FIN 300 EXAM 2

What is a bond?

a debt security where the issuer borrows money from investors and agrees to pay back the principal with interest over a fixed period.

IOUs, usually long term

Fixed income securities

Primary issuer of bonds

Governments

States, Cities, Countries (municipal bonds)

Corporations

US agencies

Primary buyers of bonds

Individuals

Banks/Insurance companies

Pension Funds

Mutual Funds

Money Managers

Soverigns

Hedge Funds

Types of Bonds

• US Treasury Bonds: 35% of the US bond market

• Government Bonds: Issued by governments, low risk (e.g., Treasury bonds).

• Corporate Bonds: Issued by companies, higher risk and return than government bonds.

• Municipal Bonds: Issued by local governments, often tax-exempt.

• Convertible Bonds: Can be converted into company shares.

• Zero-Coupon Bonds: Sold at a discount, no periodic interest, paid at maturity.

• Sovereign, Junk, Savings

How Interest Rates effect bonds

If IR increases, bond prices decreases

Coupon

IR on a bond instrument used to calculate the annual cash flow the bond issuer promises to pay the bond holder

Yield to Maturity

total annual return an investor can expect if the bond is held until it is repaid, considering all coupon payments and the difference between purchase price and face value

Par value

the face value of a bond or stock, representing the amount paid back to the bondholder at maturity or the nominal value of a share

Discount

when a bond is sold for less than its par value

Premium

when a bond is sold for more than its par value

Par

a bond or stock is priced exactly at its face value

Why is YTM preferred as a metric?

• Reflects the total expected return if the bond is held to maturity, including all coupon payments and capital gains/losses.

• Allows comparison of bonds with different prices, coupons, and maturities on a consistent basis.

• Accounts for the time value of money by discounting future cash flows.

• Helps investors evaluate the true profitability of a bond investment, not just the coupon rate

Convertible bond

a bond that can be exchanged for a predetermined number of the issuer’s shares, combining features of debt and equity

Zero-coupon bond

pays no periodic interest and is sold at a discount; the investor receives the face value at maturity.

Treasury Bonds

Largest segment of the US bond market.

Backed by the FULL FAITH and CREDIT of the US government.

They are the only asset in the US that is considered riskless.

Reason: the US government has both the power to tax and print money. No other entity has these powers in the US.

Although considered riskless, they do have risk. (political, IR, Inflation, Opportunity Cost)

30 years

Risks with Bonds in general

Interest Rate Risk

Reinvestment risk: the risk that the IR at which interim cash flows can be reinvested will fall. This risk is greater for longer holding periods.

Call risk—Possibility of bonds being called back before maturity.

Credit Risk: also, default risk, downgrade risk, credit spread risk

Inflation risk

Exchange Rate risk: if investing in a bond where payments are made in a foreign currency, it has unknown dollar cash flows due to currency fluctuations.

Liquidity risk

What is the yield curve and why is it important?

a graph that plots the interest rates (or yields) of bonds with the same credit quality but different maturities, typically government bonds like U.S. Treasuries. It shows the relationship between the time to maturity (on the x-axis) and the yield (on the y-axis).

What is a realized yield

the actual return an investor earns on a bond or fixed-income investment over a specific holding period, considering all cash flows received (coupons, interest, principal repayments) and the price at which the investment was sold or redeemed

What is interest rate risk?

the risk that changes in market interest rates will affect the value of a bond or fixed-income investment.

What is a call provision?

a feature in some bonds that gives the issuer the right to repay the bond before its scheduled maturity date.

allows the issuer to repurchase and retire the debt security.

Why do companies use call provisions?

1. Refinancing Debt at Lower Interest Rates:
   When market interest rates decline after a bond is issued, companies can call the existing bonds and issue new debt at a lower coupon rate, reducing their interest expenses.

2. Managing Capital Structure:
   Call provisions allow companies to adjust their debt levels more easily—paying off debt early if they have excess cash or want to reduce leverage.

3. Taking Advantage of Improved Credit Ratings:
   If a company’s credit rating improves, it can issue bonds at better terms and call older, higher-cost bonds.

4. Flexibility in Financial Planning:
   Call provisions provide companies with an option to respond to changing market conditions, business needs, or strategic opportunities without being locked into long-term debt.

Trade-Offs of call provisions

• Issuers pay higher interest rates on callable bonds to compensate investors for the risk of early redemption.

• This cost is often worthwhile given the potential savings and flexibility gained.

Bond ratings

assessments of the credit quality of bonds issued by companies, governments, or other entities. They indicate the likelihood that the issuer will repay the bond’s principal and interest on time.

TIPS: Treasury Inflation Protected Securities

a Treasury bond that is indexed to inflation to protect investors from the negative effects of rising prices. The principal value rises as inflation rises. Inflation is the pace at which prices increase throughout the U.S. economy as measured by the Consumer Price Index or CPI.

pay interest twice per year, initially the interest rate is set at a fixed rate.

Pros and Cons of TIP investing.

designed to preserve purchasing power in the long run by protecting investors against the risk of inflation.

present virtually no default risk because they're treasury bonds.

They're not risk-free. market prices move substantially with changes in real interest rates.

good for diversification purposes.

If you believe inflation will be an issue, you should buy them.

If not, other options may be better suited for your portfolio.

Causes of inflation

Commodity price increases: i.e., oil, gas, lumber, wheat, corn, etc.

Increased medical care expenses.

Increased housing and rental prices.

Wage inflation

Demand pull/cost push: Demand-pull conditions occur when demand from consumers pulls prices up. Cost-push occurs when supply cost force prices higher.

Tuition

Expectations of inflation

Government spending.

When a country lowers its currency's exchange rates, it creates cost-push inflation in imports. That makes foreign goods more expensive compared to locally produced goods.

Government regulation: i.e., tariffs reducing imports. Could cause shortages.

Strip bonds/zero-coupon bond

• No periodic interest payments:
  Unlike regular bonds, strip bonds pay no coupons during their life.

• Single payment at maturity:
  Investors receive only the face value (principal) at maturity.

• Created by “stripping” coupons:
  The bond’s coupon payments and principal are separated into individual zero-coupon securities, each sold separately.

• Private Sector

For strips, accrued interest is taxed each year even though interest has not been paid. Thus, these instruments are negative cash flow until the maturity date.

One good usage: for people saving for college, if you were to buy the Strips in a custodial account, the tax hit goes against the kids which is usually smaller or nonexistent. Another reason for parents to invest in these is that they can be done cheaply and in a staggered fashion. Explain.

Government Agency Bonds

• Issued by entities like Fannie Mae, Freddie Mac, Ginnie Mae (in the U.S.), or similar agencies worldwide.

• These agencies are either federally sponsored enterprises (FSEs) or government-owned.

• They often support housing, agriculture, education, or infrastructure financing.

• Safety:
  Lower credit risk compared to corporate bonds.

• Income:
  Steady interest payments.

• Diversification:
  Adds a conservative fixed-income component to portfolios.

Agency Issues

1. Debenture

2. Mortgage-backed Security

Debenture

a type of unsecured bond issued by a corporation or government entity to raise capital.

Mortgage-backed Security

a type of asset-backed security that represents an ownership interest in a pool of mortgage loans

Maturity Date

the day the bond expires

Risk factors affecting bonds:

Inflation (currently one of the two major risks)

Credit Risk Default Risk

Interest rate movements (trajectory is upward for IR)

Monetary policy Fiscal Policy

Taxation policy Liquidity

Business/sector risk: i.e., currently the brick and mortar retail sector.

Contractual provision risk: this is the call risk feature. Explain.

Current Yield

measure of the income (interest) return an investor earns from a bond relative to its current market price
Annual Interest Payment/Current Price

Accrued Interest

the interest that has accumulated on a bond or loan since the last interest payment date up to, but not including, the current date

Corporate Bond

a debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company's physical assets may be used as collateral for bonds.

have priority over common and preferred stockholders.

Most issues have what is called a CALL PROVISION

all contain DEFAULT RISK. Bond ratings are a useful tool for investors.

CALL PROVISION

feature in a bond or other debt instrument that gives the issuer the right to redeem (pay off) the bond before its scheduled maturity date.

Types of Corporate Bonds

Mortgage bonds: the most secure. They are backed by the real estate of the corporation issuing them.

Equipment Trust Bonds: Equipment trust bond is a bond secured by tangible property, such as airplane, equipment or physical assets. It is usually issued by a transportation company such as a railroad or shipping line to secure payment, as the title for the equipment is held in trust for the holders of the issue.

Debentures/Unsecured Bonds: supported by the general creditworthiness of the company issuing them. They are UNSECURED. Could be risky if dealing with a less than viable company

Mortgage bonds

the most secure. They are backed by the real estate of the corporation issuing them.

Equipment Trust Bonds:

a bond secured by tangible property, such as airplane, equipment or physical assets. It is usually issued by a transportation company such as a railroad or shipping line to secure payment, as the title for the equipment is held in trust for the holders of the issue.

Debentures/Unsecured Bonds

supported by the general creditworthiness of the company issuing them. Could be risky if dealing with a less than viable company

Convertible Bonds

• Can be converted into a predetermined number of the company’s shares.

• Offer potential upside from stock price appreciation, usually with lower coupons.

Junk Bond

type of corporate bond that carries a higher risk of default compared to investment-grade bonds. Because of this elevated risk, junk bonds offer higher yields to attract investors.

Founder Michael Milken

The primary bond rating companies are:

Standard and Poor's

Moody's

Fitch

Bloomberg also rates bonds as well under a company called DBRS.

Bond Rating scale

Highest: AAA

AA1/AA+

AA2/AA

AA3/AA-

A1/A+

A2/A

A3/A-

What 2 companies have an AAA rating

J&J and Microsoft

Municipal Bonds:

Issued by local governments, often tax-exempt.

Broadest type: General Obligation Bond

Revenue Bond

another type of Muni bond that is backed by the revenue generated by a specific project being financed by the bond issue.

In other words, the money raised by the bond offering directly finances the project, and the project—once complete—generates the revenues to pay back the interest and principal on the bonds to investors.