Chapter 17

Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Eighth Editionby

Frank K. Reilly & Keith C. Brown

Chapter 17

Chapter 17Bond 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?


• 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?


• 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?


• 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?

• 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

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 IssuesUnited 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

Where:i = coupon rate of the municipal obligationsT = marginal tax rate of the investor

)-(1ETY

Ti

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 non-

residents

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 Last Last EST UST EST $

(Ticker) Price Yield Spread VOL

Ford 7.45 July 16 2031 80.625 9.461 503 30213,645




Ford 7.45 July 16 2031 80.625 9.461 503 30213,645

Issued by Ford Motor Company




Ford 7.45 July 16 2031 80.625 9.461 503 30213,645

The maturity date of this bond




Ford 7.45 July 16 2031 80.625 9.461 503 30213,645

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




Ford 7.45 July 16 2031 80.625 9.461 503 30213,645

The computed yield spread for the Ford bond is 503 basis points (5.03 basis points)




Ford 7.45 July 16 2031 80.625 9.461 503 30213,645

Comparable U.S. treasury Issue




Ford 7.45 July 16 2031 80.625 9.461 503 30213,645

The trading volume for this bond is over $213 million

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 QuotesGOVT. BONDS & NOTES

Maturity AskRate Mo/Yr Bid Asked Chg. Yld. 5.750 Nov 05n 101:05 101:06 …. 3.13

Treasury and Agency Bond QuotesGOVT. BONDS & NOTES

Maturity AskRate Mo/Yr Bid Asked Chg. Yld. 5.750 Nov 05n 101:05 101:06 …. 3.13This 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 Quotes200 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 maturityM/S/F = mandatory sinking fund(C97) = this bond became callable in 1997When 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

http://www.bondheads.comhttp://www.investinginbonds.comhttp://www.fitch.comhttp://www.moodys.comhttp://www.standardandpoors.com/ratingshttp://www.bradynet.comhttp://www.publicdebt.treas.gov

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 topicsChapter 18

• The Analysis and Valuation of Bonds

Documents

Chapter 17