Premium Priced Bonds Offer Value
By TJ Kim
October 11, 2012
There is a common belief that a high coupon bonds should trade wider than par-coupon bonds, disregarding the bond’s maturity . However, credit analyst from Citi group, Jason Shoup and Sonam T Pokwal argue that currently high coupon bonds with maturity inside 10 years are cheaply priced due to the fact that jump risk premium is weighed too high on these bonds.
Two credit analysts constructed a yield using bonds priced at par with maturities ranging from 1 year to 30 years. And on the same grid, they also plotted bonds traded at discount or premium. The analysis suggests,
“… we show the result of applying the process to Caterpillar Inc. We highlight the bonds used for calibration and the model-predicted yields of the off-market coupon bonds. In particular, the CAT 7.9s of 2018 stand out as significantly mispriced, in our view. The current yield is around 1.76%, but the model-predicted yield is only 1.04% – roughly 5 points higher. Of course, the model does not take into account liquidity, which, in practice, clearly contributes to the high-dollar discount. Indeed, the CAT 7.9s of 2018 haven’t traded in block size in over two months according to TRACE even though the issue size is $900mm. And yet, we’d argue that liquidity alone is an insufficient excuse for pricing high-coupon bonds so cheaply. For if one looks at the model implied errors for each Caterpillar bond (Figure 4), it’s clear that the shorter-dated bonds have larger errors than the longer-dated bonds. In other cases, the errors at the long end are of similar magnitude to the errors at the short end when expressed in price terms. Consequently, the error when viewed in terms of spread or yield is actually much greater at the short end than the long end.”
In conclusion, based on this analysis, high-coupon bonds with maturities inside of 10 years are priced lower than they should be. Two credit analysts attribute this to the fact that the market weighs depreciatory factors, uncertainty of cash flow and illiquidity premium, too much when pricing high-coupon bonds with 10 year or less maturities.
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