CHAPTER FOUR BOND FUNDAMENTALS Practical Investment Management Robert A. Strong

South-Western College Publishing © Outline  Bond Principles  Identification of Bonds  Classification of Bonds  Terms of Repayment  Bond Cash Flows  Convertible and Exchangeable Bonds  Registration  The Financial Page Listing  Basic Information  Footnotes  Government Bonds

South-Western College Publishing ©  Bond Pricing and Returns  Valuation Equations  Yield to Maturity  Spot Rates  Realized Compound Yield  Current Yield  Accrued Interest  Bond Risks  Price Risks  Convenience Risks Outline

South-Western College Publishing © Bond Principles: Identification of Bonds  Bonds are identified by issuer, coupon rate, and maturity.  The face value of a bond is called its par value.  e.g. 5 of “Hertz sevens of 03” (Hertz 7s03)  A legal document called the indenture contains the details of the bond issue.

South-Western College Publishing © Bond Principles: Classification of Bonds Method 1: By issuer a. government e.g. US Treasury, federal agency, state, local b. corporation e.g. industrial, utility, financial, transportation c. others e.g. foreign government, foreign corporation, World Bank

South-Western College Publishing © Bond Principles: Classification of Bonds Method 2: By security a. unsecured debt - backed by faith in the taxing power of the government, or the good name of the company (debenture) b. secured debt e.g. revenue bond, assessment bond, mortgage, collateral trust bond, equipment trust certificate

South-Western College Publishing © Bond Principles: Classification of Bonds Method 3: By term a. short-term -  a year e.g. US Treasury bills b. intermediate-term e.g. US Treasury notes (2 to 10 years ) c. long-term e.g. US Treasury bonds (  10 years) d. open-ended e.g. corporate line of credit e. serial bond - a portfolio of bonds with staggered terms

South-Western College Publishing © Bond Principles: Terms of Repayment  interest only - the periodic payments are entirely interest  sinking fund - periodically, a portion of the debt principal is set aside or a certain number of the bonds is retired  balloon loan - most of the principal is due at the end of the loan period  income bond- interest is payable only if it is earned

South-Western College Publishing © Bond Principles: Bond Cash Flows  annuities - most bonds are annuities plus an ultimate repayment of principal  zero coupon - only the par value is returned at maturity  variable (adjustable) rate - the rate fluctuates in accordance with some market index or predetermined schedule  consols - a level rate of interest is paid perpetually

South-Western College Publishing © Bond Principles: Options  convertible bond - may be exchanged for common stock in the company that issued the bond  exchangeable bond - may be exchanged for shares in another firm

South-Western College Publishing © Bond Principles: Registration  bearer (coupon) bonds - belong to whomever legally hold them; no longer issued in the United States because of tax considerations  registered bonds - the bonds show the bondholder’s name  book entry bonds - bond ownership is reflected only in the accounting records

The Financial Page Listing Basic Information Cur Net Bonds Yld Vol Close Chg. AMR 9s ¾ Footnotes cv - convertiblezr - zero coupon vj - bankruptcydc - deep discount f - trading flat Government Bonds Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. 6 Feb 26 86:09 86: South-Western College Publishing ©

Bond Pricing & Returns: Valuation Equations 1. Annuities The bond pricing relationship is customarily expressed in terms of semiannual periods. South-Western College Publishing ©

Bond Pricing & Returns: Valuation Equations 2. Zero Coupon Bonds 3. Variable Rate Bonds South-Western College Publishing ©

South-Western College Publishing © Bond Pricing & Returns: Valuation Equations 4. Consols

South-Western College Publishing © Bond Pricing & Returns: Yield to Maturity The yield to maturity is the single interest rate that, when applied to the stream of cash flows associated with a bond, causes the present value of those cash flows to equal the bond’s market price.

South-Western College Publishing © A heuristic: Bond Pricing & Returns: Yield to Maturity  The yield to maturity calculation carries an assumption that coupon proceeds are reinvested at the yield to maturity.

South-Western College Publishing © Bond Pricing & Returns: Yield to Maturity  If a bond pays periodic interest, it is not possible to lock in a prescribed yield to maturity.  A plot of interest rates against time to maturity is known as a yield curve. yield time

South-Western College Publishing © Bond Pricing & Returns: Spot Rates  A spot rate is the yield to maturity of a zero coupon security of the chosen maturity.  A treasury strip is a government bond or note that has been decomposed into two parts, one for the stream of interest payments and one for the return of principal at maturity.  The yield to maturity is a derived statistic after the bond price is known.

Bond Pricing & Returns Realized Compound Yield: How can two investments paying interest on two different time schedules be compared? South-Western College Publishing ©

South-Western College Publishing © Bond Pricing & Returns: Current Yield  The current yield only measures the return associated with the bond’s interest payments.  A bond whose market price is less than its par value is selling at a discount. The price of such bonds rise as maturity approaches.  If the market price is more than the par value, the bond sells at a premium.

South-Western College Publishing © Bond Pricing & Returns: Accrued Interest  Interest is earned for each day that a bond is held, although interest payments are generally made twice a year only.  A bond buyer must pay the accrued interest to the seller of the bond.  dirty price = bond price + accrued interest clean price = bond price  By convention, accrued interest is calculated using a 360-day year.

South-Western College Publishing © Bond Risks: Price Risks  default risk - the possibility that the issuer of the bond is unable to pay - rated by agencies like Moody’s and Standard & Poor’s  interest rate risk - the chance of loss due to changing interest rates

South-Western College Publishing © Bond Risks: Convenience Risks  call risk - the possibility that the company will exercise a bond’s call feature  reinvestment rate risk - the chance that the interest received cannot be reinvested to earn as much as the bond’s original yield to maturity - the higher the coupon on a bond, the higher its reinvestment rate risk  marketability risk - the difficulty of selling a bond in the secondary market

South-Western College Publishing © Review  Bond Principles  Identification of Bonds  Classification of Bonds  Terms of Repayment  Bond Cash Flows  Convertible and Exchangeable Bonds  Registration  The Financial Page Listing  Basic Information  Footnotes  Government Bonds

South-Western College Publishing © Review  Bond Pricing and Returns  Valuation Equations  Yield to Maturity  Spot Rates  Realized Compound Yield  Current Yield  Accrued Interest  Bond Risks  Price Risks  Convenience Risks