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Chapter 7 – Bond Concepts

What are they? Types and issuers Junk Convertibles Callables Asset-backed Credit ratings. Calculations YTM Price Current yield Tax impacts Relationships Price Term Type. Chapter 7 – Bond Concepts. Types of Bonds. Bond – a long-term promissory note

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Chapter 7 – Bond Concepts

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  1. What are they? Types and issuers Junk Convertibles Callables Asset-backed Credit ratings Calculations YTM Price Current yield Tax impacts Relationships Price Term Type Chapter 7 – Bond Concepts

  2. Types of Bonds • Bond – a long-term promissory note • Pays a fixed amount of interest each period • At maturity, principal is repaid • Types • Secured and Asset-backed securities • Debentures – unsecured • Subordinated debentures – “junior” • Junk or High-yield bonds • Municipals – non taxable interest

  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. Characteristics and Terms • Superior claim over stock in bankruptcy • Par value – maturity value is usually $1,000 • Coupon rate – percentage of par paid in annual interest, often paid semiannually • Maturity – length of time or date of repayment of principal • Accrued interest – seller entitled to interest from last payment date

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

  6. Indenture • Legal agreement between issuer and independent trustee (bank) representing bondholders • Includes terms, rights and obligations of each • Convenants protect holders • Covenants may cover asset sales/purchases, dividend limits, future borrowings, interest, mergers, etc.

  7. Other Provisions • Callability – issuer may redeem before maturity • Tax shield – interest expense is tax deductible. • At 34% tax, 8% becomes 5.28% • Current yield (not YTM) = annual interest divided by market price

  8. 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 lower rate than on comparable nonconvertible securities • Look at coupon and conversion ratio

  9. 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 say first five years • Premiums: say 105% of par in year 6, 104% year 7 … par in year 11. • Effect: callables pay a higher rate

  10. Zero Coupon Bonds • No interest paid until maturity • Sold at steep discount, say 60¢ on the $ • Discount represents unpaid interest • Disadvantages: huge outflow at maturity; not callable; tax issues for holder • Advantages: interest deferred; deductible by issuer; no reinvestment problem for holder

  11. Asset-Backed Securities • Bonds or notes owning pool of financial assets; outright asset sale • Credit cards, car loans, other assets • Credit ratings: 90% rated AAA • Based on quality of assets, not issuer’s credit • Process called “securitization” • More details on my web page

  12. Municipal Bonds

  13. Credit Ratings • Judgment of risk potential by rating firm • Standard & Poors, Moody’s, Fitch • Factors: leverage, coverage, liquidity, profitability ratios; cash to debt, size, etc • Range from AAA to D (in default) • BB and below called junk or speculative bonds • Did they predict Enron? No!

  14. S & P Ratings

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

  16. Quality SpreadsTen Year Maturity YieldSpreadExample USTN 4.40 AAA 4.71% +31 GE & UPS AA 4.91 51 Abbott Labs A 5.25 85 McDonalds BBB 5.70 145 GM BB 7.90 350 Goodyear

  17. Bond Valuation • Value of any asset: present value of expected cash flows discounted to PV at market’s rate • Considering amount, timing, riskiness • Market rate – the collective rate of return required by investors in that security • Rate based on risk; different rates for different bonds

  18. Valuation Steps 1. Estimate amount and timing of each cash flow • Most US bonds pay interest semiannually 2. Determine required rate of return – what’s available on similar bonds? 3. Calculate PV of each cash flow discounted at required or market rate

  19. Yield to Maturity • Rate holder earns if bond held to maturity • Price may be more or less than par value • One year bond pays 6%, market rate is 10% • Market price in very round numbers to get 10% ($100) is $960 • Holder receives $40 cap gain + $ 60 interest

  20. 6% bond,due 2 years;market rate = 10%. Semiannual pmts TimeCF 5% PVIFPV 6 mo $30 .9524 $28.57 12 mo 30 .9070 27.21 18 30 .8638 25.92 24 30 .8227 24.68 1,000 .8227 822.70 Market value is 92.908% of par or $929.08

  21. Hitting the Right Keys Market PriceYield to Maturity N 4 N 4 PMT 30 PMT 30 FV 1000 * FV 1000 I/Y 5 PV 929.08 +/- * CPT PV - 929.08 CPT I/Y = 5 5 * 2 = 10 * No +/- sign * Needs +/- sign

  22. Important Valuation Relationships # 1. Value of bond is inversely related to changes in interest rates • If rates increase, price falls Why? Cash flow is fixed. Only way to increase yield is to reduce price. Price of five year bond with 12% coupon, price is $1,000 if rate is 12% • Price is $899 if rate 15% , $1,117 if 9%

  23. Relation #2 • If market rate equals coupon rate, bond sells at par • If market rate exceeds coupon, bond sells for less than par (discount pond) • If rate less than coupon sells above par (premium bond)

  24. #2 Example • The market value will be less than par if the investors’ required rate of return is above the coupon rate; converse is true • Five Year, 12% Bond RequiredCouponPrice 12% 12% $1,000 15 12 899 9 12 1,117

  25. Interest Rate and Price Changes

  26. Relationship #3 • Long-term bond subject to greater price risk than short-term bond Price of 12% 5 and 10 year Bonds Rate5 year10 year 9% $1,117 $1,192 12% 1,000 1,000 15% 899 849

  27. 5 and 10 Year Price Sensitivity

  28. FinCoach Tips • Be able to calculate market price and yield to maturity • (The return the investor would earn if he bought the bond at the market price and held it to maturity = I/Y) • Read questions carefully - look for • Coupon dollars, coupon rates, payment frequency

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