 Personal Finance PowerPoint Presentation How Bond Market Pricing Works Prepare to get financially fed by practicing personal finance Most of this information comes from Investopedia How Bond Market Pricing Works, which you can find online Take a look at the references, resources, continue your research from there This by Barry Nielsen, updated August 31, 2020 And prior presentations, we've been taking a look at investment goals Investment strategies, investment tools, keeping them in mind We're now looking at how Bond Market Pricing Works We're going to be using a baseball analogy here So the U.S. Bond Market is like baseball You have to understand and appreciate the rules and strategies Or else it will seem boring So you might think investing in general is boring And even more so investing in bonds But no, you just don't understand the rules It's as exciting as baseball Which is also not the most action-packed area But if you like the stats and whatnot, which of course I do Then it becomes quite exciting Pops to life and it's going to be a great analogy here So it's also like baseball in that Its rules and pricing conventions have evolved and Conceived esoteric at times So you've got to think about the changes that have happened With relation to the rules over time As you're doing kind of comparisons to seeing what's going on So in the official Major League rule book It takes more than 3,600 words to cover the rules Of what the pitcher can and cannot do So you might think the pitcher just sits up there And throws the ball to the hitter But no, there's a whole lot of stuff that the pitcher can And cannot do up there And you've got to be aware of that So in this article we're going to cover Bond market pricing conventions And less than 1,800 words Bond market classifications are briefly discussed Followed by yield calculations, pricing benchmarks And pricing spreads Basic knowledge of these pricing conventions Will make the bond market seem as exciting As the best World Series baseball game So that's super exciting of course The World Series baseball game The World Series game here Everybody's excited for that So bond market classification The bond market consists of a great number of issuers And types of securities To talk about each specific type Might fill an entire textbook Therefore for the purpose of discussing How various bond market pricing conventions work We make the following major bond classifications So we've got the US Treasuries A bond issued by the United States Department Of the Treasury We've got the corporate bonds Bonds issued by corporations that carry An investment grade rating High yield bonds Bonds with ratings below investment grade Also known as non-investment grade bonds Or junk bonds Mortgage backed securities, MBS As the name implies A bond collateralized by the cash flow Of principal and interest payments From an underlying pool of single family Residential mortgages We've got the asset backed securities MBS A bond collateralized by the cash flow Of an underlying pool of assets Such as auto loans Credit card receivables Home equity loans Aircraft leases etc The list of assets that have been Securitized into ABS Is almost endless Agency bonds Debt issued by government-sponsored entities GSEs Including Fannie Mae, Freddie Mac Home loan banks Municipal bonds or munis A bond issued by a state city Or local government or its agencies Collateralized debt obligations CDOs A type of asset backed security Backed by any one or several Other ABS, MBS Bonds or loans A bond's expected return Yield is the measure used most Frequently to estimate Or determine an bond's expected return Yield is also used As a relative value Measure between bonds So when we're trying to compare bonds We're trying to figure the yield as a way Or a method to do that comparison There are two primary yield measures That must be understood To understand how different bond Market pricing conventions work Yield to maturity and Spot rates A yield to maturity calculation Is made by determining the interest rate Discount rate that will make The sum of the bond's cash flows Plus accrued interest equal To the current price of the bond So we might do some of these in our example problem To get a better grasp of it But Note when you're thinking of the bond You can think of it as future cash flows We've got future cash flows That we know what they're going to be Because they're in the term of the bond Typically being something like the semi-annual interest payments Meaning a stream of payments Newer type of payments going forward And then we've got the value that we're going to receive At the maturity, which is you think Like the face about, kind of like the return Of the principal. We can use Our present value factors then To take that future cash flows And discount it to figure out The discount rate at which It matches basically the price Of the bond one way that we would Value the bond one way that the market Would then Figure the price. So this calculation Has two important assumptions First that the bond will be held Until maturity and second That the bond's cash flows can be reinvested At the yield to maturity A spot rate calculation Is made by determining the interest rate Discount rate that makes the present value Of a zero coupon bond Equal to its price A series of spot rates Must be calculated to price A coupon paying bond Each cash flow must be discounted Using the appropriate spot rate Such that the sum Of the present value of each cash Flow equals the price. So let's look at that one more time. A spot rate calculation is made by Determining the interest rate discount Rate that makes the present value Of a zero coupon bond That would be a bond that doesn't have the interest rate But basically you buy it at a discount And at the end, typically You buy it at a discount and at the end You'd get the face amount and so the interest That you get at the end A zero coupon bond equal to its price So a series of spot rates Must be calculated to price A coupon paying bond So when you look at a coupon to paying bond One that's going to have those interest payments If you're going to look at the spot rate Then you're going to have the multiple spot rates Because now you've got these multiple spots Or points in time in the future For those future cash flows Each cash flow must be discounted Using the appropriate spot rate Such that the sum of the present values Of each cash flow equals The price. So as we discussed below Spot rates are most often used As a building block To relative value comparisons For certain types of bonds Benchmarks for bonds Most bonds are priced relative to a benchmark This is where bond market Pricing gets a little tricky Different bond classifications As we have defined them Above use different pricing Benchmarks. Some of the most common pricing benchmarks Are on the run US Treasuries The most current series Many bonds are priced relative To a specific treasury bond For example, the on the run 10 year Treasury might be used as the pricing Benchmark for a 10 year Corporate bond issue. So note When you're looking at the government bonds We can use them kind of as the benchmark One of the reasons you might do so Is because they don't have that default risk That is there with the corporate bonds Because you would think that the government The US government would be able to Service their debt so they can be used As a good kind of comparison tool For the benchmarking. When the maturity Of a bond cannot be known with exactness Because of call or put features The bond is frequently priced To a benchmark curve This is because the estimated maturity Of the callable or portable bond Most likely does not coincide Exactly with the maturity Of a specific treasury Benchmark pricing curves Are constructed using the yields Of underlying securities With maturities from 3 months To 30 years. Several different Benchmark interest rates Or securities are used to construct Benchmark pricing curves Because there are gaps In the maturities of securities Used to construct a curve Yields must be interloaked Between the observable yields For example one of the most commonly used Benchmark curves is the On the run US treasury curve Which is constructed using the most Recently issued US treasury Bonds, notes and bills Because securities are only issued By the treasury Treasury with 3 month 6 month, 2 year 3 year, 5 year 10 year and 30 year maturities The yield of theoretical bonds With maturities that lay between Those maturities Must be interloping So this treasury curve Is known as the interloping Yield curve Or the I curve By bond market participants Other popular bond Benchmarking pricing curves You got the spot rate treasury curve A curve constructed using the Theoretical spot rates Of US treasuries You got the swap curve Constructed using the fixed interest rate Side of interest rate Swaps We got the euro dollar curve A curve constructed using the Interest rates derived from Euro dollar feature pricing We got the agency curve A curve constructed using the Yields of non-callable fixed rate Agency debt Yield spreads for bonds A bonds yield relative to the yield Of its benchmark is called a spread The spread is used with a pricing Mechanism and as relative value Comparison between bonds For example, a trader might say That a certain corporation bond Is trading at a spread of 75 Basis points above the 10-year treasury This means that the yield to maturity Of the bond is at 75 Bonds above the 10-year treasury This means that the yield to maturity Of the bond is at 75 Bonds above the 10-year treasury This means that the yield to maturity Of the bond is 0.75% greater Than the yield to maturity Of the on the run 10-year treasury So we're comparing it there Looking at the spread Notably, if a different corporation bond With the same credit rating Outlook and duration We're trading at a spread Of 90 basis points On a relative value basis The second bond would be a Better buy We're using these benchmarks Of course to do these kind of comparisons Within the market To value the bonds and the returns Of the bonds taken into consideration The risks related to the bonds And trying to tie them to the benchmark So there are different types Of spread calculations used for The different pricing benchmarks The four primary yield spread calculations Are one, nominal yield spread The difference in the yield To maturity of a bond And the yield to maturity of its benchmark You got the number two Zero volatility spread The Z spread The constant spread that When added to the yield at each Point on the spot rate Treasury curve where a bond's Cash flow is received Will make the price of a security Equal to the present value Of its cash flows Number three, option Adjusted spread, the OAS And OAS is used to evaluate Bonds with embedded options such as A callable bond or portable bond Which we've seen in prior presentations It is the constant spread that When added to the yield at each Point on a spot rate curve Usually the U.S. Treasury spot Rate curve where a bond's Cash flow is received Will make the price of the bond Equal to the present value of Its cash flow However, to calculate the OAS The spot rate curve is given multiple Interest rate pass In other words, many different spot Rate curves are calculated And the different interest rate pass Are averaged And OAS accounts for Interest rate volatility and the Probability of the prepayment Of principle of the bond We got number four, discount margin The DM bonds with Variable interest rates are usually Priced close to their par value This is because the interest rate On a variable rate bond Adjusts to current interest rate Rates based on changes In the bond's reference rate The DM discount margin Is the spread that When added to the bond's current Refer reference rate Will equate the bond's cash Flows to its current price So types of bonds and their Benchmark spread calculations We got the high yield bonds These are like the junk bonds Are usually priced at a nominal Yield spread to a specific On-the-run U.S. Treasury bond However, sometimes when the credit Ratings an outlook of a high yield Bond deteriorates The bond will start to trade at An actual dollar price For example, such a bond trades At $75.87 As opposed to 500 basis Points over the 10-year Treasury Corporate bonds A corporate bond is usually priced At a nominal yield spread To a specific on-the-run U.S. Treasury bond That matches its maturity For example, 10-year corporate bonds Are priced to the 10-year treasury So types of bonds And their benchmark spread calculation Continued, we got the mortgage backed securities The MBS There are many different types of Securities, many of them trade on a Nominal yield spread At their weighted average life To the U.S. Treasury eye curve Some adjusted rate MBS Or get back securities Trade at a DM Others trade at Z spread Some CMOs trade At a nominal yield spread To a specific treasury For example, a 10-year Planned amortization class Bond might trade at A nominal yield spread To the on-the-run 10-year treasury, a Z bond Might trade at a nominal yield spread To the on-the-run 30-year treasury Because MBS Have embedded call options Borrowers have the Free option Of prepaying their mortgages They are frequently Evaluated using an OAS So we got the asset backed securities The ABS Frequently trade at a Nominal yield spread At their weighted average life To the swap curve Types of bonds and their benchmark Spread calculations We got the agencies Frequently trade at nominal yield Spread to a specific treasury Such as the on-the-run 10-year treasury We've got the callable agencies Or sometimes evaluated Based on an OAS Where the spot rate curves Are derived from the yields On non-callable agencies You got the municipal bonds Because of the tax advantages Of the municipal bonds, usually Not taxable, their yields Are not as highly Correlated with U.S. treasury Yields as other bonds Therefore, the munis frequently trade On an outright yield To maturity, or even a Dollar price. However, These yields, as a ratio To the benchmark treasury yield Is sometimes used as a relative Value measure. We've got the Collateralized debt obligations The CDOs, like the MBS and ABS That frequently back ODCDOs There are many different pricing benchmarks And yield measures used to price CDOs. The euro-dollar Curve is sometimes used as a Benchmark. Discount margins Used on floating rate tranches OAS calculations are made For relative value analysis So what's the bottom line? Bond market pricing conventions Are a little bit tricky But like baseball rules understanding The basic Basics Remove some of the ambiguity And may even make it enjoyable So bond pricing is really Just a matter of identifying A pricing benchmark Determining a spread and understanding The difference between two basic yield Calculations yield to maturity And spot rates. With that Knowledge understanding how Various types of bonds Are priced shouldn't Be intimidating.