Background on Bonds

Background on Bonds

n     Bonds represent long-term debt securities

l      Contractual

l      Promise to pay future cash flows to investors

n     The issuer of the bond is obligated to pay:

l      Interest (or coupon) payments periodically usually semiannually

l      Par or face value (principal) at maturity

n     Primary vs. secondary market for bonds

Background on Bonds

The issuer’s cost of financing with bonds

u   Determined by current market rates and risk

u   Usually fixed throughout term

u   Determines periodic interest payments

Background on Bonds

The yield to maturity (YTM) is the yield that equates the future coupon and principal payments with the bond price

l      The YTM is the investor’s expected rate of return if the bond is held to maturity

Background on Bonds

U. S. Treasury Bonds

n     Issued by the U.S. Treasury to finance federal government expenditures

n     Maturity

l      Notes, < 10 Years

l      Bonds, > 10 to 30 Years

n     Active OTC Secondary Market

n     Semiannual Interest Payments

n     Benchmark Debt Security for Any Maturity

Treasury Bonds

n     Treasury Bond Quotations

8.38  Aug. 2013-18 103:05 103.11  YTM?

l      Coupon rate

l      Maturity date

l      Bid/Ask price as percent of face value

l      Fractions of price in 32nds

u   Example: Bid price 103:05, Ask price 103:11

Treasury Bonds

l      Stripped Treasury bonds

u   Zero-coupon securities are sold with claims on U. S. Treasury bonds held in a trust

n   One security represents the principal payment (PO) at maturity

n   Other securities represents the interest payments (IO) at interest paying dates

Treasury Bonds

l      Intended for investors who seek inflation protection with their investments

l      Coupon rates less than other Treasuries

l      Principal value adjusted for the U.S. inflation rate (CPI) every 6 months

l      Coupon income increases with inflation

Municipal Bonds

n     State and local government obligations

n     Revenue bonds vs. general obligation bonds

n     Investor interest income exempt from federal income tax

Corporate Bonds

n     When corporations want to borrow for long-term periods they issue corporate bonds

l      Usually pay semiannual interest

l      Most have maturities between 10-30 years

l      Public offering vs. private placement

l      Limited exchange, larger OTC secondary market

Corporate Bonds

l      Indenture

u   Legal document specifying rights and obligations of issuer and bondholder

l      Trustee

u   Represents bondholders to assure compliance with indenture

Corporate Bonds

Sinking Fund Provision

u   Requirement that the firm retire a certain amount or number of bonds each year

u   Protects investors with principal reduction

l      Protective Covenants

u   Places restrictions on the firm to protect bondholders

u   Examples: limits dividends and officer salaries, restricts additional debt

Corporate Bonds

l      Call provisions:  Ability to pay bonds off early

u   Call premium

u   Advantage to issuers; disadvantage to investor

l      Bond collateral

u   Usually consists of a mortgage on real property

u   Unsecured bonds are called debentures and are backed only by the general credit of the issuing firm

Corporate Bonds

l      Low-coupon and zero-coupon bonds

l      Variable-rate bonds

l      Convertible bonds

Corporate Bonds

n     Junk Bonds

l      Junk bonds are also called high-yield bonds or noninvestment rated bonds

l      Popularized in the direct finance boom of the 1980s to finance acquisitions and leveraged buyouts (LBO)

l      The risk premium is generally the highest among corporate bonds

Corporate Bonds Market Quotation

ATT 6 ½  29  7.3  214  88 5/8th +1/4

§     AT&T bond quote for 1/13/02 (U.S. Exchange Bond)

§     6.5% coupon rate

§     Maturity in 2029

§     7.3% current yield (annual interest/price)

§     214 bonds traded on this day

§     Bond priced at close of day 88 5/8th % of face ($1000) or $886.25

§     Bond price up ¼ point for the day or $2.50

Globalization of Bond Markets

n     Investment in foreign currency securities

n     Overseas issuance by firms

n     Bonds that are sold in countries other than the country represented by the currency denominating them are called Eurobonds