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Chapter 17

Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown. Chapter 17. Chapter 17 Bond Fundamentals. Questions to be answered:

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Chapter 17

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  1. Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementEighth Editionby Frank K. Reilly & Keith C. Brown Chapter 17

  2. Chapter 17Bond Fundamentals Questions to be answered: • What are some of the basic features of bonds that affect their risk, return, and value? • What is the current country structure of the world bond market and how has the makeup of the global bond market changed in recent years?

  3. Chapter 17Bond Fundamentals • What are the major components of the world bond market and the international bond market? • What are bond ratings and what is their purpose? • What is the difference between investment-grade bonds and high-yield (junk) bonds?

  4. Chapter 17Bond Fundamentals • What are the characteristics of bonds in the major bond categories such as governments (including TIPS), agencies, municipalities, and corporates? • How does the makeup of the bond market in major countries such as the United States, Japan, the United Kingdom, and Germany differ?

  5. Chapter 17Bond Fundamentals • What are the important characteristics of corporate bond issues developed in the United States during the past decade such as mortgage-backed securities, other asset-backed securities, zero-coupon and deep discount bonds, high-yield bonds, and structured notes? • How do you read the quotes available for the alternative bond categories (e.g., governments, municipalities, corporates)?

  6. Basic Features of a Bond • Pay a fixed amount of interest periodically to the holder of record • Repay a fixed amount of principal at the date of maturity

  7. Basic Features of a Bond • Bond market is divided by maturity • Money Market - short-term issues that mature within one year • Notes - intermediate-term issues that mature between one and ten years • Bonds - long-term obligations with maturity greater than ten years • Remaining life (maturity) affect price volatility

  8. Bond Characteristics • Intrinsic features • Coupon - yield (interest income) • Maturity - term or serial (municipalities) • Principal value - different from market value • Type of ownership - bearer or registered • Types of Issues • Secured (senior) bonds • Unsecured bonds (debentures) • Subordinated (junior) debentures

  9. Bond Characteristics • Indenture provisions • Features affecting a bond’s maturity • Callable (call premium) • Noncallable • Deferred call • Nonrefunding provision • Sinking fund

  10. Rates of Return on Bonds where: HPRi,t = the holding period for bond i during the period t Pi,t+1 = the market price of bond i at the end of period t Pi,t = the market price of bond i at the beginning of period t Inti,t = the interest payments on bond i during period t The holding period yield (HPY) is: HPY = HPR - 1

  11. The Global Bond-Market Structure • Participating issuers • 1. Federal governments • 2. Agencies of the federal government • 3. State and local political subdivisions (municipalities) • 4. Corporations • 5. International issues • Foreign bonds • Eurobonds

  12. Participating Investors • Individual investors • Institutional investors • Life Insurance Companies • Commercial Banks • Property and Liability Insurance Companies • Pension Funds • Mutual Funds

  13. Bond Ratings Major Rating Agencies • Standard & Poor’s • Moody’s • Fitch Investor Services

  14. Alternative Bond Issues Domestic government bonds • United States - T-bills, notes, bonds. TIPS • Japan - medium term, long term, super long term • Eurozone – government bonds • United Kingdom - short gilts, medium gilts, long gilts

  15. Government Agency Issues United States • Not direct issues, but backed by “full faith and credit” of the U.S. government • GNMA pass-through certificates Japan • Government associate organizations United Kingdom • There are no agency bonds in the U.K. Eurozone • Agency bonds are not broken down in the Eurozone

  16. Municipal Bonds • General obligation (GO) bonds • Revenue bonds • Interest payments are exempt from federal income tax • Convert the tax-free yield of a municipal bond selling close to par to an equivalent taxable yield (ETY)

  17. Equivalent Taxable Yield Where: i = coupon rate of the municipal obligations T = marginal tax rate of the investor

  18. Municipal Bond Guarantees • Bond insured against default risk • Insurance is irrevocable for the life of the issue • Four private bond insurance carriers • Municipal Bond Investors Assurance (MBIA) • American Municipal Bond Assurance Corporation (AMBAC) • Financial Security Assurance • Financial Guaranty Insurance Company (FGIC)

  19. Municipal Bond Guarantees • Insured bonds obtain AAA (Aaa) ratings • Issues with private guarantees have more active secondary market, and lower required yield

  20. Corporate Bonds • Mortgage bonds • Collateral trust bonds • Equipment trust certificates • Collateralized mortgage obligations (CMOs) • Other asset-backed securities (ABS) • Variable rate notes

  21. Corporate Bonds • Zero-coupon and deep-discount bonds • Minicoupon bonds • Original-issue discount (OID) bonds • Taxes due on the implied interest • High-yield bonds (speculative bonds and junk bonds) • Noninvestment grade with rating below BBB or Baa

  22. Japanese Corporate Bond Market • Bonds issued by industrial firms or utilities • Minimum issuing requirements are specified by the Ministry of Finance • Bonds issued by banks to finance loans to corporation • Commercial banks • Long-term credit banks • Mutual loan and savings banks • Specialized financial institutions

  23. U.K. Corporate Bond Market • Debentures • Unsecured loans • Convertible bonds

  24. Eurozone Corporate Bond Market • Nonbank corporate bonds including industrial and utility firms • “Corporate-monetary Financial” including borrowing by banks

  25. International Bonds • Foreign bonds are sold in one country and currency by a borrower of a different nationality • Yankee bonds are U.S. dollar denominated bonds sold in the U.S. but issued by a foreign firm • Eurobonds are underwritten by international bond syndicates and sold in several national markets

  26. International Bonds • United States • Yankee bonds register with SEC • Eurodollar bond market affected by changes in value of U.S. dollar

  27. International Bonds • Japan • Samuri bonds - yen denominated issued by non-Japanese firms in Japan • Euroyen bonds - yen denominated, sold outside Japan

  28. International Bonds • United Kingdom • Bulldog bonds are sterling-denominated bonds issued by non-English firms and sold in London • Eurosterling bonds are sold in markets outside London by international syndicates

  29. International Bonds • Eurozone • Market popular among foreign issuers including issuers domiciled in the U.S. • Impressive growth in Eurobonds issued by non-residents

  30. Obtaining Information on Bonds • Less emphasis on fundamental analysis • Most bond investors rely on rating agencies for credit analysis • Market and economic conditions • Intrinsic bond features • Popular publications available: • Wall Street Journal, Barron’s, Business Week, Fortune, Forbes, Federal Reserve Bulletin, Survey of Current Business

  31. Bond Publications • Treasury Bulletin • Standard & Poor’s Bond Guide • Moody’s Bond Record • Moody’s Bond Survey • Fitch Rating Register • Fitch Corporate Credit Analysis • Fitch Municipal Credit Analysis • Investment Dealers Digest • Credit Markets • Duff & Phelps Credit Decisions • The Bond Player

  32. Sources of Bond Quotes • Bank and Quotation Record • The Blue List of Current Municipal Offerings • Wall Street Journal • Barron’s

  33. Interpreting Bond Quotes • Quoted on basis of yield or price • Price quotes are percentage of par • 98 1/2 is not $98.50 but 98.5% of par • A municipal $5,000 bond quoted at 98 1/2 would be $4,925

  34. Corporate Bond Quotes Company Last Last EST UST EST $ (Ticker) Price Yield Spread VOL Ford 7.45July 162031 80.625 9.461 50330 213,645

  35. Corporate Bond Quotes CompanyLast Last EST UST EST $ (Ticker) Price Yield Spread VOL Ford7.45July 162031 80.625 9.461 50330 213,645 Issued by Ford Motor Company

  36. Corporate Bond Quotes Company Last Last EST UST EST $ (Ticker) Price Yield Spread VOL Ford 7.45July 162031 80.625 9.461 50330 213,645 The maturity date of this bond

  37. Corporate Bond Quotes Company Last Last EST UST EST $ (Ticker) Price Yield Spread VOL Ford 7.45July 162031 80.625 9.461 50330 213,645 The last transaction price was 80.625 percent of par or $806.25, which implies an yield to maturity (YTM) for this bond of 9.461 percent

  38. Corporate Bond Quotes Company Last Last EST UST EST $ (Ticker) Price Yield Spread VOL Ford 7.45July 162031 80.625 9.461 50330 213,645 The computed yield spread for the Ford bond is 503 basis points (5.03 basis points)

  39. Corporate Bond Quotes Company Last Last EST UST EST $ (Ticker) Price Yield Spread VOL Ford 7.45July 162031 80.625 9.461 50330 213,645 Comparable U.S. treasury Issue

  40. Corporate Bond Quotes Company Last Last EST UST EST $ (Ticker) Price Yield Spread VOL Ford 7.45July 162031 80.625 9.461 50330 213,645 The trading volume for this bond is over $213 million

  41. Treasury and Agency Bond Quotes • Notations • “n” = treasury note • “i” = inflation-indexed issue • “p” = treasury note on which nonresident aliens are exempt from withholding taxes on interest • Quotes resemble those used for OTC securities because they contain both bid and ask prices

  42. Treasury and Agency Bond Quotes GOVT. BONDS & NOTES Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. 5.750 Nov 05n 101:05 101:06 …. 3.13

  43. Treasury and Agency Bond Quotes GOVT. BONDS & NOTES Maturity Ask Rate Mo/Yr Bid Asked Chg. Yld. 5.750 Nov 05n 101:05 101:06 …. 3.13 This is a 5.75 percent obligation bond due in November 2005. The bid quote is 101:05, and the ask is 101:06

  44. Treasury and Agency Bond Quotes • U.S. Treasury Strips • “ci” is the coupon interest portion stripped from the note • “np” is the principal payment for the treasury note • Treasury Bills • Pure discount instrument - there is no coupon, they pay par at maturity • The bid-ask is not the price but the yield

  45. Municipal Bond Quotes Quote from The Blue List of Current Municipal Offerings $200,000 of Indiana State Office Building bonds Guaranteed by MBIA These are zero coupon bonds due July 1, 2010 The yield to maturity is given as 5.6% To determine the price you compute the discount value The dealer offering the bonds is Bear Sterns, listed in the back of the publication with their phone number 200 INDIANA ST OFFICE BLDG COMMN MBIA 0.000 07/01/10 5.60 BEARSTER

  46. Municipal Bond Quotes • Notations ETM = escrow till maturity M/S/F = mandatory sinking fund (C97) = this bond became callable in 1997 When the market yield equals the coupon rate, the price is 100 and they are referred to as dollar bonds “+” in the left column indicates a new item “#” before yield to maturity or price indicates a change

  47. http://www.bondheads.com http://www.investinginbonds.com http://www.fitch.com http://www.moodys.com http://www.standardandpoors.com/ratings http://www.bradynet.com http://www.publicdebt.treas.gov The InternetInvestments Online

  48. End of Chapter 17 • Bond Fundamentals

  49. Future topicsChapter 18 • The Analysis and Valuation of Bonds

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