Investing in Bonds

Exploring practical issues related to investing in bonds.
Learning objectives condensed into key points:
- Detailed understanding of the three types of bonds: corporate, municipal, treasury.
- Ability to calculate bond value at any time.
- Understanding embedded options in corporate bonds.

Treasury Bills (T-Bills):
- Maturities of one year or less.
- No coupon payments; sold at a discount to par value.
- Interest embedded in the bond, reflected by the price difference from par value.
Treasury Notes (T-Notes) and Bonds (T-Bonds):
- Pay semiannual coupons.
- Issued in denominations of $1,000 or $10,000.
- Par value either fixed or inflation-adjusted.
- Default risk free due to federal backing but still subject to interest rate risk.
- Priced as a percentage of par; e.g., a bond trading at 96 has a price of $960 (96% of $1,000 par).

Bonds often traded between coupon payment dates, necessitating day count conventions.
Day Count Convention for Treasuries: Actual/Actual.
- Determine actual number of days between coupon payment dates.
- Example: T-note with maturity 07/31/2026, coupon rate 4.25%, ask yield 5%, purchased on 07/18/2025:
  - Ask price = 99.36% of par.
  - 378 days calculation (07/18/2025 to 07/31/2026).
  - Result: $3.78 divided by 365, term = 1.04, multiplied by 2 = term 2.08.

Buying/selling bonds incurs accrued interest, sharing next coupon payment between buyer and seller.
Formula to calculate accrued interest:
- Accrued Interest = (Coupon Payment) * (Actual Days Since Last Coupon Payment / Actual Days in Coupon Period).
Quoted price referred to as clean price; total of clean price + accrued interest = dirty price.

TIPS (Treasury Inflation Protected Securities): Par value adjusted every six months based on CPI.
Example of CPI impact on par value: if CPI increases by 50 basis points, par value adjusts from $1,000 to $1,005.
Increased coupon payments compensate investors for inflation risk.

Stripping treasuries involves separating interest and principal (Separate Trading of Registered Interest and Principal Securities).
Example: five-year bond with semiannual payments can be stripped into 10 coupon strips and 1 principal strip for interest rate risk management.

Issued by state and local governments, minimum denomination of $5,000.
General obligation bonds vs revenue bonds:
- General Obligation Bonds: Backed by full taxing authority of municipality.
- Revenue Bonds: Financing specific projects (e.g., toll roads), limited to project revenues.

Coupon rates free from federal income tax.
Specific to issuing states; e.g., residents of Pennsylvania not taxed on local munis.
Higher attractiveness for investors in high tax brackets.
Calculation of taxable equivalent rate for comparison with taxable bonds:
- Taxable Equivalent Rate = (Muni Rate) / (1 - Investor's Tax Rate).

Used as long-term finance alternatives to bank debt by large corporations.
Coupon rates influenced by credit ratings:
- Higher ratings lead to lower coupon rates/spreads over treasury bonds.

Call Option: Issuer can redeem bonds early when interest rates fall.
Put Option: Bondholder can sell bonds back to issuer if interest rates rise.
Impact of options on valuation complexity; forecast future market rates with backward induction method.
Convertible Bonds: Can be exchanged for a predetermined number of shares in issuing company; exchange flexibility leads to lower coupon rates.

Ratings assess default risk assigned by agencies like Moody's and S&P.
Highest rating (AAA) indicates low default risk; lowest rating (D) indicates default.
Investment grade rating is BBB- or higher; below this is considered junk.

Treasury Securities: 3 types: bills, notes, bonds.
Municipal Bonds (Munis): Semiannual coupon bonds from state/local governments, two types include:
- General Obligation Bonds:
  - Backed by full taxing authority of municipality.
- Revenue Bonds:
  - Finance specific projects.
Corporate Bonds: Issued by large corporations, options may be embedded for additional flexibility.