BONDS

1. BONDS Markets & Investments Lecture 2

2. A bear market is the time to be buying bonds. John Woolway President & Chief Investment Officer Vantage Investment Partners Overall, the new data were very positive for the economy and bad for bonds. Ralph Axel Bond Analyst Bank of America Merrill Lynch BONDS Markets & Investments Lecture 2

3. OUTLINE • Introduction to Bonds • Government Bonds • Corporate Bonds • Bond Interest Rates Markets & Investments Lecture 2

4. INTRODUCTION TO BONDS • What is a bond? • Why do companies sell bonds? • Why do people buy bonds? • Bond Terms • Marketable Securities Markets & Investments Lecture 2

5. What Is a Bond? • Bonds are a form of debt issued by businesses (or governments, which we will get to later) and sold to individuals or institutions typically through investment banks. Markets & Investments Lecture 2

6. Why Do Companies Sell Bonds? • Bonds are simply another way that businesses can raise the money (the capital) that they need to make products and develop services that they can sell to consumers. • Since bond interest payments are an expense, they can be deducted from revenue earned by a company, thus reducing income and taxes. This is not true of dividends. • Moreover, bondholders are not owners of the firm, as are common stockholders. Markets & Investments Lecture 2

7. Why Do People Buy Bonds? • When a company issues stock, it does not owe the buyer of the stock anything. The stockholder hopes that the company will do well, and that therefore the stockholder will make money on his investment. • Since bonds are debt, however, the business that issues bonds owes the buyers of those bonds (the bondholders) money whether or not the company is profitable. • For example, if you bought a $10,000 bond with a 6.0% coupon rate that matured in ten years, you would receive $600 (.06 X $10,000) each year for the next ten years, and you would receive (get back) your $10,000 principal (principal is the amount you invested) at the end of the ten-year period in good years and bad years. • Only if the business went bankrupt would you lose all or part of your investment. • Even in the case of bankruptcy, though, bondholders are paid before all stockholders (preferred and common stockholders) if there is any money left in the bankrupt company. Markets & Investments Lecture 2

8. Why Do People Buy Bonds? • Compared to stocks, bonds are less risky. • Over time, though, the returns on bonds are lower than the returns on stocks (investors are compensated for risk). • Bonds are also typically bought by people looking for income (as opposed to capital gains, or wealth creation). Markets & Investments Lecture 2

9. Bond Terms • Par Value • Coupon Rate • Maturity • Yield Markets & Investments Lecture 2

10. Par Value • Par value is the face value, or stated value, of the bond. • In the example above (under “Why Do People Buy Bonds?”), the par value of the bond is $10,000. • Frequently, but not always, the par value is the amount we pay to buy the bond. • Sometimes bonds are sold at a discount (for less than par value) • Sometimes bonds are sold at a premium (for more than par value). Markets & Investments Lecture 2

11. Coupon rate • Coupon rate is the stated rate of interest on the bond. • The coupon rate is a percentage of the par value. • In the example above (under “Why Do People Buy Bonds?”), the coupon rate is 6% (which means 6% of $10,000). Markets & Investments Lecture 2

12. Maturity • When a bond matures, the company that issued the bond returns the bondholder’s principal and stops paying interest payments. In other words, the investment is at an end. • In the example above (under “Why Do People Buy Bonds?”), the maturity is ten years. Markets & Investments Lecture 2

13. Yield • Yield refers to the return on the amount you invested. • There are two types of yield. • Current yield • This is the percentage return on a bond in any one year. Thus it would be yearly interest payments divided by the bond’s price. • Yield to maturity • This is the average annual percentage return on a bond assuming you keep the bond (and do not sell it) until the bond matures, and that you get all the future interest payments on the bond and your principal back when the bond matures. Markets & Investments Lecture 2

14. Marketable Securities • Like stocks, bonds are marketable securities. • They are sold by companies and in bond markets. • People can buy a new issue of a bond from the corporation that is issuing the bond, or they can buy an existing issue of a bond from a person who bought the bond. • If you own a bond, you do not have to wait until the bond matures to get your principal back. You can sell the bond to another person. Markets & Investments Lecture 2

15. Marketable Securities • Interest Rate Risk • Depending on interest rates, you may get less (or more) than you originally paid for the bond if you sell it before it matures. • If interest rates in an economy are declining, bond prices increase. • If the yield on a bond that I hold is 6.0%, and interest rates decline to 5.0%, the price of my bond will increase to the point where its current yield is only 5.0%. • If interest rates are increasing, bond prices decline. • if the yield on a bond that I hold is 6.0%, and interest rates increase to 7.5%, the price of my bond will decrease to the point where its current yield is also 7.5%. Markets & Investments Lecture 2

16. GOVERNMENT BONDS • Introduction to Government Bonds • U.S. Government Bonds • U.S. Government Agency Bonds • Municipal Bonds Markets & Investments Lecture 2

17. Introduction to Government Bonds • The governments of many countries in this world issue bonds as a way of raising money. • Traditionally, bonds were used as a means of funding long-term investments (such as infrastructure improvements) or temporary shortfalls in tax revenues. • In modern times, however, the governments of most developed countries chronically run government deficits, and therefore issue bonds to cover these deficits. • In other words, governments spend too much and or tax too little, and therefore need to issue bonds in order to pay for the resulting budget deficits. Markets & Investments Lecture 2

18. U.S. Government Bonds • In the United States, the national government (usually called the federal government) issues bonds, bills, and notes. • The difference among these three is the maturity. • Treasury bills are short-term debt; they mature in one year or less (usually 13 weeks, 26 weeks, or 52 weeks). • Treasury bills are U.S. government debt, but are not actually bonds, since bonds are generally considered to be debt with a maturity of more than one year. • Treasury notes mature in greater than one year, but in no more than 10 years. • Treasury bonds mature in greater than 10 years. • Usually U.S. Government bonds are simply called Treasuries or U.S. Treasuries. Markets & Investments Lecture 2

19. U.S. Government Bonds • U.S. Government bonds are backed by the full faith and credit of the United States. • This means that the U.S. Government guarantees that it will pay all interest and principal payments fully and on time. • In fact, the U.S. Government has paid interest and principal payments on its bills, notes, and bonds fully and on time throughout the history of the United States. • It has never defaulted on a payment. • To default means that a bond issuer does not make interest and/or principal payments fully and/or on time. • When a company or government defaults, it essentially goes bankrupt. Markets & Investments Lecture 2

20. U.S. Government Agency Bonds • U.S. Government Agency bonds are not the same as U.S. Treasuries. • Government Agency bonds are issued by corporations established by the U.S. Government, such as… • the U.S. Postal Service • the Federal National Mortgage Association (usually referred to by the nickname Fannie Mae) • the Federal Home Loan Mortgage Corporation (usually called Freddie Mac). • These bonds are technically not backed by the full faith and credit of the U.S. Government; however, it is extremely unlikely that the U.S. Government would ever allow these organizations to default. • In fact, during the financial crisis of 2008, when it looked like Fannie Mae and Freddie Mac were going to default on their bonds, the U.S. Government took control of these organizations in order to prevent their going bankrupt and defaulting on their bonds. Markets & Investments Lecture 2

21. Municipal Bonds • Municipal bonds are bonds issued by U.S. states and local governments. • Sometimes they are called tax-free bonds because interest payments on municipal bonds are not taxed by the federal government; moreover, they are not taxed by the state in which the bonds were issued. • For example, if you lived in the State of New Jersey and bought a bond issued by New Jersey or any local government in the state (that is, county, town, or city in New Jersey), you would pay no tax either to New Jersey or to the U.S. Federal Government on interest payments you received on that bond. • However, if you lived in the State of New Jersey and bought a bond issued by any state besides New Jersey (or by any local government in any state besides New Jersey), you would still pay no tax to the U.S. Federal Government on interest payments you received on that bond, but you would pay tax to the State of New Jersey on those interest payments. Markets & Investments Lecture 2

22. Municipal Bonds • There are two types of municipal bonds. • General Obligation Bonds • Revenue Bonds Markets & Investments Lecture 2

23. General Obligation Bonds • A general obligation bond is backed by the full faith and credit of the government that issued the bond. • Example: New Jersey general obligation bonds are backed by the full faith and credit of the State of New Jersey • Example: New York City general obligation bonds are backed by the full faith and credit of the City of New York. • General obligation bonds are typically not issued for a specific purpose. • Interest and principal are paid out of tax revenue received by the government that issued the bond. • Governments can use their full power to tax to pay interest and principal on general obligation bonds. • Example: the State of New Jersey can use both sales tax revenue (taxes paid when we buy something in a state, such as a 6% tax on the price of clothing) and income tax revenue (taxes paid on wages and salaries) to pay interest and principal on general obligation bonds. Markets & Investments Lecture 2

24. Revenue Bonds • Revenue bonds are not backed by the full faith and credit of any government. • Interest and principal on revenue bonds are usually paid out of the fees collected for a specific project. • For example, if the State of New Jersey issued revenue bonds to build a road, interest and principal on these bonds would be paid using money (called a toll) collected from drivers who used the new road. Markets & Investments Lecture 2

25. CORPORATE BONDS • Introduction to Corporate Bonds • Maturity • Forms of Issuance • Structure of Payments • Security • Callable Bonds • Convertible Bonds Markets & Investments Lecture 2

26. Introduction to Corporate Bonds • One way that many businesses raise money is by getting bank loans. • Another way, which we first looked at in the introduction to this lecture, is by issuing bonds known as corporate bonds, or simply corporates. • Issuing bonds is a common way for companies throughout the world to raise money. • The corporate bond market consists of billions of U.S. dollars worth of bonds. • In the United States, corporate bonds are usually issued in denominations (amounts) of $1,000 and $5,000. Markets & Investments Lecture 2

27. Introduction to Corporate Bonds • Corporate bonds may differ in a number of ways, such as… • when the bonds mature • how ownership is recorded • how payments are structured • whether the bonds are backed by any security (called collateral) • whether the bonds are callable • whether the bonds are convertible Markets & Investments Lecture 2

28. Maturity Markets & Investments Lecture 2

29. Forms of Issuance • When you buy a corporate bond, your ownership of the bond can be recorded in one of several ways. These are generally referred to as forms of issuance. • Registered Bonds • Book-Entry Bonds • Bearer Bonds Markets & Investments Lecture 2

30. Registered Bonds • When you buy registered bonds, you receive a piece of paper called a certificate. • The certificate states… • the name of the owner (your name) • the name of the company that issued the bond • the maturity date • the coupon rate • The par value of the bond • An agent of the company that issued the bond will then send you interest payments when they are due and your principal when the bond matures. Markets & Investments Lecture 2

31. Book-Entry Bonds • A newer (and now more common) way to issue bonds is to issue book-entry bonds. • With these bonds, the buyer does not receive a certificate of ownership. The purchase of the bonds is simply recorded in the books of the brokerage house (the investment company) that sold the bonds. • All interest and principal payments are then sent to the bondholder’s account at that investment company. Markets & Investments Lecture 2

32. Bearer Bonds • The owner of a bearer bond receives a certificate with coupons attached. • The certificate does not have the owner’s name printed on it. • The coupons are little pieces of paper, which can be removed. • To receive interest payments, the owner (or bearer) removes the appropriate coupon when an interest payment is due, and presents the coupon to the agent (frequently a bank or brokerage house) of the company that issued the bond. • The agent must then pay the interest payment to the bearer, whoever that person is. • No proof of ownership or identity is necessary. • Bearer bonds preserve the anonymity of the owner and can be used to avoid paying income taxes; however, owners of bearer bonds have very little recourse if the bonds are stolen. Markets & Investments Lecture 2

33. Bearer Bonds • Because bearer bonds allow people to avoid paying taxes, they can no longer be issued by corporations in the United States. • Bearer bonds that had been issued in the U.S. before it became illegal to do so still exist and can be legally bought and sold. • Bearer bonds are still issued in other countries. Markets & Investments Lecture 2

34. Structure of Payments • Fixed-Rate Securities • Floating-Rate Securities • Zero-Coupon Bonds Markets & Investments Lecture 2

35. Fixed-Rate Securities • Most bonds, including corporate bonds, are fixed-rate securities. • Fixed ratemeans that one interest rate is effective throughout the life of the bond. • For example, if you paid $1,000 for a corporate bond with a coupon rate of 6%, you would receive $60 in interest each year until maturity, when you would receive your $1,000 principal back. • You would receive the $60 per year no matter what happened to general interest rate levels in the economy. • Interest on bonds is usually paid twice a year. In the above example, you would actually receive $30 once every six months. Markets & Investments Lecture 2

36. Floating-Rate Securities • Some bonds are floating-rate securities. • The interest rate on these bonds can change depending on the general level of interest rates in the economy. • If interest rates increase, the bond’s interest rate will also increase. • if interest rates decline, the bond’s interest rate will also decline. Markets & Investments Lecture 2

37. Zero-Coupon Bonds • Some bonds are zero-coupon bonds. • These bonds do not pay any interest every six months. Instead, these bonds are issued at a deep discount to the face value. • For example, a $1,000 bond that is sold for $600 • At maturity, the bondholder then receives the face value of the bond, not the amount he paid when he bought the bond. • For example, $1,000 and not the $600 originally paid to buy the bond Markets & Investments Lecture 2

38. Zero-Coupon Bonds • Some government bonds (called Treasury strips) are zero-coupon bonds. • Treasury strips and zero-coupon bonds are types of original issue discount bonds. • All original issue discount bonds are issued at a discount when first sold. • Not all of them are zero-coupon bonds, however. • Some original issue discount bonds are issued at a small discount to face value, but also pay interest every six months. Markets & Investments Lecture 2

39. Security • Unsecured Bonds • Secured Bonds Markets & Investments Lecture 2

40. Unsecured Bonds • Most corporate bonds are debenture bonds (also called debentures). • Debentures are unsecured debt. • This means the bonds are backed only by the general credit of the company that issued the bonds. Markets & Investments Lecture 2

41. Secured Bonds • Generally, with secured bonds, assets are used as security for the bonds. • In effect, the bondholders own the asset and can sell it if the company that issued the bonds defaults and does not make interest or principal payments. Markets & Investments Lecture 2

42. Types of Secured Bonds • Mortgage Bonds • Equipment Trust Certificates • Collateral Trust Bonds • Guaranteed Bonds • Sinking Funds Markets & Investments Lecture 2

43. Types of Secured Bonds • Mortgage Bonds: These bonds use physical property, such as land or buildings, as collateral. If the company that issues the bonds defaults, the bondholders can then sell the property and keep the money received from the sale. • Equipment Trust Certificates: These are frequently used by transportation companies, such as airlines. The equipment being purchased (such as airplanes) with the money from the bonds is used as collateral for the bonds. Markets & Investments Lecture 2

44. Types of Secured Bonds • Collateral Trust Bonds: These bonds are backed by securities (such as stocks and bonds) owned by the company issuing the bonds. • Guaranteed Bonds: These are the bonds of one corporation that have been guaranteed by another corporation. For example, a parent company might guarantee the bonds of a subsidiary. If the subsidiary defaulted, the parent company would then have to pay interest and principal on the bonds. Markets & Investments Lecture 2

45. Types of Secured Bonds • Sinking Funds: Sinking fund provisions require the company that issued the bonds to set aside money every year to retire (pay off) the bonds. These provisions also require the issuing company to actually retire bonds (chosen by lottery) at certain specified periods in the life of the bond issue. When a company retires bonds, it redeems them. It returns to the bondholders who own those retired bonds their principal. Their investment is then at an end. This may not seem like a great benefit since these bondholders may still want to have those bonds and the income they provide. However, sinking funds lower the chance of default by dividing one large payment into many smaller payments over the life of the bond issue. Markets & Investments Lecture 2

46. Callable Bonds • Some bonds have a call feature. • The call feature allows the company that has issued bonds to redeem those bonds (return the bondholders’ principal and in effect put an end to their investment) before the maturity date. • These bonds are referred to as callable bonds. • Callable bonds have a stated call date. • The issuing company can redeem its callable bonds on or after the call date at a stated call price. • The call price is frequently the face value (remember par value?) of the bonds. • Sometimes there is a call premium and the call price is greater than the face value of the bond. • The call premium is usually stated as a percentage of the face value. For example, if a bond has a face value of $1,000, and a call price of $1,100, the call premium is 10%. Markets & Investments Lecture 2

47. Callable Bonds • Why would a company want to call (redeem) its bonds before maturity? • Sometimes companies can save money by calling their bonds. • For example, if a company issued bonds with a coupon rate of 10%, and then general interest rates in the economy declined and that same company could issue bonds with a coupon rate of 7%, the company could save money by calling the 10% bonds. Markets & Investments Lecture 2

48. Convertible Bonds • Convertible bonds give the bondholder the choice of exchanging his bonds for a specified number of shares of common stock at a specified price, called the conversion price. • For example, if you bought a $1,000 bond issued by XYZ Corp., and it specified a conversion price of $10 for 100 shares of common stock, you could exchange your entire $1,000 bond for 100 shares of XYZ common stock at a price of $10 per share of stock. Markets & Investments Lecture 2

49. BOND INTEREST RATES • Factors affecting bond interest rates: • General interest rates in the economy • When the bond issue matures • The credit rating of the company (or government) that issued the bonds • Taxes • The collateral backing the bond • The terms of the bond issue Markets & Investments Lecture 2

50. General Interest Rates in the Economy • What is an interest rate? It is the price of money. • Like any other price, interest rates are controlled by market forces, specifically the supply and demand for money. • At any given level of supply of money, interest rates will increase if the demand for money increases, and decrease if the demand for money decreases. • At any given level of demand for money, interest rates will increase if the supply of money decreases, and decrease if the supply of money increases. Markets & Investments Lecture 2