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CHAPTERS 9, 18, 19 & 20
 Interest Rates (Chapter 9)
 Corporate Bonds (Chapter 18)
 Government Bonds (Chapter 19)
 Mortgage-Backed Securities (Chapter 20)
 Introduction to Bonds (Lecture Notes)



                          “Gentlemen Prefer Bonds”
                                  Andrew Carnegie
                                                                       2


What are Bonds?
   Negotiable, publicly traded long-term debt
    securities, whereby the issuer agrees to pay a
    fixed amount of interest over a specified
    period of time and to repay a fixed amount of
    principal at maturity
     a.k.a. “Fixed-income” Securities, “Debt Financing”
     A bond is really just an IOU issued by…
        A corporation – “Corporate Bonds”
        A municipality (state or local) – “Municipal Bonds”
        The Federal government – “Treasury Bonds”
     The bondholder loans money to the bond issuer
           Bonds are loans. Investors who buy bonds are “loaners”
                             instead of “owners” (stocks, equities).
                                                        3


Trust Indenture
 Contract that sets forth the terms between the
  issuer and the bondholders
 Describes bondholders’ rights and issuer’s
  obligations
 Appoints a trustee to oversee that these
  obligations are carried out
     Trustee is usually a commercial bank or a trust
      company
   Stipulates protective covenants
     Obligations of the bond issuer to keep doing
      business, keep equipment in good working order,
      make payments on time, etc.
                                                                           4


Why Invest in Bonds?
   Bondholders receive…
     Interest during the life of the bond
        Normally paid every six months
     Principal is returned when the bond is redeemed
        Typical bond maturity is from 1 to 30 years
     Potential for a capital gain or a capital loss
        If interest rates fall, there is a potential for a capital
         gain but there is also a potential for a capital loss if
         interest rates rise (much more about this later)
           But if you intend to hold the bond to maturity (when you are
            paid back), capital gains or losses will not affect you
     Some bonds offer tax advantages
     Some bonds can be converted into stocks
        “Convertible bonds” (a.k.a. “Convertibles”)
           We will deal with convertibles in detail at a later time
                                                                      5


Why Invest in Bonds?                                  (continued)

 Bondholders are first in line for repayment if
  there is default on the loans
   After taxes & payroll expenses
      (Stock holders are last in line)
 Bond prices are far less volatile than stocks
   But bond prices still fluctuate
      Bond prices can go down and do go down when
       interest rates rise
 Average returns over decades – 4% to 8%
   4% to 6% – Municipal and Treasury Bonds
   6% to 8% – Corporate Bonds (some pay much higher)
   Currently, many bonds are paying less than their historical returns.
                                              Some are paying more.
                                                           6


Bonds and Interest Rates
   By far, the most misunderstood feature about
    bonds is their inverse relationship with
    interest rates
     When interest rates fall, bond prices rise
     When interest rates rise, bond prices fall

 When interest
    rates fall,

                                          …bond prices
                                                 rise,
                                         and vice-versa.
                                                               7


Bonds versus Stocks
   Over the long term, stocks have outperformed
    bonds. So why invest in bonds?
     Stocks are far more volatile (i.e. carry more risk)
     Bonds offer an element of stability to your portfolio
     For some investors, stocks are simply too risky
        They reason: If I can obtain my long-term goals
         without taking on the risk of being invested in stocks,
         so be it
          The “I-Can-Sleep-Better-At-Night” Factor
     Bonds also make good intermediate-term
      investments
        Stocks are good long-term investments
     Sometimes, bonds are just screaming good deals!
                                                                   8


The Risks of Bond Investing
   Interest Rate Risk
     When rates fall, bond prices rise & vice-versa
     If you intend to sell the bonds in the future, a rise in
      interest rates can translate into capital losses
   Purchasing Power Risk
     The risk that your purchasing power will fall if
      inflation outstrips your return from bonds
   Business / Financial Risk
     The risk that the bond issuer will default on interest
      payments or principal repayments
        Much less a risk with municipal and Treasury bonds
          Although some muni’s have gone “belly up” in the past
                                                                        9


The Risks of Bond Investing                          (continued)

   Liquidity Risk
     The risk that there may not be sufficient buyers
      when and if an investor wants to sell their bonds
     Less of a problem with Treasuries / muni’s
     Can be a big problem with thinly-traded bonds
   Call Risk – a.k.a. Prepayment Risk
     The risk that a bond will be “called away” from the
      investor before its scheduled maturity date
        Much like a home mortgage can be refinanced
     Some bonds are non-callable

                     More about the call feature of some bonds later.
                                                                         10


 Bond Interest and Principal
   Coupon Rate
     The feature of a bond that defines the amount of
      annual interest income
     a.k.a. Nominal Rate, Coupon Yield, Nominal Yield
     The interest is usually paid every six months
        Although a scant few bonds pay from every month to
          quarterly to once a year
      The term “coupon rate” came from the fact that bonds used to have
   coupons attached to them. When the interest was due, an investor was
    required to send the coupon into the bond issuer and the issuer would
then send the bondholder the interest. To this day, earning interest from a
 bond is often called “clipping the coupon” even though now virtually all
                                      transactions are done electronically.
                                                                          11


Bond Interest and Principal                               (continued)

   Principal
      The amount of capital that must be paid at maturity
         i.e. The amount of the loan
      a.k.a. Par Value, Face Value
      The principal of most bonds is $1,000
         i.e. Bonds are denominated in $1,000 increments

    Putting coupon rate and principal together tells you how much interest
      you will receive each year. For example, a coupon rate of 7% and a
                        principal of $1,000 gives $70 of interest each year.
        And since almost all bonds are denominated in $1,000 increments,
      knowing the coupon rate gives you the amount of interest. Therefore,
    normally bond investors simply refer to their bonds by the coupon rate
                            and maturity. “I bought a 7% 30-year bond.”
                                                                  12


Maturity Dates and Bonds
   Maturity Date
     The date on which a bond matures and the
      principal must be repaid
     Term bonds mature all at once
        They are the most common
        For example, a company will issue 20-year bonds
        that all mature in 20 years on the same date
     Serial bonds have a series of maturity dates
        For example, a company may issue “series” of 20-
         year serial bonds with 20 maturity dates, each series
         maturing each year for 20 years
          Each year, a certain portion of the issue would come
           due and be paid off (i.e. the series matures)
                                                                     13


Maturity Dates and Bonds                        (continued)

   Bonds versus Notes
     Technically, there is a difference between a bond
      and a note
     Notes mature in 2 to 10 years
     Bonds mature in 10 or more years
       Usually 20 to 30 years
       Some bonds mature in 50 or 100 years
          Railroads and other industries of the late 19th century
       A very small number of bonds never mature
          They are often referred to as perpetuities or consols

           However, in practice, most investors (including myself)
             use the term bond to refer to both bonds and notes.
                                                                  14


Call Provision of Bonds
   Call Provision
     Provision that specifies whether and under what
      circumstances the issuer can retire (prepay) the
      bond prior to the maturity date
     If interest rates drop, just as a homeowner would
      want to refinance their mortgage, a bond issuer
      would want to refinance their bond loans
     The issuer “calls in” the bonds
        The bonds are “called away” from the bond investor
     a.k.a. Prepayment of bonds
        All others factors being equal, investors would prefer non-
                                  callable bonds to callable bonds.
                                                                     15


Call Provision of Bonds                            (continued)

   Three Types of Call Provisions
     Freely Callable
        Can be retired at any time
     Non-callable
        The issuer is prohibited from retiring the bond before
         the maturity date
     Deferred Call
        a.k.a. Call Protection Period, Call Deferment Period
        The issuer must wait for a certain length of time to
         pass before the bonds can be called
      Most corporate and municipal bonds are freely callable or have a
       deferred call. Treasuries are always non-callable. Which of the
         above provisions is least desirable? Which is most desirable?
                                                                    16


Call Provision of Bonds                           (continued)
   Call Premium
     The amount that is added to a bond’s par value
      and paid to investors when a bond is retired
      prematurely
        Example: $85 premium
        Like the “prepayment penalty” of a home mortgage
   Call Price
     The price the issuer must pay to retire a bond
      prematurely
        Equal to the par value plus the call premium
        Example: $1,000 par + $85 premium = $1,085 call
         price
 If there is no call premium, the bond is said to be “callable at par.”
                                                                     17


Principals of Bond Price Behavior
   Premium Bond
     A bond with a market value greater than the par
      value
        Occurs when prevailing interest rates drop below the
         coupon rate
   Discount Bond
     A bond with a market value lower than par value
        Occurs when prevailing interest rates are greater
         than the coupon rate
        Also occurs when and if the investment community
         believes that the bond issuer is in danger of
         defaulting on interest payments or principal
         payments
                        If there is no premium nor discount, the
                              bond is said to be “selling at par.”
                                                             18


Principals of Bond Price Behavior
                                           (continued)

    “Wait a minute. Why would a bond sell at a
     premium or a discount to its par value?
      If the loan is for $1,000, the bond would always
       sell for $1,000, right?”
      No. Since the interest rate of your bond doesn’t
       change, the price of the bond changes to reflect
       the change in the prevailing interest rates within
       the financial industry

                                     Remember the image of
                                             the see-saw?
                                                       19


Principals of Bond Price Behavior
                                         (continued)

   Example 1 – Premium: Bond paying 10%
     The bond’s face value is $1,000
     The bond’s interest per year is $100
        10% of $1,000 = $100
   Interest rates fall to 8%
     Now, investors have to pay $1,250 to get the same
      amount of interest
        8% of $1,250 = $100
   The result is your bond is now worth more than
    it was (capital gain if sold)
     The bond could be sold at a high premium
                                                        20


Principals of Bond Price Behavior
                                         (continued)

   Example 2 – Discount: Bond paying 10%
     The bond’s face value is $1,000
     The bond’s interest per year is $100
        10% of $1,000 = $100
   Interest rates rise to 12%
     Now, investors need only pay $833.33 to get the
      same amount of interest
        12% of $833.33 = $100
   The result is your bond is now worth less than
    it was (capital loss if sold)
     The bond would be sold at a large discount
                                                                       21


Principals of Bond Price Behavior
                                                    (continued)

    The amount of the premium or discount is not
     only related to the amount of the fall or rise of
     interest rates
      In general, the greater the fall or rise in interest
       rates, the greater the premium or discount
    The maturity date is also very important
        In general, the longer the maturity, the greater the
          premium or discount                  Just like a see-saw, the
                          Interest Rates Rise farther out you are, the
                     2 yr
                                               greater the rise or fall.
               10 yr                            This is why long-term
   30 yr
                                                bonds are riskier than
 Price of Bonds Fall
                                                     short-term bonds.
                                         22


Principals of Bond Price Behavior
                           (continued)
                                                                      23


Principals of Bond Price Behavior
                                                 (continued)

    In general,
      Long-term bonds exhibit greater price volatility
         And a greater opportunity for capital gain or loss
      Intermediate-term and short-term bonds exhibit
       lesser price volatility
         And a lesser opportunity for capital gain or loss
         Bonds very close to maturity act very similar to
          short-term investments such as money markets
       However, if you intend to keep the bonds until they mature,
        then you are not concerned about the price volatility. You
       will always receive the par value of the bond (except in the
                                      rare case of a bond default).
                                                          24


Principals of Bond Price Behavior
                                           (continued)




 When would you be buying bonds? When would you be selling?
                                                                             25


Treasury Bonds & Notes
   Treasuries, Governments, T-bonds, T-notes
   Treasury Notes      Don’t confuse T-bonds & T-notes
     2 to 10 years                 with Treasury Bills (T-bills). T-bills
   Treasury Bonds                     are short-term debt obligations.
     Greater than 10 years
   Treasury Inflation-Indexed Obligations – TIPs
     Principal is adjusted each year by inflation rate
   Agency Bonds (example: Gov’t National Mortgage Assoc.)
     Not direct obligations of the United States Treasury
     Technically not the same weight as Treasuries
        But considered very safe with almost no risk of
         default (Example: Fannie & Freddie were bailed out in the debacle!)
                         Treasuries are exempt from state income taxes.
                                                              26


Treasury Bonds & Notes                      (continued)

   Treasury Inflation-Indexed Obligations – TIPs
     A type of Treasury security that provides protection
        against inflation by adjusting investor returns for
        the annual rate of inflation
       Initially, pay less interest than other Treasuries
        but…
       Par value is adjusted upward each year to keep
        pace with inflation, therefore…
       The interest payment goes up every year as the
        par value increases, however…
       You must pay taxes on the interest and the
        increase in the par value even though you did not
        receive the increase in par value as cash
                                                                                27


Mortgage-Backed Bonds
   A debt issue secured by a pool of home mortgages;
    issued primarily by government-sponsored entities
     A type of agency bond that pools together home mortgages
        and repackages them into bonds
       a.k.a. Pass-through Securities, Participation Certificates,
        Collateralized Mortgage Obligations (CMOs), Collaterialzed
        Debt Obligations (CDOs), Mortgage-Backed Securities
       Monthly payments consist of interest and principal
       Responsible for 70% of home loan funding
       Government National Mortgage Association (“Ginnie Mae”)
       Federal Home Loan Mortgage Corporation (“Freddie Mac”)
       Federal National Mortgage Association (“Fannie Mae”)
         In the past, Fannie & Freddie had been very successful. They are now in
        distress. Much of the current crisis revolves around these CDO’s / MBS’s.
                                                             28


Asset-Backed Securities
   “Securitization”
     The process of transforming lending vehicles such
      as mortgages into marketable securities
        But can be done with almost any debt or asset
        Success of mortgage-backed bonds spread into…
   Asset-Backed Securities
     Securities similar to mortgage-backed securities
      that are backed by a pool of bank loans, leases,
      and other assets
        Car loans, credit card loans, patents, stocks and
         bonds, even David Bowie – “Bowie Bonds”
        a.k.a. Collateralized Bond Obligations (CBOs),
         Structured Investment Vehicles (SIVs)
                                                            29


Municipal Bonds
   Municipal Bonds – a.k.a. Muni’s, Muni Bonds
     Debt securities issued by states, counties, cities,
      and other political subdivisions; most of these
      bonds are tax-exempt (free of Federal income tax
      on interest income)
       But capital gains, if any, are not tax-exempt
       Careful! Some are not tax-exempt if you are subject
        to the Alternative Minimum Tax (AMT)
     Municipal bonds are very popular with individual
      investors
       Especially high income and high net worth taxpayers
     Some muni bonds are insured (desirable feature)
                                                               30


Municipal Bonds                                  (continued)

   Types of Municipal Bonds
     General Obligation Bonds (a.k.a. GOs)
       Municipal bonds backed by the full faith, credit, and
        taxing power of the issuer
     Revenue Bonds
       Municipal bonds that require payment of principal
        and interest only if sufficient revenue is generated by
        the issuer
          Less desirable than GO bonds – Why?
     Special Tax Bonds
        Municipal bonds that are payable from the proceeds
         of a special tax
        Proposition AA & R bonds are Special Tax Bonds
          The South Bay voters had to approve the tax
                                                             31


Municipal Bonds                             (continued)

   Municipal Bond Tax Advantages
     Free from Federal income taxes
        Taxable Equivalent Yield for Federal tax-exempt
     If purchased by investors in that municipality, they
      are also often free from state and local taxes
       Taxable Equivalent Yield for both Federal & state
        tax-exempt
       Example: California taxpayers do not have to pay
        Federal income tax nor California income tax on
        California Municipal Bonds
     The higher the tax bracket of the investor, the
      higher the taxable equivalent yield
     However, capital gains, if any, are never exempt
                                                                    32


Corporate Bonds
   Secured
     Senior Bonds – a.k.a. Senior Lien Bonds
        Backed by a claim on specific property of the issuer
        Mortgage Bonds (example: real estate)
        Collateral Trust Bonds (example: airplanes, railroad
         equipment)
     Junior Bonds – a.k.a. Junior Lien Bonds
        a.k.a. Second Mortgage Bonds
        Second in priority (like a second mortgage on your home)
   Unsecured
     Debentures, Subordinated debentures
        Backed by the “full faith and credit” of the corporation
     Income Bonds
        Unsecured bonds requiring that interest be paid only
         after a certain amount of income is earned
                                                          33


Zero-Coupon Bonds
   Bonds with no coupons (i.e. no interest payments)
    that are sold at a deep discount from par value
     Instead of receiving interest in cash, the bonds
      simply accrue (grow) in value until maturity
     Example: $1,000 bond maturing in 20 years at
      6.25% would cost $300
        After 10 years, it would be worth $550
     Disadvantages
       Very sensitive to interest rate changes exhibiting
        wide price swings
       The IRS expects you to pay taxes on the accrued
        interest even though you didn’t receive it in cash!
     Often used in tax-sheltered accounts such as IRAs
                                                                34


Junk Bonds
   High-risk securities that have low ratings but
    produce high yields
     a.k.a. High-yield bonds, non-investment grade
     Issued primarily by corporations but there are
      some municipal junk bonds
     Traditionally, reserved for bonds that were in
      distress
        In the 1980’s, junk bonds became an industry as
        companies not large enough to issue bonds began to
        issue bonds with very high interest rates
     Very high risk but often offer the opportunity for
      large capital gains as well as high income
        Unlike most all bonds, junk bonds tend to follow the
        stock market (a.k.a. high correlation with stocks)
                                                                      35


Foreign Bonds
   U.S.-Pay Bonds
     Interest and principal payments paid in U. S. dollars
     a.k.a. Dollar-Denominated Bonds
     No risk of currency fluctuations
   Foreign-Pay Bonds
     Interest and principal payments paid in foreign currencies
     Incur currency fluctuation risk along with all the normal risks
      associated with bonds
        If the U.S. dollar rises relative to the foreign currency, the
         value of the bond will fall
        If the U.S. dollar falls relative to the foreign currency, the
         value of the bond will rise
     Very difficult for an individual investor to purchase
        Best done via a global bond mutual fund
                                                                          36


Bond Ratings
   Letter grades that designate investment quality
    and are assigned to a bond issue by rating
    agencies
      The higher the rating, the better the quality of the
       bond
      Two largest rating agencies
          Standard & Poor’s
          Moody’s
      Think of them as “idiot lights” on your dashboard
     In the wake of the 2001/2002 corporate scandals, the rating agencies
     were caught completely off guard. They didn’t downgrade Enron and
    WorldCom until they were practically in default. They are again being
                called to task because of the mortgage-backed bond crisis.
     Yep, you guessed it: They screwed up again, but this time, they almost
                                         brought down the entire economy!
                                                                37


Bond Ratings                                    (continued)

 Moody S & P                       Definition
  Aaa   AAA    Highest-grade – “gilt-edge”
  Aa     AA    High-grade
  A       A    Medium-grade
  Baa   BBB    Medium-grade – last investment-grade rating
  Ba     BB    Starts non-investment-grade; Speculative
  B       B    More speculative – moderate protection
 Caa    CCC    Poor quality – in danger of default
  Ca     CC    Poorest quality – close to or de-facto default
  C       C    Moody C: In default
          D    S&P C: Not paying interest; S&P D: In default
        Anything Baa or BBB or above is “investment-grade.”
                                                                38


Bond Ratings                                (continued)

   The rating agencies further fine tune their
    ratings
     Standard & Poor’s might add a “+” or a “-” its rating
        Example: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB,
         BBB-, etc.
     Moody’s might add a “1,” “2,” or “3”
        Example: Aa1, Aa2, Aa3,




                                Kinda’ silly, dontcha’ think?
                                                                39


Bond Trading
   Bond trading is very difficult for retail investors
       Trading volume is often thin
       Most bonds trade over-the-counter
       Bond traders normally trade in the $100,000 range
       Expect poor prices for transactions under $10,000
         Unless you are big, don’t expect to be treated well
            Remember John Meriweather?
     Investors use banks and other entities to trade
        bonds (as well as brokers)
         Example: The Bond Buyer
   Exceptions are Treasury bonds, notes, & bills
     Can be purchased directly from the Treasury
     http://www.treasurydirect.gov
                                                                   40


Bond Quotes
   Bonds are normally quoted as a percentage of
    par
     Example: 97.25 means 97.25% of par
        Since par is almost always $1,000, one bond would
         cost 97.25% * $1,000 = $972.50
        (Or simply multiply the 97.25 times 10)
           (Move the decimal point one to the right)



     97.25 is a bond quote for a bond selling at a discount. A bond
    selling at a premium would be quoted over 100. A bond selling
                                      at par would be quoted at 100.
     You can use http://finance.yahoo.com/bonds or www.finra.org
                  (Investors , Market Data / Bonds) for bond quotes.
                                                            41


CHAPTERS 9, 18, 19 & 20
 Interest Rates (Chapter 9)
 Corporate Bonds (Chapter 18)
 Government Bonds (Chapter 19)
 Mortgage-Backed Securities (Chapter 20)
 Introduction to Bonds (Lecture Notes)



     Next week: Chapter 10, Bond Prices, Valuation and Yields

				
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