Assignment Questions Excel data entry and modeling is not introduced at this late stage of the course, so some of these questions involve only simple calculations and interpretation of Excel calculations already done for you. MBAD 6234 Financial Markets will use Excel extensively, so plan for some time to practice Excel if you need to. ?Custom Excel Tutorial.xls? is posted on the Bb Syllabus page for that purpose. #1? Explain the calculations in each of the three panels below, one at a time. Explain the purpose of the calculation and the procedure of the calculation, i.e., how the data inputs determine the output ? the result. Bond Questions Support Sheets.xlsx (posted on Bb assignment page) has ?live? sheets so you can see how the calculations work. buy at par BOND CASH FLOWS 1994 1995 1996 1997 1998 Purchase Price -1000 Interest 102.5 102.5 102.5 102.5 Sale Price 1000 Sum -1000 102.5 102.5 102.5 1102.5 YTM 10.25% buy at discount BOND CASH FLOWS 1994 1995 1996 1997 1998 Purchase Price -900 Interest 102.5 102.5 102.5 102.5 Sale Price 1000 Sum -900 102.5 102.5 102.5 1102.5 YTM 13.66% buy at premium BOND CASH FLOWS 1994 1995 1996 1997 1998 Purchase Price -1100 Interest 102.5 102.5 102.5 102.5 Sale Price 1000 Sum -1100 102.5 102.5 102.5 1102.5 YTM 7.28% #2? Explain the calculations in each of the two panels below, one at a time. As in #1, consider the inputs and output ? the results. Then, explain the difference between the two panels. Use Bond Questions Support Sheets.xlsx, as for #1 above. #3- Determine the yield to maturity on a 10-year 6% bond selling at par if the going rate (current interest rate for newly issued bonds of the same quality rating) is 6%? This is a think question; not a calculation question. Briefly explain how you reached your answer. #4- If Treasury bonds are risk free, why is there a standard deviation around their mean rate of return? Refer to the table on page 17 of this PDF. HINT: Examine the blue treasury interest rate trend in the chart on page 4. #5? Your pension fund has a sub-portfolio of bonds. The duration of this bond portfolio is 8 years. The current market value of the bond portfolio is $1,000,000. Calculate the price change expected on the bond portfolio if interest rates rise from their current level of 5% to 7%, and discuss whether or not this is an example of interest rate risk. #6- Explain in one sentence why the duration on a zero coupon bond is equal to its maturity.

ALL ABOUT BONDS (FIXED-INCOME SECURITIES) Now, attention shifts to the valuation of specific assets: bonds, stocks, and businesses. First, how the cash flows (of bonds, stocks, businesses) are forecasted, and second, given the cash flow forecast, how the cash flows are valued. This focus is on bonds and bond markets this week, then next week on stocks and stock markets. For MBAD 6234 Financial Management, the next module, understanding the valuation of bonds and stocks using Excel, is vital. It is assumed that you know Time Value of Money from previous courses. (A TVM tutorial is posted if you need it for a refresher.) The assignment for both weeks is answers to questions, in a Word file, as usual. Learning Objectives Understand the building blocks of bond pricing: coupon rate, maturity, and quality Understand the techniques for valuing bonds based on present value of future cash flows Understand that bond prices are inversely related to interest rates Familiarity with the levels and trends of historical interest rates CONTENTS OF THIS FILE 1. Cohen Fixed Income (Bonds) 'Lecture' (vital) 2. S&P Ratings (Agency?) A-United States Loses Prized AAA Credit Rating From S&P, August 6, 2011. B-Cost of Ratings Suit, April 19, 2013. C-Update, February, 2015 (perspective) 3. Reaping of Wisdom on 'Junk', Francesco Guerrera, The Wall Street Journal, May 7, 2013 (perspective) 4. Treasurys Can Be Painful, as History Shows, The Wall Street Journal, September 20, 2010 (perspective) 5. A Fog Warning, Again, for Municipal Bonds, February 18, 2012, The New York Times (important) 6. A Bond Market Plunge That Baffles The Experts, James B. Stewart, The New York Times, June 7, 2013 (vital- also important insights into personal investing) 7. Six Short Recent videos discussing the bond market, (current viewpoints from experts) Assignment Questions Excel data entry and modeling is not introduced at this late stage of the course, so some of these questions involve only simple calculations and interpretation of Excel calculations already done for you. MBAD 6234 Financial Markets will use Excel extensively, so plan for some time to practice Excel if you need to. 'Custom Excel Tutorial.xls' is posted on the Bb Syllabus page for that purpose. #1- Explain the calculations in each of the three panels below, one at a time. Explain the purpose of the calculation and the procedure of the calculation, i.e., how the data inputs determine the output - the result. Bond Questions Support Sheets.xlsx (posted on Bb assignment page) has 'live' sheets so you can see how the calculations work. Purchase Price Interest Sale Price Sum YTM -1000 10.25% buy at discount Purchase Price Interest Sale Price Sum YTM 1994 -900 -900 13.66% buy at premium Purchase Price Interest Sale Price Sum YTM 2 1994 -1100 1996 1997 1998 102.5 102.5 102.5 102.5 102.5 102.5 1000 1102.5 BOND CASH FLOWS 1995 1996 1997 1998 102.5 1994 -1000 BOND CASH FLOWS 1995 102.5 buy at par 102.5 102.5 102.5 102.5 102.5 102.5 1000 1102.5 1997 1998 102.5 1000 1102.5 BOND CASH FLOWS 1995 1996 102.5 -1100 7.28% 102.5 102.5 102.5 102.5 102.5 #2- Explain the calculations in each of the two panels below, one at a time. As in #1, consider the inputs and output - the results. Then, explain the difference between the two panels. Use Bond Questions Support Sheets.xlsx, as for #1 above. SOLVE FOR YTM GIVEN PRICE Market Price Interest Maturity Pmt Sum YTM 0 -932.26 2 3 4 50.00 50.00 50.00 50.00 50.00 50.00 50.00 1,000.00 1,050.00 1 50.00 2 50.00 3 50.00 50.00 -932.26 7.00% 1 50.00 50.00 SOLVE FOR PRICE GIVEN YTM 0 Interest Maturity Pmt Cash Flows Req. R of R Value 4 50.00 1,000.00 1,050.00 7.00% 932.26 #3- Determine the yield to maturity on a 10-year 6% bond selling at par if the going rate (current interest rate for newly issued bonds of the same quality rating) is 6%? This is a think question; not a calculation question. Briefly explain how you reached your answer. #4- If Treasury bonds are risk free, why is there a standard deviation around their mean rate of return? Refer to the table on page 17 of this PDF. HINT: Examine the blue treasury interest rate trend in the chart on page 4. #5- Your pension fund has a sub-portfolio of bonds. The duration of this bond portfolio is 8 years. The current market value of the bond portfolio is $1,000,000. Calculate the price change expected on the bond portfolio if interest rates rise from their current level of 5% to 7%, and discuss whether or not this is an example of interest rate risk. #6- Explain in one sentence why the duration on a zero coupon bond is equal to its maturity. ITEM #1- COHEN FIXED INCOME (BONDS) 'LECTURE' Quick Overview - Bond Market Review (zoom the page to get a better view of the charts) Scan the chart below to get oriented as we begin this discussion (the same chart is covered again below). It shows interest rate trends since 1990. 6-month Treasury bills were the most volatile. The other sectors of the bond market mostly tracked one another through 2007, then began to diverge. Baa bonds spiked (in terms of yield; their prices fell), the spread between their yields and Aaa yields widening because of a recessionfueled flight to quality. Remember that interest on municipal bonds is always free of Federal income tax, so interpret their yields in that light - municipal yields are not grossed up to their tax-equivalent yields in this chart. 3 Common Misperceptions About Bonds Bonds are safe investments. Investors lose money in bonds. The price of bonds, like the price of stocks, can be volatile. Changes in interest rates and changes in the quality ratings of bonds drive the volatility, as does panic in markets, especially when investors borrow money to invest in bonds and are subject to margin calls. Buy-and-hold investors, those who hold their bonds until they mature, will not lose money if the bond issuer does not default. Bonds are liquid investments. Bond issuance has exploded over the past few decades, as has trading in bonds, as you know from Weeks 1-5 of this course. You also know that transparency in bond markets is not the same as it is in stock markets; most stocks trade in listed markets (organized exchanges) while most bonds trade over-the-counter. Markets for many bonds are thinly traded and not well documented. Bond investing is easy and boring. No, it's not, for reasons stated above. The inputs to bond valuation are complex and bond prices are subject to plenty of volatility, much of it very difficult to forecast. Defining a Bond In the image below of a Twentieth-Century Fox Film Corporation bond, notice the 10% coupon rate, the $1,000 dollar par value, and the maturity date in 1998 (the month and day should also be clearly stated - just 1998 is not enough). It is described as a subordinated debenture, meaning that it is unsecured (no collateral). 4 Therefore, the three building blocks of the bond are before you: 1. par value is $1,000 2. coupon rate is 10% per year 3. maturity date is ??/??/1998 (month and day not legible) Quality rating, the measure of how risky a bond is, is not written on the bond. You can take it for granted that the coupon rate takes into account the risk level of the bond, determined from the existing interest rate structure in the capital markets, on the day the bond was issued. The credit rating firms, misnamed 'agencies', are for-profit businesses often paid by the firms they rate: Standard & Poor's, Moody's, Fitch. The top panel of the spreadsheet below portrays the cash flows for this bond, purchased at par for $1,000 (B3) in 1994 - exactly 5 years before the bond matures. Interest coupons of $102.50 were received each year, 10 % of $1,000, and when the bond matured in 1998, the $1,000 par was paid back. Row 6 sums the cash flows over the investment horizon. The yield to maturity produced by the $1,000 investment is calculated in B7, 10.25%, which you would know without calculations because $102.50 return on a $1,000 investment is 10%, the coupon rate. The second panel shows what happened if the bond was purchased in 1994 at a discount (B11) because market interest rates had gone up from the time the bond was issued, producing a 13.66% YTM in B15. The red-colored cells are the only cells that change from panel-to-panel, the price of the bond when it was purchased, and the resulting YTM. The other flows can't change because they are fixed by the bond contract. 5 The third panel shows what happened if the bond was purchased in 1994 at a premium (B19) because market interest rates had gone down from the time the bond was issued, producing a 7.28% YTM in B23. This discussion illustrates a key principle, the inverse relationship between bond prices and interest rates. Because a bond has a fixed coupon rate and maturity, its price changes in response to the prevailing interest rates in the economy. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 A buy at par B C D BOND CASH FLOWS 1994 1995 1996 -1000 102.5 102.5 Purchase Price Interest Sale Price Sum YTM -1000 10.25% 102.5 102.5 BOND CASH FLOWS 1994 1995 1996 -900 102.5 102.5 buy at discount Purchase Price Interest Sale Price Sum YTM -900 13.66% 102.5 102.5 BOND CASH FLOWS 1994 1995 1996 -1100 102.5 102.5 buy at premium Purchase Price Interest Sale Price Sum YTM -1100 7.28% 102.5 102.5 E F 1997 1998 102.5 102.5 102.5 1000 1102.5 1997 1998 102.5 102.5 102.5 1000 1102.5 1997 1998 102.5 102.5 1000 1102.5 102.5 As the default risk of a bond increases, its credit rating decreases. The riskiness of a bond is determined by times interest earned (coverage ratio) debt ratio These are vital ratios that will be discussed in MBAD 6234 Financial Markets - although you already learned them in Accounting. The data panel below shows times interest earned (coverage) and debt/capital ratios associated with credit ratings from AAA to CCC. These ratios shift over time, so the data are suggestive - they are not meant to apply to right now. AAA Times interest earned Total debt/capital AA A BBB BB B CCC 23.8 6.2% 13.6 34.8% 6.9 39.8% 4.2 45.6% 2.3 57.2% 0.9 74.2% 0.4 101.2% It was stated above that a bond is described by three building blocks in the contract between the issuing corporation and the investor. Let's add a fourth one, quality, i.e., its credit rating. 6 1. 2. 3. 4. par value is $1,000 coupon rate is 10% per year maturity date is ??/??/1998 quality. Par value is important to an investor, but it is not needed in valuation, because we can assume par values in multiples of $100 and get the same results. Think of the coupon rate of 6% is $6 per hundred of par value. Bond Valuation Like any asset, bonds are valued based on a calculation of the present value of their cash flows. The cash flow of US Treasury securities, is very predictable because they are default proof, i.e., risk free. The key factors that impact the price of a U.S. Treasury security are the amount of the periodic coupon payments, the current level of interest rates, and the time until the bond matures. For the other two categories of bonds, corporates and municipals, relative riskiness as to the possibility of default, is measured by their ratings. The price of a bond is the summation of the present value of all future cash flows depicted by the formula: n P = CFt 1/(1 + ir )t t=1 Where: n = the number of periods until the bond matures CFt = the cash flow received in period t Ir = the required rate of return on the particular bond Alternatively, visualize a bond's cash flows with this time line diagram, where the 50s are interest payments and the 1000 is the maturity payment, over the 15-year maturity: Better still, an Excel spreadsheet offers a visualization of both the valuation equation and the diagram, plus, you can enter the inputs and perform the calculations. In the first panel below, the price of the bond is known, $932.26. The $50 interest payments are known, and the $1,000 maturity payment is known. The Sum row shows you the totaled cash flows for this bond. Excel uses its Internal Rate of Return function to calculate the yield on these cash flows, YTM = 7%. In the second panel below, the situation is turned around. The cash flows for the bond are known as in the first panel, as is the 7% required rate of return demanded by the investor. Excel discounts the cash flows at the 7% required rate of return to determine the price of the bond, $932.26. 7 SOLVE FOR YTM GIVEN PRICE Market Price Interest Maturity Pmt Sum YTM 0 -932.26 2 3 4 50.00 50.00 50.00 50.00 50.00 50.00 50.00 1,000.00 1,050.00 1 50.00 2 50.00 3 50.00 50.00 -932.26 7.00% 1 50.00 50.00 SOLVE FOR PRICE GIVEN YTM 0 Interest Maturity Pmt Cash Flows Req. R of R Value 4 50.00 1,000.00 1,050.00 7.00% 932.26 The required rate of return on the bond is also referred to as its yield-to-maturity (YTM). A bond with a coupon rate of 6% may have a higher or lower yield-to-maturity. A bond that has a higher yield-to-maturity than its coupon will sell at a lower price than its face value, referred to as a discount. A bond that has a lower yield to maturity than its coupon will sell at a higher price than its face value, referred to as a premium. Coupon rate is determined at the time a bond is issued, consistent with the level of interest rates at that time. This is called the 'going rate'. As interest rates gyrate during the life of the bond, the price of the bond adjusts upwards or downwards so that it's yield to maturity approximates the 'going rate'. 8 Recapping the Above plus How to Use the Excel Formulas See tab#2 in Bond Questions Support Template.xlsx for a summary 'bond diagram'. Think of a bond as a contract between issuer and investor. Issuer promises to pay a fixed rate of interest (coupon rate) for a fixed period of time (years to maturity), the repay the principal (amount borrowed - par amount). Therefore, the VALUE of the bond is the present value of its future cash flows, discounted at the REQUIRED RATE OF RETURN demanded by the investor (called YTM, YIELD TO MATURITY). The coupon rate is fixed and does not change. (Current yield = annual interest payment divided price paid for the bond, stated as a percentage) The years to maturity is fixed and does not change. The par amount is fixed and does not change. The investor's required rate of return changes, depending on interest rate trends (as interest rates rise, investors demand higher return), and the credit rating of the bond (RISK - the greater the risk, the greater the required rate of return). Interest is $50 per year (5% coupon rate * $1000 par amount), the years to maturity is four years, and the maturity payment is $1000 (par amount). Sum the cash flows, and discount them to their present value using the 7% required rate of return (required YTM), and you get $932.26 for the value of the bond. If the market price of the bond is less than $932.26, the investor would buy it. If it is priced at more than $932.26, the investor would not buy it because the YTM would be too low...below the required rate of return. In this calculation, Value is the unknown number that you solve for. The formula in B23 is =NPV(B22, C21.F21) You can do the present value calculation by hand by taking the present value at 7% of each of the cash flows, one at a time, and summing them. The calculation can be turned around if you know the market price and want to find out what the rate of return (YTM) is, i.e., you solve for YTM. A 18 19 20 21 22 23 B C D E F 0 Interest Maturity Payment Cash Flows Req. Rate of Return Value 1 50 2 50 3 50 0 7.00% $932.26 50 50 50 4 50 1000 1050 The Excel panel below allows you to enter the price paid for the bond by the investor, the interest (par amount * coupon rate), and return of the par amount when the bond matures (sale price). 9 A 10 11 12 13 14 15 Market Price Interest Maturity Payment Sum YTM B C 0 -932.26 D E F 2 3 4 50 -932.26 7.00% 1 50 50 50 50 50 50 1000 1050 Market Price at period zero (the time of purchase) must be entered in B11 as a negative number...it is a cash outflow. The other numbers are positive...cash inflows. I hope you learned the concept of INTERNAL RATE OF RETURN when you learned about Time Value of Money Calculations. If not, wait until MBAD 234. The solved-for YTM of 7% in B15 is calculated with the IRR built-in function in Excel. It is analogous to the interest rate on a savings account in a bank: you deposit $932.26, withdraw $50 at the end of the next 4 years, and at the end of the 4 th year close the account and withdraw $1000. The rate of return, IRR, (in bond valuation it is called YTM) is the rate the savings account would offer for the above-stated transactions to take place. To calculate IRR (YTM), you need Excel or a financial calculator. It is not a formula and cannot be calculated by hand - it is a trial and error calculation that will be explained in class. The built-in formula in B15 is =IRR(B14.F14) If you get an error message, it means that the computer stopped the trial-and-error process of calculating IRR before it got a result...the pre-set number of trial-and-error iterations did not produce a result. By entering a guess of the IRR in the built-in formula, you give Excel a hint, such as 5%, about where to start the trial-and-error process: =IRR(b14.f14, .05) You can't do the IRR calculation by hand; you need either Excel or a financial calculator. Bond Duration The metric called duration is used to measure how sensitive a bond (or a bond portfolio) price is to changes in interest rates. Think back to what was said about volatility in bond prices - that volatility is driven by changes in interest rates in the economy and changes in the bond rating. Major shifts in interest rates, and major shifts in ratings, as we have recently experienced in a panic-driven economy, cause volatility in bond prices. The duration metric allows you to predict how much price change will occur in a bond given a change in interest rates, a valuable tool for investors who want to control for risk - in this context risk is defined as a loss in the market value of a bond. The duration tool would not be relevant to an investor who intends to hold the bond to maturity. However volatile the interim price movements of a bond, in response to interest rate gyrations in the economy, as long as the issuer does not default, the bond will be worth 100 cents on the dollar at its maturity date. (If you are interested, and it's okay if you are not, the root of the mark-to-market controversy lies here...for investors who intend to hold to maturity, where default risk is low, marking to market as prices fall, is irrelevant, except where regulations require adjustments to capital to compensate for the (transitory) loss in value.) 10 Wikipedia does a good job of defining duration in relatively non-technical language, with my shortening and paraphrasing: The duration of a bond is a measure of the sensitivity of the bond's price to interest rate movements. It is equal to the ratio of the percentage reduction in the bond's price to the percentage increase in the yield of the bond (or vice versa). The units of duration are years, and duration is always between 0 years and the time to maturity of the bond. It is equal to the time to maturity if and only if the bond is a zero-coupon bond. One way to follow this is that the value of more distant cash flows is more sensitive to the interest rate, or yield: when calculating the present value of the cash flows under a bond, one divides each future cash flow by the (yield plus one) to the power of the number of years until that cash flow occurs: (1 + y) n - thus the present value of more distant future cash flows is more sensitive to changes in yield. Consider these points: A bond that pays interest on a semi-annual basis will have a duration that is less than its maturity. A zero coupon bond, where all cash flows are received only at maturity, has a duration equal to its maturity. Maturity is a deficient measure of risk because it only takes into account the final payment at maturity and not all interim cash flows. Duration is a measure of the weighted average time until receipt of all cash flows. The formula for duration is: n t x PV(Ct) / price of the bond t=1 Where: t= Ct = time period in which the cash flow is received interest or principal payment occurring in time period t All else being equal, some properties of duration are: Longer maturity bonds have higher duration; however, duration increases at a decreasing rate as maturity lengthens, so long bonds are more price volatile than short bonds. These are discount bonds. Lower coupon bonds have higher duration. Lower yield-to-maturity bonds have higher duration. In the spreadsheet shown below, you can see how duration is calculated. I will not ask you to do the calculation of duration, but you are expected to understand generally how the duration metric is calculated, and how it is used. Column J is the period number Column K lists the cash flows - K82 says that bond is bought for $850, at a discount. K84.K95 tells you the coupon rate is 14%, paid semi-annually. K95 tells you the maturity payment is $1000. The bond matures in 6 years (12 interest payments). 11 Column L is the present value of each cash flow in Column K, discounted at the yield to maturity of the bond, 18.2%. L84.L95 sums to the price of the bond, $850, as it should, since the price of the bond is the present value of its cash flows discounted at the investor's required rate of return, YTM. Column M is the ratio of each cash flow to the price of the bond. Disregard the -1 in M83. Column N shows the time periods as half years because the interest payments are semi-annual. Column O multiplies Column M by Column O to accomplish the time weighting. The sum of Column O is the duration metric, 4.088. The formula for the price change calculations is % P = -DUR X (i/(1+i) The percentage change in the price of the bond equals minus duration (inverse relationship) times the ratio of the interest rate percentage change to the (1+beginning interest rate) J K L M N O 8 2 p e r io d cf pv of cf p v /p r ic e tim e p v * tim e 83 0 -8 5 0 -8 5 0 .0 0 -1 0 0 84 1 70 6 4 .1 6 0 .0 7 5 0 .5 0 .0 3 8 85 2 70 5 8 .8 0 0 .0 6 9 1 0 .0 6 9 86 3 70 5 3 .9 0 0 .0 6 3 1 .5 0 .0 9 5 87 4 70 4 9 .4 0 0 .0 5 8 2 0 .1 1 6 88 5 70 4 5 .2 7 0 .0 5 3 2 .5 0 .1 3 3 89 6 70 4 1 .5 0 0 .0 4 9 3 0 .1 4 6 90 7 70 3 8 .0 3 0 .0 4 5 3 .5 0 .1 5 7 91 8 70 3 4 .8 6 0 .0 4 1 4 0 .1 6 4 92 9 70 3 1 .9 5 0 .0 3 8 4 .5 0 .1 6 9 93 10 70 2 9 .2 8 0 .0 3 4 5 0 .1 7 2 94 11 70 2 6 .8 4 0 .0 3 2 5 .5 0 .1 7 4 95 12 1070 3 7 6 .0 1 0 .4 4 2 6 2 .6 5 4 9 6 from 18.2% to 17.2% with duration of 4.008 gives falling 97 1 8 .2 % 8 5 0 .0 0 4 .0 8 8 -4.008 x (-.01/(1.182) = about .0346 98 y tm dur Therefore, interest rates 3.46% x $850 = about $29.40 price rise triggered by the 100 basis point (1%) change in interest rates For example, if you have $500,000 in a bond portfolio with duration of 10 (portfolio duration is the dollar-weighted average of the individual bond durations), a rise in interest rates from 4% to 6% would cause a loss in market value of about $96,153. -10 x (.02/1.04) = about .1923 19.23% X $500,000 = about $96,153. The diagram below shows the inverse relationship between bond prices and interest rates. As interest rates move upwards, bond prices move downwards. The green line for a 30-year bond is much steeper than the blue line for a 1-year bond. This long bond has a higher duration than a short bond, hence it will have a bigger percentage change driven by a given percentage change in interest rates. We are not going to discuss the curvature in the line, beyond the scope of this course. 12 Reinvestment Rate Risk Imagine a buy-hold 20-year bond in a pension fund with a yield to maturity of 6%. Each year, interest rates gyrate up and down, and coupon income is reinvested at the prevailing going rate. Over a holding period of 20 years, will the pension account grow at a compounded rate of 6%? Maybe yes; maybe no. Compounding occurs at the various yields into which annual coupon income is invested, year-by-year. If rates steadily decline over the 20 years, or stay below the 6% YTM of the bond, the overall growth of the bond account will be less than 6%. Of course, it may be above 6% if the trend of interest rates is upwards, or always above the 6% YTM of the bond. The issue of reinvestment rate risk is important to portfolio managers, especially those who run pension funds, because a target rate of return for a long time horizon, set in terms of the YTM on the bond purchased, may not be achieved. Zero-coupon bonds do not have reinvestment rate risk because they have no coupons. (Please know that the term 'coupon' is archaic. Most bonds automatically pay interest to their registered owners. Owners do not 'clip the coupon' from the bond and send it in to claim payment, as was done a long time ago. Every now and then, a story is reported about 'bearer bonds with coupons attached\" being stolen. It's finders keepers because these are unregistered bonds.) Determination of Interest Rates Interest rate forecasting is an arcane subject - not within the scope of this course. It is reasonable, however, to discuss the components of interest rates. This short list shows the standard determinants. Think of it as a foundation with bricks layered on top of it, row by row. Real (inflation-adjusted) risk-free rate (shortest term Treasury bill) 13 Inflation risk premium Default risk premium Maturity premium Liquidity premium Most Active Investment Grade Bonds Issuer Name GENERAL ELEC CAP CORP MTN BE APPLE INC RABOBANK NEDERLAN D DEP MTNS BE BANK NEW YORK MTN BK ENT GOLDMAN SACHS GROUP INC JPMORGAN CHASE & CO PETROBRA S GLBL FIN BV AMERICAN EXPRESS CO APPLE INC Symbol GE.AUA AAPL400180 9 Coupon Maturity Moody's/S& P/Fitch 2.90% Jan-17 A1 /AA+ / 2.40% May-23 Aa1 /AA+ / RABO39814 35 1.70% Mar-18 Aa2 /AA- / BK3919186 1.30% Jan-18 Aa3 /A+ /AA- GS3956651 3.63% Jan-23 A3 /A- /A JPM.QZZ 2.60% Jan-16 A2 /A /A+ PBR4006641 3.00% A3 /BBB Jan-19 /BBB AXP4007495 AAPL400181 0 1.55% A3 /BBB+ May-18 /A+ 3.85% May-43 Aa1 /AA+ / 3.30% The first two determinants are embedded in Low Yield% the market Last (going rate) on all securities: rate Change the floor rate on a T-bill and a premium to compensate104.422 for purchasing power risk. 105.823 103.819 0.118 1.616965 Securities 94.1794other than Treasury 96.217 93.934 -0.1596 3.087996 billsotes/bonds have default risk depending on their credit ratings, hence the default risk 98.94 98.103 98.492 0.026 2.034057 premium. Longer term securities require 98.762 98.712 98.712 0.829 committing money for a 1.590923 time during longer which uncertainty can occur, hence the 99.066 96.823 97.087 0.033 3.993017 maturity premium. Securities that are thinly traded101.7 require a liquidity premium to 103.65689 103.445 -0.23461 1.237804 compensate for a loss in value if they must be 97.208 94.576 94.812 marked down to be -2.31132 4.046803 sold. High Jan-23 Baa2 /A- /A BANK AMER CORP BAC3953005 99.552 Symbol SLM CORP S3888638 Coupon 7.00% S3928946 DISH390306 5 6.00% GJM.GX 7.50% HMA389780 8 MLET36774 70 5.88% 7.38% 10.00% Maturity Aug-20 Nov-22 Moody's/S& P/Fitch High B3 /B+ /B+ B3 /B+ /B+ Jul-22 Ba3 /BB- /BBSep-20 B1 /B+ /BB- 98.385 -0.157 1.894541 95.386 95.57 -0.54 3.857936 You need to be familiar with the general run of capital market rates that exist in the economy. No need to memorize them, just be aware that theseLast trends Change and know how to exist Yield% Low interpret them. 97.636 Most Active High Yield Bonds Issuer Name SPRINT NEXTEL CORP SPRINT NEXTEL CORP DISH DBS CORP ALLY FINL INC HEALTH MGMT ASSOC INC NEW HARRAHS OPER INC RITE AID CORP DISH DBS CORP SANDRIDGE ENERGY INC 98.207 Five Charts Showing Historical Trends 92.923793 90.163 90.5 0.197471 4.426009 107.75 106.25 107.5 0.75 5.707577 #1 Corporate bond ratings and prices in 103.375 102.75 103 0.25 5.584985 June 2013 (zoom page if necessary) 102 99.33 0.08 5.970856 Source: FINRA 99.33 TRACE data. Reference information 114.1875 114.33 -0.17 5.106691 from Reuters DataScope Data. Credit ratings from Moody's, Standard & Poor's, and Fitch Ratings. 116.25 Jan-20 B3 /B- /BB- 111.5 109.5 109.5 -0.125 4.773575 Dec-18 /CCC- /CC 61.25 57.6875 57.6875 -0.3125 24.375469 112.1875 111.75 111.75 0.0625 4.05203 98.5 95 95.5 1.75 5.602435 101.439 97.53 98 -0.812 7.846344 107.559 105.7 107.535 1.135 3.210645 RAD.HU DISH399622 5 8.00% Aug-20 B1 /B+ /BB- 5.00% Mar-23 Ba3 /BB- /BB- SD.AH 7.50% Mar-21 SLM.GJK 6.25% Jan-16 B2 /B- / Ba1 /BBB/BB+ Most Active Convertible Bonds Issuer Name XILINX INC XILINX INC NAVISTAR INTL CORP NEW LAM RESEARCH CORP TESLA MTRS INC ELECTRONI C ARTS INC TIBCO SOFTWARE INC TAKE-TWO INTERACTIV E SOFTWARE SALIX PHARMACE UTICALS INC STARWOOD PPTY TR INC Symbol XLNX.GD XLNX.GB NAV.GM Coupon Maturity 2.63% Jun-17 3.13% Mar-37 Moody's/S& P/Fitch High Low Last Change Yield% /BBB+ / 144.3065 139.5998 140.955 -3.984 -6.242657 /BBB- / 137.1235 132.693 132.8393 -4.9635 1.479683 3.00% Oct-14 /CCC+ /CC 1.25% May-18 /BBB- / 1.50% Jun-18 // 0.75% Jul-16 // MS4001241 2.25% May-32 TTWO39288 51 1.75% SLXP399243 4 STWD39682 94 LRCX385491 1 TSLA400790 1 ERTS38767 67 100.5 98.95 99.2249 -0.3671 3.600712 113 110.5 110.55 -0.7 -0.849109 109.071 107.5 107.7121 1.3121 -0.05396 103.2 102.0212 102.066 -0.161 0.077799 // 98.4109 97.9703 98.125 -0.125 2.373758 Dec-16 // 114.6463 111.733 113.5 -5.5234 -2.003392 1.50% Mar-19 // 121.5929 119.25 119.25 -0.4978 -1.677958 4.55% Mar-18 /BB- / 106.366 105.9148 106.267 -0.1774 3.106874 14 15 The first column lists the name of the corporate issuer. The second column lists the symbol that describes the bond. The third column lists the coupon rate on the bond. The fourth column lists the maturity date on the bond. The fifth column lists three ratings. Obviously, the rating is not printed on the bond. Ratings are provided by the so-called 'ratings agencies': Moody's, S&P, and Fitch. These companies (private businesses, not regulated by the government - I resist calling them 'agencies') charge fees for these ratings, paid by the firms who issue the bonds. Strange combination, isn't it? Ratings sometimes differ between Moody's and Standard and Poor's. Columns 6-8 list the high, low, and last (closing) price for this particular day, as a percentage of the par value (face value) of the bond. The ninth column lists the percentage change in price for the day. The tenth column lists yield to maturity. That's the key number that the investor is looking at, relating YTM (return) to rating (risk). I'm not suggesting that you graph it on paper - you can do it with your eye - comparing the yield to maturity to the rating, to see the risk-return trade-off: the lower the risk, the lower the yield to maturity. The following are some observations gleaned from examining the data: Some bonds are discount bonds and others are premium bonds. Discern which is which. If the corporation issued the same bond today, it would likely have a lower coupon rate because interest rates have dropped. So the previously issued bond, in order to have the same yield to maturity as a newly issued bond of the same quality, sells at a premium. Notice the relationship between the rating and the yield (YTM). The lower the rating, the higher the yield. Convertible bonds (exchangeable for common stock) sell at lower YTMs than straight (no convertibility) bonds because the option value of the conversion pushes the price up and the YTM down. #2- Long-term rates of return and risk for six asset classes and inflation The context is rates of return and standard deviations of the fixed-income asset classes: long-term governments, intermediate-term governments, and Treasury bills, compared to equities. These data cover the period 1926-2005. (The Week 3 PDF showed the updated information; it will be repeated in Week 7.) Geometric Arithmetic Standard Mean Mean Deviation Largecompany stocks Smallcompany stocks Long-term corporate bonds Long-term government bonds Intermediateterm government bonds US Treasury bills Inflation 10.4% 12.3% 20.2% 12.6% 17.4% 32.9% 5.9% 6.2% 8.5% 5.5% 5.8% 9.2% 5.3% 5.5% 5.7% 3.7% 3.8% 3.1% 3.0% 3.1% 4.3% Are you surprised that bond returns have standard deviations? You should not be the least bit surprised, after the discussions in the PDF about bond price volatility, caused by gyrating interest rates and changes in credit ratings (the government bonds in the table 16 are subject only to gyrating interest rates, not changes in credit ratings). Since prices of Treasury bonds change, rates of return change with them. A standard deviation describes the distribution of these rates of return around their average rates of return. #3- Yield curve You should know what a yield curve is and how to interpret it. The yield curve for Federal government securities on 26 September 2011 is shown below. The dark line is for that day. The light line is for one month ago - meaning that single day one month prior. The light gray line is for one year ago - that single day one year prior. The horizontal axis lists the maturity dates, so the chart plots YTM from left to right as maturity increases. That's the purpose of a yield curve. Risk is held constant - all securities shown are Federal government bonds with no default risk, i.e., risk free. Comparing the lines tells you how rates have changed. Notice that short-term rates have changed little and long-term rates have changed more. Source: The Wall Street Journal, September 26, 2011 The yield curve below is for 18 February 2012, little changed from 26 September 2011. 17 This is the yield curve as of June 13, 2013. Yield curve above as of February 4, 2014 US TREASURY YIELD CURVE 18 http://www.bondsonline.com/Todays_Market/Composite_Bond_Yields_table.php Follow the link above - optional - to see both tabular and graphical data for Treasurys, Municipals, Corporates, and Certificates of Deposit. Below are two other yield curves, from the PIMCO website. The one above as of now shows the typical upward-sloping curve. The one on the left below shows a flat curve as of the date shown, when there was very little difference between the yields on short and long Treasuries. The one on the right below shows an inverted curve, when short rates were higher than long rates. 19 #4 - Interest rate trends for five bond market sectors - 1990 through now 'Seasoned' refers to the amount of time the bond has been trading, allowing traders and investors to become familiar with it. 'Unseasoned' securities, which haven't been trading long, typically might sell at higher yields to maturity because they're viewed as a little riskier until they become seasoned. The blue line is the 6-month T-bill, showing the most volatility, which you would expect because short rates are more volatile than long rates. The other lines track together, not exactly the same, but close. Let's look at them one at a time. The brown line is the seasoned BAA, riskier than the green line for AAA, so it carries a higher yield to maturity. Notice the vertical distance between the lines. That is called the 'spread'. It doesn't stay constant. Investors change their impressions of the relative riskiness of the bonds. When one is regarded as much more risky than the other, the yield spread widens. The red line is the 20-year treasury security, default-free. Why is that below the two corporate bonds? It is default-risk free, so it must carry a lower yield to maturity than a bond with default risk. Yield spread varies quite a bit over that period of time. The purple line is municipals. They are tax-free, with lower yields to maturity, not because they are default-risk free (they do have default risk), but because there is no Federal income tax payable on the interest income. There is a calculation that puts municipal bonds on a taxable equivalent basis; if these were adjusted to a taxable equivalent basis they would have higher yield-to-maturity. The taxable equivalent yield equation is: muni yield/(1-tax rate); if the muni YTM is 4% and the investor's tax rate is 36%, the taxable equivalent yield is .04/.64=.0625, or 6.25%. The following are some generalities gleaned from examining the data: You can see that short rates are more volatile than long rates. You can see a downward trend in rates in all sectors. 20 You can see a tendency for the spreads between the rates in different sectors to narrow during some time periods and widen during others. Widening is occurring now because of increased risk aversion during the financial crisis. Spreads between different sectors tell you how much the market is paying investors for taking on risk. The narrower the spread between a default-free treasury bill and a Baa corporate bond, the less the risk premium earned by an investor. Recent spread widening has now narrowed. #5- Interest rate spread: Aaa to Baa Yields The same thing as above can be read from the #4 chart, but, I want to highlight the concept of spreads. The yield differential between different sectors of the bond market is a metric used to forecast the direction of bond prices - very hard to do. Nevertheless, a wide spread, combined with the notion of regression to the mean, may indicate a reversal in spreads that are either historically too high or too low. But, to be sure, the wide spread in recent years is a flight to quality, forcing yields on lower quality bonds to go up (investors demanding more return as they perceive greater risk). Also, remember the inverse relationship between bond prices and interest rates - as yields rise, bond prices fall. 21 ITEM #2- S&P RATINGS (AGENCY?) A-UNITED STATES LOSES PRIZED AAA CREDIT RATING FROM S&P By Walter Brandimarte and Daniel Bases, NEW YORK Aug 6, 2011 (Reuters) - The United States lost its top-tier AAA credit rating from Standard & Poor's on Friday in an unprecedented blow to the world's largest economy in the wake of a political battle that took the country to the brink of default. S&P cut the long-term U.S. credit rating by one notch to AA-plus on concerns about the government's budget deficit and rising debt burden. The action is likely to eventually raise borrowing costs for the American government, companies and consumers. "The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics," S&P said in a statement. The outlook on the new U.S. credit rating is "negative," S&P said in a statement, indicating another downgrade was possible in the next 12 to 18 months. The move reflects the deterioration in the global economic standing of the United States, which has had a AAA credit rating from S&P since 1941, and it could have implications for the U.S. dollar's reserve currency status. "The global system must now adjust to the many implications and uncertainties of the once-unthinkable loss of America's AAA," said Mohamed El-Erian, co-chief investment officer at Pacific Investment Management Co which oversees $1.2 trillion in assets. The decision follows a fierce political battle in Congress over cutting spending and raising taxes to reduce the government's debt burden and allow its statutory borrowing limit to be raised. On August 2, President Barack Obama signed legislation designed to reduce the fiscal deficit by $2.1 trillion over 10 years. But that was well short of the $4 trillion in savings S&P had called for as a good "down payment" on fixing America's finances. The political gridlock in Washington over addressing the long-term fiscal problems facing the United States came against the backdrop of slowing U.S. economic growth and led to the worst week in the U.S. stock market in two years. The S&P 500 stock index fell 10.8 percent in the past 10 trading days on concerns that the U.S. economy may be heading into another recession and because the European debt crisis has worsened. Treasury bonds, once indisputably seen as the safest security in the world, are now rated lower than bonds issued by countries such as Britain, Germany, France or Canada. B- COST OF RATINGS SUIT: $225 MILLION By Jeannette Neumann, The Wall Street Journal, April 29, 2013 Friday's settlement that ended lawsuits against two credit-rating firms and Morgan Stanley MS +0.98% will cost the three companies a total of about $225 million, according to a person familiar with the matter. 22 The settlement amount was divided evenly between Standard & Poor's Ratings Services, Moody's Investors Service and Morgan Stanley, this person said. Terms of the agreement, announced about two weeks before a trial was set to start, weren't disclosed in a court filing Friday. Reuters The settlement was divided among S&P, Moody's and Morgan Stanley. McGraw-Hill Cos.' Standard & Poor's Ratings Services and Moody's Corp.'s Moody's Investors Service and Morgan Stanley were accused by more than a dozen plaintiffs of inflating and concealing the risks in mortgage-related deals called Cheyne and Rhinebridge. More than a dozen plaintiffs, led by Abu Dhabi Commercial Bank and King County, Washington, claimed Morgan Stanley also was responsible for losses suffered by investors because the two deals were created and sold by the securities firm's investment bankers. The deals plummeted in value during the financial crisis. The Cheyne lawsuit sought $638 million in alleged lost principal and interest, according to Piper Jaffray PJC +0.64% & Co. analyst Peter Appert. The Rhinebridge lawsuit sought $70 million, he said. The settlement amount is less than one-third of the total sought by investors in Cheyne and Rhinebridge. The $75 million cost to S&P is likely to be a relief to some McGraw-Hill shareholders, who are wrestling to assess the company's potential exposure to February's lawsuits against the rating firm by the U.S. Justice Department and state attorneys general. Those suits allege that S&P misrepresented the independence and objectivity of its precrisis ratings. The company has repeatedly said the federal and state suits are "meritless" and is fighting them in federal and state courts across the U.S. A jury trial for the Cheyne-related suit was set to start May 13 in a federal court in New York. The trial was scheduled to take as long as eight weeks. Legal experts predicted a public airing of many of the same claims that are at the heart of the Justice Department's lawsuit. No trial date had been set for the Rhinebridge suit. Rhinebridge and Cheyne were so-called structured investment vehicles. A SIV is an entity that issues short-term commercial paper and medium-term notes to then buy long-term assets such as bonds backed by home mortgages. Plaintiffs in the two suits claim ratings on both deals were inflated, concealing their risks. Spokesmen for McGraw-Hill, Moody's and Morgan Stanley declined to comment. Investors breathed a sigh of relief Monday about the settlement. Moody's shares jumped 8.3%, or $4.57, to $59.69 in New York Stock Exchange composite trading at 4 p.m., while McGraw-Hill rose 2.8%, or $1.45, to $53.45 and Morgan Stanley climbed 3.8%, or 81 cents, to $22.21. McGraw-Hill is set to report first-quarter earnings on Tuesday morning. 23 In a research note Monday, Mr. Appert wrote that Friday's settlement "removes ongoing legal costs for [Moody's] and [McGraw-Hill] and eliminates the risk of a jury trial and potential appeals process that could have lasted several years." The Piper Jaffray analyst added: "While the rating agencies have not traditionally settled, our sense is the settlement is based on balancing legal costs and the risk of a negative outcome with the cost of a settlement." He said both rating firms have "adequate balance sheets to cover a settlement." As part of their preparation for trial, plaintiffs in the Cheyne and Rhinebridge suits amassed thousands of pages of alleged email correspondence, testimony and other documents. In an August 2012 ruling, U.S. District Judge Shira Scheindlin in Manhattan cited several pieces of that correspondence, allowing some of the plaintiffs' allegations to move closer to trial. One example: an email where S&P's lead analyst on the Cheyne deal wrote: "I had difficulties explaining 'HOW' we got to those numbers since there is no science behind it." The judge also cited an email from a Moody's analyst who wrote that there was "no actual data backing the current model assumptions" on the Cheyne deal. "Perhaps most relevant is evidence provided by plaintiffs indicating that Morgan Stanley pressured the rating agencies to issue ratings it did not believe were accurate," the judge wrote. She cited a July 2004 email from S&P's top Cheyne analyst to Morgan Stanley's lead banker on the deal. The S&P analyst told the banker that the rating firm planned to assign triple-B ratings to some of the notes. The Morgan Stanley banker replied that "the position the committee is taking is very inappropriate." Rating analysts at S&P and other rating firms are on committees that vote and then rate securities. "S&P acquiesced and assigned the notes an 'A' rating," Judge Scheindlin wrote. The Morgan Stanley banker "boasted that Morgan Stanley's efforts 'did get us the rating we wanted in the end,'" she added. A version of this article appeared April 30, 2013, on page C3 in the U.S. edition of The Wall Street Journal, with the headline: Cost of Ratings Suit: $225 Million. C- UPDATE - FEBRUARY 2015 - DEAL BOOK, THE NEW YORK TIMES BY SYDNEY EMBER THE ROAD TO S.&P.'S SETTLEMENT An overflow crowd of government regulators, including attorneys general from states across the country, spent a day in January ticking off their demands before eventually negotiating a $1.37 billion settlement with the giant ratings agency Standard & Poor's, Ben Protess reports in DealBook. The settlement, expected to be announced on Tuesday, was the culmination of a heated, twoyear fight between S.&P. and the Justice Department, according to an account assembled through interviews. The Justice Department's case and lawsuits from 19 state attorneys generalgenerated years of animosity, the interviews show, that eased only after management changes at S.&P. and the Justice Department allowed both sides to reconsider their bargaining positions, Mr. Protess writes. S.&P., for instance, 24 agreed to retract its claim that the Department's lawsuit was "retaliation" for S.&P.'s decision to cut the credit rating of the United States in the summer of 2011. S.&.P. also managed to wring a number of concessions from the government, avoiding, for example, admitting that it had committed fraud. Still, S.&.P.'s payout, which is big enough to erase the rating agency's operating profit for a year, underscores the risks of not settling in the first place. "If S.&P. had backed down two years ago, when the Justice Department was readying its case and willing to settle for what it called '$1 billion plus,' the rating agency most likely could have paid a similar penalty without accruing tens of millions of dollars in legal fees," Mr. Protess writes. A lastditch attempt at the settlement occurred in January at the Justice Department. A compromise eventually emerged, but not without doughnuts and a dish of Hershey's Kisses. ITEM #3- REAPING WISDOM ON 'JUNK' By Francesco Guerrera, The Wall Street Journal, May 7, 2013 Behind the hype of high-yield corporate bonds and investors' understandable desire to make money, bad habits are creeping back in. In 1977, a band of Los Angeles-based traders led by Michael Milken helped Texas International, an oil company, raise the first "junk" bond. The small issue$30 millionopened a chapter in the history of finance. From then on, companies with less-than-pristine balance sheets were able to tap capital markets, while investors had the option of betting on securities with higher risks, and potentially higher returns, than traditional corporate bonds. 'Junk' debt pioneer Michael Milken. Last week, one of those traders, Leon Black, returned to L.A. and surveyed the landscape 36 years on. "The financing market is as good as we have ever seen it," Mr. Black, now the head of the private-equity firm Apollo Global Management LLC, said at a conference organized by his old boss at Drexel Burnham Lambert Inc. As declarations go, Mr. Black's comment is to Wall Street what prime minister Harold Macmillan's "we have never had it so good" was to Britain in 1957: a statement of fact and a bearish signal for the future. (Within years, Mr. Macmillan's government had become deeply unpopular. By 1963, he was gone.) 25 Facts first, worries later. Mr. Black's comments stand to reasonwith central banks keeping rates low around the world, investors crave returns from riskier assets like "junk" bonds and equities. Issuance of high-yield bonds, the more polite moniker for "junk," hit records in both the U.S. and Europe in 2012, according to Dealogic. This year has started in the same vein, with high-yield volumes rising at the fastest-ever clip. That is great news for companies such as cable television operator Charter Communications Inc., which just saved a bundle by selling $1 billion of bonds to replace more-expensive debt. For investors, though, the glut of demand is beating down returns. Last week, junk bond yields, which move inversely to prices, plumbed new lows to an average of about 5.2%. If we carry on like this, we may have to change the name of the asset class to "not-so-high-yield" bonds. Fund managers don't care. The important number for them is the spread between returns on junk and returns on Treasuries. On that front, junk is still some 4.5 percentage points above Uncle Sam's papera rich premium and well above the crazily tight spread of 2.4 percentage points seen just before the financial crisis. The euphoria is such that Jeff Cohen, co-head of U.S. syndicated loan capital markets at Credit Suisse AG, recently told The Wall Street Journal: "Junk is a misnomer." I wouldn't rush to change the name just yet. Behind the hype and investors' understandable desire to make money, bad habits are creeping back in. As a veteran of the 2007-2008 turmoil, I am focused on one in particular: "covenant-lite" loans. "Cov-lite" borrowers are the financial equivalent of people with commitment problems. These loans provide the borrowerusually private-equity firms or junk-rated companieswith plenty of opportunities to delay paying back the full amount. Issuance of these loans exploded just before the crisis, as buyout firms launched ever-larger takeovers and banks engaged in a destructive race to the bottom, ceding a huge amount of power to borrowers and ending up with large losses. Cov-lites are now coming back. Last year saw the biggest issuance since 2007 and this year is on course to beat 2012. That is worrisome, even for some users of risky paper. Ironically for a conference bearing the name of the father of junk-bond market, the Milken jamboree was overflowing with financiers expressing concern about cheap debt. At one panel, I listened as two big-time property developersStarwood Capital Group's Barry Sternlicht and Equity International's Sam Zellwere almost apologetic for how easy it is to raise money in the current environment. 26 Mr. Black himself sounded a gloomy note. Asked whether Apollo would take advantage of the wave of cheap capital to go on an acquisition spree, Mr. Black said that rising stock markets actually made it a great time to sell or list companies. Rivals seem to agree. High valuations and the reluctance on the part of cash-rich corporations to dispose of assets have offset the wave of cheap money, leaving private-equity firms more willing to sell than to buy. Last year, U.S. private-equity "exits"sales, initial public offerings and other divestmentsreached the highest level since 2007. "It's almost biblical: There's a time to reap and there's a time to sow. We are harvesting now," Mr. Black said. For investors' sake, let's hope the Old Testament parallels stop there. A few verses later, the Bible reads: "All go unto one place; all are of the dust, and all turn to dust again." Francesco Guerrera is The Wall Street Journal's Financial Editor Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved ITEM #4- TREASURYS CAN BE PAINFUL, AS HISTORY SHOWS By Ben Levisohn, The Wall Street Journal, September 20, 2010, At the start of the month, with pessimism on the economy peaking, investors rushed to buy longterm Treasurys and dump stocks. For now at least, their timing couldn't have been worse. Since then, 10-year Treasurys have lost 2.2% and 30-year bonds are down 6.9%. The Dow Jones Industrial Average has gained 5.6%. In their rush for safety, many investors may have forgotten that Treasurys are far from risk free. This year's Treasury rally has been spurred by fears of a double-dip recession and deflation. With yields so low, the risks to investors may outweigh the rewardsespecially if those fears fail to materialize. 27 "In order to embrace buying Treasurys now you have to believe U.S. inflation is permanently impaired and growth will be dismal for an extended period," says Tad Rivelle, chief investment officer of fixed income at TCW. "Knock the underpinning from either and it's hard to justify Treasurys at these levels." The recent losses in long-term Treasurys have been modest compared with this year's gain of about 16%. And, of course, investors will only lose money if they sell before the bonds mature. Even then, any losses are unlikely to be as big as losses that could be incurred with stocks or junk bonds. But history has shown that owning Treasurys can be painful. In 2003, the 10-year Treasury yield jumped one percentage point in just two months, resulting in an 8.2% loss in the 10-year Treasury and a 13.3% drop in the 30-year bond based on total returns. Yields rose 2.4 percentage points during a 13-month period beginning Oct. 31, 1993, resulting in a 10.6% loss on the 10-year note. No period, however, can trump the spike in yields that resulted from Federal Reserve Chairman Paul Volcker's battle with inflation. As Mr. Volcker raised the federal-funds rate from 4.17% in January of 1977 to 22.36% in July 1982, yields on 10-year notes surged from around 8.8% to as high as 15.84%, causing a loss of 10.8%. By that point, no one was interested in buying Treasurys. "Many people were saying 'I'm not investing at 15%it's got to be higher,' " said Carl Kaufman, portfolio manager of Osterweis Strategic Income Fund. In the short-term, it would take just a bit of good news or renewed concerns about budget deficits and inflation for Treasurys to suffer losses, even if the economy remains weak. Even in a benign scenario, a return to 4% yields in the 10-year is a possibility, according to William Larkin, portfolio manager for fixed income at Cabot Money Management Inc. in Salem, Mass. That would result in losses of 6.8% on 10-year bonds and more than 10% for the 30-year. "If data keep coming in positive, that would be reasonable in the next six months," Mr. Larkin says. "People forget that we weren't there that long ago." On Friday, the 10-year yield stood at 2.746%. Brian Rehling, the St. Louis-based chief fixed-income strategist at Wells Fargo Advisors, is looking for an even larger rise in yields over the next two years. Mr. Rehling says the 10-year yield could rise to 4.5% in 24 months, generating an 8.2% loss from late August levels. The 30-year yield could jump to 5.3% in the same time, generating a loss of as much as 18.3%. "As the economy recovers, people will be willing to take risks again," Mr. Rehling says. "That could drive rates higher." The worst-case scenario: a spike that sends yields near double-digit levels. It is not out of the realm of possibility, Mr. Rehling says. If the U.S. is to experience another rate shock, it's likely to result from worries about its ability to pay its debt. The dollar's role as a reserve currency makes such a shock unlikely but not impossible. But if the global economy recovers enough that investors decide to dump Treasurys in favor of riskier assets, yields could spike above 6%, Mr. Rehling says. The damage? Investors in 10-year Treasurys would lose around 20% if yields rise to, say, 7% over the next two years. Thirty-year Treasurys would lose about 34% if the yield rises to 7.5%. 28 "You'd see significant losses on long-dated securities," Mr. Rehling says. "Investors say they don't care what the price does, but when it falls dramatically they care more than they thought they did." ITEM #5- A FOG WARNING, AGAIN, FOR MUNICIPAL BONDS By Gretchen Morgenson, The New York Times, February 18, 2012 FEW areas of finance are as opaque as the municipal bond market. Which is astounding, when you consider how crucial this $4 trillion market is to the nation's economic life. Sure, munis seem boring. But without them, state and local finances would collapse. Witness the mess in Jefferson County, Ala., which declared bankruptcy last fall. And so the Securities and Exchange Commission with good reason is trying to bring transparency to the muni market by increasing disclosure requirements. As a result, issuers of munis must now post financial statements, bond rating changes and other material information promptly on the EMMA data site of the Municipal Securities Rulemaking Board. It's a good start. Some 55,000 entities in America issue municipal bonds. But not all of them are adapting well to a new, open world. A case in point is the West Penn Allegheny Health System, one of the biggest bond issuers in muni-land. This five-hospital system in the Pittsburgh area posted $1.6 billion of revenue in its 2011 fiscal year. It has almost $740 million in bonds outstanding, most of which were issued in mid2007. The sheer size of the West Penn bond issue makes it a muni bond bellwether. A genuine market exists for its debt; trades take place fairly often, unlike the situation for many other government bodies, whose bonds essentially change hands by appointment. But West Penn is also worth watching because it has been subject to an S.E.C. investigation since August 2008. An earnings restatement in July 2008 prompted the inquiry, which became a formal investigation in February 2009. West Penn is also noteworthy because it emerged out of the failure in 1998 of the Allegheny Health, Education, and Research Foundation. The bankruptcy of Aherf, as it was known, was the largest among nonprofit health care providers at the time, according to Moody's Investors Service. Some $555 million in debt was affected. Today, West Penn is struggling again. It lost $56 million in the six months ended last December. Its pension plan is underfunded by $200 million. Moody's and Fitch Ratings downgraded West Penn's bond rating last fall, pushing it deeper into junk territory. And last December, KPMG, its auditor, said the system's financial performance for fiscal 2011 raised \"substantial doubt\" about its \"ability to continue as a going concern.\" A potential life raft popped up last year, when West Penn announced a partnership with Highmark Inc., a health insurer with 4.8 million members in Pennsylvania and West Virginia. Under a deal struck in November, Highmark said it would commit up to $475 million over three years to strengthen West Penn's hospitals. So far, West Penn has received $100 million. Obviously, this combination would provide a needed backstop for West Penn. But because it would involve a health care payer teaming up with a health care provider, the agreement must be approved by Pennsylvania's insurance department and attorney general. 29 That will take time, maybe 12 months or longer, according to the Fitch analysts. West Penn, meanwhile, is hemorrhaging cash. As of Dec. 31, the system had 58 days worth of cash on hand. More worrisome is that the potential partnership has attracted interest from the antitrust division of the Justice Department, which has asked that documents relating to the Highmark-West Penn partnership be produced within the next few weeks. Bond holders may be unaware of the Justice Department investigation, however; West Penn has not disclosed it. Such silent treatment from West Penn management is typical, some large bond holders say. The turnaround team hired last fall by West Penn has met with hospital employees, doctors and the Pittsburgh community to outline its plans. But bond holders' requests to meet with management and discuss its turnaround strategy have been rejected, according to a spokeswoman for United Missouri Bank, the bond trustee. Given that the bonds make up roughly three-quarters of West Penn's capital structure, giving those holders the cold shoulder seems odd. It might be acceptable if the system's operations were thriving. But considering West Penn's deteriorating financial position, you'd think its management would be eager to tell its story to bond holders, if only to reassure them. DAN LAURENT, a spokesman for West Penn said the system \"has and will continue to fully comply with all of its disclosure obligations.\" On the question of why the new management team had not met with bond holders, he said that it had recently met with the bond trustee and its advisers. Mr. Laurent declined to comment on the Justice Department investigation. But its silence is also strange, given that West Penn's disclosure practices are already on the S.E.C.'s radar. The regulator has sought information \"related to certain disclosures by WPAHS,\" according to the system's financial statements. As is the custom in such cases, a spokesman for the S.E.C. declined to comment on the status of its investigation. Because the West Penn bond issue looms so large in the muni market, many institutions hold West Penn's debt. The $3.3 billion Goldman Sachs High Yield Municipal fund is an example; as of Dec. 31, it held West Penn bonds with a face value of $90 million. But individuals are also sizable players. So far this month, a vast majority of trades in West Penn bonds were for less than $50,000 worth of the debt. Last week, two transactions totaling $150,000 took place at a price of $84.75. Yields on those trades were about 6.5 percent, a lofty figure, considering that the interest on these bonds is at least exempt from federal income taxes. Although those prices are down some from January trades around par, or $100, investors don't seem exceedingly concerned about West Penn's future. They may be counting on approval of the Highmark transaction or, failing that, perhaps they expect another buyer to emerge. How things at West Penn will play out is anybody's guess. What is clear is this: While disclosure in the muni market has improved, largely at the insistence of federal regulators, getting the full picture from s