Chapter 1

1. Chapter 1 Introduction to Bond Markets

2. Intro to Fixed Income Markets • What is a bond? • A bond is simply a loan, but in the form of a security. • The issuer of the bond is the borrower and investors (bondholders) are the lenders. • Bonds are used to finance a firm’s (usually long-term) investments. • Why would a firm issue bonds rather than get a bank loan? • Bank loans tend to involve shorter term lending periods. • Covenant – set of rules placed on firms designed to stabilize performance and reduce the likelihood of default.

3. Bond Market Characteristics • Primary market: where new bonds are issued to investors. • Secondary market: where previously issued bonds trade. • Most secondary market trading occurs in a decentralized (fragmented) OTC market—in part because no two bonds are alike. • Some corporate bonds trade on exchanges (NYSE is the largest organized market for corporate bonds). • Size of bond market: • Face value of all bonds outstanding worldwide in 2006 was $67.4 Trillion. • Contrast this with the equities where global capitalization was $54.2 Trillion.1

4. Bond Market Sectors • Treasury Sector: debt issued by US government: • Treasury bills, notes, and bonds. • US government is largest issuer of securities in the world. • Agency Sector: securities issued by government-sponsored organizations. • Municipal Sector: debt issued by state and local governments • Also called the “tax-exempt” sector. • Subsectors: General obligation sector and Revenue sector

5. Bond Market Sectors • Corporate Sector: debt issued by corporations (also called credit sector): • Commercial paper, notes, bonds. • Subsectors: investment grade and noninvestment grade sectors. • Asset-backed Sector – issuer pools loans and receivables as collateral for the issuance of securities. • Mortgage-backed Sector – debt backed by pool of mortgage loans: • Subsectors: Residential mortgage sector and Commercial mortgage sector.

6. Summary of Bond Features • Bond features are outlined in a contract between the issuer and investors (called the indenture): • Term to maturity • Principal amount • Coupon rate • Amortization features • Embedded options.

7. Feature 1: Term to Maturity • Term to maturity: # of years until the bond expires. • Usually just called “term” or “maturity.” • Bond terms: • Short term: 1 to 5 years. • Intermediate term: 5 to 12 years. • Long term: > 12 years.

8. Features 2 and 3: Principal & Coupon Rate • Principal: The amount the issuer agrees to repay to bondholders at the maturity date. • Also commonly called: face value, par value, maturity value. • Coupon Rate: the annual interest rate the issuer agrees to pay on the face value (principal). • The coupon is the annual amount the issuer promises to pay (in $): • coupon = coupon rate  principal • The coupon is paid semiannually on most bonds.

9. Coupon Rate, Aside • Some bonds pay no coupons (zero-coupon bonds). • Zeros are sold at a substantial discount to face value and redeemed at face value at expiration. • All interest is therefore received at expiration. • Some bonds have floating coupons: • The coupon resets periodically, according to some formula, so that it increases and decreases with interest rates. (called a floater) • A formula is applied so the coupon goes up when interest rates go down and vice versa (called an inverse floater)

10. Floating Rate Bonds • The coupon for a floater is determined by the following general formula: • Floater coupon = floating reference rate + fixed margin (in bps) • Examples: • Floater coupon = 1-month LIBOR rate + 150bps • Floater coupon = 3-month T-bill rate + 80bps

11. Feature 4: Amortization • The principal on a bond can be paid two ways: • Paid all at once at expiration (“bullet” maturity). • Paid little-by-little over the life of the bond according to a schedule (amortizing). • One advantage of a bond that amortizes principal is that the issuer won’t have to fund a big “balloon payment” at expiration.

12. Feature 5: Embedded Options • Options are actions that can be taken by either the issuer or the investor. • The most common is a call provision: Grants issuer the right to retire bonds (fully or partially) prior to maturity. • Advantageous refinancing tool for issuers—enables old bond to be replaced with a new lower interest rate bond if interest rates decline. • Detrimental to investors since it forces them to reinvest funds at a lower interest rate. • Put provision: Enables the bondholder to sell the issue back to issuer at par value prior to expiration. • This is advantageous to investors since if interest rate rise, bond prices fall. Investors can sell bonds at face value.

13. Feature 5: Embedded Options • Convertible bond – gives bondholders the right to exchange the bond for a specified number of shares of common stock. • This is advantageous to investors if firm’s stock price goes up. • Exchangeable bond – allows bondholders to exchange the bond for a specified number of shares of common stock of another firm. • Other options exist.

14. Risks Associated with Bond Investing • Interest-rate risk – risk the price of a bond will decline as a result of interest rate changes (also called market risk) • The major risk faced by bond investors. • Reinvestment risk – risk that the interest rate at which intermediate cash flows can be reinvested will fall. • Call risk – This presents three risks to investors: • Reduces the certainty of the cash flow pattern. • Exposes the investor to reinvestment risk (since calls occur when interest rates decline). • Capital appreciation of a callable bond may be reduced as a result of the call feature.

15. Risks Associated with Bond Investing • Credit risk – risk that issuer will fail to satisfy the terms of the bond. There are two forms of credit risk: • Default risk: Risk the issuer does not repay part or all of its financial obligation. • If issuer defaults, the investor gets only a fraction of the face value (called the recovery rate). • Credit deterioration risk: Risk that the credit quality of the issuer decreases (e.g. change in debt rating). • If a issuer’s credit rating deteriorates, the investor still receives face value of the debt at maturity. • Credit risk can be assessed by looking at credit ratings issued by one of the three rating agencies: • Standard & Poor’s, Moody’s, and Fitch.

16. More on Credit Risk • The yield on a risky bond is made up of two components: • Yield on a similar maturity Treasury issue (risk-free) • The premium to compensate for the risks associated with the risky bond. • Rrisky = Rf + RP • The part of the “RP” attributable to default risk is called the credit spread.

17. Risks Associated with Bond Investing • Inflation risk – the risk that the purchasing power of a bond’s cash flows may decline. • Example: • 2007: Coupon rate = 8% Inflation rate = 3% Real rate = ? • 2008: Coupon rate = 8% Inflation rate = 6% Real rate = ? • Floating rate bonds have a lower level of inflation risk than coupon bonds.

18. Risks Associated with Bond Investing • Exchange rate risk – if a bond is denominated in a foreign currency (e.g., the euro), the value of the cash flows in US$ will be uncertain. • Liquidity risk – the risk that the bond cannot be sold with ease at (or near) its current value. • Unimportant for investors holding a bond to maturity. • Liquidity can be measured by the bid-ask spread. The wider the spread the less liquid a bond is. • Sometimes called marketability risk.

19. Risks Associated with Bond Investing • Volatility risk – the value of embedded options is determined partly by the volatility of interest rates. The price of a bond with embedded options will change as interest rate volatility changes. • Risk risk – The bond market has been a hotbed of financial innovation. The risk/return characteristics of innovative securities are not always understood. Risk risk is “not knowing what the risk of a security is.”