bonds: fixed income securities economics 71a: spring 2007 mayo chapter 12 lecture notes 4.3
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Bonds:Fixed Income Securities
Economics 71a: Spring 2007
Mayo chapter 12
Lecture notes 4.3
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Goals
HistoryFeatures and structureBond ratings
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Bond Returns
Interest and capital gains Stock comparison: dividends and cap
gainsMost income in the form of interest
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Two Parts
= (capital gain) + (Interest)€
Rt+1 =Pt+1 + I t+1 −Pt
Pt
Rt+1 =Pt+1 −PtPt
+I t+1
Pt
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Annual Historical Returns
Raw Returns Inflation Adjusted
Stocks 12.4% 9.2%
Corp Bonds 6.3% 3.2%
Gov’t Bonds 5.8% 2.8%
TBills 3.8% 0.7%
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Bonds in the 1990’s
1990-1999 Bonds, 8.7% (nominal, no inflation adjustment) $10,000 -> $23,000 Stocks 18.2% (nominal) $10,000 -> $53,000
1990-2003(June) Bonds, 9.7% (nominal) $10,000 -> $35,000 Stocks, 10.2% (nominal) $10,000 -> $37,000
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Bond Return Summary
Generally, lower returns than stocksBut also, less risk than stocks
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Bond Risks
Interest rate riskPurchasing power risk (inflation)Default or business riskLiquidity riskCall risk
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Goals
HistoryFeatures and structureBond ratings
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Bond Features
Agreement to borrow money Amount of loan
Principal, “par value” Paid back at set date in the future “maturity”
Interest payments Coupon interest rate Percentage of principal Made on regular schedule
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Example
Bond structure Principal = $1000 Maturity = 10 years Coupon = 5%, semiannual
Cashflows Pays $25 in interest every 6 months
(Interest payment is fixed.) 10 years from now pays back $1000 + $25
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Bond Legal Structure
Indenture Specifies rights of bond holders
Restrictions often include Requirements on accounting practices Firm should pay taxes Constrain future borrowing Limit dividend payments on stock
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Current Bond Price
Discount Price < Par
Premium Price > Par
Depends on interest ratesBond yield = coupon/price
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Call Provisions
Issuer (firm) can buy back the bonds (call) at a specified price (call premium)
Call provisions specify the price, and time period in which this can happen
Most corporate bonds are callableSimilar to refinancing for individuals Important risk component for investors
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Sinking Funds
Schedule to pay back principal over time
Different from call Option versus requirement
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Secured Debt
Backed by some kind of property Mortgages: real estate Plant and equipment Financial assets Income streams (Mass. turnpike)
Unsecured debt (junior bonds, debentures) No asset backing Ok for large reliable firms
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Difference Between Debt (Bonds) and Equity (Stock)
Voting rights D: none, E: yes
Claims on firm assets D: senior to equity, E: subordinate to debt
Maturity D: fixed, E: none
TaxesTrading/liquidity
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Borrower Costs
What affects the interest rate borrowers pay? Maturity (length of bond) Size (total loan) Default risk Market interest rates
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Market SegmentsTrillions of U.S. $
U.S. treasury bonds: 2.2Agency securities: 2.1
Federal home loan, Student loan marketing association
Municipal bonds: 1.5Corporate bonds: 5.2Mortgage backed securities: 2.9Foreign issues (eurodollar): 3.3
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Special Bond Types
Treasury bonds Municipal bonds Zero coupon bonds Floating rate bonds (floaters) Inflation adjusted bonds Junk bonds Mortgage backed securities Asset-backed securities Convertible bonds Foreign bonds
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U.S. Treasury Bonds
Borrowing of the U.S. federal government Very low risk/High liquidity $1,000 denominations Maturities
2, 3, 5, 10 years (notes) 20, 30 years (bonds)
Interest income exempt from state and local taxes, but not federal taxes
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Municipal Bonds
Local state, county, city bonds Interest
Exempt from federal taxes Usually free from state tax if you reside in
the state the bond was issued byCapital gains
Not exempt
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Muni Bonds: Taxable equivalent yield
€
(Taxable yield)(1 - tax rate) = (Tax free yield)
Taxable yield = Tax free yield(1- tax rate)
Muni yield = 5%, tax rate = 35%
0.05(1- .35)
= 7.69%
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Zero Coupon Bonds
Zero coupon (interest) paymentsPrincipal onlyTrade at discount
Example: $1040 in 1 year Price today = $1000 Yield (return) = 4%
Constructed zero coupon bonds: Strips
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Floating Rate Bonds(Floaters)
Coupon payments tied to current interest rates
Coupon might be principal*(T-bill rate) 1000*(2.5%)
Similarities to adjustable rate mortgages
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Inflation Adjusted Bonds
Treasury inflation-indexed obligation TIPS
Par value adjusted up with inflation $1000 bond, 3% inflation In one year goes to $1030
Coupons are a percentage of par and rise too
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Junk Bonds
High yieldHigh risk (default likely)Unsecured Famous in the 1980’s
Leveraged buyoutsAre they a good investment?
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Mortgage Backed Securities(Mortgage Bonds)
Pool of mortgagesPay off principal over timeSome pools high risk
SubprimeTricky refinancing questions
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Asset-backed Securities
Bonds backed by revenue streams Car loans/credit cards (large pool) Mass turnpike bonds (tolls)
David Bowie bonds Backed by revenue stream for albums IP Securitization
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Convertible Bonds
Bonds that can be converted into a fixed number of shares of common stock
Value moves with stock price (and interest rates)
Difficult valuation
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Foreign Bonds
Yankee bonds Dollar bonds issued in U.S. by foreign or
international corporationsEuro bonds
Dollar bonds issued outside the U.S.
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Goals
HistoryFeatures and structureBond ratings
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Bond Ratings
Agencies rate the riskiness of a bond Essentially the chance that it will default
See page 257 Bond ratings (Standard and Poor’s)
AAA, high-grade A, medium-grade >=BBB, Investment grade <BBB, speculative grade or “junk” bonds C, No interest paid D, In default
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Bond Ratings and Default Probabilities (Economist, March 23, 2005)
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Rating Agencies
S&P Rates $30 trillion in debt
Moody’s Fitch
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Problems for Raters
Missed Enron, WorldCom, Parmalat Lack of competition Should there be more official oversight Firms starting consulting businesses
Help firms that they are rating Serious conflict of interest
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Ratings Taken Seriously
Many investment funds having ratings requirements “No junk bonds” Ratings triggers : loans called back if
ratings fall
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Goals
HistoryFeatures and structureBond ratings