Fin 334 Chapter 10 (final)

How ratings work

-A firm's financial strength and stability are very important in determining the appropriate rating. -Generally, higher ratings are associated with more profitable companies that: +rely less on debt as a form of financing +are more liquid +have stronger cash flows +have no trouble servicing their debt in a prompt and timely fashion

Historical returns

-As with stocks, total returns in the bond market are made up of current income from bond's interest payments and capital gains (or losses) from changes in the bond's value. -During a period of rising rates, total returns on bonds include capital losses that can sometimes exceed the bonds' current interest income, resulting in a negative total return. +Total returns on U.S. Treasury bonds were negative in 10 out of 52 years (Table 10.1); years with negative total returns on bonds were years in which bond yields rose. -The inverse relationship between bond prices and yields can also work in investors' favor. Years with the highest total returns on bonds (Table 10.1) are almost always years in which bond yields fell during the year.

Quoting bond prices

-Bonds are not widely quoted in the financial press like stocks are. -Prices of all types of bonds are usually expressed as a percent of par. -The price of bond depends on its coupon and maturity, so these are usually included in a price quote.

Corporate and government bond rates tend to move together, but corporate bond rates are higher.

-Corporate bonds are more risky and thus require a higher rate to compensate for this risk. -Difference between the corporate and government bond rates is called the yield spread, or credit spread.

Two basic types of municipal bonds:

-General obligation bonds -revenue bonds

The bond market is:

-Mainly over-the-counter in nature. -Far more stable than the stock market. -Growing rapidly The U.S. bond market is quite a bit larger than the U.S. stock market.

The behavior of interest rates is the most important influence on bond returns.

-When interest rates rise, bond prices fall. -When interest rates drop, bond prices move up.

bonds

-publicly traded, long-term debt securities. They are often referred to as "fixed income securities" because the payments are usually fixed. -The issuer (borrower) agrees to pay a fixed amount of interest periodically and to repay a fixed amount of principal at maturity. -Like stocks, bonds can provide two types of income: (1) current income and (2) capital gains.

junior bonds

: Unsecured debt, backed only by the promise of the issuer to pay interest and principal on a timely basis.

serial bond

: a bond issue that has a series of bonds with different maturity dates, perhaps as many as 15 or 20, within a single bond offering.

premium bond

: a bond that sells for more than its par value; Occurs when market interest rates drop below the bond's coupon rate.

term to maturity

: amount of time remaining on a bond's life until it matures.

bond ratings

: letter grades that rating agencies give to new bond issues, corresponding to a certain level of credit risk.

refunding provision

: prohibits the premature retirement of an issue from proceeds of a lower-coupon bond. -a nonrefundable bond can still be called at any time as long as the money that the company uses to retire the bond prematurely comes from a source other than, new lower coupon bond issues

interest rate risk

: the chance that changes in interest rates will negatively affect the bond's value -interest rate risk is the most important risk that fixed income investors face because it is the major cause of price volatility in the bond market

In U.S. Treasury and agency bond quotes are stated in thirty-seconds of a point (1 point equals $10):

A quote for a T-bond of 94:16 translates to 94 16/32 or 94.5% of par, assuming $1,000 par value (i.e., $945.00).

In the corporate and municipal markets, bond prices are expressed in decimals:

A quote of 87.562 translates into a price of 87.562% of par or $875.62 for a bond with a $1,000 par value.

Ratings change as the financial condition of the issuer changes.

All rated issues are reviewed regularly to ensure the assigned rating is valid. -Upgrades and downgrades

Bonds versus stocks

Compared to stocks, bonds generally offer lower returns. -Main benefits of bonds in a portfolio: +Lower risk +High levels of current income +Diversification -Bonds add an element of stability to a portfolio.

Junk bonds

Highly speculative securities that have received low, sub-investment grade ratings. -Often take the form of subordinated debentures. -Called "junk" because of their high risk of default. -Typically offer very high yields. -Prices tend to behave more like stocks than bonds.

Municipal bonds: tax advantages

Interest is tax-exempt for Federal taxes Interest can be tax-exempt from state and local taxes if you live in the state where the bond was issued.

Corporate bonds

Issued by corporations from four major segments: -Industrials -Public Utilities -Transportation -Financial services +Wide variety of bond quality and bond types available +Popular with individuals because of the steady, predictable income they provide.

Treasury bonds

Issued by the U.S. Treasury, all Treasury obligations are of the highest quality because they are backed by the "full faith and credit" of the U.S. government. -Interest is paid semiannually and exempt from state and local taxes. -Today the Treasury issues only noncallable securities. -The Treasury issues its securities at regularly scheduled auctions.

The maturity of an issue has a greater impact on price volatility than the coupon does.

Prices of bonds with longer maturities are affected more by changes in interest rates.

What ratings mean

Ratings are tied to bond yields: the higher the rating the lower the yield. -A bond's rating has an impact on how sensitive its price is to interest rate movements as well as to changes in the company's financial performance. -Bond ratings serve to relieve individual investors of the time and cost of a thorough credit analysis of their own, but keep in mind: +Bond ratings only measure an issue's default risk, which is not related at all to an issue's exposure to interest rate risk. +Ratings agencies do make mistakes.

term bond

a bond issue that has a single, fairly lengthy maturity date for all the bonds being issued; most common type.

debenture

a bond that is totally unsecured, meaning there is no collateral backing up the obligation.

discount bond

a bond that sells for less than its par value; Occurs when market interest rates are above the bond's coupon rate.

mortgage-backed bond

a debt issue that is secured by a pool of residential mortgages. (interest paid monthly like mortgages and tax free) -The monthly payments received by bondholders are, like mortgage payments, made up of both principal and interest. -Issued primarily by three federal agencies: =Government National Mortgage Association (GNMA) +Federal Home Loan Mortgage Corporation (FHLMC) +Federal National Mortgage Association (FNMA) -Self-liquidating investment, since a portion of the monthly cash flow is repayment of the principal.

Note

a debt security that's originally issued with a maturity of 2 to 10 years (unlike bonds which are usually issued with a maturity of more than 10 years).

PIK bond

an unusual type of junk bond -PIK stands for "payment in kind" -Rather than paying the bond's coupon in cash, the issuer can make annual interest payments in the form of additional debt, usually for five or six years, before making interest payments in real money.

first and refunding bonds

are a combination of first mortgage and junior lien bonds . -bonds secured in part by a first mortgage on some of the issuer's property and in part by second or third mortgages on other properties. -Less secure than straight first-mortgage bonds.

Equipment Trust Certificates

are secured by specific pieces of equipment, such as boxcars and airplanes.

revenue bonds

are serviced by the income generated from specific income-producing projects (e.g. toll road)

general obligation bonds

backed by the full faith, credit, and taxing power of the issuer

investment-grade bonds

bonds receiving one of the top four ratings, indicating financially strong, well-run companies.

Junk Bonds (High-Yield Bonds)

bonds with below-investment-grade ratings, reflecting issuers lacking financial strength.

The price of a bond is a function of the bond's:

coupon, its maturity, and the level of market interest rates.

agency bonds

debt securities issued by various agencies and organizations of the U.S. government: -Federal Home Loan Bank -Federal Farm Credit Systems -Small Business Administration -Student Loan Marketing Association -Federal National Mortgage Association +High quality securities with almost no risk of default. +Usually provide yields that are slightly above the market rates for Treasuries.

zero-coupon bonds

don't pay interest and are sold at a deep discount from their par value -Increase in value over time at a compound rate of return; At maturity, the difference in value from their initial cost represents the bond's return. -Subject to tremendous price volatility as interest rates fluctuate. -Interest must be reported as it is accrued for tax purposes, even though no interest is actually received

call feature

every bond is issued with a call feature, which stipulates whether and under what conditions a bond can be called in for retirement prior to maturity. -Call features work for the benefit of the issuer, allowing issuers to take advantage of declines in market interest rates. The investor is left with a much lower rate of return than would be the case if the bond was not called.

Treasury Inflation-Protected Securities (TIPS)

first issued in 1997, these securities offer investors the opportunity to stay ahead of inflation by periodically adjusting their returns for any inflation that has occurred. -Maturities of 5, 10 and 30 years -Pay interest semiannually -Eliminates purchasing power risk -Lower risk than ordinary bonds, TIPS generally offer lower returns than ordinary Treasury bonds do.

If investors expect a increase in interest rates, they should buy bonds with

higher coupons and shorter maturities -this choice will minimize the price decline and act to preserve as much capital as possible

bond rating agencies

institutions that perform extensive financial analysis on companies issuing bonds to assess the credit risk associated with a particular bond issue. -Examples: Moody's, Standard & Poor's, Fitch

Bonds are exposed to 5 major types of risk:

interest rate risk, purchasing power risk, business/financial risk, liquidity risk, call risk

Eurodollar bonds

issued and traded outside of the U.S. and are not registered with the SEC. -Denominated in U.S. dollars -Eurodollar market primarily aimed at institutional investors and dominated by foreign-based investors.

Yankee bonds

issued by foreign governments or corporations or by supernational agencies, like the World Bank and the InterAmerican Bank. -Issued and traded in the U.S. -Registered with SEC -All transactions are in U.S. dollars -No currency exchange rate risk

municipal bonds

issued by states, counties, cities, and other political subdivisions (school districts, water and sewer districts). -often issued as serial obligations

treasury notes

issued with maturities of 2,3,5,7, and 10 years.

freely callable

issuer can prematurely retire the bond at any time

noncallable

issuer is prohibited from retiring the bond prior to maturity

If investors expect a decline in interest rates, they should buy bonds with

lower coupons and longer maturities to capitalize gains

treasury bonds

maturity of 30-years

current yield

measures the interest component of a bond's return relative to the bond's market price (calculated as the bonds's annual coupon, divided by the bond's current market price)

Collateralized Mortgage Obligations (CMOs)

mortgage-backed bond pool that is divided into "tranches", or classes of investors, based on whether they want a short-, intermediate-, or long-term investment. -Principal payments go first to the shortest tranche until it is fully retired, then the next in sequence is paid. -Complex and potentially risky. +Prepayment (call) risk. +Different tranches have different levels of prepayment risk.

income bonds

most junior of all bonds; unsecured debts requiring that interest be paid only after a certain amount of income is earned.

split rating

occurs when a bond issue is given different ratings by major rating agencies.

call risk

risk that a bond will be "called" (retired) before its scheduled maturity date.

collateral trust bonds

secured by financial assets owned by the issuer but held in trust by a third party.

mortgage bonds

secured by real estate

senior bonds

secured obligations, meaning they are backed by a legal claim or some specific property of the issuer. -mortgage bonds, collateral trust bonds, equipment trust certificates, first and refunding bonds

Asset-backed securities (ABS)

securities backed by pools of auto loans, credit card bills, home equity lines of credit, as well as computer leases, hospital receivables, small business loans, truck rentals, even royalty fees. -Issued by corporations -Offer relatively high yields -Short maturities, typically less than 5 years -Interest and principal payments are monthly -High credit quality

Equipment Trust Certificates

special corporate issue security issued by railroad, airlines and other transportation concerns; used to purchase equipment that serves as collateral for the issue.

sinking fund

stipulates how the issuer will pay off the bond over time. -Applies only to term bonds. -Not all term bonds have sinking-fund requirements. -Sinking fund requirements usually begin 1 to 5 years after the date of issue and continue annually thereafter until all or most of the issue is paid off. +Any amount not repaid would then be retired with a single "balloon" payment at maturity. -Obligates the issuer to pay off the bond systematically over time.

call premium

the amount added to the bond's par value and paid upon call to compensate bondholders

coupon

the amount of annual interest income the issuer pays to the bondholder.

Principal (par value; face value)

the amount of capital that the borrower must repay at maturity

call price

the bond's par value plus the call premium

purchasing power risk

the chance that bond yields will lag behind inflation rates. Inflation erodes the purchasing power of money. -bonds do well if inflation rates drop

maturity date

the date when a bond matures and the principal must be repaid. -Fixed

coupon rate

the interest payment that the bond issuer makes as a percentage of the bonds par value

deferred call

the issue cannot be called until after a certain length of time has passed from the date of issue

liquidity risk

the risk that a bond will be difficult to sell at a reasonable price.

business/financial risk

the risk that the issuer of the bond will default on interest or principal payments.

taxable equivalent yield

the taxable yield that is equivalent to a municipal bond's lower, tax-free yield

subordinated debenture

unsecured bond issues whose claim is secondary to other debenture bonds.

securitization

various lending vehicles are transformed into marketable securities

municipal bond guarantees

which are an additional source of collateral in the form of insurance, which improves the quality of the bond (higher ratings and improved liquidity).

The difference between the rate on corporate bonds and the rate on government bonds is called

yield spread, or credit yield

treasury strips

zero-coupon bonds created from U.S. Treasury securities and sold by government securities dealers .