Maturity government security

The terms spread or credit spread refer to the yield differential, usually expressed in basis points, between a corporate bond and an equivalent maturity government security or point on the government curve. It can also be expressed as a spread over the swap curve. In the former case, we refer to the fixed-rate spread. In the latter, we use the term spread over EURIBOR, or over the swap curve. 

The most actively traded government securities for various maturities are called benchmark issues. Yields on these issues serve as reference interest rates which are used extensively for pricing other securities. Exhibit 1.2 is a Bloomberg screen of the benchmark bonds issued by the government of the Netherlands. European government bonds will be discussed in Chapter 5. As an illustration of a corporate bond. Exhibit 1.3 shows a Bloomberg Security Description screen for 4.875% coupon bond issued by Pirelli SPA that matures on 21 October 2008. 

Cash flow is simply the cash that is expected to be received in the future from owning a financial asset. For a fixed-income security, it does not matter whether the cash flow is interest income or repayment of principal. A security s cash flows represent the sum of each period s expected cash flow. Even if we disregard default, the cash flows for some fixed-income securities are simple to forecast accurately. Noncallable benchmark government securities possess this feature since they have known cash flows. For benchmark government securities, the cash flows consist of the coupon interest payments every year up to and including the maturity date and the principal repayment at the maturity date. 

The minimum interest rate that an investor should require is the yield available in the marketplace on a default-free cash flow. For bonds whose cash flows are denominated in euros, yields on European government securities serve as benchmarks for default-free interest rates. In some European countries, the swap curve serves as a benchmark for pricing spread product (e.g., corporate bonds). For now, we can think of the minimum interest rate that investors require as the yield on a comparable maturity benchmark security. 

Traditional yield spread analysis for a nongovernment bond involves calculating the difference between the risky bond s yield and the yield on a comparable maturity benchmark government security. As an illustration, let s use a 5.25% coupon BMW Finance bond described in Exhibit 3.10 that matures on 1 September 2006. Bloomberg s Yield Spread Analysis screen is presented in Exhibit 3.14. The yield spreads against various benchmarks appear in a box at the bottom left-hand corner of the screen. Using a settlement date of 9 July 2003, the yield spread is 31 basis points versus the interpolated 3.1-year rate on the Euro Benchmark Curve. This yield spread measure is referred to as the nominal spread. 

To illustrate the computation, let s examine a 4.2% coupon, lO-year Spanish government security that matures on July 30, 2013. Bloomberg s Yield Analysis Screen is presented in Exhibit 4.7. If the bond is priced to yield 3.724% on a settlement date of June 6, 2003, we can compute the PVBP by using the prices for either the yield at 3.734 or 3.714. The bond s initial full price at 3.724% is 104.5673. If the yield is decreased by 1 basis point to 3.714%, the PVBP is 0.085 (1104.5673 - 104.65221). Note that our PVBP calculation agrees with Bloomberg s calculation labeled PRICE VALUE OF A 0.01 that is presented in the Sensitivity Analysis box located in the lower left-hand corner of the screen. 

The repo market in government securities comprises T-bills known as Letras, bonds of between three and five years maturity (Bonos) and bonds of 10-15 years maturity (Obligaciones). Repo in Letras was introduced first, in 1987. At the start of 2002 there was approximately 251.3 billion nominal of government debt ontstanding repo volnme was approximately 141 billion per month. ... 

Most corporate bonds, as well as municipals and Treasury notes and bonds, pay interest on a semiannual basis. To find the interest paid during the year, multiply the par value (face or maturity value) of the bond by the annual coupon rate. This amount is then divided by 2 to determine the amount of interest paid every 6 months. It is important to know that corporate securities use a 180-day coupon period—a commercial year of 360 days or 30 days per month, whereas government securities use an exact year of 365 days (366 days for a leap year). In addition, corporate securities are delivered 5 business days after the sale, whereas government securities are delivered the same day or the day after the sale. Prices for these securities are calculated as of the delivery date. Finally, if a bond is sold between coupon dates, it will have accrued interest since the last coupon date. This accrued interest must be added to the quoted price to determine the actual amount that the investor is required to pay. 

But first, you should know what types of bonds are available. Among the types of bonds you can choose from are U.S. government securities, municipal bonds, corporate bonds, mortgage and asset-backed securities, federal agency securities and foreign government bonds. There are also many short-maturity options such as Treasury bills, bank certificates of deposit and commercial paper. 

To compute the expected return on equity, which is denoted by E ROE),Vx. (2.50) is applied. In this expression, E (ROE) is computed as the sum of a risk free rate and a risk premium (cpRe). The former term represents the rate of return of an investment free of default risk available in the market and is usually equal to the yield to maturity offered by a government security. The latter, represents the expected amount of return above the risk-free rate in exchange for a given amount of variance (Pratt 2002, Applequist et al. 2000). One of the most commonly employed methods to estimate the risk premium is the Capital Asset Pricing Model (CAPM). For more details regarding this topic the reader is referred to Sharpe (1999). 

Bond A long-term debt-type of security generally issued by corporations or governments to generate cash. The coupon rate is the interest rate paid to the bondholder. The maturity date is when the face value of the bond will be paid to the bondholder. 

We will illustrate the sources of euro returns using an example. In early July 2003, the 5-year German government bond (i.e., bund) was trading at 100.103 assuming a settlement date of 9 July 2003. The security description screen from Bloomberg is presented in Exhibit 3.8. This bond carries a coupon rate of 3% and matures on 11 April 2008. Cou-... 

The size of the repo market reflects the size of the cash market in government bonds, which is the largest in Europe. The instruments used in the market are listed in Exhibit 10.26. Securities marked with a are listed by ISMA as Euro GC securities. Most transactions are one-week maturity, while, unusually for repo, overnight trades are rarer. This may be because stamp duty is chargeable at a flat rate on domestic deals, and so this is an incentive for market participants to undertake longer-dura-tion repo trades. 

Tips swap. The Tips swap is based on the structure of U.S. Tips securities. It pays a periodic fixed rate on an accreting notional amount, together with an additional one-off payment on maturity. This payout profile is identical to many government IL bonds. They are similar to synthetic IL bonds described previously. 

Treasury notes have maturities of between 2 and 10 years. Because of their longer maturities, these notes have more interest rate risk associated with them and so their prices fluctuate more than T-bill prices. The U.S. government used to issue Treasury bonds, which carried maturities of 15, 20, and 30 years. The 30-year Treasury bond was just retired in November 2001. Another Treasury security is a "strip" or zero-coupon Treasury security created by separating the income streams of coupon payments and principal, wherein the holder receives no coupon payments, buys the bond at a discount, and is returned the principal at par. There is a high degree of volatility associated with strips. 

Government-chartered corporation that buys qualified mortgage loans from the financial institutions that originate them, securitizes the loans, and distributes the securities through the dealer community. The securities are not backed by the U.S. government. The market value of these securities prior to maturity is not guaranteed and will fluctuate. 

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