1. Principles of Investing FIN 330
Fixed Income
Chapter 5
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Dr. David P Echevarria

2. Student Learning Objectives
Characteristics of Debt Instruments
Types of Debt Instruments
Bond Market Operation
Bond Ratings
Global Debt Securities
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Dr. David P Echevarria

3. Characteristics of Debt Instruments
A bond is a debt security in which an investor loans money to the borrower (issuer) for the promise of interest payments and the eventual repayment of the principal at maturity.
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Dr. David P Echevarria

4. Characteristics of Debt Instruments
B. Indenture Agreement
Loan contract between lender (investor) and borrower (issuer)
Appoints the trustee;
a fiduciary responsible for guarding the lenders' interests.
Terms and conditions, legal remedies
Sets the coupon rate (interest) and interest (coupons) payment schedules
Maturity date of the issue
Nature of collateral (if any)
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Dr. David P Echevarria

5. Characteristics of Debt Instruments
C. Special Repayment Provisions
Serial Redemption
Sinking Funds
Call provision: early retirement of bonds (with premiums to be paid)
Put provision: permits bond buyer to sell bond back at face value.
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Dr. David P Echevarria

6. Types of Debt Instruments
Secured Debt: collateralized with real assets
mortgage bonds
equipment trust certificates (rolling stock)
Unsecured Debt: backed by full faith and credit of the issuer [debentures]
Senior
Junior
Subordinated
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Dr. David P Echevarria

7. Issuers of Debt Instruments
Federal Government
Bills, Notes, Bonds
Agency issues
Interest payments not subject to state or local taxation
Municipals
General Obligation Bonds (backed by taxing power)
Revenue Bonds: pay interest only if issuer makes $$$
Industrial Development Bonds
Interest payments not subject to Federal Income Tax
Corporates
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Dr. David P Echevarria

8. Bond Market Operation Most bonds sell in the OTC market
Government bonds by far the largest dollar volume: Bills, Notes, Bonds, Agency bonds
Dealers dominate secondary market
Corporate Bonds: typically better rates than government/municipal bonds.
Short-Term Securities:
T-Bills, Commercial paper, Bankers’ Acceptances, Negotiable CDs
S-T securities are mostly held in money market funds
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Dr. David P Echevarria

9. Bond Ratings [Creditworthiness]
Credit Worthiness key to interest rates paid, and a measure of the probability of default
High Quality / Investment Grade: AAA / AA, A, BBB
Legal List: acceptable credit ratings
Speculative (“Junk”): BB, B
Default: [CCC, CC, C,] D
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Dr. David P Echevarria

10. Bond Rating Agencies Credit Rating Agencies
Standard & Poor’s: Mainly corporate (industrials) and sovereign debt
Moody’s: Banking, Insurance, Corporates
Fitch’s: Full range of coverage including international issuers
Dun & Bradstreet: small to medium sized companies (213 million world-wide)
Credit ratings assigned only after bonds have been sold (issued)
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Dr. David P Echevarria

11. Agency Credit Rating Equivalents

12. Bond basics A bond is essentially a security that offers:
A series of fixed interest payments during its life
A fixed payment when it matures
Assumes the bond issuer doesn’t default.
Dollar value of Interest Payment is determined by the Coupon Rate
For example, suppose a $1,000 par value bond pays an 8% coupon rate. The annual coupon is then $80.
If the coupon is paid semi-annually, then two payments of $40 every 6-months.
If the coupon is paid quarterly, then four payments of $20 every 3-months.
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Dr. David P Echevarria

13. Bond Valuation - Review
The price of a [seasoned] bond is determined by the interest rate prevailing at the time of sale – call the Yield to Maturity (YTM).
This is the rate of total return if the bond is held until it matures.
Vb = PVIFAi,n * Coupon + PVIFi,n * Face Value
i = Coupon Rate divided by # of payments per year
n = number of periods remaining until maturity
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Dr. David P Echevarria

14. Sources of Bond Risk Interest Rate Risk Reinvestment Rate Risk
Bond values and interest rate changes are inversely correlated; as rates increase, bond values decrease.
Changes in economic risk as well as changes in expected inflation will cause interest rates to vary.
Reinvestment Rate Risk
bond valuation formulas implicitly assume that all future coupons received are reinvested at the YTM
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Dr. David P Echevarria

15. Sources of Bond Risk C. Call Risk D. Liquidity Risk
Bonds issued callable may be called prior to maturity
Most likely if rates drop fairly quickly.
D. Liquidity Risk
Bonds with relatively thin floats will have higher bid-ask spreads effectively increasing the cost of liquidity.
Bonds with thin floats may also take longer to sell.
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Dr. David P Echevarria

16. Bond Strategies Buying and selling of bonds are driven by expectations
If you expect rates to rise, invest in short term maturities; e.g., invest in T-Bills or for better yields - bonds maturing in 2 to 5 years.
As rates rise you can roll-over into higher coupon rate securities
If you expect rates to decline, invest in long term bonds.
As rates decline, the prices of L-T debt increase providing an opportunity for capital gains.
If invested in callable bonds, bonds may be retired early by issuer.
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Dr. David P Echevarria

17. Bond Pricing Terminology
Bonds may sell at a;
Premium: a bond that sells for more than its par value.
YTM < Current Yield < Coupon Rate
Discount: a bond that sells for less than its par value.
YTM > Current Yield > Coupon Rate
Par: a bond that sells at a price = face value
YTM = Current Yield = Coupon Rate
Price Quotes
Typical: as % of face value.
Example: = $
Government Bonds in 1/32nd:
Example: = /32 = => = $
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Dr. David P Echevarria

18. Treasury inflation-protection securities
“TIPS” tie the par value of the bond and the coupon payment to the general level of prices (as measured by the Consumer Price Index – CPI) in the economy.
By adjusting the par value of the bond for inflation, the bondholder no longer has to worry about inflation outpacing return.
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Dr. David P Echevarria

19. Agency bonds
Agency bonds are the debt obligations of various agencies and organizations of the U.S. government. These agencies issue bonds to help finance activities related to public purposes (like increasing home ownership or providing farming assistance).
Government sponsored enterprises are technically owned by shareholders and not part of the federal government. (Freddie Mac & Fannie Mae)
Federal agency issue bonds that are backed by the full faith and credit of the U.S. government. (Ginnie Mae)
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Dr. David P Echevarria