the bond market a deeper understanding of a major economic market based on presentations by emma...
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THE BOND MARKET
A Deeper Understanding of a Major Economic Market
Based on presentations by Emma Ricci and Meghan Barnes
WHAT IS A BOND?
A bond is a loan, a `debt security`. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer.
Components
The issuer, similar to a holder of an optionPrincipal amount, usually $1000Specified interest rate; paid to the issuer yearly (also known as the coupon)Date of maturity
Example
In 2004, Radnor township issued bonds for a total of $50 million, in order to pay for the new Middle School buildingThe maturity was 20 yearsThe coupon was 5.5 %The bond was callable (the township could pay off the bond early)
Issuers of Bonds
Corporations Finance Operations
Federal Government Treasury Securities Bills, Notes, & Bonds
Federal Agencies Government
Sponsored Enterprises
Municipal Governments and Agencies Munis are “Tax
Exempt” General Obligation Revenue
Foreign Governments and Corporations Yankee Bonds
Special Types of Bonds
Floating Rate Bonds Interest Payments Change Over the Life of
the Bond Rate is Tied to a Financial Benchmark such
as the LIBOR
Convertible Bonds Can be Exchanged for Other Securities
Types of Bonds, Continued
High-Yield / Junk Bonds Speculative Grade Bonds Rated below Baa by Moody’s or BBB by S&P Greater Risk = Higher Yield
Asset-Backed Bonds Securitized by Some Financial Asset
Zero Coupon Bonds Do Not Pay Coupons Sold at a Large Discount
Premium vs. Discount
Premium bonds: price > par valueYTM < coupon rate
Discount bonds: price < par valueYTM > coupon rate
Par bonds: price = par valueYTM = coupon rate
Trading Bonds / Bond Prices
Usually Issued in Par Values of $1,000 Price is Usually Closest to Par at the Time it
is First Issued
Dealers Post Bid and Ask PricesPrices Listed Daily in the Wall Street Journal Down to 1/8 of a DollarPrice is Equal to the Present Value of the Expected Future Cash FlowsP= C/(1+r)1 + C/(1+r)2+ C/(1+r)3 +…+ C/(1+r)n + M/(1+r)n
Yield Curve
Shows the Relationship Between Short-Term and Long-Term Yields on SecuritiesSlope can be Upward, Downward, or HorizontalRight Now, They are All Upward Sloping Longer Time to Maturity = Higher Yield
Current Yield Curves
1.) Treasury Yield Curve 2.) Agency AAA Yield Curve 3.) Corporate AAA Yield Curve 4.) Municipal AAA Yield Curve
Treasury AAA Agency AAA Corporate AAA Municipal3 mo 1.77 - - -6 mo 2.10 - - -1 yr 2.66 3.15 3.09 2.132 yr 3.71 3.95 4.14 2.693 yr 4.09 4.52 4.57 3.155 yr 4.80 5.35 5.42 3.667 yr 5.20 5.96 5.94 4.1510 yr 5.39 6.28 6.25 4.4220 yr 6.00 6.90 6.70 5.1530 yr 5.78 6.50 6.92 5.33
Bond Market Yield SummaryMarch 29, 2002
Price vs. Yield
Prices Continually Fluctuate With Changes in Interest RatesInterest Rates , Prices Interest Rates , Prices Rates of Older Issues Change to Match Those of New IssuesLonger Maturity Means More Likely Price Will Be Affected By Changes in Interest Rates
Tax Status
Some Offer Special Tax AdvantagesNo State or Local Income Tax on U.S. Treasury Bonds or MunisWanting Taxable or Tax-Exempt Income Depends on: Your Income Tax Bracket The Difference Between What Can Be
Earned From Taxable Versus Tax Exempt Securities
Bond Ratings –Measuring Default Risk
Nationally Recognized Statistical Rating OrganizationsHenry Varnum Poor Compiled Financial Data About Canals & Railroads Updated the Directory of Railroads, Canals and
Steamship Lines in the United States
Poor’s Publishing Successor of Henry, Collaborated with John Moody Later Went Their Separate Ways
Ratings, Continued
Moody’s Began Producing “Moody’s Investor’s Manual”Poor’s Publishing Published its Own Bond Ratings Then Merged with the Standard Statistical
Bureau to Form Standard and Poor’s
Other Rating Agencies Today Fitch Investor Service Duff and Phelps
The Rating Process
Standard and Poor’s Process as example:Rating RequestIssuer MeetingRating Committee MeetingNotification and AppealDisseminationSurveillance
Definition of the Ratings/Default Risk
Moody's S&P Fitch DCR DefinitionAaa AAA AAA AAA Prime. Maximum SafetyAa1 AA+ AA+ AA+ High Grade QualityAa2 AA AA AAAa3 AA- AA- AA-A1 A+ A+ A+ Upper Medium GradeA2 A A AA3 A- A- A-
Baa1 BBB+ BBB+ BBB+ Lower Medium GradeBaa2 BBB BBB BBBBaa3 BBB- BBB- BBB-
Ba1 BB+ BB+ BB+ Non Investment GradeBa2 BB BB BB SpeculativeBa3 BB- BB- BB-B1 B+ B+ B+ Highly SpeculativeB2 B B BB3 B- B- B-
Caa1 CCC+ CCC CCC Substantial RiskCaa2 CCC - - In Poor StandingCaa3 CCC- - -Ca - - - Extremely SpeculativeC - - - May be in Default- - DDD - Default- - DD DD- D D -- - - DP
Below this line, bonds are classified as "junk bonds"
Higher Rating Means Less Risk that the Issuer Will Default on PaymentsLower Rating Means Higher Risk Purchaser is
Compensated with a Higher Yield for Taking on this Additional Risk
Factors Effecting Default Risk
Earnings Variability More Volatile Earnings Could Mean a Greater
Possibility of Losses Exceeding Ability to Raise Funds
Age of the Firm If a Firm has a Well Established History of No
Defaults, Investors Have More Confidence in its Continued Success
Current Leverage Using Greater Financial Leverage Could Mean
Greater P/E Ratio But Could Also Mean that by Using More Borrowed
Funds Rises Relative to Equity, and Risk of Declines in Net Earnings Increases
Risk vs. Yield
Risk and Yield are Directly RelatedThe Risk Involved in an Investment Includes the Risk Free Rate Plus the Default Risk Premium
Callable Bonds
Call Privileges Gives the Issuer the Right to Retire a Bond Prior to
Maturity
Call Risk Known as Reinvestment Risk Bonds Will Be Called When Interest Rates are Falling Investors May Earn Less Than Their Expected Yield
If an Investor is Long a Callable Bond, thenCallable Bond Price =
Noncallable Bond Price – Call Option Price
Callable Bonds, Continued
Call Premium Purchaser is Compensated for Higher
Risk If Rates are High and Going to Fall, there
Will Be a Higher Call Premium If Rates are Low and Going to Rise, there
Will Be a Lower Call Premium
Advantage is for the IssuerDisadvantage is for the Purchaser
Putable Bonds
Purchaser Buys Nonputable Bond and a Put Option from the IssuerPurchaser has the Right to Sell the Bond to the Issuer at a Certain Predetermined Time and PriceIf Investor is Long a Putable Bond, then Putable Bond Price =
Nonputable Bond Price +Put Option Price
Current Price vs. Strike Price
Callable BondsIf P>E, intrinsic value is P-E and option is “in the money”If P=E, intrinsic value is 0, option is “at the money”If P<E, intrinsic value is 0 and option is “out of the money”
Putable BondsIf P<E, intrinsic value is E-P and option is “in the money”If P=E, intrinsic value is 0 and option is “at the money.”If P<E, intrinsic value is 0 and option is “out of the money.”P=Current Bond Price, E=Strike Price
Bonds vs. Certificates of Deposit
BondsIssued by Govt. or CompaniesCapital MarketNot Insured by Govt.
CDsIssued by BanksMoney MarketInsured by Federal Govt. up to $100,000
•Both could have a Call Option Attached and Expose the Purchaser to Reinvestment Risk
Stocks vs. Bonds
StocksCapital Gain/Loss
Unlimited Upside Potential with Unlimited Downside Risk
Part OwnerDividends
Company may change it or decide not to pay one at all
BondsFixed IncomeCreditorGuarantee of Principal Payment Default Risk
DIVERSIFICATION: depending on your income and ability to take risk, you will choose a different path.