TYPES OF BONDS BOND YIELD BOND MARKETS TYPES OF BONDS BOND YIELD

BONDS Bonds are debt obligations issued by governments or corporations with long-term maturities. The issuer of the bond is obligated to pay interest (coupon) payments periodically and the par at maturity. Have maturity between 10-30 years Primarily traded in the over-the-counter (OTC) market. Most bonds are owned by and traded among large financial institutions.

Bonds are often classified according to the type of issuer Treasury bonds issued by the treasury Municipal bonds issued by state and local governments Corporate bonds issued by corporations

Key Features of a Bond Par value – face amount of the bond, which is paid at maturity (assume $1,000). Coupon interest rate – stated interest rate (generally fixed) paid by the issuer. Multiply by par to get dollar payment of interest. Maturity date – years until the bond must be repaid. Issue date – when the bond was issued.

The value of financial assets It is known that the value of any financial asset is simply the present value of the cash flows the asset is expected to produce. 1 2 n k CF1 CFn CF2 Value ...

Yield to maturity The rate of return earned on a bond if it is held till maturity

Bond yields Consider an investor who purchase bonds with 10 year until maturity, par value $1000, 8% coupon rate, for $936 SET: END Solve for I 10 -936 80 1000 INPUTS N I/YR PV PMT FV OUTPUT 9%

The price path of a bond What would happen to the value of this bond if its required rate of return remained at 10%, or at 13%, or at 7% until maturity? Years to Maturity 1,372 1,211 1,000 837 775 30 25 20 15 10 5 0 kd = 7%. kd = 13%. kd = 10%. VB

Treasury Bonds: The U.S. treasury commonly issues Treasury notes or Treasury bonds to finance federal government expenditures. The minimum domination for treasury notes or bonds is $1,000. The key difference between a note and bond is that note maturities are usually less than 10 years, while bond maturities are 10 years or more. The yield from holding s Treasury bond, as with other bonds, depends on the coupon rate and on the difference between the purchase price and selling price.

Treasury Bond Auction Offerings are conducted through periodic auctions-middle of each quarter. Competitive or noncompetitive bids.

Bond dealers serve as intermediaries in the secondary market by matching up buyers and sellers of treasury bonds. These dealers quote a bid and ask price for both sellers and buyers of existing treasury bonds Dealers profit from the bid-ask spread.

Treasury Bonds Quotations: The Treasury bond quotations in newspapers are typically listed in order of maturity. From an investor’s point of view, the coupon rate advantage over the other two bonds is essentially offset by the high price to be paid for that bond.

Stripped Bonds The cash flows of bonds are commonly transformed – stripped by securities firms – so that one security represents the principal payment only while a second security represents the interest payments. For example, a 10 yr T-bond with a par value $100,000 has a 12% coupon rate and semiannual coupon payments. This bond can be stripped into A Principal only (PO) security that will provide $100,000 upon maturity and An interest only (IO) security that will provide 20 semiannual payments of $60,000 each

Investors who desire a lump-sum payment in the distant future may prefer the principal-only part, while investors desiring periodic cash inflows may prefer the interest-only part.

Inflation-Indexed Treasury Bonds The return is tied to the inflation rate. Intended for Investors who wish to ensure their returns must keep up with the increase in prices. Coupon rate is lower than other Treasury bonds while the Principal value is increased by the amount of inflation rate every six months. Example: A 10-year inflation indexed bond with a par value of $10,000 and coupon rate is 4 %. If inflation during first six months is 1%. Par value will increase by $100 (1% x 10,000). Coupon payment is equal to $202 (2% x new par value 10,100).

Saving Bonds Issued by the Treasury, attractive to small investors due to a range of low to high denominations. Offer interest either based on market returns or tied to inflation rate. Interest accumulates monthly. Maturity is 30 years and do not have a secondary market.

Municipal Bonds Like the federal government, state and local governments frequently spend more than the revenues they receive. To finance the difference, they issue municipal bonds, most of which can be classified as either general obligation bonds or revenue bonds. Payments on general obligation bonds are supported by the municipal government’s ability to tax, whereas payments on revenue bonds must be generated by revenues of the project for which the bonds were issued. Revenue bonds and general obligation bonds typically promise interest payments on a semiannual basis.   The minimum denomination of municipal bond is typically $5,000.

Municipal Bonds One of the most attractive features of municipal bonds is that the interest income such bonds provide is normally exempt from federal taxes and in some cases is exempt from state and local taxes. A less active secondary market exists for these bonds.   Most of these bonds contain call provision. Variable-Rate Municipal Bonds They have floating rate based on the benchmark interest rates. Coupon payments adjusts to movements in benchmark interest rates. Some of these bonds are convertible into Fixed-rate bonds.

Municipal Bonds Municipal Bond Yields;   Yield varies from Treasury bill with the same maturity for three reasons: They must pay a risk premium above T-Bill rate to compensate for default risk. They must pay a slight premium to compensate for less liquidity as compared to a T-Bill. Income earned from Muni’s is exempt from federal taxes. This advantage offsets the other two disadvantages. Credit Risk Both type of Municipal bonds carry some degree of default risk. General obligation bonds can default if government is unable to increase tax collections. Revenue bonds can default if project can not generate sufficient revenue. Bond ratings are used by investors to make their investment decision.

Corporate Bonds: When corporations need to borrow for long-term periods, they issue corporate bonds, which usually promise the owner interest on a semiannual basis.   The minimum denomination is $1,000. Bonds can be placed in market either through large public offerings or through private placements. Interest income earned by holders is subject to federal and state taxes. Default risk is high and depends on economic conditions. Bond ratings are used by investors to assess the issuing firm’s financial conditions and ability to cover its debt payments.

Characteristics of Corporate Bonds Corporate bonds can be described according to a variety of characteristics. The bond indenture is a legal document specifying the rights and obligations of both the issuing firm and the bondholders.   If the terms of the indenture are violated, the trustee initiates legal action against the issuing firm and represents the bondholders in that action. Bank trust departments are frequently hired to perform the duties of the trustee.

Corporate Bonds: Protective Covenants: Sinking Fund Provision: Bond indentures frequently include a sinking-fund provision, or a requirement that the firm retire a certain amount of the bonds issue each year.  This provision is considered to be an advantage to the remaining bondholder, since it reduces the payments necessary at maturity. Protective Covenants: Bond indentures normally place on the issuing firm restrictions that are designed to protect the bondholders from being exposed to increasing risk during the investment period.   These so-called protective covenants frequently limit the amount of dividends and corporate officers salaries the firm can pay and also restrict the amount of additional debt the firm can issue.

Corporate Bonds: Call Provisions:   A call provision normally requires the firm to pay a price above par value when it calls its bonds. The difference between the bonds par value and call price is the call premium - typically one year’s interest, although the premium may decline as the bond approaches maturity. There are two principal approaches of a call provision. If market interest rates decline after a bond issue has been sold, the firm might end up paying a higher rate of interest than the prevailing rate for a long period of time. To retire bonds as require by a sinking fund provision. Many bonds have two different call prices: a lower price of calling the bonds to meet sinking funds requirements and a higher price if the firm calls the bond for any other reason.

Bond Collateral   Bonds can be classified according to whether they are secured by collateral and by the nature of that collateral. A first mortgage bond has first claim on the specified assets. If the bond issue is an open-end mortgage bond, the firm can issue additional bonds in the future, using the same assets as collateral and giving the same priority of claim against those assets. A closed-end mortgage bond prohibits the firm from issuing additional bonds with the same priority of claim against those assets. Blanket mortgage is used in which the bond issue is backed by all of the firm’s real property. Bonds can also be secured with a chattel mortgage, a mortgage secured by personal property.

Corporate Bonds: Debentures: Bonds unsecured by specific properties are called debentures. Backed only by the general credit of the issuing firm.   Debentures that have claims against the firm’s assets that are junior to the claims of both mortgage bonds and regular debentures are called subordinated debentures.

Bond Financing for Leverage Buyouts:   A leverage buyout is typically financed with senior debt and subordinated debt.   The senior debt accounts for 50 percent to 60 percent of LBO financing on the average. Low and Zero Coupon Bonds The low or zero coupon bonds are issued at a deep discount from par value. Investors are taxed annually on the amount of interest earned To the issuing firm, these bonds have the advantage of requiring low or no cash outflow during their life The firm is permitted to deduct the amortized discount as interest expense for federal income tax purposes, even though it doesn’t pay interest

Junk Bonds:   In recent years, the volume of low grade bonds, or junk bonds, being issued has increased substantially.   The primary investors in junk bonds are life insurance companies and pension funds. In addition, some mutual funds maintain portfolios of junk bonds. Some mutual funds allow investors to invest in a diversified portfolio of junk bonds with a small investment. Some companies issued junk bonds to obtain necessary funds for pursuing acquisition targets. Other companies issued junk bonds to restructure their capital in a manner that would discourage take over attempts. Junk bonds offer high yields to compensate investors for high risk.

Variable-Rate Bonds: They allow investors to benefit from rising market interest rates over time They allow issuers of bonds to benefit from declining rates over time. Convertible Bonds:   Allow investors to exchange a bond for a stated number of shares of the firm’s common stock.

Evaluating Bond Risk Event Risk Default Risk Interest rate risk   Treasury Bonds are normally perceived to have zero default risk, because they are backed by the federal government. municipal and corporate bonds are exposed to default risk. Event Risk: Bonds are susceptible to event risk, which typically reflects an increase in the perceived risk of default resulting from a corporate restructuring of debt or a takeover.

Interest rate risk The prices of bonds with longer terms to maturity are more susceptible to interest rate movements.   Prices of low coupon or zero-coupon bonds are more susceptible to interest rate movements. Impact of Money Supply Growth: When supply growth is increased by the Federal Reserve System, three reactions are possible. The increased money supply may result in an increased supply of loan able funds. An alternative reaction is to expect that the increased money supply growth will lead to a higher level of inflation.

Interest rate risk Impact of Oil prices:   Bond portfolio managers therefore forecast oil prices and their potential impact on inflation in order to forecast interest rates. A forecast of lower oil prices results in expectations of lower interest rates, causing bond portfolio managers to purchase more bonds. A forecast of higher oil prices results in expectations of higher interest rates, causing bond portfolio managers to sell some of their bond holdings. Impact on the Dollar: Holding other things equal, expectations of a weaker dollar are likely to increase inflationary expectations because they increase the prices of imported supplies. Simultaneous impact of all Factors: To deal with the uncertainty, bond portfolio managers often develop a variety of possible interest rate scenarios for a future point in time and estimate bond prices of each scenario.

Default Risk: Treasury Bonds are normally perceived to have zero default risk, because they are backed by the federal government.   municipal and corporate bonds are exposed to default risk. Event Risk: Bonds are susceptible to event risk, which typically reflects an increase in the perceived risk of default resulting from a corporate restructuring of debt or a takeover.

Interaction among Bond Yields: Yields among bonds can vary according to such factors as default risk, market ability and tax status. Yield differentials among bonds can change when investors perceive a characteristic of a particular type of bond to be more or less favorable then before.

Bond Portfolio Management: If bond portfolio manager expect favorable economic conditions, they will increase their holdings of bonds with higher default risk. When the economic outlook is more pessimistic, they will shift toward bonds with low or no default risk.   If bond portfolio managers anticipate lower interest rates, they may attempt to benefit from that by replacing short maturity bonds with long maturity bonds, or high coupon bonds with low or zero coupon bonds. If bond managers anticipate higher interest rates, they may concentrate on short maturity or high coupon bonds.  A more passive strategy would be to diversify among bonds that exhibit varied degrees of sensitivity to interest rate movements.

Impact of Exchange Rates on Returns of Foreign Bonds: Financial institutions often consider purchasing foreign securities whose expected returns are higher than expected returns on domestic securities. 

Diversifying Bonds Internationally: Financial institutions may attempt to reduce their exchange rate risk by diversifying among foreign securities denominated in various foreign currencies. Institutional investors also diversify their bond portfolio internationally in order to reduce exposure to interest rate risk. Over a long term investment horizon in which expectations of currency movements are periodically revised, investors that purchase international bonds may hedge some periods and remain exposed to exchange rate risk n others. Another key reason for international diversification is the reduction of credit risk. The investment in bonds issued by corporations from a single country can expose investors to a relatively high degree of credit risk.