1 Chapter 14 - Bonds A promise to repay a sum of money on a fixed date, together with interest, usually over the life of the loan Why buy bonds? –Steady income –Generally safe –Reduce risk through diversification

2 Types of Bonds Corporate bonds –Unsecured = debentures Treasuries and Agencies Inflation-indexed Municipals –State and local government agencies –Usually tax-exempt Zero coupons

3 Bonds – Issuer Types Mortgage-related $7.9T40.6% Corporations US Treasuries State & Local Gov’t Other asset-backed –Total $ %

4 Bond Features Par value – face value or principal amount repaid at maturity –Usually $1,000 per bond –Market price may be more or less than par Coupon rate – percentage of par value paid annually in interest –With 6% coupon, $1,000 bond pays $60/yr –Most bonds pay interest semi-annually, $3.

5 Capital Food Chain Secured creditors (OK if < assets) General Creditors –Debenture holders and unsecured creditors –Subordinated debenture holders Preferred stockholders Common stockholders

6 Ratings Moody’s, Standard and Poors, Fitch –Assess quality of borrower’s credit –AAA to D –Junk bonds are BB and below –Lower rating, greater risk, higher rates

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8 Junk Bonds AKA “high risk”, “non-investment grade”, “high yield” or “speculative” Low credit rating - BB and below –Higher risk, higher rates Fallen angels (companies in trouble) or new, unproven firms

9 Quality Spreads Ten Year Maturities – April 2004 YieldSpread Example USTN4.40% AAA GE & UPS AA Abbott Labs A McDonalds BBB GM BB Goodyear

10 Convertible Securities Convertible into common stock at a fixed rate at bondholder’s option $1,000 bond convertible into 20 shares –Equal to $50/share (1,000/20) –Stock rises to $60. Bond worth $1,200 (60 * 20) Offers upside potential but have lower rates than on comparable nonconvertibles Look at coupon and conversion ratio

11 Callable Bonds Redeemable at issuer’s option –Rates drop, bond called, new bonds issued –Investor forced to reinvest at lower rate Deferred calls and call premiums –Some not callable for first five years –Premium: say 105% of par year 6, 104% year 7 ….. par year 11 Effect: callables pay a higher rate.

12 Municipal Bonds Muni's are issued by states, counties, cities and school districts Interest not subject to federal taxes (usually) General obligations –backed issuer’s taxing power Revenue bonds repaid by project's revenue Muni's subject to credit risk – Orange County's and Cleveland's bankruptcy

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14 Bond Valuation Bond pays fixed amount of interest over a number of years and at maturity the bond is redeemed and you receive the par value. Value of a bond is the present value of each interest payment and the present value of the payment at maturity.

15 Evaluating Bonds Yield – return on the investment –Not the same as coupon rate (% of par value) –Current yield – ratio of annual interest to price –8% bond selling for $700 has 11.4% current yield Yield to Maturity (YTM) – return earned if held to maturity; interest plus/minus difference between par and purchase price

16 Bond Calculations US bonds pay interest semiannually –Review non-annual compounding –This means we must change the annual rate to a per period rate $1,000 two year bond with 6% coupon rate has four $30 semiannual interest payments plus $1,000 paid at maturity.

17 6% bond, Due two years; Market rate = 10%; Interest semi-ann Time CF5% PVIFPV 6 mo$ $ mo , $927.07

18 Valuation Remember: the coupon is fixed for the life of the bond The only way a bond's return can be increased is by reducing its price One year bond 8% coupon ($80); Market rate 10% ($100). Price falls to $980 $80 interest + $20 capital gain = $100

19 Relationships Inverse relation between changes in interest rates and changes in bond prices –Rates increase, bond prices fall –Rates decrease, prices rise – Bonds may sell for par value, more than par, or less than par. Market rate above coupon, sells at a discount Market below coupon, bond sells at a premium

20 Bond Values at Different Rates

21 More Relationships Longer-term bonds fluctuate more in price than shorter-tem bonds (next slide) As maturity approaches, market value approaches par value Upward movement in callable bonds limited because they may be called away from you

22 Longer-term = More Sensitive Price of 12% 5 and 10 Year Bonds Rate5 Year10 Year 9%$1,117$1, ,000 1,

23 Price Sensitivity – 5 vs. 10 Year

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26 Preferred Stock Hybrid security – similar to bonds and stock –Like bonds: usually fixed return, paid before common dividends, usually don't vote –Like stock: no maturity and failure to pay dividend does not trigger bankruptcy

27 Features of Preferred May have multiple issues with different terms Sometimes convertible into common Some have cumulative dividends May be callable Some have floating rates

28 Risks With Preferred Stock Interest rates rise, price declines Rates fall – what happens if callable? Gains limited Dividends not as secure as bond interest