Chapter 10 Bond: Tradable security that promises toyj950/Fin432/Fin432_ch10_bonds.pdfTreasury Notes and Bonds ... The Corporate Bond Market: Issued by private corporations ... Debenture

Fin432 1 Fixed Income Securities

Chapter 10 Fixed-Income Securities

Bond characteristics

Bond sectors

Bond risks

Bond ratings and quotations


Fixed Income Markets

Bond: Tradable security that promises to make a pre-specified series of payments over time. • Straight bond makes fixed coupon and principal

payment. • Bonds are traded mainly over-the-counter.

Historical Bond Yields:


Bond Versus Stocks

Compared to stocks, bonds offer lower returns Main benefits of bonds in portfolio: • Lower risk • High levels of current income • Diversification

Comparative Performance of Stocks and Bonds:


Fixed Income Markets Definitions:

Face Value (or Par Value): Principal amount or denomination that the issuer agrees to pay back to the bondholder, exclusive of interest

Coupon Rate: The interest rate that the issuer agrees to

pay each year.

Market Value: Price at which bond trades, expressed in percent of principal.

Maturity: Date that the debt will cease to exist • Term Bond is a bond that has a single maturity date • Serial Bond is a bond that has a series of different

maturity dates

Floating-rate Bond. • Coupon rate is reset periodically according to a

predetermined benchmark. • Benchmark is usually a financial index.


Fixed Income Markets Definitions:

Premium Bond. • Bond price higher than its par value. • Bond trades at a premium whenever market interest

rates drop below its coupon rate

Discount Bond. • Bond price lower than its par value. • Bond trades at a discount whenever market interest

rates move above its coupon rate Current Yield: measures of the annual interest income relative to its current market price.

price Bondinterest coupon Annual eldCurrent Yi =

Example: If an 8% coupon bond with a par of $1,000 current trades at $875, its current yield is:

80/875 = 9.14%


Bond Price Behavior

Price of a bond is a function of its coupon rate, its maturity, and market movements in interest rates.

Bonds with longer maturities move more with changes in interest rates.

Bonds with lower coupon rate move more with changes in interest rates.


Fixed Income Markets The Treasury Market:

General obligations of the federal government: no default risk.

Treasury Notes and Bonds • Pay semiannual coupons • Sold in $1,000 denominations • Maturities up to 30 years (bonds), 10

years (notes). • Bullet bonds, generally not callable

Strips: Zero-coupon bonds

Treasury Inflation-Indexed Obligations (TIPS) • Protect against inflation by adjusting investor

returns • Interest rates are very low


Fixed Income Markets The Agency Market:

Issued by government agencies

Federally related agencies: • Exlm Bank, GNMA, SBA, TVA • Guaranteed by US government

Federally sponsored agencies: • e.g., Fannie Mae, FHLB, Freddie Mac which

provide credit to the housing sector • Not guaranteed by US government and thus

subject to slight default risk • Trade at yield spread relative to Treasuries


Fixed Income Markets The Municipal Bond Market:

Issued by states, counties, cities and any other political subdivision

Issued to fund public projects

Two basic types • General obligation bonds are paid from general

fund of the issuer • Revenue bonds are paid from revenues from the

project being financed

Often guaranteed by private insurers to lower risk and interest rates

Tax exemption: • Interest on municipal bonds is not taxable at

federal level • Trade at much lower yields than Treasuries


Fixed Income Markets The Municipal Bond Market:

ratetax Federal-1bond municipal on Yield t Yield EquivalenTaxable =

Example: A municipal bond offers a yield of 6.5%. For an individual with a marginal tax bracket of 35%, what is the taxable equivalent yield of this bond?

Taxable equivalent yield = %351%5.6

− = 10%. In other words, for this individual, holding this muni is equivalent to holding a taxable bond with a yield of 10%. For this reason, municipal bonds are most attractive to individual in higher federal tax brackets (28% to 35%).


Fixed Income Markets The Corporate Bond Market:

Issued by private corporations

Subject to credit risk: • Failure to pay timely interest or principal

constitutes default • Bondholders incur a loss upon default • As compensation, bonds sell at higher yields than

Treasuries

Debenture bonds are unsecured general obligations

Mortgage bonds give bondholders a lien against specific property

Corporate bonds have special provisions: • Many bonds are callable by issuer • Many bonds have sinking fund provision


Fixed Income Markets The Corporate Bond Market:

• Call feature allows the issuer to repurchase the bonds before the maturity date

– Freely callable – Noncallable – Deferred call

• Call premium is the amount added to bond’s par value and paid upon call to compensate bondholders

• Call price is the bond’s par value plus call premium

• Sinking fund stipulates how a bond will be paid off over time

– Applies only to term bonds – Issuer is obligated to pay off the bond

systematically over time


Fixed Income Markets The Mortgage Market:

Mortgages are loans to purchase real estate

Securitization: S&Ls created securities out of bundled mortgage obligations • Mortgage Pass-Throughs are such securities • Mortgage-Backed Securities are guaranteed as to

payment by o Government National Mortgage Association (GNMA) o Federal Home Loan Mortgage Corporation (FHLMC) o Federal National Mortgage Association (FNMA)

Homeowner has the right to call the mortgage if

he/she moves, or if rates fall. • The homeowner is long a complex call option

The bondholder is short this option: • If interest rate rise, the bond will lose value • If interest rate fall, the homeowner will refinance

and repay the bond • The bondholder will require a payment, or higher

yield, to offset this option


Fixed Income Markets The Mortgage Market: Collaterized Mortgage Obligations are repackaged MBS securities with different payment streams.

• Mortgage-back bond pool that is divided into “tranches,” or classes of investors

• All principal payments go first to the shortest

tranche until it is fully retired, then the next in sequence is paid

• Allows investors to choose short-term, medium-

term or long-term investment • Potentially complex; interest rate fluctuations may

have significant impact upon bond prices


Fixed Income Markets Asset-backed Securities:

Issued by corporations and backed by pools of loans • Auto loans • Credit card loans • Home equity loans

Provide relatively high yields

Short maturities, typically 3 to 5 years

Interest and principal payments are monthly

High credit quality


Fixed Income Markets Global Bonds:

• Offer broader diversification opportunities • Interest rate trends in other countries may not follow

U.S. rates • Currency exchange rate fluctuations can impact returns

in U.S. dollars Dollar-Denominated Bonds

• Bonds issued by foreign governments or corporations and denominated in dollars

• Based on U.S. dollars • Yankee bonds are registered with the SEC and issued

and traded in U.S. • Eurodollar bonds are not registered with the SEC and

are issued and traded outside of the U.S. • No currency exchange rate risk

Foreign-Pay Bonds

• Bonds issued by foreign governments or corporations • Based on currency other than U.S. dollars • Not registered with the SEC and issued and traded

outside of the U.S. • Subject to currency exchange rate risk


Fixed Income Markets Junk Bonds:

• Highly speculative, usually subordinated debentures • Have low, sub-investment grade ratings • Typically offer very high yields • Prices tend to behave more like stocks than bonds

Zero-coupon bonds:

• Do not pay interest • Sold at deep discount from par value • Value increases over time • Subject to tremendous price volatility as interest

rates fluctuate • Interest must be reported as it is accrued for tax

purposes, even though no interest is actually received.

• Treasury strips are zero-coupon bonds created from U.S. Treasury securities.


Bond Characteristics Embedded Options:

Callable Bond • Issuer can retire the debt, fully or partially, before

the scheduled maturity date • Mortgage loans are all callable

Putable Bond • Bond holder can sell the bond back to the issuer

at a fixed price schedule

Convertible Bond. • Gives the bondholder the right to exchange the

bond for a specified number of shares of common stock


Bond Characteristics Bond Risks:

Interest rate risk (Market risk). • The major risk faced by a bond investor • A typical bond's price changes in the opposite

direction from a change in interest rate • Bond sold before maturity may therefore realize a

capital loss • Degree of price sensitivity to interest rate change

depends on bond characteristics

Reinvestment risk. • When market interest rate fall, interim cash flow

has to be reinvested at a lower interest rate. • Reinvestment risk is greater for high coupon

bonds

Offsetting effects: Interest rate risk is the risk that interest rate will rise, while reinvestment risk is the risk that interest rate will fall.



Call risk • Cash flow of a callable bond is not known with

certainty. • Issuer will call the bond when interest rate drops,

exposing investors to reinvestment risk.

Default risk • The risk that bond issuer may not be able to make

timely principal and interest payment. • Bond with default risk has a lower price than

comparable US Treasury securities, which are considered free of default risk.

Inflation risk • When inflation increases, bond with fixed coupon

will realize lower returns, as measured by purchasing power.

• Floating-rate bonds have lower inflation risk.



Exchange rate risk • A US investor holding non-dollar-denominated

bond will face exchange rate risk. • An investor holding British Pound denominated

bond will lose money when USD/GBP falls.

Liquidity risk • The risk that bond cannot be sold at or near its

market value before maturity. • Measured by the bid-ask spread

Volatility risk • The risk that a change in volatility will affect the

price of a bond adversely • Bonds with embedded options have volatility risk

because the value of option is affected by volatility.


Bond Ratings Bond Ratings:

Bond Ratings Very High

Quality High

Quality Speculative Very Poor

Standard & Poor’s AAA AA A BBB BB B CCC D Moody’s Aaa Aa A Baa Ba B Caa C Investment grade bond: A bond rated BBB and above by Standard

& Poor’s, or Baa and above by Moody’s. Speculative grade or junk bond: A bond rated BB or lower by

Standard & Poor’s, Ba or lower by Moody’s, or an unrated bond. Determinants of Bond Safety:

Coverage ratios: Ratios of company earnings to fixed costs. For example: Times-interest-earned-ratio = EBIT/interest

Leverage ratios: Debt/Equity

Liquidity ratios: Current ratio; Quick ratio

Profitability ratios: return on assets = EBIT/Total assets


Bond Quotes

• Bond quotes are stated as percentage of par value • 97 means 97% of par value • Treasuries are quoted in 32nds. • A $1,000 par value bond price at 97 would sell

for $970 • 100 means bond trades at par value


Fixed Income Markets

Readings: Chapter 10

Exercises: Chapter 10 (will NOT be collected)

Text Website: Self-assessment quiz

End-of-Chapter CFA questions (Page 449)

Problems: P10.7, 10.9, 10.15

Homework (will be collected and graded, due date to be announced)

Chapter 10: Excel with Spreadsheet (Page 456)

Documents

Chapter 10 Bond: Tradable security that promises toyj950/Fin432/Fin432_ch10_bonds.pdfTreasury Notes and Bonds ... The Corporate Bond Market: Issued by private corporations ... Debenture