Basic Features of a Bond

Financial Instruments • Pay a fixed amount of interest periodically

to the holder of record
Week 4
• Repay a fixed amount of principal at the
date of maturity
Bond Fundamentals
• Bond market is divided by maturity
– Money Market – (1 year)
Reilly & Brown
– Notes – (1 to 10 years)
Chapter 17 and 18
– Bonds – (more than 10 years)
• Maturity affects price volatility

Bond Characteristics A word on Debentures

• In most countries the term is used
• Intrinsic features interchangeably with bond, loan stock or note
– Coupon - yield (interest income)
• US: debentures are always unsecured
– Maturity - term or serial (municipalities)
– If secured they are called ‘mortgage bonds’
– Principal (Par/Face) value - different from
market value • UK: usually secured by charges on the
– Type of ownership - bearer or registered company's property
• Types of Issues • Asia:
– Secured (senior) bonds – if secured by a charge over land  ‘mortgage’
– Unsecured bonds (debentures) – if secured by other assets it’s called ‘debenture’
– Subordinated (junior) debentures – if unsecured  ‘unsecured deposit note’

Bond Characteristics The Global Bond-Market Structure

• Participating issuers
• Indenture provisions (legal details) 1. Federal governments
• Features affecting a bond’s maturity 2. Agencies of the federal government
– Callable (call premium) 3. State and local political subdivisions (municipalities)
– Noncallable 4. Corporations
– Deferred call (e.g. can only call after 5 years) 5. International issues (Foreign bonds; Eurobonds)
– Nonrefunding provision (forbids using • Participating investors
proceeds from another bond to call a given 1. Individual investors
issue. This somewhat protects bond holders)
2. Institutional investors (Life Insurance Companies;
– Sinking fund (provision to pay progressively) Commercial Banks; Property and Liability Insurance
Companies; Pension Funds; Mutual Funds)

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 Bond Ratings Alternative Bond Issues
• Main Rating companies Domestic government bonds
– Moody’s Investor Service – United States
Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, D
• T-bills, notes, bonds, TIPS (treasury inflation
– Standard & Poor’s protected securities)
AAA, AA, A, BBB, BB, B, CCC, CC, C, D
• Rating Categories – Japan:
–BBB or higher  Investment grade • medium term, long term, super long term
–BB or lower  Speculative grade (junk bonds) – Eurozone: Germany; France; Italy
–Junk Bonds are also known as High Yield Bonds
• Denominated in Euro
–Before 1977 all junk bonds were “fallen angels”, i.e.
they started as investment grade and then were • But different systems (issue, authority etc.)
downgraded.
– United Kingdom:
• Non-rated bonds
• short gilts, medium gilts, long gilts

Government Agency Issues Municipal Bonds

• General obligation (GO) bonds (normal bonds
United States
backed by the creditworthiness of the issuer).
– Not direct issues, but backed by “full faith and
• Revenue bonds (issuer will only pay if enough
credit” of the U.S. government
revenue is generated)
– GNMA (gov. nat. mortg. Assoc.) Ginnie Mae
• Interest payments are exempt from federal income
– Also: Fanny Mae; Freddie Mac tax
Japan • Convert the tax-free yield of a municipal bond
– Government associate organizations selling close to par to an equivalent taxable yield
(ETY)
Germany
– Federal Railway and Federal Post Office
i = coupon rate of the municipal obligations
T = marginal tax rate of the investor

Corporate Bonds Innovative Bonds

• Mortgage bonds (protected by issuer’s property, i.e. – Inverse Floaters
fixed assets)
Coupon rate falls when r rises (and vice versa)
• Collateral trust bonds (protected by issuer’s holding of
other financial assets)
– Asset backed bonds
Example: Coupons depends on royalties from a book or a
• Equipment trust certificates (protected by equipment, film (Walt Disney’s David Bowie bonds).
e.g.train engines and planes)
– Catastrophe bonds
• Collateralized mortgage obligations (CMOs) A bond that pays less if a catastrophe happens (bond
(bonds protected by mortgages) holder is an insurer).
• Other asset-backed securities (ABS) (cars and credit – Indexed bonds
cards).
Payments depend on the price index or the price of other
• Variable rate notes (bonds with variable coupon rate) commodities.

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 Corporate Bonds International Bonds
• Zero-coupon and deep-discount bonds • Yankee bonds are U.S. dollar denominated bonds sold
in the U.S. but issued by a foreign firm
– Minicoupon bonds or Original-issue discount
• Eurobonds are underwritten by international bond
(OID) bonds pay lower than market rates syndicates and sold in several national markets
– Taxes due on the implied interest even though • Samurai bonds - yen denominated issued by non-
no cash is received. Japanese firms in Japan
• High-yield bonds (also known as • Euroyen bonds - yen denominated, sold outside Japan
speculative bonds or junk bonds) • Bulldog bonds are sterling-denominated bonds issued
– Noninvestment grade with rating below BBB or by non-English firms and sold in London
Baa • Eurosterling bonds are sold in markets outside London
by international syndicates

Obtaining Information on Bonds Corporate Bond Quotes

Date: Week ending 29 February 2008
Last Last Est $ Vol
Company Coupon Maturity Price Yield Spread UST (000’s
• Less emphasis on fundamental analysis Citigroup 6.875 Mar 05, 2038 99.647 6.903 250 30 539,450
• Most bond investors rely on rating agencies
Issued by Citigroup
for credit analysis
6.875% coupon rate (they pay $34.375 every 6 months)
• Market and economic conditions
Matures in 2038 (almost 30 years)
• Intrinsic bond features The last transaction price on that day was $996.47
• Popular publications available: Which implies a YTM of 6.903%
– Wall Street Journal, Barron’s, Business Week, Spread = YTM(Cit.) – YTM(30 Years Gov. Bond) = 250bp
Fortune, Forbes, Federal Reserve Bulletin,
Survey of Current Business Estimated volume was $539.45 million

Corporate Bond Quotes Treasury and Agency Bond Quotes

• Notations GOVT. BONDS & NOTES
– “cv” = convertible Ask
– “zr” = zero coupon Rate Mo/Yr Bid Asked Chg. Yld.
– “dc” = deep discount (at time of issue) 31/8 Sep 12n 100:14 100:15 +9 2.35

Treasury and Agency Bond Quotes Coupon rate is 31/8=3.125%

• Notations Prices are in 32nds
– “n” = treasury note Bid ask spread is (15-14)/32 or 0.03% of par
– “p” = treasury note on which nonresident aliens Today’s bid price is higher than yesterday’s by 9/32%
are exempt from withholding taxes on interest Yield to Maturity if bought at the ask price is 2.35%

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 Accrued Interest The Fundamentals of Bond Valuation
Bond prices are quoted net of accumulated interest. The present-value model

The price you pay = Bond price + Acc. Intrst Bond Value = PVann(future coupons) + PV(par value)

Where
Accrued interest = Coupon Value × (Days past / Total days)

Example: Coupon = $50; days between coupons = Where:

Pm=the current market price of the bond
182; days since last coupon = 40. n = the number of years to maturity
Ci = the annual coupon payment for bond i
Accrued interest = 50 × (40/182) = $10.99 approx. i = the prevailing yield to maturity for this bond issue
Pp=the par value of the bond

Price: 10-yr, 8% Coupon, Face = $1,000

Equivalent Formulas
When coupon payments are constant:
Ct/2= 40 Par= 1000 2n= 20 periods r=i/2= 3%

You can find the price manually (using a calculator) using the
formula:

In Excell, input the following (for example)

=PRICE(DATE(2000,1,15),DATE(2010,1,15),0.08,0.06,100,2)

(which gives you 114.877 (per $100 rater than per $1000)

The Fundamentals of Bond Valuation The Fundamentals of Bond Valuation

• In practice interest rates are different for different • If yield < coupon rate, bond will be priced
holding periods.
at a premium to its par value
• So it is often unrealistic to assume a constant yield.
• If yield > coupon rate, bond will be priced
• In that case, the Annuity formula is no longer valid.
at a discount to its par value
• We need to discount the cash flow separately
• Price-yield relationship is convex (not a
straight line)
(See Excel sheet)
(See example in Excel sheet)

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 Zero Coupon Bonds Determinants of Bond Safety
• Coverage ratios: Earnings ÷ Fixed cash obligations
Price is always less than Par Value. Cash obligations include interest payments, lease payments, and
sinking fund payment.

At an interest rate r the fair price of a zero is • Leverage ratios (debt to equity)
High ratio signals higher risk (too much debt compared with equity).
• Liquidity ratios: Current assets ÷ Current liabilities
High ratios signals lower risk (firm is able to pay bills by selling
some of its liquid assets).
Example:
Suppose the interest rate is 10%. Then a 30 year zero coupon
• Profitability ratios: Measures profitability of firm
bond bought today should be priced at One popular measure is: Earnings ÷ Total assets
$1000/(1.10)30 =$57.31 • Cash flow to debt: Cash Flow ÷ Debt
Next year the price will be Lower ratio signals higher risk.
$1000/(1.10)29 =$63.04

Default Risk and Yield

Protection Against Default (Indentures)
• Sinking funds • Risk structure of interest rates
To spread the payment burden over several years. More risky bonds have to either sell at lower prices, or offer
higher coupon rates
P= $80 AnnF(8%,20)+$1000 PvF(8%,20) = $x
• Subordination of future debt
If we expect the firm not to be able to pay $1000, then
A clause that restricts the amount of additional borrowing. P= $80 AnnF(8%,20)+$750 PvF(8%,20) = less than $x

• Dividend restrictions • Default premiums

Limits the payments of dividends to stockholders. Risky firms promise higher yields compared with those of
identical risk free bonds.
Price(Risky bond)
• Collateral = Price(Riskless Bond, Coupon) – Premium(price)
Bond is insured with some asset(s) which the bondholder can Or
receive if the firm defaults on the bond. =Price(Riskless Bond, Coupon+premium(interest))

Computing Bond Yields Promised Yield to Maturity

Yield Measure Purpose • Widely used bond yield figure
Nominal Yield Measures the coupon rate (C÷Par) • Assumes
Current yield Measures current income rate (C÷Price) – Investor holds bond to maturity
Promised yield to maturity Measures expected rate of return for bond held – All the bond’s cash flow is reinvested at the
to maturity computed yield to maturity
Promised yield to call Measures expected rate of return for bond held
to first call date Solve for i that will
Realized (horizon) yield Measures expected rate of return for a bond equate the current price
likely to be sold prior to maturity. It considers to all cash flows from
specified reinvestment assumptions and an the bond to maturity,
estimated sales price. It can also measure the
actual rate of return on a bond during some past
similar to IRR
period of time.

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 Yield to Maturity Example Promised Yield to Call

10 yr Maturity Coupon Rate = 7% Price = $950

Solve for semiannual rate  i/2 = 3.8635%

Where:
(Hard to do it manually: Trial and Error) Pm = market price of the bond
Ci = annual coupon payment
In Excel:
nc = number of years to first call
=YIELD(DATE(2000,1,1),DATE(2010,1,1),0.07,95,100,2)
Pc = call price of the bond
Which gives 0.077269 (Excel gives you an annual YTM)

Yield to Call Realized Yield

Same as YTM except
T  changes to time of call
Par  changes to call price
We solve for y (i.e. i/2), which is the realized yield. However,
Example: A bond callable in five years, at a call price of $1100 we need to estimate the future bond price Pf. This can be
obtained from
(YTM) (Yield to Call)

EXCEL:
YTM YIELD(DATE(2000,1,1),DATE(2010,1,1),0.08,95,100,2)
YTC YIELD(DATE(2000,1,1),DATE(2005,1,1),0.08,95,110,2) Where (i/2) is the market (quoted) YTM.

Realized Yield Realized Yield

(with different reinvestment rates) (with different reinvestment rates)
The previous calculation assumes that you would reinvest the
We need to find the cash (future) value of our investment. coupons at 27.5%. This is unlikely.
We need to find the cash (future) value of our investment.
Example:
hp=2 years, n=20 years, %C=14%, YTM=10%, Par=$1000 Example:
1st coupon invested at 13% for 18 months = $70 × (1+0.065)3 = $84.55
2nd coupon invested at 12% for 12 months = $70 × (1+0.060)2 = $78.65
3rd coupon invested at 11% for 6 months = $70 × (1+0.055)1 = $78.65
4th coupon is not invested = $70 × (1+0.000) = $70.00
We then obtain a horizon yield by solving Future value of payments = $307.05

Ending Value = 1330.95+307.05 = $1638

Beginning Value = $1000

which gives i = 27.5%

which gives i = 26.32%