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Learning Objectives1. Explain the fundamental characteristics of a bond

issue.2. Explain the meaning and impact of bond ratings.3. Understand how to read bond quotes in the

financial press.4. Explain differences among various concepts of

yield such as: Current yield; Yield-to-maturity; Yield-to-call; Anticipated Realized Yield.

5. Bond Duration and Portfolio Immunization

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Bond and Fixed-Income Fundamentals

Secured and Unsecured Bonds Perpetual Bonds Sinking Fund Provisions Call provision Bond Ratings Junk Bonds Bond Quotes

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11-2

The Bond Contract A bond normally represents a long term contractual

obligation of the firm to pay interest to the bondholder as well as the face value of the bond at maturity.

Par value is the face value of the bond. Coupon rate is the actual rate on the bond. Zero-Coupon bonds are deep discount bonds which

compensate the investor through capital appreciation. Maturity date is the date on which the par value is paid.

Serial payment under which bonds are paid off in installments over the life of the issue.

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Bond Indenture

A bond indenture is a legal document which covers the major provisions in a bond agreement, administered by an independent trustee. Sinking Fund Provision Call Provision Put Provision

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Secured Bonds

A mortgage bond is backed by real property pledged as a collateral.

Equipment trust certificates are used by firms in the transportation industry.

Proceeds from the sale of certificates are used to purchase new equipment which serves as collateral for the certificate.

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Unsecured Bonds

Federal, state and local government issues are unsecured.

Debentures are long-term corporate unsecured bonds. Senior, Junior, Subordinated.

Income bonds require interest to be paid only to the extent that it is earned as current income. Failure to make interest payments will not force the firm into bankruptcy.

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The Composition of the Bond Market

Federal government is the single largest borrower. T-bills, T-notes, T-bonds and T-Strips Treasury Inflation Protection Securities (TIPS)

Federally Sponsored Credit Agency Issues Federal Home Loan Bank Export-Import Bank Federal Intermediate Credit Banks Federal Farm Credit Bank

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Bond Market Investors

The bond market is dominated by large institutional investors.

They account for the more than 85% of trading. Individual investors are active in low denomination

($1000) corporate bonds & tax-free municipal bonds and through bond mutual funds.

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Bond Market Investors (Cont.)

Banks are strong participants in the municipal bond market.

Foreign investors bank roll 10-15% of U.S. Government debts.

The bond market is a strong primary market but a relatively weak secondary market.

Bonds generally trade O.T.C. except for a few that are listed on NYSE and AMEX.

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Bond Ratings Sources

Two major bond-rating agencies are: Moody’s Investor Services, a subsidiary of Dunn

& Bradstreet. Standard & Poor’s, a subsidiary of McGraw Hill.

Secondary bond-rating agencies are: Fitch Investors Service Duff & Phelp, Inc.

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Bond Ratings

A bond rating measures the likelihood of default. Financial ratio analysis accounts for half of the evaluation.

Analysts also consider cash flow, earnings measures and industry factors.

Bond yields and bond ratings are inversely related.

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Fundamentals of the bond Valuation Process

The Value of a Bond.

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Computing Bond YieldsYield Measure Purpose

Nominal Yield Measures the coupon rateCurrent yield Measures current income rate

Promised yield to maturity

Measures expected rate of return for bond held to maturity

Promised yield to call

Measures expected rate of return for bond held to first call date

Realized (horizon) yield

Measures expected rate of return for a bond likely to be sold prior to maturity. It considers specified reinvestment assumptions and an estimated sales price. It can also measure the actual rate of return on a bond during some past period of time.

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Rates of Return Approximate Promised Yield

APY = C + (Par – Market Price)/ NMaruity .60 ( Market Price) + .4 (Par)

 Yield to Call:AYC = C + (Call Price – Market Price)/ NCall

.60 ( Market Price) + .4 (Call Price) Approximate Realized Yield

ARY = C + (Realized Price – Market Price)/ NRealize .60 ( Market Price) + .4 (Realize Price)

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Corporate Bond Quotes

Cur Net Bonds Yld Vol Close Chg ATT 81/8 22 7.7 52 1053/8 + 1/4Issued by AT&T

8.125% coupon ratematures 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

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Term Structure of Interest Rates

The relationship between maturity and interest rates. It is also known as the Yield Curve.

Expectations Hypothesis suggests that the long-term rate is an average of the expectations of the future short-term rates over the applicable time horizon.

Reinforced by borrower/lender strategies.

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Maturity

Yield

c

Maturity

Yield

a

Yield

Maturityb

Maturity

Yield

d

Normal

Figure 12-1 Term Structure of Interest Rates

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The Movement of Interest Rates (cont.)

Liquidity Preference Theory states that the shape of the yield curve is upward sloping. Investors will pay a higher price for short-term securities because they are more easily turned into cash without the risk of large price changes.

Investors demand higher returns from longer-term securities.

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The Movement of Interest Rates (cont.)

Market Segmentation Theory focuses on the demand side of the market. Banks tend to prefer Short Term liquid securities

to match the nature of their deposits. Life insurance companies invest in Long-Term

bonds to match their Long-Term obligations.

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10 20 308% 127.18% 139.59% 145.25%10 112.46 117.16 118.9312 100.00 100.00 100.0014 89.41 86.55 85.96

Source: Reprinted by permission from the Thorndike Encyclopedia of Banking and f inancial tables, 1981. Copyright ©1981, Warren, Gorham and Lamont Inc. 210 South Street, boston MA. All rights reserved.

Bond Value table

Yield to Maturity

Coupon Rate 12 percentNumber of Years

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Investment Strategy: Interest-Rate Considerations

Bond Pricing Rules 1. Bond prices and interest rates are

inversely related. 2. Prices of long-term bonds are more

sensitive to a change in yields to maturity than short-term bonds.

3. Bond price sensitivity increases at a decreasing rate as maturity increases.

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Investment Strategy: Interest-Rate Considerations (cont.)

4. Bond prices are more sensitive to a decline in market YTM than to a rise in YTM.

5. Prices of low-coupon bonds are more sensitive to a change in YTM than high coupon bonds.

6. Bond prices are more sensitive when YTM is low than when YTM is high.

7. Margin trading magnifies profits and losses of bond investments by a factor of 1/(margin requirement).

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What Determines the Price Volatility for Bonds

Five observed behaviors1. Bond prices move inversely to bond yields (interest rates)2. For a given change in yields, longer maturity bonds post larger price

changes, thus bond price volatility is directly related to maturity3. Price volatility increases at a diminishing rate as term to maturity

increases4. Price movements resulting from equal absolute increases or

decreases in yield are not symmetrical5. Higher coupon issues show smaller percentage price fluctuation for

a given change in yield, thus bond price volatility is inversely related to coupon

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What Determines the Price Volatility for Bonds

The maturity effect The coupon effect The yield level effect Some trading strategies

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The Duration Measure

Since price volatility of a bond varies inversely with its coupon and directly with its term to maturity, it is necessary to determine the best combination of these two variables to achieve your objective

A composite measure considering both coupon and maturity would be beneficial

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The Duration Measure

Developed by Frederick R. Macaulay, 1938Where: t = time period in which the coupon or principal payment occurs

Ct = interest or principal payment that occurs in period t

i = yield to maturity on the bond

price

)(

)1(

)1()(

1

1

1

n

tt

n

tt

t

n

tt

t CPVt

iC

itC

D

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Characteristics of Duration Duration of a bond with coupons is always less than its

term to maturity because duration gives weight to these interim payments A zero-coupon bond’s duration equals its maturity

There is an inverse relation between duration and coupon There is a positive relation between term to maturity and

duration, but duration increases at a decreasing rate with maturity

There is an inverse relation between YTM and duration Sinking funds and call provisions can have a dramatic

effect on a bond’s duration

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Modified Duration and Bond Price Volatility

An adjusted measure of duration can be used to approximate the price volatility of a bond

mYTM1

durationMacaulay duration modified

Where:

m = number of payments a year

YTM = nominal YTM

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Duration and Bond Price Volatility Bond price movements will vary proportionally with

modified duration for small changes in yields An estimate of the percentage change in bond prices

equals the change in yield time modified duration

iDPP

mod100Where:P = change in price for the bondP = beginning price for the bondDmod = the modified duration of the bondi = yield change in basis points divided by 100

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Trading Strategies Using Duration Longest-duration security provides the maximum price

variation If you expect a decline in interest rates, increase the average

duration of your bond portfolio to experience maximum price volatility

If you expect an increase in interest rates, reduce the average duration to minimize your price decline

Note that the duration of your portfolio is the market-value-weighted average of the duration of the individual bonds in the portfolio