Week 6 Workshop Solutions: Long-term Debt Markets

1. Inquisitive Irving is not sure he really understands securitisation and so

has asked you to explain the basics. (Past exam question)

The V&P textbook (8th edition) pages 343-346 discuss the process as well as does
the lecture notes

Securitisation is the creating and sale of new tradeable financial assets which are
backed by other, typically illiquid, existing loans or assets. This transformation
can shift risks and cash flow streams so otherwise illiquid assets become
marketable. It involves the creation of a separate entity (SPV), usually a trust,
specifically to purchase these assets which SPV then finances through the issue of
its own securities. As the cash flow and risk structuring is so important, this also
known as structured finance.

The main attraction to commercial banks and other financial institutions is that
securitisation, by taking these loans the bank’s books for regulatory purposes,
removes both the credit risk and regulatory capital requirements for holding
them. It also helps the bank to fund their clients without having to raise
deposits as well as produce a stream of fee income earned from managing the
loan portfolio (collecting payments and chasing arrears) on behalf of the SPV.

2. Woodside Petroleum Limited has issued $100 million of debentures with a

fixed interest coupon equal to current interest rates of 7.70 per cent per
annum, coupons paid half-yearly and a maturity of 10 years. (Viney &
Phillips, 8th ed., p.349 Q13)
(a) What amount will Woodside raise of the initial issue?
(b) After three years, yields on identical types of securities have risen to
8.75 per cent per annum. The existing debentures have exactly seven
years to maturity. What is the value or price of the existing debentures in
the secondary market?
(c) Discuss why the value of the debentures has changed; that is, explain
the bond price/yield relationship using the above example.

(a) What amount will Woodside raise on the initial issue of the debentures?
• The amount raised by Woodside on the initial issue of the debentures into the market will
be equal to the face value of the debentures; that is, $100 million.
• This is because current yields on this type of security, at the issue date, are equal to the
fixed interest rate paid on the debenture.

(b) After three year, yields on identical types of securities have risen to 8.75 per cent per
annum. The existing debentures now have exactly seven years to maturity. What is the
value, or price, of the existing debentures in the secondary market?
In order to calculate the value, or price, of the existing debentures in the
market, it is necessary to determine the present value of the face value,
plus the present value of the coupon stream (note: the price is being
calculated at a coupon date exactly one year after initial issue).

 1 - (1 + i )−n  
 + A(1 + i ) 
−n
P = C 
  i  
A = $100 000 000
C = $3 850 000
n = 7 x 2 = 14
i = 0.0875 / 2 = 0.043750
Present value of the face value:
= A(1 + i)-n
= $100 000 000 (1 + 0.043750)-14
= $54 909 711.40
plus:
Present value of coupon stream:
= C [1 - (1 + i)-n ]
i

= $3 850 000 [1 - (1 + 0.043750)-14 ]

0.043750
= $39 679 453.97

Price of the debenture: = $54 909 711.40 + $39 679 453.97

= $94 589 165.37

(c) Discuss why the value of the debenture has changed; that is, explain using the above
example the bond price/yield relationship.
• There is an inverse relationship between interest rate movements and price.

• The price of the existing fixed interest security (debenture) has fallen because yields in
the market have risen.
• The coupon payments on the existing bond are fixed; therefore the lower coupon (7.70%
p.a.) being paid on the existing bond is worth less to an investor. However, the investor
will require the current yield of 8.75% p.a. and as the fixed 7.70% coupon cannot be
adjusted, the equalising adjustment occurs with the lowering of the price of the existing
bond.

3. With bond investing, what is meant by “reinvestment” risk?

This question relates to text book material – see page 225.

It is that when the bond is purchased, there is an assumption via the discount rate that
future interest payments are reinvested at that same rate. In practice, interest
rates vary over the life of the debt instrument. So the reinvestment of the
interest payments every six months are likely to be quite different than the
initial interest rate. Investors are of course more concerned about reinvesting
at lower rates.

4. Comment on the following statement,

“If you are worried about losing your money, invest only in AAA rated
bonds. You will never go wrong.” (Past exam question)

The idea here is to realise that the AAA is not a guarantee of a risk free return. AAA
securities can eventually go into default. During the GFC, a number of CDO
generated AAA debt instruments failed to meet their payments

5. As money market securities are known as discounted securities, would it

be proper to refer to a long term bond as a discount bond?

The main idea here relates to a zero coupon bond. Just like a money market
instrument, the interest is effectively the difference between the purchase price
and the end face value on maturity.