1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 18

2. Chapter 18 Bond Fundamentals Questions to be answered: What are some of the basic features of bonds that affect their risk, return, and value? What is the current country structure of the world bond market and how has the makeup of the global bond market changed in recent years?

3. Chapter 18 Bond Fundamentals What are the major components of the world bond market and the international bond market? What are bond ratings and what is their purpose? What is the difference between investment- grade bonds and high-yield (junk) bonds?

4. Chapter 18 Bond Fundamentals What are the characteristics of bonds in the major bond categories such as governments (including TIPS), agencies, municipalities, and corporates? How does the makeup of the bond market in major countries such as the United States, Japan, the United Kingdom, and Germany differ?

5. Chapter 18 Bond Fundamentals What are the important characteristics of corporate bond issues developed in the United States during the past decade such as mortgage-backed securities, other asset-backed securities, zero-coupon and deep discount bonds, high-yield bonds, and structured notes?

6. Chapter 18 Bond Fundamentals Within each of the major bond categories, what are the differences between major countries such as the United States, Japan, the United Kingdom, and Germany How do you read the quotes available for the alternative bond categories (e.g., governments, municipalities, corporates)?

7. Basic Features of a Bond Pay a fixed amount of interest periodically to the holder of record Repay a fixed amount of principal at the date of maturity

8. Basic Features of a Bond Bond market is divided by maturity –Money Market - short-term issues that mature within one year –Notes - intermediate-term issues that mature between one and ten years –Bonds - long-term obligations with maturity greater than ten years Remaining life (maturity) affect price volatility

9. Bond Characteristics Intrinsic features –Coupon - yield (interest income) –Maturity - term or serial (municipalities) –Principal value - different from market value –Type of ownership - bearer or registered Types of Issues –Secured (senior) bonds –Unsecured bonds (debentures) –Subordinated (junior) debentures

10. Bond Characteristics Indenture provisions Features affecting a bond’s maturity –Callable (call premium) –Noncallable –Deferred call –Nonrefunding provision –Sinking fund

11. Rates of Return on Bonds where: HPR i,t = the holding period for bond i during the period t P i,t+1 = the market price of bond i at the end of period t P i,t = the market price of bond i at the beginning of period t Int i,t = the interest payments on bond i during period t The holding period yield (HPY) is: HPY = HPR - 1

12. The Global Bond-Market Structure Participating issuers –1. Federal governments –2. Agencies of the federal government –3. State and local political subdivisions (municipalities) –4. Corporations –5. International issues Foreign bonds Eurobonds

13. Participating Investors Individual investors Institutional investors –Life Insurance Companies –Commercial Banks –Property and Liability Insurance Companies –Pension Funds –Mutual Funds

14. Bond Ratings Ratings Services 1. Duff and Phelps 2. Fitch Investors Service 3. Moody’s 4. Standard & Poor’s Non-rated bonds

15. Alternative Bond Issues Domestic government bonds –United States - T-bills, notes, bonds. TIPS –Japan - medium term, long term, super long term –Germany - bund bonds, contract with Kassenverien liquid market provided by Bundesbank –United Kingdom - short gilts, medium gilts, long gilts

16. Government Agency Issues United States –Not direct issues, but backed by “full faith and credit” of the U.S. government –GNMA pass-through certificates Japan –Government associate organizations Germany –Federal Railway and Federal Post Office

17. Municipal Bonds General obligation (GO) bonds Revenue bonds Interest payments are exempt from federal income tax Convert the tax-free yield of a municipal bond selling close to par to an equivalent taxable yield (ETY)

18. Equivalent Taxable Yield Where: i = coupon rate of the municipal obligations T = marginal tax rate of the investor

19. Municipal Bond Guarantees Bond insured against default risk –Insurance is irrevocable for the life of the issue Four private bond insurance carriers –Municipal Bond Investors Assurance (MBIA) –American Municipal Bond Assurance Corporation (AMBAC) –Financial Security Assurance –Financial Guaranty Insurance Company (FGIC)

20. Municipal Bond Guarantees Insured bonds obtain AAA (Aaa) ratings Issues with private guarantees have more active secondary market, and lower required yield

21. Corporate Bonds Mortgage bonds Collateral trust bonds Equipment trust certificates Collateralized mortgage obligations (CMOs) Other asset-backed securities (ABS) Variable rate notes

22. Corporate Bonds Zero-coupon and deep-discount bonds –Minicoupon bonds –Original-issue discount (OID) bonds –Taxes due on the implied interest High-yield bonds (speculative bonds and junk bonds) –Noninvestment grade with rating below BBB or Baa

23. Japanese Corporate Bond Market Bonds issued by industrial firms or utilities Minimum issuing requirements are specified by the Ministry of Finance Bonds issued by banks to finance loans to corporation –Commercial banks –Long-term credit banks –Mutual loan and savings banks –Specialized financial institutions

24. German Corporate Bond Market Bank bonds German mortgage bonds German commercial bonds Private Loan Agreements (Schuldscheindarlehen)

25. U.K. Corporate Bond Markets Debentures Unsecured loans Convertible bonds

26. International Bonds Foreign bonds are sold in one country and currency by a borrower of a different nationality –Yankee bonds are U.S. dollar denominated bonds sold in the U.S. but issued by a foreign firm Eurobonds are underwritten by international bond syndicates and sold in several national markets

27. International Bonds United States –Yankee bonds register with SEC –Eurodollar bond market affected by changes in value of U.S. dollar

28. International Bonds Japan –Samuri bonds - yen denominated issued by non-Japanese firms in Japan –Euroyen bonds - yen denominated, sold outside Japan

29. International Bonds Germany –DM-denominated bonds issued by foreign companies are Eurobonds

30. International Bonds United Kingdom –Bulldog bonds are sterling-denominated bonds issued by non-English firms and sold in London –Eurosterling bonds are sold in markets outside London by international syndicates

31. Obtaining Information on Bonds Less emphasis on fundamental analysis Most bond investors rely on rating agencies for credit analysis Market and economic conditions Intrinsic bond features Popular publications available: –Wall Street Journal, Barron’s, Business Week, Fortune, Forbes, Federal Reserve Bulletin, Survey of Current Business

32. Bond Publications Treasury Bulletin Standard & Poor’s Bond Guide Moody’s Bond Record Moody’s Bond Survey Fitch Rating Register Fitch Corporate Credit Analysis Fitch Municipal Credit Analysis Investment Dealers Digest Credit Markets Duff & Phelps Credit Decisions The Bond Player

33. Sources of Bond Quotes Bank and Quotation Record The Blue List of Current Municipal Offerings Wall Street Journal Barron’s

34. Interpreting Bond Quotes Quoted on basis of yield or price Price quotes are percentage of par –98 1/2 is not $98.50 but 98.5% of par –A municipal $5,000 bond quoted at 98 1/2 would be $4,925

35. Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4

36. Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T

37. Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate

38. Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate matures in 2022

39. Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7%

40. Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7% 52 of these bonds traded that day

41. Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7% 52 of these bonds traded that day The closing price was 105 3 / 8 % of par

42. Corporate Bond Quotes Cur Net Bonds Yld Vol Close Chg ATT 8 1 / 8 22 7.7 52 105 3 / 8 + 1 / 4 Issued by AT&T 8.125% coupon rate matures in 2022 Current yield = coupon/market price = 7.7% 52 of these bonds traded that day The closing price was 105 3 / 8 % of par which was up 1/4 from the prior day

43. Corporate Bond Quotes Notations –“cv” = convertible –“zr” = zero coupon –“dc” = deep discount (at time of issue) Accrued interest must be added to price quoted

44. Treasury and Agency Bond Quotes Notations –“n” = treasury note –“p” = treasury note on which nonresident aliens are exempt from withholding taxes on interest Quotes resemble OTC securities with bid and ask prices

45. Treasury and Agency Bond Quotes GOVT. BONDS & NOTES Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. 5 5 / 8 Dec 99n 100:08 100:10 …. 5.04

46. Treasury and Agency Bond Quotes GOVT. BONDS & NOTES Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. 5 5 / 8 Dec 99n 100:08 100:10 …. 5.04 Prices are in 32nds usually with a very small spread between bid and ask

47. Treasury and Agency Bond Quotes U.S. Treasury Strips –“ci” is the coupon interest portion stripped from the note –“np” is the principal payment for the treasury note Treasury Bills –Pure discount instrument - there is no coupon, they pay par at maturity –The bid-ask is not the price but the yield

48. Municipal Bond Quotes 200 INDIANA ST OFFICE BLDG COMMN MBIA 0.000 07/01/05 5.60 BEARSTER Quote from The Blue List of Current Municipal Offerings $200,000 of Indiana State Office Building bonds Guaranteed by MBIA These are zero coupon bonds due July 1, 2005 The yield to maturity is given as 5.6% To determine the price you compute the discount value The dealer offering the bonds is Bear Sterns, listed in the back of the publication with their phone number

49. Municipal Bond Quotes Notations ETM = escrow till maturity M/S/F = mandatory sinking fund (C97) = this bond became callable in 1997 When the market yield equals the coupon rate, the price is 100 and they are referred to as dollar bonds “+” in the left column indicates a new item “#” before yield to maturity or price indicates a change

50. The Internet Investments Online www.bonds-online.com www.prusec.com/daily.htm www.fitchinv.com www.moodys.com www.standardandpoors.com/ratings www.bradynet.com www.bondmarkets.com

51. End of Chapter 15 –Bond Fundamentals

52. Future topics Chapter 19 The Analysis and Valuation of Bonds