Introduction to Debt Markets Investments 14 Introduction to Debt Markets Bonds vs. Stocks In the Rearview Mirror Sources of Risks Debt Classes

Bonds vs. Stocks Sizing Bond (2009) and Stock Markets (Q3 2008) Investments 14

Rearview Mirror Investments 14 Investments 14 Year 2000: ECB hiked rate 175 basis point, Morgan Stanley German Bond up 7.25% vs stocks down. Bank of England hiked rate by 50 basis point, Morgan Stanley UK Government bond up 8.91% vs a loss of 10.21% for FTSE 100. Bond return based on Lehman Aggregate Bond Index Investments 14

Rearview Mirror Investments 14 Investments 14 Year 2000: ECB hiked rate 175 basis point, Morgan Stanley German Bond up 7.25% vs stocks down. Bank of England hiked rate by 50 basis point, Morgan Stanley UK Government bond up 8.91% vs a loss of 10.21% for FTSE 100. Bond return based on Lehman Aggregate Bond Index Investments 14

Why Bonds? Bonds form an important asset class Investments 14 Why Bonds? Bonds form an important asset class Sources of risk and return in bonds Interest rate risk Reinvestment risk Default risk When liabilities are fixed in nominal terms, investing in suitably chosen bond portfolios may lead to lower risk May not be necessary to consider all asset classes and use mean variance optimization methods Bond mispricing may arbitrage opportunities for an active portfolio manager Investments 14

Issuers of Bonds U.S. Treasury Municipalities Corporations Investments 14 Issuers of Bonds U.S. Treasury Notes and Bonds Municipalities Tax-Exempt Bonds Corporations Corporate Bonds, Preferred Stock International Governments and Corporations Innovative Bonds Indexed Bonds Floaters and Reverse Floaters Investments 14

Source of Risks Interest Rate Risk (Market Risk) Inflation Risk Investments 14 Source of Risks Interest Rate Risk (Market Risk) The major factor affecting bond prices The price of bond changes in the opposite direction of interest change All bonds are exposed Inflation Risk Inflation reduces purchasing power Yield changes to reflect the expected inflation Reinvestment Risk No guarantees that coupon payments could be reinvested at the same rate Investments 14

Source of Risks Credit Risk Liquidity Risk FX Risk Investments 14 Source of Risks Credit Risk Inability of issuer to pay coupon and/or principal Corporate, Emerging market and high-yield bonds Credit linked debt securities, credit derivatives Liquidity Risk Inability to unload position without substantial loss Municipal, Corporate, and Emerging market bond FX Risk The risk of exchange rate fluctuation in reducing the return on a foreign bond Investments 14

Debt Classes: Definition Investments 14 Debt Classes: Definition Bond (Fixed Income Security) A security obligating issuer to pay interest and principal to the holder on specified dates. Coupon Interest rate, e.g. 4%, 5 3/4%, etc. Face/par value or Principal amount, e.g. $100 MM, $3B. Maturity, e.g. 3 month, 1 year, 30 years, etc. Bond can be classified according to its attributes Payment type, e.g. semi-annual coupon, amortizing, etc. Issuer, e.g. government, agency, corporate, etc. Maturity, e.g. short, medium, long, etc. Security, e.g. secured, unsecured debenture, etc. Investments 14

Debt Classes: Payment Type Investments 14 Debt Classes: Payment Type Pure Discount or Zero-Coupon Bond No coupon payments prior to maturity. Bond’s face value paid at maturity. Coupon Bond A stated coupon paid periodically prior to maturity. Perpetual (Consol) Bond A stated coupon paid at periodic intervals. Self-Amortizing Bond Certain amount paid at each payment period. No balloon payment at maturity. Investments 14

Debt Classes: U.S.Treasuries Investments 14 Debt Classes: U.S.Treasuries Treasury Bills maturity  1 year when issued typically 3 months and 6 months pure discount bond, no coupon Treasury Notes Maturity: 1 year  maturity  10 years when issued Typically, 2, 3, 5, and 10 year Coupon: semi-annual Treasury Bonds Maturity: >10 years when issued Typically, 20, 30 (last issued Feb 15, 2001) Investments 14

Debt Classes: U.S.Treasuries Investments 14 Debt Classes: U.S.Treasuries Treasury STRIPS are zero-coupon securities that are made by “stripping” coupons or principals from Government Notes and Bonds. Treasury Strips are issued under the U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) program. Prices of Notes, Bonds, and STRIPS are quoted as prices per $100 of face value. Prices of Bills are quoted in terms of rate of discount. Investments 14

Debt Classes: Corporate Bonds Investments 14 Debt Classes: Corporate Bonds Secured Debt (backed by collateral assets) Secured by real property Property reverts to bondholder upon default Subordinate Debenture General creditors subordinate to secured debt Higher priority over stockholders Other Features of corporate bonds Convertible bonds: convertible to equity Callable bonds: issuer’s right to buys back bond Putable bonds: holder’s right to sell bond to issuer Sinking funds: reduced face amount over time Investments 14

Corporate Bonds – Default Risk One of the biggest differences between Corporate Bonds and U.S. Treasury Bonds is the default risk on corporate bonds Corporate bonds are rated on the basis of their default risk by a few rating companies Investments 14

Factors Used by Rating Companies Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt Effects of bond covenants Moody’s acquired KMV to use option pricing theory to rate corporate bonds Investments 14

Corporate Bonds – Default Ratings Rating Companies Moody’s Investor Service Standard & Poor’s Fitch Rating Categories Investment grade Aaa, Aa, A, Baa by Moody’s ratings AAA, AA, A, BBB by S&P ratings Speculative grade or “Junk” bonds Rated below Baa by Moody’s and BBB by S&P Investments 14

Debt Classes: Corporate Bonds Investments 14 Debt Classes: Corporate Bonds Credit Rating Investments 14

Average One-Year Credit Loss Rates Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006 Investments 14

Ratings and Average Time to Default Original Rating Average # of Years from Original Rating to Default AAA 8.0 AA 9.5 A 8.5 BBB 6.5 BB 4.8 B 3.6 CCC 3.3 Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006 Investments 14

Mean and Median Recovery Rates Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006 Investments 14

Protection Against Default Investments 14 Protection Against Default Sinking funds Subordination of future debt Dividend restrictions Collateral Investments 14

Investments 14 Bond Provisions Call Provision allows the issuer to repurchase the bond at a specified call price before the maturity date Put Provision allows a bondholder to reclaim a principal, or to extend bond’s life Convertible Provision allows a bondholder to exchange a bond for common stock Typically are callable as well Secured Bonds have specific collaterals for bonds Sinking Funds guarantee gradual repurchase of corporate bonds by the issuer Floating Rate Bonds have interest payments tied to some measure of current market rates Investments 14

Comparing Bonds – On the Importance of Fine Print Investments 14 Comparing Bonds – On the Importance of Fine Print Yield is useful for comparing similar bonds to see if which bond may be cheaper Detailed analysis focuses on bonds identified this way: “Similar” Cash flows Duration Credit risk Call, Put, Conversion and other provisions Investments 14

“Similar” Bonds Example Investments 14 “Similar” Bonds Example Two U.S. Treasury bonds of same maturity from July 1, 2004 WSJ: The first bond has a coupon rate of 4.75%, and yields 4.56% The second bond has a coupon rate of 13.25%, and yields only 3.71% (!!!) The difference is that the second bond is CALLABLE!!! It was issued as a 30yr bond in May of 1984, and is callable at par value in 25 years, i.e. in May of 2009 Now it is almost 100% certain that it will be called, hence it now trades as bond maturing in 2009: Rate Maturity Bid Asked Chg Mo/Yr Yield 4 3/4  May 14 n   101:15  101:16  +10  4.56  13 1/4  May 14   142:03  142:04  +11  3.71  Rate Maturity Bid Asked Chg Mo/Yr Yield 3 7/8  May 09 n   100:22  100:23  +9  3.71  5 1/2   108:02  108:03  +10  3.67  Investments 14

Investments 14 Bond Provisions Bond provisions may alter the structure of cash flows, affecting bond prices and yields Call Provision allows the issuer to repurchase the bond at a specified call price before the maturity date Relationship between Interest Rate and Callable Bond Price Investments 14

Investments 14 Yield to Call Bonds are most likely to be called when their price exceeds the call price It implies that premium bonds will be called at the earliest date when the bond becomes callable Hence yield quoted in WSJ for callable premium bonds is in fact yield to call (recall previous example)!!! Example of cash flows difference for a callable bond: A 30yr bond with 8% coupon sells for $115, and is callable in 10 years at par   Cash Flow to Call Cash Flow to Maturity Coupon payment $4 Number of semi-annual periods 20 periods 60 periods Final payment (principal) $100 Price $115 Yield to Call Yield to Maturity 5.98% 6.82% Investments 14

Debt Classes: Municipal Bonds Investments 14 Debt Classes: Municipal Bonds Municipal Bonds Maturity varies from one month to 40 years Exempt from federal taxes and state taxes (for residents of issuing state) Generally two types: Revenue bonds backed by the revenue of a particular project e.g. water bond General Obligation bonds backed by the tax revenue of local government e.g. school bond Riskier than U.S. Government bonds Investments 14

Source of Risks – Foreign Bonds Investments 14 Source of Risks – Foreign Bonds Investments 14

Bond Resources WSJ - Bonds Yahoo – Bonds Bloomberg - Bonds Investments 14 Bond Resources WSJ - Bonds Yahoo – Bonds Bloomberg - Bonds Lehman Brothers Bond Indices (what’s left of them…) www.investinginbonds.com PIMCO - Everything You Need to Know About Bonds Investments 14