Bonds:

Fixed Income Securities

Goals
History
Features and structure
Bond ratings
Bond Returns
Interest and capital gains
Stock comparison: dividends and cap
gains
Most income in the form of interest
Two Parts
= (capital gain) + (Interest)

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Annual Historical Returns
Raw Returns Inflation
Adjusted
Stocks 12.4% 9.2%
Corp Bonds 6.3% 3.2%
Govt Bonds 5.8% 2.8%
TBills 3.8% 0.7%
Bonds in the 1990s
1990-1999
Bonds, 8.7% (nominal, no inflation adjustment)
$10,000 -> $23,000
Stocks 18.2% (nominal)
$10,000 -> $53,000
1990-2003(June)
Bonds, 9.7% (nominal)
$10,000 -> $35,000
Stocks, 10.2% (nominal)
$10,000 -> $37,000

Bond Return Summary
Generally, lower returns than stocks
But also, less risk than stocks
Bond Risks
Interest rate risk
Purchasing power risk (inflation)
Default or business risk
Liquidity risk
Call risk
Goals
History
Features and structure
Bond ratings
Bond Features
Agreement to borrow money
Amount of loan
Principal, par value
Paid back at set date in the future maturity
Interest payments
Coupon interest rate
Percentage of principal
Made on regular schedule
Example
Bond structure
Principal = $1000
Maturity = 10 years
Coupon = 5%, semiannual
Cashflows
Pays $25 in interest every 6 months
(Interest payment is fixed.)
10 years from now pays back $1000 + $25

Bond Legal Structure
Indenture
Specifies rights of bond holders
Restrictions often include
Requirements on accounting practices
Firm should pay taxes
Constrain future borrowing
Limit dividend payments on stock
Current Bond Price
Discount
Price < Par
Premium
Price > Par
Depends on interest rates
Bond yield = coupon/price
Call Provisions
Issuer (firm) can buy back the bonds
(call) at a specified price (call premium)
Call provisions specify the price, and
time period in which this can happen
Most corporate bonds are callable
Similar to refinancing for individuals
Important risk component for investors
Sinking Funds
Schedule to pay back principal over
time
Different from call
Option versus requirement
Secured Debt
Backed by some kind of property
Mortgages: real estate
Plant and equipment
Financial assets
Income streams (Mass. turnpike)
Unsecured debt (junior bonds, debentures)
No asset backing
Ok for large reliable firms
Difference Between Debt
(Bonds) and Equity (Stock)
Voting rights
D: none, E: yes
Claims on firm assets
D: senior to equity, E: subordinate to debt
Maturity
D: fixed, E: none
Taxes
Trading/liquidity
Borrower Costs
What affects the interest rate borrowers
pay?
Maturity (length of bond)
Size (total loan)
Default risk
Market interest rates
Market Segments
Trillions of U.S. $
U.S. treasury bonds: 2.2
Agency securities: 2.1
Federal home loan, Student loan marketing
association
Municipal bonds: 1.5
Corporate bonds: 5.2
Mortgage backed securities: 2.9
Foreign issues (eurodollar): 3.3
Special Bond Types
Treasury bonds
Municipal bonds
Zero coupon bonds
Floating rate bonds (floaters)
Inflation adjusted bonds
Junk bonds
Mortgage backed securities
Asset-backed securities
Convertible bonds
Foreign bonds
U.S. Treasury Bonds
Borrowing of the U.S. federal government
Very low risk/High liquidity
$1,000 denominations
Maturities
2, 3, 5, 10 years (notes)
20, 30 years (bonds)
Interest income exempt from state and local
taxes, but not federal taxes

Municipal Bonds
Local state, county, city bonds
Interest
Exempt from federal taxes
Usually free from state tax if you reside in
the state the bond was issued by
Capital gains
Not exempt

Muni Bonds: Taxable
equivalent yield

(Taxable yield)(1 - tax rate) = (Tax free yield)
Taxable yield =
Tax free yield
(1- tax rate)
Muni yield = 5%, tax rate = 35%
0.05
(1- .35)
7.69%
Zero Coupon Bonds
Zero coupon (interest) payments
Principal only
Trade at discount
Example: $1040 in 1 year
Price today = $1000
Yield (return) = 4%
Constructed zero coupon bonds: Strips
Floating Rate Bonds
(Floaters)
Coupon payments tied to current
interest rates
Coupon might be principal*(T-bill rate)
1000*(2.5%)
Similarities to adjustable rate mortgages
Inflation Adjusted Bonds
Treasury inflation-indexed obligation
TIPS
Par value adjusted up with inflation
$1000 bond, 3% inflation
In one year goes to $1030
Coupons are a percentage of par and
rise too

Junk Bonds
High yield
High risk (default likely)
Unsecured
Famous in the 1980s
Leveraged buyouts
Are they a good investment?

Mortgage Backed Securities
(Mortgage Bonds)
Pool of mortgages
Pay off principal over time
Some pools high risk
Subprime
Tricky refinancing questions
Asset-backed Securities
Bonds backed by revenue streams
Car loans/credit cards (large pool)
Mass turnpike bonds (tolls)
David Bowie bonds
Backed by revenue stream for albums
IP Securitization

Convertible Bonds
Bonds that can be converted into a fixed
number of shares of common stock
Value moves with stock price (and
interest rates)
Difficult valuation
Foreign Bonds
Yankee bonds
Dollar bonds issued in U.S. by foreign or
international corporations
Euro bonds
Dollar bonds issued outside the U.S.
Goals
History
Features and structure
Bond ratings
Bond Ratings
Agencies rate the riskiness of a bond
Essentially the chance that it will default
See page 257
Bond ratings (Standard and Poors)
AAA, high-grade
A, medium-grade
>=BBB, Investment grade
<BBB, speculative grade or junk bonds
C, No interest paid
D, In default
Bond Ratings and Default Probabilities
(Economist, March 23, 2005)
Rating Agencies
S&P
Rates $30 trillion in debt
Moodys
Fitch

Problems for Raters
Missed Enron, WorldCom, Parmalat
Lack of competition
Should there be more official oversight
Firms starting consulting businesses
Help firms that they are rating
Serious conflict of interest


Ratings Taken Seriously
Many investment funds having ratings
requirements
No junk bonds
Ratings triggers : loans called back if
ratings fall


Goals
History
Features and structure
Bond ratings