Module 4 Bonds

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Module 4Bonds
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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.

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Income is not rising but debt is
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People are raiding the piggy bank
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Spending power?
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The big picture
http//www.nytimes.com/interactive/2008/07/20/busi
ness/20debt-trap.html?scp1sqdebt20trap202008-
07-20interactivestcse
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Which of the following factors can a lender use
to evaluate your credit?

• Gender
• Age
• Childbearing plans
• Marital status
• Change in marital status
• Loans
• Public assistance
• Dependents
• How long youve lived at your house

• Alimony
• Race
• Color
• National origin
• People in the neighborhood where you want to buy
• How long youve had your job
• Salary

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What does your credit report affect?

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

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Analyze a credit report
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Your credit score
Source www.myfico.com
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Credit Scores
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Credit ratings and cost of credit
Source www.myfico.com 3/21/07
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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

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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

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True or False?

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

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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?

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Why do companies, governments, etc. issue bonds?
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How have bonds done as investments?
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How do you make money from bonds?
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You can also have a gain or loss on a bond
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It boils down to two factor coupon and maturity.
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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?

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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.

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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
  its 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

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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

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Current Yield

• Annual interest divided by price you paid
• Lets you know what you get every year
• Might want to compare to other investments
• Doesnt consider what you sell for

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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.

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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)

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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?

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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

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Calculate nominal yield, current yield, yield to
maturity and yield to call. You are buying 3-1-00.
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Answer sheet
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US Bond Choices
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Choices - Treasuries
Deficit 9 T (12/06)
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Who do we owe?
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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

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Evaluating Munis

• It is 02-22-2001. You're looking at two bonds
  given the same credit rating by Standard and
  Poors. 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.

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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

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Evaluate these
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Choices - Corporate Bonds

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

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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.

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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

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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.

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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
• Dont hear from borrower for a long time
• Taxed even though you dont have the cash

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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.

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Choices - Credit Ratings
Investment Grade
Junk
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Calculate the yield and explain any differences.
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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

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Bond Funds

• About 8000 bond funds with 15 of mutual fund
  assets.
• For investors who dont want to buy individual
  bonds.
• Some pros believe that small investors should
  only buy bond funds.

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Go to www.bloomberg.com http//www.morningstar.co
m/Check out the bond fund returns.
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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

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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. Theyre
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.
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Assess Interest Rate Risk Are we at a high
point or low point for bond interest rates?
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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.