Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 17
Chapter 17
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 17
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 investment-grade
bonds and high-yield (junk) bonds?
Chapter 17
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 17
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 assetbacked securities, zero-coupon and deep
discount bonds, high-yield bonds, and
structured notes?
• 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
Major Rating Agencies
• Standard & Poor’s
• Moody’s
• Fitch Investor Services
Alternative Bond Issues
Domestic government bonds
– United States - T-bills, notes, bonds. TIPS
– Japan - medium term, long term, super long
term
– Eurozone – government bonds
– 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
United Kingdom
– There are no agency bonds in the U.K.
Eurozone
– Agency bonds are not broken down in the
Eurozone
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
U.K. Corporate Bond Market
• Debentures
• Unsecured loans
• Convertible bonds
Eurozone Corporate Bond Market
• Nonbank corporate bonds including
industrial and utility firms
• “Corporate-monetary Financial” including
borrowing by banks
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
• 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
International Bonds
• Eurozone
– Market popular among foreign issuers
including issuers domiciled in the U.S.
– Impressive growth in Eurobonds issued by nonresidents
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
Company
(Ticker)
Ford 7.45 July 16 2031
Last Last EST UST EST $
Price Yield Spread
VOL
80.625
9.461
503
30
213,645
Corporate Bond Quotes
Company
(Ticker)
Ford 7.45 July 16 2031
Last Last EST UST EST $
Price Yield Spread
VOL
80.625
Issued by Ford Motor Company
9.461
503
30
213,645
Corporate Bond Quotes
Company
(Ticker)
Ford 7.45 July 16 2031
Last Last EST UST EST $
Price Yield Spread
VOL
80.625
The maturity date of this bond
9.461
503
30
213,645
Corporate Bond Quotes
Company
(Ticker)
Ford 7.45 July 16 2031
Last Last EST UST EST $
Price Yield Spread
VOL
80.625
9.461
503
30
213,645
The last transaction price was 80.625 percent of par or $806.25,
which implies an yield to maturity (YTM) for this bond of
9.461 percent
Corporate Bond Quotes
Company
(Ticker)
Ford 7.45 July 16 2031
Last Last EST UST EST $
Price Yield Spread
VOL
80.625
9.461
503
30
213,645
The computed yield spread for the Ford bond is 503 basis
points (5.03 basis points)
Corporate Bond Quotes
Company
(Ticker)
Ford 7.45 July 16 2031
Last Last EST UST EST $
Price Yield Spread
VOL
80.625
Comparable U.S. treasury Issue
9.461
503
30
213,645
Corporate Bond Quotes
Company
(Ticker)
Ford 7.45 July 16 2031
Last Last EST UST EST $
Price Yield Spread
VOL
80.625
9.461
503
30
The trading volume for this bond is over $213 million
213,645
Treasury and Agency Bond Quotes
• Notations
– “n” = treasury note
– “i” = inflation-indexed issue
– “p” = treasury note on which nonresident aliens
are exempt from withholding taxes on interest
• Quotes resemble those used for OTC
securities because they contain both bid and
ask prices
Treasury and Agency Bond Quotes
GOVT. BONDS & NOTES
Maturity
Rate Mo/Yr
Bid
Asked Chg.
5.750 Nov 05n 101:05 101:06
….
Ask
Yld.
3.13
Treasury and Agency Bond Quotes
GOVT. BONDS & NOTES
Maturity
Rate Mo/Yr
Bid
Asked Chg.
Ask
Yld.
5.750 Nov 05n 101:05 101:06
….
3.13
This is a 5.75 percent obligation bond due in
November 2005. The bid quote is 101:05, and
the ask is 101:06
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 07/01/10 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, 2010
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
http://www.bondheads.com
http://www.investinginbonds.com
http://www.fitch.com
http://www.moodys.com
http://www.standardandpoors.com/ratings
http://www.bradynet.com
http://www.publicdebt.treas.gov
End of Chapter 17
–Bond Fundamentals
Future topics
Chapter 18
• The Analysis and Valuation of Bonds