1 Chapter 7 – Bond Concepts What are they? Types and issuers –Junk –Convertibles –Callables –Asset-backed Credit ratings Calculations –YTM –Price –Current yield –Tax impacts Relationships –Price –Term –Type

2 Types of Bonds Bond – a long-term promissory note –Pays a fixed amount of interest each period –At maturity, principal is repaid Types –Secured and Asset-backed securities –Debentures – unsecured –Subordinated debentures – “junior” –Junk or High-yield bonds –Municipals – non taxable interest

3 Bonds- Issuer Types Mortgage-related $7.9T 40.6% Corporations US Treasuries State & Local Gov’t Other-asset backed Total $ %

4 Characteristics and Terms Superior claim over stock in bankruptcy Par value – maturity value is usually $1,000 Coupon rate – percentage of par paid in annual interest, often paid semiannually Maturity – length of time or date of repayment of principal Accrued interest – seller entitled to interest from last payment date

5 Capital Food Chain Secured creditors (OK if < assets) General creditors: –Debenture holders & unsecured creditors –Subordinated debenture holders Preferred stockholders Common stockholders

6 Indenture Legal agreement between issuer and independent trustee (bank) representing bondholders –Includes terms, rights and obligations of each –Convenants protect holders Covenants may cover asset sales/purchases, dividend limits, future borrowings, interest, mergers, etc.

7 Other Provisions Callability – issuer may redeem before maturity Tax shield – interest expense is tax deductible. At 34% tax, 8% becomes 5.28% Current yield (not YTM) = annual interest divided by market price

8 Convertible Securities Convertible into common stock at a fixed rate at bondholder’s option $1,000 bond convertible into 20 shares –Equal to $50/share (1,000/20) –Stock rises to $60, bond worth $1,200 (60 * 20) Offers upside potential but lower rate than on comparable nonconvertible securities Look at coupon and conversion ratio

9 Callable Bonds Redeemable at issuer’s option –Rates drop, bond called, new bonds issued –Investor forced to reinvest at lower rate Deferred calls and call premiums –Some not callable for say first five years –Premiums: say 105% of par in year 6, 104% year 7 … par in year 11. Effect: callables pay a higher rate

10 Zero Coupon Bonds No interest paid until maturity Sold at steep discount, say 60¢ on the $ –Discount represents unpaid interest Disadvantages: huge outflow at maturity; not callable; tax issues for holder Advantages: interest deferred; deductible by issuer; no reinvestment problem for holder

11 Asset-Backed Securities Bonds or notes owning pool of financial assets; outright asset sale –Credit cards, car loans, other assets Credit ratings: 90% rated AAA –Based on quality of assets, not issuer’s credit Process called “securitization” More details on my web page

12 Municipal Bonds

13 Credit Ratings Judgment of risk potential by rating firm –Standard & Poors, Moody’s, Fitch Factors: leverage, coverage, liquidity, profitability ratios; cash to debt, size, etc Range from AAA to D (in default) –BB and below called junk or speculative bonds –Did they predict Enron? No!

14 S & P Ratings

15 Junk Bonds AKA “high risk”, “non-investment grade”, “high yield” or “speculative” Low credit rating – rated BB and below –Higher risk, higher rates Fallen angels (crisis) or new, unproven firms

16 Quality Spreads Ten Year Maturity YieldSpreadExample USTN4.40 AAA4.71% +31 GE & UPS AA Abbott Labs A McDonalds BBB GM BB Goodyear

17 Bond Valuation Value of any asset: present value of expected cash flows discounted to PV at market’s rate –Considering amount, timing, riskiness Market rate – the collective rate of return required by investors in that security –Rate based on risk; different rates for different bonds

18 Valuation Steps 1. Estimate amount and timing of each cash flow –Most US bonds pay interest semiannually 2. Determine required rate of return – what’s available on similar bonds? 3. Calculate PV of each cash flow discounted at required or market rate

19 Yield to Maturity Rate holder earns if bond held to maturity Price may be more or less than par value One year bond pays 6%, market rate is 10% Market price in very round numbers to get 10% ($100) is $960 Holder receives $40 cap gain + $ 60 interest

20 6% bond,due 2 years;market rate = 10%. Semiannual pmts TimeCF 5% PVIF PV 6 mo$ $ mo , Market value is % of par or $929.08

21 Hitting the Right Keys Market Price Yield to Maturity N4N 4 PMT30PMT 30 FV1000 *FV 1000 I/Y5PV /- * CPT PV CPT I/Y = 5 5 * 2 = 10 * No +/- sign* Needs +/- sign

22 Important Valuation Relationships # 1. Value of bond is inversely related to changes in interest rates –If rates increase, price falls Why? Cash flow is fixed. Only way to increase yield is to reduce price. Price of five year bond with 12% coupon, price is $1,000 if rate is 12% –Price is $899 if rate 15%, $1,117 if 9%

23 Relation #2 If market rate equals coupon rate, bond sells at par If market rate exceeds coupon, bond sells for less than par (discount pond) If rate less than coupon sells above par (premium bond)

24 #2 Example The market value will be less than par if the investors’ required rate of return is above the coupon rate; converse is true Five Year, 12% Bond RequiredCouponPrice 12%12%$1, ,117

25 Interest Rate and Price Changes

26 Relationship #3 Long-term bond subject to greater price risk than short-term bond Price of 12% 5 and 10 year Bonds Rate5 year10 year 9%$1,117$1,192 12% 1,000 1,000 15%

27 5 and 10 Year Price Sensitivity

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29 FinCoach Tips Be able to calculate market price and yield to maturity –(The return the investor would earn if he bought the bond at the market price and held it to maturity = I/Y) Read questions carefully - look for –Coupon dollars, coupon rates, payment frequency