Bond Basics

The problem large organizations run into is that they

typically need far more money than the average bank can
provide.

The solution is to raise money by issuing bonds (or other

debt instruments) to a public market. Thousands of
investors then each lend a portion of the capital needed.

a bond is nothing more than a loan of which you are the

lender. The organization that sells a bond is known as the
issuer.
 Bond Basics
The issuer of a bond must pay the investor something extra for the privilege of using his or her
money. This "extra" comes in the form of interest payments, which are made at a
predetermined rate and schedule. The interest rate is often referred to as the coupon.

The date on which the issuer has to repay the amount borrowed, known as face value, is called
the maturity date.

Bonds are known as fixed-income securities because you know the exact amount of cash you'll
get back, provided you hold the security until maturity.

The primary advantage of being a creditor is a higher claim on assets than that of shareholders.

In the case of bankruptcy a bondholder will get paid before a shareholder does.
 Bond Basics-Characteristics

Face Value/Par Value Coupon or Interest Rate

Face value or par value is the amount of The coupon is the amount the
money a holder will receive back once a bondholder will receive as interest
bond matures. A newly issued bond payments.
usually sells at the par value. Corporate Most bonds pay interest every 6 months
bonds normally have a par value of
$1,000, but this amount can be much
greater for government bonds.
When a bond's price trades above the
face value it is said to be selling at a
premium. When a bond sells below face
value, it is said to be selling at a
discount.
 Bond Basics-
Characteristics

• Maturity
– The maturity date is the future day on which
the investor's principal will be repaid.
– Maturities can range from as little as one day to
as long as 30 years (though terms of 100 years
have been issued!).
A bond that matures in one year is much more
predictable and thus less risky than a bond that
matures in 20 years. Therefore, in general, the
longer the time to maturity, the higher the
interest rate.
– Also, all things being equal, a longer term bond
will fluctuate more than a shorter term bond.
 Bond Basics-Characteristics
• The Issuer
– is an extremely important factor as their
stability is your main assurance of getting paid
back. For example, the U.S. Government is far
more secure than any corporation. Their default
risk--the chance of the debt not being paid
back--is extremely small, so small that the U.S.
government securities are known as risk free
assets.
– a government will always be able to bring in
future revenue through taxation.
– A company on the other hand must continue to
make profits, which is far from guaranteed. This
means the corporations must offer a higher yield
in order to entice investors--this is the
risk/return tradeoff in action.
 Bond Ratings
Bond Rating
Grade Risk
Moody's S&P/ Fitch
Aaa AAA Investment Highest Quality
Aa AA Investment High Quality
A A Investment Strong
Baa BBB Investment Medium Grade
Ba,B BB,B Junk Speculative
Caa/Ca/C CCC/CC/C Junk Highly Spec
C D Junk In Default
 Reading Bond Quotations

Column 1: Issuer - This is the company,

state (or province), or country that is
issuing the bond.
Column 2: Coupon rate on the bond.
Column 3: Maturity date.
Column 4: Bid price. It is quoted in
Terms of 100% of the par value.
Column 5: The current yield.
 Short and Long-Term Federal Government Securities

• A. Treasury Bills Short

• B. CD’s Short
• C. Treasury Notes Medium
• D. Treasury Bonds Long
• E. US Savings Bonds Long
 Short and Long-Term Corporate
Securities

A. Negotiable CD’s Short

B. Bankers’ Acceptances Short
C. B Commercial Paper Short
D. Eurodollar Loans Short
E. Mortgage Bonds Long
F. Collateral Trust Bonds Long
G. Debenture Bonds Long
H. Subordinated Debentures Long
I. Convertible Debentures Medium
 Long-Term State and Local
Government Securities
A. General • Largest category of municipal bonds
• Secured by the full faith, credit, and taxing
Obligation power of the issuing municipality
• Payable from unlimited ad valorem taxes on all
Bonds Long taxable property

B. Limited • Principal and interest are payable solely from

Obligation the revenues produced by the project they are
intended to finance
Bonds Long
 The Determinants
of Bond Quality
Ratings

• A. Earnings can be:

– 1. Stable (Paper Industry)
– 2. Seasonal (Farming
Industry)
– 3. Cyclical (Housing)
– 4. Erratic (A firm with a few
large customers)
 Riskiness of Bond Issuer’s
Earnings

(EBIT)
TIE = Income for Bond Servicing
Total Interest Payments

The TIE ratio measures the ability to “cover” the fixed

annual interest
payments.
Debt Securities Yield and Return

Four ways to measure investment

performance

• 1. Coupon Rate - this is a stated rate

• and does not measure performance
• per se
• 2. Holding Period Return
• 3. Current Yield
• 4. Yield to Maturity
 Bond Terms
coupon rate face value/par value maturity date
fixed-income principal premium
discount default risk risk-free asset
bond rating blue-chip junk bond
current yield YTM Gov’t T-bills
gov’t. T-notes Gov’t. T-bonds muni bonds
callable bonds convertible bonds zero-coupon
bond ETF credit quality yield-to-call
call protection dirty price clean price
 Summary
• Bonds are just like IOUs. Buying a bond means you are lending out your money.
• Bonds are also called fixed-income securities because the cash flow from them is fixed.
• Stocks are equity; bonds are debt.
• The key reason to purchase bonds is to diversify your portfolio.
• The issuers of bonds are governments and corporations.
• A bond is characterized by its face value, coupon rate, maturity and issuer.
• Yield is the rate of return you get on a bond.
• When price goes up, yield goes down, and vice versa.
• When interest rates rise, the price of bonds in the market falls, and vice versa.
• Bills, notes and bonds are all fixed-income securities classified by maturity.
• Government bonds are the safest bonds, followed by municipal bonds, and then
corporate bonds.
• Bonds are not risk free. It's always possible - especially in the case of corporate bonds –
for the borrower to default on the debt payments.
• High-risk/high-yield bonds are known as junk bonds.
• You can purchase most bonds through a brokerage or bank. If you are a U.S. citizen,
you can buy government bonds through TreasuryDirect.
• Often, brokers will not charge a commission to buy bonds but will mark up the price
instead.
 Summary
• Bonds vary according to characteristics such as type of issuer, priority,
coupon rate, and redemption features.
• Bond prices may be either dirty or clean, depending on when the last
coupon payment was made and how much interest has been accrued.
• Yield is a measure of income an investor receives if he or she holds a
bond until maturity, and required yield is the minimum income a bond
must offer in order to attract investors.
• Current yield is a basic calculation of the annual percentage return an
investor receives from his or her initial investment
• Yield to maturity is the resulting interest rate an investor receives if he
or she invests all coupon payments at a constant interest rate until the
bond matures.
• The term structure of interest rates, or yield curve, is useful in
determining the direction of market interest rates.
• The yield curve demonstrates the concept of the credit spread
between corporate and government fixed income securities.
Review Questions:
What is the difference
Why are T-Bills between a collateral
considered risk free? trust bond and a
mortgage bond?

The two major types

A quotation of 87.16
of State and Local
would suggest a price
government bonds
of how much?
include:

What is the difference What is the yield

between current yield spread on debt
and YTM? securities?