Transcript The Bond Market - Villanova University

THE BOND MARKET
A Deeper Understanding of a
Major Economic Market
Based on presentations by Emma
Ricci and Meghan Barnes
WHAT IS A BOND?
A bond is a loan, a `debt security`.
When you purchase a bond, you are
lending money to a government,
municipality, corporation, federal
agency or other entity known as the
issuer.
Components
The issuer, similar to a holder of an
option
Principal amount, usually $1000
Specified interest rate; paid to the
issuer yearly (also known as the
coupon)
Date of maturity
Example
In 2004, Radnor township issued bonds
for a total of $50 million, in order to pay
for the new Middle School building
The maturity was 20 years
The coupon was 5.5 %
The bond was callable (the township
could pay off the bond early)
Issuers of Bonds
Corporations

Finance Operations
Federal Government


Treasury Securities
Bills, Notes, & Bonds
Federal Agencies

Government
Sponsored Enterprises
Municipal Governments
and Agencies



Munis are “Tax Exempt”
General Obligation
Revenue
Foreign Governments
and Corporations

Yankee Bonds
Special Types of Bonds
Floating Rate Bonds


Interest Payments Change Over the Life of the
Bond
Rate is Tied to a Financial Benchmark such as the
LIBOR
Convertible Bonds

Can be Exchanged for Other Securities
Types of Bonds, Continued
High-Yield / Junk Bonds



Speculative Grade Bonds
Rated below Baa by Moody’s or BBB by S&P
Greater Risk = Higher Yield
Asset-Backed Bonds

Securitized by Some Financial Asset
Zero Coupon Bonds


Do Not Pay Coupons
Sold at a Large Discount
Premium vs. Discount
Premium bonds: price > par value
YTM < coupon rate
Discount bonds: price < par value
YTM > coupon rate
Par bonds: price = par value
YTM = coupon rate
Trading Bonds / Bond Prices
Usually Issued in Par Values of $1,000

Price is Usually Closest to Par at the Time it is First
Issued
Dealers Post Bid and Ask Prices
Prices Listed Daily in the Wall Street Journal
Down to 1/8 of a Dollar
Price is Equal to the Present Value of the
Expected Future Cash Flows
P= C/(1+r)1 + C/(1+r)2+ C/(1+r)3 +…+ C/(1+r)n
+ M/(1+r)n
Yield Curve
Shows the Relationship Between ShortTerm and Long-Term Yields on
Securities
Slope can be Upward, Downward, or
Horizontal
Right Now, They are All Upward Sloping

Longer Time to Maturity = Higher Yield
Current Yield Curves
3 mo
6 mo
1 yr
2 yr
3 yr
5 yr
7 yr
10 yr
20 yr
30 yr
1.) Treasury Yield Curve
Bond Market Yield Summary
March 29, 2002
Treasury AAA Agency AAA Corporate AAA Municipal
1.77
2.10
2.66
3.15
3.09
2.13
3.71
3.95
4.14
2.69
4.09
4.52
4.57
3.15
4.80
5.35
5.42
3.66
5.20
5.96
5.94
4.15
5.39
6.28
6.25
4.42
6.00
6.90
6.70
5.15
5.78
6.50
6.92
5.33
2.) Agency AAA Yield Curve
3.) Corporate AAA Yield Curve
4.) Municipal AAA Yield Curve
Price vs. Yield
Prices Continually Fluctuate With Changes in
Interest Rates
Interest Rates h, Prices i
Interest Rates i, Prices h
Rates of Older Issues Change to Match Those
of New Issues
Longer Maturity Means More Likely Price Will
Be Affected By Changes in Interest Rates
Tax Status
Some Offer Special Tax Advantages
No State or Local Income Tax on U.S.
Treasury Bonds or Munis
Wanting Taxable or Tax-Exempt Income
Depends on:


Your Income Tax Bracket
The Difference Between What Can Be Earned
From Taxable Versus Tax Exempt Securities
Bond Ratings –
Measuring Default Risk
Nationally Recognized Statistical Rating
Organizations
Henry Varnum Poor


Compiled Financial Data About Canals & Railroads
Updated the Directory of Railroads, Canals and
Steamship Lines in the United States
Poor’s Publishing


Successor of Henry, Collaborated with John Moody
Later Went Their Separate Ways
Ratings, Continued
Moody’s Began Producing “Moody’s Investor’s
Manual”
Poor’s Publishing Published its Own Bond
Ratings

Then Merged with the Standard Statistical Bureau
to Form Standard and Poor’s
Other Rating Agencies Today


Fitch Investor Service
Duff and Phelps
The Rating Process
Standard and Poor’s Process as example:
Rating Request
Issuer Meeting
Rating Committee Meeting
Notification and Appeal
Dissemination
Surveillance
Definition of the
Ratings/Default Risk
Moody's
S&P
Aaa
AAA
Aa1
AA+
Aa2
AA
Aa3
AAA1
A+
A2
A
A3
ABaa1
BBB+
Baa2
BBB
Baa3
BBBBelow this line,
Ba1
BB+
Ba2
BB
Ba3
BBB1
B+
B2
B
B3
BCaa1
CCC+
Caa2
CCC
Caa3
CCCCa
C
D
-
Fitch
DCR
Definition
AAA
AAA
Prime. Maximum Safety
AA+
AA+
High Grade Quality
AA
AA
AAAAA+
A+
Upper Medium Grade
A
A
AABBB+
BBB+
Lower Medium Grade
BBB
BBB
BBBBBBbonds are classified as "junk bonds"
BB+
BB+
Non Investment Grade
BB
BB
Speculative
BBBBB+
B+
Highly Speculative
B
B
BBCCC
CCC
Substantial Risk
In Poor Standing
Extremely Speculative
May be in Default
DDD
Default
DD
DD
D
DP
Higher Rating Means
Less Risk that the
Issuer Will Default on
Payments
Lower Rating Means
Higher Risk

Purchaser is
Compensated with a
Higher Yield for Taking
on this Additional Risk
Factors Effecting Default Risk
Earnings Variability

More Volatile Earnings Could Mean a Greater
Possibility of Losses Exceeding Ability to Raise
Funds
Age of the Firm

If a Firm has a Well Established History of No
Defaults, Investors Have More Confidence in its
Continued Success
Current Leverage


Using Greater Financial Leverage Could Mean
Greater P/E Ratio
But Could Also Mean that by Using More Borrowed
Funds Rises Relative to Equity, and Risk of
Declines in Net Earnings Increases
Risk vs. Yield
Risk and Yield are
Directly Related
The Risk Involved in
an Investment
Includes the Risk
Free Rate Plus the
Default Risk
Premium
Callable Bonds
Call Privileges

Gives the Issuer the Right to Retire a Bond Prior to
Maturity
Call Risk



Known as Reinvestment Risk
Bonds Will Be Called When Interest Rates are
Falling
Investors May Earn Less Than Their Expected
Yield
If an Investor is Long a Callable Bond, then
Callable Bond Price =
Noncallable Bond Price – Call Option Price
Callable Bonds, Continued
Call Premium

Purchaser is Compensated for Higher Risk
 If Rates are High and Going to Fall, there Will
Be a Higher Call Premium
 If Rates are Low and Going to Rise, there Will
Be a Lower Call Premium
Advantage is for the Issuer
Disadvantage is for the Purchaser
Putable Bonds
Purchaser Buys Nonputable Bond and a Put
Option from the Issuer
Purchaser has the Right to Sell the Bond to
the Issuer at a Certain Predetermined Time
and Price
If Investor is Long a Putable Bond, then

Putable Bond Price =
Nonputable Bond Price +Put Option Price
Current Price vs. Strike Price
Callable Bonds
If P>E, intrinsic value is
P-E and option is “in the
money”
If P=E, intrinsic value is
0, option is “at the
money”
If P<E, intrinsic value is
0 and option is “out of
the money”
Putable Bonds
If P<E, intrinsic value is
E-P and option is “in the
money”
If P=E, intrinsic value is
0 and option is “at the
money.”
If P<E, intrinsic value is
0 and option is “out of
the money.”
P=Current Bond Price,
E=Strike Price
Bonds vs. Certificates of
Deposit
Bonds
Issued by Govt. or
Companies
Capital Market
Not Insured by Govt.
CDs
Issued by Banks
Money Market
Insured by Federal
Govt. up to $100,000
•Both could have a Call Option Attached and Expose
the Purchaser to Reinvestment Risk
Stocks vs. Bonds
Stocks
Capital Gain/Loss

Unlimited Upside
Potential with Unlimited
Downside Risk
Part Owner
Dividends

Company may change it
or decide not to pay one
at all
Bonds
Fixed Income
Creditor
Guarantee of
Principal Payment

Default Risk
DIVERSIFICATION: depending on your income and
ability to take risk, you will choose a different path.