Chapter Eleven

1. Chapter Eleven Bond and Fixed-Income Fundamentals © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

2. Bond and Fixed-Income Fundamentals • The Bond Contract • Secured and Unsecured Bonds • The Composition of the Bond Market • Bond Market Investors • Distribution Procedures

3. Bond and Fixed-Income Fundamentals • Junk Bonds • Bond Quotes • Bond Markets, Capital Market Theory and Efficiency • The Global Bond Market • Other Forms of Fixed-Income Securities • Preferred Stock as an Alternative to Debt

4. Bond Market Career Opportunities • More new bond offerings than new common stock offerings • Most financially rewarding jobs on Wall Street go to sophisticated analysts and dealers in the bond market • Players in this market must understand: • The terms, & • Financial ramifications of bond trading

5. Definition of a Bond • A debt investment, with which the investor loans money to an entity (company or government) that borrows the funds for a defined period of time at a specified interest rate • The indebted entity issues investors a certificate, or bond, that states the interest rate (coupon rate) that will be paid and when the loaned funds are to be returned (maturity date)

6. The Bond Contract

7. The Bond Contract Key concept

8. The Bond Contract

9. The Bond Contract

10. Secured and Unsecured Bonds

11. Secured and Unsecured Bonds

12. The Composition of the Bond Market • U.S. Government Securities • Federally Sponsored Credit Agency Issues • State and Local Government Securities • Corporate Securities

13. U.S. Government SecuritiesTreasury Bills (T-bills) • Maturities 91 and 182 days • Trade on a discount basis • Minimum units of $1,000 • Active secondary market www.treasurydirect.gov

14. U.S. Government SecuritiesTreasury Note (T-note) • Extremely popular investments • Maturity of 1 to 10 years • Pays interest semi-annually • Minimum units of $1,000

15. U.S. Government SecuritiesTreasury Bonds (T-bonds) • Longterm in nature, mature in 10 to 30 years • Treasury Department stopped issuing Treasury bond in October 2001 • Many are still unredeemed and earning interest, with a significant number of years remaining until maturity • Units of $1,000 and higher • Taxable for IRS (Federal Tax) • Tax exempt for state and local taxes

16. U.S. Government SecuritiesTreasury strips = Zero-coupon Securities • STRIP = Separate Trading of Registered Interest and Principal Securities • Fixed-income securities • Sold at a significant discount to face value • No interest payments • Mature at par • Backed by the U.S. Government • Minimal risk • Tax benefits in certain states

17. Risk & the U.S. Government Securities But they are affected by other types of risk Treasuries are considered free from credit risk Interest-rate risk & Inflation risk

18. Inflation-Indexed Treasury Securities • Treasury Inflation Protection Securities (TIPS) • Offering started in January 1997 • Intention: Protect investors against inflation • Investor receives TWO (2) forms of return 1. Annual interest rate paid semiannually 2. Automatic increase in initial principal to account for inflation

19. Federally Sponsored Credit Agency Issues • Issued by various agencies of the government • Federal National Mortgage Association • Federal Home Loan Bank • Authorized by an act of Congress to finance federal projects • NOT direct obligations of the Treasury • Direct obligations of the issuing agencies • Slightly higher yield than U.S. government securities

20. Federally Sponsored Credit Agency Issues • Agency issues support the housing industry • Trade in denominations of $5,000 and up • Maturities from 1 to 40 years – avg. 15 yrs • Examples: • Federal Intermediate Credit Banks • Federal Farm Credit Bank • Export-Import Bank

21. Federally Sponsored Credit Agency Issues • GNMAE (Ginnie Mae) Government National Mortgage Association • Buys mortgages from various lenders at a discount • Issues securities to public against these mortgages • Investors receive monthly payments = Interest + Principal payments on mortgages • pass-thru www.ginniemae.gov

22. State and Local Government Securities DEFINITION Municipal Bonds: Debt securities issued by state & local governments Most important feature: Tax exempt nature of interest payment Attractive investment for: individuals in high tax brackets

23. How to Calculate the Equivalent Interest Rate on a Municipal Bond (i.e. tax exempt) with other Taxable Bonds Y = Equivalent before-tax yield on a taxable investment i = Yield on the municipal obligation T = Marginal tax rate of the investor

24. Corporate Securities • Main source of financing for U.S. corporations • 80 to 85% of firms’ external financial needs • Corporate market subunits: • Industrials (from hi tech to discount chain stores) • Public utilities • Rails & transportation • Financial issues • Banks • Finance companies • Insurance

25. Corporate Securities • Generally trade in units of $1,000 • Higher risk than government issues • ALL income is taxable for federal, state, & local • Possible disadvantage: subject to call Higher (expected) yields

26. Bond Market Investors • So far, covered the issuer or supply side • Now consider the investor or demand side • Bond market is dominated (80 to 85% of trading) by large institutional investors: • Insurance companies • Banks • Pension funds • Mutual funds

27. Bond Market Investors • Relatively strong primary market (new issues) • Relatively weak secondary market (resale market) • Question that a bond investor must consider: How close to the going market price can I dispose of the issue? (A 5 or 10% discount might be unacceptable) • Foreign investors buy 10 to 15% of the U.S. government’s debt

28. Distribution Procedures • Shelf registration • SEC Rule 415 • Large companies file one comprehensive registration statement for future long-term financing (multiple issues) • Issue bonds through an investment banker without further SEC approval • Issue may be on the shelf for up to 2 years

29. Private Placement • Bond offerings sold privately to investors • Insurance companies • Pension funds • Offered by industrial firms (not public utilities) • Limited or nonexistent secondary market • Slightly higher yield due to lack of liquidity

30. Bond Ratings Corporate financial management & Institutional portfolio managers Keep a close eye On bond rating procedures

31. Two Major Bond Rating Agencies Standard & Poor’s Moody’s Investors Service www.moodys.com Requires FREE registration www.standardandpoors.com No registration needed (a subsidiary of McGraw-Hill, Inc.)

32. Bond Ratings • Moody’s and Standard & Poor’s rank • Corporate bonds • Municipal bonds • Private placement commercial paper • Preferred stock issues • Offerings of foreign • U.S. Government bonds are considered to be risk free (no ratings) Companies Governments

33. Description of Bond Ratings • Moody’s and Standard & Poor’s ratings • Categories shown on the next 7 slides • The first four categories are assumed to represent investment-grade quality • Large institutional investors • Insurance companies • Banks • Pension funds confine their activities to ONLY the first four categories

34. Description of Bond Ratings

35. Description of Bond Ratings

36. Description of Bond Ratings

37. Description of Bond Ratings

38. Description of Bond Ratings Speculative Speculative

39. Description of Bond Ratings

40. Description of Bond Ratings

41. Junk Bonds Appropriate only for the portfolio of investors with a higher than average risk tolerance Possible reasons for being in the junk bond category: • “Fallen angel” bonds - companies that once had high credit rankings but now face hard times • “Emerging growth” companies – not yet established small firms • Companies undergoing restructuring as a result of a leveraged buyout or as part of fending off an unfriendly takeover offer

42. Bond Markets, Capital Market Theory and Efficiency • Lower rated bonds tend to trade at larger yields than higher quality bonds • Risk premium is higher on lower rated bonds Bonds return Equity investment return • Equity is riskier than bonds • Bonds have a contractual agreement to receive principal & interest payments >

43. The Global Bond Market • In excess of $40 trillion • U.S. makes up approximately 49% of the market • Japan 19% • Germany 12% • Italy 5% • In certain years, foreign bonds perform better than U.S. bonds • In 1996, the total return in the bond market • U.S. 1.4% • Italy 30.4% • United Kingdom 17.8% • Potential benefits to international diversification

44. Dollar-Denominated Bonds • Bonds in which the payment is in dollars Examples – • Yankee bondsissued by • foreign governments • corporations, or • major agencies (e.g. World Bank) • Traded in the U.S. • Denominated (payable) in U.S dollars • Eurodollar bonds • Denominated in dollars • Issued & traded outside the U.S. Eurodollars could be issued in any country outside the United States (not just in Europe!)

45. Foreign-Pay Bonds • Issued in a foreign country • Payable in that country’s currency e.g. Japanese government bond payable in yen • Currency exposure to a U.S. investor • Foreign-pay bond may go up or down against the U.S. dollar

46. Other Forms of Fixed-Income Securities • Certificates of Deposit (CDs) • Commercial Paper • Bankers’ Acceptance • Money Market Funds • Money Market Accounts

47. Preferred Stock as an Alternative to Debt • Between bonds and common stock • Bondholders can claim against the corporation • Common stockholders have no such claim but are the ultimate owners • Preferred stockholders entitled to receive a stipulated dividend • In bad times, preferred stock dividends may be omitted by the corporation

48. Features of Preferred Stock • Convertible • Callable • Cumulative