The Bond Market

Meghan BarnesApril 10, 2002

Overview

Bonds and Bond PurchasersIssuers of BondsCommon Types of BondsBond PricesMeasures of Yield and ReturnTaxesBond Ratings – Measuring Default RiskOptions on BondsBonds vs. Other Investments

Bonds and Bond Purchasers

Bonds are debt instrumentsPurchasers are Creditors of Issuing Companies Look at Marketability and Liquidity

“Fixed Income” SecuritiesInterest Rate Semi-Annual Interest Payments Interest Rate = Annualized Ratio of:

Borrowing Cost/ the Amount Borrowed Basis Point

Issuers of Bonds

Corporations Finance Operations

Federal Government Treasury Securities Bills, Notes, & Bonds

Federal Agencies Government

Sponsored Enterprises

Municipal Governments and Agencies Munis are “Tax

Exempt” General Obligation Revenue

Foreign Governments and Corporations Yankee Bonds

Common Types of Bonds

Floating Rate Bonds Interest Payments Change Over the Life of

the Bond Rate is Tied to a Financial Benchmark such

as the LIBOR

Convertible Bonds Can be Exchanged for Other Securities

Types of Bonds, Continued

High-Yield / Junk Bonds Speculative Grade Bonds Rated below Baa by Moody’s or BBB by S&P Greater Risk = Higher Yield

Asset-Backed Bonds Securitized by Some Financial Asset

Zero Coupon Bonds Do Not Pay Coupons Sold at a Large Discount

Premium vs. Discount

Premium bonds: price > par valueYTM < coupon rate

Discount bonds: price < par valueYTM > coupon rate

Par bonds: price = par valueYTM = coupon rate

Trading Bonds / Bond Prices

Usually Issued in Par Values of $1,000 Price is Usually Closest to Par at the Time it

is First Issued

Dealers Post Bid and Ask PricesPrices Listed Daily in the Wall Street Journal Down to 1/8 of a DollarPrice is Equal to the Present Value of the Expected Future Cash FlowsP= C/(1+r)1 + C/(1+r)2+ C/(1+r)3 +…+ C/(1+r)n + M/(1+r)n

Measures of Yield and Return

Coupon Rate Contracted Rate the

bond pays as a percent of par

Coupon Rate * Par Value = Coupon

Current Yield Ratio of the bond’s

promised annual income to its current market price

Current Yield = Annual Income Market Price

Yield to Maturity The Return an Investor

Receives on a Bond if it is Held to Maturity

P=I1/(1+y)1 + I2/(1+y)2 + … +(In+par)/(1+y)n

Holding Period Yield The Rate of Return an

Investor Receives Over the Period The Investor Actually Holds the Bond

P=I1/(1+h)1 + I2/(1+h)2 + … +(Im+Pm)/(1+y)m

Yield Curve

Shows the Relationship Between Short-Term and Long-Term Yields on SecuritiesSlope can be Upward, Downward, or HorizontalRight Now, They are All Upward Sloping Longer Time to Maturity = Higher Yield

Current Yield Curves

1.) Treasury Yield Curve 2.) Agency AAA Yield Curve 3.) Corporate AAA Yield Curve 4.) Municipal AAA Yield Curve

Treasury AAA Agency AAA Corporate AAA Municipal3 mo 1.77 - - -6 mo 2.10 - - -1 yr 2.66 3.15 3.09 2.132 yr 3.71 3.95 4.14 2.693 yr 4.09 4.52 4.57 3.155 yr 4.80 5.35 5.42 3.667 yr 5.20 5.96 5.94 4.1510 yr 5.39 6.28 6.25 4.4220 yr 6.00 6.90 6.70 5.1530 yr 5.78 6.50 6.92 5.33

Bond Market Yield SummaryMarch 29, 2002

Price vs. Yield

Prices Continually Fluctuate With Changes in Interest RatesInterest Rates , Prices Interest Rates , Prices Rates of Older Issues Change to Match Those of New IssuesLonger Maturity Means More Likely Price Will Be Affected By Changes in Interest Rates

Tax Status

Some Offer Special Tax AdvantagesNo State or Local Income Tax on U.S. Treasury Bonds or MunisWanting Taxable or Tax-Exempt Income Depends on: Your Income Tax Bracket The Difference Between What Can Be

Earned From Taxable Versus Tax Exempt Securities

Bond Ratings –Measuring Default Risk

Nationally Recognized Statistical Rating OrganizationsHenry Varnum Poor Compiled Financial Data About Canals & Railroads Updated the Directory of Railroads, Canals and

Steamship Lines in the United States

Poor’s Publishing Successor of Henry, Collaborated with John Moody Later Went Their Separate Ways

Ratings, Continued

Moody’s Began Producing “Moody’s Investor’s Manual”Poor’s Publishing Published its Own Bond Ratings Then Merged with the Standard Statistical

Bureau to Form Standard and Poor’s

Other Rating Agencies Today Fitch Investor Service Duff and Phelps

The Rating Process

Standard and Poor’s Process as example:Rating RequestIssuer MeetingRating Committee MeetingNotification and AppealDisseminationSurveillance

Definition of the Ratings/Default Risk

Moody's S&P Fitch DCR DefinitionAaa AAA AAA AAA Prime. Maximum SafetyAa1 AA+ AA+ AA+ High Grade QualityAa2 AA AA AAAa3 AA- AA- AA-A1 A+ A+ A+ Upper Medium GradeA2 A A AA3 A- A- A-

Baa1 BBB+ BBB+ BBB+ Lower Medium GradeBaa2 BBB BBB BBBBaa3 BBB- BBB- BBB-

Ba1 BB+ BB+ BB+ Non Investment GradeBa2 BB BB BB SpeculativeBa3 BB- BB- BB-B1 B+ B+ B+ Highly SpeculativeB2 B B BB3 B- B- B-

Caa1 CCC+ CCC CCC Substantial RiskCaa2 CCC - - In Poor StandingCaa3 CCC- - -Ca - - - Extremely SpeculativeC - - - May be in Default- - DDD - Default- - DD DD- D D -- - - DP

Below this line, bonds are classified as "junk bonds"

Higher Rating Means Less Risk that the Issuer Will Default on PaymentsLower Rating Means Higher Risk Purchaser is

Compensated with a Higher Yield for Taking on this Additional Risk

Factors Effecting Default Risk

Earnings Variability More Volatile Earnings Could Mean a Greater

Possibility of Losses Exceeding Ability to Raise Funds

Age of the Firm If a Firm has a Well Established History of No

Defaults, Investors Have More Confidence in its Continued Success

Current Leverage Using Greater Financial Leverage Could Mean

Greater P/E Ratio But Could Also Mean that by Using More Borrowed

Funds Rises Relative to Equity, and Risk of Declines in Net Earnings Increases

Risk vs. Yield

Risk and Yield are Directly RelatedThe Risk Involved in an Investment Includes the Risk Free Rate Plus the Default Risk Premium

Callable Bonds

Call Privileges Gives the Issuer the Right to Retire a Bond Prior to

Maturity

Call Risk Known as Reinvestment Risk Bonds Will Be Called When Interest Rates are Falling Investors May Earn Less Than Their Expected Yield

If an Investor is Long a Callable Bond, thenCallable Bond Price =

Noncallable Bond Price – Call Option Price

Callable Bonds, Continued

Call Premium Purchaser is Compensated for Higher

Risk If Rates are High and Going to Fall, there

Will Be a Higher Call Premium If Rates are Low and Going to Rise, there

Will Be a Lower Call Premium

Advantage is for the IssuerDisadvantage is for the Purchaser

Putable Bonds

Purchaser Buys Nonputable Bond and a Put Option from the IssuerPurchaser has the Right to Sell the Bond to the Issuer at a Certain Predetermined Time and PriceIf Investor is Long a Putable Bond, then Putable Bond Price =

Nonputable Bond Price +Put Option Price

Current Price vs. Strike Price

Callable BondsIf P>E, intrinsic value is P-E and option is “in the money”If P=E, intrinsic value is 0, option is “at the money”If P<E, intrinsic value is 0 and option is “out of the money”

Putable BondsIf P<E, intrinsic value is E-P and option is “in the money”If P=E, intrinsic value is 0 and option is “at the money.”If P<E, intrinsic value is 0 and option is “out of the money.”P=Current Bond Price, E=Strike Price

Bonds vs. Certificates of Deposit

BondsIssued by Govt. or CompaniesCapital MarketNot Insured by Govt.

CDsIssued by BanksMoney MarketInsured by Federal Govt. up to $100,000

•Both could have a Call Option Attached and Expose the Purchaser to Reinvestment Risk

Stocks vs. Bonds

StocksCapital Gain/Loss

Unlimited Upside Potential with Unlimited Downside Risk

Part OwnerDividends

Company may change it or decide not to pay one at all

BondsFixed IncomeCreditorGuarantee of Principal Payment Default Risk

DIVERSIFICATION: depending on your income and ability to take risk, you will choose a different path.

Questions?