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Lecture Presentation Software to accompany
Investment Analysis and Portfolio Management
Seventh Editionby
Frank K. Reilly & Keith C. Brown
Chapter 18
Chapter 18Bond 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 18Bond 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 18Bond 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 18Bond 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 asset-backed securities, zero-coupon and deep discount bonds, high-yield bonds, and structured notes?
Chapter 18Bond Fundamentals
• Within each of the major bond categories, what are the differences between major countries such as the United States, Japan, the United Kingdom, and Germany
• 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
ti,
ti,1ti,ti, P
IntPHPR
where: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
• Ratings Services
1. Duff and Phelps
2. Fitch Investors Service
3. Moody’s
4. Standard & Poor’s
• Non-rated bonds
Alternative Bond Issues
Domestic government bonds– United States - T-bills, notes, bonds. TIPS– Japan - medium term, long term, super long
term– Germany - bund bonds, contract with
Kassenverien• liquid market provided by Bundesbank
– 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
Germany– Federal Railway and Federal Post Office
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
Where:
i = coupon rate of the municipal obligations
T = marginal tax rate of the investor
)-(1ETY
T
i
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
German Corporate Bond Market
• Bank bonds
• German mortgage bonds
• German commercial bonds
• Private Loan Agreements (Schuldscheindarlehen)
U.K. Corporate Bond Markets
• Debentures
• Unsecured loans
• Convertible bonds
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
• Germany– DM-denominated bonds issued by foreign
companies are Eurobonds
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
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
Cur Net Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Corporate Bond Quotes
Cur Net Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T
Corporate Bond Quotes
Cur Net Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T
8.125% coupon rate
Corporate Bond Quotes
Cur Net Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T
8.125% coupon rate
matures in 2022
Corporate Bond Quotes
Cur Net Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T
8.125% coupon rate
matures in 2022
Current yield = coupon/market price = 7.7%
Corporate Bond Quotes
Cur Net Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T
8.125% coupon rate
matures in 2022
Current yield = coupon/market price = 7.7%
52 of these bonds traded that day
Corporate Bond Quotes
Cur Net Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T
8.125% coupon rate
matures in 2022
Current yield = coupon/market price = 7.7%
52 of these bonds traded that day
The closing price was 105 3/8% of par
Corporate Bond Quotes
Cur Net Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T
8.125% coupon rate
matures in 2022
Current yield = coupon/market price = 7.7%
52 of these bonds traded that day
The closing price was 105 3/8% of par which was up 1/4 from the prior day
Corporate Bond Quotes
• Notations– “cv” = convertible– “zr” = zero coupon– “dc” = deep discount (at time of issue)
• Accrued interest must be added to price quoted
Treasury and Agency Bond Quotes
• Notations– “n” = treasury note– “p” = treasury note on which nonresident aliens
are exempt from withholding taxes on interest
• Quotes resemble OTC securities with bid and ask prices
Treasury and Agency Bond Quotes
GOVT. BONDS & NOTES Maturity AskRate Mo/Yr Bid Asked Chg. Yld. 55/8 Dec 99n 100:08 100:10 …. 5.04
Treasury and Agency Bond Quotes
GOVT. BONDS & NOTES Maturity AskRate Mo/Yr Bid Asked Chg. Yld. 55/8 Dec 99n 100:08 100:10 …. 5.04
Prices are in 32nds usually with a very small spread between bid and ask
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 Quotes200 INDIANA ST OFFICE BLDG COMMN MBIA 0.000 07/01/05 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, 2005
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 InternetInvestments Online
www.bonds-online.com
www.prusec.com/daily.htm
www.fitchinv.com
www.moodys.com
www.standardandpoors.com/ratings
www.bradynet.com
www.bondmarkets.com
End of Chapter 15–Bond Fundamentals
Future topicsChapter 19
• The Analysis and Valuation of Bonds