JWI 531 Financial Management II, Week3 summary, 4/27/13
How to value Bonds and capitalize on shifts in the bond markets to strike the best deal for your organization.
Takeaways this week are :
1. Bond market
Bonds are also known as Debt, fixed income, credit
Purpose of Bonds - help finance institutional initiatives
Companies, Govts, nonprofits turn to bond market to raise capital
2. Bond basics
investor receives interest payments from borrower
when bond matures, principal is returned to investor
3. Face value or Par value is the amount borrower promises to repay to an investor at maturity
4. Coupon rate is the annual interest on principal
5. Yield is the total return earned on a bond at maturity
6. When interest rates rise, existing Bond prices fall - this is because newer bonds issued at higher interest rate will deliver higher returns and therefore be in higher demand
7. Top credit rating agencies in the US - Moody's, Stand & Poor's, Fitch
They classify bonds as Investment Grade, Junk Grade
8. Fixed income investments in the US
(a) Treasurys - investors lend money to US govt; perceived as risk free; can print money to repay debt; highest quality investing instrument so far; this status may change
(b) Agencies - investors take loans from Banks; agencies such as US government & quasi-government agencies***buy the loans, repackage them (Mortgage backed securities) and sell to investors
***Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage corp (Freddie Mac), Govt National Mortgage Association (Ginnie Mae)
(c) Corporate Bonds - Companies sell bonds to raise capital just like they do with stocks.
(d) Municipal bonds - issued by state & local governments to raise funds; higher risk of bankruptcy and therefore must pay higher interest; raise taxes or cut expenses to manage.
(e) International bonds - BRIC,Mexico, Venezuela, Eurozone, Far East offer sovereign bonds like US Treasury or foreign corporate bonds; higher perceived risk and therefore higher
interest rate; volatility from interest rates and inflation.
9. Risk from Bond issuer point of view
Fixed income investments in the US (JWI 531, W3, L1)
(i). Treasurys - investors lend money to US govt which is perceived as risk free. US government can print money to repay debt, which makes this the highest quality investing instrument.
Risk: This status as risk free instrument may change within this century. If investors lose faith in the US government and leave is droves, forcing the US government to print more money, the value of the dollar will go down with long term stalling and repurcussions to economy.
(ii). Agencies - investors take loans from Banks; agencies such as US government & quasi-government agencies***buy the loans, repackage them (Mortgage backed securities) and sell to investors
***Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage corp (Freddie Mac), Govt National Mortgage Association (Ginnie Mae)
Risk: Complexity rises to a point where issuer is no longer in control and a global financial meltdown looms like the one we had in 2007-2009.
(iii). Corporate Bonds - Companies sell bonds to raise capital just like they do with stocks.
Risk: Risk of Default would bring down the credit rating of the firm. The firm will lose potential investors in the future.
(iv). Municipal bonds - issued by state & local governments to raise funds
Risk: higher risk of bankruptcy since unlike the Federal government, state and local governments can't print more money and therefore must pay higher interest. Munis must raise taxes or cut expenses to manage - both are unpopular among voters.
(v). International bonds - BRIC,Mexico, Venezuela, Eurozone, Far East offer sovereign bonds like US Treasury or foreign corporate bonds; Risk - higher perceived risk and therefore must offer higher interest rate; volatility from changes in interest rates and inflation. Changes in unstable political regimes can make this a shaky investment.
10. Risk from a bond investor point of view
Risk of investing in bonds is the chance that one will lose some or all the money invested.
Various types of risks are shown below along with the impact to the bottom line for the investor.
In a developing economy like India, inflation poses the greatest risk. We see the impact of inflation already with commodity prices - such as tomatoes and onions - showing a sharp rise and causing major challenges to those in lower economic strata.
In a developed economy such as the US, rise in interest rate over the long term poses a higher risk.
Over a long term, interest rates are generally expected to climb up.
Risk Type Scenario Impact
1. Market Bond Market Declines Lose Money
2. Selection Chosen Security underperforms market Lower Returns
3. Timing Value declines after purchase, rises after sale Missed Opportunity
4. Event LBO, Debt restructuring, Merger, Recap Delayed payments
5. Default Issuing company troubled & files for bankruptcy Missed payments
6. Downgrade Company perceived by market to be riskier Selling price falls
7. i% Rate Rising interest rate Bond price falls
8. Contraction Declining interest rate, faster prepayment Reinvest at lower rate
9. Extension Rising interest rate, principal returned late Missed opportunity for higher yields
10. Inflation Value of principal falls Par value worth less in future
11. Call Company returns principal early NET Return drops
12. Taxation Investor should pay Capital gains taxes Cost of bond increases
13. Liquidity Bonds trade only sporadically Can't get out quickly
14. Reinvestment reinvest interest income & returned principal Lower rate of return
Dr DP
References
1.JWI 531 Week3, Lecture1
2. http://www.investinginbonds.com/learnmore.asp?catid=3&id=383
3. http://money.cnn.com/magazines/moneymag/money101/lesson7/index5.htm
4. http://www.investopedia.com/articles/bonds/08/bond-risks.asp
No comments:
Post a Comment