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

Investments 142 Bonds vs. Stocks  Sizing Bond (2009) and Stock Markets (Q3 2008) $34.3 T $14.1 T

Investments 143 Rearview Mirror

Investments 144 Rearview Mirror

Investments 145 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 146 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 147 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 148 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 149 General Bond Characteristics  Price  Face or par value  Coupon rate  Compounding and payment frequency  Indenture, i.e. attached options, covenants, etc.

Investments 1410 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 1411 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.  Bond’s face value paid at 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 1412 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)  Coupon: semi-annual

Investments 1413 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 1414 Example from July 1, 2004 WSJ  U.S. Treasury Notes and Bonds are typically issued with face value of $10,000, and pay semi-annual coupons  The following bond quoted in the July 1, 2004 WSJ:  Matures in February 2026 (2/15/2026)  Coupon rate is 6%. Semi-annual coupon payments are made on 2/15 and 8/15 of each year in the amount of (0.06 x $10,000)/2 = $300  At maturity (2/15/2026) the payment is the coupon of $300 plus the principal of $10,000  Quoted decimal price per $100 par is $108 8/32 = $  Quoted bond price is $10, Rate Maturity BidAskedChg Asked Mo/YrYield 6 Feb :07 108:

Investments 1415 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 1416 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 1417 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 1418 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 1419 Debt Classes: Corporate Bonds  Credit Rating

Investments 1420 Average One-Year Credit Loss Rates Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006

Investments 1421 Ratings and Average Time to Default Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006 Original Rating Average # of Years from Original Rating to Default AAA8.0 AA9.5 A8.5 BBB6.5 BB4.8 B3.6 CCC3.3

Investments 1422 Mean and Median Recovery Rates Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006

Investments 1423 Protection Against Default  Sinking funds  Subordination of future debt  Dividend restrictions  Collateral

Investments 1424 Promised Return vs. Expected Return Takeaways  Bonds of firms in distress do have high promised yield  Example  TEMBEC INDS INC 8.625% bond maturing in 6/30/2009  The current yield is %  YTM is %  The open question:  What return you expect to get?

Investments 1425 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 1426 “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 BidAskedChg Asked Mo/YrYield 4 3/4 May 14 n 101:15 101: /4 May :03 142: Rate Maturity BidAskedChg Asked Mo/YrYield 3 7/8 May 09 n 100:22 100: /2 May 09 n 108:02 108:

Investments 1427 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 1428 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 CallCash Flow to Maturity Coupon payment$4 Number of semi-annual periods20 periods60 periods Final payment (principal)$100 Price$115 Yield to CallYield to Maturity 5.98%6.82%

Investments 1429 Bond Provisions Continued  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 1430 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 1431 Debt Classes: Non-US Issues  Investment Grade Bond outside US  Bonds issued by foreign companies and nations  Greater than $7 trillion by 2001  e.g., U.K. Gilts, Japan’s JGBs, Germany’s Bunds, French’s OATs, etc.  Emerging Market Bond  Bonds issued by governments and companies of emerging economies  $1.2 trillion by 1995  Denomination in local currency or US$  Some issues have principal and a few coupon backed by US government (Brady bond)

Investments 1432 Source of Risks

Investments 1433 Bond Resources    bonds.yahoo.com bonds.yahoo.com  PIMCO PIMCO  Lehman Brothers Bond Indices Lehman Brothers Bond Indices  Bloomberg Bond Rates Bloomberg Bond Rates  Live Market Analysis on Bonds and Related Topics Live Market Analysis on Bonds and Related Topics

Investments 1434 Wrap-up  Debt Classes  Issuer, security, and payment type  Source of Risks  Interest, inflation, reinvestment, credit, liquidity, currency