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