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Chapter Eleven Bond and Fixed-Income Fundamentals 1 Mc. Graw-Hill/Irwin © 2006 The Mc. Graw-Hill Chapter Eleven Bond and Fixed-Income Fundamentals 1 Mc. Graw-Hill/Irwin © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Bond and Fixed-Income Fundamentals n n n The Bond Contract Secured and Unsecured Bonds Bond and Fixed-Income Fundamentals n n n The Bond Contract Secured and Unsecured Bonds The Composition of the Bond Market Investors Distribution Procedures 2

Bond and Fixed-Income Fundamentals n n n Junk Bonds Bond Quotes Bond Markets, Capital Bond and Fixed-Income Fundamentals n n n Junk Bonds Bond Quotes Bond Markets, Capital Market Theory and Efficiency The Global Bond Market Other Forms of Fixed-Income Securities Preferred Stock as an Alternative to Debt 3

Bond Market Career Opportunities n n n More new bond offerings than new common Bond Market Career Opportunities n n n More new bond offerings than new common stock offerings Most financially rewarding jobs on Wall Street go to sophisticated analysts and dealers in the bond market Players in this market must understand: • The terms, & • Financial ramifications of bond trading 4

Definition of a Bond n n A debt investment, with which the investor loans Definition of a Bond n n A debt investment, with which the investor loans money to an entity (company or government) that borrows the funds for a defined period of time at a specified interest rate The indebted entity issues investors a certificate, or bond, that states the interest rate (coupon rate) that will be paid and when the loaned funds are to be returned (maturity date) 5

The Bond Contract Term Description Major provisions/ agreement n Over 100 pages long Bond The Bond Contract Term Description Major provisions/ agreement n Over 100 pages long Bond n Complicated legal document indenture n Administered by a trustee (usually a commercial bank) n Par value Face value of a bond n Corporate: $1, 000 n Fed, state, & local: $5, 000 or $10, 000 n 6

Ke y co nc ep t Term Coupon rate Variablerate notes (floatingrate notes) The Ke y co nc ep t Term Coupon rate Variablerate notes (floatingrate notes) The Bond Contract Description n Actual interest on the bond n Payable semiannually TO THE EXTENT THAT INTEREST RATES IN THE MARKET GO ABOVE OR BELOW THE COUPON RATE, THE MARKET PRICE OF THE BOND WILL CHANGE FROM PAR VALUE Coupon rate fixed for a short period n Then varies with a stipulated shortterm rate (e. g. U. S. Treasury bills) n 7

The Bond Contract Term Description Debt issued at values substantially below maturity value Zero-coupon The Bond Contract Term Description Debt issued at values substantially below maturity value Zero-coupon n No semiannual cash interest paid bonds n Investor receives return in the form of capital appreciation n Date at which final payment is due at the Maturity date stipulated par value Serial payment Bonds paid off in installments over the life of the issue (e. g. Municipal bonds) 8

The Bond Contract Term Description Semiannual or annual contributions by the Sinking-fund bond issuer The Bond Contract Term Description Semiannual or annual contributions by the Sinking-fund bond issuer into a fund run by a trustee for the purposes of debt retirement n Allows the corporation to call or force in debt issue prior to maturity Call provision n Price paid usually 3 to 5% above par n Usually deferred 5 to 10 years Enables the bondholder to sell a longterm bond back to the corporation at par Put provision value (useful when market interest rates have gone up) 9

Secured and Unsecured Bonds Term Secured debt Mortgage agreement After-acquired property clause Description Debt Secured and Unsecured Bonds Term Secured debt Mortgage agreement After-acquired property clause Description Debt backed by collateral Real property (plant & equipment) pledged as a security for a loan Any new property be placed under the original mortgage Proceeds from the bond Equipment trust certificate used to buy equipment, (used by transportation industry: which in turn serves as collateral rail roads, airlines, etc. ) for the trust certificate 10

Secured and Unsecured Bonds Term Debenture Income bonds Description Unsecured corporate debt issue n Secured and Unsecured Bonds Term Debenture Income bonds Description Unsecured corporate debt issue n Higher yields due to higher risk n For companies with less favorable prospects n Interest is to be paid only to the extent that it is earned as current income n 11

The Composition of the Bond Market n n U. S. Government Securities Federally Sponsored The Composition of the Bond Market n n U. S. Government Securities Federally Sponsored Credit Agency Issues State and Local Government Securities Corporate Securities 12

U. S. Government Securities Treasury Bills (T-bills) n n Maturities 91 and 182 days U. S. Government Securities Treasury Bills (T-bills) n n Maturities 91 and 182 days Trade on a discount basis Minimum units of $1, 000 Active secondary market www. treasurydirect. gov 13

U. S. Government Securities Treasury Note (T-note) Extremely popular investments n Maturity of 1 U. S. Government Securities Treasury Note (T-note) Extremely popular investments n Maturity of 1 to 10 years n Pays interest semi-annually n Minimum units of $1, 000 n 14

U. S. Government Securities Treasury Bonds (T-bonds) n n n Long term in nature, U. S. Government Securities Treasury Bonds (T-bonds) n n n Long term in nature, mature in 10 to 30 years Treasury Department stopped issuing Treasury bond in October 2001 Many are still unredeemed and earning interest, with a significant number of years remaining until maturity Units of $1, 000 and higher Taxable for IRS (Federal Tax) Tax exempt for state and local taxes 15

U. S. Government Securities Treasury strips = Zero-coupon Securities n n n STRIP = U. S. Government Securities Treasury strips = Zero-coupon Securities n n n STRIP = Separate Trading of Registered Interest and Principal Securities Fixed-income securities Sold at a significant discount to face value No interest payments Mature at par Backed by the U. S. Government Minimal risk n Tax benefits in certain states n 16

Risk & the U. S. Government Securities Treasuries are considered free from credit risk Risk & the U. S. Government Securities Treasuries are considered free from credit risk But they are affected by other types of risk Interest-rate risk & Inflation risk 17

Inflation-Indexed Treasury Securities n n Treasury Inflation Protection Securities (TIPS) Offering started in January Inflation-Indexed Treasury Securities n n Treasury Inflation Protection Securities (TIPS) Offering started in January 1997 Intention: Protect investors against inflation Investor receives TWO (2) forms of return 1. Annual interest rate paid semiannually 2. Automatic increase in initial principal to account for inflation 18

Federally Sponsored Credit Agency Issues n Issued by various agencies of the government • Federally Sponsored Credit Agency Issues n Issued by various agencies of the government • Federal National Mortgage Association • Federal Home Loan Bank n n Authorized by an act of Congress to finance federal projects NOT direct obligations of the Treasury Direct obligations of the issuing agencies Slightly higher yield than U. S. government securities 19

Federally Sponsored Credit Agency Issues n n Agency issues support the housing industry Trade Federally Sponsored Credit Agency Issues n n Agency issues support the housing industry Trade in denominations of $5, 000 and up Maturities from 1 to 40 years – avg. 15 yrs Examples: • Federal Intermediate Credit Banks • Federal Farm Credit Bank • Export-Import Bank 20

Federally Sponsored Credit Agency Issues n n GNMAE (Ginnie Mae) Government National Mortgage Association Federally Sponsored Credit Agency Issues n n GNMAE (Ginnie Mae) Government National Mortgage Association Buys mortgages from various lenders at a discount Issues securities to public against these mortgages Investors receive monthly payments = pass-thru Interest + Principal payments on mortgages www. ginniemae. gov 21

State and Local Government Securities DEFINITION Municipal Bonds: Debt securities issued by state & State and Local Government Securities DEFINITION Municipal Bonds: Debt securities issued by state & local governments Most important feature: Tax exempt nature of interest payment Attractive investment for: individuals in high tax brackets 22

How to Calculate the Equivalent Interest Rate on a Municipal Bond (i. e. tax How to Calculate the Equivalent Interest Rate on a Municipal Bond (i. e. tax exempt) with other Taxable Bonds Y = Equivalent before-tax yield on a taxable investment i = Yield on the municipal obligation 23 T = Marginal tax rate of the investor

Corporate Securities n n n Main source of financing for U. S. corporations 80 Corporate Securities n n n Main source of financing for U. S. corporations 80 to 85% of firms’ external financial needs Corporate market subunits: • Industrials (from hi tech to discount chain stores) • Public utilities • Rails & transportation • Banks • Financial issues • Finance companies • Insurance 24

Corporate Securities n n Generally trade in units of $1, 000 Higher risk than Corporate Securities n n Generally trade in units of $1, 000 Higher risk than government issues Higher (expected) yields n n ALL income is taxable for federal, state, & local Possible disadvantage: subject to call 25

Bond Market Investors n n n So far, covered the issuer or supply side Bond Market Investors n n n So far, covered the issuer or supply side Now consider the investor or demand side Bond market is dominated (80 to 85% of trading) by large institutional investors: Insurance companies n Banks n Pension funds n Mutual funds n 26

Bond Market Investors n n n Relatively strong primary market (new issues) Relatively weak Bond Market Investors n n n Relatively strong primary market (new issues) Relatively weak secondary market (resale market) Question that a bond investor must consider: How close to the going market price can I dispose of the issue? n (A 5 or 10% discount might be unacceptable) Foreign investors buy 10 to 15% of the U. S. government’s debt 27

Distribution Procedures n n n Shelf registration SEC Rule 415 Large companies file one Distribution Procedures n n n Shelf registration SEC Rule 415 Large companies file one comprehensive registration statement for future long-term financing (multiple issues) Issue bonds through an investment banker without further SEC approval Issue may be on the shelf for up to 2 years 28

Private Placement n n Bond offerings sold privately to investors • Insurance companies • Private Placement n n Bond offerings sold privately to investors • Insurance companies • Pension funds Offered by industrial firms (not public utilities) Limited or nonexistent secondary market Slightly higher yield due to lack of liquidity 29

Bond Ratings Corporate financial management & Institutional portfolio managers Keep a close eye On Bond Ratings Corporate financial management & Institutional portfolio managers Keep a close eye On bond rating procedures 30

Two Major Bond Rating Agencies Moody’s Investors Service www. moodys. com Requires FREE registration Two Major Bond Rating Agencies Moody’s Investors Service www. moodys. com Requires FREE registration Standard & Poor’s www. standardandpoors. com No registration needed (a subsidiary of Mc. Graw-Hill, Inc. ) 31

Bond Ratings n n Moody’s and Standard & Poor’s rank • Corporate bonds • Bond Ratings n n Moody’s and Standard & Poor’s rank • Corporate bonds • Municipal bonds • Private placement commercial paper • Preferred stock issues Companies • Offerings of foreign Governments U. S. Government bonds are considered to be risk free (no ratings) 32

Description of Bond Ratings n n Moody’s and Standard & Poor’s ratings Categories shown Description of Bond Ratings n n Moody’s and Standard & Poor’s ratings Categories shown on the next 7 slides The first four categories are assumed to represent investment-grade quality Large institutional investors • Insurance companies • Banks • Pension funds confine their activities to ONLY the first four categories 33

Description of Bond Ratings Standard Quality Moody’s & Poor’s Description Best quality n Smallest Description of Bond Ratings Standard Quality Moody’s & Poor’s Description Best quality n Smallest degree of investment risk n “Gilt edge” n Interest protected by a large or very stable profit margin n Principal is secure n High grade Aaa AAA 34

Description of Bond Ratings Standard Quality Moody’s & Poor’s Description High quality n High-grade Description of Bond Ratings Standard Quality Moody’s & Poor’s Description High quality n High-grade bonds n Rated lower than the best bonds because margins of protection may not be as large n High grade Aa AA 35

Description of Bond Ratings Standard Quality Moody’s & Poor’s Description Favorable investment attributes n Description of Bond Ratings Standard Quality Moody’s & Poor’s Description Favorable investment attributes n Upper-mediumgrade obligations n Principal and interest are considered secure n Medium grade A A 36

Description of Bond Ratings Standard Quality Moody’s & Poor’s Description Medium-grade obligations n Neither Description of Bond Ratings Standard Quality Moody’s & Poor’s Description Medium-grade obligations n Neither highly nor poorly secured n Medium grade Baa BBB 37

Description of Bond Ratings Standard Quality Moody’s & Poor’s Description Speculative n Future not Description of Bond Ratings Standard Quality Moody’s & Poor’s Description Speculative n Future not certain n Interest & principal moderate protection n Lack qualities of desirable investment n Interest & principal – min. protection Sp ec ula tiv e n Ba BB B B 38

Description of Bond Ratings Standard Quality Moody’s & Poor’s Description In poor standing n Description of Bond Ratings Standard Quality Moody’s & Poor’s Description In poor standing n Issues may be in default n Principal & interest – in danger n Highly speculative n Often in default n Other shortcomings n Default Caa CCC Default Ca CC 39

Description of Bond Ratings Standard Quality Moody’s & Poor’s Description Lowest-rated class in Moody’s Description of Bond Ratings Standard Quality Moody’s & Poor’s Description Lowest-rated class in Moody’s designation n Extremely poor prospects of attaining any real investment standing n Interest not currently being paid n Default C C D Default in interest and/or principal n 40

Junk Bonds Appropriate only for the portfolio of investors with a higher than average Junk Bonds Appropriate only for the portfolio of investors with a higher than average risk tolerance Possible reasons for being in the junk bond category: n n n “Fallen angel” bonds - companies that once had high credit rankings but now face hard times “Emerging growth” companies – not yet established small firms Companies undergoing restructuring as a result of a leveraged buyout or as part of fending off an unfriendly takeover offer 41

Bond Markets, Capital Market Theory and Efficiency n Lower rated bonds tend to trade Bond Markets, Capital Market Theory and Efficiency n Lower rated bonds tend to trade at larger yields than higher quality bonds Risk premium is higher on lower rated bonds Bonds return n n > > n Equity investment return Equity is riskier than bonds Bonds have a contractual agreement to receive principal & interest payments 42

The Global Bond Market n n n n In excess of $40 trillion U. The Global Bond Market n n n n In excess of $40 trillion U. S. makes up approximately 49% of the market Japan 19% Germany 12% Italy 5% In certain years, foreign bonds perform better than U. S. bonds In 1996, the total return in the bond market • U. S. 1. 4% • Italy 30. 4% • United Kingdom 17. 8% Potential benefits to international diversification 43

Dollar-Denominated Bonds in which the payment is in dollars Examples – n Yankee bonds Dollar-Denominated Bonds in which the payment is in dollars Examples – n Yankee bonds issued by n • • • n foreign governments corporations, or major agencies (e. g. World Bank) Traded in the U. S. Denominated (payable) in U. S dollars Eurodollar bonds • Denominated in dollars • Issued & traded outside the U. S. Eurodollars could be issued in any country outside the United States (not just in Europe!) 44

Foreign-Pay Bonds Issued in a foreign country n Payable in that country’s currency e. Foreign-Pay Bonds Issued in a foreign country n Payable in that country’s currency e. g. Japanese government bond payable in yen n Currency exposure to a U. S. investor n Foreign-pay bond may go up or down against the U. S. dollar n 45

Other Forms of Fixed-Income Securities Certificates of Deposit (CDs) n Commercial Paper n Bankers’ Other Forms of Fixed-Income Securities Certificates of Deposit (CDs) n Commercial Paper n Bankers’ Acceptance n Money Market Funds n Money Market Accounts n 46

Preferred Stock as an Alternative to Debt n n n Between bonds and common Preferred Stock as an Alternative to Debt n n n Between bonds and common stock Bondholders can claim against the corporation Common stockholders have no such claim but are the ultimate owners Preferred stockholders entitled to receive a stipulated dividend In bad times, preferred stock dividends may be omitted by the corporation 47

Features of Preferred Stock n n n Convertible Callable Cumulative 48 Features of Preferred Stock n n n Convertible Callable Cumulative 48

Websites Comments www. bondmarkets. com Provides bond information and trading. www. moodys. com Provides Websites Comments www. bondmarkets. com Provides bond information and trading. www. moodys. com Provides bond information; some is fee based www. bondsonline. com Provides bond information www. smartmoney. com Provides information on bond yields, bond investing, and related topics 49

Websites Comments www. breifing. com Provides some bond trading information and general information about Websites Comments www. breifing. com Provides some bond trading information and general information about bonds www. teachmefinance. com Education site pertaining to finance and bonds www. investorguide. com Links to sites provide information on government and corporate bonds 50

Summary n n n Debt plays an important role in our economy Issuer’s and Summary n n n Debt plays an important role in our economy Issuer’s and investor’s viewpoints Primary fund raisers in the bond market are • U. S. Treasury • Federally sponsored credit agencies • State governments • Local governments • Corporations 51

Summary n Bond instruments are evaluated on the basis of • • • n Summary n Bond instruments are evaluated on the basis of • • • n n Yield Maturity Method of repayment Security provisions Overall risk Tax treatment Greater protection & privileges result in lower yield Important feature: rating received by Moody’s Investors Service or Standard & Poor’s 52

Summary n n n Ratings range from AAA to D Ratings determine the required Summary n n n Ratings range from AAA to D Ratings determine the required yield to sell a security Some factors affecting ratings: • • • Cash flow Earnings generation in relation to interest Operating margins Return on invested capital Total assets Qualitative factors (e. g. managers ability) 53