond  Pricing:   Two  Types  of  Yield  Curves   16 Pure  Yield  Curve   On-­‐the-­‐Run  Yield  Curve   •  Uses  stripped  or  zero   coupon  Treasuries   •  May  differ  significantly   from  the  on-­‐the-­‐run   yield  curve   •  Uses  recently-­‐issued   coupon  bonds  selling  at   or  near  par   •  The  one  typically   published  by  the   financial  press   INVESTMENTS  |  BODIE.

Bond  Yields:  YTM  vs.  rela=onships  are  reversed     17 INVESTMENTS  |  BODIE.  Current  Yield   •  Yield  to  Maturity   •  Bond’s  internal  rate  of  return   •  The  interest  rate  that  makes  the  PV  of  a  bond’s   payments  equal  to  its  price.  KANE.  assumes  that  all  bond   coupons  can  be  reinvested  at  the  YTM   •  Current  Yield   •  Bond’s  annual  coupon  payment  divided  by  the  bond   price   •  For  premium  bonds   Coupon  rate  >    Current  yield  >  YTM   •  For  discount  bonds.  MARCUS   .

 KANE.  MARCUS   .Bond  Yields:  Yield  to  Call   •  If  interest  rates  fall.  the  risk  of  call  is   negligible  and  the  values  of  the  straight  and   the  callable  bond  converge   18 INVESTMENTS  |  BODIE.  price  of  straight  bond  can   rise  considerably   •  The  price  of  the  callable  bond  is  flat  over  a   range  of  low  interest  rates  because  the  risk  of   repurchase  or  call  is  high   •  When  interest  rates  are  high.

 KANE.Figure  14.  MARCUS   .4  Bond  Prices:  Callable  and     Straight  Debt   19 INVESTMENTS  |  BODIE.

 KANE.Bond  Yields:     Realized  Yield  versus  YTM   •  Reinvestment  Assump=ons   •  Holding  Period  Return   •  Changes  in  rates  affect  returns   •  Reinvestment  of  coupon  payments   •  Change  in  price  of  the  bond   20 INVESTMENTS  |  BODIE.  MARCUS   .

 HPR   21 YTM   HPR   •  It  is  the  average  return   if  the  bond  is  held  to   maturity   •  Depends  on  coupon   rate.  and  par   value   •  All  of  these  are  readily   observable   •  It  is  the  rate  of  return   over  a  par=cular   investment  period   •  Depends  on  the  bond’s   price  at  the  end  of  the   holding  period.  MARCUS   .Bond  Prices  Over  Time:     YTM  vs.  an   unknown  future  value   •  Can  only  be  forecasted   INVESTMENTS  |  BODIE.  maturity.  KANE.

Yield components
Real risk-free interest rate +
Expected inflation rate +
Maturity Premium
=Sovereign Bond Yield
Liquidity Premium +
Credit spread
= Corporate Bond Spread
Corporate Bond Yield = Sovereign Yield + Corporate Spread
Corporate Bond Spreads increase with maturity.

22

Yields spreads and economic sensitivity
Post-GFC era
• 

• 
• 

• 

Credit spreads have narrowed
with ‘reach for yield’
Relaxed investors because
default rates have been low

Conventional soft economy
• 

Credit spreads deteriorate

• 

Investors require wider risk
premium because of rising default
risk

• 

Issuance drives spreads wider
when investors are reluctant
holders

• 

Secondary market liquidity
deteriorates so liquidity premiums
expand

Significant issuance has had little
effect on spreads
Secondary market has been
reasonable healthy

23

Australian bond pricing

P = the price per $100 face value (rounded to 3 decimal places)
v = 1/(1+i) where i is half yearly yield = y/200 where y is %pa
f = number of days from settlement to next interest payment date
d = number of days in the half year ending on the next interest
payment data (181-184)
g = the half-yearly rate of coupon payment per 100
n = the term in half years from the next interest-payment date to
maturity
24

Bond pricing and accrued interest •  Accrued interest = gx(1-f/d) Bond prices may be quoted including accrued interest (Australian practice ) or net of accrued interest (‘clean’ – US practice) The Australian formula naturally calculates the price including accrued interest US based software (excel. financial calculators) are based around the ‘clean’ price convention 25 .

 KANE.1  Principal  and  Interest  Payments     for  a  Treasury  Inflation  Protected  Security   There are only $5b Australian Government Indexed Bonds on issue compared to $350b conventional Australian Government Bonds 26 INVESTMENTS  |  BODIE.Table  14.  MARCUS   .

Bank bills 27 .

Bond pricing and yield sensitivity •  Bond pricing is based on yields convertible half yearly •  If we measure time in years then the pricing formula is effectively: −2t # y& P = ∑ Ct ⋅ %1+ ( $ 2' −2t−1 $ y' dP = ∑ Ct ⋅ (−2t ) ⋅ &1+ ) % 2( dy ! dP $ # & ! 1 $ " dy % = −# & × ∑ t ⋅ wt P " 1+ y / 2 % 28 −2t $1' $ 1 ' $ y' ⋅ & ) = −& ) ⋅ ∑ Ct ⋅ t ⋅ &1+ ) % 2 ( % 1+ y / 2 ( % 2( where −2t " y% wt = Ct ⋅ $1+ ' # 2& /P .

Bond pricing and yield sensitivity •  The duration is the weighted average term of cash flows with weights determined as the proportion of valuation at that point in time •  This is commonly referred to as Macaulay duration (1938) MacaulayDuration = ∑ t ⋅ wt •  −2t where " y% wt = Ct ⋅ $1+ ' # 2& Modified Duration is the first derivative relative to price : " dP % $ ' 1 # dy & ModifiedDuration = − = × MacaulayDuration P (1+ y / 2) 29 /P .

8% = 110.30% •  The corresponding Macaulay duration is 8. price changes inversely by 8. P at 3.002) = 8.42 years 30 .30 years •  Because of the relation to Macaulay duration it is quoted in years rather than as a percentage (which would be more logical) •  For every 1% change in yields.584x0.584.800. •  P at 3% = 108. P at 2.800)/(2x108.Bond pricing and yield sensitivity •  Because this is a first derivative we can estimate modified duration by pricing the bond at yields either side of the current yield and estimating by difference P −P ModifiedDuration ≅ − + 2 × P × Δy •  Consider a ten year 4% coupon bond with the market yield at 3%.403 •  Modified Duration = (110.2%=106.403 – 106.

 a  bond’s  dura=on   generally  increases  with  its  =me  to  maturity   31 INVESTMENTS  |  BODIE.  a  bond’s  dura=on  is   higher  when  the  coupon  rate  is  lower   •  Rule  3       •  Holding  the  coupon  rate  constant.Interest  Rate  Risk   •  What  Determines  Dura=on?   •  Rule  1     •  The  dura=on  of  a  zero-­‐coupon  bond  equals  its  =me   to  maturity   •  Rule  2       •  Holding  maturity  constant.  KANE.  MARCUS   .

Interest  Rate  Risk   •  What  Determines  Dura=on?   •  Rule  4       •  Holding  other  factors  constant.  KANE.  MARCUS   .  the  dura=on  of  a   coupon  bond  is  higher  when  the  bond’s  yield  to   maturity  is  lower   •  Rules  5           32 •  The  dura=on  of  a  level  perpetuity  is  equal  to:        (1  +  y)  /  y   INVESTMENTS  |  BODIE.

referred to as Convexity •  Convexity is related to the spread of cash flows around the duration P+ + P− − 2 × P Convexity ≅ 2 × P × (Δy)2 •  Convexity = (106..584 x 0.Bond pricing and yield sensitivity •  The relationship between price and yield is non-linear •  Recall Taylor’s theorem h2 f (x + h) = f (x) + h ⋅ f "(x) + f ""(x) +.800+110..3 using previous example 33 . 2! •  Estimating change in price is improved by taking account of the second derivative.002^2) = 40..584)/(2 x 108.403-2x108.

188 at 3.Bond pricing and yield sensitivity ΔP 2 ≅ −ModDur × Δy + 1 × Convexity × ( Δy ) 2 P ( ) •  If we wanted to estimate the change in price for an increase in yield from 3% to 3.50%.10% P •  The actual price is 104.3× 0.30 × 0.5 × 40.0050 2 = −4. a change of -4.5% yield.05% •  In practice portfolios can be priced directly without any approximation formula •  However these concepts are relevant in risk management (eg what is the duration of the fixed interest portfolio) 34 . based on our example ΔP = −8.0050 + 0.

and the duration contribution will be zero .Frank Redington (greatest British actuary ever) Redington’s 1952 paper on immunization •  Set duration of assets equal to duration of liabilities •  Have convexity of assets greater than convexity of liabilities If assets and liabilities have the same duration. Δ ( A − L) 2 1 = −(DurA − DurL ) × Δy + × (ConvA − ConvL ) × ( Δy) 2 L ( ) The convexity contribution will always be positive. the the assetliability hedge can be improved by increasing the convexity of the assets.

the high convexity portfolio will underperform a matched convexity portfolio •  Need to model the risks of asset/liability mismatch more thoroughly . the asset portfolio will have a wider spread of maturities eg maturity barbell •  This is OK if the yield curve experiences a parallel shift •  However if the yield curve steepens for example at the same time as shifting.Immunization issues •  To achieve greater convexity than liabilities.

Default  Risk  and  Bond  Pricing   •  Credit  Default  Swaps  (CDS)   •  Acts  like  an  insurance  policy  on  the  default  risk  of   a  corporate  bond  or  loan   •  Buyer  pays  annual  premiums   •  Issuer  agrees  to  buy  the  bond  in  a  default  or  pay   the  difference  between  par  and  market  values  to   the  CDS  buyer   37 INVESTMENTS  |  BODIE.  MARCUS   .  KANE.

Default  Risk  and  Bond  Pricing   •  Credit  Default  Swaps   •  Ins=tu=onal  bondholders.g.  e.  used  CDS  to   enhance  creditworthiness  of  their  loan  por_olios.  MARCUS   .   to  manufacture  AAA  debt   •  Can  also  be  used  to  speculate  that  bond  prices  will   fall   •  This  means  there  can  be  more  CDS  outstanding   than  there  are  bonds  to  insure   38 INVESTMENTS  |  BODIE.  KANE.  banks.

 MARCUS   .Figure  14.12  Prices  of  Credit  Default  Swaps   39 INVESTMENTS  |  BODIE.  KANE.

Credit Risk (1) •  The risk of loss resulting from the borrower (issuer of debt) failing to make full and timely payments of interest and/or principal •  Expected loss=Default Probability x Loss given default •  For investment grade credits the focus is on default probability. which is very low •  For speculative grade credit. loss given default becomes very important •  Recovery rates vary widely by industry •  They also depend on the credit cycle .

Credit Risk (2) •  Corporate yield spreads depend on credit worthiness and market liquidity •  Credit rating can migrate with atendency for speculative grade credits to become even lower rated .

Recovery Rating .

Average 3 Year Corporate Transition Rates (1981-2014) Source: Standard & Poor’s 2015 Note for speculative grade the tendency is for ratings to deteriorate rather than improve .

Investment Grade and Speculative Grade •  Investment grade is rated BBB.and above •  Risk of default is very low for investment grade (circa 2% over 5 years) so covenants and collateral matter much less •  However for speculative grade (BB+ and below) default risk is significantly higher and lending tends to be ‘secured’ •  ‘Secured’ needs to be interpreted carefully •  A significant number of ‘secured’ loans ultimately realise losses on default •  For speculative grade the investor needs to consider both risk of default and loss in the event of default .

First Lien. Second Lien. subordination •  Lien refers to the security of loan •  First lien ranks ahead of second lien in regard to specific collateral •  Ideally collateral is enough to satisfy both first and second lien with some left over for general unsecured creditors •  If collateral is not enough to satisfy claim of first lien. they both rank equally from there on •  Subordinated debt ranks after senior creditors which may be secured and unsecured (eg general obligation bonds) •  Investment grade borrowers typically don’t need to offer security via specific collateral .

Ratings Agencies and Credit Ratings •  The common credit rating refers to risk of default •  A separate rating addresses loss severity •  Ratings agencies were guilty of over-rating structured credit leading up to GFC •  Standard corporate credit ratings have been reliable •  The market will usually anticipate downgrades so beware discrepancies between yield and rating •  Issuer rating refers usually to senior unsecured debt •  Specific issues may be notched (eg subordinate debt will be rated lower) .

Credit Rating (S&P) .

Credit Rating (S&P) US Industrial companies – 3 year average Source: Standard & Poor’s 2011 .

Ratings and default by time horizon .

Ratings and default by time horizon .

Default rates and investment grade (2) .

Default rates and investment grade (1) Default rates are cyclical. especially for speculative grade .

Default rates vary significantly by industry .

Surges in speculative grade issuance have tended to lead the default cycle .

Recovery Rating Distribution .

Loan covenants (1) •  Two types – incurrence (light) and maintenance(restrictive) covenants •  At the investment grade level (bonds) where default risk is remote incurrence covenants are common •  Incurrence covenants are triggered where the issuer takes an action (paying a dividend. making an acquisition. issuing more debt) •  For example more debt may not be able to be issued if the multiple of debt to cash flow falls below a threshold (eg 5 times) .

Loan covenants (2) •  Maintenance covenants (high yield credit) require the issuer to have ongoing satisfactory financial health. even if there is no intention to issue more debt •  For example if cash flow declines and debt to cash flow increases a maintenance covenant might be breached •  Maintenance covenants allow lenders to take action earlier with the onset of financial distress •  They may increase the spread or seek additional collateral •  Covenants on new issues tend to be stronger during weak economic conditions .

short term debt). fixed charges (debt service plus capex and rent) •  Leverage – debt to equity or cash flow (eg total debt to EBITDA) •  Current-ratio – current assets (cash. receivables. inventories) to current liabilities (accounts apyable. debt service (interest plus repayments). Quick ratio excludes inventories. securities.Loan covenants (3) Maintenance covenants are typically more detailed and may include: •  Coverage – minimum level of cash flow or earnings relative to interest. •  Tangible-net-worth – minimum level of book value less intangibles) •  Maximum-capital-expenditures .

new loans or bond issues are required to pay maturing debt •  Secured loans in a debt structure make unsecured loans less attractive .High Yield Credit and Liquidity Risk •  High yield companies can have fragile liquidity •  They may have a slow cash conversion cycle (eg high inventory and receivables) •  No access to commercial paper market so rely on banks which may impose tight restrictions •  Private companies cannot easily issue equity •  Rollover risk .

and there bonds/loans fall in value .High yield credit is susceptible to a perfect storm •  Profitability of companies with high operational leverage is adversely affected by an economic downturn •  Liquidity can tighten as banks become more cautious with short-term funding. further crimping profitability •  Debt becomes difficult to roll over – investors are reluctant •  The default cycle awakens and spreads widen. reducing the market value of these loans •  Companies that can only afford cheap debt are in trouble even if they can roll over loans •  Collateral is worth less so loss given default increases •  Investors get stuck as the secondary market dries up.

with risk of security becoming perpetual •  Bank capital notes – similar to a converting preference shares The Australian corporate bond market is largely traded ‘overthe-counter’ (ie not through an exchange) .Floating rate mischief on the ASX (1) There are a range of interest bearing securities traded on the ASX: •  Australian Government Bonds (for retail investors •  Unsecured notes – sometimes issued by insurers as regulatory capital •  Convertible notes – debt with an option over equity •  Corporate preference shares – conversion or redemption may be at company’s option.

and may be deferred (eg if APRA says so!) . the investor should be compensated by a yield premium •  Interest is not always cumulative.Floating rate mischief on the ASX (2) •  Floating rate securities are of no standard form and need to be analysed thoroughly •  Typically pay a margin above Bank Bill Swap Rate •  Although they have zero yield curve duration they still have spread duration because of term to maturity •  Bank capital notes are every bit as vulnerable as equity in the event of financial stress (that’s why they’re Tier 1 capital) •  Where an issuer has options (eg to redeem early).