Lesson 3 and 4: Bonds and Types of Bonds

bond

• a loan from an investor to an issuer

• most bonds have a par value of $1,000

bond coupon

• the annual interest rate paid on the face amount of a bond

• quoted as a percentage of par

• typically paid out semiannually

bond prices and interest rates

• as rates change, outstanding bonds adjust so their yield is similar to what new bonds are paying

• when interest rates rise, lower bond prices

• when interest rates fall, raise bond prices

interest rate risk

• the risk that the price of a bond will change due to changes in prevailing interest rates

• most volatile: low coupon and long maturity (longer duration)

duration

a measure in years of how much a bond’s price is likely to change when interest rates move

current yield

coupon yield divided by market price → annual interest / current market value

yield to maturity (YTM)

overall return if a bond is held until maturity

yield to call

the same as YTM but assumes the bond is called

bond quotations

• state the price of the bond as a percentage of its par value

• ex. quote of 112 → price of the bond is $1,120

zero coupon bonds

• bonds that pay $0 annual interest and are instead priced at a deep discount at issuance and mature at full face value, with the difference representing the investor’s return

• long term investment objectives like retirement or college

risks of zero coupon bonds

1. high interest rate risk

2. phantom income tax on annual accretion → getting taxed before the payment is actually received

accretion

the upward adjustment of a discount bond’s cost basis

callable bonds

• allow the issuer to redeem the bond at a set price before maturity

• bonds cannot be called during the call protection period, providing safety for investors

puttable bonds

allows the investor to demand early repayment of principal

convertible bond

investor can convert the bond into a fixed number of common shares

call risk

• the risk that a bond is redeemed before its maturity and interest payments stop

• bonds are called by the issuer when interest rates are low

reinvestment rate risk

• the risk that an investor is unable to reinvest capital at a previously earned rate of return

• the investable capital could be interest payments or the return of principal from a called bond

inflationary risk

• the risk that an investment’s returns provide reduced purchasing power because the return is fixed (a coupon), but costs are rising

• also applies to preferred stock

credit risk

• the risk of default i.e. that an issuer cannot make interest and/or principal payments

• rating agencies help investors evaluate this risk

• good credit = high liquidity, bad credit = low liquidity

accrued interest

• the interest that a bond holder has earned but not yet received

• interest accrues to the seller up to, but excluding settlement

• corp + muni bonds accrue using 30 day months (T+1)

• gov bonds accrue using actual days in each month (T+1)

US government fixed income securities

• no credit risk

• safety of principal

• low yield

• interest is taxed at the federal level

Secured corporate bonds

• backed by collateral

• mortgage bond → real estate, collateral trust bond → securities, equipment trust obligations → equipment

Unsecured corporate bonds (debentures)

backed by good faith and credit of the issuing corporation

basis points (bp)

• a unit of measurement to discuss changes in interest rates

• each bp is equals one-hundredth of a percentage point → 100 bps in 1%

adjusting premium bonds by amortization

• the cost basis will be adjusted downwards each year so that at maturity an investor’s cost basis is $1,000 par

• amortization also affects the profit or loss on the transaction should an investor sell the bond prior to maturity

dated date

• the date when interest begins to accrue on fixed income securities

• only relevant for new issuances and once regular semi-annual coupon payments begin, it is no longer relevant

refunding

the process of calling a bond when interest rates have fallen and issuing a new bond with a lower coupon rate

Eurodollar bonds

• bonds issued and traded outside the US but denominated in US dollars and not registered w/ the SEC

• used by company’s to make their securities more marketable if their home currency is unstable

Eurodollar deposits

US dollars held in a bank abroad

conversion price

• the price paid per share on conversion for convertible bonds

• fixed at issuance

conversion ratio

• the number of shares received on conversion

• fixed at issuance

• par value / conversion price

parity price

the point at which the price of a convertible bond equals the market value of stock received on conversion

T-Bills

• a US Treasury security with maturity up to one year

• no semiannual interest

• quoted on an annualized discount percentage

T-Notes and T-Bonds

• maturity: 2-10 years (T-notes); 30 years (T-bonds)

• pay semiannual coupon

• quoted as a percentage of par in 32nds of a point → quote of 95:16 = 95 16/32 = $955

STRIPS

US gov issued zero coupon bonds

Treasury receipts

• Zero-coupon securities issued by BDs but backed by treasuries

• unlike STRIPS, these have credit risk

TIPS - Treasury Inflation Protected Security

US gov issued coupon bonds that adjust based on the inflation rate (CPI)

series I bond

• a non-marketable US Treasury savings bond

• pays a combination of fixed and variable interest (linked to the rate of inflation)

government agencies

• subsidiaries of US government

• explicit guarantee for MBS

• ex. Ginnie Mae

government sponsored enterprises

• created/chartered by US government

• implied guarantee for MBS

• ex. Fannie Mae or Freddie Mac

mortgage-backed securities (MBS)

• bonds secured by mortgages and other real estate loans

• each bond represents a sliver of all the mortgages

• interest payments are monthly and most mortgages are paid off before full term

• not suitable for investors seeking dependable and consistent income

MBS risks

• low interest rates → more prepayments (refinancing) → shorter maturity → reinvestment risk

• high interest rates → fewer prepayments → longer maturity → extension risk

municipal bonds

• municipal securities that finance projects for the public good

• primary investment objective for investors is tax-free interest income → always federally tax-free and triple-tax free if in state

general obligation bonds

• a type of muni where the interest and principal are paid from general tax receipts

• used to finance projects that don’t produce revenue → schools, libraries, parks, etc.

• backed by the “full faith and credit” of the issuer and its taxing power

revenue bonds

• a type of muni where the interest and principal are paid from revenue produced by the project the bond financed

• roads, bridges, tunnels → tolls, local hospital → patient fees

industrial development revenue bonds

• a type of taxable muni that is issued on behalf of a corporation

• a municipality will issue debt to build a facility then lease it back to the corporation

• the debt’s credit quality is tied to the corporation since the debt is the corporation’s responsibility

money market instruments

• consists of short-term (one year or less) debt instruments

• investment objective is safety and liquidity

• include treasury bills, commercial paper, certificates of deposit and bankers’ acceptances

Commercial paper

• an unsecured promissory note issued by corporation at a discount

• typically has maximum maturity of 270 days

certificates of deposit (CD)

• a type of money market instrument that is non-negotiable which means they cannot be traded in the secondary market and only redeemed with the issuing bank

• negotiable ones can be traded on the secondary market and have a minimum face value of $100,000

bankers’ acceptances

• a short-term, negotiable money market instrument that is used to finance and facilitate international trade

• has a maturity of 180 days or less and is issued by the borrower and guaranteed by a commercial bank

marketable US government securities

can be freely traded by investors and include US Treasury securities such as Treasury bills, Treasury notes, and Treasury bonds

non-marketable US government securities

cannot be resold by investor and thus have no secondary market

official statement

• the primary disclosure document used in a muni offering

• includes all relevant info for investors such as the risks of bonds

securitization

the process of pooling individual mortgages together to create mortgage backed securities

collateralized mortgage obligation (CMOs)

• mortgage backed securities that have been structured by BDs and divided into distinct pieces called tranches

• each tranche has unique characteristics as it relates to credit quality, expected maturity, exposure to prepayments