Ch18 of Reilly & Brown

Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Seventh Editionby

Frank K. Reilly & Keith C. Brown

Chapter 18

Chapter 18Bond 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?


• 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?


• 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?


• 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?


• 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)?

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

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

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

Bond Characteristics

• Indenture provisions

• Features affecting a bond’s maturity– Callable (call premium)– Noncallable– Deferred call– Nonrefunding provision– Sinking fund

Rates of Return on Bonds

ti,

ti,1ti,ti, P

IntPHPR

where:HPRi,t = the holding period for bond i during the period t

Pi,t+1 = the market price of bond i at the end of period t

Pi,t = the market price of bond i at the beginning of period t

Inti,t = the interest payments on bond i during period t

The holding period yield (HPY) is:

HPY = HPR - 1

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

Participating Investors

• Individual investors

• Institutional investors– Life Insurance Companies– Commercial Banks– Property and Liability Insurance Companies– Pension Funds– Mutual Funds

Bond Ratings

• Ratings Services

1. Duff and Phelps

2. Fitch Investors Service

3. Moody’s

4. Standard & Poor’s

• Non-rated bonds

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

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

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)

Equivalent Taxable Yield

Where:

i = coupon rate of the municipal obligations

T = marginal tax rate of the investor

)-(1ETY

T

i

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)

Municipal Bond Guarantees

• Insured bonds obtain AAA (Aaa) ratings

• Issues with private guarantees have more active secondary market, and lower required yield

Corporate Bonds

• Mortgage bonds

• Collateral trust bonds

• Equipment trust certificates

• Collateralized mortgage obligations (CMOs)

• Other asset-backed securities (ABS)

• Variable rate notes

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

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

German Corporate Bond Market

• Bank bonds

• German mortgage bonds

• German commercial bonds

• Private Loan Agreements (Schuldscheindarlehen)

U.K. Corporate Bond Markets

• Debentures

• Unsecured loans

• Convertible bonds

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

International Bonds

• United States– Yankee bonds register with SEC– Eurodollar bond market affected by changes in

value of U.S. dollar

International Bonds

• Japan– Samuri bonds - yen denominated issued by

non-Japanese firms in Japan– Euroyen bonds - yen denominated, sold outside

Japan

International Bonds

• Germany– DM-denominated bonds issued by foreign

companies are Eurobonds

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

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

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

Sources of Bond Quotes

• Bank and Quotation Record

• The Blue List of Current Municipal Offerings

• Wall Street Journal

• Barron’s

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

Corporate Bond Quotes

Cur Net Bonds Yld Vol Close Chg

ATT 81/8 22 7.7 52 1053/8 + 1/4



ATT 81/8 22 7.7 52 1053/8 + 1/4

Issued by AT&T



ATT 81/8 22 7.7 52 1053/8 + 1/4

Issued by AT&T

8.125% coupon rate



ATT 81/8 22 7.7 52 1053/8 + 1/4

Issued by AT&T

8.125% coupon rate

matures in 2022



ATT 81/8 22 7.7 52 1053/8 + 1/4

Issued by AT&T

8.125% coupon rate

matures in 2022

Current yield = coupon/market price = 7.7%



ATT 81/8 22 7.7 52 1053/8 + 1/4

Issued by AT&T

8.125% coupon rate

matures in 2022


52 of these bonds traded that day



ATT 81/8 22 7.7 52 1053/8 + 1/4

Issued by AT&T

8.125% coupon rate

matures in 2022



The closing price was 105 3/8% of par



ATT 81/8 22 7.7 52 1053/8 + 1/4

Issued by AT&T

8.125% coupon rate

matures in 2022



The closing price was 105 3/8% of par which was up 1/4 from the prior day


• Notations– “cv” = convertible– “zr” = zero coupon– “dc” = deep discount (at time of issue)

• Accrued interest must be added to price quoted

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


GOVT. BONDS & NOTES Maturity AskRate Mo/Yr Bid Asked Chg. Yld. 55/8 Dec 99n 100:08 100:10 …. 5.04


GOVT. BONDS & NOTES Maturity AskRate Mo/Yr Bid Asked Chg. Yld. 55/8 Dec 99n 100:08 100:10 …. 5.04

Prices are in 32nds usually with a very small spread between bid and ask


• 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

Municipal Bond Quotes200 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

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

The InternetInvestments 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

http://www.bonds-online.com/

http://www.prusec.com/daily.htm

http://www.fitchinv.com/

http://www.moodys.com/

http://www.standardandpoors.com/ratings

http://www.bradynet.com/

http://www.bondmarkets.com/

End of Chapter 15–Bond Fundamentals

Future topicsChapter 19

• The Analysis and Valuation of Bonds

Ch18 of Reilly & Brown

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