Finance 300Financial Markets

Lecture 19

Professor J. Petry, Fall, 2002©

http://www.cba.uiuc.edu/jpetry/Fin_300_fa02/http://webboard.cites.uiuc.edu/

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HousekeepingAgenda

– Exam III is Tuesday, November 5th. – Will cover Chapters VI, VII. – We will NOT cover Chapter VIII. We will not cover convertibles bonds (p. 238-

39; TTD;VII-9, parts d, e, f.) – Exam will be similar in layout and emphasis as prior exams.

» 30-40 multiple choice questions. » Study notes, and book.» Problems as well as conceptual questions.» Formula sheet will be provided. A copy is on the web.» Office Hours: Friday, 1:00-2:50; Monday, 2:00-4:00.

– Stewardship reports are due Thursday, November 7th.– See webpage and back of book for template and completed examples.

– TAs are available for help on Bond Project. See WebBoard for office hours.

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TTD VII-2 -- In 2000 P&G issues at par 10,000,000 in 7% bonds maturing October 2, 2030. The bond is callable after 10 years with a call premium of 10%, declining ½% per year after that.

A. What is the yield to maturity?B. What is the yield to call?

Assume that in 2010 the market yield for P&G 7% 2030 bond is 7%.C. What is the call price of the bond?D. What would be the price of the bond if it were not callable?E. Will P& G call the bond?F. If John Q. Investor purchased $10,000 in P&G bonds at par in 2000 and sells the

bonds in 2010 at 10,000, what is his holding period yield?Assume that in 2015 the required yield for the P&G 7% 2030 bond is 5%.

G. What is the call price of the bond?H. What would be the price of the bond if it were not callable?I. If P&G calls the issue and finances the recall with a new 15 year bond issue at

5% how much does P&G save on its semi-annual coupon payment and principal repayment?

J. What is the net present value of this saving?K. If John Q. Investor purchased $10,000 in P&G bonds at par in 2000 and uses the

proceeds from the callable bonds to buy the new P&G 5% 2030 bonds, what is his realized yield-to-maturity on the original bond purchase?

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Chapter VII – Corporate & Other IssuesCorporate Bond Ratings

– Bonds are rated to provide investors with information regarding the default risk of a bond. S&P and Moody’s are by far the most commonly referenced bond rating companies.

– There are two basic classifications for corporate bonds. 1. Investment Grade: Also known as High Grade. Bonds that have been

assigned to one of the top four ratings groups (AAA, AA, A, BBB by S&P or Aaa, Aa, A or Baa for Moody’s). These bonds are perceived to be reasonably safe investments.

2. Speculative Grade: Also known as Junk Bonds or High Yield bonds. Bonds which have been assigned a lower rating (BB, B, CCC, CC, C or D by S&P or Ba, B, Caa, Ca, or C by Moody’s). If a bond loses its investment grade rating it is sometimes referred to as a “Fallen Angel”.

– The lower the rating category, the more likely is default. As a consequence yields vary inversely with credit ratings.

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Chapter VII – Corporate & Other IssuesCorporate Bond Ratings

Grade Moody's S&P ExplanationInvestment Aaa AAA Strongest possible capacity to pay interest andGrade principal

Aa AA Very strong capacity to pay interest and principal

A A Strong capacity to pay interest and principal. More susceptible to changes in economic conditions.

Baa BBB Adequate capacity to pay interest and principalalthough the firm is susceptible to changing economicconditions.

Speculative Ba BB The firm faces exposure to adverse business conditionsGrade or the debt is subordinated to senior debt assigned a

Baa/BBB rating.B BB The firm faces exposure to adverse business conditions

which is likely to affect ability to pay interest or principal, or the debt is subordinated to senior debtassigned a Ba/BB rating.

Caa/Ca CCC/CC/C Currently identifiable vulnerability to default or thedebt is subordinated to senior debt assigned a higher rating.

C D In default.

NR NR Not rated either because no request has been made orthere is insufficient data to rate the issue.

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Chapter VII – Corporate & Other IssuesCorporate Bonds—Yield Structure

– There are six primary attributes that are significant in valuing a bond:

1. Term to maturity 2. Coupon rate3. Call provisions 4. Liquidity (marketability)5. Risk of default 6. Tax status

– Yield Structure: The overall pattern of yields that reflect these attributes. All six attributes impact yields in some way, and hence are considered part of the yield structure. To simplify our lives, we usually deal with one aspect of yield structure at a time.

– Yield Spread: Often just referred to as “spread” is the difference in yield of a liquid corporate issue and the Treasury issue of a similar coupon and maturity. The yield spread generally increases with term to maturity.

• If IBM 2013 trades at 81/2% and a Treasury trades at 6%, then the yield spread is 2.5% or 250bps. IBM trades 250bps over Treasuries.

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Chapter VII – Corporate & Other IssuesCorporate Bonds—Risk Structure

– Risk Structure: The set of yields for bonds with similar coupon, term, liquidity etc, but with different default risks is called the risk structure.

– Risk Premium: The difference between the expected yield-to-maturity and the yield to maturity of the risk-free bond. The risk premium arises out of economy-wide or market-wide risk and thus reflects systematic risk.

– Default Premium: The difference between the expected yield to maturity of a bond and the promised yield to maturity. The former is different from the latter to the extent default is considered possible. One can assign probabilities to this possibility. The weighted average of expected returns becomes the expected yield to maturity. This is firm specific risk.

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Chapter VII – Corporate & Other IssuesCorporate Bonds—Risk Structure

• We estimate the 6% IBM 2013 has a 4% probability of default. It is currently yielding 7.50%. The 6% 2013 Treasury yields 6%. 0.04 probability * 0.00% return if default0.96 probability * 7.50% promised yield to maturity

7.20% expected yield to maturityRisk premium = 7.20% - 6.00% (risk free rate) = 1.20% or 120bpsDefault premium = 7.50% - 7.20% = .30% or 30 bps.

– TTD: VII-6 6% 2013 Treasuries yield 6%; the 6% IBM 2013 with a 4% probability of default yields 7.5%; and the 6% Hypothetical Resources 2013 with a 10% probability of default yields 7.90%. Should you buy the IBM or the HR bond?

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Chapter VII – Corporate & Other IssuesCorporate Bonds—Yield Structure

– Things to Do: VII-8From your experience as an investment manager for Investments Unlimited you know that normally the yield spread between Baa and Aaa rated 20 year corporates is 40bps, and the yield spread between Aaa rated 20-year corporates and 20 year Treasury Bonds is 80bps.

This morning your computer tells you that 20 year bonds are trading at the following yields.6.80% T-bonds7.35% Aaa/AAA rated corporates7.90% Baa/BBB rated corporates

You immediately jump into action. What do you do?

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Chapter VII – Corporate & Other IssuesCorporate Bonds

While we have not covered every item in the course-packet, unless it is specifically mentioned as not on the exam, it is fair game. That includes:

Bond Market IndecesPreferred SharesMedium Term NotesWarrants