Bond fundamentals Chapter 17

Basic features of a bond Issuer of bond agrees to: 1. Pay a fixed amount of interest periodically to the holder of record 2. Repay a fixed amount of principal at the date of maturity

Basic features of a bond Bond market is divided by maturity: Short-term issues with maturities of one year or less. Money market Intermediate-term issues with maturities in excess of 1 year but less than 10 years. These instruments are known as notes Long-term obligations with maturities in excess of 10 years, called bonds

Bond characteristics A bond can be characterized based on 1. intrinsic features 2. Types 3. Indenture provisions 4. Features that affect its cash flows and/or its maturity

Intrinsic features Coupon: income that the bond investor will receive over the life (or holding period) of the issue Term to maturity: date or the number of years before a bond matures Term bond has a single maturity date Serial obligation bond issue has a series of maturity dates.

Intrinsic features Principal or par value: represents the original value of the obligation Not the same as the market value Market prices fluctuate because of differences between their coupons and the prevailing market interest rate If market interest rate is above the coupon rate, the bond will sell at a discount to par If market interest rate is below the coupon rate, the bond will sell at a premium above par If market interest = coupon rate, bond will sell at par

Types of issues Secured (or) senior bonds: backed by a legal claim on some specified property of the issuer in case of default Unsecured bonds secured by the general credit of the issuer

Types of issues Subordinate (junior) debentures: Subordinated debt is a loan or security that ranks below other loans and securities with regard to claims on a company's assets. In the case of borrower default, creditors who own the debt wont be paid out until after senior debt holders are paid in full. Refunding issues: provide funds to prematurely retire another issue

Bond Characteristics Indenture provisions The indenture is the contract between the issuer and the bondholder specifying the issuer’s legal requirements Features affecting a bond’s maturity Callable (call premium) Noncallable Deferred call Nonrefunding provision Sinking fund

Callable bonds Call option features that can affect the life (maturity) of a bond Freely callable provision: allows the issuer to retire the bond at any time with a typical notification period of 30 to 60 days Deferred call provision: issue cannot be called for a certain period of time after the date of issue (e.g. 5 to 10 years) At the end of the deferred call period the issue becomes freely callable

Callable bonds Callable bonds have a call premium Amount above maturity value that issuer must pay to the bondholder for prematurely retiring the bond

Noncallable bonds can never retire the bond prior to its maturity

Nonrefunding provision Refunding protection is Bond provision that keeps an issuer from using cheaper debt (lower coupon refunding bond) to redeem a bond issue before it matures. Protect bondholders from a typical refunding Can be called and retired prior to maturity using other sources of funds like cash from operations, the sale of assets, etc.

Refunding protection Let's assume Company XYZ issues $10 million of 10% coupon bonds that mature in 10 years. If after five years market rates on similar bonds fall to 5%, Company XYZ would be very tempted to redeem what are now bonds with a relatively high interest rate. To do this, it could borrow money at 5% and pay off the 10% bonds. f the Company XYZ bonds have refunding protection, it can't. The refunding protection prevents Company XYZ from redeeming the bond if the proceeds from the redemption are from cheaper bonds ranking equally or senior to the 10% bonds. So, issuing 5% bonds to pay off the 10% bonds won't work. ©

Sinking Funds Specified that a bond must be paid off systematically over its life rather than only at maturity May commence at the end of the first year or may be deferred for 5 to 10 years from the date of issue Amount of issue that must be repaid before maturity from a sinking fund can range from a nominal sum to 100% Example: A bond issue with a 20 year maturity might have a sinking fund that requires that 5% of the issue be retired every year beginning in year 10. By year 20, half of the issue has been retired and the rest is paid of at maturity. .

Bond Rating There are three main rating agencies: 1.Fitch Investors service 2. Moody’s 3. Standard and poor’s Bond rating provide the fundamental analysis for thousands of issue. The rating agencies analyze the issuing organization and the specific issue to determine the probability of default and inform the market of their analysis through their rating. Triple A (AAA) is the highest rating possible. .

Interpreting Bond Quotes Price quotes are always interpreted as a percentage of par. Example, a quote of 98.5 does not mean $98.5 but 98.5 of par. In other words, the dollar price is derived from the quote giving the par value. If the par value, for example, is $5000 on a municipal bond, and the price of the issue quoted at 98.5, then it means that the price would be $4,925.

Interpreting Bond Quotes The estimated spread: is one of the bond quotation columns. The figure is in basis points (100 basis points is one percentage point) It indicates how the YTM for one bond compared to the yield to maturity for a treasury note or bond of equal maturity So if the spread for one bond is 250 basis points (2.5%), which means that if the yield of this corporate bond is 6.5% then the yield on the treasury note is 6.5%- 2.5% = 4.5%

Municipal Bonds Municipal Bonds A municipal bond is a debt security issued by a state or county to finance its capital expenditures including the construction of highways, bridges or schools Interest payments are exempt from federal income tax making them very attractive to people in high income tax brackets. Convert the tax-free yield of a municipal bond selling close to par to an equivalent taxable yield (ETY) where: i = coupon rate of the municipal obligations T = marginal tax rate of the investor