Chapter 10. Fixed Income Markets. Fixed-Income Securities

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1 Chapter 10 Fixed-Income Securities Bond: Tradable security that promises to make a pre-specified series of payments over time. Straight bond makes fixed coupon and principal payment. Bonds are traded mainly over-the-counter. Historical Bond Yields: Bond characteristics Bond sectors Bond risks Bond ratings and quotations Fin432 1 Fixed Income Securities Fin432 2 Fixed Income Securities

2 Bond Versus Stocks Compared to stocks, bonds offer lower returns Main benefits of bonds in portfolio: Lower risk High levels of current income Diversification Comparative Performance of Stocks and Bonds: Definitions: Face Value (or Par Value): Principal amount or denomination that the issuer agrees to pay back to the bondholder, exclusive of interest Coupon Rate: The interest rate that the issuer agrees to pay each year. Market Value: Price at which bond trades, expressed in percent of principal. Maturity: Date that the debt will cease to exist Term Bond is a bond that has a single maturity date Serial Bond is a bond that has a series of different maturity dates Floating-rate Bond. Coupon rate is reset periodically according to a predetermined benchmark. Benchmark is usually a financial index. Fin432 3 Fixed Income Securities Fin432 4 Fixed Income Securities

3 Definitions: Premium Bond. Bond price higher than its par value. Bond trades at a premium whenever market interest rates drop below its coupon rate Discount Bond. Bond price lower than its par value. Bond trades at a discount whenever market interest rates move above its coupon rate Bond Price Behavior Price of a bond is a function of its coupon rate, its maturity, and market movements in interest rates. Bonds with longer maturities move more with changes in interest rates. Bonds with lower coupon rate move more with changes in interest rates. Current Yield: measures of the annual interest income relative to its current market price. Current Yi eld = Annual coupon interest Bond price Example: If an 8% coupon bond with a par of $1,000 current trades at $875, its current yield is: 80/875 = 9.14% Fin432 5 Fixed Income Securities Fin432 6 Fixed Income Securities

4 The Treasury Market: General obligations of the federal government: no default risk. Treasury Notes and Bonds Pay semiannual coupons Sold in $1,000 denominations Maturities up to 30 years (bonds), 10 years (notes). Bullet bonds, generally not callable Strips: Zero-coupon bonds Treasury Inflation-Indexed Obligations (TIPS) Protect against inflation by adjusting investor returns Interest rates are very low The Agency Market: Issued by government agencies Federally related agencies: Exlm Bank, GNMA, SBA, TVA Guaranteed by US government Federally sponsored agencies: e.g., Fannie Mae, FHLB, Freddie Mac which provide credit to the housing sector Not guaranteed by US government and thus subject to slight default risk Trade at yield spread relative to Treasuries Fin432 7 Fixed Income Securities Fin432 8 Fixed Income Securities

5 The Municipal Bond Market: Issued by states, counties, cities and any other political subdivision Issued to fund public projects Two basic types General obligation bonds are paid from general fund of the issuer Revenue bonds are paid from revenues from the project being financed Often guaranteed by private insurers to lower risk and interest rates Tax exemption: Interest on municipal bonds is not taxable at federal level Trade at much lower yields than Treasuries The Municipal Bond Market: Taxable Equivalent Yield = Example: Yield on municipal bond 1- Federal tax rate A municipal bond offers a yield of 6.5%. For an individual with a marginal tax bracket of 35%, what is the taxable equivalent yield of this bond? 6.5% Taxable equivalent yield = 1 35% = 10%. In other words, for this individual, holding this muni is equivalent to holding a taxable bond with a yield of 10%. For this reason, municipal bonds are most attractive to individual in higher federal tax brackets (28% to 35%). Fin432 9 Fixed Income Securities Fin Fixed Income Securities

6 The Corporate Bond Market: Issued by private corporations Subject to credit risk: Failure to pay timely interest or principal constitutes default Bondholders incur a loss upon default As compensation, bonds sell at higher yields than Treasuries Debenture bonds are unsecured general obligations Mortgage bonds give bondholders a lien against specific property Corporate bonds have special provisions: Many bonds are callable by issuer Many bonds have sinking fund provision The Corporate Bond Market: Call feature allows the issuer to repurchase the bonds before the maturity date Freely callable Noncallable Deferred call Call premium is the amount added to bond s par value and paid upon call to compensate bondholders Call price is the bond s par value plus call premium Sinking fund stipulates how a bond will be paid off over time Applies only to term bonds Issuer is obligated to pay off the bond systematically over time Fin Fixed Income Securities Fin Fixed Income Securities

7 The Mortgage Market: Mortgages are loans to purchase real estate Securitization: S&Ls created securities out of bundled mortgage obligations Mortgage Pass-Throughs are such securities Mortgage-Backed Securities are guaranteed as to payment by o Government National Mortgage Association (GNMA) o Federal Home Loan Mortgage Corporation (FHLMC) o Federal National Mortgage Association (FNMA) Homeowner has the right to call the mortgage if he/she moves, or if rates fall. The homeowner is long a complex call option The bondholder is short this option: If interest rate rise, the bond will lose value If interest rate fall, the homeowner will refinance and repay the bond The bondholder will require a payment, or higher yield, to offset this option The Mortgage Market: Collaterized Mortgage Obligations are repackaged MBS securities with different payment streams. Mortgage-back bond pool that is divided into tranches, or classes of investors All principal payments go first to the shortest tranche until it is fully retired, then the next in sequence is paid Allows investors to choose short-term, mediumterm or long-term investment Potentially complex; interest rate fluctuations may have significant impact upon bond prices Fin Fixed Income Securities Fin Fixed Income Securities

8 Asset-backed Securities: Issued by corporations and backed by pools of loans Auto loans Credit card loans Home equity loans Provide relatively high yields Short maturities, typically 3 to 5 years Interest and principal payments are monthly High credit quality Global Bonds: Offer broader diversification opportunities Interest rate trends in other countries may not follow U.S. rates Currency exchange rate fluctuations can impact returns in U.S. dollars Dollar-Denominated Bonds Bonds issued by foreign governments or corporations and denominated in dollars Based on U.S. dollars Yankee bonds are registered with the SEC and issued and traded in U.S. Eurodollar bonds are not registered with the SEC and are issued and traded outside of the U.S. No currency exchange rate risk Foreign-Pay Bonds Bonds issued by foreign governments or corporations Based on currency other than U.S. dollars Not registered with the SEC and issued and traded outside of the U.S. Subject to currency exchange rate risk Fin Fixed Income Securities Fin Fixed Income Securities

9 Junk Bonds: Highly speculative, usually subordinated debentures Have low, sub-investment grade ratings Typically offer very high yields Prices tend to behave more like stocks than bonds Zero-coupon bonds: Do not pay interest Sold at deep discount from par value Value increases over time Subject to tremendous price volatility as interest rates fluctuate Interest must be reported as it is accrued for tax purposes, even though no interest is actually received. Treasury strips are zero-coupon bonds created from U.S. Treasury securities. Bond Characteristics Embedded Options: Callable Bond Issuer can retire the debt, fully or partially, before the scheduled maturity date Mortgage loans are all callable Putable Bond Bond holder can sell the bond back to the issuer at a fixed price schedule Convertible Bond. Gives the bondholder the right to exchange the bond for a specified number of shares of common stock Fin Fixed Income Securities Fin Fixed Income Securities

10 Bond Characteristics Bond Risks: Interest rate risk (Market risk). The major risk faced by a bond investor A typical bond's price changes in the opposite direction from a change in interest rate Bond sold before maturity may therefore realize a capital loss Degree of price sensitivity to interest rate change depends on bond characteristics Reinvestment risk. When market interest rate fall, interim cash flow has to be reinvested at a lower interest rate. Reinvestment risk is greater for high coupon bonds Offsetting effects: Interest rate risk is the risk that interest rate will rise, while reinvestment risk is the risk that interest rate will fall. Bond Characteristics Bond Risks: Call risk Cash flow of a callable bond is not known with certainty. Issuer will call the bond when interest rate drops, exposing investors to reinvestment risk. Default risk The risk that bond issuer may not be able to make timely principal and interest payment. Bond with default risk has a lower price than comparable US Treasury securities, which are considered free of default risk. Inflation risk When inflation increases, bond with fixed coupon will realize lower returns, as measured by purchasing power. Floating-rate bonds have lower inflation risk. Fin Fixed Income Securities Fin Fixed Income Securities

11 Bond Characteristics Bond Risks: Exchange rate risk A US investor holding non-dollar-denominated bond will face exchange rate risk. An investor holding British Pound denominated bond will lose money when USD/GBP falls. Liquidity risk The risk that bond cannot be sold at or near its market value before maturity. Measured by the bid-ask spread Volatility risk The risk that a change in volatility will affect the price of a bond adversely Bonds with embedded options have volatility risk because the value of option is affected by volatility. Bond Ratings Bond Ratings: Bond Ratings Very High High Quality Quality Speculative Very Poor Standard & Poor s AAA AA A BBB BB B CCC D Moody s Aaa Aa A Baa Ba B Caa C Investment grade bond: A bond rated BBB and above by Standard & Poor s, or Baa and above by Moody s. Speculative grade or junk bond: A bond rated BB or lower by Standard & Poor s, Ba or lower by Moody s, or an unrated bond. Determinants of Bond Safety: Coverage ratios: Ratios of company earnings to fixed costs. For example: Times-interest-earned-ratio = EBIT/interest Leverage ratios: Debt/Equity Liquidity ratios: Current ratio; Quick ratio Profitability ratios: return on assets = EBIT/Total assets Fin Fixed Income Securities Fin Fixed Income Securities

12 Bond Quotes Bond quotes are stated as percentage of par value 97 means 97% of par value Treasuries are quoted in 32nds. A $1,000 par value bond price at 97 would sell for $ means bond trades at par value Readings: Chapter 10 Exercises: Chapter 10 (will NOT be collected) Text Website: Self-assessment quiz End-of-Chapter CFA questions (Page 449) Problems: P10.7, 10.9, Homework (will be collected and graded, due date to be announced) Chapter 10: Excel with Spreadsheet (Page 456) Fin Fixed Income Securities Fin Fixed Income Securities

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