Evaluating Popular Investments Lesson 4 Bond Characteristics

Evaluating Popular

InvestmentsLesson 4

Bond Characteristics

Bonds Characteristics

Aim: What are the important characteristics

of a bond that you need to know to become an effective bond investor?

Do Now: Identify why people invest in bonds and

not stock.

Do Now answer: They want safety. They are willing to trade the chance to go big (ie: invest in a stock that soars) for the assurance that they will be paid interest and their money back when the bond’s term ends.


To assess a company’s risk of failing, bond investors turn to the following three credit ratings agencies:

Rating Process For Bonds

A “AAA” high grade bond offers more security but a lower yield than a “C” bond

A “C” bond is more riskybut has a higher yield

Ratings are based the issuers financial strength which indicates whether or not it will be able to make their principal and interest payments to the bond holder on time

CREDIT RATINGS*MOODY’S STANDARD & POOR’S FITCH

INVESTMENT GRADE

STRONGEST Aaa AAA AAA

Aa AA AA

A A A

Baa BBB BBB

NON-INVESTMENT GRADE

WEAKEST

Ba BB BB

B B B

Caa CCC CCC

Ca CC CC

C C C

C D D

*These credit ratings are reflective of obligations with long-term maturities.

Bond Characteristics

Debenture Bonds – An unsecured bond, meaning it is not backed by any collateral. Collateral can be a real asset (ex. Building) or a financial asset (ex. Loan or Bond). Most bonds are debentures.

Collateralized Bonds – Are backed by either a financial asset or a real asset. In the case of bankruptcy, the assets are sold and the proceeds are used to pay back the holder of the collateralized bonds. Collateralized bonds are safer than debenture bonds and, therefore, offer lower yield (ie: coupon).

Debenture vs. Collateralized


Refers to the currency in which the bond is issued and its coupon and principal payments are paid.

Large corporations that do business in many countries may find it preferable to issue bonds in one currency over another.

The most common currencies are: U.S. Dollar, Euros, and Japanese Yen

Currency Denomination

Redemption Characteristics

When a bond is issued with a call option, the issuer has the option to “call it in” (ie: retire the bond) before maturity date at a set price, known as the call price, that’s usually a little higher than face value.

So that a bond isn’t called soon after the bond is bought new, a certain number of years of call protection exist.

Scenario: In 2014, XYZ Corp issues a 25-year 9% bond that cannot be called until 2024. How many years of call protection does the bond have? Answer: 10 years, from 2014 to 2024

Callable Bonds


In what scenarios might a corporation be interested in calling its bonds? Answer 1: It no longer needs the money! Answer 2: Dropping interest rates motivate the

corporation to refinance its debt. What do you suppose refinance means?

Answer: Issuing news bonds at a lower rate than the originals and using the money tocall in (ie: retire) the original bonds.

Callable Bonds


Gives the bondholder the option to exchange the bond for a set number of shares of common stock in the issuing company

Bond

Bondholder

Common Stock

Convertible Bonds


ABC Corporation announces that it is offering a new 10-year $1,000 face value bond with a coupon of 5%.

To give investors a choice, it also offers a 10-year $1,000 face value bond that can be converted into 20 shares.

Given that a fair rate on ABC’s ordinary bond is 5%, should the coupon on the convertible bond be higher or lower than 5%? Why? Answer: Lower. The ability to convert has value, so

investors will be willing to earn less interest!

Convertible Bonds (example)


Let’s say that the price of an ABC share is currently $30. As we stated earlier, the bond may be converted into 20 shares.

To see if it worthwhile to convertible the $1,000 bond to stock, how do we compute what we’ll have by converting? Answer: $30 share price x 20 shares = $600.

With such a low figure, how can we say the ability to convert is valuable? Answer: We have 10 years for the stock to go up!

Convertible Bonds (continued)

Looking back… for the investor…Upside Downside

Owning stock

May make a lot of money! Not entitled to receive dividends; may lose everything if company fails

Owning bonds

Entitled to regular payments and money back at maturity; will receive some money back if company fails

What can be earned is limited


For the investors, which “downside” problem does a convertible bond solve? Answer: The ability to make a lot of money! You

now have the upside of a stock with the downside protection of a bond.

So, what’s the catch? Answer: You’ll earn less interest every year than

with an ordinary bond. There is no guarantee the stock will rise enough to make it worthwhile for you to convert!



Looking at it from the corporation’s standpoint, why is it tempting to issue convertible instead of ordinary bonds? Answer: The corporation has to pay less interest!

What are the pros and cons for the corporation when a conversion takes place? Pro: Interest is no longer due and there’s no maturity

date payment to worry about. Con: Existing shareholders will become upset

because they are being diluted.



Is it possible for a bond to have both features? Answer: Yes.

Remember the ABC Corporation with the $30 share price? It issued a 10-yr bond convertible to 20 shares.

Fast forward to the 6th year of the bond. The stock has risen to $80 per share! The company announces that in 30 days, it will call the bond. What will bondholders do? Answer: Convert their bond really fast!

Are There Callable Convertible Bonds?


The corporation knows this will be the response of its bondholders. Therefore, this is known as a … Answer: … forced conversion.

Here’s another question: Why haven’t bondholders converted already if it’s clear that 20 shares are now worth more than one bond? Answer: Its safer to keep the bond. They can

convert just before they’re ready to sell out of the investment!

Callable Convertible Bonds


A means of repaying funds that were borrowed by requiring the issuer to begin setting aside money in advance of the maturity date

• The issuer makes periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market

Sinking Fund Bonds

Coupon StructureThe coupon structure is the interest rate stated on a bond when the bond is offered. It is the percentage of the bond principal value that will be paid, usually semi-annually or annually, as the coupon payment to the owner of the bond.

Example: XYZ Corp issued a $1,000 6% bond that’s due in the year 2030. Each year the company must pay $1,000 * 6% = $60 in interest to the holder of the bond.

Coupon StructureFixed Rate Bond The majority of bonds are fixed rate, such as in

our example. The fixed rate was 6% per year. The coupon rate does not fluctuate, ever!

Floating Rate Bond Bonds that have a coupon rate that is adjusted

periodically, or “floats”, in conjunction with a short term rate, such as LIBOR (London Inter-Bank Offer Rate).

Payment of PrincipalThe bond’s principal can be repaid with a “balloon payment” or through amortization.

Balloon Payment Simply means that if a company issued, say, 10-

year bonds and borrowed a total of $100 million when the maturity date arrives a decade later, it owes back the $100 million at that time

Each year during the term of the bond, the issuer pays just interest to the bondholders.

The vast majority of bonds are of this type!

Payment of PrincipalAmortization The process by which the principal balance

gradually declines over time and is at zero by the time the maturity date arrives

Each year, the issuer pays interest plus additional money that pays off part of the principal borrowed

In the beginning, the majority of the fixed payment is interest. As the payments continue, a larger portion of the payment pays the principal and a smaller portion is needed to pay the interest.

Usually seen in car and home loans, not bonds.

Payment of PrincipalExample: $10,000 loan paid off in equal monthly payments of $860.66 over one year.

TermWhat is the normal range of bonds terms? The most common number of years representing the

longest term offered is 30 years. On the short side:

we will see in a later lesson that the U.S. Government offers several different bond terms that are all under one year!

Corporations issue bonds, called Commercial Paper, that have terms from 1 to 270 days. They can be used to raise cash to pay bills, buy inventory, allow their customers pay for a purchases over time, etc.

Lesson Summary 1 of 21. How do we get a sense of the risk of buying the

bonds of a particular company?

2. Why is a collateralized bond safer for the investor than a debenture?

3. How can a bond issuer give itself the ability to retrieve its bonds before the maturity date?

4. What can investors do to gain the safety of bonds but with potential upside of owning stock at the same time?

5. How can bond investors ensure that the issuer will have the money needed to redeem the bonds at maturity?

Lesson Summary 2 of 26. What are the two types of coupon structures,

and which is by far the most common?

7. What are the two types of repayment structures, and which is by far the most common?

8. What is the general term range available to investors?

9. What are the important characteristics of a bond that you need to know to become an effective bond investor?

Web Challenge #1Q: Why do companies issue mortgage bonds?

• A: The make potential bond investors feel much safer. In case the company goes under, there’s a specific asset that will be sold to ensure repayment!

• Also, because there’s less risk, the investor will be willing to accept a lower coupon rate.

• Challenge: Research three companies that have issued mortgage bonds in the last year. What assets were pledged? Look for any indication as to why they decided to issue them instead of ordinary debentures.

Web Challenge #2Challenge: We said earlier that the coupon rate is almost always fixed. Floating rate bonds are much rarer. Research three companies that have issued floating rate bonds in the last year.

Read the article for clues as to why it chose to go this unusual route. Why did it?

Extra: What is the biggest risk to a company of issuing a floating rate bond?

Web Challenge #3Challenge: Find a company that intends to issue a convertible bond. Record: The company’s current share price The conversion price that the author of the

article has already calculated How much higher the share price has to go

to make it worthwhile to convert the bond into shares of stock Do you think the stock can get there given

the term of the bond?

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Evaluating Popular Investments Lesson 4 Bond Characteristics