Finance 300 Financial Markets Lecture 18 Fall, 2001© Professor J. Petry

2 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market –Call Features Some T-bonds had been issued with a call feature 5 years prior to maturity. These bonds are no longer issued, though some remain outstanding. There have never been callable notes. –For callable bonds trading at a premium to face value, yields are calculated to the nearest call date. For callable bonds trading at a discount, yields are calculated to maturity. –Flower Bonds Certain government issues which had tax advantages to investors because they could be par to pay Federal Estate Taxes. These bonds are no longer being issued, and all issues have matured as of –Stripped Treasuries As we saw in Chapter VI, coupon bonds can be taken apart and sold separately. This becomes a stripped treasury bond. You then have individual prices and yields for each coupon payment and the principal.

3 Chapter VI – Government Bonds Federal Agencies –Some Federal Agencies issue their own securities to finance their own activities. There is about 1.3 trillion in outstanding debt of this type. –Agencies generally formed for public policy reasons to channel credit to a particular sector of the economy that congress believes is not receiving adequate credit through normal private sources. –Most debt is issued to support home mortgages and farm credit. –Agency debt is not regulated by the SEC.

4 Chapter VI – Government Bonds Muni’s –Tax exempt bonds issued by state and local governments. There are about 88,000 such government entities in the US with about 1.3 trillion in debt outstanding. –Muni’s are similar to treasury and corporate bonds, but interest income is exempt from federal income taxation, as well as taxation from state and local taxes of the home state. The exception to this tax exemption regards federal capital gains taxes—which still applies. –The wide variety of muni bonds (callable, differing maturities, etc) is a function of the large number of issues. No SEC regulation of this market. –There are a number of different types of Muni’s General Obligation Bonds: backed by “the full faith and credit” (I.e. taxing power) of the issuer. These bonds are generally viewed as nearly free of default risk.

5 Chapter VI – Government Bonds Muni’s (cont’d) Revenue Bonds: issued to finance particular projects and are backed by either revenues from that project or by the municipal agency operating the project. –Typical issues of revenue bonds include airports, hospitals, turnpikes and port authorities. Revenue bonds are have a higher default risk than do GO bonds. Industrial Development Bonds are a particular type of Revenue bond. IDBs are issued to finance commercial enterprises, such as the construction of a factory that can then be operated by a private firm. In effect, this allows the firm access to the municipalities ability to borrow at tax free rates. –The tax treatment of muni’s allows them to be issued at a much lower yield than would be acceptable to purchasers if they were not tax advantaged.

6 Chapter VI – Government Bonds Muni’s (cont’d) –y ( 1 – t ) = y m or y = y m / ( 1 - t ) y = traditional taxable yield t = marginal tax rate of the borrower y m = the equivalent yield on a tax-free municipal bond What yield should the City of Champaign place on its next 20 year GO bond if the equivalent Treasury bond yields 4.5%, and marginal tax rates in Champaign average 25%? 4.5% (1-.25) = 3.38% If an investor is considering a federal Treasury bond which yields 5.0% or a municipal bond which yields 3.8%, and the investors marginal tax rate is.20%, which bond is preferable? What if the investor’s marginal tax rate goes to 30%? –Tax Risk: The additional risk of investing in muni’s which arises by the possibility that the tax exemption might change. Changes might involve the marginal tax rate of the investor, or the tax status of a particular municipal bond issue.

7 Chapter VI – Government Bonds Muni’s –Muni’s are traded over-the-counter, and are generally qouted on a yield basis. –Bond Buyer: A daily publication of fixed income statistics and indeces including new issue information –Munifacts: on line access to BondBuyer data. –Blue List: Short for “The Blue List of Current Municipal Offerings put out daily by S&P. Contains prices, yields and other market information.

8 Chapter VII – Corporate & Other Issues Corporate Bonds –Long term debt issued by private corporations typically paying semi-annual coupons and returning the face value of the bond at maturity. –Indenture Deed: The contract setting out the terms of the bond issue. Maturity –Serial Bond: issues arranged such that the principal comes due on a series of specific dates rather than all at the end. Serial bonds are frequently used when the collateral which secures them is an asset which depreciates over time (see Equipment Trust Certificate below). –Bullet Maturity: Issues in which the entire principal comes due at maturity. –Corporate bonds can mature on any day of the month.

9 Chapter VII – Corporate & Other Issues Corporate Bonds Ownership: –Registered Bonds: The company’s registrar or trustee records the ownership of each bond. Interest and principal are paid directly to the registered owner. –Registered with Coupons: Ownership is registered but the interest is not paid automatically; the bondholder must claim each interest payment by detaching the coupon and presenting it to the company. –Bearer Bonds: The certificate itself constitutes evidence of ownership. The owner must present the coupons to claim interest payments and the certificate itself to claim the principal.

10 Chapter VII – Corporate & Other Issues Corporate Bonds Security: –Senior Bond: A senior or secured bond is backed by a legal claim of specified assets of the firm. Most issues by utility and transportation companies are secured by specific assets. If the company defaults, the trustee or bondholder may take possession of the relevant assets. If the assets do not satisfy the claim, the remaining debt has a general claim alongside other unsecured debt. Mortgage bonds: debt issues which grant the bondholder a first mortgage lien on specified property. Because this gives the bondholders the legal right to seize the and sell the property it provides greater security to the bondholder and a lower interest rate for the issuer. If the mortgage is “closed”, no other debt may be secured by the same property, if it is “open” there is no limit placed on other liens which may be placed on the property.

11 Chapter VII – Corporate & Other Issues Corporate Bonds Security (cont’d): Collateral Trust Bonds: Issues secured by stocks, bonds or notes placed with a trustee. Generally these bonds are issued by holding companies: firms whose assets consist of common stock of their subsidiaries. The problem with collateral trust bonds is that this common stock represents a claim on the subsidiary that is junior to all other claims of assets of the subsidiaries. Therefore the indenture to collateral trust bonds will generally place restrictions on any other bond or preferred shares the subsidiary issues. Equipment Trust Certificates: Issues secured by equipment. These are generally issued by transportation companies (railroads, airlines, trucking firms, etc) who use the funds raised by the bond issue to purchase equipment (airplanes, trucks, etc) which is in turn used as collateral for the bond issue. ETCs are generally issued as serial bonds; the serial maturities reflect the nature of the collateral, which is subject to substantial wear and tear and deteriorates over time.

12 Chapter VII – Corporate & Other Issues Corporate Bonds Security: –Junior Bond: A junior or unsecured bond is backed only by the issuer’s promise of timely payment of interest and principal. Almost all debt issued by industrial and financial companies are general unsecured obligations. Debenture: Longer term unsecured debt issues. Debenture holders have a claim on the firm’s assets after secured debt bondholders. Subordinated Debentures: Subordinated debenture holders have a claim on the firm’s assets after secured debt and debenture bondholders. Guaranteed Bonds: Debt issues that are guaranteed by another entity, another company or by the personal assets of the company’s management.

13 Chapter VII – Corporate & Other Issues Corporate Bonds Accrued Accounting: –Coporate bonds have a few additional wrinkles to worry about when they change hands. As with government bonds, the issues involve the proper accounting of the accrued interest earned. Settlement Date: The date on which the security must be delivered and paid for. Corporate bonds generally settle three business days after the purchase. Accrued interest and yields are calculated as of the settlement date. 30/360: Corporate bonds are traded on a 30/360 basis. We therefore assume 30 days in every month, and 360 days in every year. As an example: you buy a 4 ¾ August 15, 2003 bond on June 10 th, priced at 98 ¾. –The coupons on this bond are paid semiannually on Aug 15 th and February 15 th. –The total coupon will be $47,500 for $1,000,000 in bonds. $23,750 per coupon.

14 Chapter VII – Corporate & Other Issues Corporate Bonds Accrued Accounting (cont’d): –With every month now having the same number of days, our calculations get a bit easier: Aug 15 th to Feb 15 th = (30-15) =180. –This is true for Feb 15 th to Aug 15 th also, and as a matter of fact for all possible dates. We also no longer care about leap year, as Feb always has 30 days. –So in the case of this bond, you own it from June 13 th (we will always use the day you bought the bond +3 days by assuming those three days are business days) –Feb 15 th to June 13 th = (30-15) = 118 days –June 13 th to August 15 th = (30-13) =62 (double check: = 180) –Therefore: previous owner is due: 118/180*23,750=15,569.44, and you receive the remainder 23, =8, (double check: 62/180*23,750=8,180.56) –Invoice price: base price of the bond, plus accrued interest: $987, base price $15,569.44accrued interest $1,003,069.44invoice price

15 Chapter VII – Corporate & Other Issues Corporate Bonds Accrued Accounting (cont’d): Things to Do VII-1 –On June 13 th, 2000 you put in an order for a $1,000, /8 May 2007, corporate bond quoted at 132 ¾. 1.What is the purchase price of this bond before accrued interest? 2.Accrued interest for how many days, adds how much to the price of the bond? 3.What is the total invoice price of the bond? 4.When will you receive your first coupon? 5.How much will you receive on the first coupon date? 6.On the first coupon payment date, you will have earned how much interest over how many days?