An Introduction to Bonds

1. An Introduction to Bonds Tina Horvath

2. What is a Bond? • Debt instrument: When one purchases a bond, one essentially lends an organization such as the government or a corporation a specified amount of money which the borrower agrees to repay at a designated time. • Why buy a bond? • In exchange for permission to borrow money from the lender, the organization agrees to pay annual interest payments on the amount borrowed. • Components: • principal - face value of the bond (typically $1000) • coupon - rate of interest • maturity - time till issuer will repay borrower

3. Different Types of Bonds • Corporate • Government (Treasury) • Municipal

4. Corporate Bonds • Corporate bonds are issued so that companies can finance expansion or raise funds for other expenses. • Senior debt - bonds that are backed by specific assets of the company. • Debenture - a bond whose issue is secured simply by the promise of the company to repay the amount borrowed. • Default Risk (Ratings) • Standard & Poor: AAA = good credit, CCC = poor standing • Moody: Aaa = good credit, Caa = poor standing • Special cases: • “junk bonds” - bonds with high default rating (CCC, Caa or worse) • convertible bonds - bonds that can be exchanged for other securities

5. Government Bonds • Government, or Treasury bonds, are especially noted for their lack of risk since they are backed by the US government. • bill - maturity of a year or less • note - maturity of 1-10 years • bond - maturity of 10+ years • STRIPS - Separate Trading Registered Interest and Principal Securities, or STRIPS, can be split up into separate interest and principal payments, with each payment trading as a separate security. Example: zero coupon bonds • The Federal Reserve retains some control over the bond market by • open-market operations: buying or selling US Treasuries in order to control the money supply • changing the discount rate: raising or lowering the rate which in turn raises or lowers general interest rates • setting reserve requirements: increasing reserves and thereby raising interest rates or decreasing reserves and thereby decreasing rates

6. Municipal Bonds • Municipal bonds are state and local government bonds. • Tax free, not subject to federal taxes • Two types of municipal bonds: • general obligation bonds - funded by property taxes, sales taxes, and income tax • revenue bonds - funded by revenue from a particular project; e.g., a government issues a revenue bond in order to build a turnpike and repays these bonds with the tolls collected.

7. Yields • Coupon yield: the interest paid on the principal based on the coupon rate. • Current yield: yield based on interest payments with respect to the purchase price of the bond (discount, premium). • Yield to maturity (YTM): estimates the total amount that one can earn over the total life of the bond. • YTM = coupon + prorated discount or premium (face value + purchase price) / 2

8. What Determines Bond Prices? • Current market interest rates: Bond prices tend to increase when interest rates fall and decrease when rates rise. • Inflation: High inflation will devalue a bond. • Liquidity: The ease and cost of trading a particular bond will affect the price. • Political risk: People tend not to invest when the government seems unstable.

9. Bonds in the Real World