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Chapter 14 - Bonds

• A promise to repay a sum of money on a fixed date, together with interest, usually over the life of the loan

• Why buy bonds?– Steady income– Generally safe– Reduce risk through diversification

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Types of Bonds

• Corporate bonds– Unsecured = debentures

• Treasuries and Agencies• Inflation-indexed• Municipals

– State and local government agencies– Usually tax-exempt

• Zero coupons

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Bonds – Issuer Types

• Mortgage-related $7.9T40.6%

• Corporations 4.4 22.6• US Treasuries 3.6 18.5• State & Local Gov’t 1.9 9.8• Other asset-backed 1.7 8.5

– Total $19.5 100.0%

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Bond Features

• Par value – face value or principal amount repaid at maturity– Usually $1,000 per bond– Market price may be more or less than par

• Coupon rate – percentage of par value paid annually in interest– With 6% coupon, $1,000 bond pays $60/yr– Most bonds pay interest semi-annually, $3.

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Capital Food Chain

• Secured creditors (OK if < assets)• General Creditors

– Debenture holders and unsecured creditors– Subordinated debenture holders

• Preferred stockholders• Common stockholders

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Ratings

• Moody’s, Standard and Poors, Fitch– Assess quality of borrower’s credit– AAA to D– Junk bonds are BB and below– Lower rating, greater risk, higher rates

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Junk Bonds

• AKA “high risk”, “non-investment grade”, “high yield” or “speculative”

• Low credit rating - BB and below– Higher risk, higher rates

• Fallen angels (companies in trouble) or new, unproven firms

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Quality SpreadsTen Year Maturities – April 2004

Yield Spread ExampleUSTN 4.40%AAA 4.71 +31 GE & UPSAA 4.91 51 Abbott Labs A5.25 85 McDonaldsBBB 5.85 145 GMBB 7.90 350 Goodyear

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Convertible Securities

Convertible into common stock at a fixed rate at bondholder’s option

$1,000 bond convertible into 20 shares– Equal to $50/share (1,000/20)– Stock rises to $60. Bond worth $1,200 (60 * 20)

Offers upside potential but have lower rates than on comparable nonconvertibles

Look at coupon and conversion ratio

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Callable Bonds

• Redeemable at issuer’s option– Rates drop, bond called, new bonds issued– Investor forced to reinvest at lower rate

• Deferred calls and call premiums– Some not callable for first five years– Premium: say 105% of par year 6, 104%

year 7 ….. par year 11• Effect: callables pay a higher rate.

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Municipal Bonds

• Muni's are issued by states, counties, cities and school districts

• Interest not subject to federal taxes (usually)• General obligations

– backed issuer’s taxing power• Revenue bonds repaid by project's revenue• Muni's subject to credit risk – Orange

County's and Cleveland's bankruptcy

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Bond Valuation

• Bond pays fixed amount of interest over a number of years and at maturity the bond is redeemed and you receive the par value.

• Value of a bond is the present value of each interest payment and the present value of the payment at maturity.

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Evaluating Bonds

• Yield – return on the investment– Not the same as coupon rate (% of par value)– Current yield – ratio of annual interest to price– 8% bond selling for $700 has 11.4% current

yield• Yield to Maturity (YTM) – return earned if

held to maturity; interest plus/minus difference between par and purchase price

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Bond Calculations

• US bonds pay interest semiannually– Review non-annual compounding– This means we must change the annual rate to a

per period rate • $1,000 two year bond with 6% coupon rate

has four $30 semiannual interest payments plus $1,000 paid at maturity.

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6% bond, Due two years; Market rate = 10%; Interest semi-ann

Time CF 5% PVIF PV6 mo $30 .9524 $28.5712 mo 30 .9070 27.2118 30 .8638 25.9124 30 .8227 24.68 1,000 .8227 822.70

$927.07

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Valuation

Remember: the coupon is fixed for the life of the bond

The only way a bond's return can be increased is by reducing its price

One year bond 8% coupon ($80); Market rate 10% ($100). Price falls to $980

$80 interest + $20 capital gain = $100

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Relationships

Inverse relation between changes in interest rates and changes in bond prices– Rates increase, bond prices fall– Rates decrease, prices rise– Bonds may sell for par value, more than

par, or less than par.• Market rate above coupon, sells at a discount• Market below coupon, bond sells at a premium

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Bond Values at Different Rates

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More Relationships

• Longer-term bonds fluctuate more in price than shorter-tem bonds (next slide)

• As maturity approaches, market value approaches par value

• Upward movement in callable bonds limited because they may be called away from you

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Longer-term = More Sensitive

Price of 12% 5 and 10 Year Bonds

Rate 5 Year 10 Year9% $1,117 $1,19212 1,000 1,00015 899 848

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Price Sensitivity – 5 vs. 10 Year

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Preferred Stock

Hybrid security – similar to bonds and stock– Like bonds: usually fixed return, paid before

common dividends, usually don't vote– Like stock: no maturity and failure to pay

dividend does not trigger bankruptcy

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Features of Preferred

• May have multiple issues with different terms

• Sometimes convertible into common• Some have cumulative dividends• May be callable• Some have floating rates

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Risks With Preferred Stock

Interest rates rise, price declines

Rates fall – what happens if callable?

Gains limited

Dividends not as secure as bond interest