1 c hapters 9, 18, 19 & 20 “gentlemen prefer bonds” andrew carnegie interest rates (chapter...

1

CHAPTERS 9, 18, 19 & 20

“Gentlemen Prefer Bonds”

Andrew Carnegie

Interest Rates (Chapter 9)

Corporate Bonds (Chapter 18)

Government Bonds (Chapter 19)

Mortgage-Backed Securities (Chapter 20)

Introduction to Bonds (Lecture Notes)

2

What are Bonds? Negotiable, publicly traded long-term debt

securities, whereby the issuer agrees to pay a fixed amount of interest over a specified period of time and to repay a fixed amount of principal at maturity a.k.a. “Fixed-income” Securities, “Debt Financing” A bond is really just an IOU issued by…

A corporation – “Corporate Bonds” A municipality (state or local) – “Municipal Bonds” The Federal government – “Treasury Bonds”

The bondholder loans money to the bond issuer

Bonds are loans. Investors who buy bonds are “loaners” instead of “owners” (stocks, equities).

3

Trust Indenture Contract that sets forth the terms between the

issuer and the bondholders Describes bondholders’ rights and issuer’s

obligations Appoints a trustee to oversee that these

obligations are carried out Trustee is usually a commercial bank or a trust

company Stipulates protective covenants

Obligations of the bond issuer to keep doing business, keep equipment in good working order, make payments on time, etc.

4

Why Invest in Bonds? Bondholders receive…

Interest during the life of the bond Normally paid every six months

Principal is returned when the bond is redeemed Typical bond maturity is from 1 to 30 years

Potential for a capital gain or a capital loss If interest rates fall, there is a potential for a capital

gain but there is also a potential for a capital loss if interest rates rise (much more about this later) But if you intend to hold the bond to maturity (when you are

paid back), capital gains or losses will not affect you Some bonds offer tax advantages Some bonds can be converted into stocks

“Convertible bonds” (a.k.a. “Convertibles”) We will deal with convertibles in detail at a later time

5

Why Invest in Bonds? Bondholders are first in line for repayment if

there is default on the loans After taxes & payroll expenses

(Stock holders are last in line) Bond prices are far less volatile than stocks

But bond prices still fluctuate Bond prices can go down and do go down when

interest rates rise Average returns over decades – 4% to 8%

4% to 6% – Municipal and Treasury Bonds 6% to 8% – Corporate Bonds (some pay much higher)

(continued)

Currently, many bonds are paying less than their historical returns. Some are paying more.

6

By far, the most misunderstood feature about bonds is their inverse relationship with interest rates When interest rates fall, bond prices rise When interest rates rise, bond prices fall

When interest rates fall,

…bond prices rise,

and vice-versa.

Bonds and Interest Rates

7

Bonds versus Stocks Over the long term, stocks have outperformed

bonds. So why invest in bonds? Stocks are far more volatile (i.e. carry more risk) Bonds offer an element of stability to your portfolio For some investors, stocks are simply too risky

They reason: If I can obtain my long-term goals without taking on the risk of being invested in stocks, so be it The “I-Can-Sleep-Better-At-Night” Factor

Bonds also make good intermediate-term investments Stocks are good long-term investments

Sometimes, bonds are just screaming good deals!

8

The Risks of Bond Investing Interest Rate Risk

When rates fall, bond prices rise & vice-versa If you intend to sell the bonds in the future, a rise in

interest rates can translate into capital losses

Purchasing Power Risk The risk that your purchasing power will fall if

inflation outstrips your return from bonds

Business / Financial Risk The risk that the bond issuer will default on interest

payments or principal repayments Much less a risk with municipal and Treasury bonds

Although some muni’s have gone “belly up” in the past

9

The Risks of Bond Investing Liquidity Risk

The risk that there may not be sufficient buyers when and if an investor wants to sell their bonds

Less of a problem with Treasuries / muni’s Can be a big problem with thinly-traded bonds

Call Risk – a.k.a. Prepayment Risk The risk that a bond will be “called away” from the

investor before its scheduled maturity date Much like a home mortgage can be refinanced

Some bonds are non-callable

(continued)

More about the call feature of some bonds later.

10

Bond Interest and Principal Coupon Rate

The feature of a bond that defines the amount of annual interest income

a.k.a. Nominal Rate, Coupon Yield, Nominal Yield The interest is usually paid every six months

Although a scant few bonds pay from every month to quarterly to once a year

The term “coupon rate” came from the fact that bonds used to have coupons attached to them. When the interest was due, an investor was required to send the coupon into the bond issuer and the issuer would

then send the bondholder the interest. To this day, earning interest from a bond is often called “clipping the coupon” even though now virtually

all transactions are done electronically.

11

Bond Interest and Principal(continued)

Putting coupon rate and principal together tells you how much interest you will receive each year. For example, a coupon rate of 7% and a

principal of $1,000 gives $70 of interest each year.And since almost all bonds are denominated in $1,000 increments,

knowing the coupon rate gives you the amount of interest. Therefore, normally bond investors simply refer to their bonds by the coupon rate

and maturity. “I bought a 7% 30-year bond.”

Principal The amount of capital that must be paid at maturity

i.e. The amount of the loan a.k.a. Par Value, Face Value The principal of most bonds is $1,000

i.e. Bonds are denominated in $1,000 increments

12

Maturity Date The date on which a bond matures and the

principal must be repaid Term bonds mature all at once

They are the most common For example, a company will issue 20-year bonds

that all mature in 20 years on the same date Serial bonds have a series of maturity dates

For example, a company may issue “series” of 20-year serial bonds with 20 maturity dates, each series maturing each year for 20 years Each year, a certain portion of the issue would come

due and be paid off (i.e. the series matures)

Maturity Dates and Bonds

13

Bonds versus Notes Technically, there is a difference between a bond

and a note Notes mature in 2 to 10 years Bonds mature in 10 or more years

Usually 20 to 30 years Some bonds mature in 50 or 100 years

Railroads and other industries of the late 19th century A very small number of bonds never mature

They are often referred to as perpetuities or consols

Maturity Dates and Bonds(continued)

However, in practice, most investors (including myself) use the term bond to refer to both bonds and notes.

14

Call Provision Provision that specifies whether and under what

circumstances the issuer can retire (prepay) the bond prior to the maturity date

If interest rates drop, just as a homeowner would want to refinance their mortgage, a bond issuer would want to refinance their bond loans

The issuer “calls in” the bonds The bonds are “called away” from the bond investor

a.k.a. Prepayment of bonds

Call Provision of Bonds

All others factors being equal, investors would prefer non-callable bonds to callable bonds.

15

Three Types of Call Provisions Freely Callable

Can be retired at any time Non-callable

The issuer is prohibited from retiring the bond before the maturity date

Deferred Call a.k.a. Call Protection Period, Call Deferment Period The issuer must wait for a certain length of time to

pass before the bonds can be called


Most corporate and municipal bonds are freely callable or have a deferred call. Treasuries are always non-callable. Which of the

above provisions is least desirable? Which is most desirable?

(continued)

16

Call Premium The amount that is added to a bond’s par value

and paid to investors when a bond is retired prematurely Example: $85 premium Like the “prepayment penalty” of a home mortgage

Call Price The price the issuer must pay to retire a bond

prematurely Equal to the par value plus the call premium Example: $1,000 par + $85 premium = $1,085 call

price


If there is no call premium, the bond is said to be “callable at par.”

(continued)

17

Premium Bond A bond with a market value greater than the par

value Occurs when prevailing interest rates drop below the

coupon rate Discount Bond

A bond with a market value lower than par value Occurs when prevailing interest rates are greater

than the coupon rate Also occurs when and if the investment community

believes that the bond issuer is in danger of defaulting on interest payments or principal payments

Principals of Bond Price Behavior

If there is no premium nor discount, the bond is said to be “selling at par.”

18

“Wait a minute. Why would a bond sell at a premium or a discount to its par value? If the loan is for $1,000, the bond would always

sell for $1,000, right?” No. Since the interest rate of your bond doesn’t

change, the price of the bond changes to reflect the change in the prevailing interest rates within the financial industry

(continued)


Remember the image of the see-saw?

19

Example 1 – Premium: Bond paying 10% The bond’s face value is $1,000 The bond’s interest per year is $100

10% of $1,000 = $100

Interest rates fall to 8% Now, investors have to pay $1,250 to get the same

amount of interest 8% of $1,250 = $100

The result is your bond is now worth more than it was (capital gain if sold) The bond could be sold at a high premium

Principals of Bond Price Behavior(continued)

20

Example 2 – Discount: Bond paying 10% The bond’s face value is $1,000 The bond’s interest per year is $100

10% of $1,000 = $100

Interest rates rise to 12% Now, investors need only pay $833.33 to get the

same amount of interest 12% of $833.33 = $100

The result is your bond is now worth less than it was (capital loss if sold) The bond would be sold at a large discount

Principals of Bond Price Behavior(continued)

21

The amount of the premium or discount is not only related to the amount of the fall or rise of interest rates In general, the greater the fall or rise in interest

rates, the greater the premium or discount The maturity date is also very important

In general, the longer the maturity, the greater the premium or discount

(continued)


Just like a see-saw, the farther out you are, the greater the rise or fall. This is why long-term bonds are riskier than

short-term bonds.

30 yr10 yr

2 yr

Interest Rates Rise

Price of Bonds Fall

22

(continued)


23

In general, Long-term bonds exhibit greater price volatility

And a greater opportunity for capital gain or loss Intermediate-term and short-term bonds exhibit

lesser price volatility And a lesser opportunity for capital gain or loss Bonds very close to maturity act very similar to

short-term investments such as money markets

(continued)


However, if you intend to keep the bonds until they mature, then you are not concerned about the price volatility. You will always receive the par value of the bond (except in the

rare case of a bond default).

24

(continued)


When would you be buying bonds? When would you be selling?

0%

2%

4%

6%

8%

10%

12%

14%

16%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Yield on Bonds

Yield on Stocks

25

Treasuries, Governments, T-bonds, T-notes Treasury Notes

2 to 10 years Treasury Bonds

Greater than 10 years Treasury Inflation-Indexed Obligations – TIPs

Principal is adjusted each year by inflation rate Agency Bonds (example: Gov’t National Mortgage Assoc.)

Not direct obligations of the United States Treasury Technically not the same weight as Treasuries

But considered very safe with almost no risk of default (Example: Fannie & Freddie were bailed out in the debacle!)

Treasury Bonds & Notes

Don’t confuse T-bonds & T-notes with Treasury Bills (T-bills). T-bills

are short-term debt obligations.

Treasuries are exempt from state income taxes.

26

Treasury Inflation-Indexed Obligations – TIPs A type of Treasury security that provides protection

against inflation by adjusting investor returns for the annual rate of inflation

Initially, pay less interest than other Treasuries but…

Par value is adjusted upward each year to keep pace with inflation, therefore…

The interest payment goes up every year as the par value increases, however…

You must pay taxes on the interest and the increase in the par value even though you did not receive the increase in par value as cash

Treasury Bonds & Notes(continued)

27

A debt issue secured by a pool of home mortgages; issued primarily by government-sponsored entities A type of agency bond that pools together home mortgages

and repackages them into bonds a.k.a. Pass-through Securities, Participation Certificates,

Collateralized Mortgage Obligations (CMOs), Collaterialzed Debt Obligations (CDOs), Mortgage-Backed Securities

Monthly payments consist of interest and principal Responsible for 70% of home loan funding Government National Mortgage Association (“Ginnie Mae”) Federal Home Loan Mortgage Corporation (“Freddie Mac”) Federal National Mortgage Association (“Fannie Mae”)

Mortgage-Backed Bonds

In the past, Fannie & Freddie had been very successful. They are now in distress. Much of the 2008/2009 crisis revolved around these CDO’s / MBS’s.

28

“Securitization” The process of transforming lending vehicles such

as mortgages into marketable securities But can be done with almost any debt or asset Success of mortgage-backed bonds spread into…

Asset-Backed Securities Securities similar to mortgage-backed securities

that are backed by a pool of bank loans, leases, and other assets Car loans, credit card loans, patents, stocks and

bonds, even David Bowie – “Bowie Bonds” a.k.a. Collateralized Bond Obligations (CBOs),

Structured Investment Vehicles (SIVs)

Asset-Backed Securities

29

Municipal Bonds – a.k.a. Muni’s, Muni Bonds Debt securities issued by states, counties, cities,

and other political subdivisions; most of these bonds are tax-exempt (free of Federal income tax on interest income) But capital gains, if any, are not tax-exempt Careful! Some are not tax-exempt if you are subject

to the Alternative Minimum Tax (AMT) Municipal bonds are very popular with individual

investors Especially high income and high net worth taxpayers

Some muni bonds are insured (desirable feature)

Municipal Bonds

30

Types of Municipal Bonds General Obligation Bonds (a.k.a. GOs)

Municipal bonds backed by the full faith, credit, and taxing power of the issuer

Revenue Bonds Municipal bonds that require payment of principal

and interest only if sufficient revenue is generated by the issuer Less desirable than GO bonds – Why?

Special Tax Bonds Municipal bonds that are payable from the proceeds

of a special tax Proposition AA & R bonds are Special Tax Bonds

The South Bay voters had to approve the tax

Municipal Bonds(continued)

31

Municipal Bond Tax Advantages Free from Federal income taxes

Taxable Equivalent Yield for Federal tax-exempt If purchased by investors in that municipality, they

are also often free from state and local taxes Taxable Equivalent Yield for both Federal & state

tax-exempt Example: California taxpayers do not have to pay

Federal income tax nor California income tax on California Municipal Bonds

The higher the tax bracket of the investor, the higher the taxable equivalent yield

However, capital gains, if any, are never exempt

Municipal Bonds(continued)

32

Secured Senior Bonds – a.k.a. Senior Lien Bonds

Backed by a claim on specific property of the issuer Mortgage Bonds (example: real estate) Collateral Trust Bonds (example: airplanes, railroad equipment)

Junior Bonds – a.k.a. Junior Lien Bonds a.k.a. Second Mortgage Bonds Second in priority (like a second mortgage on your home)

Unsecured Debentures, Subordinated debentures

Backed by the “full faith and credit” of the corporation Income Bonds

Unsecured bonds requiring that interest be paid only after a certain amount of income is earned

Corporate Bonds

33

Bonds with no coupons (i.e. no interest payments) that are sold at a deep discount from par value Instead of receiving interest in cash, the bonds

simply accrue (grow) in value until maturity Example: $1,000 bond maturing in 20 years at

6.25% would cost $300 After 10 years, it would be worth $550

Disadvantages Very sensitive to interest rate changes exhibiting

wide price swings The IRS expects you to pay taxes on the accrued

interest even though you didn’t receive it in cash! Often used in tax-sheltered accounts such as IRAs

Zero-Coupon Bonds

34

High-risk securities that have low ratings but produce high yields a.k.a. High-yield bonds, non-investment grade Issued primarily by corporations but there are

some municipal junk bonds Traditionally, reserved for bonds that were in

distress In the 1980’s, junk bonds became an industry as

companies not large enough to issue bonds began to issue bonds with very high interest rates

Very high risk but often offer the opportunity for large capital gains as well as high income Unlike most all bonds, junk bonds tend to follow the

stock market (a.k.a. high correlation with stocks)

Junk Bonds

35

U.S.-Pay Bonds Interest and principal payments paid in U. S. dollars a.k.a. Dollar-Denominated Bonds No risk of currency fluctuations

Foreign-Pay Bonds Interest and principal payments paid in foreign currencies Incur currency fluctuation risk along with all the normal risks

associated with bonds If the U.S. dollar rises relative to the foreign currency, the

value of the bond will fall If the U.S. dollar falls relative to the foreign currency, the

value of the bond will rise Very difficult for an individual investor to purchase

Best done via a global bond mutual fund

Foreign Bonds

36

Letter grades that designate investment quality and are assigned to a bond issue by rating agencies The higher the rating, the better the quality of the

bond Two largest rating agencies

Standard & Poor’s Moody’s

Think of them as “idiot lights” on your dashboard

Bond Ratings

In the wake of the 2001/2002 corporate scandals, the rating agencies were caught completely off guard. They didn’t downgrade Enron and

WorldCom until they were practically in default. They are again being called to task because of the mortgage-backed bond crisis.

Yep, you guessed it! They screwed up again, but this time, they almost brought down the entire economy!

37

(continued)

Anything Baa or BBB or above is “investment-grade.”

Moody S & P Definition

Aaa AAA Highest-grade – “gilt-edge”

Aa AA High-grade

A A Medium-grade

Baa BBB Medium-grade – last investment-grade rating

Ba BB Starts non-investment-grade; Speculative

B B More speculative – moderate protection

Caa CCC Poor quality – in danger of default

Ca CC Poorest quality – close to or de-facto default

C C

D

Moody C: In default

S&P C: Not paying interest; S&P D: In default

Bond Ratings

38

The rating agencies further fine tune their ratings Standard & Poor’s might add a “+” or a “-” its rating

Example: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, etc.

Moody’s might add a “1,” “2,” or “3” Example: Aa1, Aa2, Aa3,

Bond Ratings(continued)

Kinda’ silly, dontcha’ think?

39

Bond trading is very difficult for retail investors Trading volume is often thin Most bonds trade over-the-counter Bond traders normally trade in the $100,000 range Expect poor prices for transactions under $10,000

Unless you are big, don’t expect to be treated well Remember John Meriweather?

Investors use banks and other entities to trade bonds (as well as brokers) Example: The Bond Buyer

Exceptions are Treasury bonds, notes, & bills Can be purchased directly from the Treasury http://www.treasurydirect.gov

Bond Trading

40

Bonds are normally quoted as a percentage of par Example: 97.25 means 97.25% of par

Since par is almost always $1,000, one bond would cost 97.25% * $1,000 = $972.50

(Or simply multiply the 97.25 times 10) (Move the decimal point one to the right)

Bond Quotes

97.25 is a bond quote for a bond selling at a discount. A bond selling at a premium would be quoted over 100. A bond selling

at par would be quoted at 100.You can use http://finance.yahoo.com/bonds or www.finra.org

(Investors , Market Data / Bonds) for bond quotes.

41

Next week: Chapter 10, Bond Prices, Valuation and Yields

Interest Rates (Chapter 9)

Corporate Bonds (Chapter 18)

Government Bonds (Chapter 19)

Mortgage-Backed Securities (Chapter 20)

Introduction to Bonds (Lecture Notes)

CHAPTERS 9, 18, 19 & 20

1 c hapters 9, 18, 19 & 20 “gentlemen prefer bonds” andrew carnegie interest rates (chapter...

Documents