Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 18
 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?
 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?
 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?
 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?
 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)?
 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
Pi, t +1 + Int i, t
HPR i, t =
Pi, t
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
i
ETY =
(1 - T )
Where:
i = coupon rate of the municipal obligations
T = marginal tax rate of the investor
 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
 Corporate Bond Quotes
Cur Net
Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T
 Corporate Bond Quotes
Cur Net
Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T
8.125% coupon rate
 Corporate Bond Quotes
Cur Net
Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T
8.125% coupon rate
matures in 2022
 Corporate Bond Quotes
Cur Net
Bonds Yld Vol Close Chg
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%
 Corporate Bond Quotes
Cur Net
Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T 52 of these bonds traded that day
8.125% coupon rate
matures in 2022
Current yield = coupon/market price = 7.7%
 Corporate Bond Quotes
Cur Net
Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T 52 of these bonds traded that day
8.125% coupon rate
matures in 2022
Current yield = coupon/market price = 7.7%
The closing price was 105 3/8% of par
 Corporate Bond Quotes
Cur Net
Bonds Yld Vol Close Chg
ATT 81/8 22 7.7 52 1053/8 + 1/4
Issued by AT&T 52 of these bonds traded that day
8.125% coupon rate
matures in 2022
Current yield = coupon/market price = 7.7%
The closing price was 105 3/8% of par which was up 1/4
from the prior day
 Corporate Bond Quotes
• 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
Treasury and Agency Bond Quotes
GOVT. BONDS & NOTES
Maturity Ask
Rate Mo/Yr Bid Asked Chg. Yld.
55/8 Dec 99n 100:08 100:10 …. 5.04
Treasury and Agency Bond Quotes
GOVT. BONDS & NOTES
Maturity Ask
Rate 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
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
 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
 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 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
End of Chapter 15
–Bond Fundamentals
 Future topics
Chapter 19
• The Analysis and Valuation of
Bonds