The Bond Market Meghan Barnes April 10, 2002

Overview Bonds and Bond Purchasers Issuers of Bonds Common Types of Bonds Bond Prices Measures of Yield and Return Taxes Bond Ratings – Measuring Default Risk Options on Bonds Bonds vs. Other Investments

Bonds and Bond Purchasers Bonds are debt instruments Purchasers are Creditors of Issuing Companies Look at Marketability and Liquidity “Fixed Income” Securities Interest Rate Semi-Annual Interest Payments Interest Rate = Annualized Ratio of:  Borrowing Cost/ the Amount Borrowed Basis Point

Issuers of Bonds Corporations Finance Operations Federal Government Treasury Securities Bills, Notes, & Bonds Federal Agencies Government Sponsored Enterprises Municipal Governments and Agencies Munis are “Tax Exempt” General Obligation Revenue Foreign Governments and Corporations Yankee Bonds

Common Types of Bonds Floating Rate Bonds Interest Payments Change Over the Life of the Bond Rate is Tied to a Financial Benchmark such as the LIBOR Convertible Bonds Can be Exchanged for Other Securities

Types of Bonds, Continued High-Yield / Junk Bonds Speculative Grade Bonds Rated below Baa by Moody’s or BBB by S&P Greater Risk = Higher Yield Asset-Backed Bonds Securitized by Some Financial Asset Zero Coupon Bonds Do Not Pay Coupons Sold at a Large Discount

Premium vs. Discount Premium bonds:price > par value YTM < coupon rate Discount bonds:price < par value YTM > coupon rate Par bonds:price = par value YTM = coupon rate

Trading Bonds / Bond Prices Usually Issued in Par Values of $1,000 Price is Usually Closest to Par at the Time it is First Issued Dealers Post Bid and Ask Prices Prices Listed Daily in the Wall Street Journal Down to 1/8 of a Dollar Price is Equal to the Present Value of the Expected Future Cash Flows P= C/(1+r) 1 + C/(1+r) 2 + C/(1+r) 3 +…+ C/(1+r) n + M/(1+r) n

Measures of Yield and Return Coupon Rate Contracted Rate the bond pays as a percent of par Coupon Rate * Par Value = Coupon Current Yield Ratio of the bond’s promised annual income to its current market price Current Yield = Annual Income Market Price Yield to Maturity The Return an Investor Receives on a Bond if it is Held to Maturity P=I 1 /(1+y) 1 + I 2 /(1+y) 2 + … +(I n +par)/(1+y) n Holding Period Yield The Rate of Return an Investor Receives Over the Period The Investor Actually Holds the Bond P=I 1 /(1+h) 1 + I 2 /(1+h) 2 + … +(I m +P m )/(1+y) m

Yield Curve Shows the Relationship Between Short- Term and Long-Term Yields on Securities Slope can be Upward, Downward, or Horizontal Right Now, They are All Upward Sloping Longer Time to Maturity = Higher Yield

Current Yield Curves 1.) Treasury Yield Curve 2.) Agency AAA Yield Curve 3.) Corporate AAA Yield Curve 4.) Municipal AAA Yield Curve

Price vs. Yield Prices Continually Fluctuate With Changes in Interest Rates Interest Rates , Prices  Interest Rates , Prices  Rates of Older Issues Change to Match Those of New Issues Longer Maturity Means More Likely Price Will Be Affected By Changes in Interest Rates

Tax Status Some Offer Special Tax Advantages No State or Local Income Tax on U.S. Treasury Bonds or Munis Wanting Taxable or Tax-Exempt Income Depends on: Your Income Tax Bracket The Difference Between What Can Be Earned From Taxable Versus Tax Exempt Securities

Bond Ratings – Measuring Default Risk Nationally Recognized Statistical Rating Organizations Henry Varnum Poor Compiled Financial Data About Canals & Railroads Updated the Directory of Railroads, Canals and Steamship Lines in the United States Poor’s Publishing Successor of Henry, Collaborated with John Moody Later Went Their Separate Ways

Ratings, Continued Moody’s Began Producing “Moody’s Investor’s Manual” Poor’s Publishing Published its Own Bond Ratings Then Merged with the Standard Statistical Bureau to Form Standard and Poor’s Other Rating Agencies Today Fitch Investor Service Duff and Phelps

The Rating Process Standard and Poor’s Process as example: Rating Request Issuer Meeting Rating Committee Meeting Notification and Appeal Dissemination Surveillance

Definition of the Ratings/Default Risk Higher Rating Means Less Risk that the Issuer Will Default on Payments Lower Rating Means Higher Risk Purchaser is Compensated with a Higher Yield for Taking on this Additional Risk

Factors Effecting Default Risk Earnings Variability More Volatile Earnings Could Mean a Greater Possibility of Losses Exceeding Ability to Raise Funds Age of the Firm If a Firm has a Well Established History of No Defaults, Investors Have More Confidence in its Continued Success Current Leverage Using Greater Financial Leverage Could Mean Greater P/E Ratio But Could Also Mean that by Using More Borrowed Funds Rises Relative to Equity, and Risk of Declines in Net Earnings Increases

Risk vs. Yield Risk and Yield are Directly Related The Risk Involved in an Investment Includes the Risk Free Rate Plus the Default Risk Premium

Callable Bonds Call Privileges Gives the Issuer the Right to Retire a Bond Prior to Maturity Call Risk Known as Reinvestment Risk Bonds Will Be Called When Interest Rates are Falling Investors May Earn Less Than Their Expected Yield If an Investor is Long a Callable Bond, then Callable Bond Price = Noncallable Bond Price – Call Option Price

Callable Bonds, Continued Call Premium Purchaser is Compensated for Higher Risk  If Rates are High and Going to Fall, there Will Be a Higher Call Premium  If Rates are Low and Going to Rise, there Will Be a Lower Call Premium Advantage is for the Issuer Disadvantage is for the Purchaser

Putable Bonds Purchaser Buys Nonputable Bond and a Put Option from the Issuer Purchaser has the Right to Sell the Bond to the Issuer at a Certain Predetermined Time and Price If Investor is Long a Putable Bond, then Putable Bond Price = Nonputable Bond Price +Put Option Price

Current Price vs. Strike Price Callable Bonds If P>E, intrinsic value is P-E and option is “in the money” If P=E, intrinsic value is 0, option is “at the money” If P<E, intrinsic value is 0 and option is “out of the money” Putable Bonds If P<E, intrinsic value is E-P and option is “in the money” If P=E, intrinsic value is 0 and option is “at the money.” If P<E, intrinsic value is 0 and option is “out of the money.” P=Current Bond Price, E=Strike Price

Bonds vs. Certificates of Deposit Bonds Issued by Govt. or Companies Capital Market Not Insured by Govt. CDs Issued by Banks Money Market Insured by Federal Govt. up to $100,000 Both could have a Call Option Attached and Expose the Purchaser to Reinvestment Risk

Stocks vs. Bonds Stocks Capital Gain/Loss Unlimited Upside Potential with Unlimited Downside Risk Part Owner Dividends Company may change it or decide not to pay one at all Bonds Fixed Income Creditor Guarantee of Principal Payment Default Risk DIVERSIFICATION: depending on your income and ability to take risk, you will choose a different path.

Questions?