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					Module 4
 Bonds




           1
           Module 4 - Learning Objectives
•   Define bond issuer, par or face value, coupon rate, maturity date and call date.
•   Explain why entities issue bonds.
•   Explain how an investor makes money from bonds.
•   Define and calculate nominal yield, current yield, yield to maturity and yield to
    call.
•   Define and differentiate Treasuries, municipal bonds, mortgage securities, and
    corporate bonds.
•   Differentiate short, medium, long and zero coupon bonds.
•   Explain what credit rating measures.
•   Define bond fund.
•   Explain how an investor purchases a bond.
•   Evaluate a bond using yield, maturity, issuer, credit rating, and interest rate
    environment.
•   Explain how to monitor bond investments with regards to interest rate, call and
    credit risk.
•   Select a bond based on financial goals.
                                                                                2
                Income is not rising but debt is
                                   Consumer debt has doubled in the past 10 years
                                          (Consumer credit $ millions - does not include mortgages)
    3000000


    2500000


    2000000


    1500000


    1000000


     500000


         0
              1980
                     1981
                            1982
                                   1983
                                           1984
                                                  1985
                                                         1986
                                                                1987
                                                                       1988
                                                                              1989
                                                                                     1990
                                                                                            1991
                                                                                                   1992
                                                                                                          1993
                                                                                                                 1994
                                                                                                                        1995
                                                                                                                               1996
                                                                                                                                      1997
                                                                                                                                             1998
                                                                                                                                                    1999
                                                                                                                                                           2000
                                                                                                                                                                  2001
                                                                                                                                                                         2002
                                                                                                                                                                                2003
                                                                                                                                                                                       2004
                                                                                                                                                                                              2005
                                                                                                                                                                                                     2006
                                                                                                                                                                                                            2007
DRAFT 3/6/2007                                                                                             3
     People are raiding the piggy bank
                      Homeowner equity is falling as more debt is assumed
                               (Homeowner's equity/Value of Household Real Estate)
         90%

         80%

         70%

         60%

         50%

         40%

         30%

         20%

         10%

         0%
                  1950-9        1960-9        1970-9        1980-9        1990-9     2000-6

               Source: Mortgage Bankers Association




DRAFT 3/6/2007                                         4
                            Spending power?
                 Personal Disposable Income and Outstanding Household Debt
                                          $ Billions
     12,000



     10,000            Personal Disposable Income

                       Outstanding Household Debt
      8,000



      6,000



      4,000



      2,000



         0
              1979         1984        1989             1994   1999     2004




DRAFT 3/6/2007                                      5
                                       The big picture




http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?scp=1&sq=debt%20trap%202008-07-%20interactive&st=cse
                                                              6
Which of the following factors can a lender use to evaluate your
                            credit?

•   Gender                         • Alimony
•   Age                            • Race
•   Childbearing plans             • Color
•   Marital status                 • National origin
•   Change in marital status       • People in the
•   Loans                            neighborhood where you
•   Public assistance                want to buy
•   Dependents                     • How long you’ve had your
                                     job
•   How long you’ve lived at
    your house                     • Salary
                               7
What does your credit report affect?

• Interest rates
• Job opportunities - Can your prospective employer
  check your credit report?
• Insurance
• Ability to assume debt




                      8
Analyze a credit report




                          9
                         Your credit score
                       Types of credit
                           used
                            10%               Credit Rating
             New credit
               10%                            Payment history
                                                  35%



    Length of credit
        history
         15%




                       Amounts owed
Source:   www.myfico.com 30%
                                         10
Credit Scores




      11
                Credit ratings and cost of credit

  If your FICO       Your interest      and your monthly
      score is           rate is            payment is

    760 - 850            5.78%                 $1,264
    700 - 759              6%                  $1,295
    680 - 699            6.18%                 $1,320
    660 - 679            6.39%                 $1,350
    640 - 659            6.82%                 $1,411
    620 - 639            7.37%                 $1,491

Source: www.myfico.com 3/21/07
                             12
              Credit Check-up

• Get a free credit report every year
  www.annualcreditreport.com or call: 877-
  322-8228

• Correct any errors by contacting the
  company in writing – they must resolve the
  error in 30 days



                       13
           Debt as an Investment

• Investors can get on the other side of the
  fence by lending money to people or entities
  who want to borrow
• Bonds are usually the investments




                                                 14
               True or False?

• You could go through your entire investing
  life without investing in bonds.
• You should only invest in bonds when you’re
  older.
• Stocks always return better than bonds.
• Bonds are boring investments.


                                            15
16
It is January, 2001. You are analyzing a T-bond $1000
   face value that matures in January 2011 and has a
                    6.125% coupon.

•   Who is the issuer of the bond?
•   How much will you get in interest per year?
•   How many years will you get the interest?
•   What will you get back when the bond
    matures?


                                                    17
Why do companies, governments, etc.
          issue bonds?




                                      18
How have bonds done as investments?




                                      19
How do you make money from bonds?




                                    20
You can also have a gain or loss on a bond




                                         21
It boils down to two factor: coupon and
                maturity.




                                      22
                     Pop quiz

• When interest rates go up, bond prices go where?
• When interest rates go down, bond prices go where?
• Shorter maturity bonds are more or less sensitive to
  interest rate changes than longer maturity bonds?
• Smaller coupon bonds are more or less sensitive to
  interest rate changes than larger coupon bonds?



                                                    23
               Figure this out

• On 2-22-01 you buy a Motorola $1000 face
  value bond with a maturity date of 10-01-
  2097 and a coupon of 5.22. The bond has a
  credit rating of A. Equivalent bonds are
  giving 7.895%. Calculate the price of this
  bond.


                                               24
25
                Nominal Yield

• What the issuer pays on the par value of the
  bond
• It is the return you get if you buy the bond
  when it’s issued and hold it until it matures
• In a bond quote, annual interest is not given,
  so you have to figure out annual interest by
  using nominal yield and multiplying by par
  value
                                                   26
 The following are $1000 par value bonds
and their coupon rates. What is the annual
             interest on each?


• Ford Motor (car company) 6.7%
• Hewlett Packard (computers) 7.15%
• Kroger (supermarkets) 6.8%

                                        27
                 Current Yield

•   Annual interest divided by price you paid
•   Let’s you know what you get every year
•   Might want to compare to other investments
•   Doesn’t consider what you sell for




                                                 28
          Calculate current yield

• Alcoa (aluminum manufacturer) $1000
  par value bonds with a coupon rate of
  6.5% and maturity of 10 years traded at
  104.075. Calculate the current yield.




                                            29
              Yield to Maturity

• May have bought a bond at a premium or
  discount
• When the bond is redeemed, you will have a
  capital loss or gain
• Yield to maturity takes this into consideration
• More complete measure of return from the
  bond (includes interest and gain or loss)

                                                30
        Calculate the yield to maturity

• It's 2-22-01 and you're evaluating a University of
  North Carolina at Greenville $1000 par value bond
  with a coupon of 6.0 and a maturity date of 04-01-
  2021. The bond is quoted at 111.225.
• What is the nominal yield?
• What is the current yield?
• What is the yield to maturity?


                                                       31
                      Yield to Call
• Certain bonds may be called (redeemed before the
  maturity date) by the issuer
• This can change your return on the bond
• Callable bonds are riskier and need to be assessed using
  yield to call
• Similar to yield to maturity except earliest call date is
  used rather than maturity date
• Yield to call is higher than yield to maturity when the
  bond is bought at a discount
• Yield to call is lower than yield to maturity when the
  bond is bought at a premium
                                                          32
Calculate nominal yield, current yield, yield
   to maturity and yield to call. You are
              buying 3-1-00.
             Coupon
  Entity              Maturity     Call Date   Quote
             Rate
  Alaska     6.75     12-01-2033 6-1-2001   101.5
  Alabama    5.75     08-15-2023 08-15-2009 101.2
  Valley
             5.6      11-01-2016 11-01-2007 87.72
  Alabama
  Arkansas
             5        06-01-2013               98.853
  Health
  Arkansas
             7.375    02-01-2030 02-01-2010 102.25
  Hospital



                                                        33
                                        Answer sheet
                                                          Annual
                                                Price
                                                          Interest
                                                (Quote                Current
                                                          (Coupon                                  Yield to
                                                as                    Yield        Yield to Call
           Coupon              Call                       Rate as                                  Maturity
Entity              Maturity            Quote   Percent               (Annual      (From
           Rate                Date                       Percent ×                                (From
                                                × $1000               Interest ÷   Calculator)
                                                          $1000                                    Calculator)
                                                Face                  Price)
                                                          Face
                                                Value)
                                                          Value)

                                                                      $67.50 ÷
                    12-01-     6-1-
Alaska     6.75                         101.5   $1015     $67.50      $1015 =      5.64            6.64
                    2033       2001
                                                                      6.65%
                                                                      $57.50 ÷
                    08-15-     08-15-
Alabama    5.75                         101.2   $1012     $57.50      $1012 =      5.58            5.66
                    2023       2009
                                                                      5.68%
                                                                      $56 ÷
Valley              11-01-     11-01-
           5.6                          87.72   $877.2    $56         $877.2 =     7.75            6.85
Alabama             2016       2007
                                                                      6.38%
                                                                      $50 ÷
Arkansa             06-01-
           5                            98.853 $988.53    $50         $988.53 =    Noncallable     5.12
s Health            2013
                                                                      5.06%
Arkansa                                                               $73.75 ÷
                    02-01-     02-01-
s          7.375                        102.25 $1022.5    $73.75      $1022.50 =   7.05            7.19
                    2030       2010
Hospital                                                              7.21%




                                                                                                                 34
                              US Bond Choices
                                                            US Bonds Outstanding 2007
             US Bonds Issued 2007                                 Total $32 T
              Total $6.2 Trillion                         Asset-            Municipal
       Asset-               Municipal                    Backed               8%
       Backed                 7%                           13%     Asset-                    Treasury
 Federal 15%                            Treasury    Federal        Backed                      15%
 Agency                                   12%       Agency          8%
Securities                                         Securities
  15%                                                 9%




 Corporate                          Mortgage
   Debt                             -Related
   18%                                33%                                               Mortgage-
                                                     Corporate
                                                                                         Related
                                                       Debt
                                                                                          28%
                                                       19%
                                                                                        35
                          World Bonds 2007
       Sterling             Total $56 T
         5%       Other
         Yen       6%
         0%
                                   US
                                  39%




Euro
50%



                                             36
                        Choices - Treasuries




                                          Deficit $9 T (12/06)
Type      Maturity        Features
                          Sold at a discount to face value. The difference between
          3, 6, or 12     what you paid and the face value (what you get at
T-bills
          month           maturity) is the interest. The 90-day or 3-month interest
                          rate is an important benchmark.
        2, 3, 5, or 10
T-notes                   Pays interest semiannually.
        years
T-bonds 11-30 years       Pays interest semiannually.

                                                                                      37
Who do we owe?




                 38
          Choices - Municipal Bonds

• Issued by state and local government
• May have tax advantages (be careful--not all muni
  interest is tax free)
• Not as safe as treasuries but still relatively safe
• May be backed by tax revenues or revenues of
  facility



                                                        39
                 Evaluating Munis

• It is 02-22-2001. You're looking at two bonds given
  the same credit rating by Standard and Poor’s.
  Calcualte their yields and explain why the yields are
  different.
        • .Coca Cola with a maturity date of
          09/15/2022 and a coupon of 8 is quoted at
          117.325.
        • .Pennsylvania State Health Services with a
          maturity date of 01/01/2022 and a coupon of
          5.75 is quoted at 101.812.                    40
Choices - Mortgage-backed Securities
                    • Mortgage-backed securities
                      are created when individual
                      homeowner mortgages are
                      bundled and sold to investors
                    • May be guaranteed by Ginnie
                      Mae, Fannie Mae, or Freddie
                      Mac
                    • Irregular payments because
                      homeowners may prepay
                      mortgage--based on average
                      life rather than maturity
                    • Highest risk of prepayment
                      when interest rates fall--bad
                      for bondholder
                                                 41
42
                             Evaluate these

The following table lists mortgage securities quoted on 5-9-00.
Explain what each column is.
How risky are these investments?
If you were about to retire, which one would you choose?

                               Maturity
Issuer    CUSIP     Coupon                   Quote Yield to Maturity   Average Life
                               Date
          31359U
FNMA                6.00       11-18-15      97.521 7.48               1.80
          BF1
          3133TC
FHLMC               6.00       05-15-20      94.092 7.72               4.25
          HA9
          3837H0
GNMA                7.00       4-20-27       89.952 8.52               10.83
          6R9
          3133TE
FHLMC               6.5        7-15-28       84.428 8.16               20.49
          QJ6
          31359U
FNMA                6.0        02-18-07      99.494 7.67               0.23
          BD6




                                                                                      43
             Choices - Corporate Bonds


Types of
                   Companies                                   Influencing Factors
Bonds
                   Manufacturers, retailers, mining, energy,
Industrial                                                     Business cycle
                   service
Financial
                   Banks, brokerage, insurance                 Interest rates
Services
                                                               Regulations,
Public Utilities   Telephone, electric, gas, water
                                                               legislation
Transportation     Airlines, railroads, trucking               Oil prices


  • Issued by large corporations to finance their business.
  • Listed on the NYSE or sold over the counter.
  • Some corporations offer convertible bonds.
                                                                                     44
                  Evaluate this

• Amazon issued $681 million in convertible 10-year
  notes in 1999. The coupon rate was 6 7/8%. Each
  $1000 bond is convertible to 9.529 shares of
  Amazon stock. In early 2001, Amazon is selling at
  about $15 a share. If you are holding these bonds,
  would it be more profitable to convert to stock or
  hold the bond? Give your reasons why.



                                                       45
Choices - Maturity

            • During normal
              economic expansion,
              the longer the term the
              higher the interest rate
            • This is because the
              longer the term, the
              higher the risk




                                    46
 The date is 2-22-2001. You are evaluating three
 municipal bonds. Calculate the yield to maturity
for each and discuss why they might be different.
• New York Metropolitan Transit Authority bond quoted at
  109.603 with a coupon of 5.4. Maturity date is 04-01-2011.
  Credit rating is AAA.
• Philadelphia General Purpose bond quoted at 98.234 with a
  coupon of 4.9. Maturity date is 09-15-2021. Credit rating is
  AAA.
• King County General Purpose bond quoted at 101.25 with a
  coupon of 5.25. Maturity date is 01-01-2034. Credit rating is
  AAA.

                                                              47
          Choices - Zero Coupon Bonds




• Pros:
   – Can buy bond with little money upfront
   – Bigger gains if interest rates fall
• Cons:
   – Bigger losses if interest rate rise
   – Don’t hear from borrower for a long time
   – Taxed even though you don’t have the cash   48
   The effect of interest rate changes on
                    zeros
• Last year. You bought a 30-year par value
  $1000 zero coupon bond that yielded 6%.
  Calculate the price you paid.
• This year. Interest rates have fallen to 5%.
  Calculate the value of your zero coupon
  bond.

                                                 49
                         Choices - Credit Ratings
                            Bond Credit Rating and Default Rates
Percent Defaults
100

90

80

70
                   Investment
60                                                Junk
                     Grade
50

40

30

20

10

 0
        AAA         AA       A     BBB     BB      B      CCC      D   50
      Source: Moody's
Bond Ratings
                                                             Standard
                                                   Moody's                Quality
                                                             and Poor's
Investment Grade
Best quality. Interest payments are protected
by earnings and principal is secure. Actual        Aaa       AAA          High grade
default rate less than 2%.
Protection on interest is not as high as Aaa
but still high quality. Actual default rate less   Aa        AA           High grade
than 2%.
Over the long term, some risk to investment.
                                                   A         A            Medium
Actual default rate less than 5%.
Adequate for now but may be unreliable over
                                                   Baa       BBB          Medium
time. Actual default rate 5%.
Non Investment Grade
Future is not certain. Moderate protection of
interest and principal. Some speculation.          Ba        BB           Speculative
Actual default rate 17%.
Small protection of interest and principal.
                                                   B         B            Speculative
Actual default rate 26%.
Poor standing. May be in default. Actual
                                                   Caa       CCC          Default
default rate over 40%.
Often in default. Highly speculative.              Ca        CC           Default
                                                                          Poor
Extremely poor prospects. In default.              C
                                                                          Investment
                                                             No
                                                   C
                                                             interest.
                                                             D            In default.
                                                                                        51
     Calculate the yield and explain any
                 differences.


                                 Maturity   Credit
Company       Coupon   Quote
                                 Date       Rating
Daimler
              8.5      103.950   01/18/2031 A
Chrysler
Conseco       6.4      100       06/15/2011 BB-
Xerox         .57      35.625    04/21/2018 BB+
Owens
              7.5      30.50     08/01/2018 D
Corning
Pacific Gas   8.25     91        11/01/2022 CCC


                                                     52
  Even countries have credit ratings. Consider the current
  economic status of the following countries. What would
       you guess the rating of their debt would be?
• Here's a guideline: the U.S. is Aaa, China is A3, Brazil is B2, and Russia is
  B3. Once you have made your guesses, go out to the web and check out
  www.moodys.com. You'll find country ratings under Ratings/Sovereign
  Ratings.
        United Kingdom
        Mexico
        Argentina
          Bahamas
          Canada
          Israel
         • Colombia

                                                                             53
                Bond Funds

• About 8000 bond funds with 15% of mutual
  fund assets.
• For investors who don’t want to buy
  individual bonds.
• Some pros believe that small investors should
  only buy bond funds.


                                              54
  Go to www.bloomberg.com
 http://www.morningstar.com/
Check out the bond fund returns.




                                   55
                  Buying Bonds
• Treasuries - direct from government, broker, unit
  trust, or fund
• Municipal bonds - broker, unit trust, or fund
• Mortgage-backed bonds - broker, unit trust, or fund
• Corporate bonds - broker, unit trust, or fund




                                                    56
Interest Rate Food Chain   Risk and return
                           holds for bonds as
                           well. Less risk means
                           less return.
                           Muni bonds typically
                           give the lowest
                           interest because of
                           tax status.
                           Treasuries are next.
                           They’re safe.
                           Mortgage-backed are
                           safe but they have
                           call risk.
                           Corporate bonds are
                           the riskier with junk
                           being extremely
                           risky. But yields are
                           also better.    57
Assess Interest Rate Risk – Are we at a high
point or low point for bond interest rates?
                                                                       Historical Interest Rates

          20

          18                                                                                                                                                                    Corporate Baa

                                                                                                                                                                                90-Day T-Bill
          16
                                                                                                                                                                                Corporate AAA
          14
                                                                                                                                                                                5-Year T-Note

          12                                                                                                                                                                    30-Year T-Bond

          10
Percent




           8

           6

           4

           2

           0                                                                                                                                                                                                                                           58
               1982
                      1982
                             1983
                                    1983
                                           1984
                                                  1984
                                                         1985
                                                                1986
                                                                       1986
                                                                              1987
                                                                                     1987
                                                                                            1988
                                                                                                   1989
                                                                                                          1989
                                                                                                                 1990
                                                                                                                        1990
                                                                                                                               1991
                                                                                                                                      1991
                                                                                                                                             1992
                                                                                                                                                    1993
                                                                                                                                                           1993
                                                                                                                                                                  1994
                                                                                                                                                                         1994
                                                                                                                                                                                 1995
                                                                                                                                                                                        1996
                                                                                                                                                                                               1996
                                                                                                                                                                                                      1997
                                                                                                                                                                                                             1997
                                                                                                                                                                                                                    1998
                                                                                                                                                                                                                           1998
                                                                                                                                                                                                                                  1999
                                                                                                                                                                                                                                         2000
                                                                                                                                                                                                                                                2000
                     Monitor

• Monitor your bonds. They can change.
  – Interest rate risk: What is the interest rate
    environment when you buy? How is it changing?
  – Call risk: Call risk is highest when interest rates
    drop.
  – Credit risk: Issuers can undergo drastic changes
    in financial viability. Keep tabs on this.


                                                      59

				
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