Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 18 Chapter 18 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? Chapter 18 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 investmentgrade bonds and high-yield (junk) bonds? Chapter 18 Bond Fundamentals • What are the characteristics of bonds in the major bond categories such as governments (including TIPS), 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? Chapter 18 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? Chapter 18 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 • How do you read the quotes available for the alternative bond categories (e.g., governments, municipalities, corporates)? 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 Basic Features of a Bond • Bond market is divided by maturity – Money Market - short-term issues that mature within one year – Notes - intermediate-term issues that mature between one and ten years – Bonds - long-term obligations with maturity greater than ten years • Remaining life (maturity) affect price volatility 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 Bond Characteristics • Indenture provisions • Features affecting a bond’s maturity – – – – – Callable (call premium) Noncallable Deferred call Nonrefunding provision Sinking fund Rates of Return on Bonds HPR i,t where: Pi,t 1 Int i,t Pi,t HPRi,t = the holding period for bond i during the period t Pi,t+1 = the market price of bond i at the end of period t Pi,t = the market price of bond i at the beginning of period t Inti,t = the interest payments on bond i during period t The holding period yield (HPY) is: HPY = HPR - 1 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 Participating Investors • Individual investors • Institutional investors – – – – – Life Insurance Companies Commercial Banks Property and Liability Insurance Companies Pension Funds Mutual Funds Bond Ratings • Ratings Services 1. Duff and Phelps 2. Fitch Investors Service 3. Moody’s 4. Standard & Poor’s • Non-rated bonds Alternative Bond Issues Domestic government bonds – United States - T-bills, notes, bonds. TIPS – 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 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 Municipal Bonds • General obligation (GO) 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) Equivalent Taxable Yield i ETY (1 - T ) Where: i = coupon rate of the municipal obligations T = marginal tax rate of the investor 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) Municipal Bond Guarantees • Insured bonds obtain AAA (Aaa) ratings • Issues with private guarantees have more active secondary market, and lower required yield Corporate Bonds • • • • Mortgage bonds Collateral trust bonds Equipment trust certificates Collateralized mortgage obligations (CMOs) • Other asset-backed securities (ABS) • Variable rate notes 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 with rating below BBB or Baa Japanese Corporate Bond Market • Bonds issued by industrial firms or utilities • Minimum issuing requirements are specified by the Ministry of Finance • Bonds issued by banks to finance loans to corporation – – – – Commercial banks Long-term credit banks Mutual loan and savings banks Specialized financial institutions German Corporate Bond Market • • • • Bank bonds German mortgage bonds German commercial bonds Private Loan Agreements (Schuldscheindarlehen) U.K. Corporate Bond Markets • Debentures • Unsecured loans • Convertible bonds 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 International Bonds • United States – Yankee bonds register with SEC – Eurodollar bond market affected by changes in value of U.S. dollar International Bonds • Japan – Samuri bonds - yen denominated issued by non-Japanese firms in Japan – Euroyen bonds - yen denominated, sold outside Japan International Bonds • Germany – DM-denominated bonds issued by foreign companies are Eurobonds 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 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 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 Sources of Bond Quotes • Bank and Quotation Record • The Blue List of Current Municipal Offerings • Wall Street Journal • Barron’s 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 Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 81/8 22 7.7 52 1053/8 + 1/4 Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 81/8 22 7.7 52 1053/8 + 1/4 Issued by AT&T Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 81/8 22 7.7 52 1053/8 + 1/4 Issued by AT&T 8.125% coupon rate Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 81/8 22 7.7 52 1053/8 + 1/4 Issued by AT&T 8.125% coupon rate matures in 2022 Corporate Bond Quotes Cur Bonds Yld Vol Close ATT 81/8 22 7.7 52 1053/8 Net Chg + 1/4 Issued by AT&T 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7% Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 81/8 22 7.7 52 1053/8 + 1/4 Issued by AT&T 52 of these bonds traded that day 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7% Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 81/8 22 7.7 52 1053/8 + 1/4 Issued by AT&T 52 of these bonds traded that day 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7% The closing price was 105 3/8% of par Corporate Bond Quotes Cur Bonds Yld Vol Close ATT 81/8 22 7.7 52 1053/8 Net Chg + 1/4 Issued by AT&T 52 of these bonds traded that day 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7% The closing price was 105 3/8% of par which was up 1/4 from the prior day Corporate Bond Quotes • Notations – “cv” = convertible – “zr” = zero coupon – “dc” = deep discount (at time of issue) • Accrued interest must be added to price quoted 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 Treasury and Agency Bond Quotes GOVT. BONDS & NOTES Maturity Rate Mo/Yr Bid Asked 55/8 Dec 99n 100:08 100:10 Chg. Ask Yld. …. 5.04 Treasury and Agency Bond Quotes GOVT. BONDS & NOTES Maturity Rate Mo/Yr Bid Asked 55/8 Dec 99n 100:08 100:10 Chg. Ask Yld. …. 5.04 Prices are in 32nds usually with a very small spread between bid and ask 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 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 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 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 End of Chapter 15 –Bond Fundamentals Future topics Chapter 19 • The Analysis and Valuation of Bonds
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