VI: Debt Market Instruments 17: Government Bonds 18: Municipal Bonds 19: Corporate Bonds

VI: Debt Market Instruments

17: Government Bonds

18: Municipal Bonds

19: Corporate Bonds

Chapter 17: Treasury Bonds

US Treasury Securities

© Oltheten & Waspi 2012

Chapter 17: Treasury Bonds © Oltheten & Waspi 2012

US Treasury Securities

T-Bills: Maturity of less than one year at issue Discount paper

T-Notes: Two to ten years at issue

T-Bonds: More than ten years at issue

Semi-annual coupon

Mature on the 15th (or the last day) of the month


Pricing

Government Bonds and NotesRate Maturity Bid Ask Chg Ask Yld

9 ¼ 6

Aug 13Aug 13n

103:2398:22

103:25+

98:24+3+3

5.86 5.86

June 12, 2012


Pricing

Buy $1,000,000 T-Note maturing August 15, 2013. Settlement is T+1

The note is purchased June 12 for settlement June 13, 2012.

The price is quoted at 98:24 Priced to actual days (365 or 366)

Chapter 18: Municipal Bonds © Oltheten & Waspi 2012

Municipal Bonds


Municipal Bonds

Municipal Bonds are issued by States Counties Municipalities Townships School Districts Special Districts Authorities (Airports, Bridges etc.).


Tax treatment

In the US the interest on Municipal Notes is exempt from Federal Taxes and exempt from state taxes in the state of issue.

Example Treasury yield = 6% Target Investor in Illinois pays marginal tax of 26% 6%(1-.26) = 0.0444 Illinois can issue comparable bonds at a yield of 4.44%


Pay to Play

The Muni Market is an inefficient market This provides the opportunity for both

profit and abuse.

Chapter 19: Corporate Bonds

Corporate Bonds


Chapter 19: Corporate Bonds © Oltheten & Waspi 2012

Security

Senior Bond Backed by a legal claim to specific assets

Junior Bond Backed by the Corporation’s ability to pay

principal and interest as promised


Unsecured Debt

Debentures Long term unsecured issue

Subordinated Debentures Second class Debentures


Secured Debt

The security is defined in the Indenture and can take various forms such as: Mortgage Bonds Collateral Trust Bonds Equipment Trust Certificates


Pricing


Corporate Bonds and NotesRate Maturity Bid Ask Chg Ask

Yld

Intel 9¼DVC 6%

Aug 15, 13Aug 15, 13

103.7298.69

103.7898.75

+3+3

5.865.86

June 10, 2012


Pricing

Buy $1,000,000 Discovery Café bond maturing August 15, 2013.

Settlement is T+3 The note is purchased June 10 for settlement June 13, 2012.

The price is quoted at 98.75 Priced to 360 days in a year


Callable Bonds


Call

A callable bond allows the issuer (borrower) to pay the principal off early

Call Issuer (DVC) Investor (John Q. Investor)


The Bond

In June 1995 DVC issues $10 million in a 30 year, 7% bond The issue is in 10,000 $1,000 bonds This issue is callable after 10 years with a call

premium of 10% declining at ½% per year 2005 – 10.0% - 110.00 2006 - 9.5% - 109.50 2007 - 9.0% - 109.00 ….. 2024 - 0.5% - 100.50 2025 - 0.0% - 100.00 (Maturity Date)


Call Schedule

First Call

98

100

102

104

106

108

110

112

1995 2000 2005 2010 2015 2020 2025



The Issuer

June 2005 Should DVC pay off the bond early?

Yields on comparable bonds have fallen to 5% According to the terms of the indenture DVC can call

the bond in 2005 at par plus 10%

Should DVC borrow $11m at 5% to pay off a debt of $10m at 7%


CallCall $10m in 7% 2025 bonds @ 110.00

Issue $11m in 5% 2025 bonds @ 100.00

Borrow $11m and pay off $10m debt

Results in …



CallCoupon payments on $10m at 7%:

Coupon payments on $11m at 5%:

Lower semi-annual coupon payments

and …



Call$10m principal on 7% bonds in 2025

$11m Principal on 5% bonds in 2025

higher principal repayment.



Timeline

$0 -$75,000 -$75,000

$1,000,000

-$75,000-$75,000 -$75,000

June ‘05 June ‘06 Dec ‘06Dec ‘05 Dec ‘24 June ‘25

Call &re-issue


Call

Discovery Café calls the 2025 7% bond in June 2005 and refinances with a new 2025 5% bond.


The Investor

John Q. Investor purchases a $10,000 DVC 7% bond at issue at par.

He calculates his Yield to Maturity …

Chapter 19: Corporate Bonds

Yield to Maturity

0.07Yd2Yd

1

$10,000

2Yd

1

$350$10,000P 60

60

1nn


2005

John, having fallen asleep in Finance 300, is totally unaware that the bond is callable.

He does know that yields have fallen to 5%

He thinks his bond is worth …


2005

100


Price toyield 5%

P = 125.102775

John thinks his bond is worth $12,510.28

7%


2005

John plans to sell his bond at $12,510.28

He calculates his holding period yield as …


Holding Period

125.102775


100

7%


Call

John’s broker informs him that the DVC 7% 2025 has been called at 10%


Yield to Call

110.00


John is informed that his bond was called at $11,000.00

100

7%


Call

John is persuaded to replace his 7% bonds with 5% bonds


Call

John calculates his Realized Yield …

10,000

June ‘95 June ‘05 June ‘25

-10,000

7%June ‘15

Call 11,000.

-11,000 11,000

5%

$350 coupons

$275 coupons $275 coupons


Calculator Techniques

CF0 = -10,000 C01 = 350 F01 = 20 C02 = 275 F02 = 39 C03 = 11,275 F03 = 1 IRR[CPT] = 3.22

original investment coupon received Dec ‘95 …

… through June ’05 coupon received Dec ’05 …

… through Dec ’24 principal plus final coupon

…received June ‘25


Call

June ‘95 June ‘05

June ‘25

-10,000

7%

June ‘15

-11,000 11,000

5%

$350 coupons

$275 coupons $275 coupons

11,000


Yields In 1995 when Yields are 7% we calculate

Promised Yield to Maturity 1995-2025

Yield to call 1995-2005

In 2005 when Yields are 5% we calculate

Holding Period Yield if not callable

1995-2005

Realized Yield 1995-2025


Questions & Problems

19-1

Debt Markets I

Documents

VI: Debt Market Instruments 17: Government Bonds 18: Municipal Bonds 19: Corporate Bonds