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VI: Debt Market Instruments 17: Government Bonds 18: Municipal Bonds 19: Corporate Bonds
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Chapter 17: Treasury Bonds US Treasury Securities © Oltheten & Waspi 2012
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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
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Chapter 17: Treasury Bonds Pricing Government Bonds and Notes RateMaturityBidAskChgAsk Yld 9 ¼ 6 Aug 13 Aug 13n 103:23 98:22 103:25 + 98:24 +3 5.86 June 12, 2012 © Oltheten & Waspi 2012
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Chapter 17: Treasury Bonds © Oltheten & Waspi 2012 Pricing Buy $1,000,000 T-Note maturing August 15, 2013. Settlement is T+1 The note is purchased June 12 for settlement June 13, 2012. The price is quoted at 98:24 Priced to actual days (365 or 366)
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Chapter 18: Municipal Bonds Municipal Bonds © Oltheten & Waspi 2012
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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.).
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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) = 0.0444 Illinois can issue comparable bonds at a yield of 4.44%
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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.
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Chapter 19: Corporate Bonds Corporate Bonds © Oltheten & Waspi 2012
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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
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Unsecured Debt Debentures Long term unsecured issue Subordinated Debentures Second class Debentures
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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
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Pricing © Oltheten & Waspi 2012 Corporate Bonds and Notes RateMaturityBidAskChgAsk Yld Intel 9¼ DVC 6% Aug 15, 13 103.72 98.69 103.78 98.75+3 5.86 June 10, 2012
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Pricing Buy $1,000,000 Discovery Café bond maturing August 15, 2013. Settlement is T+3 The note is purchased June 10 for settlement June 13, 2012. The price is quoted at 98.75 Priced to 360 days in a year
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Chapter 19: Corporate Bonds Callable Bonds © Oltheten & Waspi 2012
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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)
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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% - 110.00 2006 - 9.5% - 109.50 2007 - 9.0% - 109.00 ….. 2024 - 0.5% - 100.50 2025 - 0.0% - 100.00 (Maturity Date)
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call Schedule © Oltheten & Waspi 2012
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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%
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call $10min 7%2025 bonds@ 110. 00 Issue$11min 5%2025 bonds@ 100. 00 Borrow $11m and pay off $10m debt Results in … © Oltheten & Waspi 2012
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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
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call $10mprincipal on 7% bondsin 2025 $11mPrincipal on 5% bondsin 2025 higher principal repayment. © Oltheten & Waspi 2012
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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
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call Discovery Café calls the 2025 7% bond in June 2005 and refinances with a new 2025 5% bond.
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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 …
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Chapter 19: Corporate Bonds Yield to Maturity
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 2005 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 …
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Chapter 19: Corporate Bonds 2005 © Oltheten & Waspi 2012 100 June ‘05June ‘06 Dec ‘06 Dec ‘05 Dec ‘24 June ‘25 Price to yield 5% P = 125.102775 John thinks his bond is worth $12,510.28 7%
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 2005 John plans to sell his bond at $12,510.28 He calculates his holding period yield as …
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Chapter 19: Corporate Bonds Holding Period © Oltheten & Waspi 2012 125.102775 June ‘95June ‘96 Dec ‘96 Dec ‘95 Dec ‘04 June ‘05 100 7%
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call John’s broker informs him that the DVC 7% 2025 has been called at 10%
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Chapter 19: Corporate Bonds Yield to Call © Oltheten & Waspi 2012 110.00 June ‘95June ‘96 Dec ‘96 Dec ‘95 Dec ‘04 June ‘05 John is informed that his bond was called at $11,000.00 100 7%
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Call John is persuaded to replace his 7% bonds with 5% bonds
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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 11,000 5%5% $350 coupons $275 coupons
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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
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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
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Chapter 19: Corporate Bonds Yields © Oltheten & Waspi 2012 In 1995 when Yields are 7% we calculate Promised Yield to Maturity1995-2025 Yield to call1995-2005 In 2005 when Yields are 5% we calculate Holding Period Yield if not callable 1995-2005 Realized Yield1995-2025
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Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Questions & Problems 19-1
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Debt Markets I
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