Principles of Investing FIN 330 Fixed Income Chapter 5 All Rights Reserved Dr. David P Echevarria

Student Learning Objectives Characteristics of Debt Instruments Types of Debt Instruments Bond Market Operation Bond Ratings Global Debt Securities All Rights Reserved Dr. David P Echevarria

Characteristics of Debt Instruments A bond is a debt security in which an investor loans money to the borrower (issuer) for the promise of interest payments and the eventual repayment of the principal at maturity. All Rights Reserved Dr. David P Echevarria

Characteristics of Debt Instruments B. Indenture Agreement Loan contract between lender (investor) and borrower (issuer) Appoints the trustee; a fiduciary responsible for guarding the lenders' interests. Terms and conditions, legal remedies Sets the coupon rate (interest) and interest (coupons) payment schedules Maturity date of the issue Nature of collateral (if any) All Rights Reserved Dr. David P Echevarria

Characteristics of Debt Instruments C. Special Repayment Provisions Serial Redemption Sinking Funds Call provision: early retirement of bonds (with premiums to be paid) Put provision: permits bond buyer to sell bond back at face value. All Rights Reserved Dr. David P Echevarria

Types of Debt Instruments Secured Debt: collateralized with real assets mortgage bonds equipment trust certificates (rolling stock) Unsecured Debt: backed by full faith and credit of the issuer [debentures] Senior Junior Subordinated All Rights Reserved Dr. David P Echevarria

Issuers of Debt Instruments Federal Government Bills, Notes, Bonds Agency issues Interest payments not subject to state or local taxation Municipals General Obligation Bonds (backed by taxing power) Revenue Bonds: pay interest only if issuer makes $$$ Industrial Development Bonds Interest payments not subject to Federal Income Tax Corporates All Rights Reserved Dr. David P Echevarria

Bond Market Operation Most bonds sell in the OTC market Government bonds by far the largest dollar volume: Bills, Notes, Bonds, Agency bonds Dealers dominate secondary market Corporate Bonds: typically better rates than government/municipal bonds. Short-Term Securities: T-Bills, Commercial paper, Bankers’ Acceptances, Negotiable CDs S-T securities are mostly held in money market funds All Rights Reserved Dr. David P Echevarria

Bond Ratings [Creditworthiness] Credit Worthiness key to interest rates paid, and a measure of the probability of default High Quality / Investment Grade: AAA / AA, A, BBB Legal List: acceptable credit ratings Speculative (“Junk”): BB, B Default: [CCC, CC, C,] D All Rights Reserved Dr. David P Echevarria

Bond Rating Agencies Credit Rating Agencies Standard & Poor’s: Mainly corporate (industrials) and sovereign debt Moody’s: Banking, Insurance, Corporates Fitch’s: Full range of coverage including international issuers Dun & Bradstreet: small to medium sized companies (213 million world-wide) Credit ratings assigned only after bonds have been sold (issued) All Rights Reserved Dr. David P Echevarria

Agency Credit Rating Equivalents

Bond basics A bond is essentially a security that offers: A series of fixed interest payments during its life A fixed payment when it matures Assumes the bond issuer doesn’t default. Dollar value of Interest Payment is determined by the Coupon Rate For example, suppose a $1,000 par value bond pays an 8% coupon rate. The annual coupon is then $80. If the coupon is paid semi-annually, then two payments of $40 every 6-months. If the coupon is paid quarterly, then four payments of $20 every 3-months. All Rights Reserved Dr. David P Echevarria

Bond Valuation - Review The price of a [seasoned] bond is determined by the interest rate prevailing at the time of sale – call the Yield to Maturity (YTM). This is the rate of total return if the bond is held until it matures. Vb = PVIFAi,n * Coupon + PVIFi,n * Face Value i = Coupon Rate divided by # of payments per year n = number of periods remaining until maturity All Rights Reserved Dr. David P Echevarria

Sources of Bond Risk Interest Rate Risk Reinvestment Rate Risk Bond values and interest rate changes are inversely correlated; as rates increase, bond values decrease. Changes in economic risk as well as changes in expected inflation will cause interest rates to vary. Reinvestment Rate Risk bond valuation formulas implicitly assume that all future coupons received are reinvested at the YTM All Rights Reserved Dr. David P Echevarria

Sources of Bond Risk C. Call Risk D. Liquidity Risk Bonds issued callable may be called prior to maturity Most likely if rates drop fairly quickly. D. Liquidity Risk Bonds with relatively thin floats will have higher bid-ask spreads effectively increasing the cost of liquidity. Bonds with thin floats may also take longer to sell. All Rights Reserved Dr. David P Echevarria

Bond Strategies Buying and selling of bonds are driven by expectations If you expect rates to rise, invest in short term maturities; e.g., invest in T-Bills or for better yields - bonds maturing in 2 to 5 years. As rates rise you can roll-over into higher coupon rate securities If you expect rates to decline, invest in long term bonds. As rates decline, the prices of L-T debt increase providing an opportunity for capital gains. If invested in callable bonds, bonds may be retired early by issuer. All Rights Reserved Dr. David P Echevarria

Bond Pricing Terminology Bonds may sell at a; Premium: a bond that sells for more than its par value. YTM < Current Yield < Coupon Rate Discount: a bond that sells for less than its par value. YTM > Current Yield > Coupon Rate Par: a bond that sells at a price = face value YTM = Current Yield = Coupon Rate Price Quotes Typical: as % of face value. Example: 104.335 = $1043.35 Government Bonds in 1/32nd: Example: 102.11 = 102 + 11/32 = 0.3438 => 102.3438 = $1023.44 All Rights Reserved Dr. David P Echevarria

Treasury inflation-protection securities “TIPS” tie the par value of the bond and the coupon payment to the general level of prices (as measured by the Consumer Price Index – CPI) in the economy. By adjusting the par value of the bond for inflation, the bondholder no longer has to worry about inflation outpacing return. All Rights Reserved Dr. David P Echevarria

Agency bonds Agency bonds are the debt obligations of various agencies and organizations of the U.S. government. These agencies issue bonds to help finance activities related to public purposes (like increasing home ownership or providing farming assistance). Government sponsored enterprises are technically owned by shareholders and not part of the federal government. (Freddie Mac & Fannie Mae) Federal agency issue bonds that are backed by the full faith and credit of the U.S. government. (Ginnie Mae) All Rights Reserved Dr. David P Echevarria