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FIN 200 Investments

CHAPTER 14CHAPTER 14

Bond Prices and Yields

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Cyclical UnemploymentA factor of overall unemployment that relates to the cyclical

trends in growth and production that occur within the business cycle. When business cycles are at their peak, cyclical unemployment will be low because total economic output is being maximized. When economic output falls, as measured by the gross domestic product (GDP), the business cycle is low and cyclical unemployment will rise.

Economists describe cyclical unemployment as the result of businesses not having enough demand for labor to employ all those who are looking for work. The lack of employer demand comes from a lack of spending and consumption in the overall economy.

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Definition of 'Bull Market'

A financial market of a group of securities in which prices are rising or are expected to rise. The term "bull market" is most often used to refer to the stock market, but can be applied to anything that is traded, such as bonds, currencies and commodities. 

Investopedia explains 'Bull Market'

Bull markets are characterized by optimism, investor confidence and expectations that strong results will continue. It's difficult to predict consistently when the trends in the market will change. Part of the difficulty is that psychological effects and speculation may sometimes play a large role in the markets.

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The use of "bull" and "bear" to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air while a bear swipes its paws down. These actions are metaphors for the movement of a market. If the trend is up, it's a bull market. If the trend is down, it's a bear market.

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The video we will watch can be found at the following address.

http://www.investopedia.com/video/play/what-are-bull-and-bear-markets#axzz1opwLoJui

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Different Issuers of Bonds

• U.S. Treasury– Notes and Bonds

• Corporations• Municipalities• International Governments and Corporations• Innovative Bonds

– Floaters and Inverse Floaters– Asset-Backed– Catastrophe

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Face or par value = the amount that the borrowing institution has to repay the lender (you or me) at maturity. Remember that bond markets can sell bonds for more

or less than the maturity value. Coupon rate = the interest rate earned by the

lender. Example.

$1,000 bond with a coupon rate of 8% for 30 years.

This bond may or may not have cost $1,000.

The interest is $80 per year, paid in installments of $40 semi-annually (twice a year).

Bond Characteristics

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Zero coupon bond = no coupon payments. These bonds are sold for a price far less than

the par value. Investors receive par value at maturity. The return (profit) comes from the difference

between the issue price and the payment of par value at maturity.

These bonds are not attractive to people who rely on the income stream.

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Compounding and payments When coupon payments are reinvested as soon

as they are received, the benefit of compounding is realized.

Indenture = the contract between the issuer (borrower) and the bondholder.

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Figure 14.1 Listing of Treasury IssuesPage 447 in your textbook

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The highlighted bond in Figure 14.1 matures in January 2011.

The letter n = Treasury note, not a bond. The coupon rate is 4.25% and par value is

$1,000. The interest rate is $42.50 per year but

payments are semi-annual, so they will pay $21.25 in July and January.

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Bid and Asked Prices are quoted in points (percentages) plus fractions of 1/32 of a point.

These prices are quoted as a percentage of par value (maturity price).

The bid price of the note is 98:07 = 98 7/32 = 98.219% of par value or $982.19

The asked price is 99:08 = 99 8/32 % of par, or $982.50

Remember: The bid price is the price at which you can

sell the bond to a dealer. The asked price is the price that you can buy

the bond from the dealer

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The last column “Ask Yld” is a measure of the average rate of return if the purchaser holds it until the maturity date.

Remember: The letter i after the maturity year, are bonds

or notes that are indexed to inflation and their yields (interest = profit) should be interpreted as after-inflation, or real returns.

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The prices that are quoted in the financial pages must be adjusted for the interest that has accrued between the last coupon payment and the next coupon payment.

When a bond is purchased between coupon payments, the buyer has the additional cost of paying the seller the accrued interest since the last payment.

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Example. If the last coupon payment was 30 days ago,

then the buyer owes the seller 30 days of interest.If there are 365 days in the year, and this

semi-annual period has 182 days, the seller is owed 30/182 of the coupon.

8% coupon = $40 semi-annually$40 X (30/182) = $6.59If the quoted price of the bond or note is $990, then the price the buyer pays will be $990 + $6.59 = $996.59

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Figure 14.2 Listing of Corporate Bonds

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Corporate BondsSome corporations are active traders and are available on a formal exchange.Most corporate bonds are traded by dealers, who quote based on computer network.Figure 14.2 give the following information: Coupon, maturity, price and yield to maturity.The rating column is the estimation of bond safety given by the three major bond-rating agencies. A is the safest, B less, etc.

Safer bonds have lower yields.

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Call ProvisionsTo call a bond is a choice that the issuer has to buy it back at a specified ‘call price’ before the maturity date.When might a call provision be exercised?If a company issues a bond with a high coupon rate when market interest rates are high, and the interest rates then fall, the firm might like to retire the high-coupon debt and issue new bonds at a lower coupon rate to reduce interest payments.This is called refunding.

Callable bonds come with a period of call protection, which is an initial time during which the bonds are not callable. They are known as ‘deferred callable bonds’.

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The corporation benefits and the bondholder carries the burden when they must take a give up the higher rate.

Concept Check 1 – page 449.What is the answer?

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QUESTION: Why are many bonds callable? What is the disadvantage to the investor of a callable bond? What does the investor receive in exchange for a bond being callable? How are bond valuation calculations affected if bonds are callable?

ANSWER: Many bonds are callable to give the issuer the option of calling the bond in and refunding (reissuing) the bond if interest rates decline. Bonds issued in a high interest rate environment will have the call feature. Interest rates must decline enough to offset the cost of floating a new issue. The disadvantage to the investor is that the investor will not receive that long stream of constant income that the bondholder would have received with a noncallable bond. In return, the yields on callable bonds are usually slightly higher than the yields on noncallable bonds of equivalent risk. When the bond is called, the investor receives the call price (an amount greater than par value). The bond valuation calculation should include the call price rather than the par value as the final amount received; also, only the cash flows until the first call should be discounted. The result is that the investor should be looking at yield to first call, not yield to maturity, for callable bonds.

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Question:If you are buying a coupon bond between interest paying dates, is the amount you would pay to your broker for the bond more or less than the amount quoted in the financial quotation pages? Discuss the differences and how these differences arise. 

If you are buying a bond between interest paying dates, you will pay more than the amount quoted in the financial pages. You will pay that price plus the interest that has accrued since the last interest paying date. That interest belongs to the seller of the bond and will be remitted to the seller by the broker. When the next interest paying date arrives, you will receive the entire coupon payment.

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QUESTION:What are the taxation ramifications of zero coupon bonds? How has this taxation procedure changed over the years? How has this change affected the demand for these bonds? 

The only return on a zero coupon bond is the capital gain realized when the bond is sold. Initially, the investor was required to pay capital gains tax only when the bond was sold. However, the IRS later decided that part of this capital gain each year was really imputed interest and thus now one must pay tax on this imputed interest income (income that the investor has not yet received). As a result, zero coupon bonds are no longer particularly attractive for individual investors and institutional investors subject to income tax. However, zeros remain attractive to institutional investors not subject to income taxes, such as pension plans and endowments.

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Why were mortgage-backed CDOs a disaster in 2007?

they were formed by pooling sub-prime mortgageshome prices stalledthe mortgages were variable rate loans and interest rates increased

Mortgage-backed CDOs formed by pooling sub-prime mortgages, home prices stalled, the mortgages were variable rate loans and interest rates increased.

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Convertible Bonds

Convertible bonds offer the choice of,1.Taking the par value, or2.Exchanging the bond par value for a specified number of common stock shares.

Example.A convertible bond is issued with a par value of $1,000 and is convertible to 40 shares of stock.

If the current share value is $20, the option to convert is not profitable, but if the price increases to $30, the value of the shares is $1,200 of stock

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The ‘market conversion value’ is the current value of the shares for which the bonds may be exchanged. At $20 the conversion rate for 40 shares of common stock is $800.The ‘conversion premium’ is the excess of the bond value over its conversion value. ExampleIf the bond were currently selling for $950 and common stock price is $20 per share, the conversion premium is $150.

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Puttable BondsThe reverse of the callable bond.A ‘put bond’, or ‘extendable bond’ gives the option to the bondholder.If the coupon rate is higher than current market yields (profits), the bondholder may choose to extend the bond’s life.If the current coupon rate is lower than the current market yields, the bondholder will choose to not extend, take their par value (reclaim their principal) and reinvest at a higher rate.

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Floating Rate BondsThe interest payments are tied to a separate measure of a current market rate.Example.The rate may be 2% above a T-bill. If the T-bill rate drops, so does the interest rate.The benefit is that the bond will always pay at approximately the current market rate.

The risk is that floaters do not change with the financial health of the firm. If the firm is doing poorly, the resale value will decrease.

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Preferred StockPreferred stock is an equity, it can also be considered a fixed-income investment because it promises to pay a specified stream of dividends.Unlike bonds, failure to pay at the promised time does not result in bankruptcy, but the dividends owed accumulate.Common stockholders can not receive any dividends until the preferred dividends are paid in full.

In the case of bankruptcy, the order of priority is bondholders, preferred stock and then common stock.

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In the last 20 years, adjustable preferred stock (floating-rate linked to a national measure of current market interest rates) has become popular.

Dividends on preferred stock are not tax deductible (bonds are tax deductible), which makes it less attractive to firms to use as a way to raise capital.

However, the benefit is that profits (dividends) are only taxed 30%. This does make it attractive for corporations to buy each other’s preferred stock.

Example. If you earn $10,000 in dividends you will only pay tax on $3,000 of it.

If your tax rate is 35%, you will pay .35 X $3,000 = $1,050. If you had to pay 35% tax on the whole amount, your tax bill would be $3,500.

The firm’s effective tax rate is therefore .30 X 35% = 10.5%.