Session 5 Fixed income instruments

30017 Corporate Finance

Lecture Slides
Session 5: Fixed income instruments

1
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 Session 5 Fixed income instruments

Q&A
• Cases:

› Team up in groups of 3 to 5 and register the group on Bb

› Get the case from the library
- search for course code 30017 under course reserves
› Submit 1 pdf with your common solution to the case on Bb
- Details on the format of the write-up and hints are uploaded on Bb
› Bring a print-out of the case and your solution.

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 Session 5 Fixed income instruments

Topics covered

Origin of the yield curve and concepts of interest rates

Corporate credit risk

Callable and convertible bonds

Expectations
This is a more advanced chapter, and the material is getting more technical.
We are building on what you already know about fixed income markets.
Make sure you have reviewed the material in the Appendix of theses notes
(these are prerequisites from previous courses, especially FMI).

Reading
BMA 3
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Fixed-income instruments:
the many different kinds of debt
• Fixed income securities are financial claims with promised cash flows of fixed
amounts paid at fixed dates

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Main features of bonds

1. Issuer
› US Treasury/Government
› States, municipalities, and agencies
› Corporations
› Foreign governments (sovereign bonds)

2. Term (number of years to maturity)

› Short (less than 1 year), e.g. Commercial paper
› Long (more than 1 year), e.g. Corporate bonds

3. Price vs. face value

› Bonds may sell at a premium, at a discount, at par.

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Main features of bonds (2)

4. Coupon
› Coupon rate: total annual interest payment per dollar face value
› Period (usually semi-annual)
› Fixed or variable (floaters and inverse floaters)
› Nominal or inflation-indexed (TIIS / TIPS)
› Possibly no coupons (zero-coupon bond)
5. Credit risk (Default risk)
› Risk free
› Defaultable
6. Seniority and security
› Senior, subordinated senior, junior…
› Secured by properties and equipment, other assets of the
issuer, Sinking fund provisions
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Main features of bonds (3)

7. Covenants
› Restrictions on additional issues, dividends, and other corporate
actions.

8. Option provisions
› Callability: After a certain period, issuer has the right to pay back
the loan before it matures.
› Putability: After a certain period, bondholder has the right to
demand payment of the loan before maturity.
› Convertibility: After a certain period, bondholder has the right to
exchange the bond for stocks of the issuer.

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Example – $250million J.C. Penney bond

1 Issuer
2 Term
3 Price vs face value

4 Coupon

7 Covenants

6 Seniority/security

8 Option provisions

5 Credit risk

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Valuing a Bond

The price of a bond is the present value of all cash flows

generated by the bond (i.e. coupons and face value)
discounted at the required rate of return

cpn cpn (cpn + par )

PV = + + .... +
(1 + r ) (1 + r )
1 2
(1 + r ) t

Note: “cpn” is commonly used as an abbreviation for “coupon”

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Valuing a Bond

Example - France
In October 2014 you purchase 100 euros of bonds in
France which pay a 4.25% coupon every year. If the
bond matures in 2018 and the YTM is 0.15%, what is
the value of the bond?

4.25 4.25 4.25 104.25

PV = + + +
1.0015 (1.0015) (1.0015) (1.0015)4
2 3

= 116.34 euros

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Valuing a Bond as an Annuity

PV(bond) = PV(annuity of coupons) + PV(principal)

PV (bond) = (cpn × PVAF) + (final payment × discount factor)

 1 1  100
= 4.25 ×  − 4
+
 . 0015 . 0015(1 + . 0015 )  (1 + . 0015 )4

= 116.34

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Discount rates - Concepts

1. Yield To Maturity (YTM) – The Internal Rate of Return

(IRR) on an interest bearing instrument

2. Spot Rate - The actual interest rate today (t=0)

3. Yield curve: describes the relationship between short term

and long term interest rates.

4. Forward Rate & No Arbitrage - The interest rate, fixed

today, on a loan made in the future at a fixed time.

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1. Yield to maturity
Definition: the rate that equalizes the price of the bond with the PV of its cash
flows.

• Yield-to-maturity (YTM) of a coupon bond, denoted by i, is given by:

• PV stands for present value; FV for face value (also called “principal”)

• Coupon bonds can trade at discounts or premiums to face value

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Practice question

• A $100 treasury bond expires in 5 years. It pays a coupon

rate of 5%. If the market price of this bond is 112.11, what
is the YTM?

C0 C1 C2 C3 C4 C5
-112.11 5 5 5 5 105

Calculate IRR =
Use a financial calculator or Excel for
this
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2. Spot rates

Spot interest rate, rt, is the current (annualized) interest rate for maturity
date t
• rt is for payments only on date t
• rt is different for each different date t

Example. Spot interest rates on August 2014

The set of spot interest rates for different maturities gives the term
structure of interest rates, which refers to the relation between spot
rates and their maturities

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Practice question
Current 1- and 2- year spot interest rates are 5% and 6% respectively.

1. What is the price of a 2-year Treasury coupon bond with a face value of
$100 and a coupon rate of 6% ?

2. What is the associated YTM ?

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Practice question
Current 1- and 2- year spot interest rates are 5% and 6% respectively.

1. What is the price of a 2-year Treasury coupon bond with a face value of
$100 and a coupon rate of 6% ?

2. What is the associated YTM ? 5.970%

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3. What is the Yield Curve?

• The current yield US curve on Bloomberg:

› www.bloomberg.com/markets/rates-bonds/government-bonds/us/
• Non-US yield curves:
› Japan - http://www.bloomberg.com/markets/rates-bonds/government-bonds/japan
› Euro area - https://www.ecb.europa.eu/stats/money/yc/html/index.en.html

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Concept: ZEROS

• A zero coupon bond (ZCB) is a fixed income instrument that

› Pays no coupon
› Pays 100% of notional at maturity
› But never pays anything in between

For example: Suppose there exists an asset that pays 1EUR in 5

years from now
What would be the price of this 1EUR today?

• It is similar to an Arrow-Debreu asset

› This is an asset that pays 1 EUR in a given state of the world
› … and pays never anything else

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How can we obtain the yield curve?

Example:
› STRIPS (Separate Trading of Registered Interest and Principal
Securities) which are zero-coupon issued by the US government
(these bonds are stripped from coupons, naked in a sense), with a
face value of 1 dollar to be paid at maturity are traded at the
following prices:
Maturity (year) 1/4 1/2 1 2 5 10 30
Price 0.9999 0.9997 0.9981 0.9898 0.9127 0.7383 0.2938

› Take, for example, the 5-year ZCB

1 1
=
0.9127 = 
→ r = − 1 1.84%
(1 + r5 ) 5 5 1/5
(0.9127)

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Deriving the Yield Curve

• Let’s do this for all maturities

• Then we get:
Yield Curve
4.50
maturity price yield
4.00
0.25 0.9999 0.04
3.50
0.5 0.9997 0.06 3.00
1 0.9981 0.19 2.50
2 0.9898 0.51 2.00
5 0.9127 1.84 1.50

10 0.7383 3.08 1.00

30 0.2938 4.17 0.50

0.00
0.25 0.5 1 2 5 10 30

• We can obtain (invert) the yield curve from market prices!

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Discount rate concepts

We can use the yield curve to define two types of rates:

1. Spot Rate - The interest rate today for a given maturity t

› As in the example before, this is just the yield of sovereign bond at
maturity t
2. Forward Rate – Interest rate, fixed today, for some time in the future at
a fixed time

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Forward and Spot Interest Rates

Forward interest rates are today’s rates for transactions between two future dates,
for instance, t1 and t2.

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4. Forward Rates

Deriving forward rates

Suppose that discount bond prices are as follows:

• Can you quote the forward rate for one year starting in three years
from now?
• We can use the above spot rates

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4. Forward Rates & No Arbitrage

• If you invest in the 4-year spot rate today, then

› You should obtain the same final payoff if you invest in the 3-year
spot rate and then in the forward rate starting in 3 years from now
for one year:

› (1+s4)4 = (1+s3)3×(1+f3,1)
› This gives:
f3,1 = 8.51%

This holds for any maturity (T) and length of forward rate (T-t)
› (1+sT)T=(1+sT-t)t×(1+ft,T-t)T-t

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4. Forward Rates & No Arbitrage

Practice question. Suppose that discount bond prices are as follows:
t 1 2 3 4
Bt 0.9524 0.8900 0.8278 0.7629
rt 0.05 0.06 0.065 0.07

A customer wants a forward contract to borrow $20M three years from now for
one year. Can you (a bank) quote a rate? Answer 8.51% (above)

Suppose you can buy/(short-)sell bonds at the prices given in the previous slide.
What should you do to obtain the forward rate of 8.51%?

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4. Forward Rates & No Arbitrage

Suppose you can buy/(short-)sell bonds at the prices given in the previous
slide. What should you do to obtain the forward rate of 8.51%?

• Buy $20 million of 3-year discount bonds, costing 20*0.8278=16.566

• Finance this by selling 4year discount bonds, for a reimbursement cost equal to
16.566/0.7629=21.701
Year 0 Year 3 Year 4
Buy 3-year -16.556 20 0
bonds
Sell 4-year 16.556 0 -21.701
bonds
Total 0 20 -21.701

• The interest for this loan in the future is given by:

(21.701/20)-1=8.51%
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4. Forward Rates & No Arbitrage

Suppose a bank offers you a forward rate equal to 8.00%. Could you find a
profitable arbitrage opportunity?

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 Session 5 Fixed income instruments

4. Forward Rates & No Arbitrage

Suppose a bank offers you a forward rate equal to 8.00%. Could you find a
profitable arbitrage opportunity?

Year 0 Year 3 Year 4

Sell 3-year 16.556 -20 0

bonds

Buy 4-year -16.556 0 +21.701

bonds

Take Bank 0 20 -21.60

Contract (8%)
Sum 0 0 +0.101

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5. Credit risk

• Fixed-income securities have promised payoffs of fixed amounts at

fixed times
• Sovereign and corporate bonds carry the risk of failing to pay as
promised
• Default risk (credit risk) refers to the risk that a debt issuer fails to
make the promised payments (interest or principal)
• Some Examples
› Governments:
- Argentina declared in default by S&P in 2014 (previous default
2001)
- Greece defaults on US$138bn in 2012
› Corporates: Lehman Brothers, Worldcom, General Motors, Enron,
Chrysler, United Airlines, Caesars Entertainment

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Bond ratings
• Bond ratings provide indications of the likelihood of default by each
issuer
• The highest-quality bonds are rated triple A. Bonds rated triple B or
above are investment grade. Lower-rated bonds are called high-yield,
or junk, bonds.

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Ratings and Default rates

Cumulative average default rates (%), Moody’s 1970-2006

Interpretation: A company with an initial credit rating of Baa has a probability

of 0.181% of defaulting by the end of the first year, a cumulative probability of
0.506% by the end of the second year, and so on …

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The yield spread

• The yield spread at maturity T is the difference in yields between the

bond of any issuer and the risk-free rate
• In the Eurozone the benchmark for the risk-free rate is typically the
German Bund
• In the U.S. the risk-free benchmark is the Treasury Bill
• Generally, it holds true that
› YT = yT + CRPT
› The yield (Y) of a bond of any issuer is the risk-free rate (y) plus
the credit risk premium (CRP)
› Thus, the yield spread (Y-y) just equals the credit risk premium

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The yield spread

Yield spreads between corporate and 10-year Treasury bonds

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Yield Spread Practice

The following table summarizes the yields to maturity on several one-year, zero-
coupon securities:

a) What is the price (expressed as a percentage of the face value) of a one-year,

zero-coupon corporate bond with a AAA rating?

b) What is the credit spread on AAA-rated corporate bonds?

c) What is the credit spread on B-rated corporate bonds?

d) How does the credit spread change with the bond rating? Why?

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Yield Spread Practice

The following table summarizes the yields to maturity on several one-year, zero-
coupon securities:

• What is the price (expressed as a percentage of the face value) of a one-year,

zero-coupon corporate bond with a AAA rating?
100
𝑃𝑃 = = 96.899.
1 + 0.032
• What is the credit spread on AAA-rated corporate bonds?
0.032 – 0.031 = 0.1%.
• What is the credit spread on B-rated corporate bonds?
0.049 – 0.031 = 1.8%.
• How does the credit spread change with the bond rating? Why?
Increases as the bond rating falls, because lower rated bonds are riskier
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Why do we care about yields?

• If yields increase, then it increases the debt financing cost of the

issuer
• These are no good news – the issuer has less resources available for
investment

Example: In one week from now a large bond of 1EUR billion of firm A is
maturing. The current yield of the bond is 3% and the bond had a
maturity at issuance of 5 years. The firm wants to issue another 1EUR
billion bond with maturity 5 years to repay the notional of the existing
bond (i.e, to refinance). Suddenly, due to increasing uncertainty in the
economy, the yield increases to 5%. By how much increase the debt
costs of the firm approximately?

• ≈ 1billion × 2% = 20EUR million!

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Covenants
• Shareholders who control the firm can expropriate wealth from
bondholders by making assets more risky, reducing assets through
the payment of dividends, or adding liabilities.
• We will discuss such strategies when we discuss bankruptcy
• As a result, virtually all debt contracts contain covenants to restrict
these kinds of activities.
• Firms go to great length to avoid covenant violations – since violating
covenants takes away (some) control rights of management.
• Example: Lear Corp 2008
› 2008 Annual Report:
“As a result, as of December 31, 2008, we were no longer in
compliance with the leverage ratio covenant contained in our
primary credit facility. We have been engaged in active
discussions with a steering committee consisting of several
significant lenders to address issues under our primary credit
facility.”
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