VI: Debt Market Instruments 17: Government Bonds 18: Municipal Bonds 19: Corporate Bonds

Chapter 17: Treasury Bonds US Treasury Securities © Oltheten & Waspi 2012

Chapter 17: Treasury Bonds © Oltheten & Waspi 2012 US Treasury Securities  T-Bills:  Maturity of less than one year at issue  Discount paper  T-Notes:  Two to ten years at issue  T-Bonds:  More than ten years at issue  Semi-annual coupon  Mature on the 15th (or the last day) of the month

Chapter 17: Treasury Bonds Pricing Government Bonds and Notes RateMaturityBidAskChgAsk Yld 9 ¼ 6 Aug 13 Aug 13n 103:23 98:22 103: : June 12, 2012 © Oltheten & Waspi 2012

Chapter 17: Treasury Bonds © Oltheten & Waspi 2012 Pricing  Buy $1,000,000 T-Note maturing August 15,  Settlement is T+1  The note is purchased June 12  for settlement June 13,  The price is quoted at 98:24  Priced to actual days (365 or 366)

Chapter 18: Municipal Bonds Municipal Bonds © Oltheten & Waspi 2012

Chapter 18: Municipal Bonds © Oltheten & Waspi 2012 Municipal Bonds  Municipal Bonds are issued by  States  Counties  Municipalities  Townships  School Districts  Special Districts  Authorities (Airports, Bridges etc.).

Chapter 18: Municipal Bonds © Oltheten & Waspi 2012 Tax treatment  In the US the interest on Municipal Notes is exempt from Federal Taxes and exempt from state taxes in the state of issue.  Example  Treasury yield = 6%  Target Investor in Illinois pays marginal tax of 26%  6%(1-.26) =  Illinois can issue comparable bonds at a yield of 4.44%

Chapter 18: Municipal Bonds © Oltheten & Waspi 2012 Pay to Play  The Muni Market is an inefficient market  This provides the opportunity for both profit and abuse.

Chapter 19: Corporate Bonds Corporate Bonds © Oltheten & Waspi 2012

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Security  Senior Bond  Backed by a legal claim to specific assets  Junior Bond  Backed by the Corporation’s ability to pay principal and interest as promised

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Unsecured Debt  Debentures  Long term unsecured issue  Subordinated Debentures  Second class Debentures

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Secured Debt  The security is defined in the Indenture and can take various forms such as:  Mortgage Bonds  Collateral Trust Bonds  Equipment Trust Certificates

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Pricing © Oltheten & Waspi 2012 Corporate Bonds and Notes RateMaturityBidAskChgAsk Yld Intel 9¼ DVC 6% Aug 15, June 10, 2012

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Pricing  Buy $1,000,000 Discovery Café bond maturing August 15,  Settlement is T+3  The note is purchased June 10  for settlement June 13,  The price is quoted at  Priced to 360 days in a year

Chapter 19: Corporate Bonds Callable Bonds © Oltheten & Waspi 2012

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call  A callable bond allows the issuer (borrower) to pay the principal off early  Call  Issuer (DVC)  Investor (John Q. Investor)

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 The Bond  In June 1995 DVC issues $10 million in a 30 year, 7% bond  The issue is in 10,000 $1,000 bonds  This issue is callable after 10 years with a call premium of 10% declining at ½% per year  2005 – 10.0%  %  %  …..  %  % (Maturity Date)

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call Schedule © Oltheten & Waspi 2012

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 The Issuer  June 2005  Should DVC pay off the bond early?  Yields on comparable bonds have fallen to 5%  According to the terms of the indenture DVC can call the bond in 2005 at par plus 10%  Should DVC borrow $11m at 5% to pay off a debt of $10m at 7%

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call $10min 7% Issue$11min 5%  Borrow $11m and pay off $10m debt Results in … © Oltheten & Waspi 2012

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call Coupon payments on$10mat 7%: Coupon payments on$11mat 5%:  Lower semi-annual coupon payments and … © Oltheten & Waspi 2012

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call $10mprincipal on 7% bondsin 2025 $11mPrincipal on 5% bondsin 2025  higher principal repayment. © Oltheten & Waspi 2012

Chapter 19: Corporate Bonds Timeline © Oltheten & Waspi 2012 $0 -$75,000 $1,000,000 -$75,000 June ‘05June ‘06 Dec ‘06 Dec ‘05 Dec ‘24 June ‘25 Call & re-issue

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call  Discovery Café calls the % bond in June 2005 and refinances with a new % bond.

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 The Investor  John Q. Investor purchases a $10,000 DVC 7% bond at issue at par.  He calculates his Yield to Maturity …

Chapter 19: Corporate Bonds Yield to Maturity

Chapter 19: Corporate Bonds © Oltheten & Waspi  John, having fallen asleep in Finance 300, is totally unaware that the bond is callable.  He does know that yields have fallen to 5%  He thinks his bond is worth …

Chapter 19: Corporate Bonds 2005 © Oltheten & Waspi June ‘05June ‘06 Dec ‘06 Dec ‘05 Dec ‘24 June ‘25 Price to yield 5% P = John thinks his bond is worth $12, %

Chapter 19: Corporate Bonds © Oltheten & Waspi  John plans to sell his bond at $12,  He calculates his holding period yield as …

Chapter 19: Corporate Bonds Holding Period © Oltheten & Waspi June ‘95June ‘96 Dec ‘96 Dec ‘95 Dec ‘04 June ‘ %

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call  John’s broker informs him that the DVC 7% 2025 has been called at 10%

Chapter 19: Corporate Bonds Yield to Call © Oltheten & Waspi June ‘95June ‘96 Dec ‘96 Dec ‘95 Dec ‘04 June ‘05 John is informed that his bond was called at $11, %

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call  John is persuaded to replace his 7% bonds with 5% bonds

Chapter 19: Corporate Bonds Call © Oltheten & Waspi 2012  John calculates his Realized Yield … 10,000 June ‘95June ‘05 June ‘25 -10,000 7% June ‘15 Call 11, ,000 11,000 5%5% $350 coupons $275 coupons

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Calculator Techniques  CF0 = -10,000  C01 = 350  F01 = 20  C02 = 275  F02 = 39  C03 = 11,275  F03 = 1  IRR [CPT] = 3.22  original investment  coupon received Dec ‘95 … … through June ’05  coupon received Dec ’05 … … through Dec ’24  principal plus final coupon …received June ‘25

Chapter 19: Corporate Bonds Call © Oltheten & Waspi 2012 June ‘95June ‘05 June ‘25 -10,000 7% June ‘15 -11,00011,000 5% $350 coupons $275 coupons 11,000

Chapter 19: Corporate Bonds Yields © Oltheten & Waspi 2012 In 1995 when Yields are 7% we calculate Promised Yield to Maturity Yield to call In 2005 when Yields are 5% we calculate Holding Period Yield if not callable Realized Yield

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Questions & Problems  19-1

Debt Markets I