Corporate Bonds
A Corporate bond is a security issued by a
corporation.

It represents a promise to pay bondholders a fixed
sum of money (called the bond’s principal, or par or
face value) at a future maturity date, along with
periodic payments of interest (called coupons).

Bonds issued with a standard, relatively simple set of
features are popularly called Plain Vanilla Bonds (or
“bullet” bonds).
 Debentures are unsecured bonds issued by a
corporation.
 Mortgage bonds are debt secured with a property lien.
 Collateral trust bonds are debt secured with financial
collateral.
 Equipment trust certificates are shares in a trust with
income from a lease contract.

A Bond indenture is a formal written agreement
between the corporation and the bondholders.

This agreement spells out, in detail, the obligations of
the corporation, the rights of the corporation, and the
rights of the bondholders (with respect to the bond
issue.)

In practice, few bond investors read the original
indenture. Instead, they might refer to an indenture
summary provided in the prospectus of the bond issue.

Different bond issues can usually be differentiated
according to the seniority of their claims on the firm’s
assets in case of default.

 Senior Debentures are the bonds paid first in case of default.
 Subordinated Debentures are paid after senior debentures.
Bond seniority may be protected by a negative
pledge clause.

 A negative pledge clause prohibits a new debt issue that would
have seniority over existing bonds.
A traditional, fixed-price call provision allows the
issuer to buy back all or part of its outstanding bonds
at a specified call price sometime before the bonds
mature.


When interest rates fall, bond prices increase.
 The corporation can “call-in” the existing bonds, i.e., pay the call
price.
 The corporation can then issue new bonds with a lower coupon.
 This process is called bond refunding.
No matter how low market interest rates fall, the
maximum price of an unprotected fixed-price callable
bond is most likely its call price.

Like a fixed-price call provision, a make-whole call provision
allows the issuer to pay off the remaining debt early. However,

 The issuer must pay the bondholders a price equal to the present value
of all remaining payments.
 The discount rate used to calculate this present value is equal to:
 The yield of a comparable maturity U.S. Treasury security
 A fixed, pre-specified make-whole premium

As interest rates decrease:
 the make-whole call price increases
 But, even in the region of low yields, these bonds still exhibit the
standard convex price-yield relationship in all yield regions.
A bond with a put provision can be sold back to the
issuer at a pre-specified price (normally set at par
value) on any of a sequence of pre-specified dates.

Bonds with put provisions are often called
extendible bonds.

Convertible bonds are bonds that can be exchanged for
common stock according to a pre-specified conversion
ratio (i.e., the number of shares acquired).

 Suppose the conversion ratio for a $1,000 par value bond is 20 shares.

Conversion Price = Bond Par Value / Conversion Ratio
 Then, the conversion price is $50 ($1,000 / 20).

Conversion Value = Price Per Share X Conversion Ratio
 If the market price per share of stock is currently $40, the conversion
value is $800 ($40 x 20).
Bond maturity and principal payment provisions - Term
bonds are issued with a single maturity date, while serial
bonds are issued with a regular sequence of maturity
dates.

Term bonds normally have a sinking fund, which is an
account used to repay some bondholders before maturity.

 Money paid into a sinking fund can only be used to pay bondholders.
 Some bondholders are repaid before the stated maturity of their
bonds, whether they want to be repaid or not.
 At maturity, only a portion of the original bond issue will still be
outstanding.
Coupon payment provisions - An exact schedule of
coupon payment dates is specified.

If a company suspends payment of coupon interest, the
company is said to be in default:

 Bondholders have the unconditional right to timely repayment.
 Bondholders have the right to bring legal action to get paid.
 Companies in default have the right to seek protection from inflexible
bondholders in bankruptcy court.
If there is default, it is often in the best interests of the
bondholders and the company to avoid court and
negotiate a new bond issue to replace the existing one.

A bond indenture is likely to contain a number of
protective covenants.

Protective Covenants are restrictions designed to
protect bondholders.

 Negative covenant (“thou shalt not”) example - The firm cannot pay
dividends to stockholders in excess of what is allowed by a formula
based on the firm’s earnings.
 Positive covenant (“thou shalt”) example - Proceeds from the sale of
assets must be used either to acquire other assets of equal value or to
redeem outstanding bonds.
A Private placement is a new bond issue sold
privately to one or more parties. That is, this new
bond issue is not available to the general public.

Private placements are exempt from registration
requirements with the SEC, although they often have
formal indentures.

Debt issued without an indenture is basically a
simple IOU of the corporation.

A corporation usually subscribes to several bond rating
agencies for a credit evaluation of a new bond issue.

Each contracted rating agency will then provides a
credit rating - an assessment of the credit quality of the
bond issue based on the issuer’s financial condition.

 The best known rating agencies in the U.S. are Moody’s Investors
Services and Standard & Poors Corporation.
 Rating agencies in the U.S. also include Duff and Phelps; Fitch
Investors Service; and McCarthy, Crisanti, and Maffei.

A bond’s credit rating helps determine its yield spread.
The yield spread is the extra return (increased yield to
maturity) that investors demand for buying a bond with a
lower credit rating (and higher risk).

Yield spreads are often quoted in basis points over
Treasury notes and bonds. That is,

 Suppose we see a 5-year Aaa/AAA yield spread equal to 59.
 This means the YTM on this bond is 59 basis points (0.59%) greater
than 5-year U.S. Treasury notes.
High-yield bonds are bonds with a speculative credit
rating (Moody’s Ba , S&P BB).

As a result of this poor credit rating, a yield premium
must be offered on these bonds to compensate
investors for higher credit risk.


High-yield bonds are also called junk bonds.
At the request of the SEC, corporate bond trades are
now reported through TRACE.

TRACE provides a means for bond investors to get
accurate, up-to-date price information.

TRACE has dramatically improved the information
available about bond trades.

 Transaction prices are now reported on more than 4,000 bonds
 That is, about 75% of market volume for investment grade bonds.
 More bonds will be added to TRACE over time.





www.investinginbonds.com (for more information on corporate bonds)
www.sec.gov (U.S. Securities and Exchange Commission)
www.convertbond.com (for more information about convertible bonds)
www.bondsonline.com (follow the "corporate bond spreads" link)
www.nasdbondinfo.com (for TRACE data on bond trades)

Websites for companies in this chapter:





www.nwa.com (Northwest Airlines)
www.amd.com (Advanced Micro Devices)
www.marriott.com (Marriott International, Inc.)
www.hostmarriott.com (Host Marriott Corporation)
Websites for Ratings Agencies:





www.duffllc.com (Duff and Phelps, LLC.)
www.fitchibca.com (Fitch Investors Service)
www.moodys.com (Moody’s)
www.standardpoor.com (Standard & Poor’s)
www.mcmwatch.com (MCM)



Corporate Bond Basics
Types of Corporate Bonds
Bond Indentures
 Bond Seniority Provisions
 Call Provisions
 Fixed-Price
 Make-Whole






Put Provisions
Bond-to-Stock Conversion Provisions
Graphical Analysis of Convertible Bond Prices
Bond Maturity and Principal Payment Provisions
Sinking Fund Provisions
Coupon Payment Provisions
Protective Covenants
Bonds Without Indentures
Preferred Stock
Adjustable-Rate Bonds and Adjustable-Rate Preferred
Stock
 Corporate Bond Credit Ratings
 High-Yield (Junk) Bonds





Bond Market Trading, TRACE

Homework: 2, 7, 14
Government Bonds
In 2005, the gross public debt of the U.S. government
was more than $4 trillion, making it the largest single
borrower in the world.

The U.S. Treasury finances government debt by issuing
marketable as well as non-marketable securities.


Municipal government debt is also a large debt market.
 In the U.S., there are more than 80,000 state and local governments.
 Together, they contribute about $2 trillion of outstanding debt.

Marketable securities can be traded among investors.
Marketable securities issued by the U.S. Government
include T-bills, T-notes, and T-bonds.

Non-marketable securities must be redeemed by the
issuer.

Non-marketable securities include U.S. Savings Bonds,
Government Account Series, and State and Local
Government Series.

T-bills are Short-term obligations with maturities of 13,
26, or 52 weeks (when issued).

T-bills pay only their face value (or redemption value) at
maturity.

Face value denominations for T-bills are as small as
$1,000.

T-bills are sold on a discount basis (the discount
represents the imputed interest on the bill).

T-notes are medium-term obligations, usually with
maturities of 2, 5, or 10 years (when issued).

T-notes pay semiannual coupons (at a fixed coupon
rate) in addition to their face value (at maturity).

T-notes have face value denominations as small as
$1,000.

T-bonds are long-term obligations with maturities of
more than 10 years (when issued).

T-bonds pay semiannual coupons (at a fixed coupon
rate) in addition to their face value (at maturity).

T-bonds have face value denominations as small as
$1,000.

STRIPS: Separate Trading of Registered Interest and
Principal of Securities

STRIPS were originally derived from 10-year T-notes and
30-year T-bonds

 A 30-year T-bond can be separated into 61 strips - 60 semiannual
coupons + a single face value payment

STRIPS are effectively zero coupon bonds (zeroes).
The YTM of a STRIP is the interest rates the investors
will receive if the STRIP is held until maturity.

What is the price of a STRIPS maturing in 20 years
with a face value of $10,000 and a semiannual YTM of
7%?

The STRIPS price is calculated as the present value
of a single cash flow. That is,

STRIPS PRICE 
$10,000
1  0.07 2
40
 $2,525.72
Recall: The price of a bond is found by adding together the present value
of the bond’s coupon payments and the present value of the bond’s face
value.


The formula is:


C 
1
FV

Bond Price 
1
2M 
2M
YTM 
YTM
YTM
1
1

2 
2




In the formula, C represents the annual coupon payments (in $), FV is the
face value of the bond (in $), and M is the maturity of the bond, measured in
years.

In recent years, the U.S. Treasury has issued
securities that guarantee a fixed rate of return in
excess of realized inflation rates.


These inflation-indexed U.S. Treasury securities:
 Pay a fixed coupon rate on their current principal, and
 Adjust their principal semiannually according to the most recent
inflation rate

The Federal Reserve Bank conducts regularly scheduled
auctions for T-bills, notes, and bonds.

4-week, 13-week, and 26-week T-bills are auctioned weekly.

2-year T-notes are auctioned monthly.
5-year and 10-year T-bonds auctions occur about four times
per year for each maturity.

The U.S. Treasury posts auction FAQs, results, and other
details at:
www.publicdebt.treas.gov

At each Treasury auction, the Federal Reserve
accepts sealed bids of two types.

 Competitive bids specify a bid price/yield and a bid quantity.
Such bids can only be submitted by Treasury securities dealers.
 Noncompetitive bids specify only a bid quantity, and may be
submitted by individual investors.
The price and yield of the issue is determined by the
results of the competitive auction process.

All noncompetitive bids are accepted automatically
and are subtracted from the total issue amount.

Then, a stop-out bid is determined. This is the price
at which all competitive bids are sufficient to finance
the remaining amount.

Since 1998, all U.S. Treasury auctions have been
single-price auctions in which all accepted bids pay the
stop-out bid.

The U.S. Treasury offers an investment opportunity
for individual investors by issuing two types of
Savings Bonds:


Series EE Savings Bonds:
 Have face value denominations ranging from $50 to $10,000,
 Are sold at exactly half the face value.
 Treasury guarantees the bond will double in value in no more
than twenty years





Fixed interest rate (known at time of purchase)
Earn interest for up to thirty years
Accrue interest semiannually
Must be held at least one year
3-month interest penalty if held for less than 5 years

Series I Savings Bonds:




Have face value denominations ranging from $50 to $10,000.
Are sold at face value.
Earn interest for up to thirty years
Accrue interest semiannually (the interest rate is set at a fixed
rate plus the recent inflation rate), and
 Can be redeemed after 12 months
 At redemption, the investor receives the original price plus
interest earned
 But, investors redeeming Series I bonds within the first 5 years
of purchase incur a three-month earnings penalty
Most U.S. government agencies consolidate their
borrowing through the Federal Financing Bank, which
obtains funds directly from the U.S. Treasury.

However, several federal agencies are authorized to
issue securities directly to the public. Examples
include:

 The Resolution Trust Funding Corporation
 The World Bank
 The Tennessee Valley Authority
Bonds issued by U.S. government agencies share an
almost equal credit quality with U.S. Treasury issues.

They are attractive in that they offer higher yields
than comparable U.S. Treasury securities.

However, the market for agency debt is less active
than the market for U.S. Treasury debt.

 Compared to T-bonds, agency bonds have a wider bid-ask
spread.
Municipal notes and bonds, or munis, are
intermediate- to long-term interest-bearing
obligations of state and local governments, or
agencies of those governments.

Because their coupon interest is usually exempt
from federal income tax, the market for municipal
debt is commonly called the tax-exempt market.

The federal income tax exemption makes municipal
bonds attractive to investors in the highest income
tax brackets.

However, yields on municipal debt are less than
yields on corporate debt with similar features and
credit quality.

The risk of default is also real despite their usuallyhigh credit ratings.

Bonds issued by a municipality that are secured by the
full faith and credit (general taxing powers) of the issuer
are known as general obligation bonds (GOs).

Municipal bonds secured by revenues collected from a
specific project or projects are called revenue bonds.

 Example: Airport and seaport development bonds that are secured by
user fees and lease revenues.
Hybrid bonds are municipal bonds secured by project
revenues with some form of general obligation credit
guarantees.

 A common form of hybrid is the moral obligation bond.

Suppose you are trying to decide whether to buy:
 A corporate bond paying an annual coupon interest of 8%, or
 A municipal bond paying an annual coupon interest of 5%

How do you decide?
 If the purchase was for a tax-exempt retirement account, the
corporate bond is preferred because the coupon is higher.
 But, if the purchase is not tax-exempt, the decision should be made on
an after-tax basis.
 That is, you must calculate an equivalent taxable yield or
you must calculate an aftertax yield
Equivalent Taxable Yield 
Tax Exempt Yield
1 - Marginal Tax Rate
Aftertax y ield  Taxable Yield  (1 - Marginal Tax Rate)

Suppose you are in the 35% marginal tax bracket:
Equivalent Taxable Yield 
Tax Exempt Yield
5%

 7.69%
1 - Marginal Tax Rate 1 - 0.35

You would choose the corporate bond in this case (8% > 7.69%).

Instead, suppose you are in the 40% marginal tax bracket:
Aftertax Y ield  8%  (1 - .40)  4.8%

You would choose the municipal bond in this case (5% > 4.8%).
The Tax Reform Act of 1986 imposed notable
restrictions on the types of municipal bonds that qualify
for federal tax exemption of interest payments.

In particular, the act expanded the definition of private
activity bonds, which are taxable municipal bonds used to
finance facilities used by private businesses.

 The yields on such bonds are often similar to the yields on corporate
bonds.









www.publicdebt.treas.gov (lots of information on Treasuries)
www.investinginbonds.com (information on bonds, bonds, bonds)
www.ustreas.gov (visit the U.S. Treasury)
www.savingsbonds.com (for the latest on Savings Bonds)
www.bondmarkets.com (Bond Market Association)
www.municipalbonds.com (check out munis)
www.firstmiami.com (First Miami - muni bonds purchasable on-line)
www.lebenthal.com (buy muni bonds on-line)
www.muniauction.com (Muni Bond Auction on-line)

Government Bond Basics

U.S. Treasury Bills, Notes, Bonds, and STRIPS
 Treasury Bond and Note Prices
 Inflation-Indexed Treasury Securities

U.S. Treasury Auctions

U.S. Savings Bonds
 Series EE Savings Bonds
 Series I Savings Bonds

Federal Government Agency Securities

Municipal Bonds




Municipal Bond Features
Types of Municipal Bonds
Municipal Bond Credit Ratings
Municipal Bond Insurance

Equivalent Taxable Yield

Taxable Municipal Bonds

Homework: 2, 3, 8, 17