FIN 3403 - Chapter 7 Part 2

Bond Ratings

Firms pay to have their debt rated as an assessment of their creditworthiness

Leading bond-rating firms

Moody's and Standard & Poor's (S&P)

Bond-rating firms

rank firms based on how likely they are to default and how protected creditors would be if they were to default. These ratings allow investors to assess whose debt they want to invest their money in!

fallen angels

Bonds that drop into junk territory

investment grade bonds

bonds rated BBB or Baa or higher

Junk bonds

everything below BBB or Baa

Crossover Bonds

Firms that receive different quality ratings from different agencies

What is the US Debt

U.S. debt sits at just over 40 trillion dollars (Oct 2026)

When the government wants to borrow money for more than a year, it...

...issues Treasury notes and bonds to the public

US Treasury Default Risk

U.S. treasury issues have no default risk (in theory)

State and local governments also borrow money by issuing notes and bonds called

municipal bonds or "munis"

Municipal Bond Aspects

Default risk varies on these bonds, just like with corporations, These bonds are almost always callable, These bonds are exempt from income tax; because of this tax break, they offer much lower yield than taxable bonds.

Zero coupon bonds

also known as zeroes, are bonds that make no coupon payments and are thus initially priced at a deep discount

Zero Coupon Bonds Aspects

For tax purposes, the issuer of a zero coupon bond deducts interest every year even though no interest is actually paid. Similarly, the owner must pay taxes on interest accrued every year, even though no interest is actually received. Attractive investment for tax-exempt investors with long-term dollar- denominated liabilities (e.g., pension funds) because the future dollar value is known with relative certainty

Catastrophe bonds

bonds that cover disasters, such as storms or earthquakes. They pay some percentage to the owners of the bond each period, but if one of these events occurs, investors lose some or all of their money.

Warrants

gives the buyer of a bond the right to purchase shares of stock in the company at a fixed price; valuable if the stock price climbs!

Convertible bonds

can be swapped for a fixed number of shares of stock any time before maturity at the holder's discretion.

Put bonds

allow the holder to force the issuer to buy back the bond at a stated price; the opposite of a callable bond, in a sense.

floating-rate bonds (floaters)

coupon payments are adjustable, with adjustments tied to an interest rate index. Value depends on how coupon payment adjustments are defined

Most floaters have the following features

Holder has right to redeem note at par on the coupon payment date after some specified amount of time (i.e., put provision). Coupon rate has floor and ceiling, meaning the coupon is subject to a minimum and a maximum. In this case, the coupon rate is said to be "capped," and the upper and lower rates may be called the collar

Collar

upper and lower rates where the coupon rate is "capped"

Inflation-linked bonds

have coupons that are adjusted according to the inflation rate (principal amount may be adjusted as well). May be called "TIPS," or Treasury Inflation-Protected Securities

Sharia Law prohibits charging Riba

prohibits interest

Sukuk

Islamic bonds. There are many possible structures to sukuk, such as partial ownership in a debt (sukuk al-murabaha) or an asset (sukuk al-ijara). In the case of a sukuk al-ijara, there is a binding promise to repurchase a certain asset by the issuer at maturity. Before the sukuk matures, rent is paid on the asset. Most sukuk are bought and held to maturity; therefore, secondary markets in sukuk are extremely illiquid

Bond Markets

Bonds are bought and sold every day at a much higher volume than stocks! The U.S. Treasury market is the largest securities market in the world.

Most trading in bonds takes place in

over the counter markets, or OTC markets

One reason the bond markets are so big

the number of bond issues far exceeds the number of stock issues

There are two reasons for bond issues exceeding stock issues

1. A corporation would typically have only one common stock issue outstanding, whereas a large corporation could easily have a dozen or more note and bond issues outstanding. 2. Federal, state, and local borrowing is enormous

A financial market is transparent if

it is possible to easily observe its prices and trading volume

Trade Reporting and Compliance Engine (TRACE)

In 2002, transparency in the corporate bond market began to improve, as new regulations required dealers to report trade information. TRACE bond quotes are available online

Bid price

the price a dealer is willing to pay for a security

Ask price

the price a dealer is willing to take for a security

Bid-ask spread

the difference between the bid price and ask price

Treasury prices

are quoted as a percentage of face value

Change in the asked price from the previous day

measured as a percentage of face value, is also quoted

Accrued interest

interest that has been accumulated but not yet paid

Clean Price

the price of a bond net of accrued interest. (excluding). this is the price that is typically quoted

Dirty Price

the price of a bond including accrued interest, also known as the full or invoice price. This is the price that the buyer actually pays!

Interest rates are an important consideration...

...when discussing interest rates, yield and returns.

Real rates

interest rates that have been adjusted for inflation

Nominal rates

interest rates that have not been adjusted for inflation

The Fisher Effect

Investors don't care about how much money they have per se but rather how much stuff they can buy with that money

Irving Fisher

created a formula that converts nominal rates into real rates for this purpose.

Fisher Effect Formula

1 + R = (1 + r) x (1 + h)

The determinants of a bond's yield are broken into two groups

those common to all bonds and those specific to the specific issuer

term structure of interest rates

the relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money

When long-term rates are higher than short-term rates, we say that the term structure is

upward sloping

When short-term rates are higher than long-term rates, we say the term structure is

downward sloping

Term structure can also be "humped"

which is usually because rates increase at first, but then begin to decline as we look at longer and longer-term rates

What determines the shape of the term structure?

1. Real rate of interest 2. Expected future inflation 3. Interest rate risk premium

Inflation premium

the portion of a nominal interest rate that represents compensation for expected future inflation. Upward-sloping term structure may reflect anticipated increases in inflation, while a downward-sloping term structure probably reflects the belief that inflation will be falling in the future

Interest rate risk premium

the compensation investors demand for bearing interest rate risk. Interest rate risk premium increases with maturity, but it increases at a decreasing rate