Chapter 14 - Bonds

1. Chapter 14 - Bonds • A promise to repay a sum of money on a fixed date, together with interest, usually over the life of the loan • Why buy bonds? • Steady income • Generally safe • Reduce risk through diversification

2. Types of Bonds • Corporate bonds • Unsecured = debentures • Treasuries and Agencies • Inflation-indexed • Municipals • State and local government agencies • Usually tax-exempt • Zero coupons

3. Bonds – Issuer Types • Mortgage-related $7.9T 40.6% • Corporations 4.4 22.6 • US Treasuries 3.6 18.5 • State & Local Gov’t 1.9 9.8 • Other asset-backed 1.78.5 • Total $19.5 100.0%

4. Bond Features • Par value – face value or principal amount repaid at maturity • Usually $1,000 per bond • Market price may be more or less than par • Coupon rate – percentage of par value paid annually in interest • With 6% coupon, $1,000 bond pays $60/yr • Most bonds pay interest semi-annually, $3.

5. Capital Food Chain • Secured creditors (OK if < assets) • General Creditors • Debenture holders and unsecured creditors • Subordinated debenture holders • Preferred stockholders • Common stockholders

6. Ratings • Moody’s, Standard and Poors, Fitch • Assess quality of borrower’s credit • AAA to D • Junk bonds are BB and below • Lower rating, greater risk, higher rates

8. Junk Bonds • AKA “high risk”, “non-investment grade”, “high yield” or “speculative” • Low credit rating - BB and below • Higher risk, higher rates • Fallen angels (companies in trouble) or new, unproven firms

9. Quality SpreadsTen Year Maturities – April 2004 YieldSpreadExample USTN 4.40% AAA 4.71 +31 GE & UPS AA 4.91 51 Abbott Labs A 5.25 85 McDonalds BBB 5.85 145 GM BB 7.90 350 Goodyear

10. Convertible Securities Convertible into common stock at a fixed rate at bondholder’s option $1,000 bond convertible into 20 shares • Equal to $50/share (1,000/20) • Stock rises to $60. Bond worth $1,200 (60 * 20) Offers upside potential but have lower rates than on comparable nonconvertibles Look at coupon and conversion ratio

11. Callable Bonds • Redeemable at issuer’s option • Rates drop, bond called, new bonds issued • Investor forced to reinvest at lower rate • Deferred calls and call premiums • Some not callable for first five years • Premium: say 105% of par year 6, 104% year 7 ….. par year 11 • Effect: callables pay a higher rate.

12. Municipal Bonds • Muni's are issued by states, counties, cities and school districts • Interest not subject to federal taxes (usually) • General obligations • backed issuer’s taxing power • Revenue bonds repaid by project's revenue • Muni's subject to credit risk – Orange County's and Cleveland's bankruptcy

14. Bond Valuation • Bond pays fixed amount of interest over a number of years and at maturity the bond is redeemed and you receive the par value. • Value of a bond is the present value of each interest payment and the present value of the payment at maturity.

15. Evaluating Bonds • Yield – return on the investment • Not the same as coupon rate (% of par value) • Current yield – ratio of annual interest to price • 8% bond selling for $700 has 11.4% current yield • Yield to Maturity (YTM) – return earned if held to maturity; interest plus/minus difference between par and purchase price

16. Bond Calculations • US bonds pay interest semiannually • Review non-annual compounding • This means we must change the annual rate to a per period rate • $1,000 two year bond with 6% coupon rate has four $30 semiannual interest payments plus $1,000 paid at maturity.

17. 6% bond, Due two years; Market rate = 10%; Interest semi-ann Time CF 5% PVIFPV 6 mo $30 .9524 $28.57 12 mo 30 .9070 27.21 • 30 .8638 25.91 • 30 .8227 24.68 1,000 .8227 822.70 $927.07

18. Valuation Remember: the coupon is fixed for the life of the bond The only way a bond's return can be increased is by reducing its price One year bond 8% coupon ($80); Market rate 10% ($100). Price falls to $980 $80 interest + $20 capital gain = $100

19. Relationships Inverse relation between changes in interest rates and changes in bond prices • Rates increase, bond prices fall • Rates decrease, prices rise • Bonds may sell for par value, more than par, or less than par. • Market rate above coupon, sells at a discount • Market below coupon, bond sells at a premium

20. Bond Values at Different Rates

21. More Relationships • Longer-term bonds fluctuate more in price than shorter-tem bonds (next slide) • As maturity approaches, market value approaches par value • Upward movement in callable bonds limited because they may be called away from you

22. Longer-term = More Sensitive Price of 12% 5 and 10 Year Bonds Rate5 Year10 Year 9% $1,117 $1,192 • 1,000 1,000 15 899 848

23. Price Sensitivity – 5 vs. 10 Year

26. Preferred Stock Hybrid security – similar to bonds and stock • Like bonds: usually fixed return, paid before common dividends, usually don't vote • Like stock: no maturity and failure to pay dividend does not trigger bankruptcy

27. Features of Preferred • May have multiple issues with different terms • Sometimes convertible into common • Some have cumulative dividends • May be callable • Some have floating rates

28. Risks With Preferred Stock Interest rates rise, price declines Rates fall – what happens if callable? Gains limited Dividends not as secure as bond interest