VI. DEBT SECURITIES

A. Bonds

1. Defined as debt obligations issued by government, governmental agencies, and corporations

a. Par – Face value (usually $1,000, quoted as a percentage – 100 or more or less) – bonds are issued at par, but the market value of a bond can be more or less than par

b. Discount – When a bond sells for less than par

c. Premium – When a bond sells for more than par

d. Coupon – The annual interest rate paid as a percentage of par. Bonds generally pay semi-annually (twice per year), at one-half of the coupon rate per payment (originally, coupons were attached to the physical bond certificate, then “clipped” and presented to the corporation for payment

A. Bonds

e. Interest Rate – The fixed percentage of par paid annually (in two payments) to the bondholder

f. Bondholder – An individual or institution that purchases bonds, becoming a creditor of the corporation

g. Issuer – The government, governmental agency, or company that sells the bond

h. Maturity – Date upon which the issuer of a bond must return the original principal amount of the bond plus the final interest payment to the bondholder

i. Floating an Issue – The government, governmental agencies, and corporations issue bonds with a set coupon, and, based upon demand, may issue more

A. Bonds

j. Indenture – The legal agreement governing the terms of the bond issue

k. Book Entry Bond – A bond that is registered electronically, with no physical certificate issued

l. Bearer Bond – Has no investor name when it is issued, whomever possesses the certificate has a right to receive interest payments and repayment of principal

m. Secondary Market – Similar to a stock exchange, where bonds are bought or sold by brokers – the money for purchase or sale goes to the seller or purchaser, like stocks, bonds bought on the secondary market do not provide any additional funds to the issuer

A. Bonds

2. Types of Bondsa. Government Securities

i. Treasury Bills – Issued by the United States government, backed by the full faith and credit of the United States government – the safest security, matures in 26 weeks or less, sold at a discount and matures at par

ii. Treasury Notes – 2, 3, 5 and 10 year maturities, pay interest every six months (semi-annually), with a fixed coupon

iii. Treasury Bonds – 10+ year maturities, pay interest semi-annually, fixed coupon

A. Bondsiv. Strips – Created by broker-dealers, consist of bonds

sold at a discount with no interest payments

v. Treasury Inflation Protected Securities (TIPS) – Have a semi-annual fixed rate coupon, with par (face) value adjusted twice per year based upon changes in the Consumer Price Index

vi. Municipal Bonds – Issued by state and local governments and governmental agencies, may not be as credit worthy as Treasuries, generally exempt from federal income tax and from state taxes for purchasers who live in the state of issue• General Obligation – where interest and principle are paid from

tax revenues.• Revenue Bond – paid by specific fees collected by the issuer.

A. Bonds

b. Agency Securities – Issued by government sponsored entities, implicitly backed by the issuing government, but explicitly backed by the issuing agency – provide higher yields than direct government securities, with somewhat higher risk – See:

A. Bonds

c. Corporate Bonds – Debt securities issued by corporations, have a greater claim on the firm’s assets than equity instruments, backed only by the issuing company, with risk quantified by rating agencies

d. Commercial Paper – Similar to Treasury Bills, issued by corporations at a discount, with a maturity of 90 days or less

A. Bonds

B. Other Types of Debt Securities

1. Money Market Funds – Short term investments consisting of a pool of short term debt securities, “marked to market” daily so that face value ($1.00) never changes, but interest yields change daily

2. Asset Backed Securities – Debt obligations backed or “collateralized” by other forms of debt

a. Government agency asset backed securities – Consist of “pools” of mortgages, with repayment of principal and interest guaranteed by the full faith and credit of the United States government Welcome to Ginnie Mae , http://www.ginniemae.gov/investors/ocs_pdf/2008-088.pdf REMIC Definition

B. Other Types of Debt Securities

b. Quasi Governmental Agency Securities – Issued by corporations originally organized as governmental agencies, with the implicit understanding that repayments of principal and interest are guaranteed by the federal government – see:

c. Collateralized Mortgage Obligations – Backed by “pools” of mortgages, can be issued by GNMA, FHLMC, or by investment banks – see:

d. Certificates of Automobile Receivables – Backed by pools of car loans – see:

B. Other Types of Debt Securities3. Certificates of Deposit (CDs) – Issued by banks, fully

federally insured through the FDIC up to $250,000 per person or corporation per bank – see:

4. Annuities – Issued by insurance companies, designed to provide retirement income – provides a future stream of monthly payments for investment of a lump sum, often with a fixed interest rate – the dollar value of payments varies depending upon the assumed interest rate – see:

5. Guaranteed Investment Contracts – Issued by an insurance company with a guaranteed interest rate and a specific term (similar to a bond), however, GICs are not marketable

B. Other Types of Debt Securities

6. Hybrid Securitiesa. Preferred Stock – An equity security with a

specified, obligated dividend payment rate with no specific maturity – does not have the voting rights of common shares

b. Convertible Bonds and Convertible Preferred Stocks – Pay regular dividends or interest, but can be exchanged for a set number of shares of common stock at a set price – see:

C. The Yield Curve and Interest Rates1. Maturity – The term of a bond – the period

after which the fixed income security must return principal and accrued interest to the purchaser

a. Short term = 1 year or lessb. Intermediate term = Greater than 1 year through

10 yearsc. Long term = Greater than 10 years

2. Yield to Maturity – A measure of rate of return adjusting for both the selling price of the bond (discount or premium from face value) and the bond’s interest coupon rate

C. The Yield Curve and Interest Rates

C. The Yield Curve and Interest RatesBond Valuation Example

Face Value 1,000$ Annual Coupon Rate 8.00%Annual Required Return 9.50%Years to Maturity 3.0 Payment Frequency 2

Value of Bond 961.63$

=-PV(B4/B6,B5*B6,B3/B6*B2,B2)Valuation Between Periods, the Hard Way

Fraction of Period Elapsed 0.50 Bond Value Between Payment Dates 984.20$ This is the "Dirty Price"Accrued Interest 20.00 Clean Price 964.20$

See:

C. The Yield Curve and Interest Rates3. Generally, the longer the term of a fixed income security,

the greater its interest yield and/or yield to maturity.4. The normal slope of the yield curve is upward over the

maturity of the bond – greater yields for longer terms (positive yield curve).

5. The yield curve changes constantly, and can be a predictor of economic activity – Historic yield curve, the relationship between stocks and bonds. For example, an inverted yield curve often predicts a recession.

6. If interest rates in the market are greater than the coupon rate of a debt security, that security will sell at a discount – if market interest rates are lower than the coupon rate of a debt security, that security will sell at a premium

C. The Yield Curve and Interest Rates7. Capital Appreciation (Depreciation) – Gain or loss in

a fixed income security’s market value due to market interest rate changes

8. Duration – A formula accounting for a debt security’s interest coupon and its term to maturity

a. The higher the coupon interest rate, the shorter the duration for fixed income securities of a similar term to maturity

b. The lower the coupon interest rate, the longer the duration for fixed income securities of a similar term to maturity

c. The longer the duration of a fixed income security, the more volatile the security’s price (similar to maturity – the longer the maturity of a fixed income security, the greater will be its price volatility

C. The Yield Curve and Interest Rates

9. Buy and Hold – Purchasing bonds with no intention of selling them, bonds are held to maturity to avoid capital gains and losses

10. Riding the Yield Curve – Purchasing bonds at the “long end” of the yield curve, holding them until they become short term securities, then selling them for a capital gain – works best if the yield curve remains steeply positive

11. Bond Laddering – Buying bonds with different maturities, then reinvesting the proceeds at maturity into longer term securities

D. Risks of Fixed Income Security Investing

1. Inflation Risk – Inflation increases to a rate greater than the fixed income security coupon, decreasing the market value of the security, and penalizing investors for purchasing fixed income securities

2. Reinvestment Risk – The risk that the investor will not, upon maturity and/or upon coupon payment dates, be able to obtain a yield as great as the coupon rate of the fixed income security

D. Risks of Fixed Income Security Investing

3. Risk of Capital Loss – If a sale is required before maturity, investor is “locked in” until maturity to realize par value, or, if interest rates rise, there may be a capital loss upon liquidation

4. Default Risk – The issuer may become unable to make interest payments to bondholders and/or to repay bond principal upon maturity – for lower quality bonds, the price depends more upon changes in the firm’s credit rating than upon prevailing interest rates

E. Valuing a Bond1. Discount or Premium – The price paid for a bond

either less or greater than par (100), based upon market interest rates at the time of purchase

2. Coupon Yield – Based upon par value, the interest paid per year as a percentage of par

3. Current Yield – Annual Interest

Price Paid

Based upon the market price of a bond, may be higher or lower than the coupon yield depending upon market interest rates

E. Valuing a Bond4. Yield to Maturity – Money gained or lost when a

bond matures at par (versus price paid), plus interest, plus interest on interest – assumes reinvestment of coupon payments at the same interest rate

Ex. – Bond has a 6.0% coupon, with 5 years to maturity – buy at par and hold to maturity

• Bond pays $30 (on $1,000 face) 2x per year = 10 payments = $300 over 5 years

• Buyer receives $1,000 on maturity, plus $300 interest

$1,300 less cost ($1,000) = $300

E. Valuing a Bond• Ex. 2: Same coupon, same date of issue, but

purchased 2 years after issue when market interest rates for three year bonds with a similar rating are 8.0%

Price = 94.76 (94.76% of par) based upon market yield to maturity – after 3 years, the investor receives:

$180 coupon payments ($30, 2x/year, 6 periods)

$1,000 face

$1,180 less $947.60 (price paid) = $232.40

Note: If the investor had purchased an 8.0% coupon bond at par, the interest yield would have been $240 over 3 years

E. Valuing a Bond• Ex. 3: Same coupon, same date of issue, but

purchased 2 years after issue when market interest rates for three year bonds with a similar rating are 4.0%

Price = 105.60 (105.60% of par) based upon market yield to maturity – after 3 years, the investor receives:

$180 coupon payments ($30, 2x/year, 6 periods)

$1,000 face

$1,180 less $1,056 (price paid) = $124.00

Note: If the investor had purchased a 4.0% coupon bond at par, the interest yield would have been $120 over 3 years

F. Buying and Selling Bonds1. Price depends upon interest rates – when interest

rates fall, bond prices rise; when interest rates rise, bond prices fall

2. Bonds are not as liquid as major company stocks – it is a smaller market, and there is not always a buyer for a seller of bonds on the market

a. Bid – The price that a buyer offersb. Ask – The price that a seller wantsc. Spread – The difference between bid and askd. Markup – Dealer commission charge – can be as much as

4.0% to 5.0% -- Treasury markups are generally less than 0.5% for large orders, as the market is large and highly liquid, bonds that are lower rated and/or small positions have a higher markup

G. Bond Variations

1. Bonds That May Provide Lower Returns to Investors

a. Callable Bonds – Can be redeemed by the issuer prior to the stated maturity

i. Call Schedule -– A list of dates and prices at which bonds may be redeemed, or a date after which a bond may be called at any time

ii. Market Interest Rates and Bond Calls – If the bond provides a coupon yield greater than market interest rates, it is likely to be called; if the coupon yield is less than market interest rates, it is not likely to be called

G. Bond Variations

b. Sinking Fund – Bonds are issued with a “pool” of money set aside (and/or paid in annually) by an issuer to redeem bonds at call or upon maturity – provide lower yields, but are more safe as there will be money available to repay purchasers

G. Bond Variations

2. Bonds With Conditionsa. Subordinated Bonds – Have a lower claim on

assets than other debt issuesb. Senior Bonds – First in line against corporate

assetsc. Floating Rate Bonds – Provide periodic

adjustment of bond interest paymentsd. Prefunded Bonds – Bonds whose repayment is

guaranteed by another bond issue – proceeds of other issue may be invested in Treasuries, which can be sold to redeem prefunded bonds

G. Bond Variationse. Insured Bonds – An insurance policy backs

payment of principal and interest

f. Bonds with Equity Warrants – Corporate bonds which include a right to buy the issuer’s stock at a specified time and price

g. Collateral Trust Bonds – Bonds that are backed by securities that may be liquidated to make payments to bondholders.

h. Put Bonds – Bonds that may be tendered for redemption at par prior to stated maturity

G. Bond Variations

3. Bond Alternativesa. Convertible Bonds – Can be changed into

company stock at a price and quantity set upon issue, upon a date specified at issue, or upon maturity

i. Generally subordinated debentures

ii. Generally have call provisions limiting returns if the firm’s stock price increases

G. Bond Variations

b. Zero Coupon Bonds – Issued at a discount, mature at par, with accrued interest and issue price adding up to par

i. Price Volatility – Have a longer duration than coupon paying bonds, and thus greater price volatility than coupon paying bonds of the same maturity

ii. Taxes are due annually on accrued interest

H. Buying and Selling Bonds1. Bonds trade over the counter – brokers match

buyers and sellers.

2. While Treasury Securities are almost always available for purchase or sale, other bonds are much less liquid (cannot guarantee one day purchase or sale).

3. The purchaser of a bond must pay accrued interest to the seller – the proportionate share of interest that has been earned since the last coupon payment

H. Buying and Selling Bonds4. Bond commissions are paid to brokers in the form of

a mark-up – an addition to the price paid or a subtraction from the purchase price

5. While markups on Treasury Securities are generally less than 0.5%, markups for corporate bonds can be as high as 5%, depending upon the size of the trade and the difficulty of the purchase or sale (credit rating, size of issue).

6. Markups can be quantified by determining the bid/ask spread

a. Bid – What purchasers are willing to pay

b. Ask – The price that sellers are requesting

H. Buying and Selling Bonds7. In the absence of a “bond exchange,” FINRA

maintains the Trade Reporting and Compliance Engine.

8. The Municipal Securities Rulemaking Board maintains real time tracking of municipal bond trades.