Bond Evaluation, Selection, and Management

R. Stafford Johnson

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9780470478356
• eBook ISBN: 9780470644645
• Edition: 2
• Topic: Commerce
• Subtopic: Finance

A fully revised guide to fixed income securities that reflects current market conditions

The Second Edition of Bond Evaluation, Selection, and Management combines fundamental and advanced topics in the field, offering comprehensive coverage of bond and debt management.

This fully updated and revised edition provides you with the basics needed to understand various strategies, and explanations of cutting edge advanced topics. Focusing on essential concepts, models, and numerical examples, this book will help you quickly become familiar with the tools needed to effectively select, evaluate, and manage bonds.

• Covers both the fundamental and advanced topics in the field, including debt securities, bonds with embedded options, asset-backed securities, and bond derivatives
• Reinforces important concepts through review questions, web exercises, and practice problems in each chapter
• Reviews the history of the credit markets from the 1980s to the present with a retrospective look at the 2008 financial crisis
• Contains "Interview Boxes" consisting of questions and answers with distinguished fixed-income portfolio managers, traders, analysts, and academicians

Filled with in-depth insights and practical advice, this reliable resource offers a solid foundation in understanding the complexities of evaluating and selecting bonds and other fixed income securities.

PART One

Bond Evaluation

CHAPTER 1

Overview of the Financial System

1.1 REAL AND FINANCIAL ASSETS

Most new businesses begin when an individual or a group of individuals come up with an idea: manufacturing a new type of computer, developing land for a future housing subdivision, or launching a new Internet company. To make the idea a commercial reality, though, requires funds that the individual or group generally lacks or personally does not want to commit. Consequently, the fledgling business sells financial claims or instruments to raise the funds necessary to buy the capital goods (equipment, land, etc.), as well as the human capital (architects, engineers, lawyers, etc.) needed to launch the project. Technically, such instruments are claims against the income of the business represented by a certificate, receipt, or other legal document. In this process of initiating and implementing the idea, both real and financial assets are therefore created. The real assets consist of both the tangible and intangible capital goods, as well as human capital, which are combined with labor to form the business. The business, in turn, transforms the idea into the production and sale of goods or services that will generate a future stream of earnings. The financial assets, on the other hand, consist of the financial claims on the earnings. Those individuals or institutions that provided the initial funds and resources hold these assets. Furthermore, if the idea is successful, then the new business may find it advantageous to initiate other new projects that it again may finance through the sale of financial claims. Thus, over time, more real and financial assets are created.

The creation of financial claims, of course, is not limited to the business sector. The federal government’s expenditures on national defense and the space program and state governments’ expenditures on the construction of highways, for example, represent the development of real assets that these units of government often finance through the sale of financial claims on either the revenue generated from a particular public sector project or from future tax revenues. Similarly, the purchase of a house or a car by a household often is financed by a loan from a savings and loan or commercial bank. The loan represents a claim by the financial institution on a portion of the borrower’s future income, as well as a claim on the ownership of the real asset (house or car) in the event the household defaults on its promise.

Modern economies expend enormous amounts of money on real assets to maintain their standards of living. Such expenditures usually require funds that are beyond the levels a business, household, or unit of government has or wants to commit at a given point in time. As a result, to raise the requisite amounts, economic entities sell financial claims. Those buying the financial claims therefore supply funds to the economic entity in return for promises that the entity will provide them with a future flow of income. As such, financial claims can be described as financial assets.

All financial assets provide a promise of a future return to the owners. Unlike real assets, though, financial assets do not depreciate (since they are in the form of certificates or information in a computer file), and they are fungible, meaning they can be converted into cash or other assets. There are many different types of financial assets. All of them, though, can be divided into two general categories—equity and debt. Common stock is the most popular form of equity claim. It entitles the holder to dividends or shares in the business’s residual profit and participation in the management of the firm, usually indirectly through voting rights. The stock market, where existing stock shares are traded, is the most widely followed market in the world and it receives considerable focus in many investments and securities analysis texts. The focus of this book, though, is on the other general type of financial asset—debt. Businesses finance more of their real assets and operations with debt than equity, whereas governments and households finance their entire real assets and operations with debt. This chapter provides a preliminary overview of the types of debt securities and markets, whereas Chapters 6-12 provide a more detailed analysis.

1.2 TYPES OF DEBT CLAIMS

Debt claims are loans whereby the borrower agrees to pay a fixed income per period, defined as a coupon or interest, and to repay the borrowed funds, defined as the principal (also called redemption value, maturity value, par value, and face value). Within this broad description, debt instruments can take on many different forms. For example, debt can take the form of a loan by a financial institution such as a commercial bank, insurance company, or savings and loan bank. In this case, the terms of the agreement and the contract instrument generally are prepared by the lender/creditor, and the instrument often is nonnegotiable, meaning it cannot be sold to another party. A debt instrument also can take the form of a bond or note, whereby the borrower obtains her loan by selling (also referred to as issuing) contracts or IOUs to pay interest and principal to investors/lenders. Many of these claims, in turn, are negotiable, often being sold to other investors before they mature.

Debt instruments also can differ in terms of the features of the contract: the number of future interest payments, when and how the principal is to be paid—at maturity (i.e., the end of the contract) or spread out over the life of the contract (amortized)—and the recourse the lender has should the borrower fail to meet her contractual commitments (i.e., collateral or security). For many debt instruments, standard features include the following:

1. Term to Maturity: Number of years over which the issuer promises to meet the obligations. (Maturity refers to the date that the debt will cease to exist.) Generally, bonds with maturities between 1 and 5 years are considered short term; those with maturities between 5 and 12 years are considered intermediate-term; and those with maturities greater than 12 years are considered long term.

2. Principal: The amount that the issuer/borrower agrees to repay the bondholder /lender.

3. Coupon Rate (or Nominal Rate): The rate the issuer/borrower agrees to pay each period. The dollar amount is called the coupon. There are, though, zero coupon bonds in which the investor earns interest between the price paid and the principal, and floating-rate notes where the coupon rate is reset periodically based on a formula.

4. Amortization: The principal repayment of a bond can be repaid either at maturity or over the life of the bond. When principal is repaid over the life of the bond, there is a schedule of principal repayments. The schedule is called the amortization schedule. Securities with an amortization schedule are called amortizing securities, whereas securities without an amortized schedule (those paying total principal at maturity) are called nonamortizing securities.

5. Embedded Options: Bonds often have embedded option features in their contracts, such as a call feature giving the issuer the right to buy back the bond from the bondholder before maturity at a specific price—a callable bond.

Finally, the type of borrower or issuer—business, government, household, or financial institution—can differentiate the debt instruments. Businesses sell three general types of debt instruments, corporate bonds, medium-term notes, and commercial paper, and borrow from financial institutions, usually with long-term or intermediate-term loans from commercial banks or insurance companies and with short-term lines of credit from banks. The corporate bonds they sell usually pay the buyer/lender coupon interest semiannually and a principal at maturity. For example, a manufacturing company building a $10 million processing plant might finance the cost by selling 10,000 bonds at a price of $1,000 per bond, with each bond promising to pay $50 in interest every June 15th and January 15th for the next 10 years and a principal of $1,000 at maturity. In general, corporate bonds are long-term securities, sometimes secured by specific real assets that bondholders can claim in case the corporation fails to meet its contractual obligation (defaults). Corporate bonds also have a priority of claims over stockholders on ...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Preface
• Acknowledgments
• PART One - Bond Evaluation
• PART TWO - Debt Markets
• PART Three - Bond Strategies and the Evaluation of Bonds with Embedded Options
• PART Four - Debt Derivatives: Futures and Options
• PART FIVE - Swaps
• APPENDIX A - Uses of Exponents and Logarithms
• APPENDIX B - Mathematical Statistical Concepts
• APPENDIX C - Primer on Return, Present Value, and Future Value
• APPENDIX D - Web Site Information and Examples
• APPENDIX E - Global Investments and Exchange Rates
• APPENDIX F - Arbitrage Features of the Calibration Model
• APPENDIX G - T-Bond Delivery Procedure and Equilibrium Pricing
• APPENDIX H - Pricing Interest Rate Options with a Binomial Interest Rate Tree
• APPENDIX I - Pricing Interest Rate Options with the Black Futures Option Model
• What’s on the Companion Web Site
• Answers and Solutions to Select End-of-Chapter Problems
• GLOSSARY OF TERMS
• Index