Originally posted by: BansheeX
There are only two things that can happen when you make a loan, LK: it gets paid back or it doesn't. A bond's value is thus discounted solely against the probability of default. There are a variety of risks which could make default more likely, and consumers will look at those to assess the amount they're willing to trade, thereby setting the price at which the asset is liquid. Mark to market is a standard accounting practice and most accurately reflects current value. It was a simple statement and concept, your fevered academic ranting isn't relevant criticism here, but since it's your sworn duty to poop on any thread mentioning Schiff or Paul, I forgive you.
ROFL, you're such a tool that you don't even realize the trash you spew.
Bonds get discounted all of the time according to the term structure of interest rates compared to the cashflows of the bond. If interest rates and the term structure is *exactly* the same at *ALL TIMES* during the life of the bond, then the price of the bond would be at par. However, the chances of that happening are nil.
Consider the *FACT* that bonds that yield higher interest rates, in a lower interest rate environment, for the market and desire of the coupon, trade at above par. Does this now mean that the chances the company will default are less than 0%?
Fuck no, it means that the PV of the bond's cashflow is greater than the original 100 par value.
So, for example, if a $100 bond's cashflows yielded 10% per year, for 10 years, with a bullet payment at maturity and current risk- free interest rates are 2% greater than the rate when the bond was priced (lets say it priced at 10% rates, now rates are 12%, liquidity, risk, and other premiums stay *EXACTLY* the same), then the PV of the bond would be...
10/(1+12%)^1 + 10/(1+12%)^2....110/(1+12%)^n, n being the term of the bond. This bond would price below par (since rates went up compared to the original discount rate)
Now, let's say that the risk-free rate + spread was always constant, originally priced...PV would be this...
10/(1+10%)^1 + 10/(1+10%)^2....110/(1+10%)^n
Now let's say that rates went down...
10/(1+5%)^1 + 10/(1+5%)^2....110/(1+5%)^n, bond trades above par.
Now' let's say that the bond trades as if there was a default...
10/(1+10%)^1 + 10/(1+10%)^2....55/(1+10%)^n
Now, you see, that we estimate that after a default, we'll get 50% recoveries with a 100% likelihood of default.
Let's say we assume 50% default with 50% severity.
That would mean...
10/(1+10%)^1 + 10/(1+10%)^2....82.5/(1+10%)^n
But let's combine the two...
10/(1+15%)^1 + 10/(1+15%)^2....82.5/(1+15%)^n
Intreresting, no? Sure, default CAN be priced in, but it isn't the only factor, as you say.
Let's say that the bond's cashflows are different compared to the yield curve. If the bullet payment occurs at odd times, then the discount rate may be different, causing the cashflows to be different.
You do know what duration is, right? Ohh fuck no, you don't, but I'll explain it to you.
Duration is the measurement of a bond's price differential given the differential in interest rates. Thus, if interest rates go up 1%, does the bond's price go down more than 1%, or less than 1%?
It all depends on how the cashflows are structured.
What about convexity? It is a measurement of how a bond's cashflows alter the price the price of the bond given the interest rate environment and the cashflows. If a bond's price fuctuates higher with more smaller movements in rates, it is a very convexed bond, if not, it isn't very convex.
Now, lets say that telecom bonds are more favored than auto manufacturer bonds, thus the price for telecom bonds goes up (yield goes down) and prices for auto bonds goes down (yield goes up, implied discount rate is higher). Is that default?
No.
It is simple preference of the market, not default likelihood.
There are many theories in the bond market as to how bond rates are favored (or not), preferred habitat, term structure, and others, are just samples. Preferred habitat shows that during movements of favor of bonds, terms, and rates, certain habitats of the prior 3 traits may be more favorable than others. If it is more favorable, it is more desire, and the price is higher (yield is lower). If it is less favored, price is lower (yield is higher). Preferred habitats have been shown to change quite rapidly, depending on the current structure of investors.
Given that many funds cannot partake in high-yield assets, if a bond becomes less favored (rates go up), mutual funds may have requirements to dump the bond. Since it isn't a preferred yield, the downward pressure can become more severe.
As far as mark-to-bullshit, what happens if there is no market for a certain bond? Should we merely trade it at the discount rate anybody who wants to buy, will buy it at?
What if the only people who will buy it discount the cashflows at 50%?
10/(1+50%)^1 + 10/(1+50%)^2....110/(1+50%)^n
Wow, that bond is way below par!
Who says that the bond's 50% yield is just default? Well, of course it isn't! It is liquidity premium, risk-free yield, and risk premium.
Right now, I know many AAA bonds that have a very low likelihood of defaulting that were priced at S+60bps before, but are now pricing at S+10%. Why? Because the liquidity in that area is low.
Why is it low? Because people can buy other bonds they prefer at a little lower yield, but they like them better because they know the bonds better. Preferred habitat.
Ohhh, I know you like to deride this as all hooey-pooey, but bond math has been around for hundreds, if not thousands, of years. It is a market that is far larger than equities, and one that is grounded in quite a bit of science. It is also one you don't have one fucking clue about, but like to dismiss out of hand because it's easy, since learning is "hard".
Bond math isn't "acedemic ranting", it is market practice. The CFA charter isn't an acedemic study, per se, it is an application of real-world study for real world application. Something which you have no idea about.
I know that you'll take this long, well thought-out, and learned post and just trash it with non-witty one-liners (ohhhh..."Academic ranting!", how witty!). It's what a cowardwardly, ignorant, slack-jacked knuckle-dragger does when he has no idea how to counter reality.
But I'd love for you to prove me wrong. Please, entertain us with a nice discourse on bond math. People here may actually learn something from somebody other than me, evan, or JS80, or a relatively small group of others.
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