Bonds:

Fixed Income Securities

Economics 71a: Spring 2007
Mayo chapter 12
Lecture notes 4.3
 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

Pt+1 + I t+1 − Pt
Rt+1 =
Pt
Pt+1 − Pt I t+1
Rt+1 = +
Pt Pt

= (capital gain) + (Interest)

€
 Annual Historical Returns
Raw Returns Inflation
Adjusted
Stocks 12.4% 9.2%

Corp Bonds 6.3% 3.2%

Gov’t Bonds 5.8% 2.8%

TBills 3.8% 0.7%

 Bonds in the 1990’s
 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)

Tax free yield
Taxable yield =
(1 - tax rate)
Muni yield = 5%, tax rate = 35%
0.05
= 7.69%
(1-.35)
 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 1980’s
 Leveraged buyouts
 Are they a good investment?
 Mortgage Backed Securities
(Mortgage Bonds)
 Poolof 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 Poor’s)
 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
 Moody’s
 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