Transcript VI. DEBT SECURITIES

VI. DEBT SECURITIES
A. Bonds
1.
Defined as debt obligations issued by government,
governmental agencies, and corporations
a.
b.
c.
d.
Par – Face value (usually $1,000, quoted as a percentage
– 100 or more or less) – bonds are issued at par, but the
market value of a bond can be more or less than par
Discount – When a bond sells for less than par
Premium – When a bond sells for more than par
Coupon – The annual interest rate paid as a percentage of
par. Bonds generally pay semi-annually (twice per year),
at one-half of the coupon rate per payment (originally,
coupons were attached to the physical bond certificate,
then “clipped” and presented to the corporation for
payment
A. Bonds
e. Interest Rate – The fixed percentage of par paid annually
(in two payments) to the bondholder
f. Bondholder – An individual or institution that purchases
bonds, becoming a creditor of the corporation
g. Issuer – The government, governmental agency, or
company that sells the bond
h. Maturity – Date upon which the issuer of a bond must
return the original principal amount of the bond plus the
final interest payment to the bondholder
i. Floating an Issue – The government, governmental
agencies, and corporations issue bonds with a set coupon,
and, based upon demand, may issue more
A. Bonds
Indenture – The legal agreement governing the terms of
the bond issue
k. Book Entry Bond – A bond that is registered electronically,
with no physical certificate issued
l. Bearer Bond – Has no investor name when it is issued,
whomever possesses the certificate has a right to receive
interest payments and repayment of principal
m. Secondary Market – Similar to a stock exchange, where
bonds are bought or sold by brokers – the money for
purchase or sale goes to the seller or purchaser, like
stocks, bonds bought on the secondary market do not
provide any additional funds to the issuer
j.
A. Bonds
2. Types of Bonds
a. Government Securities
Treasury Bills – Issued by the United States
government, backed by the full faith and credit of the
United States government – the safest security,
matures in 26 weeks or less, sold at a discount and
matures at par
ii. Treasury Notes – 2, 3, 5 and 10 year maturities, pay
interest every six months (semi-annually), with a fixed
coupon
iii. Treasury Bonds – 10+ year maturities, pay interest
semi-annually, fixed coupon
i.
A. Bonds
iv. Strips – Created by broker-dealers, consist of bonds
sold at a discount with no interest payments
v. Treasury Inflation Protected Securities (TIPS) – Have a
semi-annual fixed rate coupon, with par (face) value
adjusted twice per year based upon changes in the
Consumer Price Index
vi. Municipal Bonds – Issued by state and local
governments and governmental agencies, may not be
as credit worthy as Treasuries, generally exempt from
federal income tax and from state taxes for purchasers
who live in the state of issue
• General Obligation – where interest and principle are paid from
tax revenues.
• Revenue Bond – paid by specific fees collected by the issuer.
A. Bonds
b. Agency Securities – Issued by government
sponsored entities, implicitly backed by the
issuing government, but explicitly backed by
the issuing agency – provide higher yields
than direct government securities, with
somewhat higher risk – See:
A. Bonds
c. Corporate Bonds – Debt securities issued by
corporations, have a greater claim on the
firm’s assets than equity instruments, backed
only by the issuing company, with risk
quantified by rating agencies
d. Commercial Paper – Similar to Treasury Bills,
issued by corporations at a discount, with a
maturity of 90 days or less
A. Bonds
B. Other Types of Debt Securities
1. Money Market Funds – Short term investments
consisting of a pool of short term debt securities,
“marked to market” daily so that face value ($1.00)
never changes, but interest yields change daily
2. Asset Backed Securities – Debt obligations backed
or “collateralized” by other forms of debt
a. Government agency asset backed securities – Consist of
“pools” of mortgages, with repayment of principal and
interest guaranteed by the full faith and credit of the United
States government Welcome to Ginnie Mae ,
http://www.ginniemae.gov/investors/ocs_pdf/2008-088.pdf
REMIC Definition
B. Other Types of Debt Securities
b. Quasi Governmental Agency Securities – Issued by
corporations originally organized as governmental
agencies, with the implicit understanding that repayments
of principal and interest are guaranteed by the federal
government – see:
c. Collateralized Mortgage Obligations – Backed by “pools” of
mortgages, can be issued by GNMA, FHLMC, or by
investment banks – see:
d. Certificates of Automobile Receivables – Backed by pools
of car loans – see:
B. Other Types of Debt Securities
3. Certificates of Deposit (CDs) – Issued by banks, fully
federally insured through the FDIC up to $250,000
per person or corporation per bank – see:
4. Annuities – Issued by insurance companies,
designed to provide retirement income – provides a
future stream of monthly payments for investment of
a lump sum, often with a fixed interest rate – the
dollar value of payments varies depending upon the
assumed interest rate – see:
5. Guaranteed Investment Contracts – Issued by an
insurance company with a guaranteed interest rate
and a specific term (similar to a bond), however,
GICs are not marketable
B. Other Types of Debt Securities
6. Hybrid Securities
a. Preferred Stock – An equity security with a
specified, obligated dividend payment rate with
no specific maturity – does not have the voting
rights of common shares
b. Convertible Bonds and Convertible Preferred
Stocks – Pay regular dividends or interest, but
can be exchanged for a set number of shares of
common stock at a set price – see:
C. The Yield Curve and Interest Rates
1. Maturity – The term of a bond – the period
after which the fixed income security must
return principal and accrued interest to the
purchaser
a. Short term = 1 year or less
b. Intermediate term = Greater than 1 year through
10 years
c. Long term = Greater than 10 years
2. Yield to Maturity – A measure of rate of return
adjusting for both the selling price of the bond
(discount or premium from face value) and the
bond’s interest coupon rate
C. The Yield Curve and Interest Rates
C. The Yield Curve and Interest Rates
Bond Valuation Example
See:
Face Value
Annual Coupon Rate
Annual Required Return
Years to Maturity
Payment Frequency
$
1,000
8.00%
9.50%
3.0
2
Value of Bond
$ 961.63
=-PV(B4/B6,B5*B6,B3/B6*B2,
Valuation Between Periods, the Hard Way
Fraction of Period Elapsed
0.50
Bond Value Between Payment Dates $ 984.20 This is the "Dirty Pr
Accrued Interest
20.00
Clean Price
$ 964.20
C. The Yield Curve and Interest Rates
3.
4.
5.
6.
Generally, the longer the term of a fixed income security,
the greater its interest yield and/or yield to maturity.
The normal slope of the yield curve is upward over the
maturity of the bond – greater yields for longer terms
(positive yield curve).
The yield curve changes constantly, and can be a
predictor of economic activity – Historic yield curve, the
relationship between stocks and bonds. For example,
an inverted yield curve often predicts a recession.
If interest rates in the market are greater than the
coupon rate of a debt security, that security will sell at a
discount – if market interest rates are lower than the
coupon rate of a debt security, that security will sell at a
premium
C. The Yield Curve and Interest Rates
7. Capital Appreciation (Depreciation) – Gain or loss in
a fixed income security’s market value due to market
interest rate changes
8. Duration – A formula accounting for a debt security’s
interest coupon and its term to maturity
a. The higher the coupon interest rate, the shorter the
duration for fixed income securities of a similar term to
maturity
b. The lower the coupon interest rate, the longer the duration
for fixed income securities of a similar term to maturity
c. The longer the duration of a fixed income security, the
more volatile the security’s price (similar to maturity – the
longer the maturity of a fixed income security, the greater
will be its price volatility
C. The Yield Curve and Interest Rates
9. Buy and Hold – Purchasing bonds with no intention
of selling them, bonds are held to maturity to avoid
capital gains and losses
10. Riding the Yield Curve – Purchasing bonds at the
“long end” of the yield curve, holding them until they
become short term securities, then selling them for a
capital gain – works best if the yield curve remains
steeply positive
11. Bond Laddering – Buying bonds with different
maturities, then reinvesting the proceeds at maturity
into longer term securities
D. Risks of Fixed Income Security Investing
1. Inflation Risk – Inflation increases to a rate greater
than the fixed income security coupon, decreasing
the market value of the security, and penalizing
investors for purchasing fixed income securities
2. Reinvestment Risk – The risk that the investor will
not, upon maturity and/or upon coupon payment
dates, be able to obtain a yield as great as the
coupon rate of the fixed income security
D. Risks of Fixed Income Security Investing
3. Risk of Capital Loss – If a sale is required
before maturity, investor is “locked in” until
maturity to realize par value, or, if interest
rates rise, there may be a capital loss upon
liquidation
4. Default Risk – The issuer may become unable
to make interest payments to bondholders
and/or to repay bond principal upon maturity –
for lower quality bonds, the price depends
more upon changes in the firm’s credit rating
than upon prevailing interest rates
E. Valuing a Bond
1. Discount or Premium – The price paid for a bond
either less or greater than par (100), based upon
market interest rates at the time of purchase
2. Coupon Yield – Based upon par value, the interest
paid per year as a percentage of par
3. Current Yield – Annual Interest
Price Paid
Based upon the market price of a bond, may be
higher or lower than the coupon yield depending
upon market interest rates
E. Valuing a Bond
4. Yield to Maturity – Money gained or lost when a
bond matures at par (versus price paid), plus
interest, plus interest on interest – assumes
reinvestment of coupon payments at the same
interest rate
Ex. – Bond has a 6.0% coupon, with 5 years to maturity
– buy at par and hold to maturity
•
Bond pays $30 (on $1,000 face) 2x per year = 10
payments = $300 over 5 years
•
Buyer receives $1,000 on maturity, plus
$300 interest
$1,300 less cost ($1,000) = $300
E. Valuing a Bond
• Ex. 2: Same coupon, same date of issue, but
purchased 2 years after issue when market interest
rates for three year bonds with a similar rating are
8.0%
Price = 94.76 (94.76% of par) based upon market
yield to maturity – after 3 years, the investor receives:
$180 coupon payments ($30, 2x/year, 6 periods)
$1,000 face
$1,180 less $947.60 (price paid) = $232.40
Note: If the investor had purchased an 8.0% coupon bond at par,
the interest yield would have been $240 over 3 years
E. Valuing a Bond
• Ex. 3: Same coupon, same date of issue, but
purchased 2 years after issue when market interest
rates for three year bonds with a similar rating are
4.0%
Price = 105.60 (105.60% of par) based upon market
yield to maturity – after 3 years, the investor receives:
$180 coupon payments ($30, 2x/year, 6 periods)
$1,000 face
$1,180 less $1,056 (price paid) = $124.00
Note: If the investor had purchased a 4.0% coupon bond at par,
the interest yield would have been $120 over 3 years
F. Buying and Selling Bonds
1. Price depends upon interest rates – when interest
rates fall, bond prices rise; when interest rates rise,
bond prices fall
2. Bonds are not as liquid as major company stocks – it
is a smaller market, and there is not always a buyer
for a seller of bonds on the market
a.
b.
c.
d.
Bid – The price that a buyer offers
Ask – The price that a seller wants
Spread – The difference between bid and ask
Markup – Dealer commission charge – can be as much as
4.0% to 5.0% -- Treasury markups are generally less than
0.5% for large orders, as the market is large and highly
liquid, bonds that are lower rated and/or small positions
have a higher markup
G. Bond Variations
1. Bonds That May Provide Lower Returns to
Investors
a. Callable Bonds – Can be redeemed by the issuer
prior to the stated maturity
i.
Call Schedule -– A list of dates and prices at which
bonds may be redeemed, or a date after which a bond
may be called at any time
ii. Market Interest Rates and Bond Calls – If the bond
provides a coupon yield greater than market interest
rates, it is likely to be called; if the coupon yield is less
than market interest rates, it is not likely to be called
G. Bond Variations
b. Sinking Fund – Bonds are issued with a
“pool” of money set aside (and/or paid in
annually) by an issuer to redeem bonds
at call or upon maturity – provide lower
yields, but are more safe as there will be
money available to repay purchasers
G. Bond Variations
2. Bonds With Conditions
a. Subordinated Bonds – Have a lower claim on
assets than other debt issues
b. Senior Bonds – First in line against corporate
assets
c. Floating Rate Bonds – Provide periodic
adjustment of bond interest payments
d. Prefunded Bonds – Bonds whose repayment is
guaranteed by another bond issue – proceeds of
other issue may be invested in Treasuries, which
can be sold to redeem prefunded bonds
G. Bond Variations
e. Insured Bonds – An insurance policy backs
payment of principal and interest
f. Bonds with Equity Warrants – Corporate bonds
which include a right to buy the issuer’s stock
at a specified time and price
g. Collateral Trust Bonds – Bonds that are
backed by securities that may be liquidated to
make payments to bondholders.
h. Put Bonds – Bonds that may be tendered for
redemption at par prior to stated maturity
G. Bond Variations
3. Bond Alternatives
a. Convertible Bonds – Can be changed into
company stock at a price and quantity set
upon issue, upon a date specified at issue,
or upon maturity
i. Generally subordinated debentures
ii. Generally have call provisions limiting returns if
the firm’s stock price increases
G. Bond Variations
b. Zero Coupon Bonds – Issued at a discount,
mature at par, with accrued interest and
issue price adding up to par
Price Volatility – Have a longer duration than
coupon paying bonds, and thus greater price
volatility than coupon paying bonds of the same
maturity
ii. Taxes are due annually on accrued interest
i.
H. Buying and Selling Bonds
1. Bonds trade over the counter – brokers match
buyers and sellers.
2. While Treasury Securities are almost always
available for purchase or sale, other bonds
are much less liquid (cannot guarantee one
day purchase or sale).
3. The purchaser of a bond must pay accrued
interest to the seller – the proportionate share
of interest that has been earned since the last
coupon payment
H. Buying and Selling Bonds
4. Bond commissions are paid to brokers in the form of
a mark-up – an addition to the price paid or a
subtraction from the purchase price
5. While markups on Treasury Securities are generally
less than 0.5%, markups for corporate bonds can be
as high as 5%, depending upon the size of the trade
and the difficulty of the purchase or sale (credit
rating, size of issue).
6. Markups can be quantified by determining the bid/ask
spread
a. Bid – What purchasers are willing to pay
b. Ask – The price that sellers are requesting
H. Buying and Selling Bonds
7. In the absence of a “bond exchange,” FINRA
maintains the Trade Reporting and Compliance
Engine.
8. The Municipal Securities Rulemaking Board
maintains real time tracking of municipal bond trades.