Investment Portfolio Theory
Fixed income securities (debt securities): promise of a fixed stream of income
and they are pre-determined. The counter party can be seen as a borrower; thus,
they are also debt.
- Very little uncertainty
- Credit worthiness is the biggest source of uncertainty
Other forms of risk are market interest rates (example: interest rates are raised by
the Central Bank, and you might be stuck with a contract that has a lower rate, and
the value of your contract falls)
Examples:
- Government bonds (treasure bills (short run – months), notes (few years), bonds (very
long term)). Considered risk free
- Municipal bonds
- Corporate bonds (bonds, convertible bonds (stock), paper)
- Bank loans (debt security held by the bank)
- Pooled securitized debt (Collateralized debt obligations (CDOs), MDS, ABS)
- Preferred stocks (equity) with a clearly defined promised payment stream of accrued
dividends. Its difference to normal bonds is that if it does not pay the dividends there
is no bankruptcy event
Nonbank loans (from hedge funds)
Mortgages (debt of buying real estate)
In the US the Credit market debt was more than twice the size of the stock market
(2012)
Bond components
- Face value or par value or principal (the amount you owe the issuer at the end)
- Maturity date (when is the par value owed)
- Coupon rate (nominal interest rate on the bond, always quoted yearly)
- Coupon frequency (determines how frequently you receive the coupon rate, twice per
year or annually, for example)
Example:
- 20-year bond, $1000 face value, 5% coupon rate paid semi-annually:
- $1000 principal repaid at maturity
- Two coupon payments of 25 per year
- 20-year bond, $1000 face value, 0% coupon rate:
- Only $1000 principal repaid at maturity (zero-coupon bond)
- Interest or holding period return in 20 years is = (1000/400) – 1 = 150% or
(1000/400)^(1/20) - 1 = 47% per annum
Different bonds categories
- Bond types:
Straight fixed rate bonds
- Features: fixed coupon, fixed maturity date, no other options (callable, conversion,
…), all bonds sold at the same time
Convertible bonds
- Can be convertible into stocks at a predefined conversion ratio
- As an investor, you would convert the bond when the stock prices are high
,- Example: $1000 face value and 4% coupon worth $1040 today with a conversion
ratio of 100. Stock prices $11 today. Hence, you get 100 stocks worth $11 if you
convert ($1100), in this case you would exercise.
- Called “in-the-money” if value of shares obtainable via conversion > bond value
Contingent Convertible Bonds (CoCos)
- Converted automatically in equity at a pre-determined distress trigger event
- Not good for investors as it gets converted when firms are doing badly (risk of going
bankrupt). You become an equity holder (lowest priority in a bankruptcy case)
- Good for other bond holders of the firm: Company deleverages and becomes re-
capitalized (safer at bad times, boost its equity)
- For equity holders: Disadvantage: their equity (ownership) stake is diluted.
Advantage: distress is mitigated (the firm’s value is higher)
- Popular amongst banks given that they are cheaper than issuing equity
- Popular amongst regulators because they count as Tier 1 or Tier 2 capital (which you
need to fulfill the Basel 3 framework regulation). In the case a bank is in distress, the
creditors are made equity holders, and the equity cushion is increased and a bailout by
the government can be avoided
- Problem: What happens when there is a systemic crisis (lots of banks struggle at the
same time) ⁇ Many debt investors suddenly become equity investors (riskier for
them) and makes it more likely that the investor starts to struggle (another sector -
investment funds - could be drawn into the crisis). Triggered investors might opt to
sue the CoCo issuers.
Callable bonds
- Issuer reserves the bond at a specified call price before the maturity date. Right to
repurchase
- Usually, you cannot call at any point in time! Pre-specified points that are usually not
at the early life of the bond (call-protected)
- Advantage to the issuer: can refinance if financing gets cheaper
- Disadvantage to lender: May receive money back right when interest rates are low
and other investments opportunities are unattractive
Puttable bond
- Investor can terminate the contract or extend the maturity date
- When would you demand early repayment of principal: when interest rate rises in the
market -> advantage to the lender/investor and burden to the issuer (must keep paying
higher returns when refinancing would be beneficial OR has to rollover a bond at a
time when interests are higher than when prior bond was issued)
- Disadvantage to the issuer: price of such bond is higher, and it gets a lower return
Floaters (Floating rate bonds)
- Coupon rate varies with some benchmark, which is often the LIBOR (your coupon
changes overtime)
- Advantage to investor: protected against interest rate risk (there is still a risk of the
market rate increasing, but it can also decrease) – price of this bond will be higher and
will have a lower yield due to risk mitigation
Serial bonds
- Staggered maturity dates (the principal is not paid back completely at the end but
rather gradually over time)
,- Similar to a sinking fund or mortgage loan when the firm is bound to put aside money
at specific intervals for the principal repayment
- Advantage for holder: reduces default risk at maturity date
- Disadvantage for issuer: need to make pre-payments (burden)
- Comes at cost to lenders: more expensive and a lower yield for the investor
Bond market innovations
- CoCos
- Preferred stocks: issued by private equity firms.
Preferred stocks with bond-like features
Investors like it because they are liquid, traded on an exchange, and when a
payment is missed it does not trigger a default (more flexibility)
However, it does not give you practical ownership or voting rights, so the firm
can call them back art a certain price (usually if the firm is doing really well)
A lot like a callable bond. Depends on credit worthiness (have a credit rating),
cannot be called at certain dates, and dividends are called coupon payments
If they are not called, they are treated like a perpetuity
- Cat (-astrophe) Bonds
If disaster hits, you don’t get your principal back
Investor acts as an insurer
Principal is waived if specified trigger of a natural disaster occurs (hurricanes,
earthquake, and floods)
Usage: issued by reinsurance industry to spread risk across markets
Purchased by long-term investors (pension funds, life insurers)
Good diversification (low correlation with other asset classes)
- Social impact bonds (or social benefit bonds)
Impact investing: designed to deliver both financial and social return
Setting: non-profit organization receives a government contract to provide
welfare services on behalf of the government. Government promises a bonus if
they deliver good results
They need bonds to finance their project and since it is a non-profit, they can’t
keep the bonus anyways (cannot make profit) so they use the bonus to make
they financing cheaper and promise this bonus to the bond holders (they
become partial equity holders)
Incentives:
Bondholders benefit from the social performance of the non-profit (may seek
engagement and provide advice to improve performance)
Non-profit organizations: want to raise future finances and pay lower future
yields to earn profits and invest those in other programs that are part of their
mission (incentives to exceed the social performance targets)
- Securitized bonds
Bonds tied to expected cash flow (risky) from another asset that is underlying
the contract
Hybrid finance (you take part on the business risk as an investor)
Collateralized debt obligation (CDOs), Asset-backed securities (ABS) (vehicle
loans, student loans…), Mortgage-backed securities (MBS) (CDO with a real
estate as a collateral)
, Securitization
- Basic idea: A bunch of assets with rather low quality and we want to create a new
asset that qualifies for better rating (a better rating would ensure that pension funds
are allowed to invest)
- Two step process:
1. Pooling: create a pool of loans, mortgages, other collateralized assets into one
portfolio
2. Tranching: create a capital structure with a prioritization of claims
- Senior tranche (receive the first payment), Mezzanine tranche, and Junior tranche (are
paid only if there is NO default)
- The more assets you pool, the larger the fraction of tranches with higher credit rating
the average rating of the underlying assets
- You can pool many junior tranches
- Key parameters to price/rate securitized bonds:
1. Default probability
2. Correlation of defaults within portfolios
3. Correlation of defaults across portfolios
4. Collateral recovery rates for defaulted loans
- For the first order CDO, higher default correlation is better for Mezzanine and Junior
tranches because the probability that all will pay increases if they are correlated and
that is all Junior tranches care about
Default risk
-
- Determinants of Credit Risk Classification
Financial ratios: coverage ratios (earnings/fixed costs -> the higher the better),
Cashflow-to-debt ratio (higher ratio is better), leverage ratios (debt-to-equity -
> lower ratio is better), liquidity ratios, profitability ratios (ROA, ROE)
Covenants (legal clause the issuer and investor agreed to):
Restrictions on payouts to shareholders (if the firm does badly, it is not
allowed to pay dividends to make coupon payments safer for bond holders)
Fixed income securities (debt securities): promise of a fixed stream of income
and they are pre-determined. The counter party can be seen as a borrower; thus,
they are also debt.
- Very little uncertainty
- Credit worthiness is the biggest source of uncertainty
Other forms of risk are market interest rates (example: interest rates are raised by
the Central Bank, and you might be stuck with a contract that has a lower rate, and
the value of your contract falls)
Examples:
- Government bonds (treasure bills (short run – months), notes (few years), bonds (very
long term)). Considered risk free
- Municipal bonds
- Corporate bonds (bonds, convertible bonds (stock), paper)
- Bank loans (debt security held by the bank)
- Pooled securitized debt (Collateralized debt obligations (CDOs), MDS, ABS)
- Preferred stocks (equity) with a clearly defined promised payment stream of accrued
dividends. Its difference to normal bonds is that if it does not pay the dividends there
is no bankruptcy event
Nonbank loans (from hedge funds)
Mortgages (debt of buying real estate)
In the US the Credit market debt was more than twice the size of the stock market
(2012)
Bond components
- Face value or par value or principal (the amount you owe the issuer at the end)
- Maturity date (when is the par value owed)
- Coupon rate (nominal interest rate on the bond, always quoted yearly)
- Coupon frequency (determines how frequently you receive the coupon rate, twice per
year or annually, for example)
Example:
- 20-year bond, $1000 face value, 5% coupon rate paid semi-annually:
- $1000 principal repaid at maturity
- Two coupon payments of 25 per year
- 20-year bond, $1000 face value, 0% coupon rate:
- Only $1000 principal repaid at maturity (zero-coupon bond)
- Interest or holding period return in 20 years is = (1000/400) – 1 = 150% or
(1000/400)^(1/20) - 1 = 47% per annum
Different bonds categories
- Bond types:
Straight fixed rate bonds
- Features: fixed coupon, fixed maturity date, no other options (callable, conversion,
…), all bonds sold at the same time
Convertible bonds
- Can be convertible into stocks at a predefined conversion ratio
- As an investor, you would convert the bond when the stock prices are high
,- Example: $1000 face value and 4% coupon worth $1040 today with a conversion
ratio of 100. Stock prices $11 today. Hence, you get 100 stocks worth $11 if you
convert ($1100), in this case you would exercise.
- Called “in-the-money” if value of shares obtainable via conversion > bond value
Contingent Convertible Bonds (CoCos)
- Converted automatically in equity at a pre-determined distress trigger event
- Not good for investors as it gets converted when firms are doing badly (risk of going
bankrupt). You become an equity holder (lowest priority in a bankruptcy case)
- Good for other bond holders of the firm: Company deleverages and becomes re-
capitalized (safer at bad times, boost its equity)
- For equity holders: Disadvantage: their equity (ownership) stake is diluted.
Advantage: distress is mitigated (the firm’s value is higher)
- Popular amongst banks given that they are cheaper than issuing equity
- Popular amongst regulators because they count as Tier 1 or Tier 2 capital (which you
need to fulfill the Basel 3 framework regulation). In the case a bank is in distress, the
creditors are made equity holders, and the equity cushion is increased and a bailout by
the government can be avoided
- Problem: What happens when there is a systemic crisis (lots of banks struggle at the
same time) ⁇ Many debt investors suddenly become equity investors (riskier for
them) and makes it more likely that the investor starts to struggle (another sector -
investment funds - could be drawn into the crisis). Triggered investors might opt to
sue the CoCo issuers.
Callable bonds
- Issuer reserves the bond at a specified call price before the maturity date. Right to
repurchase
- Usually, you cannot call at any point in time! Pre-specified points that are usually not
at the early life of the bond (call-protected)
- Advantage to the issuer: can refinance if financing gets cheaper
- Disadvantage to lender: May receive money back right when interest rates are low
and other investments opportunities are unattractive
Puttable bond
- Investor can terminate the contract or extend the maturity date
- When would you demand early repayment of principal: when interest rate rises in the
market -> advantage to the lender/investor and burden to the issuer (must keep paying
higher returns when refinancing would be beneficial OR has to rollover a bond at a
time when interests are higher than when prior bond was issued)
- Disadvantage to the issuer: price of such bond is higher, and it gets a lower return
Floaters (Floating rate bonds)
- Coupon rate varies with some benchmark, which is often the LIBOR (your coupon
changes overtime)
- Advantage to investor: protected against interest rate risk (there is still a risk of the
market rate increasing, but it can also decrease) – price of this bond will be higher and
will have a lower yield due to risk mitigation
Serial bonds
- Staggered maturity dates (the principal is not paid back completely at the end but
rather gradually over time)
,- Similar to a sinking fund or mortgage loan when the firm is bound to put aside money
at specific intervals for the principal repayment
- Advantage for holder: reduces default risk at maturity date
- Disadvantage for issuer: need to make pre-payments (burden)
- Comes at cost to lenders: more expensive and a lower yield for the investor
Bond market innovations
- CoCos
- Preferred stocks: issued by private equity firms.
Preferred stocks with bond-like features
Investors like it because they are liquid, traded on an exchange, and when a
payment is missed it does not trigger a default (more flexibility)
However, it does not give you practical ownership or voting rights, so the firm
can call them back art a certain price (usually if the firm is doing really well)
A lot like a callable bond. Depends on credit worthiness (have a credit rating),
cannot be called at certain dates, and dividends are called coupon payments
If they are not called, they are treated like a perpetuity
- Cat (-astrophe) Bonds
If disaster hits, you don’t get your principal back
Investor acts as an insurer
Principal is waived if specified trigger of a natural disaster occurs (hurricanes,
earthquake, and floods)
Usage: issued by reinsurance industry to spread risk across markets
Purchased by long-term investors (pension funds, life insurers)
Good diversification (low correlation with other asset classes)
- Social impact bonds (or social benefit bonds)
Impact investing: designed to deliver both financial and social return
Setting: non-profit organization receives a government contract to provide
welfare services on behalf of the government. Government promises a bonus if
they deliver good results
They need bonds to finance their project and since it is a non-profit, they can’t
keep the bonus anyways (cannot make profit) so they use the bonus to make
they financing cheaper and promise this bonus to the bond holders (they
become partial equity holders)
Incentives:
Bondholders benefit from the social performance of the non-profit (may seek
engagement and provide advice to improve performance)
Non-profit organizations: want to raise future finances and pay lower future
yields to earn profits and invest those in other programs that are part of their
mission (incentives to exceed the social performance targets)
- Securitized bonds
Bonds tied to expected cash flow (risky) from another asset that is underlying
the contract
Hybrid finance (you take part on the business risk as an investor)
Collateralized debt obligation (CDOs), Asset-backed securities (ABS) (vehicle
loans, student loans…), Mortgage-backed securities (MBS) (CDO with a real
estate as a collateral)
, Securitization
- Basic idea: A bunch of assets with rather low quality and we want to create a new
asset that qualifies for better rating (a better rating would ensure that pension funds
are allowed to invest)
- Two step process:
1. Pooling: create a pool of loans, mortgages, other collateralized assets into one
portfolio
2. Tranching: create a capital structure with a prioritization of claims
- Senior tranche (receive the first payment), Mezzanine tranche, and Junior tranche (are
paid only if there is NO default)
- The more assets you pool, the larger the fraction of tranches with higher credit rating
the average rating of the underlying assets
- You can pool many junior tranches
- Key parameters to price/rate securitized bonds:
1. Default probability
2. Correlation of defaults within portfolios
3. Correlation of defaults across portfolios
4. Collateral recovery rates for defaulted loans
- For the first order CDO, higher default correlation is better for Mezzanine and Junior
tranches because the probability that all will pay increases if they are correlated and
that is all Junior tranches care about
Default risk
-
- Determinants of Credit Risk Classification
Financial ratios: coverage ratios (earnings/fixed costs -> the higher the better),
Cashflow-to-debt ratio (higher ratio is better), leverage ratios (debt-to-equity -
> lower ratio is better), liquidity ratios, profitability ratios (ROA, ROE)
Covenants (legal clause the issuer and investor agreed to):
Restrictions on payouts to shareholders (if the firm does badly, it is not
allowed to pay dividends to make coupon payments safer for bond holders)
