CHAPTER FOUR

BOND FUNDAMENTALS

Practical Investment Management

Robert A. Strong

South-Western College Publishing ©1998 2

Outline

Bond Principles Identification of Bonds

Classification of Bonds

Terms of Repayment

Bond Cash Flows

Convertible and Exchangeable Bonds

Registration

The Financial Page Listing Basic Information

Footnotes

Government Bonds

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Bond Pricing and Returns Valuation Equations

Yield to Maturity

Spot Rates

Realized Compound Yield

Current Yield

Accrued Interest

Bond Risks Price Risks

Convenience Risks

Outline

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Bond Principles: Identification of Bonds

Bonds are identified by issuer, coupon rate, and maturity.

The face value of a bond is called its par value.

e.g. 5 of “Hertz sevens of 03” (Hertz 7s03)

A legal document called the indenture contains the details of the bond issue.

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Bond Principles: Classification of Bonds

Method 1: By issuer

a. government e.g. US Treasury, federal agency, state, local

b. corporation e.g. industrial, utility, financial, transportation

c. others e.g. foreign government, foreign corporation, World Bank

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Bond Principles: Classification of Bonds

Method 2: By security

a. unsecured debt - backed by faith in the taxingpower of the government, or the good name ofthe company (debenture)

b. secured debt e.g. revenue bond, assessmentbond, mortgage, collateral trust bond, equipment trust certificate

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Bond Principles: Classification of Bonds

Method 3: By term

a. short-term - a year e.g. US Treasury bills

b. intermediate-term e.g. US Treasury notes (2 to 10 years )

c. long-term e.g. US Treasury bonds ( 10 years)

d. open-ended e.g. corporate line of credit

e. serial bond - a portfolio of bonds with staggered terms

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Bond Principles: Terms of Repayment

interest only - the periodic payments are entirely interest

sinking fund - periodically, a portion of the debt principal is set aside or a certain number of the bonds is retired

balloon loan - most of the principal is due at the end of the loan period

income bond- interest is payable only if it is earned

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Bond Principles: Bond Cash Flows

annuities - most bonds are annuities plus an ultimate repayment of principal

zero coupon - only the par value is returned at maturity

variable (adjustable) rate - the rate fluctuates in accordance with some market index or predetermined schedule

consols - a level rate of interest is paid perpetually

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Bond Principles: Options

convertible bond - may be exchanged for common stock in the company that issued the bond

exchangeable bond - may be exchanged for shares in another firm

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Bond Principles: Registration

bearer (coupon) bonds - belong to whomever legally hold them; no longer issued in the United States because of tax considerations

registered bonds - the bonds show the bondholder’s name

book entry bonds - bond ownership is reflected only in the accounting records

The Financial Page Listing

Basic Information

Cur Net Bonds Yld Vol Close Chg.AMR 9s16 8.4 23 107 + ¾

Footnotescv - convertible zr - zero couponvj - bankruptcy dc - deep discountf - trading flat

GovernmentBonds

Maturity AskRate Mo/Yr Bid Asked Chg. Yld. 6 Feb 26 86:09 86:11 - 9 7.11

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Bond Pricing & Returns: Valuation Equations

1. AnnuitiesThe bond pricing relationship is customarily expressed in terms of semiannual periods.

present the from periods semiannual in time ratediscount

periods semiannual in bond the of term where

1

value par

1

interest

al)PV(princip t)PV(interes price bondcurrent

1

trn

rr n

n

tt

22

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Bond Pricing & Returns: Valuation Equations

2. Zero Coupon Bonds

nr 1

value par al)PV(princip price bondcurrent

3. Variable Rate Bonds

n

tttr

t

1 21

timeat flow cash price bondcurrent

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Bond Pricing & Returns: Valuation Equations

4. Consols

r

t

r

t

tt

timeat flow cash

timeat flow cash price bondcurrent

1 1

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Bond Pricing & Returns: Yield to Maturity

The yield to maturity is the single interest rate that, when applied to the stream of cash flows associated with a bond, causes the present value of those cash flows to equal the bond’s market price.

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value) 0.4(par price) 0.6(market

maturity until yearsvalue par - pricemarket

-interest annual YTMapprox

A heuristic:

Bond Pricing & Returns: Yield to Maturity

The yield to maturity calculation carries an assumption that coupon proceeds are reinvested at the yield to maturity.

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Bond Pricing & Returns: Yield to Maturity

If a bond pays periodic interest, it is not possible to lock in a prescribed yield to maturity.

A plot of interest rates against time tomaturity is known as a yield curve.

yield

time

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Bond Pricing & Returns: Spot Rates

A spot rate is the yield to maturity ofa zero coupon security of the chosen maturity.

A treasury strip is a government bond or notethat has been decomposed into two parts, one for the stream of interest payments and one for the return of principal at maturity.

The yield to maturity is a derived statistic afterthe bond price is known.

Bond Pricing & Returns

Realized Compound Yield:

yearper payments of number maturity to yield where

1 rate annual effective

xr

x

rx

1

How can two investments paying interest on two different time schedules be compared?

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Bond Pricing & Returns: Current Yield

The current yield only measures the return associated with the bond’s interest payments.

A bond whose market price is less than its par value is selling at a discount. The price of such bonds rise as maturity approaches.

If the market price is more than the parvalue, the bond sells at a premium.

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Bond Pricing & Returns: Accrued Interest

Interest is earned for each day that a bond is held, although interest payments are generally made twice a year only.

A bond buyer must pay the accrued interest to the seller of the bond.

dirty price = bond price + accrued interestclean price = bond price

By convention, accrued interest iscalculated using a 360-day year.

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Bond Risks: Price Risks

default risk - the possibility that the issuer of the bond is unable to pay - rated by agencies like Moody’s and Standard & Poor’s

interest rate risk - the chance of loss due to changing interest rates

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Bond Risks: Convenience Risks

call risk - the possibility that the company will exercise a bond’s call feature

reinvestment rate risk - the chance that the interest received cannot be reinvested to earn as much as the bond’s original yield to maturity - the higher the coupon on a bond, the higher its reinvestment rate risk

marketability risk - the difficulty of selling a bond in the secondary market

South-Western College Publishing ©1998 25

Review

Bond Principles Identification of Bonds

Classification of Bonds

Terms of Repayment

Bond Cash Flows

Convertible and Exchangeable Bonds

Registration

The Financial Page Listing Basic Information

Footnotes

Government Bonds

South-Western College Publishing ©1998 26

Review

Bond Pricing and Returns Valuation Equations

Yield to Maturity

Spot Rates

Realized Compound Yield

Current Yield

Accrued Interest

Bond Risks Price Risks

Convenience Risks