Bonds and Fixed Income Fundamentals |1

BONDS, often referred to as FIXED INCOME SECURITIES are negotiable, publicly traded, long-term debt securities where the bondholders are actually lending money to the issuer Why consider bonds in your portfolio? Bonds reduce risk through diversification. Bonds produce steady current income. Bonds can be a safe investment if held to maturity. Bonds are less risky than stocks, although their returns are lower as well. If interest rates drop, bond prices will rise. Exposure to Risk 1. Interest Rate Risks major cause of price volatility in the bond market market interest rate - bond prices as interest rates become volatile, so do bond prices 2. Purchasing Power Risks inflation erodes the purchasing power of money creating purchasing power risk when inflation is low, bonds do pretty well 3. Business/Financial Risk a.k.a. Credit risk or Default risk issuer defaults on interest and/or principal payments 4. Liquidity Risk risk that a bond will be difficult to sell at a reasonable price if investor wants to sell it 5. Call Risk/Prepayment Risk risk that bond will be called (retired) before its scheduled maturity date Features of a Bond Principal/Par value face amount of the bond, which is paid at maturity (remains fixed over its life). Coupon interest rate stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest. Maturity date the date when the bond must be repaid. Term bonds carry a single maturity date Serial bonds have a series of maturity dates Principles of Bond Price Behavior Lower market rates lead to higher bond prices The greater the moves in interest rates, the greater the swings in bond prices

PROVISIONS 1. CALL FEATURES the bond is called or retired before maturity date; the net result the investor is left with much lower rate of return than anticipated work for the benefit of the issuer 3 types of call features: a. Freely callable retire at any time b. Noncallable cannot be retired prior to maturity c. Deferred call noncallable during deferment period and becomes callable thereafter 2. SINKING FUNDS provision specifying how the issuer will pay off the bond is over time obligates the issuer to pay off promptly or else be in default 3. REFUNDING PROVISION some bonds (temporarily) prohibit the issuer from paying off one bond with the proceeds from another by including a refunding provision BOND RATING indicate the amount of redit riindicate the amount of redit risk embedded in a bond and are widely used by fixed-income investors rating agencies o Moodys o Standard & Poors o Fitch Investors Service lesser known

- the higher the rating, the lower the yield - Bonds with below investment-grade ratings are called highyield bonds or junk bonds. - ratings change as the financial condition of the issuer changes
Credit Rating PHILIPPINES S&P BBBMOODYSStable BAA3 FITCH Positive BBB= Lower Medium Grade - Adequate capacity to pay principal and interest but possibly lacking certain pprotective elements against adverse economic conditions

Premium bond one that sells for more than its par value Discount bond sells for less than par

Bonds and Fixed Income Fundamentals |2

SECURED OR UNSECURED DEBT A. Senior Bonds secured obligations, backed by a legal claim on some specific property of the issuer Mortgage bonds secured by real estate Collateral trust bonds backed by financial assets owned by the issuer but held in trust by a third party Equipment trust certificates secured by specific pieces of equipment First and Refunding bonds combination of first mortgage and junior lien bonds B. Junior Bonds unsecured, backed only by the promise of the issuer to pay interest and principal on a timely basis Debenture backed by the good name of the issuer Subordinated debentures have claim on income secondary to other debenture bonds Income bonds require that interest be paid only after a certain amount of income is earned A. MAJOR MARKET SEGMENTS 1. Teasury bonds backed by full faith and credit of the government , dominant force in the fixedincome market carry 30-year maturity exempt from state or local taxes Treasury Inflation Protected Securities (TIPS) 2. Agency bonds issued by various gencies and organizations of the government very high quality securities that have almost no risk of default 3. Municipal bonds (munis) issued by state and local governments in the form of either general obligation (backed by full faith, credit and taxing power of the issuer) or revenue bonds (serviced by the income generated from specific incomeproducing projects Taxable Equivalent Yield measures the level of return a fully taxable bond would have to provide in order to match the after-tax return of a lower-yielding, tax free issue unsecured and has low claim on asset called junk because of their high risk of default

CONVERTIBLE SECURITIES/BONDS Basic features and characteristics: a. They are initially issued as bonds, but can subsequently be converted into shares of common stock. b. They offer investors a stream of fixed income (annual coupon payments), plus an eequity kicker (a conversion feature). c. The value of a convertible is driven by the price behavior of the underlying common stock (when the stock price is at or above its conversion price), or by market interest rates and the behavior of the bonds (when the stocks price is well below its conversion price) d. The two key values of a convertible are: its conversion (stock) value its investment (bond) value

MEASURING THE VALUE OF A CONVERTIBLE 1. CONVERSION VALUE indicates what a convertible issue would trade for if it were priced to sell on the basis of its stock value

Conversion Equivalent/Conversion Parity indicates the price at which the common stock would have to sell in order to make the convertible security worth its present marke price.

Conversion Premium the extent to which the market price of the convertible exceeds its conversion value

4.

Corporate bonds make up the majornongovernment secto of the market and are backed by the assets and profitability of the issuing companies

Payback Period a measure of the length of time it will take to recover the conversion premium from the extra interest income earned on the convertible.

B. SPECIALTY ISSUES bonds possessing unusual issue characteristics coupon or repayment provisions that are out of the ordinary 1. Zero-Coupon bonds no coupons rather, sold at a deep discount from their par values and then increase in value over time at a compound rate of return. The cheaper the zero-coupon bond rate, the greter the return an investor can earn. 2. Mortgage-Backed Securities secured by a pool of residential mortgages 3. Asset-Backed Securities backed by pools of auto loans, credit card bills, and home equity lines, as well as computer leases, hospital receivables, small business loans, truck rentals, and even royalty fees. 4. Junk bonds or high-yield bonds highly speculative securities that have received low, sub-investment-grade ratings (typically Ba or B)

2.

INVESTMENT VALUE the price at which the bond would trade if it were nonconvertible and if it were priced at or near the prevailing market yields of comparable nonconvertible bonds