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
Chapter 17: Treasury Bonds © Oltheten & Waspi 2012
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
Chapter 17: Treasury Bonds © Oltheten & Waspi 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
Chapter 18: Municipal Bonds © Oltheten & Waspi 2012
Municipal Bonds
Municipal Bonds are issued by States Counties Municipalities Townships School Districts Special Districts Authorities (Airports, Bridges etc.).
Chapter 18: Municipal Bonds © Oltheten & Waspi 2012
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%
Chapter 18: Municipal Bonds © Oltheten & Waspi 2012
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
© Oltheten & Waspi 2012
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
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Unsecured Debt
Debentures Long term unsecured issue
Subordinated Debentures Second class Debentures
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Secured Debt
The security is defined in the Indenture and can take various forms such as: Mortgage Bonds Collateral Trust Bonds Equipment Trust Certificates
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Pricing
© Oltheten & Waspi 2012
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
Chapter 19: Corporate Bonds © Oltheten & Waspi 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
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Callable Bonds
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Call
A callable bond allows the issuer (borrower) to pay the principal off early
Call Issuer (DVC) Investor (John Q. Investor)
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
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)
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Call Schedule
First Call
98
100
102
104
106
108
110
112
1995 2000 2005 2010 2015 2020 2025
© Oltheten & Waspi 2012
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
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%
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
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 …
© Oltheten & Waspi 2012
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
CallCoupon payments on $10m at 7%:
Coupon payments on $11m at 5%:
Lower semi-annual coupon payments
and …
© Oltheten & Waspi 2012
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Call$10m principal on 7% bonds in 2025
$11m Principal on 5% bonds in 2025
higher principal repayment.
© Oltheten & Waspi 2012
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
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
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Call
Discovery Café calls the 2025 7% bond in June 2005 and refinances with a new 2025 5% bond.
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
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
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
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 …
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
2005
100
June ‘05 June ‘06 Dec ‘06Dec ‘05 Dec ‘24 June ‘25
Price toyield 5%
P = 125.102775
John thinks his bond is worth $12,510.28
7%
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
2005
John plans to sell his bond at $12,510.28
He calculates his holding period yield as …
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Holding Period
125.102775
June ‘95 June ‘96 Dec ‘96Dec ‘95 Dec ‘04 June ‘05
100
7%
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Call
John’s broker informs him that the DVC 7% 2025 has been called at 10%
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Yield to Call
110.00
June ‘95 June ‘96 Dec ‘96Dec ‘95 Dec ‘04 June ‘05
John is informed that his bond was called at $11,000.00
100
7%
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Call
John is persuaded to replace his 7% bonds with 5% bonds
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
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
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
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
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
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
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
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
Chapter 19: Corporate Bonds © Oltheten & Waspi 2012
Questions & Problems
19-1
Debt Markets I