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18/19. Corporate Bonds / Government Bonds. Bonds. Our goal in this chapter is to understand the basic types and features of corporate bonds and government bonds (Federal, state and local). Corporate Bond Basics. A Corporate bond is a security issued by a corporation.
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18/19 Corporate Bonds / Government Bonds
Bonds • Our goal in this chapter is to understand the basic types and features of corporate bonds and government bonds (Federal, state and local).
Corporate Bond Basics • A Corporate bond is a security issued by a corporation. • It represents a promise to pay bondholders a fixed sum of money (called the bond’s principal, or par or face value) at a future maturity date, along with periodic payments of interest (called coupons).
Corporate Bond Basics • Corporate bonds differ from common stock in three fundamental ways.
Corporate Bond Basics • There are several trillion dollars of corporate bonds outstanding in the United States. • More than half of these are owned by life insurance companies and pension funds. • These institutions can eliminate much of their financial risk via cash flow matching. • They can also diversify away most default risk by including a large number of different bond issues in their portfolios.
Corporate Bond Types • Bonds issued with a standard, relatively simple set of features are popularly called Plain Vanilla Bonds (or “bullet” bonds). • Debentures are unsecured bonds issued by a corporation.
Corporate Bonds Types • Mortgage bonds are debt secured with a property lien. • Collateral trust bonds are debt secured with financial collateral. • Equipment trust certificates are shares in a trust with income from a lease contract.
Bond Indentures • A Bond Indenture is a formal written agreement between the corporation and the bondholders. • This agreement spells out, in detail, the obligations of the corporation, the rights of the corporation, and the rights of the bondholders (with respect to the bond issue.) • In practice, few bond investors read the original indenture. Instead, they might refer to an indenture summary provided in the prospectus of the bond issue.
Bond Indentures, Cont. • The Trust Indenture Act of 1939 requires that any bond issue subject to regulation by the Securities and Exchange Commission (SEC) must have a trustee appointed to represent the interests of the bondholders. • Trustees are typically arms of commercial banks.
Bond Indentures, Seniority Provisions • Different bond issues can usually be differentiated according to the seniority of their claims on the firm’s assets in case of default. • Senior Debentures are the bonds paid first in case of default. • Subordinated Debentures are paid after senior debentures. • Bond seniority may be protected by a negative pledge clause. • A negative pledge clause prohibits a new debt issue that would have seniority over existing bonds.
Bond Indentures, Fixed-Price Call Provisions • Most corporate bonds have a call provision attached. • A traditional, fixed-price call provision allows the issuer to buy back all or part of its outstanding bonds at a specified call price sometime before the bonds mature. • When interest rates fall, bond prices increase. • The corporation can “call-in” the existing bonds, i.e., pay the call price. • The corporation can then issue new bonds with a lower coupon. • This process is called bond refunding.
Bond Indentures, Fixed-Price Call Provisions • Three features are usually attached to restrict an issuer’s call privilege: • Bonds usually have a deferred call provision • The call price includes a call premium over par value. • Some have a refunding provision.
Bond Indentures, Make-Whole Call Provisions • Make-whole call provisions have recently become common • Like a fixed-price call provision, a make-whole call provision allows the issuer to pay off the remaining debt early. However, • The issuer must pay the bondholders a price equal to the present value of all remaining payments. • The discount rate used to calculate this present value is equal to: • The yield of a comparable maturity U.S. Treasury security • A fixed, pre-specified make-whole premium • As interest rates decrease the make-whole call price increases
Bond Indentures, Put Provisions • A bond with a put provision can be sold back to the issuer at a pre-specified price (normally set at par value) on any of a sequence of pre-specified dates. • Bonds with put provisions are often called extendible bonds.
Bond Indentures, Bond-to-Stock Conversion Provisions • Convertible bonds are bonds that can be exchanged for common stock according to a pre-specified conversion ratio (i.e., the number of shares acquired). Conversion Price = Bond Par Value / Conversion Ratio • Conversion Value = Price Per Share × Conversion Ratio
Bond Indentures,Bond Maturity Provisions • Bond maturity and principal payment provisions - term bonds are issued with a single maturity date, while serial bonds are issued with a regular sequence of maturity dates. • Term bonds normally have a sinking fund, which is an account used to repay some bondholders before maturity. • Money paid into a sinking fund can only be used to pay bondholders. • Some bondholders are repaid before the stated maturity of their bonds, whether they want to be repaid or not. • At maturity, only a portion of the original bond issue will still be outstanding.
Bond Indentures,Principal Payment Provisions • Coupon payment provisions - An exact schedule of coupon payment dates is specified. • If a company suspends payment of coupon interest, the company is said to be indefault,a serious matter. • Bondholders have the unconditional right to timely repayment. • Bondholders have the right to bring legal action to get paid. • Companies in default have the right to seek protection from inflexible bondholders in bankruptcy court. • If there is default, it is often in the best interests of the bondholders and the company to avoid court and negotiate a new bond issue to replace the existing one.
Protective Covenants • A bond indenture is likely to contain a number of protective covenants. • Protective Covenantsare restrictions designed to protect bondholders. • Negative covenant (“thou shalt not”) example - The firm cannot pay dividends to stockholders in excess of what is allowed by a formula based on the firm’s earnings. • Positive covenant (“thou shalt”) example - Proceeds from the sale of assets must be used either to acquire other assets of equal value or to redeem outstanding bonds.
Event Risk • Event riskis the possibility that the issuing corporation will experience a significant change in its bond credit quality.
Bonds Without Indentures • A private placement is a new bond issue sold privately to one or more parties. That is, this new bond issue is not available to the general public. • Private placements are exempt from registration requirements with the SEC, although they often have formal indentures. • Debt issued without an indenture is basically a simple IOU of the corporation.
Corporate Bond Credit Ratings • A corporation usually subscribes to several bond rating agencies for a credit evaluation of a new bond issue. • Each contracted rating agency will then provide a credit rating - an assessment of the credit quality of the bond issue based on the issuer’s financial condition. • The best known rating agencies in the U.S. are Moody’s Investors Services and Standard & Poors Corporation. • Rating agencies in the U.S. also include Duff and Phelps; Fitch Investors Service; and McCarthy, Crisanti, and Maffei.
The Importance of Corporate Bond Credit Ratings • Only a few institutional investors have the resources and expertise necessary to evaluate correctly the credit quality of a particular bond. • Many financial institutions have prudent investment guidelines stipulating that only securities with a certain level of investment safety may be included in their portfolios. • Can there be a bias in the ratings?
The Yield Spread • A bond’s credit rating helps determine its yield spread. • The yield spread is the extra return (increased yield to maturity) that investors demand for buying a bond with a lower credit rating (and higher risk). • Yield spreads are often quoted in basis points over Treasury notes and bonds.
High Yield Bonds("Junk" Bonds) • High-yield bondsare bonds with a speculativecredit rating. • As a result of this poor credit rating, a yield premium must be offered on these bonds to compensate investors for higher credit risk. • High-yield bonds are also called junk bonds.
Bond Market Trading • An active secondary market with a substantial volume of bond trading exists, thus satisfying most of the liquidity needs of investors. • Corporate bond trading is characteristically an OTC activity.
Trade Reporting and Compliance Engine (TRACE) • At the request of the SEC, corporate bond trades are now reported through TRACE. • TRACE provides a means for bond investors to get accurate, up-to-date price information. • TRACE has dramatically improved the information available about bond trades.
Government Bond Basics • In 2007, the gross public debt of the U.S. government was more than $5 trillion. • Today, that debt is closer to $11 trillion. • The U.S. Treasury finances government debt by issuing marketable as well as non-marketable securities. • Municipal government debt is also a large debt market. • In the U.S., there are more than 85,000 state and local governments. • Together, they contribute about $2 trillion of outstanding debt.
Government Bond Basics • Marketable securities can be traded among investors. • Marketable securities issued by the U.S. Government include T-bills, T-notes, and T-bonds. • Non-marketable securities must be redeemed by the issuer. • Non-marketable securities include U.S. Savings Bonds, Government Account Series, and State and Local Government Series.
U.S. Treasury Bills (T-bills) • T-bills are Short-term obligations with maturities of 13, 26, or 52 weeks (when issued). • T-bills pay only their face value (or redemption value) at maturity. • Face value denominations for T-bills are as small as $1,000. • T-bills are sold on a discount basis (the discount represents the imputed interest on the bill).
U.S. Treasury Notes (T-notes) • T-notes are medium-term obligations, usually with maturities of 2, 5, or 10 years (when issued). • T-notes pay semiannual coupons (at a fixed coupon rate) in addition to their face value (at maturity). • T-notes have face value denominations as small as $1,000.
U.S. Treasury Bonds (T-bonds) • T-bonds are long-term obligations with maturities of more than 10 years (when issued). • T-bonds pay semiannual coupons (at a fixed coupon rate) in addition to their face value (at maturity). • T-bonds have face value denominations as small as $1,000.
U.S. Treasury STRIPS • STRIPS: Separate Trading of Registered Interest and Principal of Securities • STRIPS were originally derived from 10-year T-notes and 30-year T-bonds • A 30-year T-bond can be separated into 61 strips - 60 semiannual coupons + a single face value payment • STRIPS are effectively zero coupon bonds (zeroes). • The Yield to maturity (YTM) of a STRIP is the interest rates (or return) the investors will receive if the STRIP is held until maturity.
Inflation-Indexed Treasury Securities • In recent years, the U.S. Treasury has issued securities that guarantee a fixed rate of return in excess of realized inflation rates. • These securities are referred to asTIPS(for Treasury Inflation-Protected Securities). • These inflation-indexed U.S. Treasury securities: • Pay a fixed coupon rate on their current principal, and • Adjust their principal semiannually according to the most recent inflation rate
U.S. Treasury, General Auction Pattern • The Federal Reserve Bank conducts regularly scheduled auctions for T-bills, notes, and bonds. • 4-week, 13-week, and 26-week T-bills are auctioned weekly. • 2-year T-notes are auctioned monthly. • 5-year and 10-year T-note auctions occur about four times per year for each maturity. • The U.S. Treasury posts auction FAQs, results, and other details at: www.treasurydirect.gov • You can also buy treasuries directly from this website.
U.S. Treasury Auctions, Details • At each Treasury auction, the Federal Reserve accepts sealed bids of two types. • Competitive bids specify a bid price/yield and a bid quantity. Such bids can only be submitted by Treasury securities dealers. • Noncompetitive bids specify only a bid quantity, and may be submitted by individual investors. • The price and yield of the issue is determined by the results of the competitive auction process.
U.S. Treasury Auctions, More Details • All noncompetitive bids are accepted automatically and are subtracted from the total issue amount. • Then, a stop-out bid is determined. This is the price at which all competitive bids are sufficient to finance the remaining amount. • Since 1998, all U.S. Treasury auctions have been single-price auctions in which all accepted bids pay the stop-out bid.
U.S. Savings Bonds • The U.S. Treasury offers an investment opportunity for individual investors by issuing two types of Savings Bonds: • Series EE Savings Bonds: • Have face value denominations ranging from $50 to $10,000, • The paper version is sold at exactly half the face value, the electronic version is sold at face value. • Treasury guarantees the paper EE bond will double in value in no more than twenty years. • Fixed interest rate (known at time of purchase) • Earn interest for up to thirty years • Accrue interest semiannually • Must be held at least one year • 3-month interest penalty if held for less than 5 years
U.S. Savings Bonds • Series I Savings Bonds: • Have face value denominations ranging from $50 to $10,000. • Are sold at face value. • Earn interest for up to thirty years • Accrue interest semiannually (the interest rate is set at a fixed rate plus the recent inflation rate), and • Can be redeemed after 12 months • At redemption, the investor receives the original price plus interest earned • But, investors redeeming Series I bonds within the first 5 years of purchase incur a three-month earnings penalty
Federal Government Agency Securities • Most U.S. government agencies consolidate their borrowing through the Federal Financing Bank, which obtains funds directly from the U.S. Treasury. • However, several federal agencies are authorized to issue securities directly to the public. Examples include: • The Resolution Trust Funding Corporation • The World Bank • The Tennessee Valley Authority
Federal Government Agency Securities • Bonds issued by U.S. government agencies share an almost equal credit quality with U.S. Treasury issues. • They are attractive in that they offer higher yields than comparable U.S. Treasury securities. • However, the market for agency debt is less active than the market for U.S. Treasury debt. • Compared to T-bonds, agency bonds have a wider bid-ask spread.
Municipal Bonds • Municipal notes and bonds, or munis, are intermediate- to long-term interest-bearing obligations of state and local governments, or agencies of those governments. • Because their coupon interest is usually exempt from federal income tax, the market for municipal debt is commonly called the tax-exempt market.
Municipal Bonds • The federal income tax exemption makes municipal bonds attractive to investors in the highest income tax brackets. • However, yields on municipal debt are less than yields on corporate debt with similar features and credit quality. • The risk of default is also real despite their usually-high credit ratings.
Municipal Bond Features • Municipal bonds: • Are typically callable. • Pay semiannual coupons. • Have a par value denomination of $5,000. • Have prices that are stated as a percentage of par value (though municipal bond dealers commonly use yield quotes in their trading procedures). • Are commonly issued with a serial maturity structure (hence the term serial bonds, versus term bonds). • May be putable, or have variable interest rates, or both (variable-rate demand obligation, VRDO), and • May be strippable (hence creating muni-strips).
Types of Municipal Bonds • Bonds issued by a municipality that are secured by the full faith and credit (general taxing powers) of the issuer are known as general obligation bonds (GOs). • Municipal bonds secured by revenues collected from a specific project or projects are called revenue bonds. • Example: Airport and seaport development bonds that are secured by user fees and lease revenues. • Hybrid bonds are municipal bonds secured by project revenues with some form of general obligation credit guarantees. • A common form of hybrid is the moral obligation bond.
Equivalent Taxable Yield • Suppose you are trying to decide whether to buy: • A corporate bond paying annual coupon interest of 8%, or • A municipal bond paying annual coupon interest of 5% • How do you decide? • If the purchase was for a tax-exempt retirement account, the corporate bond is preferred because the coupon is higher. • But, if the purchase is not tax-exempt, the decision should be made on an after-tax basis. • That is, you must calculate an equivalent taxable yield or you must calculate an aftertax yield
Readings • All of chapter 18 (except 18.7 and 18.8) and 19 (except T bond and note prices and 19.7, 19.8).
