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Chapter 11

Chapter 11. Bond and Fixed-Income Fundamentals. Objectives. Explain the fundamental characteristics of a bond issue Describe the differences among bonds offered by the U.S. government, state and local governments, and corporations

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Chapter 11

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  1. Chapter 11 Bond and Fixed-Income Fundamentals

  2. Objectives • Explain the fundamental characteristics of a bond issue • Describe the differences among bonds offered by the U.S. government, state and local governments, and corporations • Explain the difference between a private placement and public distribution of a bond

  3. Objectives continued • Explain the meaning and impact of bond ratings • Understand how to read bond quotes in the financial press • Describe the characteristics of other forms of fixed-income securities such as preferred stock, money market funds, ect.

  4. Bond and Fixed-Income Fundamentals • The Bond Contract • Secured and Unsecured Bonds • The Composition of the Bond Market • Bond Market Investors • Distribution Procedures • Bond Ratings

  5. Bond and Fixed-Income Fundamentals • Junk Bonds or High-Yield Bonds • Bond Quotes • Bond Markets, Capital Market Theory and Efficiency • The Global Bond Market • Other Forms of Fixed-Income Securities • Preferred Stock as an Alternative to Debt

  6. Bond Market Career Opportunities • More new bond offerings than new common stock offerings • Many financially rewarding jobs on Wall Street go to sophisticated analysts and dealers in the bond market • Players in this market must understand: • The terms, & • Financial ramifications of bond trading

  7. Definition of a Bond • Long-term contractual obligation of the firm to pay interest to the bondholder as well as the face value of the bond at maturity

  8. The Bond Contract

  9. The Bond Contract Key concept

  10. The Bond Contract

  11. The Bond Contract

  12. Secured and Unsecured Bonds

  13. Secured and Unsecured Bonds

  14. The Composition of the Bond Market • U.S. Government Securities • Federally Sponsored Credit Agency Issues • State and Local Government Securities • Corporate Securities

  15. Long-Term Funds Raised by Business and Government

  16. U.S. Government SecuritiesTreasury Bills (T-bills) • Maturities 91 and 182 days • Trade on a discount basis • Minimum units of $1,000 • Active secondary market www.treasurydirect.gov

  17. U.S. Government SecuritiesTreasury Note (T-note) • Extremely popular investments • Maturity of 1 to 10 years • Pays interest semi-annually • Minimum units of $1,000

  18. U.S. Government SecuritiesTreasury Bonds (T-bonds) • Longterm in nature • Mature in 10 to 30 years • Units of $1,000 and higher • Taxable for IRS (Federal Tax) • Tax exempt for state and local taxes

  19. U.S. Government SecuritiesTreasury strips = Zero-coupon Securities • STRIP = Separate Trading of Registered Interest and Principal Securities • Regular Treasury notes and bonds repackaged by government security dealers as individual, zero-coupon securities • Tax benefits in certain states

  20. U.S. Government SecuritiesTreasury strips = Zero-coupon Securities • Example: • 25-year Treasury bond has 50 semiannual interest payments and one final principal payment • Each of these 51 payments could be stripped off and sold as a zero-coupon strip

  21. IRS & the Zero-coupon Bonds • IRS taxes zero-coupon bonds (including Treasury strips) as if interest were paid annually (!) even though no cash flow is received until maturity • IRS tax is based on amortizing the built-in gain over the life of the instrument • For tax reasons, zero coupons are usually only appropriate for retirement accounts & pension funds

  22. Risk & the U.S. Government Securities But they are affected by other types of risk Treasuries are considered free from credit risk Interest-rate risk & Inflation risk

  23. Inflation-Indexed Treasury Securities • Treasury Inflation Protection Securities (TIPS) • Offering started in January 1997 • Intention: Protect investors against inflation • Investor receives TWO (2) forms of return 1. Annual interest rate paid semiannually 2. Automatic increase in initial principal to account for inflation

  24. Federally Sponsored Credit Agency Issues • Issued by various agencies of the government • Federal National Mortgage Association • Federal Home Loan Bank • Authorized by an act of Congress to finance federal projects • NOT direct obligations of the Treasury • Direct obligations of the issuing agencies • Slightly higher yield than U.S. government securities

  25. Federally Sponsored Credit Agency Issues • Agency issues support the housing industry • Trade in denominations of $5,000 and up • Maturities from 1 to 40 years – avg. 15 yrs • Examples: • Federal Home Loan Bank • Federal Intermediate Credit Banks • Federal Farm Credit Bank • Export-Import Bank

  26. Federally Sponsored Credit Agency Issues • GNMAE (Ginnie Mae) Government National Mortgage Association • Buys mortgages from various lenders at a discount • Issues securities to public against these mortgages • Investors receive monthly payments = Interest + Principal payments on mortgages • pass-thru www.ginniemae.gov

  27. State and Local Government Securities DEFINITION Municipal Bonds: Debt securities issued by state & local governments Most important feature: Tax exempt nature of interest payment Attractive investment for: individuals in high tax brackets

  28. How to Calculate the Equivalent Interest Rate on a Municipal Bond (i.e. tax exempt) with other Taxable Bonds Y = Equivalent before-tax yield on a taxable investment i = Yield on the municipal obligation T = Marginal tax rate of the investor

  29. Equivalent before-tax yield on taxable investment • Example: • Investor has a marginal tax rate of 35% and is evaluating a municipal bond paying 6%. • The equivalent before-tax yield on a taxable investment would be:

  30. Marginal Tax Rates and Return Equivalents

  31. Comparable Yields on Long-Term Municipals Taxable Corporates (Yearly Averages)

  32. General Obligation vs. Revenue Bonds • General Obligation Issue • Backed by full faith, credit, and “taxing power” of the governmental unit • Revenue Bond • Repayment of issue is fully dependent on the revenue-generating capability of a specific project or venture such as: • Toll road • Bridge • Municipal arena • Higher credit quality for general obligation issue than for revenue bonds

  33. Municipal Bond Guarantee • Third-party insurer may be used to guarantee all interest and principal payments will be made • 30% of all municipal bonds are guaranteed by insurance companies • These issues receive highest rating possible (AAA) because guaranteeing insurance companies are rated AAA.

  34. Corporate Securities • Main source of financing for U.S. corporations • Bonds supply 80 to 85% of firms’ external financial needs • Corporate market subunits: • Industrials (from hi tech to discount chain stores) • Public utilities (largest segment of corporate bond market) • Rails & transportation • Financial issues • Banks • Finance companies • Insurance

  35. Comparative yields on Aa Bonds among Corporate Issuers

  36. Corporate Securities • Generally trade in units of $1,000 • Higher risk than government issues • ALL income is taxable for federal, state, & local • Possible disadvantage: subject to call Higher (expected) yields

  37. Bond Market Investors • Bond market is dominated by large institutional investors • Insurance companies • Banks • Pension funds • Mutual funds • Institutional Investors account for 80 to 85 percent of trading in key segments of bond market

  38. Bond Market Investors • Relatively strong primary market (new issues) • Relatively weak secondary market (resale market) • Dominated by over-the-counter transactions • Question that a bond investor must consider: How close to the going market price can I dispose of the issue? (5 or 10% discount might be unacceptable) • Foreign investors buy 10 to 15% of the U.S. government’s debt

  39. Distribution Procedures • Shelf registration under SEC Rule 415 • Permits large companies to file one comprehensive registration statement for future long-term financing (multiple issues) • Firms can issue bonds through an investment banker without further SEC approval • Further issues said to be sitting on the shelf • May be on the shelf for up to 2 years

  40. Distribution Procedures continued • Half of new public bond issues are distributed through shelf registration process • Other half through traditional large syndicate of investment bankers

  41. Private Placement • Bond offerings sold privately to investors • Insurance companies • Pension funds • Offered by industrial firms (not public utilities) • Limited or nonexistent secondary market • Slightly higher yield due to lack of liquidity

  42. Bond Ratings Corporate financial management & Institutional portfolio managers Keep a close eye On bond rating procedures

  43. Two Major Bond Rating Agencies Standard & Poor’s Moody’s Investors Service www.moodys.com Requires FREE registration www.standardandpoors.com No registration needed (a subsidiary of McGraw-Hill, Inc.)

  44. Bond Ratings • Moody’s and Standard & Poor’s rank • Corporate bonds • Municipal bonds • Private placement commercial paper • Preferred stock issues • Offerings of foreign • U.S. Government bonds are considered to be risk free (no ratings) Companies Governments

  45. Description of Bond Ratings • Moody’s and Standard & Poor’s ratings • Categories shown on the next slide • The first four categories are assumed to represent investment-grade quality • Large institutional investors • Insurance companies • Banks • Pension funds confine their activities to ONLY the first four categories

  46. Description of Bond Ratings

  47. Junk Bonds or High Yield Bonds Any bond not considered investment quality Appropriate only for the portfolio of investors with a higher than average risk tolerance Possible reasons for being in the junk bond category: • “Fallen angel” bonds - companies that once had high credit rankings but now face hard times • “Emerging growth” companies – not yet established small firms • Companies undergoing restructuring as result of leveraged buyout or as part of fending off unfriendly takeover offer

  48. Bond QuotesWall Street Journal & other sources provide daily bond quotes EXAMPLE - Ford Motor Credit Company bonds Coupon rate = 7% Maturing in 2013 “Last Price” = 106.538 Quote is NOT actual dollars Quote is a % of par value Corporate bonds trade in units of $1,000 106.538 represents $1,065.38 ( = $1,000 x 106.538%) Interest in the tables is “Last Yield” = True rate of return bond investor is receiving = 6.097% = Yield to maturity (covered in the next chapter) For name write Ford Motor Credit For maturity write 2013 Click http://cxa.marketwatch.com

  49. Quotes of Government Issues Treasury Bonds, Notes , and Bills • T-notes & T-bonds traded on the basis of price as a % of par value • Ask price • Bid price • Spread • T-bills quoted on the basis of yield

  50. Quotes on Government Securities Example Price for 4.250 Treasury note due January 2110 is quoted as 105.27 bid and 105.28 asked. These prices translate into 10527/32percent and 10528/32 percent of $1,000. The bid price on a $1,000 note would be 105.84375% × $1,000 = $1,058.4375 The ask price on a $1,000 note would be 105.87500% × $1,000 = $1,058.7500 The spread between the bid and ask price is $.3125

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