1 Chapter Eleven Bond and Fixed-Income Fundamentals McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

11

Chapter Eleven

Bond and Fixed-Income Fundamentals

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

22

Bond and Fixed-Income Bond and Fixed-Income FundamentalsFundamentals

The Bond ContractThe Bond Contract Secured and Unsecured BondsSecured and Unsecured Bonds The Composition of the Bond MarketThe Composition of the Bond Market Bond Market InvestorsBond Market Investors Distribution ProceduresDistribution Procedures

33

Bond and Fixed-Income Bond and Fixed-Income FundamentalsFundamentals

Junk BondsJunk Bonds Bond QuotesBond Quotes Bond Markets, Capital Market Theory and Bond Markets, Capital Market Theory and

EfficiencyEfficiency The Global Bond MarketThe Global Bond Market Other Forms of Fixed-Income SecuritiesOther Forms of Fixed-Income Securities Preferred Stock as an Alternative to DebtPreferred Stock as an Alternative to Debt

44

Bond Market Bond Market Career OpportunitiesCareer Opportunities

More new bond offerings than new More new bond offerings than new common stock offeringscommon stock offerings

Most financially rewarding jobs on Wall Most financially rewarding jobs on Wall Street go to sophisticated analysts and Street go to sophisticated analysts and dealers in the bond marketdealers in the bond market

Players in this market must understand:Players in this market must understand:• The terms, &The terms, &• Financial ramifications of bond tradingFinancial ramifications of bond trading

55

Definition of a BondDefinition of a Bond

A debt investment, with which the investor A debt investment, with which the investor loans money to an entity (company or loans money to an entity (company or government) that borrows the funds for a government) that borrows the funds for a defined period of time at a specified interest defined period of time at a specified interest raterate

The indebted entity issues investors a The indebted entity issues investors a certificate, or bond, that states the interest rate certificate, or bond, that states the interest rate (coupon rate) that will be paid and when the (coupon rate) that will be paid and when the loaned funds are to be returned (maturity loaned funds are to be returned (maturity date)date)

66

The Bond ContractThe Bond Contract

TermTerm DescriptionDescription

Bond Bond indentureindenture

Major provisions/ agreementMajor provisions/ agreement Over 100 pages longOver 100 pages long Complicated legal documentComplicated legal document Administered by a trusteeAdministered by a trustee

(usually a commercial bank)(usually a commercial bank)

Par Par valuevalue

Face value of a bondFace value of a bond Corporate: $1,000Corporate: $1,000 Fed, state, & local: $5,000 or $10,000Fed, state, & local: $5,000 or $10,000

77

The Bond ContractThe Bond ContractTermTerm DescriptionDescription

Coupon Coupon raterate

Actual interest on the bondActual interest on the bond Payable semiannuallyPayable semiannuallyTO THE EXTENT THAT INTEREST TO THE EXTENT THAT INTEREST RATES IN THE MARKET GO ABOVE RATES IN THE MARKET GO ABOVE OR BELOW THE COUPON RATE, THE OR BELOW THE COUPON RATE, THE MARKET PRICE OF THE BOND WILL MARKET PRICE OF THE BOND WILL CHANGE FROM PAR VALUECHANGE FROM PAR VALUE

Variable-Variable-rate notes rate notes (floating-(floating-rate notes)rate notes)

Coupon rate fixed for a short periodCoupon rate fixed for a short period Then varies with a stipulated short-Then varies with a stipulated short-

term rate (e.g. U.S. Treasury bills)term rate (e.g. U.S. Treasury bills)

Key c

oncept

Key c

oncept

88

The Bond ContractThe Bond Contract


Zero-coupon Zero-coupon bondsbonds

Debt issued at values substantially Debt issued at values substantially

below maturity valuebelow maturity value No semiannual cash interest paidNo semiannual cash interest paid Investor receives return in the formInvestor receives return in the form

of capital appreciation of capital appreciation

Maturity dateMaturity dateDate at which final payment is due at the Date at which final payment is due at the stipulated par valuestipulated par value

Serial Serial paymentpayment

Bonds paid off in installments over the Bonds paid off in installments over the life of the issue (e.g. Municipal bonds)life of the issue (e.g. Municipal bonds)

99

The Bond ContractThe Bond ContractTermTerm DescriptionDescription

Sinking-fundSinking-fund

Semiannual or annual contributions by Semiannual or annual contributions by the bond issuer into a fund run by a the bond issuer into a fund run by a trustee for the purposes of debt trustee for the purposes of debt retirementretirement

Call provisionCall provision

Allows the corporation to call or force Allows the corporation to call or force

in debt issue prior to maturity in debt issue prior to maturity Price paid usually 3 to 5% above parPrice paid usually 3 to 5% above par Usually deferred 5 to 10 years Usually deferred 5 to 10 years

Put provisionPut provision

Enables the bondholder to sell a long-Enables the bondholder to sell a long-term bond back to the corporation at par term bond back to the corporation at par value (useful when market interest rates value (useful when market interest rates have gone up)have gone up)

1010

Secured and Unsecured BondsSecured and Unsecured BondsTermTerm DescriptionDescription

Secured debtSecured debt Debt backed by collateralDebt backed by collateral

Mortgage agreementMortgage agreementReal property (plant & Real property (plant & equipment) pledged as a equipment) pledged as a security for a loansecurity for a loan

After-acquired property After-acquired property clauseclause

Any new property be Any new property be placed under the original placed under the original mortgagemortgage

Equipment trust certificate Equipment trust certificate (used by transportation industry: (used by transportation industry:

rail roads, airlines, etc.)rail roads, airlines, etc.)

Proceeds from the bond Proceeds from the bond used to buy equipment, used to buy equipment, which in turn serves as which in turn serves as collateral for the trust certificatecollateral for the trust certificate

1111

Secured and Unsecured BondsSecured and Unsecured Bonds


DebentureDebenture Unsecured corporate debt issue Unsecured corporate debt issue Higher yields due to higher riskHigher yields due to higher risk

Income bondsIncome bonds

For companies withFor companies with

less favorable prospectsless favorable prospects Interest is to be paid only Interest is to be paid only

to the extent that it isto the extent that it is

earned as current incomeearned as current income

1212

The Composition of the Bond MarketThe Composition of the Bond Market

U.S. Government SecuritiesU.S. Government Securities Federally Sponsored Credit Agency Issues Federally Sponsored Credit Agency Issues State and Local Government SecuritiesState and Local Government Securities Corporate Securities Corporate Securities

1313

U.S. Government SecuritiesU.S. Government SecuritiesTreasury Bills (T-bills)Treasury Bills (T-bills)

Maturities 91 and 182 daysMaturities 91 and 182 days Trade on a discount basisTrade on a discount basis Minimum units of $1,000Minimum units of $1,000 Active secondary marketActive secondary market

www.treasurydirect.gov

1414

U.S. Government SecuritiesU.S. Government SecuritiesTreasury Note (T-note)Treasury Note (T-note)

Extremely popular investmentsExtremely popular investments Maturity of 1 to 10 yearsMaturity of 1 to 10 years Pays interest semi-annuallyPays interest semi-annually Minimum units of $1,000Minimum units of $1,000

1515

U.S. Government SecuritiesU.S. Government SecuritiesTreasury Bonds (T-bonds)Treasury Bonds (T-bonds)

LongLong term in nature, mature in 10 to 30 yearsterm in nature, mature in 10 to 30 years Treasury Department stopped issuing Treasury Treasury Department stopped issuing Treasury

bond in October 2001bond in October 2001 Many are still unredeemed and earning interest,Many are still unredeemed and earning interest, with a significant number of years remaining with a significant number of years remaining until maturityuntil maturity Units of $1,000 and higherUnits of $1,000 and higher Taxable for IRS (Federal Tax)Taxable for IRS (Federal Tax) Tax exempt for state and local taxesTax exempt for state and local taxes

1616

U.S. Government SecuritiesU.S. Government SecuritiesTreasury strips = Zero-coupon SecuritiesTreasury strips = Zero-coupon Securities

STRIP = Separate Trading of Registered STRIP = Separate Trading of Registered Interest and Principal Securities Interest and Principal Securities

Fixed-income securities Fixed-income securities Sold at a significant discount to face value Sold at a significant discount to face value No interest payments No interest payments Mature at parMature at par Backed by the U.S. GovernmentBacked by the U.S. Government Minimal risk Minimal risk Tax benefits in certain statesTax benefits in certain states

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Risk & the U.S. Government SecuritiesRisk & the U.S. Government Securities

But they are affected by other types of risk But they are affected by other types of risk

Treasuries are considered free from credit riskTreasuries are considered free from credit risk

Interest-rate Interest-rate riskrisk&&

Inflation riskInflation risk

1818

Inflation-Indexed Inflation-Indexed Treasury SecuritiesTreasury Securities

Treasury Inflation Protection Securities (TIPS)Treasury Inflation Protection Securities (TIPS) Offering started in January 1997Offering started in January 1997 Intention: Protect investors against inflationIntention: Protect investors against inflation Investor receives TWO (2) forms of returnInvestor receives TWO (2) forms of return

1. Annual interest rate paid semiannually1. Annual interest rate paid semiannually2. Automatic increase in initial principal to2. Automatic increase in initial principal to account for inflationaccount for inflation

1919

Federally Sponsored Federally Sponsored Credit Agency IssuesCredit Agency Issues

Issued by various agencies of the governmentIssued by various agencies of the government• Federal National Mortgage Association Federal National Mortgage Association • Federal Home Loan BankFederal Home Loan Bank

Authorized by an act of Congress to finance Authorized by an act of Congress to finance federal projectsfederal projects

NOT direct obligations of the TreasuryNOT direct obligations of the Treasury Direct obligations of the issuing agenciesDirect obligations of the issuing agencies Slightly higher yield than U.S. governmentSlightly higher yield than U.S. government securitiessecurities

2020


Agency issues support the housing industryAgency issues support the housing industry Trade in denominations of $5,000 and upTrade in denominations of $5,000 and up Maturities from 1 to 40 years – avg. 15 yrsMaturities from 1 to 40 years – avg. 15 yrs Examples:Examples:

• Federal Intermediate Credit BanksFederal Intermediate Credit Banks• Federal Farm Credit BankFederal Farm Credit Bank• Export-Import BankExport-Import Bank

2121


GNMAE (Ginnie Mae)GNMAE (Ginnie Mae)Government National Mortgage AssociationGovernment National Mortgage Association

Buys mortgages from various lenders at a discountBuys mortgages from various lenders at a discount Issues securities to public against these mortgagesIssues securities to public against these mortgages Investors receive monthly payments =Investors receive monthly payments = Interest Interest

+ + Principal payments on mortgagesPrincipal payments on mortgages

pass-thrupass-thru

www.ginniemae.gov

2222

State and LocalState and Local Government Securities Government Securities

DEFINITION DEFINITION

Municipal Bonds: Municipal Bonds: Debt securities issued by Debt securities issued by state & local governmentsstate & local governments

Most important feature: Most important feature: Tax exempt nature of interest paymentTax exempt nature of interest payment

Attractive investment for:Attractive investment for:individuals in high tax bracketsindividuals in high tax brackets

2323

How to Calculate the Equivalent How to Calculate the Equivalent Interest Rate on a Municipal Interest Rate on a Municipal Bond (i.e. tax exempt) with Bond (i.e. tax exempt) with

other Taxable Bondsother Taxable Bonds

)1( T

iY

Y =Y = Equivalent before-tax yield on a taxable investment Equivalent before-tax yield on a taxable investmenti =i = Yield on the municipal obligation Yield on the municipal obligationT T = Marginal tax rate of the investor= Marginal tax rate of the investor

2424

Corporate SecuritiesCorporate Securities

Main source of financing for U.S. corporationsMain source of financing for U.S. corporations 80 to 85% of firms’ external financial needs80 to 85% of firms’ external financial needs Corporate market subunits:Corporate market subunits:

• Industrials Industrials (from hi tech to discount chain stores)(from hi tech to discount chain stores)

• Public utilitiesPublic utilities

• Rails & transportationRails & transportation

• Financial issuesFinancial issues•BanksBanks•Finance companiesFinance companies•InsuranceInsurance

2525

Corporate SecuritiesCorporate Securities

Generally trade in units of $1,000Generally trade in units of $1,000 Higher risk than government issues Higher risk than government issues

ALL income is taxable for federal, state, & localALL income is taxable for federal, state, & local Possible disadvantage: subject to callPossible disadvantage: subject to call

Higher (expected) yieldsHigher (expected) yields

2626

Bond Market InvestorsBond Market Investors

So far, covered the issuer or supply sideSo far, covered the issuer or supply side Now consider the investor or demand sideNow consider the investor or demand side Bond market is dominated (80 to 85% of Bond market is dominated (80 to 85% of

trading) by large institutional investors:trading) by large institutional investors: Insurance companiesInsurance companies BanksBanks Pension fundsPension funds Mutual fundsMutual funds

2727

Bond Market InvestorsBond Market Investors Relatively strong primary market (new issues)Relatively strong primary market (new issues) Relatively weak secondary market Relatively weak secondary market (resale market)(resale market)

QuestionQuestion that a bond investor must consider: that a bond investor must consider:

How close to the going market price How close to the going market price can I dispose of the issue?can I dispose of the issue?

(A 5 or 10% discount might be unacceptable)(A 5 or 10% discount might be unacceptable) Foreign investors buy 10 to 15% of the U.S. Foreign investors buy 10 to 15% of the U.S.

government’s debtgovernment’s debt

2828

Distribution ProceduresDistribution Procedures

Shelf registration Shelf registration SEC Rule 415SEC Rule 415 Large companies file one comprehensive Large companies file one comprehensive

registration statement for future long-term registration statement for future long-term financing (multiple issues)financing (multiple issues)

Issue bonds through an investment banker Issue bonds through an investment banker without further SEC approvalwithout further SEC approval

Issue may be on the shelf for up to 2 yearsIssue may be on the shelf for up to 2 years

2929

Private PlacementPrivate Placement

Bond offerings sold privately to Bond offerings sold privately to investorsinvestors• Insurance companiesInsurance companies

• Pension fundsPension funds Offered by industrial firms (not public utilities)Offered by industrial firms (not public utilities) Limited or nonexistent secondary marketLimited or nonexistent secondary market Slightly higher yield due to lack of liquidity Slightly higher yield due to lack of liquidity

3030

Bond RatingsBond Ratings

Corporate financial management &Corporate financial management &Institutional portfolio managersInstitutional portfolio managers

On bond rating proceduresOn bond rating procedures

Keep a close eyeKeep a close eye

3131

Two Major Bond Rating AgenciesTwo Major Bond Rating Agencies

Standard & Poor’s Standard & Poor’s

www.moodys.com

Requires FREE registrationRequires FREE registration

www.standardandpoors.comNo registration neededNo registration needed

(a subsidiary of McGraw-Hill, Inc.)(a subsidiary of McGraw-Hill, Inc.)

Moody’s Investors ServiceMoody’s Investors Service

3232

Bond RatingsBond Ratings Moody’s and Standard & Poor’s rankMoody’s and Standard & Poor’s rank

• Corporate bondsCorporate bonds• Municipal bondsMunicipal bonds• Private placement commercial paperPrivate placement commercial paper• Preferred stock issuesPreferred stock issues• Offerings of foreignOfferings of foreign

U.S. Government bonds are considered to U.S. Government bonds are considered to be risk free (no ratings)be risk free (no ratings)

CompaniesCompaniesGovernmentsGovernments

3333

Description of Bond Ratings

Moody’s and Standard & Poor’s ratingsMoody’s and Standard & Poor’s ratings Categories shown on the next 7 slidesCategories shown on the next 7 slides The first four categories are assumed to The first four categories are assumed to

represent investment-grade qualityrepresent investment-grade quality Large institutional investorsLarge institutional investors

• Insurance companies Insurance companies • Banks Banks • Pension funds Pension funds

confine their activities to ONLY the first confine their activities to ONLY the first four categoriesfour categories

3434


QualityQuality Moody’sMoody’s Standard Standard & Poor’s& Poor’s DescriptionDescription

High High gradegrade AaaAaa AAAAAA

Best qualityBest quality Smallest degree of Smallest degree of

investment riskinvestment risk ““Gilt edge”Gilt edge” Interest protected by aInterest protected by a

large or very stable large or very stable

profit marginprofit margin Principal is secure Principal is secure

3535



High High gradegrade AaAa AAAA

High quality High quality High-grade bondsHigh-grade bonds Rated lower than the Rated lower than the best bonds because best bonds because margins of protection margins of protection may not be as largemay not be as large

3636



Medium Medium gradegrade AA AA

Favorable investmentFavorable investment

attributes attributes Upper-medium-gradeUpper-medium-grade

obligationsobligations Principal and interestPrincipal and interest

are considered secureare considered secure

3737



Medium Medium gradegrade BaaBaa BBBBBB

Medium-grade Medium-grade

obligations obligations Neither highly norNeither highly nor

poorly securedpoorly secured

3838



BaBa BBBB

Speculative Speculative Future not certainFuture not certain Interest & principal -Interest & principal -

moderate protectionmoderate protection

BB BB

Lack qualities of Lack qualities of desirable investmentdesirable investment Interest & principal – Interest & principal – min. protectionmin. protection

Spe

cula

tive

Spe

cula

tive

Spe

cula

tive

Spe

cula

tive

3939



DefaultDefault CaaCaa CCCCCC

In poor standingIn poor standing Issues may be in Issues may be in

defaultdefault Principal & interest –Principal & interest –

in dangerin danger

DefaultDefault CaCa CCCC

Highly speculativeHighly speculative Often in default Often in default Other shortcomings Other shortcomings

4040



DefaultDefault CC

Lowest-rated class in Lowest-rated class in Moody’s designation Moody’s designation Extremely poor Extremely poor prospects of attaining prospects of attaining any real investment any real investment standingstanding

DefaultDefault CC Interest not currently Interest not currently being paidbeing paid

DefaultDefaultDD

Default in interest Default in interest and/or principal and/or principal

4141

Junk BondsJunk Bonds

Appropriate only for the portfolio of investors Appropriate only for the portfolio of investors with a higher than average risk tolerancewith a higher than average risk tolerance

Possible reasons for being in the junk bond Possible reasons for being in the junk bond category:category:

““Fallen angel” bonds - companies that once had high Fallen angel” bonds - companies that once had high credit rankings but now face hard timescredit rankings but now face hard times

““Emerging growth” companies – not yet established Emerging growth” companies – not yet established small firmssmall firms

Companies undergoing restructuring as a result of a Companies undergoing restructuring as a result of a leveraged buyout or as part of fending off an leveraged buyout or as part of fending off an unfriendly takeover offerunfriendly takeover offer

4242

Bond Markets, Capital Market Bond Markets, Capital Market Theory and EfficiencyTheory and Efficiency

Lower rated bonds tend to trade at larger yields than higher quality bonds

Risk premium is higher on lower rated bonds

Bonds return Equity investment return

Equity is riskier than bonds Bonds have a contractual agreement to receive

principal & interest payments

>>

4343

The Global Bond MarketThe Global Bond Market In excess of $40 trillion U.S. makes up approximately 49% of the market Japan 19% Germany 12% Italy 5% In certain years, foreign bonds perform better than

U.S. bonds In 1996, the total return in the bond market

• U.S. 1.4%• Italy 30.4% • United Kingdom 17.8%

Potential benefits to international diversification

4444

Dollar-Denominated BondsDollar-Denominated Bonds Bonds in which the payment is in dollarsExamples – Yankee bonds issued by

• foreign governments• corporations, or • major agencies (e.g. World Bank) • Traded in the U.S.• Denominated (payable) in U.S dollars

Eurodollar bonds • Denominated in dollars • Issued & traded outside the U.S.

Eurodollars could be issued in any country outside the United States (not just in Europe!)

4545

Foreign-Pay BondsForeign-Pay Bonds

Issued in a foreign country Payable in that country’s currency

e.g. Japanese government bond payable in yen Currency exposure to a U.S. investor Foreign-pay bond may go up or down

against the U.S. dollar

4646

Other Forms of Other Forms of Fixed-Income Securities Fixed-Income Securities

Certificates of Deposit (CDs) Certificates of Deposit (CDs) Commercial Paper Commercial Paper Bankers’ Acceptance Bankers’ Acceptance Money Market FundsMoney Market Funds Money Market AccountsMoney Market Accounts

4747

Preferred Stock as an Preferred Stock as an Alternative to DebtAlternative to Debt

Between bonds and common stockBetween bonds and common stock Bondholders can claim against the corporation Bondholders can claim against the corporation Common stockholders have no such claim but Common stockholders have no such claim but

are the ultimate owners are the ultimate owners Preferred stockholders entitled to receive a Preferred stockholders entitled to receive a

stipulated dividend stipulated dividend In bad times, preferred stock dividends may be In bad times, preferred stock dividends may be

omitted by the corporation omitted by the corporation

4848

Features of Preferred StockFeatures of Preferred Stock

ConvertibleConvertible CallableCallable CumulativeCumulative

4949

WebsitesWebsites CommentsComments

www.bondmarkets.comwww.bondmarkets.com Provides bond information and Provides bond information and trading.trading.

www.moodys.comwww.moodys.com Provides bond information; Provides bond information; some is fee basedsome is fee based

www.bondsonline.comwww.bondsonline.com Provides bond informationProvides bond information

www.smartmoney.comwww.smartmoney.com Provides information on bond Provides information on bond yields, bond investing, and yields, bond investing, and related topicsrelated topics

5050

WebsitesWebsites CommentsComments

www.breifing.comwww.breifing.com Provides some bond Provides some bond trading information and trading information and general information about general information about bondsbonds

www.teachmefinance.comwww.teachmefinance.com Education site pertaining to Education site pertaining to finance and bondsfinance and bonds

www.investorguide.comwww.investorguide.com Links to sites provide Links to sites provide information on government information on government and corporate bondsand corporate bonds

5151

SummarySummary Debt plays an important role in our economy Debt plays an important role in our economy Issuer’s and investor’s viewpointsIssuer’s and investor’s viewpoints Primary fund raisers in the bond market are Primary fund raisers in the bond market are

• U.S. Treasury U.S. Treasury

• Federally sponsored credit agenciesFederally sponsored credit agencies

• State governmentsState governments

• Local governmentsLocal governments

• CorporationsCorporations

5252

SummarySummary Bond instruments are evaluated on the basis of Bond instruments are evaluated on the basis of

• YieldYield• MaturityMaturity• Method of repaymentMethod of repayment• Security provisions Security provisions • Overall riskOverall risk• Tax treatmentTax treatment

Greater protection & privileges result in lower yieldGreater protection & privileges result in lower yield Important feature: rating received by Moody’sImportant feature: rating received by Moody’s

Investors Service or Standard & Poor’s Investors Service or Standard & Poor’s

5353

SummarySummary Ratings range from AAA to D Ratings determine the required yield to sell a

security Some factors affecting ratings:

• Cash flow • Earnings generation in relation to interest • Operating margins • Return on invested capital • Total assets • Qualitative factors (e.g. managers ability)

1 Chapter Eleven Bond and Fixed-Income Fundamentals McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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