Answers to Concepts in Review

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1 Answers to Concepts in Review 1. Bonds are appealing to investors because they provide a generous amount of current income and they can often generate large capital gains. These two sources of income together can lead to attractive and highly competitive investor returns. Bonds make an attractive investment outlet because of their versatility. They can provide a conservative investor with high current income or they can be used aggressively by investors who prefer capital gains. Given the wide and frequent swings in interest rates, investors can find a variety of investment opportunities. In addition to their versatility, certain types of bonds can be used to shelter income from taxes. While municipal bonds are perhaps the best known tax shelters, some Treasury and federal agency bonds also give investors some tax advantages. 2. Table 10.1 shows that over the past forty-five years bond returns and market investment rates move in opposite direction. For example, 1999 bond yields rose from 6.53 to 7.05 percent. The total rate of return during 1999 was 5.76 percent, due to the decline in bond prices. Swings in market interest rates have a definite impact on annual bond returns, as shown in Table In particular, when interest rates rise, bond prices fall, and such capital losses drag bond returns down (unlike market, or promised yields, bond/total returns are made up of both interest income and capital gains or losses). When market interest rates fall, just the opposite occurs: i.e., bond prices rise and so do bond returns. 3. Bonds are exposed to the following five major types of risk: (1) Interest rate risk: This affects the market as a whole and therefore translates into market risk. When market interest rates rise, bond prices fall, and vice versa. (2) Purchasing power risk: This is the risk caused by inflation. When inflation heats up, bond yields lag behind inflation rates. A bond investor is locked into a fixed-coupon bond even though market yields are rising with inflation. (3) Business/financial risk: This refers to the risk that the issuer will default on interest and/or principal payments. Business risk is related to the quality and integrity of the issuer, whereas financial risk relates to the amount of the issuer s leverage. Treasury securities are free of this risk, although it is an important consideration for corporate and municipal bonds. (4) Liquidity risk: This is the risk that a bond will be difficult to sell if the investor wishes to do so. The bond market is primarily over-the-counter in nature, and much of the activity occurs in the primary/new issue market. With the exception of the Treasury market and most of the agency market, there is not much of a secondary market for most bonds. (5) Call risk: This refers to the risk that a bond will be retired before its scheduled maturity date. When a bond is called, the bondholders are cashed out of their investment and must then find alternative investment outlets that may have lower yields. The most important source of risk for bonds in general is interest rate risk. It is the major cause of price volatility in the bond market. As interest rates become more volatile, so do bond prices.

2 4. Issue characteristics (such as call feature and coupon) do indeed affect the yield and price behavior of a bond. For example, high-coupon bonds have higher yields than low-coupon bonds; bonds that are freely callable provide higher yields than bonds that are non-callable; usually (although not always) long maturities yield more than short maturities. With respect to price volatility, bonds with lower coupons and/or longer maturities will respond more vigorously to changes in market interest rates and therefore have greater price volatility than short-maturity and/or high-coupon bonds. 5. With a call feature, the issuer pays a call premium generally equal to one year s interest at the earliest date of call. On the other hand, sinking funds is a provision that stipulates the amount of principal that will be retired annually over the life of a bond. There are no call premiums with sinking fund provisions. The three different types of call features are: (1) Freely callable: The issue can be prematurely retired at any time. (2) Non-callable: The issuer is prohibited from retiring the bond issue prior to maturity. (3) Deferred callable: The issue cannot be called until after a certain length of time has passed from the date of issue. A bond can be freely callable but non-refundable for a certain number of years. In this case, a non-refunding or a deferred refunding issue can still be called and prematurely retired for any reason other than refunding. 6. The difference between a premium and a discount bond illustrates the inverse relationship between bond prices and market interest rates. A premium bond sells for more than its par value, which occurs when market interest rates drop below the bond s coupon rate. In contrast, a discount bond sells for less than par and is the result of market rates rising above the coupon rate. The factors that affect a bond s price, volatility are interest rates, coupon and maturity of the issue. The greater the moves in interest rates, the greater the swings in bond prices. Bonds with lower coupons and/or longer maturities respond more vigorously to changes in market rates and therefore undergo sharper price swings. 7. A percent of par quotation indicates that the issue is trading at the quoted percent of the par value of the obligation. For example, a percent of par quotation of 98 on a $1,000 par value obligation means the bond is trading at 98% of $1,000 $980. Corporate bond quotes are in thousandths of a percentage, which essentially results in corporate bond prices being in pennies. For instance, a quote of would be a price of $ Government bonds are quoted in 32nds of a point, which is one percent of par value. Hence, a bond quoted at 102:8 is priced at 102 percent and 8/32 of a percent, or percent. A government bond with a par value of $1,000 would cost $1, (e.g., $1,000) plus transaction costs.

3 8. Bond ratings are grades that are assigned to bond issues on the basis of extensive, professionally conducted financial analysis to designate investment quality. Ratings basically point to the default risk of an issue. Higher ratings mean that issues are investment grade. Lower ratings mean that issues are in the junk category and more speculative. The higher the rating, the lower the default risk and, hence, the lower the yield of an obligation. A lower rating means that the investor must assume more of the default risk and has to be compensated with a higher yield. Further, investment grade securities are far more interest sensitive and tend to exhibit more uniform price behavior than junk bonds and other lower-rated issues. For a particular bond issue, if Mergent and S&P assign different ratings (called split ratings) the issue is then said to be split rated. There are additional rating agencies with slightly different rating scales. 9. From an individual investor perspective, bond ratings relieve the drudgery of evaluating the quality of the bond. Individuals can depend on agency ratings as a viable measure of the creditworthiness of the issuer and the issuer s default risk. Over time, the rating agencies have done an excellent job of assessing bond corporate quality; hence, these ratings are objective and reliable. However, rating agencies rated mortgage-backed securities as investment grade investments prior to the real estate market collapse that began in 2007, resulting in significant bondholder losses as the homes used as collateral on these investments went into foreclosure. Bond ratings are intended to only measure an issuer s default risk, and as such, ratings provide no indication of the amount of market risk imbedded in a bond. Even the highest quality issues will go down in price when interest rates increase, subjecting investors to capital loss and market risk. 10. Bonds are securities that promise to pay a stated amount of annual interest over the life of an issue, and then repay the principal value of the bond at maturity. Bond issues have certain advantages and disadvantages, some of which depend on the issuing entity. (a) Treasury bonds are debt securities issued by the U.S. federal government to meet the ever-increasing needs of the federal budget. Advantages: High quality or low default risk (backed by the full faith and credit of the U.S. government); very popular instruments that have a well-developed secondary market; exempt from state and local taxes; many coupons and maturities available; some automatically adjust their par (maturity) value to protect investors from the impact of inflation (TIPS). Disadvantages: Due to their low risk, these issues bear low yields; make a poor inflation hedge; and many have long maturities and therefore are subject to wide price swings. (b) Agency bonds are debt securities issued by various agencies and organizations of the U.S. government like the Student Loan Marketing Association (Sallie Mae) and Government National Mortgage Association (GNMA). Typically, agency bonds offer yields slightly above the market rates for Treasuries. Advantages: Low risk (while not a part of the U.S. Government the market expects the federal government to support its independent agencies); many are exempt from state and local taxes; some pay interest monthly. Disadvantages: The secondary market is not well developed for all agency issues; low yield due to low risk (though their yield is above that of Treasury bonds); some have very high unit costs (like GNMA pass-throughs: $25,000).

4 (c) Municipal bonds are debt securities issued by states, counties, cities, and other political subdivisions like school districts and water and sewer districts. Advantages: Interest on most municipals is exempt from federal income tax and usually the state or local tax of the issuing government body; many carry a municipal bond guarantee that lowers risk; rated by Moody s and S&P. Disadvantages: Low yield for individuals in low tax brackets; most issues are not widely traded and so have poor liquidity; requires large capital investment ($5,000). (d) Corporate bonds are debt securities issued by corporations. The corporate bond market is customarily subdivided into the industrial, public utility, transportation, and financial bond segments. Advantages: Wide variety of issues; relatively attractive yields, lower $1,000 denomination; rated by Moody s and S&P relatively good liquidity in the secondary market. Disadvantages: Higher risk than government-backed bonds; long life to maturity. 11. (a) Zero-coupon bonds have no interest, or coupon, payments. They are sold at a deep discount from their par values, and then they increase in value over time at a compound rate of return so that at maturity their value is equal to par. There is no reinvestment risk of coupon payments with these bonds. However, the IRS does require that interest be reported on an accrual basis. This makes these bonds most attractive for use in tax shelter investments like IRAs. (b) CMOs, or collateralized mortgage obligations, are obligations designed to reduce the problems caused by the pass-through of principal payments on mortgage-backed bonds. Normally, all bondholders receive a pro-rated portion of the principal payments, but with CMOs investors select a short-term, intermediate, or long-term position. All principal payments are then made to the short-term investors first. Once they are paid, the next group begins receiving principal payments. Such issues are used by investors seeking the higher yields of mortgage-backed issues. The financial crisis that began in 2007, resulted in homeowner defaults a plummeting CMO values. (c) Junk bonds are low-rated, high-yielding, speculative securities issued primarily by corporations (there s also a smaller, but still sizable, market for high-yield junk municipals). In the past these issues were initially of high quality but deteriorated as the company faced troubled times. Today, the term applies to young, rapidly growing firms that use such issues for capital growth and/or to finance mergers and takeovers. These issues should only be used by investors who can accept high levels of risk. Their high yields and high risk make them inappropriate for conservative investors. (d) Yankee bonds are bonds issued by foreign governments or corporations or by so-called supranational agencies like the World Bank and the International Monetary Fund. These bonds are denominated in dollars and registered with the SEC. The bonds are issued and traded in the United States (on U.S. exchanges and the OTC market). All transactions are in U.S. dollars, eliminating any currency exchange risk. These bonds are generally very high in quality and offer competitive yields to investors. 12. Bondholders dislike inflation as increases in inflation increase nominal interest rates, thus reducing bond prices. So, the U.S. government issued bonds (i.e. TIPS) that are protected against unexpected inflation, thus making them more attractive to investors. The U.S. government likes these securities because it need not compensate investors for inflation. Hence its borrowing costs are lower.

5 The biggest advantage of TIPS for investors is the protection against unexpected changes in inflation. If the investor is risk-averse, he might prefer TIPS over conventional bonds, which are not protected against inflation. But TIPS are not very useful during periods when inflation stays dormant as interest rates on TIPS are much lower than conventional bonds. Another big disadvantage of TIPS is that investors have to pay a tax on the increasing face value of their bonds each year, while they get compensated for inflation at maturity. Hence they end up paying interest on income they don t have on hand. The tax implications of various government bonds differ. Treasury issues are subject to federal income tax, but exempt from state and local taxes. Agency issues are all subject to federal tax. Some, however, are exempt from state taxes. The interest on most municipal issues, on the other hand, is exempt from federal income taxes and, usually, the state and local taxes of the governmental unit issuing them; capital gains on municipal bonds are subject to normal federal, state, and local tax rates and must be paid on any such profits earned. 13. Asset-backed securities (ABS) are debt issues secured by a pool of bank loans, leases, and other assets. These other assets include credit card bills, computer leases, truck rentals, and royalty fees. Whereas the federal government created three primary agencies to handle mortgage-backed securities (MBS), asset-backed securities are created by investment bankers assisting corporations. ABSs have shorter maturities than MBSs. Both ABSs and MBSs provide monthly interest payments. Securitization (i.e. forming MBS and ABS) is the process whereby many lending vehicles are transformed into marketable securities. An individual credit card loan might be very risky but a pool of similar loans has a much lower risk of default because it is quite improbable that all loans in the pool would default at the same time. Hence the concept of securitization is similar to the traditional concept of risk diversification of a portfolio. 14. Dollar-denominated bonds have their cash flows (interest payment and principal repayments) denominated in dollars. On the other hand, foreign-pay bonds have their cash flows denominated in some foreign currency. The two major types of foreign, U.S.-pay bonds are Yankee bonds and Eurodollar bonds: Yankee bonds are issued by foreign governments or corporations, registered with the SEC, and issued and traded in the United States. All transactions are in United State dollars. They are generally very high in quality and offer investors very competitive yields. Eurodollar bonds are issued and traded outside the United States. They are dollardenominated but are not registered with the SEC. This means that underwriters cannot sell new issues to U.S. investors. Only seasoned Eurodollar issues can be sold in this country. Because U.S.-pay bonds are dollar-denominated, there is no currency exchange risk for an U.S. investor. But foreign-pay bonds are denominated in some currency other than dollars, traded overseas, and not registered with the SEC. These bonds are therefore subject to changes in currency exchange rates, which in turn can dramatically affect total returns to U.S. investors. There are also positive diversification advantages arising from holding both domestic bonds and foreign-pay foreign bonds.

6 15. A convertible debenture is a long-term, unsecured corporate bond carrying the provision that within a stipulated time period, the bond may be converted into a certain number of shares of the issuing corporation s common stock. A convertible preferred is very similar to a convertible bond except that it is initially issued as a preferred stock and then is convertible into common shares. Thus, a debenture is a bond and a preferred is a stock; another difference between a convertible debenture and convertible preferred is that while the conversion ratio of the debenture generally deals with large multiples of common stock, the conversion ratio of a preferred is generally very small. This is because corporate bonds are sold in $1,000 increments, while preferreds sell for $25 to $ The equity kicker feature of a convertible security gives the investor an opportunity to participate in the potential price performance of the underlying common stock. When the market price of the common is equal to or greater than the stated conversion price, the equity kicker has value to the investor and the price of the convertible will move with the common. When the price of the stock goes up, the price of the convertible will increase by a multiple that approximates its conversion ratio; likewise, if the price of the stock falls, the convertible will decline by the same multiple. (Subject to the conversion price being less than the stock price.) 17. The convertible receives value from both its bond and stock properties. At the minimum, the security is worth what it earns as a fixed-income security (present value of interest and face value at maturity). This is its bond (or investment) value, and it sets the price floor for the convertible. In addition, the security has the potential to earn a capital gain based on the fact that it can be traded for a fixed number of shares of common stock (as specified by the conversion ratio). If, for example, a $1,000 bond can be converted into 50 shares of common stock, then as the stock begins to sell for more than $20 per share (the conversion price), there is a potential capital gain, and the value of the convertible will reflect this (i.e., the behavior of the underlying common stock). 18. Conversion value is an indication of what a convertible issue would trade for if its price were based on its stock value. It is equal to the conversion ratio times the current stock price. Conversion parity indicates the price the common stock should sell for in order to make the convertible worth its present market price. It is equal to the current price of the convertible divided by the conversion ratio. Payback period is a good tool to assess the conversion premium on convertibles. The payback period is a measure of the length of time it takes for the buyer of a convertible to recover the conversion premium from the extra interest income earned on the convertible. As an investment rule, everything else being equal, the shorter the payback period, the better. The bond investment value of a convertible is a price at which the bond would trade if it were non-convertible and if it were priced at or near the prevailing market yields of comparable issues. This figure indicates how far the convertible will have to fall before it hits its price floor and begins trading as a straight debt instrument.

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