Transcript Bonds - Bellevue College

Module 4
Bonds
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Module 4 - Learning Objectives
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Define bond issuer, par or face value, coupon rate, maturity date and call date.
Explain why entities issue bonds.
Explain how an investor makes money from bonds.
Define and calculate nominal yield, current yield, yield to maturity and yield to
call.
Define and differentiate Treasuries, municipal bonds, mortgage securities, and
corporate bonds.
Differentiate short, medium, long and zero coupon bonds.
Explain what credit rating measures.
Define bond fund.
Explain how an investor purchases a bond.
Evaluate a bond using yield, maturity, issuer, credit rating, and interest rate
environment.
Explain how to monitor bond investments with regards to interest rate, call and
credit risk.
Select a bond based on financial goals.
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Income is not rising but debt is
Consumer debt has doubled in the past 10 years
(Consumer credit $ millions - does not include mortgages)
3000000
2500000
2000000
1500000
1000000
500000
DRAFT 3/6/2007
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2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
0
People are raiding the piggy bank
Homeowner equity is falling as more debt is assumed
(Homeowner's equity/Value of Household Real Estate)
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1950-9
1960-9
1970-9
1980-9
Source: Mortgage Bankers Association
DRAFT 3/6/2007
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1990-9
2000-6
Spending power?
Personal Disposable Income and Outstanding Household Debt
$ Billions
12,000
10,000
Personal Disposable Income
Outstanding Household Debt
8,000
6,000
4,000
2,000
0
1979
DRAFT 3/6/2007
1984
1989
1994
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1999
2004
The big picture
http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?scp=1&sq=debt%20trap%202008-07-%20interactive&st=cse
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Which of the following factors can a lender use to evaluate your
credit?
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Gender
Age
Childbearing plans
Marital status
Change in marital status
Loans
Public assistance
Dependents
How long you’ve lived at
your house
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Alimony
Race
Color
National origin
People in the
neighborhood where you
want to buy
• How long you’ve had your
job
• Salary
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What does your credit report affect?
• Interest rates
• Job opportunities - Can your prospective employer
check your credit report?
• Insurance
• Ability to assume debt
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Analyze a credit report
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Your credit score
Types of credit
used
10%
Credit Rating
New credit
10%
Payment history
35%
Length of credit
history
15%
Source:
Amounts owed
www.myfico.com 30%
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Credit Scores
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Credit ratings and cost of credit
If your FICO
score is
Your interest
rate is
and your monthly
payment is
760 - 850
5.78%
$1,264
700 - 759
680 - 699
6%
6.18%
$1,295
$1,320
660 - 679
640 - 659
620 - 639
6.39%
6.82%
7.37%
$1,350
$1,411
$1,491
Source: www.myfico.com 3/21/07
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Credit Check-up
• Get a free credit report every year
www.annualcreditreport.com or call: 877322-8228
• Correct any errors by contacting the
company in writing – they must resolve the
error in 30 days
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Debt as an Investment
• Investors can get on the other side of the
fence by lending money to people or entities
who want to borrow
• Bonds are usually the investments
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True or False?
• You could go through your entire investing
life without investing in bonds.
• You should only invest in bonds when you’re
older.
• Stocks always return better than bonds.
• Bonds are boring investments.
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It is January, 2001. You are analyzing a T-bond $1000
face value that matures in January 2011 and has a
6.125% coupon.
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Who is the issuer of the bond?
How much will you get in interest per year?
How many years will you get the interest?
What will you get back when the bond
matures?
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Why do companies, governments, etc.
issue bonds?
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How have bonds done as investments?
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How do you make money from bonds?
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You can also have a gain or loss on a bond
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It boils down to two factor: coupon and
maturity.
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Pop quiz
• When interest rates go up, bond prices go where?
• When interest rates go down, bond prices go where?
• Shorter maturity bonds are more or less sensitive to
interest rate changes than longer maturity bonds?
• Smaller coupon bonds are more or less sensitive to
interest rate changes than larger coupon bonds?
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Figure this out
• On 2-22-01 you buy a Motorola $1000 face
value bond with a maturity date of 10-012097 and a coupon of 5.22. The bond has a
credit rating of A. Equivalent bonds are
giving 7.895%. Calculate the price of this
bond.
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Nominal Yield
• What the issuer pays on the par value of the
bond
• It is the return you get if you buy the bond
when it’s issued and hold it until it matures
• In a bond quote, annual interest is not given,
so you have to figure out annual interest by
using nominal yield and multiplying by par
value
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The following are $1000 par value bonds
and their coupon rates. What is the annual
interest on each?
• Ford Motor (car company) 6.7%
• Hewlett Packard (computers) 7.15%
• Kroger (supermarkets) 6.8%
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Current Yield
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Annual interest divided by price you paid
Let’s you know what you get every year
Might want to compare to other investments
Doesn’t consider what you sell for
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Calculate current yield
• Alcoa (aluminum manufacturer) $1000
par value bonds with a coupon rate of
6.5% and maturity of 10 years traded at
104.075. Calculate the current yield.
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Yield to Maturity
• May have bought a bond at a premium or
discount
• When the bond is redeemed, you will have a
capital loss or gain
• Yield to maturity takes this into consideration
• More complete measure of return from the
bond (includes interest and gain or loss)
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Calculate the yield to maturity
• It's 2-22-01 and you're evaluating a University of
North Carolina at Greenville $1000 par value bond
with a coupon of 6.0 and a maturity date of 04-012021. The bond is quoted at 111.225.
• What is the nominal yield?
• What is the current yield?
• What is the yield to maturity?
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Yield to Call
• Certain bonds may be called (redeemed before the
maturity date) by the issuer
• This can change your return on the bond
• Callable bonds are riskier and need to be assessed using
yield to call
• Similar to yield to maturity except earliest call date is
used rather than maturity date
• Yield to call is higher than yield to maturity when the
bond is bought at a discount
• Yield to call is lower than yield to maturity when the
bond is bought at a premium
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Calculate nominal yield, current yield, yield
to maturity and yield to call. You are
buying 3-1-00.
Entity
Alaska
Alabama
Valley
Alabama
Arkansas
Health
Arkansas
Hospital
Coupon
Rate
6.75
5.75
Maturity
Call Date
Quote
12-01-2033 6-1-2001
101.5
08-15-2023 08-15-2009 101.2
5.6
11-01-2016 11-01-2007 87.72
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06-01-2013
7.375
02-01-2030 02-01-2010 102.25
98.853
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Answer sheet
Annual
Interest
(Coupon
Rate as
Percent ×
$1000
Face
Value)
Maturity
Call
Date
Quote
Price
(Quote
as
Percent
× $1000
Face
Value)
6.75
12-012033
6-12001
101.5
$1015
$67.50
Alabama
5.75
08-152023
08-152009
101.2
$1012
$57.50
Valley
Alabama
5.6
11-012016
11-012007
87.72
$877.2
$56
Arkansa
s Health
5
06-012013
Arkansa
s
Hospital
7.375
02-012030
Entity
Coupon
Rate
Alaska
02-012010
98.853 $988.53
$50
102.25 $1022.5
$73.75
Current
Yield
(Annual
Interest ÷
Price)
$67.50 ÷
$1015 =
6.65%
$57.50 ÷
$1012 =
5.68%
$56 ÷
$877.2 =
6.38%
$50 ÷
$988.53 =
5.06%
$73.75 ÷
$1022.50 =
7.21%
Yield to Call
(From
Calculator)
Yield to
Maturity
(From
Calculator)
5.64
6.64
5.58
5.66
7.75
6.85
Noncallable
5.12
7.05
7.19
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US Bond Choices
US Bonds Outstanding 2007
Total $32 T
US Bonds Issued 2007
Total $6.2 Trillion
AssetBacked
Federal 15%
Agency
Securities
15%
Corporate
Debt
18%
Municipal
7%
Treasury
12%
Mortgage
-Related
33%
AssetBacked
13%
Federal
Agency
Securities
9%
Corporate
Debt
19%
Municipal
8%
Treasury
15%
AssetBacked
8%
MortgageRelated
28%
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Sterling Other
6%
5%
Yen
0%
World Bonds 2007
Total $56 T
US
39%
Euro
50%
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Choices - Treasuries
Deficit $9 T (12/06)
Type
Maturity
T-bills
3, 6, or 12
month
2, 3, 5, or 10
years
T-bonds 11-30 years
T-notes
Features
Sold at a discount to face value. The difference between
what you paid and the face value (what you get at
maturity) is the interest. The 90-day or 3-month interest
rate is an important benchmark.
Pays interest semiannually.
Pays interest semiannually.
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Who do we owe?
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Choices - Municipal Bonds
• Issued by state and local government
• May have tax advantages (be careful--not all muni
interest is tax free)
• Not as safe as treasuries but still relatively safe
• May be backed by tax revenues or revenues of
facility
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Evaluating Munis
• It is 02-22-2001. You're looking at two bonds given
the same credit rating by Standard and Poor’s.
Calcualte their yields and explain why the yields are
different.
• .Coca Cola with a maturity date of
09/15/2022 and a coupon of 8 is quoted at
117.325.
• .Pennsylvania State Health Services with a
maturity date of 01/01/2022 and a coupon of
5.75 is quoted at 101.812.
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Choices - Mortgage-backed Securities
• Mortgage-backed securities
are created when individual
homeowner mortgages are
bundled and sold to investors
• May be guaranteed by Ginnie
Mae, Fannie Mae, or Freddie
Mac
• Irregular payments because
homeowners may prepay
mortgage--based on average
life rather than maturity
• Highest risk of prepayment
when interest rates fall--bad
for bondholder
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Evaluate these
The following table lists mortgage securities quoted on 5-9-00.
Explain what each column is.
How risky are these investments?
If you were about to retire, which one would you choose?
Issuer
FNMA
FHLMC
GNMA
FHLMC
FNMA
CUSIP
31359U
BF1
3133TC
HA9
3837H0
6R9
3133TE
QJ6
31359U
BD6
Coupon
Maturity
Date
Quote Yield to Maturity
Average Life
6.00
11-18-15
97.521 7.48
1.80
6.00
05-15-20
94.092 7.72
4.25
7.00
4-20-27
89.952 8.52
10.83
6.5
7-15-28
84.428 8.16
20.49
6.0
02-18-07
99.494 7.67
0.23
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Choices - Corporate Bonds
Types of
Bonds
Companies
Influencing Factors
Industrial
Manufacturers, retailers, mining, energy,
service
Business cycle
Financial
Services
Banks, brokerage, insurance
Interest rates
Public Utilities
Telephone, electric, gas, water
Transportation
Airlines, railroads, trucking
Regulations,
legislation
Oil prices
• Issued by large corporations to finance their business.
• Listed on the NYSE or sold over the counter.
• Some corporations offer convertible bonds.
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Evaluate this
• Amazon issued $681 million in convertible 10-year
notes in 1999. The coupon rate was 6 7/8%. Each
$1000 bond is convertible to 9.529 shares of
Amazon stock. In early 2001, Amazon is selling at
about $15 a share. If you are holding these bonds,
would it be more profitable to convert to stock or
hold the bond? Give your reasons why.
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Choices - Maturity
• During normal
economic expansion,
the longer the term the
higher the interest rate
• This is because the
longer the term, the
higher the risk
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The date is 2-22-2001. You are evaluating three
municipal bonds. Calculate the yield to maturity
for each and discuss why they might be different.
• New York Metropolitan Transit Authority bond quoted at
109.603 with a coupon of 5.4. Maturity date is 04-01-2011.
Credit rating is AAA.
• Philadelphia General Purpose bond quoted at 98.234 with a
coupon of 4.9. Maturity date is 09-15-2021. Credit rating is
AAA.
• King County General Purpose bond quoted at 101.25 with a
coupon of 5.25. Maturity date is 01-01-2034. Credit rating is
AAA.
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Choices - Zero Coupon Bonds
• Pros:
– Can buy bond with little money upfront
– Bigger gains if interest rates fall
• Cons:
– Bigger losses if interest rate rise
– Don’t hear from borrower for a long time
– Taxed even though you don’t have the cash
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The effect of interest rate changes on
zeros
• Last year. You bought a 30-year par value
$1000 zero coupon bond that yielded 6%.
Calculate the price you paid.
• This year. Interest rates have fallen to 5%.
Calculate the value of your zero coupon
bond.
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Choices - Credit Ratings
Bond Credit Rating and Default Rates
Percent Defaults
100
90
80
70
Investment
Grade
60
50
Junk
40
30
20
10
0
AAA
AA
Source: Moody's
A
BBB
BB
B
CCC
D
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Bond Ratings
Investment Grade
Best quality. Interest payments are protected
by earnings and principal is secure. Actual
default rate less than 2%.
Protection on interest is not as high as Aaa
but still high quality. Actual default rate less
than 2%.
Over the long term, some risk to investment.
Actual default rate less than 5%.
Adequate for now but may be unreliable over
time. Actual default rate 5%.
Non Investment Grade
Future is not certain. Moderate protection of
interest and principal. Some speculation.
Actual default rate 17%.
Small protection of interest and principal.
Actual default rate 26%.
Poor standing. May be in default. Actual
default rate over 40%.
Often in default. Highly speculative.
Extremely poor prospects. In default.
Moody's
Standard
and Poor's
Quality
Aaa
AAA
High grade
Aa
AA
High grade
A
A
Medium
Baa
BBB
Medium
Ba
BB
Speculative
B
B
Speculative
Caa
CCC
Default
Ca
CC
Default
Poor
Investment
C
C
No
interest.
D
In default.
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Calculate the yield and explain any
differences.
Company
Daimler
Chrysler
Conseco
Xerox
Owens
Corning
Pacific Gas
Coupon
Quote
Maturity
Date
Credit
Rating
8.5
103.950
01/18/2031 A
6.4
.57
100
35.625
06/15/2011 BB04/21/2018 BB+
7.5
30.50
08/01/2018 D
8.25
91
11/01/2022 CCC
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Even countries have credit ratings. Consider the current
economic status of the following countries. What would
you guess the rating of their debt would be?
• Here's a guideline: the U.S. is Aaa, China is A3, Brazil is B2, and Russia is
B3. Once you have made your guesses, go out to the web and check out
www.moodys.com. You'll find country ratings under Ratings/Sovereign
Ratings.
 United Kingdom
 Mexico
 Argentina
 Bahamas
 Canada
 Israel
• Colombia
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Bond Funds
• About 8000 bond funds with 15% of mutual
fund assets.
• For investors who don’t want to buy
individual bonds.
• Some pros believe that small investors should
only buy bond funds.
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Go to www.bloomberg.com
http://www.morningstar.com/
Check out the bond fund returns.
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Buying Bonds
• Treasuries - direct from government, broker, unit
trust, or fund
• Municipal bonds - broker, unit trust, or fund
• Mortgage-backed bonds - broker, unit trust, or fund
• Corporate bonds - broker, unit trust, or fund
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Interest Rate Food Chain
Risk and return
holds for bonds as
well. Less risk means
less return.
Muni bonds typically
give the lowest
interest because of
tax status.
Treasuries are next.
They’re safe.
Mortgage-backed are
safe but they have
call risk.
Corporate bonds are
the riskier with junk
being extremely
risky. But yields are
also better.
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Assess Interest Rate Risk – Are we at a high
point or low point for bond interest rates?
Historical Interest Rates
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Corporate Baa
90-Day T-Bill
16
Corporate AAA
14
5-Year T-Note
12
30-Year T-Bond
8
6
4
2000
2000
1999
1998
1998
1997
1997
1996
1996
1995
1994
1994
1993
1993
1992
1991
1991
1990
1990
1989
1989
1988
1987
1987
1986
1986
1985
1984
1984
1983
1983
0
1982
2
1982
Percent
10
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Monitor
• Monitor your bonds. They can change.
– Interest rate risk: What is the interest rate
environment when you buy? How is it changing?
– Call risk: Call risk is highest when interest rates
drop.
– Credit risk: Issuers can undergo drastic changes
in financial viability. Keep tabs on this.
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