1. Version 1.2 Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department Harcourt, Inc. 6277 Sea Harbor Drive Orlando, Florida 32887-6777 Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapter 15

2. Copyright © 2000 by Harcourt, Inc. All rights reserved Chapter 15 Bond Fundamentals Questions to be answered: What are some of the basic features of bonds that affect their risk, return, and value? What is the current country structure of the world bond market and how has the makeup of the global bond market changed in recent years?

3. Copyright © 2000 by Harcourt, Inc. All rights reserved Chapter 15 Bond Fundamentals What are the major components of the world bond market and the international bond market? What are bond ratings and what is their purpose? What is the difference between investment- grade bonds and high-yield (junk) bonds?

4. Copyright © 2000 by Harcourt, Inc. All rights reserved Chapter 15 Bond Fundamentals What are the characteristics of bonds in the major bond categories such as governments, agencies, municipalities, and corporates? How does the makeup of the bond market in major countries such as the United States, Japan, the United Kingdom, and Germany differ?

5. Copyright © 2000 by Harcourt, Inc. All rights reserved Chapter 15 Bond Fundamentals What are the important characteristics of corporate bond issues developed in the United States during the past decade such as mortgage-backed securities, other asset-backed securities, zero-coupon and deep discount bonds, high-yield bonds, and structured notes?

6. Copyright © 2000 by Harcourt, Inc. All rights reserved Chapter 15 Bond Fundamentals Within each of the major bond categories, what are the differences between major countries such as the United States, Japan, the United Kingdom, and Germany

7. Copyright © 2000 by Harcourt, Inc. All rights reserved Chapter 15 Bond Fundamentals What are the important characteristics of corporate bond issues developed in the United States during the past decade, such as mortgage-backed securities, other asset-backed securities, zero coupon and deep discount bonds, and high-yield bonds?

8. Copyright © 2000 by Harcourt, Inc. All rights reserved Chapter 15 Bond Fundamentals How do you read the quotes available for the alternative bond categories (e.g., governments, municipalities, corporates)?

9. Copyright © 2000 by Harcourt, Inc. All rights reserved Basic Features of a Bond Pay a fixed amount of interest periodically to the holder of record Repay a fixed amount of principal at the date of maturity

10. Copyright © 2000 by Harcourt, Inc. All rights reserved Basic Features of a Bond Bond market is divided by maturity –Money Market - short-term issues mature within one year –Notes - intermediate-term issues mature between one and ten years –Bonds - long-term obligations maturity greater than ten years Remaining life (maturity) affect price volatility

11. Copyright © 2000 by Harcourt, Inc. All rights reserved Bond Characteristics Intrinsic features –Coupon - yield (interest income) –Maturity - term or serial (municipalities) –Principal value - different from market value –Type of ownership - bearer or registered Types of Issues –Secured (senior) bonds –Unsecured bonds (debentures) –Subordinated (junior) debentures

12. Copyright © 2000 by Harcourt, Inc. All rights reserved Bond Characteristics Indenture provisions Features affecting a bond’s maturity –Callable (call premium) –Noncallable –Deferred call –Nonrefunding provision –Sinking fund

13. Copyright © 2000 by Harcourt, Inc. All rights reserved Rates of Return on Bonds where: HPR i,t = the holding period for bond i during the period t P i,t+1 = the market price of bond i at the end of period t P i,t = the market price of bond i at the beginning of period t Int i,t = the interest payments on bond i during period t The holding period yield (HPY) is: HPY = HPR - 1 15.1

14. Copyright © 2000 by Harcourt, Inc. All rights reserved The Global Bond-Market Structure Participating issuers –1. Federal governments –2. Agencies of the federal government –3. State and local political subdivisions (municipalities) –4. Corporations –5. International issues Foreign bonds Eurobonds

15. Copyright © 2000 by Harcourt, Inc. All rights reserved Participating Investors Individual investors Institutional investors

16. Copyright © 2000 by Harcourt, Inc. All rights reserved Bond Ratings Ratings Services 1. Duff and Phelps 2. Fitch Investors Service 3. Moody’s 4. Standard & Poor’s Non-rated bonds

17. Copyright © 2000 by Harcourt, Inc. All rights reserved Alternative Bond Issues Domestic government bonds –United States - T-bills, notes, bonds –Japan - medium term, long term, super long term –Germany - bund bonds, contract with Kassenverien liquid market provided by Bundesbank –United Kingdom - short gilts, medium gilts, long gilts

18. Copyright © 2000 by Harcourt, Inc. All rights reserved Government Agency Issues United States –Not direct issues, but backed by “full faith and credit” of the U.S. government –GNMA pass-through certificates Japan –Government associate organizations Germany –Federal Railway and Federal Post Office

19. Copyright © 2000 by Harcourt, Inc. All rights reserved Municipal Bonds General obligation (Gos) bonds Revenue bonds Interest payments are exempt from federal income tax Convert the tax-free yield of a municipal bond selling close to par to an equivalent taxable yield (ETY)

20. Copyright © 2000 by Harcourt, Inc. All rights reserved Equivalent Taxable Yield Where: i = coupon rate of the municipal obligations T = marginal tax rate of the investor

21. Copyright © 2000 by Harcourt, Inc. All rights reserved Municipal Bond Guarantees Bond insured against default risk –Insurance is irrevocable for the life of the issue Four private bond insurance carriers –Municipal Bond Investors Assurance (MBIA) –American Municipal Bond Assurance Corporation (AMBAC) –Financial Security Assurance –Financial Guaranty Insurance Company (FGIC)

22. Copyright © 2000 by Harcourt, Inc. All rights reserved Municipal Bond Guarantees Insured bonds obtain AAA (Aaa) ratings Issues with private guarantees have more active secondary market, and lower required yield

23. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bonds Mortgage bonds Collateral trust bonds Equipment trust certificates Collateralized mortgage obligations (CMOs) Other asset-backed securities (ABS) Variable rate notes

24. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bonds Zero-coupon and deep-discount bonds –Minicoupon bonds –Original-issue discount (OID) bonds –Taxes due on the implied interest High-yield bonds (speculative bonds and junk bonds) –Noninvestment grade rating below BBB or Baa

25. Copyright © 2000 by Harcourt, Inc. All rights reserved Japanese Corporate Bond Market Bonds issued by industrial firms or utilities Bonds issued by banks to finance loans to corporation –Commercial banks –Long-term credit banks –Mutual loan and savings banks –Specialized financial institutions

26. Copyright © 2000 by Harcourt, Inc. All rights reserved German Corporate Bond Market Bank bonds German mortgage bonds German commercial bonds Schuldscheindarlehen

27. Copyright © 2000 by Harcourt, Inc. All rights reserved U.K. Corporate Bond Markets Debentures Unsecured loans Convertible bonds

28. Copyright © 2000 by Harcourt, Inc. All rights reserved International Bonds Foreign bonds are sold in one country and currency by a borrower of a different nationality –Yankee bonds are U.S. dollar denominated bonds sold in the U.S. but issued by a foreign firm Eurobonds are underwritten by international bond syndicates and sold in several national markets

29. Copyright © 2000 by Harcourt, Inc. All rights reserved International Bonds United States –Yankee bonds register with SEC –Eurodollar bond market affected by changes in value of U.S. dollar

30. Copyright © 2000 by Harcourt, Inc. All rights reserved International Bonds Japan –Samurai bonds - yen denominated issued by non-Japanese firms in Japan –Euroyen bonds - yen denominated, sold outside Japan

31. Copyright © 2000 by Harcourt, Inc. All rights reserved International Bonds Germany –DM-denominated bonds issued by foreign companies are Eurobonds

32. Copyright © 2000 by Harcourt, Inc. All rights reserved International Bonds United Kingdom –Bulldog bonds are sterling-denominated bonds issued by non-English firms and sold in London –Eurosterling bonds are sold in markets outside London by international syndicates

33. Copyright © 2000 by Harcourt, Inc. All rights reserved Obtaining Information on Bonds Less emphasis on fundamental analysis Most bond investors rely on rating agencies for credit analysis Market and economic conditions Intrinsic bond features Popular publications available: –Wall Street Journal, Barron’s, Business Week, Fortune, Forbes, Federal Reserve Bulletin, Survey of Current Business

34. Copyright © 2000 by Harcourt, Inc. All rights reserved Bond Publications Treasury Bulletin Standard & Poor’s Bond Guide Moody’s Bond Record Moody’s Bond Survey Fitch Rating Register Fitch Corporate Credit Analysis Fitch Municipal Credit Analysis Investment Dealers Digest Credit Markets Duff & Phelps Credit Decisions The Bond Player

35. Copyright © 2000 by Harcourt, Inc. All rights reserved Sources of Bond Quotes Bank and Quotation Record The Blue List of Current Municipal Offerings Wall Street Journal Barron’s

36. Copyright © 2000 by Harcourt, Inc. All rights reserved Interpreting Bond Quotes Quoted on basis of yield or price Price quotes are percentage of par –98 1/2 is not $98.50 but 98.5% of par –A municipal $5,000 bond quoted at 98 1/2 would be $4,925

37. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4

38. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T

39. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate

40. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate matures in 2022

41. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7%

42. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7% 52 of these bonds traded that day

43. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7% 52 of these bonds traded that day The closing price was 105 3 / 8 % of par

44. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7% 52 of these bonds traded that day The closing price was 105 3 / 8 % of par which was up 1/4 from the prior day

45. Copyright © 2000 by Harcourt, Inc. All rights reserved Corporate Bond Quotes Notations –“cv” = convertible –“zr” = zero coupon –“dc” = deep discount (at time of issue) Accrued interest must be added to price quoted

46. Copyright © 2000 by Harcourt, Inc. All rights reserved Treasury and Agency Bond Quotes Notations –“n” = treasury note –“p” = treasury note on which nonresident aliens are exempt from withholding taxes on interest Quotes resemble OTC securities with bid and ask prices

47. Copyright © 2000 by Harcourt, Inc. All rights reserved Treasury and Agency Bond Quotes GOVT. BONDS & NOTES Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. 5 5 / 8 Dec 99n 100:08 100:10 …. 5.04

48. Copyright © 2000 by Harcourt, Inc. All rights reserved Treasury and Agency Bond Quotes GOVT. BONDS & NOTES Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. 5 5 / 8 Dec 99n 100:08 100:10 …. 5.04 Prices are in 32nds usually with a very small spread between bid and ask

49. Copyright © 2000 by Harcourt, Inc. All rights reserved Treasury and Agency Bond Quotes U.S. Treasury Strips –“ci” is the coupon interest portion stripped from the note –“np” is the principal payment for the treasury note Treasury Bills –Pure discount instrument - there is no coupon, they pay par at maturity –The bid-ask is not the price but the yield

50. Copyright © 2000 by Harcourt, Inc. All rights reserved Municipal Bond Quotes 200 INDIANA ST OFFICE BLDG COMMN MBIA 0.000 07/01/05 5.60 BEARSTER Quote from The Blue List of Current Municipal Offerings $200,000 of Indiana State Office Building bonds Guaranteed by MBIA These are zero coupon bonds due July 1, 2005 The yield to maturity is given as 5.6% To determine the price you compute the discount value The dealer offering the bonds is Bear Sterns, listed in the back of the publication with their phone number

51. Copyright © 2000 by Harcourt, Inc. All rights reserved Municipal Bond Quotes Notations ETM = escrow till maturity M/S/F = mandatory sinking fund (C97) = this bond became callable in 1997 When the market yield equals the coupon rate, the price is 100 and they are referred to as dollar bonds “+” in the left column indicates a new item “#” before yield to maturity or price indicates a change

52. Copyright © 2000 by Harcourt, Inc. All rights reserved The Internet Investments Online www.bonds-online.com www.prusec.com/daily.htm www.fitchinv.com www.moodys.com www.standardandpoors.com/ratings www.bradynet.com www.bondmarkets.com

53. Copyright © 2000 by Harcourt, Inc. All rights reserved End of Chapter 15 –Bond Fundamentals

54. Copyright © 2000 by Harcourt, Inc. All rights reserved Future topics Chapter 16 Computing bond yields What determines interest rates? Term-structure theories What determines the price volatility for Bonds

55. Copyright © 2000 by Harcourt, Inc. All rights reserved