Goals Bonds: Fixed Income Securities History Features and structure Bond ratings Economics 71a: Spring 2007 Mayo chapter 12 Lecture notes 4.3 Bond Returns Two Parts Interest and capital gains Stock comparison: dividends and cap gains Most income in the form of interest R t +1 = P t +1 + I t +1! P t P t R t +1 = P t +1! P t P t + I t +1 P t = (capital gain) + (Interest) 1
Annual Historical Returns Bonds in the 1990 s Stocks Corp Bonds Gov t Bonds TBills Raw Returns 12.4% 6.3% 5.8% 3.8% Inflation Adjusted 9.2% 3.2% 2.8% 0.7% 1990-1999 Bonds, 8.7% (nominal, no inflation adjustment) $10,000 -> $23,000 Stocks 18.2% (nominal) $10,000 -> $53,000 1990-2003(June) Bonds, 9.7% (nominal) $10,000 -> $35,000 Stocks, 10.2% (nominal) $10,000 -> $37,000 Bond Return Summary Generally, lower returns than stocks But also, less risk than stocks Bond Risks Interest rate risk Purchasing power risk (inflation) Default or business risk Liquidity risk Call risk 2
Goals History Features and structure Bond ratings Bond Features Agreement to borrow money Amount of loan Principal, par value Paid back at set date in the future maturity Interest payments Coupon interest rate Percentage of principal Made on regular schedule Bond structure Example Principal = $1000 Maturity = 10 years Coupon = 5%, semiannual Cashflows Pays $25 in interest every 6 months (Interest payment is fixed.) 10 years from now pays back $1000 + $25 Bond Legal Structure Indenture Specifies rights of bond holders Restrictions often include Requirements on accounting practices Firm should pay taxes Constrain future borrowing Limit dividend payments on stock 3
Current Bond Price Discount Price < Par Premium Price > Par Depends on interest rates Bond yield = coupon/price Call Provisions Issuer (firm) can buy back the bonds (call) at a specified price (call premium) Call provisions specify the price, and time period in which this can happen Most corporate bonds are callable Similar to refinancing for individuals Important risk component for investors Sinking Funds Schedule to pay back principal over time Different from call Option versus requirement Secured Debt Backed by some kind of property Mortgages: real estate Plant and equipment Financial assets Income streams (Mass. turnpike) Unsecured debt (junior bonds, debentures) No asset backing Ok for large reliable firms 4
Difference Between Debt (Bonds) and Equity (Stock) Voting rights D: none, E: yes Claims on firm assets D: senior to equity, E: subordinate to debt Maturity D: fixed, E: none Taxes Trading/liquidity Borrower Costs What affects the interest rate borrowers pay? Maturity (length of bond) Size (total loan) Default risk Market interest rates Market Segments Trillions of U.S. $ U.S. treasury bonds: 2.2 Agency securities: 2.1 Federal home loan, Student loan marketing association Municipal bonds: 1.5 Corporate bonds: 5.2 Mortgage backed securities: 2.9 Foreign issues (eurodollar): 3.3 Special Bond Types Treasury bonds Municipal bonds Zero coupon bonds Floating rate bonds (floaters) Inflation adjusted bonds Junk bonds Mortgage backed securities Asset-backed securities Convertible bonds Foreign bonds 5
U.S. Treasury Bonds Borrowing of the U.S. federal government Very low risk/high liquidity $1,000 denominations Maturities 2, 3, 5, 10 years (notes) 20, 30 years (bonds) Interest income exempt from state and local taxes, but not federal taxes Municipal Bonds Local state, county, city bonds Interest Exempt from federal taxes Usually free from state tax if you reside in the state the bond was issued by Capital gains Not exempt Muni Bonds: Taxable equivalent yield (Taxable yield)(1- tax rate) = (Tax free yield) Tax free yield Taxable yield = (1- tax rate) Muni yield = 5%, tax rate = 35% 0.05 (1-.35) = 7.69% Zero Coupon Bonds Zero coupon (interest) payments Principal only Trade at discount Example: $1040 in 1 year Price today = $1000 Yield (return) = 4% Constructed zero coupon bonds: Strips 6
Floating Rate Bonds (Floaters) Coupon payments tied to current interest rates Coupon might be principal*(t-bill rate) 1000*(2.5%) Similarities to adjustable rate mortgages Inflation Adjusted Bonds Treasury inflation-indexed obligation TIPS Par value adjusted up with inflation $1000 bond, 3% inflation In one year goes to $1030 Coupons are a percentage of par and rise too Junk Bonds High yield High risk (default likely) Unsecured Famous in the 1980 s Leveraged buyouts Are they a good investment? Mortgage Backed Securities (Mortgage Bonds) Pool of mortgages Pay off principal over time Some pools high risk Subprime Tricky refinancing questions 7
Asset-backed Securities Bonds backed by revenue streams Car loans/credit cards (large pool) Mass turnpike bonds (tolls) David Bowie bonds Backed by revenue stream for albums IP Securitization Convertible Bonds Bonds that can be converted into a fixed number of shares of common stock Value moves with stock price (and interest rates) Difficult valuation Foreign Bonds Yankee bonds Dollar bonds issued in U.S. by foreign or international corporations Euro bonds Dollar bonds issued outside the U.S. Goals History Features and structure Bond ratings 8
Bond Ratings Bond Ratings and Default Probabilities (Economist, March 23, 2005) Agencies rate the riskiness of a bond Essentially the chance that it will default See page 257 Bond ratings (Standard and Poor s) AAA, high-grade A, medium-grade >=BBB, Investment grade <BBB, speculative grade or junk bonds C, No interest paid D, In default Rating Agencies S&P Rates $30 trillion in debt Moody s Fitch Problems for Raters Missed Enron, WorldCom, Parmalat Lack of competition Should there be more official oversight Firms starting consulting businesses Help firms that they are rating Serious conflict of interest 9
Ratings Taken Seriously Many investment funds having ratings requirements No junk bonds Ratings triggers : loans called back if ratings fall Goals History Features and structure Bond ratings 10