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Module 4Bonds

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Module 4 - Learning Objectives• Define bond issuer, par or face value, coupon rate, maturity date and

call date.• Explain why entities issue bonds.• Explain how an investor makes money from bonds.• Define and calculate nominal yield, current yield, yield to maturity and

yield to call.• Define and differentiate Treasuries, municipal bonds, mortgage

securities, and corporate bonds.• Differentiate short, medium, long and zero coupon bonds.• Explain what credit rating measures.• Define bond fund.• Explain how an investor purchases a bond.• Evaluate a bond using yield, maturity, issuer, credit rating, and

interest rate environment.• Explain how to monitor bond investments with regards to interest rate,

call and credit risk.• Select a bond based on financial goals.

DRAFT 3/6/2007 3

Income is not rising but debt is

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Consumer debt has doubled in the past 10 years(Consumer credit $ millions - does not include mortgages)

DRAFT 3/6/2007 4

People are raiding the piggy bank

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Homeowner equity is falling as more debt is assumed(Homeowner's equity/Value of Household Real Estate)

Source: Mortgage Bankers Association

DRAFT 3/6/2007 5

Spending power?

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Personal Disposable Income

Outstanding Household Debt

Personal Disposable Income and Outstanding Household Debt$ Billions

The big picture

6http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?scp=1&sq=debt%20trap%202008-07-%20interactive&st=cse

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Which of the following factors can a lender use to evaluate your credit?

• Gender• Age• Childbearing plans• Marital status• Change in marital

status• Loans• Public assistance• Dependents• How long you’ve lived

at your house

• Alimony• Race• Color• National origin• People in the

neighborhood where you want to buy

• How long you’ve had your job

• Salary

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What does your credit report affect?

• Interest rates• Job opportunities - Can your

prospective employer check your credit report?

• Insurance• Ability to assume debt

Analyze a credit report

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Your credit score

Source: www.myfico.com

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Credit Scores

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Credit ratings and cost of credit

If your FICO score is

Your interest rate is

and your monthly payment is

760 - 850 5.78% $1,264

700 - 759 6% $1,295

680 - 699 6.18% $1,320

660 - 679 6.39% $1,350

640 - 659 6.82% $1,411

620 - 639 7.37% $1,491

Source: www.myfico.com 3/21/07

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Credit Check-up

• Get a free credit report every year www.annualcreditreport.com or call: 877-322-8228

• Correct any errors by contacting the company in writing – they must resolve the error in 30 days

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Debt as an Investment

• Investors can get on the other side of the fence by lending money to people or entities who want to borrow

• Bonds are usually the investments

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True or False?

• You could go through your entire investing life without investing in bonds.

• You should only invest in bonds when you’re older.

• Stocks always return better than bonds.

• Bonds are boring investments.

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It is January, 2001. You are analyzing a T-bond $1000 face value that matures in

January 2011 and has a 6.125% coupon.

• Who is the issuer of the bond? • How much will you get in interest per

year? • How many years will you get the

interest? • What will you get back when the bond

matures?

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Why do companies, governments, etc. issue bonds?

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How have bonds done as investments?

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How do you make money from bonds?

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You can also have a gain or loss on a bond

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It boils down to two factor: coupon and maturity.

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Pop quiz

• When interest rates go up, bond prices go where?

• When interest rates go down, bond prices go where?

• Shorter maturity bonds are more or less sensitive to interest rate changes than longer maturity bonds?

• Smaller coupon bonds are more or less sensitive to interest rate changes than larger coupon bonds?

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Figure this out

• On 2-22-01 you buy a Motorola $1000 face value bond with a maturity date of 10-01-2097 and a coupon of 5.22. The bond has a credit rating of A. Equivalent bonds are giving 7.895%. Calculate the price of this bond.

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Nominal Yield

• What the issuer pays on the par value of the bond

• It is the return you get if you buy the bond when it’s issued and hold it until it matures

• In a bond quote, annual interest is not given, so you have to figure out annual interest by using nominal yield and multiplying by par value

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The following are $1000 par value bonds and their coupon

rates. What is the annual interest on each?

• Ford Motor (car company) 6.7%• Hewlett Packard (computers)

7.15%• Kroger (supermarkets) 6.8%

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Current Yield

• Annual interest divided by price you paid

• Let’s you know what you get every year

• Might want to compare to other investments

• Doesn’t consider what you sell for

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Calculate current yield

• Alcoa (aluminum manufacturer) $1000 par value bonds with a coupon rate of 6.5% and maturity of 10 years traded at 104.075. Calculate the current yield.

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Yield to Maturity

• May have bought a bond at a premium or discount

• When the bond is redeemed, you will have a capital loss or gain

• Yield to maturity takes this into consideration

• More complete measure of return from the bond (includes interest and gain or loss)

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Calculate the yield to maturity

• It's 2-22-01 and you're evaluating a University of North Carolina at Greenville $1000 par value bond with a coupon of 6.0 and a maturity date of 04-01-2021. The bond is quoted at 111.225.

• What is the nominal yield? • What is the current yield? • What is the yield to maturity?

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Yield to Call• Certain bonds may be called (redeemed

before the maturity date) by the issuer• This can change your return on the bond• Callable bonds are riskier and need to be

assessed using yield to call• Similar to yield to maturity except earliest

call date is used rather than maturity date• Yield to call is higher than yield to maturity

when the bond is bought at a discount• Yield to call is lower than yield to maturity

when the bond is bought at a premium

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Calculate nominal yield, current yield, yield to maturity and yield to call. You are buying 3-1-00.

EntityCouponRate

Maturity Call Date Quote

Alaska 6.75 12-01-2033 6-1-2001 101.5Alabama 5.75 08-15-2023 08-15-2009 101.2ValleyAlabama

5.6 11-01-2016 11-01-2007 87.72

ArkansasHealth

5 06-01-2013 98.853

ArkansasHospital

7.375 02-01-2030 02-01-2010 102.25

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Answer sheet

Entity CouponRate

Maturity CallDate

Quote

Price(QuoteasPercent× $1000FaceValue)

AnnualInterest(CouponRate asPercent ×$1000FaceValue)

CurrentYield(AnnualInterest ÷Price)

Yield to Call(FromCalculator)

Yield toMaturity(FromCalculator)

Alaska 6.75 12-01-2033

6-1-2001

101.5 $1015 $67.50$67.50 ÷$1015 =6.65%

5.64 6.64

Alabama 5.75 08-15-2023

08-15-2009

101.2 $1012 $57.50$57.50 ÷$1012 =5.68%

5.58 5.66

ValleyAlabama

5.6 11-01-2016

11-01-2007

87.72 $877.2 $56$56 ÷$877.2 =6.38%

7.75 6.85

Arkansas Health

5 06-01-2013

98.853 $988.53 $50$50 ÷$988.53 =5.06%

Noncallable 5.12

ArkansasHospital

7.375 02-01-2030

02-01-2010

102.25 $1022.5 $73.75$73.75 ÷$1022.50 =7.21%

7.05 7.19

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US Bond Choices

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Choices - Treasuries

Type Maturity Features

T-bills 3, 6, or 12 month

Sold at a discount to face value. The difference between what you paid and the face value (what you get at maturity) is the interest. The 90-day or 3-month interest rate is an important benchmark.

T-notes 2, 3, 5, or 10 years

Pays interest semiannually.

T-bonds 11-30 years Pays interest semiannually.

Deficit $9 T (12/06)

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Who do we owe?

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Choices - Municipal Bonds

• Issued by state and local government• May have tax advantages (be careful--

not all muni interest is tax free)• Not as safe as treasuries but still

relatively safe• May be backed by tax revenues or

revenues of facility

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Evaluating Munis

• It is 02-22-2001. You're looking at two bonds given the same credit rating by Standard and Poor’s. Calcualte their yields and explain why the yields are different.

•.Coca Cola with a maturity date of 09/15/2022 and a coupon of 8 is quoted at 117.325.

•.Pennsylvania State Health Services with a maturity date of 01/01/2022 and a coupon of 5.75 is quoted at 101.812.

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Choices - Mortgage-backed Securities

• Mortgage-backed securities are created when individual homeowner mortgages are bundled and sold to investors

• May be guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac

• Irregular payments because homeowners may prepay mortgage--based on average life rather than maturity

• Highest risk of prepayment when interest rates fall--bad for bondholder

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Evaluate these

The following table lists mortgage securities quoted on 5-9-00.Explain what each column is.How risky are these investments?If you were about to retire, which one would you choose?

Issuer CUSIP CouponMaturityDate

Quote Yield to Maturity Average Life

FNMA31359UBF1

6.00 11-18-15 97.521 7.48 1.80

FHLMC3133TCHA9

6.00 05-15-20 94.092 7.72 4.25

GNMA3837H06R9

7.00 4-20-27 89.952 8.52 10.83

FHLMC3133TEQJ6

6.5 7-15-28 84.428 8.16 20.49

FNMA31359UBD6

6.0 02-18-07 99.494 7.67 0.23

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Choices - Corporate Bonds

Types ofBonds

Companies Influencing Factors

IndustrialManufacturers, retailers, mining, energy,service

Business cycle

FinancialServices

Banks, brokerage, insurance Interest rates

Public Utilities Telephone, electric, gas, waterRegulations,legislation

Transportation Airlines, railroads, trucking Oil prices

• Issued by large corporations to finance their business.• Listed on the NYSE or sold over the counter.• Some corporations offer convertible bonds.

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Evaluate this

• Amazon issued $681 million in convertible 10-year notes in 1999. The coupon rate was 6 7/8%. Each $1000 bond is convertible to 9.529 shares of Amazon stock. In early 2001, Amazon is selling at about $15 a share. If you are holding these bonds, would it be more profitable to convert to stock or hold the bond? Give your reasons why.

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Choices - Maturity

• During normal economic expansion, the longer the term the higher the interest rate

• This is because the longer the term, the higher the risk

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The date is 2-22-2001. You are evaluating three municipal bonds. Calculate the yield to maturity for

each and discuss why they might be different.

• New York Metropolitan Transit Authority bond quoted at 109.603 with a coupon of 5.4. Maturity date is 04-01-2011. Credit rating is AAA.

• Philadelphia General Purpose bond quoted at 98.234 with a coupon of 4.9. Maturity date is 09-15-2021. Credit rating is AAA.

• King County General Purpose bond quoted at 101.25 with a coupon of 5.25. Maturity date is 01-01-2034. Credit rating is AAA.

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Choices - Zero Coupon Bonds

• Pros: – Can buy bond with little money upfront– Bigger gains if interest rates fall

• Cons: – Bigger losses if interest rate rise– Don’t hear from borrower for a long time– Taxed even though you don’t have the cash

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The effect of interest rate changes on zeros

• Last year. You bought a 30-year par value $1000 zero coupon bond that yielded 6%. Calculate the price you paid.

• This year. Interest rates have fallen to 5%. Calculate the value of your zero coupon bond.

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Bond Credit Rating and Default Rates

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AAA AA A BBB BB B CCC D

Percent Defaults

Source: Moody's

Choices - Credit Ratings

InvestmentGrade

Junk

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Bond Ratings

Moody'sStandardand Poor's

Quality

Investment GradeBest quality. Interest payments are protectedby earnings and principal is secure. Actualdefault rate less than 2%.

Aaa AAA High grade

Protection on interest is not as high as Aaabut still high quality. Actual default rate lessthan 2%.

Aa AA High grade

Over the long term, some risk to investment.Actual default rate less than 5%.

A A Medium

Adequate for now but may be unreliable overtime. Actual default rate 5%.

Baa BBB Medium

Non Investment GradeFuture is not certain. Moderate protection ofinterest and principal. Some speculation.Actual default rate 17%.

Ba BB Speculative

Small protection of interest and principal.Actual default rate 26%.

B B Speculative

Poor standing. May be in default. Actualdefault rate over 40%.

Caa CCC Default

Often in default. Highly speculative. Ca CC Default

Extremely poor prospects. In default. CPoorInvestment

CNointerest.D In default.

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Calculate the yield and explain any differences.

Company Coupon QuoteMaturityDate

CreditRating

DaimlerChrysler

8.5 103.950 01/18/2031 A

Conseco 6.4 100 06/15/2011 BB-Xerox .57 35.625 04/21/2018 BB+OwensCorning

7.5 30.50 08/01/2018 D

Pacific Gas 8.25 91 11/01/2022 CCC

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Even countries have credit ratings. Consider the current economic status of the following countries. What would you guess

the rating of their debt would be?• Here's a guideline: the U.S. is Aaa, China is A3, Brazil is

B2, and Russia is B3. Once you have made your guesses, go out to the web and check out www.moodys.com. You'll find country ratings under Ratings/Sovereign Ratings.

United Kingdom Mexico Argentina Bahamas Canada Israel

• Colombia

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Bond Funds

• About 8000 bond funds with 15% of mutual fund assets.

• For investors who don’t want to buy individual bonds.

• Some pros believe that small investors should only buy bond funds.

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Go to www.bloomberg.com http://www.morningstar.com/

Check out the bond fund returns.

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Buying Bonds

• Treasuries - direct from government, broker, unit trust, or fund

• Municipal bonds - broker, unit trust, or fund

• Mortgage-backed bonds - broker, unit trust, or fund

• Corporate bonds - broker, unit trust, or fund

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Risk and return holds for bonds as well. Less risk means less return.

Muni bonds typically give the lowest interest because of tax status.

Treasuries are next. They’re safe.

Mortgage-backed are safe but they have call risk.

Corporate bonds are the riskier with junk being extremely risky. But yields are also better.

Interest Rate Food Chain

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Assess Interest Rate Risk – Are we at a high point or low point for bond

interest rates?Historical Interest Rates

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Corporate Baa

90-Day T-Bill

Corporate AAA

5-Year T-Note

30-Year T-Bond

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Monitor

• Monitor your bonds. They can change.– Interest rate risk: What is the interest rate

environment when you buy? How is it changing?

– Call risk: Call risk is highest when interest rates drop.

– Credit risk: Issuers can undergo drastic changes in financial viability. Keep tabs on this.