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					Chapter 1: Introduction

Text: Bond Markets, Analysis and Strategies, by Frank J. Fabbozi, Fifth Edition, Prentice
Hall, 2004.

“A bond is a debt instrument requiring the issuer (also called the debtor or borrower) to
repay to the lender/investor the amount borrowed plus interest over a specified period of
time. A typical (“plain vanilla”) bond issued in the United States specifies (1) a fixed
date when the amount borrowed (the principal) is due, and (2) the contractual amount of
interest, which typically is paid every six months. The date on which the principal is
required to be repaid is called the maturity date. Assuming that the issuer does not
default or redeem the issue prior to the maturity date, an investor holding this bond until
the maturity date is assured of a known cash flow pattern.”

Sectors of the bond market are identified by the bond issuer, U.S. Treasury (largest single
issuer), Agency, Corporates, Municipals, Mortgage Backed, Asset Backed securities.


How are the mortgage backed and asset backed sectors fundamentally different
than the other bond market sectors listed above?

Bond Features:

The bond market can be subdivided according to features of the bonds that trade in that
sector of the market.

Short term – maturity 1-5 years, medium term 5-12 years, long term maturity greater than
12 years.

fixed coupon, zero coupon, floating rate, inverse floater

Synonyms: principal = face value = par value = maturity value = redemption value

Synonyms: coupon rate = nominal rate

Importance: Multiplying the principal times the coupon rate determines the annual
income paid by the bond issuer to the bondholder.

The bond indenture is the contract specifying all contractual terms of the relationship
between the bond issuer and the bond owner. The bond trustee is typically a commercial
bank identified to monitor the bond issuer’s performance per the terms of the indenture.

Security Status – Some bond are secured by claims on specific assets of the issuer, so
that in the event of default (failure to make payment as scheduled) the bondholders have
a claim on specified assets or the proceeds from liquidation of the assets. Bonds of this
type are often referred to as mortgage bonds, collateralized bonds or collateralized
trust bonds.

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Bonds which represent a general (unsecured) obligation of the issuer are often times
referred to as debentures. Claims represented by more junior bonds (subordinated
debentures) rank behind the claims of secured bondholders, general obligation
bondholders, and other unsecured creditors.

Call Provision (Option) – Issuer’s option to payoff bond before scheduled maturity date
as specified in call provision terms.

      Callable for purpose of refinancing,

      Callable for general business purposes (financial reorganizations, sinking fund
       purposes, etc.)

Sinking Fund - Retirement of a portion of a bond issue at regularly scheduled intervals.

Conversion Option – Some bonds are convertible to equity or other assets at the option
of the bond holder.

Put Option – Some bonds can be sold back to the issuer on dates prior to the maturity
date.

Options:
Call provision, Put provision, Convertible bond: for these common embedded options
which party to the bond contract has the right, which party grants the right, does the
option make the bond contract more or less valuable?

Risks (investor viewpoint):

1. interest-rate (market risk)
2. reinvestment risk
3. call risk
4. default risk
5. inflation risk
6. exchange-rate risk
7. liquidity risk
8. volatility risk
9. risk risk
10. yield curve risk
11. event risk
12. tax risk

1. A bond’s price and its yield to maturity are inversely related.
2. A component of the total return from owning a bond is the interest earned from
   reinvesting coupon payments over the remaining time till maturity.
3. Low rates may induce a bond issuer to call the bond if the indenture contains a call
   provision.



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4. Cash flow difficulties may force the issuer to delay or omit regularly scheduled
    coupon payments.
5. The real purchasing power of dollars received at future dates is inversely related to
    the inflation rate.
6. The purchasing power of payments denominated in foreign currency is inversely
    related to the value of the domestic currency.
7. Every transaction has at least two participants.
8. The price of an option (calls and puts) is directly related to the volatility of the price
    of the asset on which the option is written.
9. Occurs when there is no frame of reference within which to assess the degree of
    uncertainty concerning the possible outcomes.
10. The shape of the term structure changes with economic conditions. The change in a
    bond’s value due to term structure fluctuations is greatly affected by the time pattern
    of the bond’s promised cash flows.
11. The interest earned on municipal securities is exempt from federal income tax, or so
    you thought?

Recent bond issuance patterns: (Assignment #1 due 8
http://www.bondmarkets.com/assets/files/ResearchQuarterly0804.pdf



Chapter 2: Pricing Bonds

When interest is paid more than one time per year, both the interest rate and the number
of periods used to compute the future value must be adjusted as follows:

r = (annual interest rate) / ( number of times interest is paid per year)
n = (number of times interest is paid per year) x (number of years)

What will be the total future dollars realized by the maturity date for $25,000,000 face
value of a 7.25% coupon, semi-annual pay bond with 22 years till maturity, if the
assumed reinvestment rate of 5.5%?

Semi annual coupon payment = 0.5* .0725*$25,000,000 = $906,250

Future value of semi-annual coupon payments @ 5.5% =
           (1  .0275 ) 44  1
$906 ,250                      $75,767 ,063
                  .0275
Face value = $25,000,000

Total future dollars = $75,767,063 + $25,000,000 = $100,767,063

What will be the total future dollars if the reinvestment rate is 5.25%?


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How important is the reinvestment rate in determining the total future dollars from
a bond investment?

The value of a financial asset is the present value of the expected cash flows discounted
at the required rate of return appropriate for the risk(s) associated with the expected cash
flows.
          Bond pricing relationship:

                   1  (1  r )  n 
          P  C                      M  (1  r )  n
                          r         
                                    
         P = Value (Price) of coupon bond
         C = Coupon payment in dollars
         r = required yield adjusted for frequency of coupon payments
         n = number of remaining coupon payments
         M = face value

Bond value is an inverse function of the required return.

The relationship between bond value and required yield is convex. Bonds with different
characteristics i.e. maturity, coupon rate, etc., have different degrees of convexity.
Convexity is a desirable property.

Bond price and time to maturity:

Use the calculator you will use on exams to find the value of $1,000 face value of a
7.75% coupon, semi-annual pay bond with 5 years till maturity as the time to maturity
decreases to zero. Assume the required return remains constant at 5.5%. Use ½ year
increments, i.e. reduce the number of future payments by one for each successive
calculation.

Use the calculator you will use on exams to find the value of $1,000 face value of a
3.75% coupon, semi-annual pay bond with 5 years till maturity as the time to maturity
decreases to zero. Assume the required return remains constant at 5.5%. Use ½ year
increments, i.e. reduce the number of future payments by one for each successive
calculation.

Compare bond values 5 years prior to maturity. Which bond has the greatest value?
Why? Compare bond values on the maturity date. Which bond has the greatest value?
Why?

Notice how the values of both bonds converge to their face value; the first bond from
above, the second from below.




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Change the required yield from 5.5% to 7.75%. Comparing bond values 5 years prior to
maturity, what happens to the value of both bonds?

Change the required yield from 7.75% to 3.0%. Comparing bond values 5 years prior to
maturity, what happens to the value of both bonds?

Accrued Interest – In the United States the buyer of a coupon bond owes the seller
accrued interest through the settlement date of the transaction. Each marketplace i.e.
Treasury, corporate, municipal, has a specific set of conventions that are used to calculate
accrued interest.

                       clean price
               +       accrued interest
                       invoice price

In an efficient market, the present value of the remaining bond payments is equivalent to
the invoice price.




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