M10 Gitman5097010 11 FI C10

Chapter 10
Fixed-Income Securities
Copyright 2011 Pearson Prentice Hall. All rights reserved.
Learning Goals
1. Explain the basic investment attributes of bonds and their use as investment vehicles.
2. Describe the essential features of a bond, note the role that bond ratings play in the market, and distinguish among different types of call, refunding, and sinking-fund provisions. 3. Explain how bonds are priced in the market and why some bonds are more volatile than others.
10-2
Learning Goals (contd)
4. Identify the different types of bonds and the kinds of investment objectives these securities can fulfill.
5. Discuss the global nature of the bond market and the difference between dollar-denominated and nondollar- denominated foreign bonds. 6. Describe the basic features and characteristics of convertible securities, and measure the value of a convertible.
10-3
What Are Bonds?

Liabilities, or publicly traded IOUs
Also called fixed income securities since payments are fixed amounts
Borrower agrees to pay a fixed amount of interest over a specified period of time Borrower agrees to repay a fixed amount of principal at a predetermined maturity date
10-4
Why Invest in Bonds?

They can provide current income for conservative investors At times, they can provide capital gains (or losses) for more aggressive investors
Some bonds can provide tax-free income

They can be used for preservation and long-term accumulation of capital
10-5
Interest Rates and Bonds

The behavior of interest rates is the single most important force in the bond market Interest rates and bond prices move in opposite directions When interest rates rise, bond prices fall When interest rates drop, bond prices move up Bond markets are bullish when interest rates are low or falling Bond markets are bearish when interest rates are high or rising
10-6
Figure 10.1 Behavior of Interest Rates Over Time (19622008)
10-7
Bonds Versus Stocks

Compared to stocks, bonds offer lower returns
Main benefits of bonds in portfolio:

Lower risk and level of stability High levels of current income Diversification
Bonds add an element of stability to a portfolio
10-8
Figure 10.2 Comparative Performance of Stocks and Bonds (1997-2008)
10-9
Bonds and Risk

Interest Rate Risk is the chance that changes in interest rates will affect the bonds value Purchasing Power Risk is the chance that bond yields will lag behind inflation rates Business/Financial Risk is the chance the issuer of the bond will default on interest and/or principal payments Liquidity Risk is the risk that a bond will be difficult to sell at a reasonable price Call Risk is the risk that a bond will be called (retired) before its scheduled maturity date
10-10
Essential Features of a Bond

Coupon is the amount of annual interest income
Current Yield is a measure of the annual interest income a bond provides relative to its current market price
Principal (par value) is the amount of capital that must be repaid at maturity Maturity Date is the date when a bond matures and the principal must be repaid Term Bond is a bond that has a single maturity date Serial Bond is a bond that has a series of different maturity dates Note is a debt security originally issued with a maturity from 2 to 10 years
10-11
Principles of Bond Price Behavior

Price of a bond is a function of its coupon rate, its maturity, and market movements in interest rates
Longer maturities move more with changes in interest rates

Premium bond has a market value that is above par value
Occur when market interest rates are below bonds coupon rate
Discount bond has a market value that is below par value

Occur when market interest rates are above bonds coupon rate
10-12
Figure 10.3 The Price Behavior of a Bond
10-13
Essential Features of a Bond (contd)

Call feature allows the issuer to repurchase the bonds before the maturity date
Freely callable Noncallable Deferred call
Call premium is the amount added to bonds par value and paid upon call to compensate bondholders Call price is the bonds par value plus call premium Refunding provision prohibits the premature retirement of an issue from proceeds of a lower-coupon refunding bond
10-14
Essential Features of a Bond (contd) Sinking fund stipulates how a bond will be paid off over time
Applies only to term bonds Issuer is obligated to pay off the bond systematically over time
10-15
Types of Secured Debt

Secured debt is backed by pledged collateral Senior bonds are backed by legal claim to specific assets Mortgage bonds are backed by real estate. Collateral trust bonds are backed by securities (stocks, bonds) held in trust by a third party Equipment trust certificates are backed by specific pieces of equipment, such as railcars or airplanes
10-16
Types of Unsecured Debt

Unsecured debt is backed only by the promise of the company to pay
Junior bonds are backed only by promise and good faith of the issuer to pay
Debenture is an unsecured (junior) bond
Subordinated debentures are unsecured bonds whose claim is secondary to other claims
Income bond requires interest to be paid only after a specific amount of income has been earned
10-17
Bond Ratings
Bond ratings are letter grades that designate investment quality Private bond rating agencies assign ratings based upon financial analysis of the bond issuer Investment grade ratings are received by financially strong companies Junk bond ratings are received by companies making payments, but default risk is high Split ratings occur when a bond issue is given different ratings by major rating agencies Higher rated bonds have less default risk and pay lower interest rates
10-18
Table 10.2 Bond Ratings
10-19
The Market for Debt Securities

Bonds are traded mainly over-the-counter
Bond price activity is remarkably stable compared to stock market

Bond market is larger than the U.S. stock market Bond market is growing rapidly
10-20
Treasury Bonds
Considered risk freeno risk of default Interest is exempt from state and local taxes Sold in $1,000 denominations Types of Treasury Bonds
Treasury notes: maturities of 2, 3, 5, 7, and 10 years Treasury bonds: mature in 30 years
Treasury Inflation-Indexed Obligations (TIPS)

Protect against inflation by adjusting investor returns Interest rates are very low Maturities of 5, 10, and 20 years
10-21
Agency Bonds
Issued by U.S. government agencies
Federal Home Loan Bank Federal National Mortgage Association Small Business Administration
High quality securities with almost no risk of default

Interest rates usually higher than Treasury issues
10-22
Municipal Bonds
Issued by states, counties, cities and any other political subdivision Issued to fund public projects Two basic types
General obligation bonds are paid from general fund of the issuer Revenue bonds are paid from revenues from the project being financed
Often guaranteed by private insurers to lower risk and interest rates

10-23
Municipal Bonds
Interest is tax-exempt for Federal taxes
Interest can be tax-exempt from state taxes if you live in the state where the bond was issued
10-24
Corporate Bonds
Issued by corporations from four major segments
Industrials Public utilities Rail and transportation bonds Financial issues
Provide higher returns than government bonds due to higher risk of default Wide variety of bond quality and bond types available
10-25
Zero-Coupon Bonds
Do not pay interest
Sold at deep discount from par value

Value increases over time Subject to tremendous price volatility as interest rates fluctuate Interest must be reported as it is accrued for tax purposes, even though no interest is actually received.
Treasury strips are zero-coupon bonds created from U.S. Treasury securities.
10-26
Mortgage-Backed Securities
Bond backed by pool of residential mortgages
Principal and interest are paid monthly

Governmental agencies are major issuers:
Government National Mortgage Association (GNMA) Federal Home Loan Mortgage Corporation (FHLMC) Federal National Mortgage Association (FNMA)
Self-liquidating investment since portion of principal is received each month
10-27
Collateralized Mortgage Securities Mortgage-back bond pool that is divided into tranches, or classes of investors All principal payments go first to the shortest tranche until it is fully retired, then the next in sequence is paid Allows investors to choose short-term, mediumterm or long-term investment Potentially complex; interest rate fluctuations may have significant impact upon bond prices
10-28
Asset-Backed Securities
Issued by corporations and backed by pools of loans
Auto loans Credit card loans Home equity loans
Provide relatively high yields Short maturities, typically 3 to 5 years Interest and principal payments are monthly High credit quality
10-29
Junk Bonds (High-Yield Bonds)

Highly speculative, usually subordinated debentures Have low, sub-investment grade ratings Typically offer very high yields Prices tend to behave more like stocks than bonds
10-30
Global Bonds
Potentially higher returns than U.S. bonds
Offer broader diversification opportunities

Interest rate trends in other countries may not follow U.S. rates Currency exchange rate fluctuations can impact returns in U.S. dollars
10-31
Dollar-Denominated Bonds
Bonds issued by foreign governments or corporations and denominated in dollars Based on U.S. dollars Yankee bonds are registered with the SEC and issued and traded in U.S. Eurodollar bonds are not registered with the SEC and are issued and traded outside of the U.S.
No currency exchange rate risk since bonds are in U.S. dollars

10-32
Foreign-Pay Bonds
Bonds issued by foreign governments or corporations Based on currency other than U.S. dollars Not registered with the SEC and issued and traded outside of the U.S. Subject to currency exchange rate risk
10-33
Convertible Securities
Fixed-income security that allows holder to convert the security into a specified number of shares of the issuing companys common stock Two major types of convertible securities:
Convertible bonds Convertible preferred stock
Equity kicker: another name for the conversion feature that allows holder to convert the security into a specified number of shares of common stock
Forced conversion: calling in of convertible bonds by the issuing firm

10-34
Convertible Securities (contd)

Conversion privilege: the conditions and specific nature of the conversion feature on convertible securities Conversion period: the time period during which a convertible issue can be converted Conversion ratio: the number of shares of common stock into which a convertible issue can be converted Conversion price: the stated price per share at which common stock will be delivered to the investor in exchange for a convertible issue
10-35
Special Types of Convertible Securities (contd) LYON (Liquid Yield Option Note)
Zero coupon bond with both a conversion feature and a put option
No current income, but no limit on potential capital appreciation Put option allows security to be sold back to issuer at prespecified prices, providing downside protection
10-36
Sources of Value
Value of convertibles is based in both the stock and the bond dimensions of the security
Convertibles trade much like common stock as the market price of the stock starts getting close to (or exceeds) the stated conversion price
Convertibles trade much like a bond when the market price of the stock is well below the conversion price
Bond price sets a price floor in case the stock price goes into a freefall
10-37
Measuring the Value of a Convertible Conversion Value: indication of what a convertible issue would trade for if it were priced to sell on the basis of its stock value
10-38
Measuring the Value of a Convertible (contd) Conversion Equivalent: the price at which the common stock would have to sell in order to make the convertible security worth its present market price
10-39
Measuring the Value of a Convertible (contd)

Conversion Premium: amount above the conversion value that investors are willing to pay; typically due to the higher current income provided by convertibles over common stock
10-40
Measuring the Value of a Convertible (contd) Payback Period: the length of time it takes for the buyer of a convertible to recover the conversion premium from the extra current income earned on the convertible
10-41
Chapter 10 Review
Learning Goals
1. Explain the basic investment attributes of bonds and their use as investment vehicles.
2. Describe the essential features of a bond, note the role that bond ratings play in the market, and distinguish among different types of call, refunding, and sinking-fund provisions. 3. Explain how bonds are priced in the market and why some bonds are more volatile than others.
10-42
Chapter 10 Review (contd)

Learning Goals (contd)
4. Identify the different types of bonds and the kinds of investment objectives these securities can fulfill.
5. Discuss the global nature of the bond market and the difference between dollar-denominated and nondollar- denominated foreign bonds. 6. Describe the basic features and characteristics of convertible securities, and measure the value of a convertible.
10-43
Chapter 10
Additional Chapter Art
Table 10.1 Historical Annual Yields and Total Rates of Return for Treasury Bonds
10-45
Figure 10.4 Auction Results for a 30-Year Treasury Bond
10-46
Table 10.3 Characteristics of Some Popular Agency Issues
10-47
Table 10.4 Taxable Equivalent Yields for Various TaxExempt Returns
10-48

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Chapter 10

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

What Are Bonds?

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Why Invest in Bonds?

Some bonds can provide tax-free income

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Interest Rates and Bonds

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Figure 10.1 Behavior of Interest Rates Over Time (19622008)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Bonds Versus Stocks

Main benefits of bonds in portfolio:

Bonds add an element of stability to a portfolio

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Figure 10.2 Comparative Performance of Stocks and Bonds (1997-2008)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Bonds and Risk

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Essential Features of a Bond

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Principles of Bond Price Behavior

Longer maturities move more with changes in interest rates

Discount bond has a market value that is below par value

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Figure 10.3 The Price Behavior of a Bond

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Essential Features of a Bond (contd)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Types of Secured Debt

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Types of Unsecured Debt

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Table 10.2 Bond Ratings

Copyright 2011 Pearson Prentice Hall. All rights reserved.

The Market for Debt Securities

Bond price activity is remarkably stable compared to stock market

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Treasury Inflation-Indexed Obligations (TIPS)

High quality securities with almost no risk of default

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Often guaranteed by private insurers to lower risk and interest rates

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Sold at deep discount from par value

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Principal and interest are paid monthly

Self-liquidating investment since portion of principal is received each month

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Junk Bonds (High-Yield Bonds)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Offer broader diversification opportunities

Copyright 2011 Pearson Prentice Hall. All rights reserved.

No currency exchange rate risk since bonds are in U.S. dollars

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Forced conversion: calling in of convertible bonds by the issuing firm

Copyright 2011 Pearson Prentice Hall. All rights reserved.