BOND FUNDAMENTALS

CHAPTER FOUR

Practical Investment Management

Robert A. Strong

A1 3

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Bond Principles Identification of Bonds Classification of Bonds

• Issuer• Security• Term

Terms of Repayment• Interest Only• Sinking Fund• Balloon Loan• Income Bond

Outline

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Bond Principles … continued Bond Cash Flows

• Annuities• Zero Coupon• Variable Rate• Consols• Inflation-Indexed Treasury Bonds

Convertible and Exchangeable Bonds Registration

• Bearer Bonds• Registered Bonds• Book Entry Bonds

Outline

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The Financial Page Listing Basic Information Footnotes Government Bonds

Bond Pricing and Returns Valuation Equations

• Annuities• Zero Coupon Bonds• Variable Rate Bonds• Consols

Outline

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Bond Pricing and Returns … continued Yield to Maturity

• Calculating the Yield to Maturity• Misreading the Yield to Maturity• The Yield Curve

Spot Rates Realized Compound Yield Current Yield Accrued Interest

Outline

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Bond Risks Price Risks

• Default Risk• Interest Rate Risk

Convenience Risks• Call Risk• Reinvestment Rate Risk• Marketability Risk

Outline

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Bond Principles: Identification of Bonds

Bonds are identified by issuer, coupon rate, and maturity.

The face value of a bond is called its par value.

e.g. 5 of “Hertz sevens of 03” (Hertz 7s03)

A legal document called the indenture contains the details of the bond issue.

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a. government e.g. US Treasury, federal agency, state, local

b. corporation e.g. industrial, utility, financial, transportation

c. others e.g. foreign government, foreign corporation, World Bank

Bond Principles: Classification of Bonds

Method 1: By issuer

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Bond Principles: Classification of Bonds

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a. unsecured debt - backed by faith in the taxingpower of the government, or the good name ofthe company (debenture)

b. secured debt e.g. revenue bond, assessmentbond, mortgage, collateral trust bond, equipment trust certificate

Bond security sometimes comes from non-traditional sources. Recently, some rock stars floated bonds using their future earnings as backing.

Method 2: By security

Bond Principles: Classification of Bonds

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Method 3: By term

a. short-term - a year e.g. US Treasury bills

b. intermediate-term e.g. US Treasury notes (2 to 10 years )

c. long-term e.g. US Treasury bonds ( 10 years)

d. open-ended e.g. corporate line of credit

e. serial bond - a portfolio of bonds with staggered terms

Bond Principles: Classification of Bonds

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Bond Principles: Classification of Bonds

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interest only - the periodic payments are entirely interest

sinking fund - periodically, a portion of the debt principal is set aside or a certain number of the bonds is retired

balloon loan - the debt may be partially amortized with each payment

income bond- interest is payable only if it is earned

Bond Principles: Terms of Repayment

annuities - most bonds are annuities plus an ultimate repayment of principal

zero coupon - only the par value is returned at maturity

variable (adjustable) rate - the rate fluctuates in accordance with some market index or predetermined schedule

consols - a level rate of interest is paid perpetually

inflation-indexed Treasury bonds - the principal value is adjusted based on the consumer price index

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Bond Principles: Bond Cash Flows

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convertible bond - may be exchanged for common stock in the company that issued the bond

exchangeable bond - may be exchanged for shares in another firm

Bond Principles: Options

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bearer (coupon) bonds - belong to whomever legally hold them; no longer issued in the United States because of tax considerations

registered bonds - the bonds show the bondholder’s name

book entry bonds - bond ownership is reflected only in the accounting records

Bond Principles: Registration

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Bond Principles: Registration

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Basic Information

Cur Net Bonds Yld Vol Close Chg.AMR 9s16 8.4 23 107 + ¾

Footnotescv - convertible zr - zero couponvj - bankruptcy dc - deep discountf - trading flat

GovernmentBonds

Maturity AskRate Mo/Yr Bid Asked Chg. Yld. 6 Feb 26 86:09 86:11 - 9 7.11

The Financial Page Listing

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The Financial Page Listing

Insert Figure 4-2 here.

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present the from periods semiannual in time ratediscount

periods semiannual in bond the of term where

1

value par

1

interest

al)PV(princip t)PV(interes price bondcurrent

1

trn

rr n

n

tt

22

1. AnnuitiesThe bond pricing relationship is customarily expressed in terms of semiannual periods.

Bond Pricing & Returns: Valuation Equations

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2. Zero Coupon Bonds

nr 1

value par al)PV(princip price bondcurrent

3. Variable Rate Bonds

n

tttr

t

1 21

timeat flow cash price bondcurrent

Bond Pricing & Returns: Valuation Equations

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4. Consols

r

t

r

t

tt

timeat flow cash

timeat flow cash price bondcurrent

1 1

Bond Pricing & Returns: Valuation Equations

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The yield to maturity is the single interest rate that, when applied to the stream of cash flows associated with a bond, causes the present value of those cash flows to equal the bond’s market price.

Bond Pricing & Returns: Yield to Maturity

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value) 0.4(par price) 0.6(market

maturity until yearsvalue par - pricemarket

-interest annual YTMapprox

A heuristic:

Bond Pricing & Returns: Yield to Maturity

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Bond Pricing & Returns: Yield to Maturity

The yield to maturity calculation carries an assumption that coupon proceeds are reinvested at the yield to maturity.

If a bond pays periodic interest, it is not possible to lock in a prescribed yield to maturity.

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Bond Pricing & Returns: Yield to Maturity

Insert Table 4-3 here.

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A plot of interest rates against time tomaturity is known as a yield curve.

yield

time

Bond Pricing & Returns: Yield to Maturity

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Bond Pricing & Returns: Yield to Maturity

Insert Figure 4-4 here.

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A spot rate is the yield to maturity ofa zero coupon security of the chosen maturity.

A treasury strip is a government bond or notethat has been decomposed into two parts, one for the stream of interest payments and one for the return of principal at maturity.

The yield to maturity is a derived statistic afterthe bond price is known.

Bond Pricing & Returns: Spot Rates

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The yield to maturity can be thought of as an “average” of the spot rates, or as a flat yield curve at some constant interest rate.

This single interest rate makes the presentvalue of the future cash flows equal to the bond’s market price.

%

Term

Yield to Maturity

Spot Rate Curve

Bond Pricing & Returns: Spot Rates

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Bond Pricing & Returns: Spot Rates

Insert Figure 4-5 here.

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Realized Compound Yield:

yearper payments of number maturity to yield where

1 rate annual effective

xr

x

rx

1

How can two investments paying interest on two different time schedules be compared?

Bond Pricing & Returns

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The current yield only measures the return associated with the bond’s interest payments.

A bond whose market price is less than its par value is selling at a discount. The price of such bonds rise as maturity approaches.

If the market price is more than the parvalue, the bond is selling at a premium.

Bond Pricing & Returns: Current Yield

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Bond Pricing & Returns: Current Yield

Insert Figure 4-6 here.

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Interest is earned for each day that a bond is held, although interest payments are generally made twice a year only.

A bond buyer must pay the accrued interest to the seller of the bond.

dirty price = bond price + accrued interestclean price = bond price

By convention, accrued interest iscalculated using a 360-day year.

Bond Pricing & Returns: Accrued Interest

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Bond Pricing & Returns: Accrued Interest

Insert Figure 4-7 here.

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default risk - the possibility that the issuer of the bond is unable to pay - rated by agencies like Moody’s and Standard & Poor’s

Bond Risks: Price Risks

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Bond Risks: Price Risks

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interest rate risk - the chance of loss due to changing interest rates

Bond Risks: Price Risks

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call risk - the possibility that the company will exercise a bond’s call feature

Bond Risks: Convenience Risks

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Bond Risks: Convenience Risks

Insert Figure 4-8 here.

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reinvestment rate risk - the chance that the interest received cannot be reinvested to earn as much as the bond’s original yield to maturity - the higher the coupon on a bond, the higher its reinvestment rate risk

marketability risk - the difficulty of selling a bond in the secondary market

Bond Risks: Convenience Risks

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Bond Principles Identification of Bonds Classification of Bonds

• Issuer• Security• Term

Terms of Repayment• Interest Only• Sinking Fund• Balloon Loan• Income Bond

Review

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Bond Principles … continued Bond Cash Flows

• Annuities• Zero Coupon• Variable Rate• Consols• Inflation-Indexed Treasury Bonds

Convertible and Exchangeable Bonds Registration

• Bearer Bonds• Registered Bonds• Book Entry Bonds

Review

South-Western / Thomson Learning © 2004 4 - 45

The Financial Page Listing Basic Information Footnotes Government Bonds

Bond Pricing and Returns Valuation Equations

• Annuities• Zero Coupon Bonds• Variable Rate Bonds• Consols

Review

South-Western / Thomson Learning © 2004 4 - 46

Bond Pricing and Returns … continued Yield to Maturity

• Calculating the Yield to Maturity• Misreading the Yield to Maturity• The Yield Curve

Spot Rates Realized Compound Yield Current Yield Accrued Interest

Review

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Bond Risks Price Risks

• Default Risk• Interest Rate Risk

Convenience Risks• Call Risk• Reinvestment Rate Risk• Marketability Risk

Review