document17

Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Eighth Editionby

Frank K. Reilly & Keith C. Brown

Chapter 17

Chapter 17Bond Fundamentals

Questions to be answered:

• What are some of the basic features of bonds that affect their risk, return, and value?

• What is the current country structure of the world bond market and how has the makeup of the global bond market changed in recent years?

• What are the major components of the world bond market and the international bond market?

• What are bond ratings and what is their purpose?

• What is the difference between investment-grade bonds and high-yield (junk) bonds?

• What are the characteristics of bonds in the major bond categories such as governments (including TIPS), agencies, municipalities, and corporates?

• How does the makeup of the bond market in major countries such as the United States, Japan, the United Kingdom, and Germany differ?

• What are the important characteristics of corporate bond issues developed in the United States during the past decade such as mortgage-backed securities, other asset-backed securities, zero-coupon and deep discount bonds, high-yield bonds, and structured notes?

• How do you read the quotes available for the alternative bond categories (e.g., governments, municipalities, corporates)?

Basic Features of a Bond

• Pay a fixed amount of interest periodically to the holder of record

• Repay a fixed amount of principal at the date of maturity

Basic Features of a Bond

• Bond market is divided by maturity– Money Market - short-term issues that mature

within one year– Notes - intermediate-term issues that mature

between one and ten years– Bonds - long-term obligations with maturity

greater than ten years

• Remaining life (maturity) affect price volatility

Bond Characteristics• Intrinsic features

– Coupon - yield (interest income)– Maturity - term or serial (municipalities)– Principal value - different from market value– Type of ownership - bearer or registered

• Types of Issues– Secured (senior) bonds– Unsecured bonds (debentures)– Subordinated (junior) debentures

Bond Characteristics

• Indenture provisions

• Features affecting a bond’s maturity– Callable (call premium)– Noncallable– Deferred call– Nonrefunding provision– Sinking fund

Rates of Return on Bonds

ti,1ti,ti, P

IntPHPR

where:HPRi,t = the holding period for bond i during the period t

Pi,t+1 = the market price of bond i at the end of period t

Pi,t = the market price of bond i at the beginning of period t

Inti,t = the interest payments on bond i during period t

The holding period yield (HPY) is:

HPY = HPR - 1

The Global Bond-Market Structure

• Participating issuers– 1. Federal governments– 2. Agencies of the federal government– 3. State and local political subdivisions

(municipalities)– 4. Corporations– 5. International issues

• Foreign bonds• Eurobonds

Participating Investors

• Individual investors

• Institutional investors– Life Insurance Companies– Commercial Banks– Property and Liability Insurance Companies– Pension Funds– Mutual Funds

Bond Ratings

Major Rating Agencies

• Standard & Poor’s

• Moody’s

• Fitch Investor Services

Alternative Bond Issues

Domestic government bonds– United States - T-bills, notes, bonds. TIPS– Japan - medium term, long term, super long

term– Eurozone – government bonds– United Kingdom - short gilts, medium gilts,

long gilts

Government Agency IssuesUnited States

– Not direct issues, but backed by “full faith and credit” of the U.S. government

– GNMA pass-through certificates

Japan– Government associate organizations

United Kingdom– There are no agency bonds in the U.K.

Eurozone– Agency bonds are not broken down in the

Eurozone

Municipal Bonds

• General obligation (GO) bonds

• Revenue bonds

• Interest payments are exempt from federal income tax

• Convert the tax-free yield of a municipal bond selling close to par to an equivalent taxable yield (ETY)

Equivalent Taxable Yield

Where:

i = coupon rate of the municipal obligations

T = marginal tax rate of the investor

)-(1ETY

Municipal Bond Guarantees• Bond insured against default risk

– Insurance is irrevocable for the life of the issue

• Four private bond insurance carriers– Municipal Bond Investors Assurance (MBIA)– American Municipal Bond Assurance

Corporation (AMBAC)– Financial Security Assurance– Financial Guaranty Insurance Company (FGIC)

Municipal Bond Guarantees

• Insured bonds obtain AAA (Aaa) ratings

• Issues with private guarantees have more active secondary market, and lower required yield

Corporate Bonds

• Mortgage bonds

• Collateral trust bonds

• Equipment trust certificates

• Collateralized mortgage obligations (CMOs)

• Other asset-backed securities (ABS)

• Variable rate notes

Corporate Bonds

• Zero-coupon and deep-discount bonds– Minicoupon bonds– Original-issue discount (OID) bonds– Taxes due on the implied interest

• High-yield bonds (speculative bonds and junk bonds)– Noninvestment grade with rating below BBB or

Japanese Corporate Bond Market

• Bonds issued by industrial firms or utilities• Minimum issuing requirements are specified

by the Ministry of Finance• Bonds issued by banks to finance loans to

corporation– Commercial banks– Long-term credit banks– Mutual loan and savings banks– Specialized financial institutions

U.K. Corporate Bond Market

• Debentures

• Unsecured loans

• Convertible bonds

Eurozone Corporate Bond Market

• Nonbank corporate bonds including industrial and utility firms

• “Corporate-monetary Financial” including borrowing by banks

International Bonds

• Foreign bonds are sold in one country and currency by a borrower of a different nationality– Yankee bonds are U.S. dollar denominated bonds

sold in the U.S. but issued by a foreign firm

• Eurobonds are underwritten by international bond syndicates and sold in several national markets

International Bonds

• United States– Yankee bonds register with SEC– Eurodollar bond market affected by changes in

value of U.S. dollar

International Bonds

• Japan– Samuri bonds - yen denominated issued by

non-Japanese firms in Japan– Euroyen bonds - yen denominated, sold outside

International Bonds

• United Kingdom– Bulldog bonds are sterling-denominated bonds

issued by non-English firms and sold in London

– Eurosterling bonds are sold in markets outside London by international syndicates

International Bonds

• Eurozone– Market popular among foreign issuers

including issuers domiciled in the U.S.– Impressive growth in Eurobonds issued by non-

residents

Obtaining Information on Bonds• Less emphasis on fundamental analysis

• Most bond investors rely on rating agencies for credit analysis

• Market and economic conditions

• Intrinsic bond features

• Popular publications available:– Wall Street Journal, Barron’s, Business Week,

Fortune, Forbes, Federal Reserve Bulletin, Survey of Current Business

Bond Publications• Treasury Bulletin• Standard & Poor’s Bond Guide• Moody’s Bond Record• Moody’s Bond Survey• Fitch Rating Register• Fitch Corporate Credit Analysis• Fitch Municipal Credit Analysis• Investment Dealers Digest• Credit Markets• Duff & Phelps Credit Decisions• The Bond Player

Sources of Bond Quotes

• Bank and Quotation Record

• The Blue List of Current Municipal Offerings

• Wall Street Journal

• Barron’s

Interpreting Bond Quotes

• Quoted on basis of yield or price

• Price quotes are percentage of par– 98 1/2 is not $98.50 but 98.5% of par– A municipal $5,000 bond quoted at 98 1/2

would be $4,925

Corporate Bond Quotes

Company Last Last EST UST EST $

(Ticker) Price Yield Spread VOL