Chapter Eleven
Bond and Fixed-Income Fundamentals
1
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bond and Fixed-Income
Fundamentals
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The Bond Contract
Secured and Unsecured Bonds
The Composition of the Bond Market
Bond Market Investors
Distribution Procedures
2
Bond and Fixed-Income
Fundamentals
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Junk Bonds
Bond Quotes
Bond Markets, Capital Market Theory and
Efficiency
The Global Bond Market
Other Forms of Fixed-Income Securities
Preferred Stock as an Alternative to Debt
3
Bond Market
Career Opportunities
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More new bond offerings than new
common stock offerings
Most financially rewarding jobs on Wall
Street go to sophisticated analysts and
dealers in the bond market
Players in this market must understand:
• The terms, &
• Financial ramifications of bond trading
4
Definition of a Bond

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A debt investment, with which the investor
loans money to an entity (company or
government) that borrows the funds for a
defined period of time at a specified
interest rate
The indebted entity issues investors a
certificate, or bond, that states the interest
rate (coupon rate) that will be paid and
when the loaned funds are to be returned
(maturity date)
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The Bond Contract
Term
Description
Major provisions/ agreement
 Over 100 pages long
Bond
 Complicated legal document
indenture
 Administered by a trustee
(usually a commercial bank)

Par
value
Face value of a bond
 Corporate: $1,000
 Fed, state, & local: $5,000 or $10,000

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The Bond Contract
Term
Coupon
rate
Description
Actual interest on the bond
 Payable semiannually

TO THE EXTENT THAT INTEREST
RATES IN THE MARKET GO ABOVE
OR BELOW THE COUPON RATE, THE
MARKET PRICE OF THE BOND WILL
CHANGE FROM PAR VALUE
Variablerate notes
(floatingrate notes)
Coupon rate fixed for a short period
 Then varies with a stipulated shortterm rate (e.g. U.S. Treasury bills)
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The Bond Contract
Term
Description
Debt issued at values substantially
below maturity value
Zero-coupon
 No semiannual cash interest paid
bonds
 Investor receives return in the form
of capital appreciation

Date at which final payment is due at the
Maturity date stipulated par value
Serial
payment
Bonds paid off in installments over the
life of the issue (e.g. Municipal bonds)
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The Bond Contract
Term
Description
Semiannual or annual contributions by
the bond issuer into a fund run by a
Sinking-fund
trustee for the purposes of debt
retirement
 Allows the corporation to call or force
in debt issue prior to maturity
Call provision
 Price paid usually 3 to 5% above par
 Usually deferred 5 to 10 years
Enables the bondholder to sell a longterm bond back to the corporation at par
Put provision
value (useful when market interest rates
have gone up)
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Secured and Unsecured Bonds
Term
Secured debt
Description
Debt backed by collateral
Real property (plant &
Mortgage agreement
equipment) pledged as a
security for a loan
Any new property be
After-acquired property
placed under the original
clause
mortgage
Proceeds from the bond
Equipment trust certificate used to buy equipment,
(used by transportation industry: which in turn serves as
rail roads, airlines, etc.)
collateral for the trust certificate
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Secured and Unsecured Bonds
Term
Debenture
Income bonds
Description
Unsecured corporate debt issue
 Higher yields due to higher risk
 For companies with
less favorable prospects
 Interest is to be paid only
to the extent that it is
earned as current income
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The Composition of the Bond Market
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U.S. Government Securities
Federally Sponsored Credit Agency Issues
State and Local Government Securities
Corporate Securities
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U.S. Government Securities
Treasury Bills (T-bills)
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Maturities 91 and 182 days
Trade on a discount basis
Minimum units of $1,000
Active secondary market
www.treasurydirect.gov
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U.S. Government Securities
Treasury Note (T-note)
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Extremely popular investments
Maturity of 1 to 10 years
Pays interest semi-annually
Minimum units of $1,000
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U.S. Government Securities
Treasury Bonds (T-bonds)
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Long term in nature, mature in 10 to 30 years
Treasury Department stopped issuing Treasury
bond in October 2001
Many are still unredeemed and earning interest,
with a significant number of years remaining
until maturity
Units of $1,000 and higher
Taxable for IRS (Federal Tax)
Tax exempt for state and local taxes
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U.S. Government Securities
Treasury strips = Zero-coupon Securities
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STRIP = Separate Trading of Registered
Interest and Principal Securities
Fixed-income securities
Sold at a significant discount to face value
No interest payments
Mature at par
Backed by the U.S. Government
Minimal risk
Tax benefits in certain states
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Risk & the U.S. Government Securities
Treasuries are considered free from credit risk
But they are affected by other types of risk
Interest-rate
risk
&
Inflation risk
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Inflation-Indexed
Treasury Securities
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Treasury Inflation Protection Securities (TIPS)
Offering started in January 1997
Intention: Protect investors against inflation
Investor receives TWO (2) forms of return
1. Annual interest rate paid semiannually
2. Automatic increase in initial principal to
account for inflation
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Federally Sponsored
Credit Agency Issues

Issued by various agencies of the government
• Federal National Mortgage Association
• Federal Home Loan Bank
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Authorized by an act of Congress to finance
federal projects
NOT direct obligations of the Treasury
Direct obligations of the issuing agencies
Slightly higher yield than U.S. government
securities
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Federally Sponsored
Credit Agency Issues
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Agency issues support the housing industry
Trade in denominations of $5,000 and up
Maturities from 1 to 40 years – avg. 15 yrs
Examples:
• Federal Intermediate Credit Banks
• Federal Farm Credit Bank
• Export-Import Bank
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Federally Sponsored
Credit Agency Issues

GNMAE (Ginnie Mae)
Government National Mortgage Association

Buys mortgages from various lenders at a discount
Issues securities to public against these mortgages
Investors receive monthly payments =


pass-thru
Interest
+
Principal payments on mortgages
www.ginniemae.gov
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State and Local
Government Securities
DEFINITION
Municipal Bonds:
Debt securities issued by
state & local governments
Most important feature:
Tax exempt nature of interest payment
Attractive investment for:
individuals in high tax brackets
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How to Calculate the Equivalent
Interest Rate on a Municipal
Bond (i.e. tax exempt) with
other Taxable Bonds
i
Y
(1  T )
Y = Equivalent before-tax yield on a taxable investment
i = Yield on the municipal obligation
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T = Marginal tax rate of the investor
Corporate Securities
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Main source of financing for U.S. corporations
80 to 85% of firms’ external financial needs
Corporate market subunits:
•
•
•
•
Industrials (from hi tech to discount chain stores)
Public utilities
Rails & transportation
•Banks
Financial issues
•Finance companies
•Insurance
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Corporate Securities
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Generally trade in units of $1,000
Higher risk than government issues
Higher (expected) yields
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ALL income is taxable for federal, state, & local
Possible disadvantage: subject to call
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Bond Market Investors
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So far, covered the issuer or supply side
Now consider the investor or demand side
Bond market is dominated (80 to 85% of
trading) by large institutional investors:
Insurance companies
 Banks
 Pension funds
 Mutual funds
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Bond Market Investors
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Relatively strong primary market (new issues)
Relatively weak secondary market (resale market)
Question that a bond investor must consider:
How close to the going market price
can I dispose of the issue?
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(A 5 or 10% discount might be unacceptable)
Foreign investors buy 10 to 15% of the U.S.
government’s debt
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Distribution Procedures
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Shelf registration
SEC Rule 415
Large companies file one comprehensive
registration statement for future long-term
financing (multiple issues)
Issue bonds through an investment banker
without further SEC approval
Issue may be on the shelf for up to 2 years
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Private Placement
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Bond offerings sold privately to investors
• Insurance companies
• Pension funds
Offered by industrial firms (not public utilities)
Limited or nonexistent secondary market
Slightly higher yield due to lack of liquidity
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Bond Ratings
Corporate financial management &
Institutional portfolio managers
Keep a close eye
On bond rating procedures
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Two Major Bond Rating Agencies
Moody’s Investors Service
www.moodys.com
Requires FREE registration
Standard & Poor’s
www.standardandpoors.com
No registration needed
(a subsidiary of McGraw-Hill, Inc.)
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Bond Ratings
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Moody’s and Standard & Poor’s rank
•
•
•
•
•
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Corporate bonds
Municipal bonds
Private placement commercial paper
Preferred stock issues
Companies
Offerings of foreign
Governments
U.S. Government bonds are considered to
be risk free (no ratings)
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Description of Bond Ratings
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Moody’s and Standard & Poor’s ratings
Categories shown on the next 7 slides
The first four categories are assumed to
represent investment-grade quality
Large institutional investors
• Insurance companies
• Banks
• Pension funds
confine their activities to ONLY the first
four categories
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Description of Bond Ratings
Standard
Quality Moody’s
& Poor’s
Description
Best quality
 Smallest degree of
investment risk
 “Gilt edge”
 Interest protected by a
large or very stable
profit margin
 Principal is secure

High
grade
Aaa
AAA
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Description of Bond Ratings
Standard
Quality Moody’s
& Poor’s
Description
High quality
 High-grade bonds
 Rated lower than the
best bonds because
margins of protection
may not be as large

High
grade
Aa
AA
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Description of Bond Ratings
Quality
Standard
Moody’s
& Poor’s
Description
Favorable investment
attributes
 Upper-medium-grade
obligations
 Principal and interest
are considered secure

Medium
grade
A
A
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Description of Bond Ratings
Standard
Quality Moody’s
& Poor’s
Description
Medium-grade
obligations
 Neither highly nor
poorly secured

Medium
grade
Baa
BBB
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Description of Bond Ratings
Standard
Quality Moody’s
& Poor’s
Description
Speculative
 Future not certain
 Interest & principal moderate protection
 Lack qualities of
desirable investment
 Interest & principal –
min. protection

Ba
BB
B
B
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Description of Bond Ratings
Standard
Quality Moody’s
& Poor’s
Description
In poor standing
 Issues may be in
default
 Principal & interest –
in danger
 Highly speculative
 Often in default
 Other shortcomings

Default
Caa
CCC
Default
Ca
CC
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Description of Bond Ratings
Standard
Quality Moody’s
& Poor’s
Description
Lowest-rated class in
Moody’s designation
 Extremely poor
prospects of attaining
any real investment
standing
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Default
Default
Default
C
C
D
Interest not currently
being paid
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Default in interest
and/or principal
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Junk Bonds
Appropriate only for the portfolio of investors
with a higher than average risk tolerance
Possible reasons for being in the junk bond
category:
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“Fallen angel” bonds - companies that once had high
credit rankings but now face hard times
“Emerging growth” companies – not yet established
small firms
Companies undergoing restructuring as a result of a
leveraged buyout or as part of fending off an
unfriendly takeover offer
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Bond Markets, Capital Market
Theory and Efficiency

Lower rated bonds tend to trade at larger yields
than higher quality bonds
Risk premium is higher on lower rated bonds
Bonds return
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>
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Equity investment return
Equity is riskier than bonds
Bonds have a contractual agreement to receive
principal & interest payments
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The Global Bond Market
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In excess of $40 trillion
U.S. makes up approximately 49% of the market
Japan 19%
Germany 12%
Italy 5%
In certain years, foreign bonds perform better than
U.S. bonds
In 1996, the total return in the bond market
• U.S. 1.4%
• Italy 30.4%
• United Kingdom 17.8%
Potential benefits to international diversification
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Dollar-Denominated Bonds
Bonds in which the payment is in dollars
Examples –
 Yankee bonds issued by
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•
•
•
•
•
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foreign governments
corporations, or
major agencies (e.g. World Bank)
Traded in the U.S.
Denominated (payable) in U.S dollars
Eurodollar bonds
• Denominated in dollars
• Issued & traded outside the U.S.
Eurodollars could be issued in any country outside the
United States (not just in Europe!)
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Foreign-Pay Bonds
Issued in a foreign country
 Payable in that country’s currency
e.g. Japanese government bond payable in yen
 Currency exposure to a U.S. investor
 Foreign-pay bond may go up or down
against the U.S. dollar
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Other Forms of
Fixed-Income Securities
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Certificates of Deposit (CDs)
Commercial Paper
Bankers’ Acceptance
Money Market Funds
Money Market Accounts
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Preferred Stock as an
Alternative to Debt
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Between bonds and common stock
Bondholders can claim against the corporation
Common stockholders have no such claim but
are the ultimate owners
Preferred stockholders entitled to receive a
stipulated dividend
In bad times, preferred stock dividends may be
omitted by the corporation
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Features of Preferred Stock
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Convertible
Callable
Cumulative
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Websites
Comments
www.bondmarkets.com
Provides bond information and
trading.
www.moodys.com
Provides bond information;
some is fee based
www.bondsonline.com
Provides bond information
www.smartmoney.com
Provides information on bond
yields, bond investing, and
related topics
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Websites
Comments
www.breifing.com
Provides some bond
trading information and
general information about
bonds
www.teachmefinance.com
Education site pertaining to
finance and bonds
www.investorguide.com
Links to sites provide
information on government
and corporate bonds
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Summary
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Debt plays an important role in our economy
Issuer’s and investor’s viewpoints
Primary fund raisers in the bond market are
•
•
•
•
•
U.S. Treasury
Federally sponsored credit agencies
State governments
Local governments
Corporations
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Summary
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Bond instruments are evaluated on the basis of
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•
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•
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Yield
Maturity
Method of repayment
Security provisions
Overall risk
Tax treatment
Greater protection & privileges result in lower yield
Important feature: rating received by Moody’s
Investors Service or Standard & Poor’s
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Summary
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Ratings range from AAA to D
Ratings determine the required yield to sell a
security
Some factors affecting ratings:
•
•
•
•
•
•
Cash flow
Earnings generation in relation to interest
Operating margins
Return on invested capital
Total assets
Qualitative factors (e.g. managers ability)
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