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Bonds: Fixed Income Securities

Bonds: Fixed Income Securities. Economics 71a: Spring 2007 Mayo chapter 12 Lecture notes 4.3. Goals. History Features and structure Bond ratings. Bond Returns. Interest and capital gains Stock comparison: dividends and cap gains Most income in the form of interest. Two Parts.

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Bonds: Fixed Income Securities

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  1. Bonds:Fixed Income Securities Economics 71a: Spring 2007 Mayo chapter 12 Lecture notes 4.3

  2. Goals • History • Features and structure • Bond ratings

  3. Bond Returns • Interest and capital gains • Stock comparison: dividends and cap gains • Most income in the form of interest

  4. Two Parts = (capital gain) + (Interest)

  5. Annual Historical Returns

  6. Bonds in the 1990’s • 1990-1999 • Bonds, 8.7% (nominal, no inflation adjustment) • $10,000 -> $23,000 • Stocks 18.2% (nominal) • $10,000 -> $53,000 • 1990-2003(June) • Bonds, 9.7% (nominal) • $10,000 -> $35,000 • Stocks, 10.2% (nominal) • $10,000 -> $37,000

  7. Bond Return Summary • Generally, lower returns than stocks • But also, less risk than stocks

  8. Bond Risks • Interest rate risk • Purchasing power risk (inflation) • Default or business risk • Liquidity risk • Call risk

  9. Goals • History • Features and structure • Bond ratings

  10. Bond Features • Agreement to borrow money • Amount of loan • Principal, “par value” • Paid back at set date in the future “maturity” • Interest payments • Coupon interest rate • Percentage of principal • Made on regular schedule

  11. Example • Bond structure • Principal = $1000 • Maturity = 10 years • Coupon = 5%, semiannual • Cashflows • Pays $25 in interest every 6 months • (Interest payment is fixed.) • 10 years from now pays back $1000 + $25

  12. Bond Legal Structure • Indenture • Specifies rights of bond holders • Restrictions often include • Requirements on accounting practices • Firm should pay taxes • Constrain future borrowing • Limit dividend payments on stock

  13. Current Bond Price • Discount • Price < Par • Premium • Price > Par • Depends on interest rates • Bond yield = coupon/price

  14. Call Provisions • Issuer (firm) can buy back the bonds (call) at a specified price (call premium) • Call provisions specify the price, and time period in which this can happen • Most corporate bonds are callable • Similar to refinancing for individuals • Important risk component for investors

  15. Sinking Funds • Schedule to pay back principal over time • Different from call • Option versus requirement

  16. Secured Debt • Backed by some kind of property • Mortgages: real estate • Plant and equipment • Financial assets • Income streams (Mass. turnpike) • Unsecured debt (junior bonds, debentures) • No asset backing • Ok for large reliable firms

  17. Difference Between Debt (Bonds) and Equity (Stock) • Voting rights • D: none, E: yes • Claims on firm assets • D: senior to equity, E: subordinate to debt • Maturity • D: fixed, E: none • Taxes • Trading/liquidity

  18. Borrower Costs • What affects the interest rate borrowers pay? • Maturity (length of bond) • Size (total loan) • Default risk • Market interest rates

  19. Market SegmentsTrillions of U.S. $ • U.S. treasury bonds: 2.2 • Agency securities: 2.1 • Federal home loan, Student loan marketing association • Municipal bonds: 1.5 • Corporate bonds: 5.2 • Mortgage backed securities: 2.9 • Foreign issues (eurodollar): 3.3

  20. Special Bond Types • Treasury bonds • Municipal bonds • Zero coupon bonds • Floating rate bonds (floaters) • Inflation adjusted bonds • Junk bonds • Mortgage backed securities • Asset-backed securities • Convertible bonds • Foreign bonds

  21. U.S. Treasury Bonds • Borrowing of the U.S. federal government • Very low risk/High liquidity • $1,000 denominations • Maturities • 2, 3, 5, 10 years (notes) • 20, 30 years (bonds) • Interest income exempt from state and local taxes, but not federal taxes

  22. Municipal Bonds • Local state, county, city bonds • Interest • Exempt from federal taxes • Usually free from state tax if you reside in the state the bond was issued by • Capital gains • Not exempt

  23. Muni Bonds: Taxable equivalent yield

  24. Zero Coupon Bonds • Zero coupon (interest) payments • Principal only • Trade at discount • Example: $1040 in 1 year • Price today = $1000 • Yield (return) = 4% • Constructed zero coupon bonds: Strips

  25. Floating Rate Bonds(Floaters) • Coupon payments tied to current interest rates • Coupon might be principal*(T-bill rate) • 1000*(2.5%) • Similarities to adjustable rate mortgages

  26. Inflation Adjusted Bonds • Treasury inflation-indexed obligation TIPS • Par value adjusted up with inflation • $1000 bond, 3% inflation • In one year goes to $1030 • Coupons are a percentage of par and rise too

  27. Junk Bonds • High yield • High risk (default likely) • Unsecured • Famous in the 1980’s • Leveraged buyouts • Are they a good investment?

  28. Mortgage Backed Securities(Mortgage Bonds) • Pool of mortgages • Pay off principal over time • Some pools high risk • Subprime • Tricky refinancing questions

  29. Asset-backed Securities • Bonds backed by revenue streams • Car loans/credit cards (large pool) • Mass turnpike bonds (tolls) • David Bowie bonds • Backed by revenue stream for albums • IP Securitization

  30. Convertible Bonds • Bonds that can be converted into a fixed number of shares of common stock • Value moves with stock price (and interest rates) • Difficult valuation

  31. Foreign Bonds • Yankee bonds • Dollar bonds issued in U.S. by foreign or international corporations • Euro bonds • Dollar bonds issued outside the U.S.

  32. Goals • History • Features and structure • Bond ratings

  33. Bond Ratings • Agencies rate the riskiness of a bond • Essentially the chance that it will default • See page 257 • Bond ratings (Standard and Poor’s) • AAA, high-grade • A, medium-grade • >=BBB, Investment grade • <BBB, speculative grade or “junk” bonds • C, No interest paid • D, In default

  34. Bond Ratings and Default Probabilities (Economist, March 23, 2005)

  35. Rating Agencies • S&P • Rates $30 trillion in debt • Moody’s • Fitch

  36. Problems for Raters • Missed Enron, WorldCom, Parmalat • Lack of competition • Should there be more official oversight • Firms starting consulting businesses • Help firms that they are rating • Serious conflict of interest

  37. Ratings Taken Seriously • Many investment funds having ratings requirements • “No junk bonds” • Ratings triggers : loans called back if ratings fall

  38. Goals • History • Features and structure • Bond ratings

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