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Chapter 13. the Bond Market 1. Bond Basics 1.1.The Indenture 1.2. Forms

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Chapter 13. the Bond Market 1. Bond Basics 1.1.The Indenture 1.2. Forms Chapter 13. The Bond Market 1. Bond basics 2. Risk 3. The mechanics of purchasing bonds Reading Chapters 13 and 14 4. Variety of corporate bonds 5. High-yield securities 6. Accrued interests, zero coupon bonds, original-issue discount bonds, and income taxation 7. Retiring debt 1 2 1. Bond Basics Yield Curve Typically the longer Bonds are long-term debt instruments (i.e. IOUs issued by the time to maturity, the higher the yield, companies) as illustrated in the Terms used in bonds yield curve graph on Coupon rate: the specified interest rate on bonds the right. Principal amount: the face value of the bond (i.e. the amount owed) There has been times when the yield Maturity date: the time of which the debt is due and the principal curve is downward amount must be paid sloping or flat. Current yield: annual income divided by the current price of the Typically those are security. periods of very high Yield to maturity: the yield that the investor earned on a bond from inflation. the time it is acquired until the maturity date Yield curve: the relationship between yield and the length of time to maturity (see next slide) 3 4 1.1.The Indenture 1.2. Forms of Debt Indenture is the document that specifies the terms of a bond issue. For publically held bonds the indenture is filed with the SEC. The Bearer bonds (also called coupon bonds) indenture specifies A bond with coupons attached or a bond whose The coupon rate, The date of maturity possession denotes ownership. A collateral, if any Common loan restrictions: Registered bonds (also called book-entry bonds) (1) limits on paying dividends A bond whose ownership is registered with the (2) limits on issuing additional debt (3) restrictions on merging or significantly changing the nature of the business commercial bank that distributes interest and principal without the prior consent of the creditors. payments. There is no coupon or any other physical A trustee, usually a commercial bank, is often appointed to be responsible for upholding the terms of a bond’s indenture. evidence of the bond. Failure to meet the terms of the indenture puts a company in default. 5 6 1 2. Risk to Bondholders 3. Mechanics of Purchasing Bonds The same sources of risk that apply to stockholders apply to bonds. Bonds are purchased in much the same way as stocks. Just like stocks, different bonds carry different risks. So there is a credit rating system for bonds. If you see a bond referred to as “ATT 8.125 22” , it Most important ratings are Moody’s and Standard & Poor’s. means this AT&T bond has a coupon rate of 8.125% Moody’s rate bonds uses Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, indicating and matures in the year 2022. the best credit to the worst. Standard and Poor’s rating uses AAA, AA, A, BBB, BB, B, CCC, C, D, Bonds earn interest every day, but typically the firm indicating the best to the worst. distributes the interest payments only twice a year. As A low rating means the issuing company has to offer a higher interest rate to compensate for the risk investors will have to take. such, when a bond is sold, the buyer owes the seller A bond that is rated BBB or better is called “investment grade” bond. accrued interest from the last time interest payment A bond that is rated below BBB is called “junk bond” or “high yield was distributed to the purchase date. bonds” If a bond is current in default and is traded without accrued interest, it is said to “trade flat”. 7 8 Convertible bonds 4. The Variety of Corporate Bonds A bond that may be converted to common stock. Variable interest rate bonds Mortgage bonds A long term bond with changing Interest rate, often tied Secured by property, especially real estate. to rate of Treasury Bills. Equipment trust certificates Another interest rate often used is LIBOR – an interest Secured by specific equipment, such as airplanes rate established daily by the British Banker’s Other asset-backed securities (securitization) Association. LIBOR is calculated in ten currencies, and is Backed up by other assets such as accounts receivable. the global benchmark for global lending and interest Securitization is the process of converting an illiquid asset rates. such as account receivable into a marketable asset. Zero coupon and discount bonds Debentures Bought at a price lower than its face value, with the face An unsecured bond value repaid at the time of maturity Income bonds Eurobonds Interest is only paid if income is earned. High risk and rarely issued. Denominated in U.S. dollars but issued aboard. 9 10 Additional forms of high-yield bonds Split coupon bonds (also called “deferred interest 5. High-Yield Securities bonds”) combines a zero or low initial coupon followed High-yield bonds are bonds that are rated below BBB or by a period with a high coupon. Baa. They are high risk bonds that offer a high yield to Example: A bond that pays no interest for the first four years compensate for the risk. They are also called “Junk bonds”. and then pay 10% for the next six years, until the bond matures. High-yield bonds may be divided into two classes. Reset securities and increasing rate bonds – bonds (1) Fallen angels: Initially investment grade bonds but rating were lowered as a result of financial problems. whose coupon is periodically reset. (2) Initial bonds issued by firms with less than investment Extendible securities – Bonds whose maturity date may grade ratings. be extended into the future. The spread in the yields between high-yield bonds and investment-grade bonds can be substantial, such as 5% in the 1980s. 11 12 2 6. Accrued interests, zero coupon bonds, original-issue discount bonds, and income taxation 7. Retiring Debt Bond interest earning are subject to income tax. Debt issues must ultimately be retired. Whoever ultimately receives the interest payment is When a bond is issued, a method for periodic retirement is responsible for the tax on that interest payment. usually specified. Two typical methods of retirement specified at the time of For zero-coupon bonds and original-issue discount issuing bonds, accrued interest is taxed as if they were Serial bonds: Some bonds mature each year. received. E.g. 1/15 of bonds issued will retired each year. After 15 years all This makes zero-coupon bonds and original-issue bonds will retire. Sinking funds: a fund into which periodic payments can be discount bonds less attractive, unless they are used in deposited, so that over time the company’s debt can be retired tax-deferred retirement accounts. E.g. For a GTE bond that matures in 2016, the provision specifies that a sinking fund to start in 1997 to retire 95% of the issue prior to maturity. 13 14 Chapter 14. The Valuation of Fixed Income Securities In addition to these two methods specified at 1. Perpetual securities issuing, there are other methods firms may be able 2. Bonds with maturity dates to use to retire their debt. 3. Fluctuations in bond prices Repurchasing debt 4. The valuation of preferred stocks If bond price declines and the bond is selling at a discount, the firm may try to retire the debt by purchasing it back in the open 5. Yields market. 6. Risk and fluctuations in yields Call feature 7. Realized returns and the reinvestment assumption The issuer has the right to retire the debt before its maturity. Often a premium is paid for exercising a call feature. This 8. Duration premium is called a “call penalty”. 9. Bond price convexity and duration 10. Management of bond portfolios 15 Basics of Bond Evaluation 1. Perpetual Securities The price of bond depends on the interest paid, First let’s consider a special case of perpetual security – a security that will pay a fixed amount of money every year the maturity date, and the return offered by forever. Preferred stocks, which will be covered later, could be comparable bonds. considered a perpetual debt instrument. Bond evaluation is essentially the same as stock The price or value of perpetual security (P) is determined as evaluation: future cash flows are discounted back PMT to the present. P = i The discount rate is what investors can earn on comparable securities (i.e., similar risk and similar PMT = annual interest payment i = discount rate terms) 17 18 3 Inverse Relationship Between Discount Rate and the Price of a Perpetual Bond Example of Perpetual Securities The higher the discount rate, the lower the value of the bond. Note again that the discount rate is the current interest rate that A perpetual bond that pays $80 a year forever. can be earned on similar investments. What should be the price of this bond? The answer will depend on the discount rate, which is defined as the interest rate that can be earned on similar investments. Assume i=10%, then P = PMT/i =$80/10%= $800 19 20 2. Bonds with Maturity Dates An Example of Bond Price with Maturity – The price of a bond with a maturity date is the present value of all Price at Issuing future payments, including A firm has a $1000 bond that P = PMT × PVFS i,( n) + FV * PVF i,( n) PMT = Interest payments each year matures in 30 years with a 10% 1 FV = Final principal payment coupon rate ($100 interest 1− + i n Assume annual compounding and payment annually). At the = PMT × 1( ) + FV × 1 i=annual discount rate time of issuing, what should i 1( + i) n n= number of years to maturity the price of the bond be, 1 PFVS = Present Value Factor Sum (see review notes for Week 1) 1− assume annual compounding? 1( +10 %) 30 1 The price of the bond (P) is = 100 × +1000 × Answer: At the time of issuing, 10 % 1( +10 %) 30 the coupon rate is the ongoing = ,1$ 000 P = PMT × PVFS i,( n) + FV * PVF i,( n) market rate so it equals to the discount rate.
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