Bonds basics

Objectives
 A. Understand risk and return for bonds
 B. Understand bond terminology
 C. Understand the major types of bonds
 D. Understand how bonds are valued
 E. Understand the costs of investing in
bonds

A. Understand Risk and Return for
Bonds
 Why Consider Bonds in your portfolio?
 Bonds reduce risk through diversification.
 Bonds produce steady current income.
 Bonds can be a safe investment if held to
maturity.
 Bonds are less risky than stocks, although their
returns are lower as well.
 If interest rates drop, bond prices will rise

Risk and Return (continued)
 Why be concerned about bonds?
 Bonds are susceptible to changes in:
 The domestic and world economy
 Domestic and world interest rates
 The business and political environment
 The growth of bond or fixed income investment
is determined by more than just interest rates
 Bonds are somewhat illiquid, may be called, and
are often sold in large denominations
 Individual bonds can be very risky investments
 Finding a good investment outlet to invest the
interest you receive from bonds may be difficult

Bonds are susceptible to a number of risks:
 Interest rate risk
 Risk that a rise (fall) in interest rates will result in
a decline (rise) in the bond’s value
 Inflation risk
 Risk that a rise (decline) in inflation will result in a
decrease (increase) in the bond’s value
 Business risk
 Risk that the bond’s value will decline due to
problems with the company’s business
 Liquidity risk
 Risk that investors will be unable to find a buyer
or seller for a bond when they need to sell or buy

 Financial risk
 How the firm raises money could affect the
financial performance of the firm and the value
of the bonds
 Political or regulatory risk
 Unanticipated changes in the tax or legal
environment will have an impact on a
company’s bonds
 Exchange rate risk
 Risk that changes in exchange rates will impact
profitability for firms working internationally

B. Understand Bond Terminology
 Par value
 The face value or amount returned to the holder
of the bond at maturity
 Coupon interest rate (or interest rate)
 The percentage of the par or face value that will
be paid annually to the holder in the form of
interest
 Maturity date
 The date when the bond expires and the loan
must be paid back
 Price
 The price that the bond sells for

Bond Terminology (continued)
 Call provision
 Allows the issuer to repurchase the bonds
before the maturity date
 Deferred calls provide more protection.
 Sinking fund
 Money set aside annually to pay off the bonds
at maturity
 Indenture
 A document that outlines the terms of the loan
agreement
 Yield
 The annual interest on a bond divided by its
price

 Issuer
 The corporation or government agency that
issues the bond
 Term or Bond Maturity:
 Short-term
 Bonds with maturity usually a year or less
 Intermediate-term
 Bonds with a maturity of 2 to 10 years
 Long-term
 Bonds with a maturity of greater than 10 years

 Bearer bonds
 Bonds with coupons attach that pay interest only
to the bearer upon surrender of the coupons
 Book-entry bonds
 Bonds which are registered and stored
electronically, similar to stock purchases
 Baby bond
 A bond with a par value of less than $1,000

 Discount bond
 A bond that is sold at a discount to its par value.
Generally, upon maturity the accrued interest
and original investment add to the bond’s par
value
 Callable bond
 A bond that can be redeemed prior to its
maturity date at the option of the issuer
 Redemption
 The process of redeeming a callable bond
before its maturity date

 Asset backed bonds
 Asset backed bonds
 Bonds backed by specific holdings of the issuing
company, such as equipment or real estate
 Debentures
 Bonds backed by the credit of the issuing company
 Mortgage-backed bonds
 Bonds backed up by a pool of mortgages
 Collateralized mortgage obligations (CMOS)
 More complex and specialized versions of mortgage
backed bonds

 Bonds with Conditions
 Subordinated bond
 Bond that will be paid after the other loan obligations of
the issuer are paid
 Floating rate bond
 Bond whose interest payments fluctuate according to a
specific benchmark interest rate
 Convertible bond
 Bond which gives the holder the right to convert the
bond to company stock instead of getting the cash
repayment

 Callable bonds
 Bonds which can be called, i.e. redeemed, before
maturity at the option of the issuer.
 Zero-coupon bond
 A discount bond which pays no interest until maturity.
 Junk Bonds
 Bonds with very low bond ratings, a higher interest rate
and default rate, and are almost always callable

 What are bond ratings?
 Bond ratings are measures of the riskiness of a
company. Ratings run from “AAA” (Standard &
Poor’s) or “aaa” (Moody’s) for the safest to “D”
for the extremely risky
 Ratings categorize bonds by default risk, the
risk of the company being unable to repay the
bond
 The major rating companies are:
 Standard & Poor’s
 Moody’s

 Bond rating company
 A private sector company that evaluates the
financial condition of the bond issuing company, its
revenues, profits, debt, and other critical areas, and
gives the company a rating which indicates the
relative safety of the bond
 Generally, the better the bond rating, the lower the interest
rate the company will have to pay to sell its bonds
 Only rate corporate and municipal bonds

 Downgrade
 A situation where a bond rating company
reduces the bond rating of a bond generally due
to a deterioration in the company’s financial
condition
 Upgrade
 A situation where a bond rating company
improves the bond rating of a bond due
generally to an improving financial condition
 Risk of Downgrading
 Should a bond’s rating be downgraded, the
seller would need to reduce the price of the
bond (resulting in a lower yield to the seller and
a higher yield to the buyer) to make up for the

C. Understand the Major Types of
Bonds (continued)
While there are many different types of bonds,
they fall under a few major headings:
 Corporate
 Treasury Debt Securities
 Municipal
 Agency
 International
 Treasury Savings Securities

Major Bond Types (continued)
 Corporate Bonds
 Types:
 Bonds secured corporate debts by collateral or real
property liens
 Secured bond, Mortgage bond
 Unsecured corporate debts
 Bonds not secured by collateral, and pay a higher
return
 Debenture
 Long-term unsecured bond
 Can have a hierarchy of payment, with
unsubordinated and subordinated debentures

 Issuer: issued by corporations
 Maturities: Can have many different maturities
 Short-term: 1 to 5 years
 Intermediate term: 6 to 10 years
 Long-term: 11 to 30+ years
 Par value: P1,000 and up
 Taxes: Subject to national and local taxes
 Risk and Return: More risky than government bonds,
but higher returns. Very little risk with highest rated
bonds

 Rated: Yes
 Trading: By brokers, either OTC or on an exchange
 Callable: Yes

 U.S. Treasury Debt Securities
 Types:
 Treasury Bills
 A short-term debt obligation issued at a discount and
redeemed at face value upon maturity in 3, 6, or 12
months
 Treasury Notes
 An intermediate-term debt obligation issued at or
near par and interest paid semiannually.
 Treasury Bonds
 A long-term debt obligation issued at or near par and
interest is paid semiannually.
 Issuer: U.S. government

 Maturities: 3 months to 30 years
 Par Value: (T-bonds/notes) $1,000, $5,000 (all)
$10,000 to $1 million
 Taxes: Exempt from state and local taxes, but
not federal taxes
 Risk and Return: Government securities, so
considered risk free.
 However, with lower risk, returns are lower as well
 Rated: No
 Trading: Auction, at the Federal Reserve.
Outstanding issues by brokers, OTC
 Callable: Usually not

 Municipal bonds
 Types:
 Revenue bonds: Bonds backed by the revenues of
a specific project
 General Obligation bonds: Bonds backed by the
taxing power of the issuer
 Issuer: Bonds issued by various state and local
governments
 Par Value: $5,000 and up

 Taxes: Exempt from federal tax
 May also be exempt from state and local tax if the
investor lives in the state from which the bond was
issued
 Risk and Return: Risk is higher than
government bonds, while returns may be lower,
due to federal tax exemption.
 Rated: Yes
 Trading: Brokers, OTC
 Callable: Sometimes

 Agency bonds
 Types:
 Issued by government agencies which were authorized by
Congress
 Federal National Mortgage Association (FNMA)
 Federal Home Loan Banks (FHLB)
 Government National Mortgage Association (GNMA)
 Issuer: Bonds issued by various federal, state, or
local agencies or institutions

 Par Value: $25,000 and up. Generally higher
minimum investment required.
 Taxes: Ginnie Mae, Fannie Mae, and Freddie
Mac are taxable. Other federal agencies are
state and local tax exempt.
 Risk and return: Somewhat higher risk and
return than Treasury bonds
 Rated: Some issues are rated
 Trading: Brokers, OTC, directly through banks
 Call Provisions: Not callable

 International Bonds
 Types:
 International Bonds
 Bonds issued by international companies and sold
internationally in various currencies
 Yankee Bonds
 Bonds issued by international companies and sold in
the U.S. in U.S. dollars
 Euro Bonds
 Bonds issued by U.S. companies and sold outside of
the U.S. in U.S. dollars

D. Understand How Bonds are
Valued
 How are bonds valued?
 Bonds are valued in many ways. Generally, the
value of a bond is determined by the price paid
for the bond, and the discounted value of all of
its interest payments and the repayment of its
par value
 The three key inputs are:
 The price and the par value of the bond
 The maturity and coupon interest payments
 The discount rate of the investor
 The price of the bond is the present value of the
price, interest payments, and future par value all
discounted at the investors discount rate

Valuation Principles (continued)
 What is the relationship between key inputs?
 Price and Par Value
 A bond whose price is less (more) than its par value is
trading at a discount (premium) to par
 Bonds trade at below (above) par when the interest
rate of the bond is lower (higher) than prevailing
market interest rates
 Suppose you own a bond with a 6% coupon rate. If
market interest rates were 4% now, because your bond
has a higher than 4% rate, investors would have to pay
you more for that bond, i.e. offer you a higher price

 Maturity and Price
 Bonds fluctuate in value, and the longer (shorter)
the time to maturity the greater (smaller) the
fluctuation.
 Since bonds take into account current changes in interest
rates, and if those rates increase, the longer (shorter) the
maturity the greater (smaller) the fluctuation in the price of
the bond

 Investor’s discount rate and price
 The value of a bond is related to the investor’s
discount rate
 Bonds are valued at the discount rate required by the
investor.
 If the discount rate increases (decreases), the investor
will require a higher (lower) return on all cash flows,
and hence a lower (higher) price
 Since coupon payments are fixed (generally) for the life
of the bond, the only input that can change to adjust for
changes in the investor’s discount rate is the bond price

 Why would an investors’ discount rate of return change?
 The investor perceives a change in the risk associated
with the firm issuing the bond
 As perceived risk increases, the investor’s discount rate
increases
 The investor perceives a change in general market
interest rates
 As general interest rates in the market increase, investors require
a higher discount rate to invest
 The investor perceives a change in the general risk in
the market (the market risk premium)
 As the perceived riskiness of the market increases, investors
require a higher discount rate to invest

 Note that the discount rate required for an
investor to invest in bonds will change
depending on each investor
 However, for bonds with a call feature the call
price limits the upward price
 As a bond approaches its maturity date, its
market value approaches it par value
 If you expect interest rates to increase, buy
short-term bonds.
 If you expect interest rates to decrease, buy
long-term non-callable bonds.

Copyright © 2006 Pearson
Addison-Wesley. All rights
reserved.
6-36
Mills Company, a large defense
contractor, on January 1, 2007,
issued a 10% coupon interest
rate, 10-year bond with a $1,000
par value that pays interest
semiannually.
Bond Valuation: Basic Bond
Valuation

Bond Valuation: Bond Fundamentals

Bond Valuation:
Bond Fundamentals (cont.)

 What is the bond yield?
 Is the total return on a bond investment
 Is not the same as the interest rate
 Is affected by the bond price which may be more
(a premium to) or less than (a discount to) face
value
 How you do measure bond yield?
 Current yield
 Yield to maturity
 Equivalent taxable yield on muni’s

 Current Yield
 Ratio of annual interest payments to the bond’s
market price
 It is calculated as:
 Annual interest payments / Market price of the bond
 Since the interest payments are fixed, the only variable that
can change is the price of the bond.

 Yield to Maturity
 This is the true yield received if the bond is held
to maturity, which assumes that all interest
payments can be reinvested at the same rate.
 It is a cash flow problem, that is best solved by use of a
calculator. The approximate yield to maturity is:
(AIP + (PV – CP)/YM) / (PV-CP)/YM
AIP = annual interest payments
PV = Par value
CP = Current market price
YM = Years to maturity

 Equivalent taxable yield (ETY)
 The yield that must be offered on a taxable bond
to give the same after-tax yield on a tax-exempt
bond
 Equivalent Taxable Yield Equation is:
 ETY = Tax-free yield / (1 – marginal tax bracket)
 Note:
 It is critical that you understand the tax implications of
each type of bond to calculate after-tax return, i.e.
municipal bonds are free from federal tax, treasury debt
securities are free from state and local taxes, etc.

 Remember the principles of investing when
investing in bonds:
 Invest tax-efficiently
 Its not what you make, but what you keep after taxes.
Take into account the tax implications of bonds
 Invest low-cost
 Buy a bond when it is first issued, rather than in the
secondary market
 Stay diversified
 Consider investing in a portfolio of bonds. If buying
single bonds, consider only high quality bonds

 Watch market interest rates
 Keep the inverse relationship between interest
rates and bond price in mind
 If interest rates are likely to rise (fall), invest in short-
term (long-term) bonds
 Know what you are investing in
 Avoid bonds that might get called.
 Stick to large issues which are more liquid
 Know yourself and your goals
 Match your bond’s maturity to your investment
time horizon.

E. Understand the cost of investing in
bonds
 What are the costs of investing in bonds?
 Explicit Costs
 Commission costs
 All bond trades incur commission costs
o Some newly issued bonds are sold without
commission cost as the issuer absorbs the costs
o Most trades however, incur commission costs,
which are paid to the broker who arranged the
trade
 Markup
 This is the difference between the buying price and
the calculated selling price

Cost of Investing in Bonds (continued)
 Explicit costs (continued)
 Custody (or annual) fees
 These are fees the brokerage house charges to hold
the bonds in your account.
o May be a minimum amount for small accounts
($15 per year), a specific charge per holding (8
basis points per security), or a percentage of
assets for large accounts (25 basis points on
assets under management)

 Implicit costs
 Taxes:
 Taxes must be taken into account to get the true return
of your portfolio but which are not noted on your
monthly reports
 Interest
 Interest is the coupon payment received each period.
These are taxed at your ordinary income rate.
 This is an expensive type of income

• Implicit costs (continued)
 Capital Gains
 This is the difference between what you paid for the bond
and what you sold it for, or the par value if you held the
bond to maturity
 Short-term:
 Gains made in selling bonds owned less than 1 year.
They are taxed at your marginal tax rate
 Long-term Capital Gains:
 Gains made in selling bonds held for more than 1 year.
These are taxed at 5-15% depending on how long you
have held the asset, and are only on the asset, not
coupon payments

 Hidden Costs (at the account level)
 Beyond the explicit and implicit costs, look for
the following hidden costs:
 Account Transfer Fees
 Charges for moving assets either into our out of an
existing account
 Account maintenance fees
 Fees for maintaining your account
 Inactivity/Minimum balance fees
 Fees because you did not trade or have account
activity during the period or because you failed to
keep a minimum balance in your account

Bonds basics

More Related Content

What's hot (17)

Similar to Bonds basics (20)

Recently uploaded (20)

Bonds basics