1. CHAPTER FOUR BOND FUNDAMENTALS Practical Investment Management Robert A. Strong

2. South-Western College Publishing ©1998 2 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

3. South-Western College Publishing ©1998 3  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

4. South-Western College Publishing ©1998 4 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.

5. South-Western College Publishing ©1998 5 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

6. South-Western College Publishing ©1998 6 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

7. South-Western College Publishing ©1998 7 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

8. South-Western College Publishing ©1998 8 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

9. South-Western College Publishing ©1998 9 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

10. South-Western College Publishing ©1998 10 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

11. South-Western College Publishing ©1998 11 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

12. The Financial Page Listing Basic Information Cur Net Bonds Yld Vol Close Chg. AMR 9s16 8.4 23 107 + 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 86:11 - 9 7.11 South-Western College Publishing ©1998 12

13. Bond Pricing & Returns: Valuation Equations 1. Annuities The bond pricing relationship is customarily expressed in terms of semiannual periods. South-Western College Publishing ©1998 13

14. Bond Pricing & Returns: Valuation Equations 2. Zero Coupon Bonds 3. Variable Rate Bonds South-Western College Publishing ©1998 14

15. South-Western College Publishing ©1998 15 Bond Pricing & Returns: Valuation Equations 4. Consols

16. South-Western College Publishing ©1998 16 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.

17. South-Western College Publishing ©1998 17 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.

18. South-Western College Publishing ©1998 18 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

19. South-Western College Publishing ©1998 19 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.

20. Bond Pricing & Returns Realized Compound Yield: How can two investments paying interest on two different time schedules be compared? South-Western College Publishing ©1998 20

21. South-Western College Publishing ©1998 21 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.

22. South-Western College Publishing ©1998 22 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.

23. South-Western College Publishing ©1998 23 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

24. South-Western College Publishing ©1998 24 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

25. South-Western College Publishing ©1998 25 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

26. South-Western College Publishing ©1998 26 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