week 24 Fixed-Income Securities (II)

Quoting Bond Prices

• Bond prices are expressed as a percent of par value.

• Corporate and municipal bond prices are quoted in decimals (e.g., 87.562 = 87.562% of par).

Call Features

• Call feature: Allows the issuer to redeem the bond before maturity.

  • Freely callable: Can be called at any time.

  • Noncallable: Cannot be called before maturity.

  • Deferred call: Cannot be called until a specified time has passed.

• Call premium: Extra amount paid upon call to compensate bondholders.

• Call price: Par value + call premium.

Secured vs. Unsecured Debt

• Senior bonds (Secured): Backed by a legal claim or specific asset.

  • Mortgage bonds: Secured by real estate.

  • Collateral trust bonds: Secured by financial assets held in trust.

  • Equipment trust certificates: Secured by equipment.

• Junior bonds (Unsecured): Backed by the issuer's promise.

  • Debenture: Totally unsecured bond.

  • Income bonds: Interest paid only after a certain income is earned.

Bond Ratings

• Bond rating agencies (e.g., Moody’s, S&P, Fitch) assess credit risk.

• Ratings are letter grades indicating credit risk.

• Higher ratings mean lower risk and are associated with financially strong companies.

• Investment-grade bonds: Top four ratings.

• Junk bonds (high-yield bonds): Below investment grade.

• Split rating: Different ratings from different agencies.

• Ratings tied to bond yields: higher rating = lower yield.

• Ratings only measure default risk, not interest rate risk.

Major Market Segments

• Corporate Bonds: Issued by corporations (industrials, utilities, transportation, financials).

  • Popular due to steady income.

  • Equipment trust certificates are common in transportation.

• Treasury Bonds: Issued by the U.S. Treasury, backed by the U.S. government.

  • Highest quality, noncallable.

  • Include Treasury Inflation-Protected Securities (TIPS).

• Treasury Inflation-Protected Securities (TIPS): Adjust returns for inflation.

  • Pay interest semiannually.

  • Lower risk, generally lower returns than ordinary bonds.

  • Example Calculation:

    • At time t, a 30-year TIPS bond with par value of \$1,000 and 2% coupon rate yields \$20 in interest per year (\[\$1,000 \times 2\]%).

    • If inflation at time t+1 increases by 3%, the par value of the bond increases by 3% to \$1,030.

    • The interest payment rises to \$20.60 per year (\[\$1,030 \times 2\]%).

    • The increase in interest payments by 3% (\[(\$20.60-\20)\]%) compensates the investor for inflation.

• Municipal Bonds (Munis): Issued by states, counties, cities.

  • Interest is tax-exempt for federal taxes.

Muni Bond Tax Exemption

• Example: A tax-free municipal bond offers a yield of 6%. To find the equivalent taxable bond yield for an investor in the 25% tax bracket:

  • 0.06 = \text{Yield on taxable bond} \times (1 - 0.25)

  • \text{Yield on taxable bond} = 0.06 \div (1 - 0.25) = 0.08

  • Conclusion: the investor is indifferent if Municipal bond offer 6% and taxable bonds offer 8% as long as they are similar in terms of risk.

Global Bond Market

• Foreign bonds offer high yields but carry currency risk.

• The U.S. has the largest bond market, followed by Japan, China, and several EU countries.

U.S.-Pay vs. Foreign-Pay Bonds

• Dollar-Denominated Bonds:

  • Yankee bonds: Issued by foreign entities, traded in the U.S., in U.S. dollars, registered with the SEC.

  • Eurodollar bonds: Issued and traded outside the U.S., denominated in U.S. dollars, not registered with the SEC.

• Foreign-Pay Bonds:

  • Denominated in a currency other than U.S. dollars, traded overseas, not registered with the SEC.

  • Subject to currency exchange rate risk.