Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Eighth Edition
by

Frank K. Reilly & Keith C. Brown

Chapter 17

Chapter 17
Bond Fundamentals
Questions to be answered:
What are some of the basic features of bonds
that affect their risk, return, and value?
What is the current country structure of the
world bond market and how has the makeup of
the global bond market changed in recent years?

Chapter 17
Bond Fundamentals
What are the major components of the world
bond market and the international bond market?
What are bond ratings and what is their purpose?
What is the difference between investment-grade
bonds and high-yield (junk) bonds?

Chapter 17
Bond Fundamentals
What are the characteristics of bonds in the
major bond categories such as governments
(including TIPS), agencies, municipalities, and
corporates?
How does the makeup of the bond market in
major countries such as the United States, Japan,
the United Kingdom, and Germany differ?

Chapter 17
Bond Fundamentals
What are the important characteristics of
corporate bond issues developed in the
United States during the past decade such as
mortgage-backed securities, other assetbacked securities, zero-coupon and deep
discount bonds, high-yield bonds, and
structured notes?
How do you read the quotes available for
the alternative bond categories (e.g.,
governments, municipalities, corporates)?

Basic Features of a Bond

Pay a fixed amount of interest periodically
to the holder of record
Repay a fixed amount of principal at the
date of maturity

Basic Features of a Bond

Bond market is divided by maturity
Money Market - short-term issues that mature
within one year
Notes - intermediate-term issues that mature
between one and ten years
Bonds - long-term obligations with maturity
greater than ten years

Remaining life (maturity) affect price

volatility

Bond Characteristics
Intrinsic features

Coupon - yield (interest income)

Maturity - term or serial (municipalities)
Principal value - different from market value
Type of ownership - bearer or registered

Types of Issues
Secured (senior) bonds
Unsecured bonds (debentures)
Subordinated (junior) debentures

Bond Characteristics
Indenture provisions
Features affecting a bonds maturity

Callable (call premium)

Noncallable
Deferred call
Nonrefunding provision
Sinking fund

Rates of Return on Bonds

HPR i, t
where:

Pi, t 1 Int i, t
Pi, t

HPRi,t = the holding period for bond i during the period t

Pi,t+1 = the market price of bond i at the end of period t
Pi,t = the market price of bond i at the beginning of period t
Inti,t = the interest payments on bond i during period t

The holding period yield (HPY) is:

HPY = HPR - 1

The Global Bond-Market

Structure
Participating issuers
1. Federal governments
2. Agencies of the federal government
3. State and local political subdivisions
(municipalities)
4. Corporations
5. International issues
Foreign bonds
Eurobonds

Participating Investors
Individual investors
Institutional investors

Life Insurance Companies

Commercial Banks
Property and Liability Insurance Companies
Pension Funds
Mutual Funds

Bond Ratings
Major Rating Agencies
Standard & Poors
Moodys
Fitch Investor Services

Alternative Bond Issues

Domestic government bonds
United States - T-bills, notes, bonds. TIPS
Japan - medium term, long term, super long
term
Eurozone government bonds
United Kingdom - short gilts, medium gilts,
long gilts

Government Agency Issues

United States
Not direct issues, but backed by full faith and
credit of the U.S. government
GNMA pass-through certificates

Japan
Government associate organizations

United Kingdom
There are no agency bonds in the U.K.

Eurozone
Agency bonds are not broken down in the
Eurozone

Municipal Bonds
General obligation (GO) bonds
Revenue bonds
Interest payments are exempt from
federal income tax
Convert the tax-free yield of a
municipal bond selling close to par to
an equivalent taxable yield (ETY)

Equivalent Taxable Yield

i
ETY
(1 - T )
Where:
i = coupon rate of the municipal obligations
T = marginal tax rate of the investor

Municipal Bond Guarantees

Bond insured against default risk
Insurance is irrevocable for the life of the issue

Four private bond insurance carriers

Municipal Bond Investors Assurance (MBIA)
American Municipal Bond Assurance
Corporation (AMBAC)
Financial Security Assurance
Financial Guaranty Insurance Company (FGIC)

Municipal Bond Guarantees

Insured bonds obtain AAA (Aaa) ratings
Issues with private guarantees have more
active secondary market, and lower required
yield

Corporate Bonds

Mortgage bonds
Collateral trust bonds
Equipment trust certificates
Collateralized mortgage obligations
(CMOs)
Other asset-backed securities (ABS)
Variable rate notes

Corporate Bonds
Zero-coupon and deep-discount bonds
Minicoupon bonds
Original-issue discount (OID) bonds
Taxes due on the implied interest

High-yield bonds (speculative bonds and

junk bonds)
Noninvestment grade with rating below BBB or
Baa

Japanese Corporate Bond Market

Bonds issued by industrial firms or utilities
Minimum issuing requirements are specified by
the Ministry of Finance
Bonds issued by banks to finance loans to
corporation

Commercial banks
Long-term credit banks
Mutual loan and savings banks
Specialized financial institutions

U.K. Corporate Bond Market

Debentures
Unsecured loans
Convertible bonds

Eurozone Corporate Bond Market

Nonbank corporate bonds including
industrial and utility firms
Corporate-monetary Financial including
borrowing by banks

International Bonds
Foreign bonds are sold in one country and
currency by a borrower of a different
nationality
Yankee bonds are U.S. dollar denominated bonds
sold in the U.S. but issued by a foreign firm

Eurobonds are underwritten by international

bond syndicates and sold in several national
markets

International Bonds
United States
Yankee bonds register with SEC
Eurodollar bond market affected by changes in
value of U.S. dollar

International Bonds
Japan
Samuri bonds - yen denominated issued by
non-Japanese firms in Japan
Euroyen bonds - yen denominated, sold outside
Japan

International Bonds
United Kingdom
Bulldog bonds are sterling-denominated bonds
issued by non-English firms and sold in
London
Eurosterling bonds are sold in markets outside
London by international syndicates

International Bonds
Eurozone
Market popular among foreign issuers
including issuers domiciled in the U.S.
Impressive growth in Eurobonds issued by nonresidents

Obtaining Information on Bonds

Less emphasis on fundamental analysis
Most bond investors rely on rating agencies
for credit analysis
Market and economic conditions
Intrinsic bond features
Popular publications available:
Wall Street Journal, Barrons, Business Week,
Fortune, Forbes, Federal Reserve Bulletin,
Survey of Current Business

Bond Publications

Treasury Bulletin
Standard & Poors Bond Guide
Moodys Bond Record
Moodys Bond Survey
Fitch Rating Register
Fitch Corporate Credit Analysis
Fitch Municipal Credit Analysis
Investment Dealers Digest
Credit Markets
Duff & Phelps Credit Decisions
The Bond Player

Sources of Bond Quotes

Bank and Quotation Record
The Blue List of Current Municipal
Offerings
Wall Street Journal
Barrons

Interpreting Bond Quotes

Quoted on basis of yield or price
Price quotes are percentage of par
98 1/2 is not $98.50 but 98.5% of par
A municipal $5,000 bond quoted at 98 1/2
would be $4,925

Corporate Bond Quotes

Company

Last

(Ticker)

Price Yield Spread

Ford 7.45 July 16 2031

80.625

Last

9.461

EST

503

UST EST $
VOL
30

213,645

Corporate Bond Quotes

Company
(Ticker)
Ford 7.45 July 16 2031

Last

Last

EST

UST EST $

Price Yield Spread

80.625

Issued by Ford Motor Company

9.461

503

VOL
30

213,645

Corporate Bond Quotes

Company

Last

(Ticker)

Price Yield Spread

Ford 7.45 July 16 2031

80.625

The maturity date of this bond

Last

9.461

EST

503

UST EST $
VOL
30

213,645

Corporate Bond Quotes

Company

Last

(Ticker)

Price Yield Spread

Ford 7.45 July 16 2031

80.625

Last

9.461

EST

503

UST EST $
VOL
30

213,645

The last transaction price was 80.625 percent of par or $806.25,

which implies an yield to maturity (YTM) for this bond of
9.461 percent

Corporate Bond Quotes

Company

Last

(Ticker)

Price Yield Spread

Ford 7.45 July 16 2031

80.625

Last

9.461

EST

503

UST EST $
VOL
30

213,645

The computed yield spread for the Ford bond is 503 basis
points (5.03 basis points)

Corporate Bond Quotes

Company

Last

(Ticker)

Price Yield Spread

Ford 7.45 July 16 2031

80.625

Comparable U.S. treasury Issue

Last

9.461

EST

503

UST EST $
VOL
30

213,645

Corporate Bond Quotes

Company

Last

(Ticker)

Price Yield Spread

Ford 7.45 July 16 2031

80.625

Last

9.461

EST

503

UST EST $
VOL
30

The trading volume for this bond is over $213 million

213,645

Treasury and Agency Bond Quotes

Notations
n = treasury note
i = inflation-indexed issue
p = treasury note on which nonresident aliens
are exempt from withholding taxes on interest

Quotes resemble those used for OTC

securities because they contain both bid and
ask prices

Treasury and Agency Bond Quotes

GOVT. BONDS & NOTES

Maturity
Rate Mo/Yr

Asked

Chg.

Ask
Yld.

5.750 Nov 05n 101:05 101:06

3.13

Bid

Treasury and Agency Bond Quotes

GOVT. BONDS & NOTES

Maturity
Rate Mo/Yr

Bid

Asked

Chg.

Ask
Yld.

5.750 Nov 05n 101:05 101:06

.
3.13
This is a 5.75 percent obligation bond due in
November 2005. The bid quote is 101:05, and
the ask is 101:06

Treasury and Agency Bond Quotes

U.S. Treasury Strips
ci is the coupon interest portion stripped from
the note
np is the principal payment for the treasury note

Treasury Bills
Pure discount instrument - there is no coupon,
they pay par at maturity
The bid-ask is not the price but the yield

Municipal Bond Quotes

200 INDIANA ST OFFICE BLDG COMMN

MBIA 0.000 07/01/10 5.60 BEARSTER

Quote from The Blue List of Current Municipal Offerings

$200,000 of Indiana State Office Building bonds
Guaranteed by MBIA
These are zero coupon bonds due July 1, 2010
The yield to maturity is given as 5.6%
To determine the price you compute the discount value
The dealer offering the bonds is Bear Sterns, listed in
the back of the publication with their phone number

Municipal Bond Quotes

Notations
ETM = escrow till maturity
M/S/F = mandatory sinking fund
(C97) = this bond became callable in 1997
When the market yield equals the coupon rate, the
price is 100 and they are referred to as dollar bonds
+ in the left column indicates a new item
# before yield to maturity or price indicates a
change

The Internet
Investments Online

http://www.bondheads.com
http://www.investinginbonds.com
http://www.fitch.com
http://www.moodys.com
http://www.standardandpoors.com/ratings
http://www.bradynet.com
http://www.publicdebt.treas.gov

End of Chapter 17
Bond Fundamentals

Future topics
Chapter 18
The Analysis and Valuation of Bonds