Bonds: Fixed Income Securities Economics 71a: Spring 2007 Mayo chapter 12 Lecture notes 4.3

Goals  History  Features and structure  Bond ratings

Bond Returns  Interest and capital gains Stock comparison: dividends and cap gains  Most income in the form of interest

Two Parts = (capital gain) + (Interest)

Annual Historical Returns Raw ReturnsInflation Adjusted Stocks12.4%9.2% Corp Bonds6.3%3.2% Gov’t Bonds5.8%2.8% TBills3.8%0.7%

Bonds in the 1990’s  Bonds, 8.7% (nominal, no inflation adjustment) $10,000 -> $23,000 Stocks 18.2% (nominal) $10,000 -> $53,000  (June) Bonds, 9.7% (nominal) $10,000 -> $35,000 Stocks, 10.2% (nominal) $10,000 -> $37,000

Bond Return Summary  Generally, lower returns than stocks  But also, less risk than stocks

Bond Risks  Interest rate risk  Purchasing power risk (inflation)  Default or business risk  Liquidity risk  Call risk

Goals  History  Features and structure  Bond ratings

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

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 $ $25

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

Current Bond Price  Discount Price < Par  Premium Price > Par  Depends on interest rates  Bond yield = coupon/price

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 callable  Similar to refinancing for individuals  Important risk component for investors

Sinking Funds  Schedule to pay back principal over time  Different from call Option versus requirement

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

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  Taxes  Trading/liquidity

Borrower Costs  What affects the interest rate borrowers pay? Maturity (length of bond) Size (total loan) Default risk Market interest rates

Market Segments Trillions of U.S. $  U.S. treasury bonds: 2.2  Agency securities: 2.1 Federal home loan, Student loan marketing association  Municipal bonds: 1.5  Corporate bonds: 5.2  Mortgage backed securities: 2.9  Foreign issues (eurodollar): 3.3

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

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

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 by  Capital gains Not exempt

Muni Bonds: Taxable equivalent yield

Zero Coupon Bonds  Zero coupon (interest) payments  Principal only  Trade at discount Example: $1040 in 1 year Price today = $1000 Yield (return) = 4%  Constructed zero coupon bonds: Strips

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

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

Junk Bonds  High yield  High risk (default likely)  Unsecured  Famous in the 1980’s Leveraged buyouts  Are they a good investment?

Mortgage Backed Securities (Mortgage Bonds)  Pool of mortgages  Pay off principal over time  Some pools high risk Subprime  Tricky refinancing questions

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

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

Foreign Bonds  Yankee bonds Dollar bonds issued in U.S. by foreign or international corporations  Euro bonds Dollar bonds issued outside the U.S.

Goals  History  Features and structure  Bond ratings

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

Bond Ratings and Default Probabilities (Economist, March 23, 2005)

Rating Agencies  S&P Rates $30 trillion in debt  Moody’s  Fitch

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

Ratings Taken Seriously  Many investment funds having ratings requirements “No junk bonds” Ratings triggers : loans called back if ratings fall

Goals  History  Features and structure  Bond ratings