Stock Market Analysis and Personal Finance

Mr. Bernstein

Bonds (aka Fixed Income)pp 306-325

March 11, 2015

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Stock Market Analysis & Personal Finance Mr. Bernstein

BondsBond is a contract to repay a loan on a given maturity date.Face value = final payout ( ~ loan amount)Bonds are traded Over the Counter (OTC) – there is no meaningful exchange

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Stock Market Analysis & Personal Finance Mr. Bernstein

Types of BondsDebentures, or unsecured bonds, are backed only by the

reputation of the issuer. Most corporate bonds are debentures

Mortgage bonds are backed by a lien on a home or other real estate

Secured bonds are backed by a lien on collateralConvertible bonds can be converted into stockBond contracts may have other provisions called covenantsJunior debt is subordinated to senior debtFloaters have coupons which adjust with interest rates

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Stock Market Analysis & Personal Finance Mr. Bernstein

Why Buy Bonds?Interest IncomeCapital Gains

When interest rates fall, bond prices riseWhen interest rates rise, bond prices fall

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Stock Market Analysis & Personal Finance Mr. Bernstein

Why Buy Bonds?Interest Income

Current Yield = Annual Income / PriceCapital Gains

When interest rates fall, bond prices riseWhen interest rates rise, bond prices fall

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Stock Market Analysis & Personal Finance Mr. Bernstein

Why Buy Bonds?Interest IncomeCapital Gains

When interest rates fall, bond prices riseWhen interest rates rise, bond prices fall

Example: Exxon 5% due 4/5/2023…at 5% yield bond price =100. At 4% yield bond price = 110. Why? 5% coupon is reduced by capital loss of 10% over ten years, or 1% per year.

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Stock Market Analysis & Personal Finance Mr. Bernstein

Why Buy Bonds?Yield to Maturity =

Coupon Income + (Pymt at maturity - Price Paid)Price Paid

Yield to Maturity is the primary measure of a bond’s value

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Stock Market Analysis & Personal Finance Mr. Bernstein

Bond RatingsRatings Agencies rate bonds based on the

likelihood of repayment at maturityMoody’s, Standard & Poor’s and Fitch are the

three major Rating AgenciesBonds are rated from D to AAABBB and above are “Investment Grade”BB and below are “High Yield” or “Junk” bonds

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Stock Market Analysis & Personal Finance Mr. Bernstein

Bond RatingsRatings Agencies are paid by issuers of new

bonds, i.e. corporations, finance companiesIs this a conflict of interest?Can investors rely on ratings?

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Stock Market Analysis & Personal Finance Mr. Bernstein

Bond PricingInvestors generally demand more yield for:

Higher perceived risk of repaymentHigher perceived risk of inflationLonger maturities

Relative value is determined by the difference between the Yield to Maturity and the yield on a comparable maturity US Treasury bond (the Spread to Treasuries)

Corporate Bond Price Information (FINRA)http://finra-markets.morningstar.com/MarketData/Default.jsp

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Stock Market Analysis & Personal Finance Mr. Bernstein

Bond PricingTo receive a higher yield to maturity, what

component of the Yield to Maturity formula must change?

Yield to Maturity = Coupon Income + (Pymt at maturity - Price Paid)

Price Paid