Debt and money ch7

• What are Bonds?

Long Term Debt securities, Corp, Gov.

• Bond Issuer

Pays interest, and par (principal) at maturity

• Bonds are classified by type of issuer such as

Treasury, fed agency, municipal, corporate

• Bearer Bonds

Unregistered - no records kept of owner

• New issues of bearer bonds were

Banned in the US in 1982

• Bonds are issued in the primary mkt through a

Telecommunications network

• Bond Yields have 2 components

(1) interest payments (2) capital gain (loss)

• When interest rates rise

Bond prices decline.

• When interest rates decline

Bond prices rise.

• Stripped Treasury Bonds, STRIPS

Separate Trading of Reg. Interest, Principal

• STRIPS are created by securities firms

Not by the US Treasury

• A stripped Treasury Bond has 2 securities

(1) principal only (PO); (2) interest only (IO)

• Stripped (PO) Bonds are also referred to as

Zero coupon Bonds

• Bond Traders like zero coupon bonds because

Prices more sensitive to int rate changes

• Inflation Indexed Treasury Bonds (TIPS)

Treasury Inflation Protected securities

• Principal of TIPS bond

Increases with inflation decreases w deflation

• When TIPS mature you are paid the greater of

The adjusted or original principal

• For a 10yr, $10,000 TIPS Bond, if Inflation doubled, investor rec

$20,000 at maturity

• For a 10yr, $10,000 TIPS Bond, if deflation occurred, investor rec

Original $10,000

• Coupon rate on TIPS fixed but $ interest pd

Rises with inflation, declines with deflation

• Municipal Bonds

Issued by State and Local governments

• 2 Types of municipal Bonds

General Obligation Bonds; Revenue Bonds

• General Obligation Bond

Supported by Muni Gov ability to tax

• Revenue Bond

Supported by revenues from proj (toll road etc)

• Tax Advantage of Muni Bonds

Int inc exempt from fed, issuing state taxes

• Corporate Bonds

Interest is taxable at state and federal level

• Junk Bonds

Corp bonds perceived as very high risk

• Yield on Junk Bonds

High compared to Treasury yields

• Major Bond investment risks

Int rate risk, credit (default) risk, Call risk

• Other Bond Investment risks

Liquidity, volatility, inflation, reinvestmnt

• Interest Rate Risk

As interest rates rise, bond prices fall

• Credit (Default) Risk

Bond issuer fails to pay interest and principal

• Liquidity Risk of a Bond

It can't be bought, sold easily to avoid loss

• Reinvestment Risk

Cash flows reinvested at lower rate than org

• Inflation Risk for a fixed rate bond

Inflation rate > than interest rate on bond

• Call Risk of a Bond

If bond called, investor has reinvestment risk

• Volatility Risk of a Bond

Change in volatility of int rates, impact value

• Exchange Rate Risk for invest in foreign bond

Adverse currency rate change reduces yield

• Unknown Bond Risk can occur when invest in

Complex, not easily understood bonds

• Investing in global gov debt markets

Evaluate foreign gov ability to meet debt obl

• Exchange Traded Notes (ETNs)

Trade like stocks, but are debt securities

• Structured Note, debt obligation that is a

Complicated fin prod, suffers mkt, liq risk

• Bond Embedded Options

Provides bond issuer or investor with an option

• What is a callable bond

Gives issuer right to call in (retire) bonds

• Embedded call option gives the bond

Issuer the right to buy back (retire) the bonds

• Price of a callable bond equals

Price of a regular bond - Price of call option

• Price of callable bond vs comp regular bond

Lower price than comp no option bond

• Yield on callable bond vs comp regular bond

Higher yield than comp no option bond

• Embedded put option gives the bond

Investor the right to sell bond back to issuer

• Price of a puttable bond equals

Price of regular bond + Price of put option