What Are Bonds?
Liabilities, or “publicly traded IOUs”
Also called “fixed income securities” since payments are fixed amounts
Borrower agrees to pay a fixed amount of interest over a specified period of time
Borrower agrees to repay a fixed amount of principal at a predetermined maturity date
Why Invest in Bonds?
They can provide current income for conservative investors
At times, they can provide capital gains (or losses) for more aggressive investors
Some bonds can provide tax-free income
They can be used for preservation and long-term accumulation of capital
Interest Rates and Bonds
The behavior of interest rates is the single most important force in the bond market
Interest rates and bond prices move in opposite directions
When interest rates rise, bond prices fall
When interest rates drop, bond prices move up
Bond markets are bullish when interest rates are low or falling
Bond markets are bearish when interest rates are high or rising
Figure 10.1 Behavior of Interest Rates Over Time (1962–2008)
Bonds Versus Stocks
Compared to stocks, bonds offer lower returns
Main benefits of bonds in portfolio:
Lower risk and level of stability
High levels of current income
Diversification
Bonds add an element of stability to a portfolio
Figure 10.2 Comparative Performance of Stocks and Bonds (1997-2008)
Bonds and Risk
Interest Rate Risk is the chance that changes in interest rates will affect the bond’s value
Purchasing Power Risk is the chance that bond yields will lag behind inflation rates
Business/Financial Risk is the chance the issuer of the bond will default on interest and/or
principal payments
Liquidity Risk is the risk that a bond will be difficult to sell at a reasonable price
Call Risk is the risk that a bond will be “called” (retired) before its scheduled maturity date
Essential Features of a Bond
Coupon is the amount of annual interest income
Current Yield is a measure of the annual interest income a bond provides relative to its
current market price
Principal (par value) is the amount of capital that must be repaid at maturity
Maturity Date is the date when a bond matures and the principal must be repaid
Term Bond is a bond that has a single maturity date
Serial Bond is a bond that has a series of different maturity dates
Note is a debt security originally issued with a maturity from 2 to 10 years
Principles of Bond Price Behavior
Price of a bond is a function of its coupon rate, its maturity, and market movements in
interest rates
Longer maturities move more with changes in interest rates
Premium bond has a market value that is above par value
Occur when market interest rates are below bond’s coupon rate
Discount bond has a market value that is below par value
Occur when market interest rates are above bond’s coupon rate
Figure 10.3 The Price Behavior of a Bond
Call feature allows the issuer to repurchase the bonds before the maturity date
Freely callable
Noncallable
Deferred call
Call premium is the amount added to bond’s par value and paid upon call to
compensate bondholders
Call price is the bond’s par value plus call premium
Refunding provision prohibits the premature retirement of an issue from proceeds of
a lower-coupon refunding bond
Sinking fund stipulates how a bond will be paid off over time
Applies only to term bonds
Issuer is obligated to pay off the bond systematically over time
Types of Secured Debt
Secured debt is backed by pledged collateral
Senior bonds are backed by legal claim to
specific assets
Mortgage bonds are backed by real estate.
Collateral trust bonds are backed by securities (stocks, bonds) held in trust by a third
party
Equipment trust certificates are backed by specific pieces of equipment, such as
railcars or airplanes
Types of Unsecured Debt
Unsecured debt is backed only by the promise of the company to pay
Junior bonds are backed only by promise and good faith of the issuer to pay
Debenture is an unsecured (junior) bond
Subordinated debentures are unsecured bonds whose claim is secondary to other
claims
Income bond requires interest to be paid only after a specific amount of income has
been earned
Bond Ratings
Bond ratings are letter grades that designate
investment quality
Private bond rating agencies assign ratings based upon financial analysis of the bond
issuer
Investment grade ratings are received by financially
strong companies
Junk bond ratings are received by companies making payments, but default risk is high
Split ratings occur when a bond issue is given different ratings by major rating
agencies
Higher rated bonds have less default risk and pay lower interest rates
The Market for Debt Securities
Bonds are traded mainly over-the-counter
Bond price activity is remarkably stable compared to stock market
Bond market is larger than the U.S. stock market
Bond market is growing rapidly
Treasury Bonds
Considered risk free—no risk of default
Interest is exempt from state and local taxes
Sold in $1,000 denominations
Types of Treasury Bonds
Treasury notes: maturities of 2, 3, 5, 7, and 10 years
Treasury bonds: mature in 30 years
Treasury Inflation-Indexed Obligations (TIPS)
Protect against inflation by adjusting investor returns
Interest rates are very low
Maturities of 5, 10, and 20 years
Agency Bonds
Issued by U.S. government agencies
Federal Home Loan Bank
Federal National Mortgage Association
Small Business Administration
High quality securities with almost no risk of default
Interest rates usually higher than Treasury issues
Municipal Bonds
Issued by states, counties, cities and any other political subdivision
Issued to fund public projects
Two basic types
General obligation bonds are paid from general fund of the issuer
Revenue bonds are paid from revenues from the project being financed
Often guaranteed by private insurers to lower risk and interest rates
Interest is tax-exempt for Federal taxes
Interest can be tax-exempt from state taxes if you live in the state where the bond was issued
Corporate Bonds
Issued by corporations from four major segments
Industrials
Public utilities
Rail and transportation bonds
Financial issues
Provide higher returns than government bonds due to higher risk of default
Wide variety of bond quality and bond types available
Zero-Coupon Bonds
Do not pay interest
Sold at deep discount from par value
Value increases over time
Subject to tremendous price volatility as interest
rates fluctuate
Interest must be reported as it is accrued for tax purposes, even though no interest is
actually received.
Treasury strips are zero-coupon bonds created from U.S. Treasury securities.
Mortgage-Backed Securities
Bond backed by pool of residential mortgages
Principal and interest are paid monthly
Governmental agencies are major issuers:
Government National Mortgage Association (GNMA)
Federal Home Loan Mortgage Corporation (FHLMC)
Federal National Mortgage Association (FNMA)
Self-liquidating investment since portion of principal is received each month
Collateralized Mortgage Securities
Mortgage-back bond pool that is divided into “tranches,” or classes of investors
All principal payments go first to the shortest tranche until it is fully retired, then the
next in sequence is paid
Allows investors to choose short-term, medium-term or long-term investment
Potentially complex; interest rate fluctuations may have significant impact upon bond
prices
Asset-Backed Securities
Issued by corporations and backed by pools of loans
Auto loans
Credit card loans
Home equity loans
Provide relatively high yields
Short maturities, typically 3 to 5 years
Interest and principal payments are monthly
High credit quality
Junk Bonds (High-Yield Bonds)
Highly speculative, usually subordinated debentures
Have low, sub-investment grade ratings
Typically offer very high yields
Prices tend to behave more like stocks than bonds
Global Bonds
Potentially higher returns than U.S. bonds
Offer broader diversification opportunities
Interest rate trends in other countries may not follow U.S. rates
Currency exchange rate fluctuations can impact returns in U.S. dollars
Dollar-Denominated Bonds
Bonds issued by foreign governments or corporations and denominated in dollars
Based on U.S. dollars
Yankee bonds are registered with the SEC and issued and traded in U.S.
Eurodollar bonds are not registered with the SEC and are issued and traded outside of
the U.S.
No currency exchange rate risk since bonds are in U.S. dollars
Foreign-Pay Bonds
Bonds issued by foreign governments or corporations
Based on currency other than U.S. dollars
Not registered with the SEC and issued and traded outside of the U.S.
Subject to currency exchange rate risk
Convertible Securities
Fixed-income security that allows holder to convert the security into a specified number of
shares of the issuing company’s common stock
Two major types of convertible securities:
Convertible bonds
Convertible preferred stock
“Equity kicker”: another name for the conversion feature that allows holder to convert the
security into a specified number of shares of common stock
Forced conversion: calling in of convertible bonds by the issuing firm
Conversion privilege: the conditions and specific nature of the conversion feature on
convertible securities
Conversion period: the time period during which a convertible issue can be converted
Conversion ratio: the number of shares of common stock into which a convertible
issue can be converted
Conversion price: the stated price per share at which common stock will be delivered
to the investor in exchange for a convertible issue
Special Types of Convertible Securities
LYON (Liquid Yield Option Note)
Zero coupon bond with both a conversion feature and a put option
No current income, but no limit on potential capital appreciation
Put option allows security to be sold back to issuer at prespecified prices, providing
downside protection
Sources of Value
Value of convertibles is based in both the stock and the bond dimensions of the
security
Convertibles trade much like common stock as the market price of the stock starts
getting close to (or exceeds) the stated conversion price
Convertibles trade much like a bond when the market price of the stock is well below
the conversion price
Bond price sets a “price floor” in case the stock price goes into a freefall
Measuring the Value of a Convertible
Conversion Value: indication of what a convertible issue would trade for if it were
priced to sell on the basis of its stock value
Conversion Equivalent: the price at which the common stock would have to sell in
order to make the convertible security worth its present market price
Conversion Premium: amount above the conversion value that investors are willing to
pay; typically due to the higher current income provided by convertibles over common
stock
Payback Period: the length of time it takes for the buyer of a convertible to recover
the conversion premium from the extra current income earned on the convertible