1. BOND FUNDAMENTALS CHAPTER FOUR Practical Investment Management Robert A. Strong A 1 3

2. South-Western / Thomson Learning © 2004 4 - 2  Bond Principles  Identification of Bonds  Classification of Bonds Issuer Security Term  Terms of Repayment Interest Only Sinking Fund Balloon Loan Income Bond Outline

3. South-Western / Thomson Learning © 2004 4 - 3  Bond Principles … continued  Bond Cash Flows Annuities Zero Coupon Variable Rate Consols Inflation-Indexed Treasury Bonds  Convertible and Exchangeable Bonds  Registration Bearer Bonds Registered Bonds Book Entry Bonds Outline

4. South-Western / Thomson Learning © 2004 4 - 4  The Financial Page Listing  Basic Information  Footnotes  Government Bonds  Bond Pricing and Returns  Valuation Equations Annuities Zero Coupon Bonds Variable Rate Bonds Consols Outline

5. South-Western / Thomson Learning © 2004 4 - 5  Bond Pricing and Returns … continued  Yield to Maturity Calculating the Yield to Maturity Misreading the Yield to Maturity The Yield Curve  Spot Rates  Realized Compound Yield  Current Yield  Accrued Interest Outline

6. South-Western / Thomson Learning © 2004 4 - 6  Bond Risks  Price Risks Default Risk Interest Rate Risk  Convenience Risks Call Risk Reinvestment Rate Risk Marketability Risk Outline

7. South-Western / Thomson Learning © 2004 4 - 7 Bond Principles: Identification of Bonds  Bonds are identified by issuer, coupon rate, and maturity.  The face value of a bond is called its par value.  e.g. 5 of “Hertz sevens of 03” (Hertz 7s03)  A legal document called the indenture contains the details of the bond issue.

8. South-Western / Thomson Learning © 2004 4 - 8 a. government e.g. US Treasury, federal agency, state, local b. corporation e.g. industrial, utility, financial, transportation c. others e.g. foreign government, foreign corporation, World Bank Bond Principles: Classification of Bonds Method 1: By issuer

9. South-Western / Thomson Learning © 2004 4 - 9 Bond Principles: Classification of Bonds Insert Table 4-1 here.

10. South-Western / Thomson Learning © 2004 4 - 10 a. unsecured debt - backed by faith in the taxing power of the government, or the good name of the company (debenture) b. secured debt e.g. revenue bond, assessment bond, mortgage, collateral trust bond, equipment trust certificate Bond security sometimes comes from non-traditional sources. Recently, some rock stars floated bonds using their future earnings as backing. Method 2: By security Bond Principles: Classification of Bonds

11. South-Western / Thomson Learning © 2004 4 - 11 Method 3: By term a. short-term -  a year e.g. US Treasury bills b. intermediate-term e.g. US Treasury notes (2 to 10 years ) c. long-term e.g. US Treasury bonds (  10 years) d. open-ended e.g. corporate line of credit e. serial bond - a portfolio of bonds with staggered terms Bond Principles: Classification of Bonds

12. South-Western / Thomson Learning © 2004 4 - 12 Bond Principles: Classification of Bonds Insert Table 4-2 here.

13. South-Western / Thomson Learning © 2004 4 - 13  interest only - the periodic payments are entirely interest  sinking fund - periodically, a portion of the debt principal is set aside or a certain number of the bonds is retired  balloon loan - the debt may be partially amortized with each payment  income bond- interest is payable only if it is earned Bond Principles: Terms of Repayment

14.  annuities - most bonds are annuities plus an ultimate repayment of principal  zero coupon - only the par value is returned at maturity  variable (adjustable) rate - the rate fluctuates in accordance with some market index or predetermined schedule  consols - a level rate of interest is paid perpetually  inflation-indexed Treasury bonds - the principal value is adjusted based on the consumer price index South-Western / Thomson Learning © 2004 4 - 14 Bond Principles: Bond Cash Flows

15. South-Western / Thomson Learning © 2004 4 - 15  convertible bond - may be exchanged for common stock in the company that issued the bond  exchangeable bond - may be exchanged for shares in another firm Bond Principles: Options

16. South-Western / Thomson Learning © 2004 4 - 16  bearer (coupon) bonds - belong to whomever legally hold them; no longer issued in the United States because of tax considerations  registered bonds - the bonds show the bondholder’s name  book entry bonds - bond ownership is reflected only in the accounting records Bond Principles: Registration

17. South-Western / Thomson Learning © 2004 4 - 17 Bond Principles: Registration Insert Figure 4-1 here.

18. South-Western / Thomson Learning © 2004 4 - 18 Basic Information Cur Net Bonds Yld Vol Close Chg. AMR 9s16 8.4 23 107 + ¾ Footnotes cv - convertiblezr - zero coupon vj - bankruptcydc - deep discount f - trading flat Government Bonds Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. 6 Feb 26 86:09 86:11 - 9 7.11 The Financial Page Listing

19. South-Western / Thomson Learning © 2004 4 - 19 The Financial Page Listing Insert Figure 4-2 here.

20. South-Western / Thomson Learning © 2004 4 - 20 1. Annuities The bond pricing relationship is customarily expressed in terms of semiannual periods. Bond Pricing & Returns: Valuation Equations

21. South-Western / Thomson Learning © 2004 4 - 21 2. Zero Coupon Bonds 3. Variable Rate Bonds Bond Pricing & Returns: Valuation Equations

22. South-Western / Thomson Learning © 2004 4 - 22 4. Consols Bond Pricing & Returns: Valuation Equations

23. South-Western / Thomson Learning © 2004 4 - 23 The yield to maturity is the single interest rate that, when applied to the stream of cash flows associated with a bond, causes the present value of those cash flows to equal the bond’s market price. Bond Pricing & Returns: Yield to Maturity

24. South-Western / Thomson Learning © 2004 4 - 24 A heuristic: Bond Pricing & Returns: Yield to Maturity

25. South-Western / Thomson Learning © 2004 4 - 25 Bond Pricing & Returns: Yield to Maturity  The yield to maturity calculation carries an assumption that coupon proceeds are reinvested at the yield to maturity.  If a bond pays periodic interest, it is not possible to lock in a prescribed yield to maturity.

26. South-Western / Thomson Learning © 2004 4 - 26 Bond Pricing & Returns: Yield to Maturity Insert Table 4-3 here.

27. South-Western / Thomson Learning © 2004 4 - 27  A plot of interest rates against time to maturity is known as a yield curve. yield time Bond Pricing & Returns: Yield to Maturity

28. South-Western / Thomson Learning © 2004 4 - 28 Bond Pricing & Returns: Yield to Maturity Insert Figure 4-4 here.

29. South-Western / Thomson Learning © 2004 4 - 29  A spot rate is the yield to maturity of a zero coupon security of the chosen maturity.  A treasury strip is a government bond or note that has been decomposed into two parts, one for the stream of interest payments and one for the return of principal at maturity.  The yield to maturity is a derived statistic after the bond price is known. Bond Pricing & Returns: Spot Rates

30. South-Western / Thomson Learning © 2004 4 - 30  The yield to maturity can be thought of as an “average” of the spot rates, or as a flat yield curve at some constant interest rate.  This single interest rate makes the present value of the future cash flows equal to the bond’s market price. % Term Yield to Maturity Spot Rate Curve Bond Pricing & Returns: Spot Rates

31. South-Western / Thomson Learning © 2004 4 - 31 Bond Pricing & Returns: Spot Rates Insert Figure 4-5 here.

32. South-Western / Thomson Learning © 2004 4 - 32 Realized Compound Yield: How can two investments paying interest on two different time schedules be compared? Bond Pricing & Returns

33. South-Western / Thomson Learning © 2004 4 - 33  The current yield only measures the return associated with the bond’s interest payments.  A bond whose market price is less than its par value is selling at a discount. The price of such bonds rise as maturity approaches.  If the market price is more than the par value, the bond is selling at a premium. Bond Pricing & Returns: Current Yield

34. South-Western / Thomson Learning © 2004 4 - 34 Bond Pricing & Returns: Current Yield Insert Figure 4-6 here.

35. South-Western / Thomson Learning © 2004 4 - 35  Interest is earned for each day that a bond is held, although interest payments are generally made twice a year only.  A bond buyer must pay the accrued interest to the seller of the bond.  dirty price = bond price + accrued interest clean price = bond price  By convention, accrued interest is calculated using a 360-day year. Bond Pricing & Returns: Accrued Interest

36. South-Western / Thomson Learning © 2004 4 - 36 Bond Pricing & Returns: Accrued Interest Insert Figure 4-7 here.

37. South-Western / Thomson Learning © 2004 4 - 37  default risk - the possibility that the issuer of the bond is unable to pay - rated by agencies like Moody’s and Standard & Poor’s Bond Risks: Price Risks

38. South-Western / Thomson Learning © 2004 4 - 38 Bond Risks: Price Risks Insert Table 4-5 here.

39. South-Western / Thomson Learning © 2004 4 - 39  interest rate risk - the chance of loss due to changing interest rates Bond Risks: Price Risks

40. South-Western / Thomson Learning © 2004 4 - 40  call risk - the possibility that the company will exercise a bond’s call feature Bond Risks: Convenience Risks

41. South-Western / Thomson Learning © 2004 4 - 41 Bond Risks: Convenience Risks Insert Figure 4-8 here.

42. South-Western / Thomson Learning © 2004 4 - 42  reinvestment rate risk - the chance that the interest received cannot be reinvested to earn as much as the bond’s original yield to maturity - the higher the coupon on a bond, the higher its reinvestment rate risk  marketability risk - the difficulty of selling a bond in the secondary market Bond Risks: Convenience Risks

43. South-Western / Thomson Learning © 2004 4 - 43  Bond Principles  Identification of Bonds  Classification of Bonds Issuer Security Term  Terms of Repayment Interest Only Sinking Fund Balloon Loan Income Bond Review

44. South-Western / Thomson Learning © 2004 4 - 44  Bond Principles … continued  Bond Cash Flows Annuities Zero Coupon Variable Rate Consols Inflation-Indexed Treasury Bonds  Convertible and Exchangeable Bonds  Registration Bearer Bonds Registered Bonds Book Entry Bonds Review

45. South-Western / Thomson Learning © 2004 4 - 45  The Financial Page Listing  Basic Information  Footnotes  Government Bonds  Bond Pricing and Returns  Valuation Equations Annuities Zero Coupon Bonds Variable Rate Bonds Consols Review

46. South-Western / Thomson Learning © 2004 4 - 46  Bond Pricing and Returns … continued  Yield to Maturity Calculating the Yield to Maturity Misreading the Yield to Maturity The Yield Curve  Spot Rates  Realized Compound Yield  Current Yield  Accrued Interest Review

47. South-Western / Thomson Learning © 2004 4 - 47  Bond Risks  Price Risks Default Risk Interest Rate Risk  Convenience Risks Call Risk Reinvestment Rate Risk Marketability Risk Review