Unit 13

Compute Bond Prices

1 Point = 1% of par = $10 Corp/Muni bonds: 1/8 point = $1.25 Gov't: 32nd's 1/4 of 1/8 where .01 =$.3125 and .16 = 1/2 = $5 When you see a corporate bond quoted at 1031⁄2, it represents a market price of $1,035. The 103 is 103% of $1,000, or $1,030, and the 1⁄2 is half of a $10 point, or $5. On a Treasury bond, that same price would be shown as 103.16 where the .16 is 16/32s or 1⁄2.

Liquidation Priority of capital structures

1. Secured creditors -(e.g., mortgage bonds, equipment trust certificates, collateral trust bonds) 2. Unsecured Creditors -(e.g., general creditors including debenture holders) 3. Subordinated Debt 4. Preferred Stock 5. Common Stock

Which of the following factors has a direct relationship to a bond's duration? A) Time to maturity B) Coupon rate C) Yield to maturity D) Rating

A. The longer the time to maturity, the higher (longer) the duration. Yield to maturity and coupon rate have an inverse relationship. That is, the higher the YTM and the coupon, the lower (shorter) the duration. The bond's rating is irrelevant. U13LO11

Treasury Bills

Always issued at a discount - Never pay interest maturities of 4 weeks, 8 weeks, 13 weeks, 26 weeks, are issued and once each 4 weeks, 52 week bills are issued. 13 week typically used for market analysis

Cash Flow analysis on mortgage backed debts uses

Average maturities

General Obligation Bonds

Backed by full faith and credit (taxes) -Issuer's authority to tax

Revenue Bonds

Backed by specific revenue source, tolls, or user fees

London Interbank Offered Rate (LIBOR)

Bank to bank short term lending rate established in London

Advantages of Eurodollar bonds

Bear no currency risk to US investors because they are US dollar denominated Rated by US rating agencies May offer higher yields than domestic bonds from the same issuer

Parity Price of Convertible Bonds

Bond is convertible into fixed number of common shares Price when bond and stock are at equal value CMV x Conversion Ratio

A new convertible bond has a provision that it cannot be called for 5 years after the issue date. This call protection is most valuable to a recent purchaser of the bond if A) interest rates are stable B) the market price of the underlying common stock is increasing C) interest rates are falling D) interest rates are rising

Convertible bonds are more sensitive to the price of the underlying common stock than they are to interest rates. Call protection would enable this investor to hold on to the bond while the stock rises in value rather than having the bond called away. U13LO8

Risk of investing in foreign bonds

Currency risk Potentially higher risk of default Generally less liquidity Generally higher trading costs

Insured Bank Deposits

Demand deposit accounts Insured Bank CD's - Time deposits -Capital Preservation -No interest rate risk -No secondary market

Advantages of Convertible Securities

Downside Protection - Assured income, Interest paid semi-annually and principal repaid at maturity Upside Potential -Bond price increase matches increase in stock price Anti-Dilutive protection -Protection agains dilution resulting from a stock split or stock dividend

Municipal Bonds

Issued by a form of gov't other than the federal government or agency of the federal gov't Interest exempt from federal taxes Exemption may also apply at state and local level -If issued in your state Capital gains subject to taxation

Benefits of Muni Bonds

Low default risk Tax-free income -Attractive to those in high federal tax brackets

Benefits of MM securities

Safety Liquidity

Benefits of Gov't issues

Safety Liquidity Best place to be when recession and deflation are predicted

Collateral Trust Bonds

Securities of company or other companies are used as collateral to debt obligations

Tax Equivalent Yield

Taxable yield * (100% - tax bracket) = Tax Free Muni Equivalent

Duration

The lower the coupon rate, the longer a bond's duration; the higher the coupon rate, the shorter the duration The longer a bond's maturity, the longer the bond's duration For coupon bonds, duration is always less than the bond's maturity Duration of a zero coupon bond is always equal to its maturity The longer a bond's duration, the more its value will change for a 1% change in interest rates; the short the duration, the less it will change If you were managing a portfolio of bonds and expected interest rates to decline, you would lengthen the average duration of the portfolio. If you were of the opinion that interest rates were going to rise, you would want to shorten the average

Treasury Notes

They pay semiannual interest as a percentage of the stated par value. They have intermediate maturities (2, 3, 5, 7, and 10 years). They mature at par value. They are noncallable.

US Treasury Bonds

They pay semiannual interest as a percentage of the stated par value. They have long-term maturities, generally 10-30 years. They mature at par value.

Money Market Instruments

Used to finance short term cash requirements Characteristics -High quality debt -Short term (one year or less) -Issued at a discount, except CD's

Debentures

debt obligation of the corporation backed only by its word and general creditworthiness sold on the general credit of the company; -their security depends on the assets and earnings of the corporation

Zero coupon bonds

duration equals maturity Issued at deep discount Appropriate for target dates No reinvestment risk High volatility Generates phantom income -Money you don't see but receive taxes on

The higher the DCF the

more valuable the investment

Yield to maturity

the annualized return of a bond if it is held to maturity YTM accentuates the return by adding a profit to bond bought at discount or subtracting the loss on a bond bought at premium YTM on a discounted bond will always be higher than that bond's current yield

Treasury bills are A) issued at par B) issued in bearer form C) issued in book entry form D) callable

All Treasury securities are issued in book entry form. Treasury bills are always issued at a discount and are never callable. U13LO1

Current Yield

Annual interest in dollars divided by the current market price

Eurobond

Any LT debt instrument issued and sold outside of the country of the currency in which it is denominated Pays interest in foreign currency Eurodollar bond -A US dollar denominated eurobond -Bond issued by a non-American company, sold outside the US and the issuer's country, but for which the principal and interest are stated and paid in US dollars

LT Debt

Atleast 5 years

Issuers of MM instruments

Corporations -Commercial paper Banks (Jumbo, $100K minimum) CD's -No prepayment penalty -Insured by FDIC (to $250k) US Gov't -All T-Bills, as well as bonds/notes in the secondary market with one year or less remaining to maturity

Gov't Agency Issues

Government National Mortgage Association (GNMA) Federal National Mortgage Corporation (FNMA)

Nominal Yield

Interesest rate stated on the face of the bond Coupon rate

Risks of Muni bonds

Interest rate risk Inflation risk Possible exposure to the AMT

Subordinated Debt

Last to be paid out

Several years ago, an investor purchased an investment-grade bond with a 6% coupon. Today that bond is priced to yield 4.6% to maturity in 5 years. If the bond is called at par in one year, the bond's yield would be A) less than 4.6%. B) more than 4.6%. C) the coupon rate of 6% because it is called at par value. D) 4.6%.

Let's take things in order. A bond with a 6% coupon is showing a YTM below 6%, the bond must be selling at a premium. When bonds selling at a premium are called in advance of the maturity date, the "loss" (the difference between the premium and the par value") is recognized sooner than expected. This results in a yield to call (YTC) that is less than the YTM. U13LO10

Advantages of investing in foreign bonds

Potentially higher returns Diversification Hedging against a drop in value of hte US dollar

Risk associated with GNMA and FNMA

Prepayment risk (Reinvestment risk) Default risk (FNMA)

Convexity

Duration is a linear measurement, while convexity follows a curve Comparing two bonds, the one with the higher convexity will show a greater price increase when yields fall and a smaller decrease when yields rise If we find two bonds with the same duration, the one with the higher convexity offers greater interest rate risk protection

Kate, age 59, has an investment portfolio exceeding $250,000. She considers herself a moderate to conservative investor. To generate additional income, she is anticipating adding bonds to her portfolio. She lives in a state that does not have an income tax and she is in the 28% federal income tax bracket. Which of the following bonds would be the best recommendation for her portfolio? A) Bond C, CCC-rated corporate debenture with an 8% coupon rate B) Bond D, AAA-rated Treasury note with a 2.55% coupon rate C) Bond A, A-rated corporate debenture with a 6.5% coupon rate D) Bond B, BBB-rated municipal bond with a 3.75% coupon rate

Even though Bond C has the highest after-tax rate of return, this bond would not be appropriate for Kate based on her risk tolerance. Therefore, Bond A would be the best choice. Calculations: Bond A: 6.5 × (1 - 0.28) = 4.68% Bond B: 3.75% Bond C: 8% × (1 - 0.28) = 5.76% Bond D: 2.55% × (1 - 0.28) = 1.84% U13LO6

Treasury inflation protected securities

Every 6 months adjustment made to prinicpal reflecting changes in CPI

Commercial Paper

Exempt from registration if matures within 270 days Issued at a discount by corporations

Risks of MM securities

Low yields Not suitable for LT investors

Disadvantages of Convertible Securities

Lower interest rates than nonconvertible debt Risk that the convertible bond may be called away before one is ready to convert

Risks of gov't issues

Lower yields Interest rate risk -Inverse relationship between interest rates and bond prices Inflation risk (Except for TIPS)

Disadvantages of Eurodollar bonds

May be lack of transparency because they are not registered with the SEC Political and country risk Less liquidity than domestic issues Currency risk (if denominated in a currency other than one's home country)

Negotiable CD's (Jumbo CD's)

Money being loaned to the bank allows the initial investor, or any subsequent owner of the CD, to sell the CD in the open market before the maturity date Pays periodic interest usually semiannually No prepayment penalty

Investment Grade bonds

Moody's Aaa - Baa S&P's AAA - BBB -Greater liquidity

GNMA

Only agency issue backed by the full faith and credit of the US gov't Pass-through certificate, monthly income some of each monthly payment to the investor represents principal, and the balance of each payment represents interest portion of each monthly payment representing interest is subject to state and local taxation and, of course, federal income tax as well

FNMA

Pass-through certificate Semi-annual income Interest is taxable at all levels

Required parts to compute the future value of the cash flow from a bond

Principal amount Coupon rate Number of interest payments

US Gov't Securities

Safest issuer - Will not default Tax exempt interest at state level -taxable at federal level

An investor owns a TIPS bond with an initial par value of $1,000. The coupon rate is 6% and, during the first year, the inflation rate is 9%. How much interest would be paid for the year? A) $60.00 B) $64.11 C) $65.40 D) $90.00

TIPS bonds have a fixed coupon rate with a principal that varies each 6 months based on the inflation rate. With an annual inflation rate of 9%, each 6 months, the principal increases by 4.5% (half of the annual rate). Each semiannual coupon is half of the 6% rate times the new principal. The arithmetic is: $1,000 x 104.5% = $1,045 x 3% = $31.35 plus, $1,045 x 104.5% = $1,092 x 3% = $32.76. Adding the 2 interest payments together results in a total of $64.11 for the year. You should be able to "eyeball" this. Any bond with a 6% coupon will pay $60 in one year ($30 x 2). Because the TIPS bond increases the principal after the first 6 months, the second interest payment will be slightly higher than $30. There is only one choice slightly higher than $60.00 and it would be that way on the real exam. U13LO1

DERP Corporation's 5% convertible debentures maturing in 2030 are currently selling for 120. The conversion price is $40. One would expect the DERP common stock to be selling A) somewhat below $48 per share B) somewhat above $48 per share C) somewhat above $30 per share D) somewhat below $30 per share

The first step here is to compute the parity price. A conversion price of $40 means the debenture is convertible into 25 shares of the common stock (par of $1,000 divided by $40 = 25 shares). With a current market price of $1,200, the parity price of the stock would be $48. Because convertible securities generally sell at a slight premium over their parity price, the stock should have a current market value a bit less than $48 per share. U13LO9