Fixed Income in a Financial Crisis (A): US Treasuries in November 2008
Academic Year 2013/2014
Executive Summary
In the first part of our report, we investigate if a 35 basis points yield spread represents mispricing of two bonds, both with the same maturity but one with a coupon rate of 10.625% and the other 4.25%. Our investigation also determines if the yield spread represents an arbitrage opportunity. In our investigation, we calculate the theoretical yield spread between the two bonds and compare the figure with the observed yield spread. It is cited in the case that the observed yield spread could be due to different liquidity premium for each bond or simply due to different durations. Through our calculations, we discover
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Through this method, we obtained theoretical yields of the 4.25% coupon bond and 10.625% coupon bond to be 2.899% and 2.639% respectively. The corresponding theoretical prices of the bonds are $108.27 for the 4.25% coupon bond and $149.31 for the 10.625% coupon bond (see Table 1 above).
Comparing each bond’s theoretical yield and price to its actual yield and price, we find that both bonds are underpriced. However, this alone is insufficient to conclude that an arbitrage opportunity exists, since our calculated theoretical prices ignore the effects of liquidity premium. As, in this exercise, we are unable to calculate what the true liquidity premium for each bond should be, we consequently do not have a true price for each bond to compare with and ascertain whether each bond is underpriced (ie. both the theoretical and actual prices may not be the true price). Nonetheless, we have calculated the implied liquidity premium for each bond as the difference between the theoretical yield and actual yield (see Table 1 above).
Yield Spread
To better determine if an arbitrage opportunity exists, the theoretical and actual yield spreads of both bonds can be compared. This determines whether both bonds are properly priced relative to each other, eliminating the need to have true prices for both bonds to determine if each bond is rightly priced. Based on our
When the contractual interest rate and the market interest rate are the same, the bonds are sold at face value. But when the contractual interest rate and the market interest rates differ then the bonds are usually sold below or above face value. If the market rate of interest is lower than the contractual interest rate then the investors will have to pay more than the face value for the bonds (premium). When a company issues 12% bonds at a time when other bonds of similar risk are paying 15%. Most investors will be more interested in buying the 12% bonds and their value will fall below their face value, which is called selling at a discount.
Bondholders face very little investment risk given UST’s high interest coverage ratio and substantial cash flows, making UST less susceptible to the risk of bankruptcy. One would be concerned about the industry’s decline and the fact that growth is driven primarily by the Price Value Market. UST is positioned as the Premium
2. Jordan, Bradford D., Susan D. Jordan, and David R. Kuipers. "The Mispricing of Callable U.S. Treasury Bonds: A Closer Look." Journal of Futures Markets 18.1 (1998): 35-51. Web.
The spread between swaps and bonds can be traded in many different ways. In this note we describe asset swapping methodologies in detail with particular emphasis on calculation of spreads, risks, and tracking of trades. The spread of bond yields to swaps is also commonly used to evaluate richness and cheapness of bonds of differing maturities. In markets where the analytical power of players is ever growing,
In 2006, Merrill Lynch became the lead book runner for a $5 billion convertible bond issue for MoGen, Inc. This was the single, largest convertible bond issuance in history and required a considerable amount of effort on the part of Merrill Lynch’s Equity Derivatives Group to convince MoGen’s management to choose Merrill Lynch over its competitors. The case is focused on Merrill Lynch’s choice of the conversion premium and coupon rate to propose to MoGen management. This pricing decision requires students understand the concept of valuing a convertible as the sum of a straight bond plus the conversion option. Valuing the conversion option as a call option requires the
2. Now, regardless of your answer to Question 1, assume that the 5-year bond selling for $800.00, the 15-year bond is selling for $865.49, and the 25-year bond is selling for $1,320.00.
Interest rate risk: When the interest rate goes up, the bond price will goes down.
* We assume a risk-free rate of 5.09%. This number comes from the current yield of the 30 year T-bond as shown in Exhibit 5.
The large debt sale from Actavis underscores how investors are buying up income-generating investments when yields on safe government debt remain low. Corporate bonds pay more yield than safe government debt to compensate for the greater risk that investors won’t get paid back. (Cherney, 2015)
. These five factors are most responsible for securities innovations including pay-in-kind bonds, inflation-indexed bonds, convertible and exchange bonds specifically designed to mitigate risk while controlling short sales of debt equities they were tied to, in addition to the fine-tuning of credit default swaps and interest rate swaps meant to drive down the overall costs and risk of transaction while increasing potential returns (Marquis, Cunningham, 1990). These and other innovations that occurred during the 1980s were also designed to assuage or mitigate the exceptional
•Yan, A., Nandy, D., and Chemmanur, T. "Why issue mandatory convertibles? Theory and empirical evidence, February (2003) Retrieved on 18.3.2008 (http://ideas.repec.org/p/ecm/nawm04/456.html)•http://www.investorwords.com/5362/yield.html. 18/3/2008.
WorldCom has the option to extend its bank loan credit facility or to issue this large $6 billion in debt. It plans to use the rolling commercial paper program to pay British Telecommunications for MCI’s share purchases, and then use bond proceeds to pay off the commercial paper program. This signals that WorldCom does not need the money immediately for a single corporate purpose, and does not need the money immediately. Therefore, perhaps it makes sense for WorldCom to issue the bonds in smaller installments rather than flooding the market with $6 billion in debt all at once. The first reason for this is that, if an underwriter must first purchase the bonds before selling to investors, an underwriter may demand greater spread in order to justify taking down an entire $6 billion in debt using the bank’s capital assets. The second
The CAT bonds are event-linked securities that pays off on the occurrence of a defined catastrophic The risks of catastrophe are shared among investors and in return they receive a rate of investment. When certain catastrophic event occurs, such as bushfire and flood mentioned above, the investor will loss their investment and the issuer receive the money to cover their loss (Cummins 2008). The ability to access the capital markets is an advantage of the CAT bonds and the bonds are attractive to investors because of the low correlations to financial variables, hence they are valuable for diversification (Litzenberger et al., 1996). Also, Harrington and Niehaus (2003) argue that another important advantage of CAT bonds as a financing mechanism is the low corporate tax costs incurred compared to equity financing and the bonds are subject to less credit risks. However, for CAT bonds, problem exists for the difficulty in determining the price or premium, giving that information regarding catastrophic events may be insufficient in most
This report is an analysis of a bond issued by Dynegy Inc. (DYN), an electric supply and sales company. DYN issued a 5.875% semi-annual coupon corporate bond on December 1, 2013 for face value of $10,000. The bond matures on June 1, 2023 with an initial call date on June 1, 2018 and a discounted call price of $9,455.00. Because this is a callable bond, we can expect a few possible yields from investing in this bond. The yield to maturity (YTM) was calculated to be 7.1367%. This will be the yield gained on the assumption that the bond is held to maturity from the settled date of October 23, 2014. The bond’s first yield to call (YTC) is the highest among the succeeding call dates and is calculated to be 8.369%. Despite being significantly higher than the YTM, DYN will not likely call the bond because the interest rate is expected to increase in the future; this means that DYN cannot refinance the debt with a lower rate. Even though the YTM is lower, we still found it to be relatively high after making a comparison with other bonds of similar characteristic. Continuing with the expectation of the bond not being called, we can expect the calculated duration of 6.66 years to hold true. This means that if an investment is made in this bond, you can expect to breakeven in year 6.66. This short period would be an attractive feature for an investor as the risk of loss is minimized time-wise.
Although this investment class can be considered the most conservative of the three, the low yield of government bonds in the past 10 years does not lend a comparative metric against many other investment opportunities (Jacobs, 2012). The fixed rate of these instruments allows for a guaranteed return, but should only be utilized at a point in an investing cycle when risk is higher than potential income growth. The 25% allocation that is invested in this class is positioned to provide a long term guaranteed investment, with the possible that these lower rates will not rise significantly in the next few years.