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Unit 1 - Introduction To Bond Markets: The Relationship Between Assets, Equity and Debt

1. The document introduces key concepts related to bond markets, including the relationship between assets, equity, and debt. It defines equity as the owner's contribution and debt as the long-term liabilities of a business. 2. Bondholders and equityholders are described and compared, noting that bondholders have fixed obligations that are prioritized over equityholders' residual claims. 3. Several risks associated with bond markets are outlined, including default risk, interest rate risk, inflation risk, and liquidity risk. Bond valuation methods such as yield to maturity and the yield curve are also introduced.

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Pulkit Aggarwal
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47 views

Unit 1 - Introduction To Bond Markets: The Relationship Between Assets, Equity and Debt

1. The document introduces key concepts related to bond markets, including the relationship between assets, equity, and debt. It defines equity as the owner's contribution and debt as the long-term liabilities of a business. 2. Bondholders and equityholders are described and compared, noting that bondholders have fixed obligations that are prioritized over equityholders' residual claims. 3. Several risks associated with bond markets are outlined, including default risk, interest rate risk, inflation risk, and liquidity risk. Bond valuation methods such as yield to maturity and the yield curve are also introduced.

Uploaded by

Pulkit Aggarwal
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Unit 1 - Introduction to Bond Markets

The relationship between assets, equity and debt

Assets = Equity + debt

Equity - Owner’s contribution


It just does not consist of initial investment of capital, but also includes profits that have been
reinvested in the entity.
Revistment = Any money the entity produces or that belongs to the owners as it represents
additional equity that they are effectively contributing.

Equity of the business


The part that belongs to the owners i.e. assets of the business minus any liabilities.
Liability - Long term debt of the business.

Debt holders :
1. Lenders to the business(bank or bond investors).
2. Obligations of debt are fixed - debt holders are entitled to a certain amount irrespective
of whether the entity has money or not. Failing to return debt leads to defaulting and
could potentially include the declaration of bankruptcy and the entity being closed.
3. More riskier than equity obligations for reasons mentioned in point #2.

Equity holders :
1. Owners of the business(Sole founder or shareholder).
2. Obligations of equity are flexible i.e. equity holders are entitled to precisely what is
available for them even if that amount is negative.
3. If an entity makes a loss, loss is just transferred over to equity holders.
4. Less riskier than debt obligations.
5. A high debt to equity ratio is risky.

Ratio between debt and equity is referred to as the capital structure of an entity.
Debt investments versus Equity investments

Bond price - The value of a bond at a time before its maturity.


Par value - The value of a bond at maturity.

Lenders have various options to invest. Whether to:


1. Lend their money to some bond issuer. This investment is safe as future value is known.
Though this doesn’t make it risk free. Current price is not fixed and can change for better
or worse. Also, chances of default is present along with interest rate risk. This usually
happens when terms are long and maturity is far away.
2. Or invest in equity stake. This investment is risky as future value is unknown.
Unit 2 - Fixed Income Risks
Why government bonds seem free of risk
1. Governments are better established and stable entities than a new business. They have
a wider and more diverse set of income sources.
2. Governments have the unique ability to have their central bank print money that can be
used to repay their debts.

Examples:
1. If a government bond is trading at a price of 800 and a corporate bond is traded at 750,
the difference of 50 can be attributed to default risk.
2. If a corporate bond is traded at 800 as well, then a rational informed investor would
prefer the government. Bond. Factors such as interest rate and maturity date can
change this though.

Default risk in addition to interest rate risk


The variation of defaultable bond price can be viewed as two layers of variations :
1. Variation in the default free bond prices.
2. Variation in the adjustment the market makes for default.

A corporate bond price can change :


1. Because the price of all bonds change i.e. market interest rates change.
2. Because the market view of the default risk of this particular bond changes. This relies
on perceptions - the market adjusts prices to account for new information as they
collectively perceive it.

Market updates prices as new information is revealed => Efficiency of the market

A comprehensive view of risk in bond markets


Credit risk is reflected in market prices, so credit risk and interest rate risk seem related.

One approach is to define market risk more inclusively whereby it includes both layers of price
variation described above.

Risks for bond market


1. Default risk - Entity not able to pay back.
2. Interest rate risk - Interest rate increase leads to reduced fixed deposit value.
3. Inflation risk - Since bonds are long term, one cannot be sure about how much this
amount will purchase at future maturity date as general prices tend to increase due to
inflation. If prices increase faster than expected, the par value will have less purchasing
power.
4. Liquidity risk - Difficult to convert one’s investment to cash due to low number of
participants in the bond market.
Unit 3 - Bond Valuation I
Zero-coupon bonds are sometimes known as discount bonds (or pure discount bonds) — the
whole instrument is based on the simple idea of a future value being discounted to some current
value

Coupon bearing bonds pays interest on surrender of the coupons, clipped from its certificate.
The holder of a coupon-bearing bond receives periodic payment (semiannually, annually, etc)
during the life of the bond.

Unit 4 - Bond Valuation II


Yield to Maturity is the interest rate that equates the present value of cash flows received from
a debt instrument with its value today.
If the bonds are semiannual bonds, change following :
1. Annual coupon is divided by 2
2. Number of years is multiplied by 2 for number of coupon payments
3. YTM is divided by 2

The price of the bond has a direct relationship with coupon rate and yield to maturity rates :
1. When the coupon rate is less than the yield to maturity, the bond sells for a discount
against its par value i.e. the price of the bond is less than the par value. This kind of a
bond is a discount bond.
2. When the coupon rate is more than the yield to maturity, the bond sells for a premium
above its par value. We call this kind of bond a premium bond.
3. When the yield to maturity and coupon rate are the same, the bond sells for its par
value. We call this kind of bond a par value bond.

The fixed cash flows at a regular interval of time is known as annuity.

P = PMT x ((1 – (1 / (1 + r) ^ -n)) / r)

The variables in the equation represent the following:


● P = the present value of annuity
● PMT = the amount in each annuity payment (in dollars)
● R= the interest or discount rate
● n= the number of payments left to receive
Yield curve - It summaries the interest rate information of the whole market in one simple
mathematical object. Referring to that object in the correct mathematical way allows you to
value any fixed income portfolio. It is the most convenient and useful way to exploit the link we
have created between prices and interest rates, because it is applicable to any portfolio. The
yield curve can be determined once, and then used over and over again for different portfolios.

We use different interest rates for different terms accounts for the term structure of interest
rates; we must remember to use interest rates with a suitable spread included in order to
account for any default risk present.
Beginning with a risk free yield curve one can add spreads to attain risky yield curves. Although
it is not obvious how large a spread is needed for a particular entity, these ideas can still be
used to make informative comparisons.

Government zero coupon bonds of many maturities are observable, in which case one needs to
calculate the corresponding yield to form a yield curve. This process is known as
bootstrapping the yield curve. It can be more difficult if only coupon bonds are observable,
because one coupon bond price does not imply a single interest rate.

Yield to Maturity
Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it
matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual
rate.

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