Bonds Chapter 12

Fixed Income securities that pay interest to bond holders mainly on

annual basis

Bonds are issued by government (treasury bonds ) or by corporations

(corporate bonds ) or by municipal (municipal bonds )

Bonds are the most popular alternative to stocks for long-term investing

Even though the bonds of a corporation are less risky than its equity,
investors still have risk: price risk and interest rate risk.

Straight bonds:

Obligates the issuer to pay to the bondholder a fixed sum of money (called
the principal, par value, stated value or face value) at the bonds maturity,
along with constant, periodic interest payments (called coupons) during
the life of the bond.

U.S. Treasury bonds are straight bonds.

Special features may be attached, creating convertible bonds, putable

bonds, putable bonds have a put feature that grants bondholders the
right to sell their bonds back to the issuer at a special put price

Bonds Prices depend on :

1. Liquidity as liquidity increases the bond prices increases
2. Default risk : the inability of the bond issuer to repay interest or
principle, as default risk increases the bond price decreases
3. Interest rate in the market : as market rates increase relative to
bonds demand decreases on bonds and the prices of bonds
decreases
4. Maturity : the higher the maturity the higher the risk the coupon
rate the lower the bond's prices

Bonds are commonly distinguished according to the relative relationship

between their selling price and their par value.
1. Premium bonds:

price > par value

i. YTM < coupon rate

2. Discount bonds:

price < par value

i. YTM > coupon rate

3. Par bonds:

price = par value

i. YTM = coupon rate

Interest rates in the market changes due to :

1. Changes in money supply by the federal reserve (federal bank)
,lowering money supply increases the interest rates ,while
increasing the money supply reduces the interest rates
2. Inflation : as inflation increases interest rates increases to
compensate investors for inflation

Yield to maturity (YTM) :The discount rate that equates a bonds price
with the present value of its future cash flows

Treasury (Gov Bonds ):

1. Issued by government
2. Very low default risk being secured by the government
3. Very liquid and deep secondary market
4. Are zero coupon bond sold at discount and pay no coupon
5. Very low interests rate due to low risk (risk free rate of return)

Treasury Inflation-Indexed Securities(TIPS): the principal amount is tied

to the current rate of inflation to protect investor purchasing power

Treasury STRIPS: the coupon and principal payments are stripped from
a T-Bond and sold as individual zero-coupon bonds.

Corporate bonds characteristics

Typically have a face value of $1,000, although some have a face value of
$5,000 or $10,000.Pay interest semi-annually

Secured Bonds:

Asset backed securities are fully collateralized by assets

Example mortgage backed securities

Called equipment trust securities

Non Secured Bonds

Called Debentures Subordinate debentures Variable rate bonds

Only secured by the credit worthiness of the issuer

Coupon Rates are variable

Junk Bonds

High default risk and low liquidity

Junk bonds typically offer interest rates three to four percentage points
higher than safer government issues.

Debt that is rated below BBB

Often, trusts and insurance companies are not permitted to invest in junk
debt

Callable Bonds

Bonds with a call provision are bonds that the issuer can call back from
the bearer (bondholders) for a callable price before maturity due to the
fact that market interest rates are higher than the bond's rates .The issuer
re issue new bonds with lower interest rates

They have higher yield than non- callable bonds

Convertible Bonds

Securities, usually bonds that can be converted into common stock.

Convertibles are most often associated with convertible bonds, which

allow bond holders to convert their creditor position to that of an equity
holder at an agreed upon price.

Registered Bonds

Replaced bearer bonds

IRS can track interest income this way

Restrictive Covenants

Conflicts with shareholder interests due to restrictions made on

management

May limit dividends, taking new debt

Corporate bond ratings

Corporate bonds have ratings. The degree of risk ranges from low-risk
(AAA) to higher risk (BBB). Any bonds rated below BBB are considered
sub-investment grade debt.

Municipal Bonds

Issued by local, county, and

state governments

Used to finance public interest projects

The major advantage is that the returns are free from federal tax.
Furthermore, local governments will sometimes make their debt nontaxable for residents, thus making some municipal bonds

Completely tax free. Because of these tax savings, the yield on a municipal
is usually lower than that of a taxable bond.

Types of municipal Bonds

A. Revenue Bond

A municipal bond supported by the revenue from a specific project

B. General Obligation Bond

General obligation bonds are issued with the belief that a municipality
will be able to repay its debt obligation through taxation or revenue from
projects. No assets are used as collateral

Agency bonds

Although not technically Treasury securities, agency bonds are issued by

government-sponsored entities.

The debt has an implicit guarantee that the government will not let the
debt default.

Financial Guarantees for Bonds

Some bond issuers purchase financial guarantees to lower the risk of

their debt.

The guarantee provides for timely payment of interest and principal, and
are usually backed by large insurance companies.

RULES
Two basic yield measures for a bond are its coupon rate and current yield.

where C

FV

face value

maturity in years

Tax-free municipal interest rate = taxable interest rate *(1 - marginal tax
rate)

annual coupon, the sum of 2 semiannual coupons

Problems
1. Suppose a $1,000 par value bond pays semiannual coupons of $40.
The annual coupon is then $80, calculate the coupon rate

2. Suppose a $1,000 par value bond paying an $80 annual coupon has a
price of $1,032.25.Calculate current yield

3. Suppose a bond has a $1,000 face value, 20 years to maturity, an 8

percent coupon rate, and a yield of 9 percent. Whats the price?

4. Suppose a bond has a $1,000 face value, with eight years to maturity
and a 7 percent coupon rate. If its yield to maturity is 9 percent, does
this bond sell at a premium or discount? Verify your answer by
calculating the bonds price.

5. Consider two bonds, both with a 9 percent coupon rate and the same
yield to maturity of 7 percent, but with different maturities of 5 and
10 years. Which has the higher price? Verify your answer by
calculating the prices.

6. Suppose a bond has ten years to maturity, a price of 900, and a

coupon rate of 8 percent. What is its yield to maturity?

7. Suppose the rate on a corporate bond is 9% and the tax rate is 28%.
The rate on a municipal bond is 6.75%. Which bond should you
choose?

11