Bonds:Fixed Income Securities

Economics 71a: Spring 2007

Mayo chapter 12

Lecture notes 4.3

Goals

HistoryFeatures and structureBond ratings

Bond Returns

Interest and capital gains Stock comparison: dividends and cap

gainsMost income in the form of interest

Two Parts

= (capital gain) + (Interest)€

Rt+1 =Pt+1 + I t+1 −Pt

Pt

Rt+1 =Pt+1 −PtPt

+I t+1

Pt

Annual Historical Returns

Raw Returns Inflation Adjusted

Stocks 12.4% 9.2%

Corp Bonds 6.3% 3.2%

Gov’t Bonds 5.8% 2.8%

TBills 3.8% 0.7%

Bonds in the 1990’s

1990-1999 Bonds, 8.7% (nominal, no inflation adjustment) $10,000 -> $23,000 Stocks 18.2% (nominal) $10,000 -> $53,000

1990-2003(June) Bonds, 9.7% (nominal) $10,000 -> $35,000 Stocks, 10.2% (nominal) $10,000 -> $37,000

Bond Return Summary

Generally, lower returns than stocksBut also, less risk than stocks

Bond Risks

Interest rate riskPurchasing power risk (inflation)Default or business riskLiquidity riskCall risk

Goals

HistoryFeatures and structureBond ratings

Bond Features

Agreement to borrow money Amount of loan

Principal, “par value” Paid back at set date in the future “maturity”

Interest payments Coupon interest rate Percentage of principal Made on regular schedule

Example

Bond structure Principal = $1000 Maturity = 10 years Coupon = 5%, semiannual

Cashflows Pays $25 in interest every 6 months

(Interest payment is fixed.) 10 years from now pays back $1000 + $25

Bond Legal Structure

Indenture Specifies rights of bond holders

Restrictions often include Requirements on accounting practices Firm should pay taxes Constrain future borrowing Limit dividend payments on stock

Current Bond Price

Discount Price < Par

Premium Price > Par

Depends on interest ratesBond yield = coupon/price

Call Provisions

Issuer (firm) can buy back the bonds (call) at a specified price (call premium)

Call provisions specify the price, and time period in which this can happen

Most corporate bonds are callableSimilar to refinancing for individuals Important risk component for investors

Sinking Funds

Schedule to pay back principal over time

Different from call Option versus requirement

Secured Debt

Backed by some kind of property Mortgages: real estate Plant and equipment Financial assets Income streams (Mass. turnpike)

Unsecured debt (junior bonds, debentures) No asset backing Ok for large reliable firms

Difference Between Debt (Bonds) and Equity (Stock)

Voting rights D: none, E: yes

Claims on firm assets D: senior to equity, E: subordinate to debt

Maturity D: fixed, E: none

TaxesTrading/liquidity

Borrower Costs

What affects the interest rate borrowers pay? Maturity (length of bond) Size (total loan) Default risk Market interest rates

Market SegmentsTrillions of U.S. $

U.S. treasury bonds: 2.2Agency securities: 2.1

Federal home loan, Student loan marketing association

Municipal bonds: 1.5Corporate bonds: 5.2Mortgage backed securities: 2.9Foreign issues (eurodollar): 3.3

Special Bond Types

Treasury bonds Municipal bonds Zero coupon bonds Floating rate bonds (floaters) Inflation adjusted bonds Junk bonds Mortgage backed securities Asset-backed securities Convertible bonds Foreign bonds

U.S. Treasury Bonds

Borrowing of the U.S. federal government Very low risk/High liquidity $1,000 denominations Maturities

2, 3, 5, 10 years (notes) 20, 30 years (bonds)

Interest income exempt from state and local taxes, but not federal taxes

Municipal Bonds

Local state, county, city bonds Interest

Exempt from federal taxes Usually free from state tax if you reside in

the state the bond was issued byCapital gains

Not exempt

Muni Bonds: Taxable equivalent yield

€

(Taxable yield)(1 - tax rate) = (Tax free yield)

Taxable yield = Tax free yield(1- tax rate)

Muni yield = 5%, tax rate = 35%

0.05(1- .35)

= 7.69%

Zero Coupon Bonds

Zero coupon (interest) paymentsPrincipal onlyTrade at discount

Example: $1040 in 1 year Price today = $1000 Yield (return) = 4%

Constructed zero coupon bonds: Strips

Floating Rate Bonds(Floaters)

Coupon payments tied to current interest rates

Coupon might be principal*(T-bill rate) 1000*(2.5%)

Similarities to adjustable rate mortgages

Inflation Adjusted Bonds

Treasury inflation-indexed obligation TIPS

Par value adjusted up with inflation $1000 bond, 3% inflation In one year goes to $1030

Coupons are a percentage of par and rise too

Junk Bonds

High yieldHigh risk (default likely)Unsecured Famous in the 1980’s

Leveraged buyoutsAre they a good investment?

Mortgage Backed Securities(Mortgage Bonds)

Pool of mortgagesPay off principal over timeSome pools high risk

SubprimeTricky refinancing questions

Asset-backed Securities

Bonds backed by revenue streams Car loans/credit cards (large pool) Mass turnpike bonds (tolls)

David Bowie bonds Backed by revenue stream for albums IP Securitization

Convertible Bonds

Bonds that can be converted into a fixed number of shares of common stock

Value moves with stock price (and interest rates)

Difficult valuation

Foreign Bonds

Yankee bonds Dollar bonds issued in U.S. by foreign or

international corporationsEuro bonds

Dollar bonds issued outside the U.S.

Goals

HistoryFeatures and structureBond ratings

Bond Ratings

Agencies rate the riskiness of a bond Essentially the chance that it will default

See page 257 Bond ratings (Standard and Poor’s)

AAA, high-grade A, medium-grade >=BBB, Investment grade <BBB, speculative grade or “junk” bonds C, No interest paid D, In default

Bond Ratings and Default Probabilities (Economist, March 23, 2005)

Rating Agencies

S&P Rates $30 trillion in debt

Moody’s Fitch

Problems for Raters

Missed Enron, WorldCom, Parmalat Lack of competition Should there be more official oversight Firms starting consulting businesses

Help firms that they are rating Serious conflict of interest

Ratings Taken Seriously

Many investment funds having ratings requirements “No junk bonds” Ratings triggers : loans called back if

ratings fall

Goals

HistoryFeatures and structureBond ratings