Background on Bonds
n Bonds represent long-term debt securities
l Contractual
l Promise to pay future cash flows to investors
n The issuer of the bond is obligated to pay:
l Interest (or coupon) payments periodically usually semiannually
l Par or face value (principal) at maturity
n Primary vs. secondary market for bonds
Background on Bonds
The issuer’s cost of financing with bonds
u Determined by current market rates and risk
u Usually fixed throughout term
u Determines periodic interest payments
Background on Bonds
The yield to maturity (YTM) is the yield that equates the future coupon and principal payments with the bond price
l The YTM is the investor’s expected rate of return if the bond is held to maturity
Background on Bonds
U. S. Treasury Bonds
n Issued by the U.S. Treasury to finance federal government expenditures
n Maturity
l Notes, < 10 Years
l Bonds, > 10 to 30 Years
n Active OTC Secondary Market
n Semiannual Interest Payments
n Benchmark Debt Security for Any Maturity
Treasury Bonds
n Treasury Bond Quotations
8.38 Aug. 2013-18 103:05 103.11 YTM?
l Coupon rate
l Maturity date
l Bid/Ask price as percent of face value
l Fractions of price in 32nds
u Example: Bid price 103:05, Ask price 103:11
Treasury Bonds
l Stripped Treasury bonds
u Zero-coupon securities are sold with claims on U. S. Treasury bonds held in a trust
n One security represents the principal payment (PO) at maturity
n Other securities represents the interest payments (IO) at interest paying dates
Treasury Bonds
l Intended for investors who seek inflation protection with their investments
l Coupon rates less than other Treasuries
l Principal value adjusted for the U.S. inflation rate (CPI) every 6 months
l Coupon income increases with inflation
Municipal Bonds
n State and local government obligations
n Revenue bonds vs. general obligation bonds
n Investor interest income exempt from federal income tax
Corporate Bonds
n When corporations want to borrow for long-term periods they issue corporate bonds
l Usually pay semiannual interest
l Most have maturities between 10-30 years
l Public offering vs. private placement
l Limited exchange, larger OTC secondary market
Corporate Bonds
l Indenture
u Legal document specifying rights and obligations of issuer and bondholder
l Trustee
u Represents bondholders to assure compliance with indenture
Corporate Bonds
Sinking Fund Provision
u Requirement that the firm retire a certain amount or number of bonds each year
u Protects investors with principal reduction
l Protective Covenants
u Places restrictions on the firm to protect bondholders
u Examples: limits dividends and officer salaries, restricts additional debt
Corporate Bonds
l Call provisions: Ability to pay bonds off early
u Call premium
u Advantage to issuers; disadvantage to investor
l Bond collateral
u Usually consists of a mortgage on real property
u Unsecured bonds are called debentures and are backed only by the general credit of the issuing firm
Corporate Bonds
l Low-coupon and zero-coupon bonds
l Variable-rate bonds
l Convertible bonds
Corporate Bonds
n Junk Bonds
l Junk bonds are also called high-yield bonds or noninvestment rated bonds
l Popularized in the direct finance boom of the 1980s to finance acquisitions and leveraged buyouts (LBO)
l The risk premium is generally the highest among corporate bonds
Corporate Bonds Market Quotation
ATT 6 ½ 29 7.3 214 88 5/8th +1/4
§ AT&T bond quote for 1/13/02 (U.S. Exchange Bond)
§ 6.5% coupon rate
§ Maturity in 2029
§ 7.3% current yield (annual interest/price)
§ 214 bonds traded on this day
§ Bond priced at close of day 88 5/8th % of face ($1000) or $886.25
§ Bond price up ¼ point for the day or $2.50
Globalization of Bond Markets
n Investment in foreign currency securities
n Overseas issuance by firms
n Bonds that are sold in countries other than the country represented by the currency denominating them are called Eurobonds