Analysis of Investments and Management of Portfolios by Keith C. Brown Frank K. Reilly

1. Analysis of Investments and  Management of Portfolios  by Keith C. Brown & Frank K. Reilly Basic Features of a Bond Global Bond Market Structure Alternative Bond Issues Obtaining Information on Bond Prices

2. 17-2 Basic Features of a Bond Bonds as fixed income securities Pay a fixed amount of interest periodically to the holder of record Repay a fixed amount of principal at the date of maturity 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

3. 17-3 Bond Characteristics Intrinsic Features Coupon: Determine the periodic interest income Term to maturity: Term bond or a serial bond Principal value: Different from market value and the common principal or par value is $1,000 Type of ownership: Bearer vs. registered bonds Types of Issues Secured (senior) bonds Unsecured bonds (debentures) Subordinated (junior) debentures

4. 17-4 Bond Characteristics Indenture provisions The indenture is the contract between the issuer and the bondholder specifying the issuer�s legal requirements Features affecting a bond�s maturity Callable (call premium) Noncallable Deferred call Nonrefunding provision Sinking fund

5. 17-5 Rates of Return on Bonds The Computations of Bond Return Holding period return where: HPRi,t = the holding period return for bond i during 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

6. 17-6 The Global Bond Market Structure The market for fixed-income securities is substantially larger than the listed equity exchanges (NYSE, TSE, LSE) because corporations tend to issue bonds rather than common stock For United States during 2007, less than 10 percent of all new security issues were equity, including preferred as well as common stock Exhibit 17.1 shows the size of the global bond market and the distribution among countries

7. 17-7 Exhibit 17.1

8. 17-8 The Global Bond Market Structure Participating Issuers Sovereign bonds (e.g., the U.S. Treasury) Quasi and foreign governments (including agency bonds) Securitized and collateralized bonds from governments or corporations Directly issued corporate bonds High-yield and/or emerging market bonds

9. Makeup of Bonds o/s by currency (31st Dec.2004) 17-9

10. Makeup of Bonds o/s by currency (31st Dec.2004) 17-10

11. 17-11 The Global Bond Market Structure Participating Investors Individual investors Institutional investors Life Insurance Companies Commercial Banks Property and Liability Insurance Companies Pension Funds Mutual Funds Two factors influencing institutions The tax code applicable to the institution The nature of the institution�s liability structure

12. 17-12 The Global Bond Market Structure Bond Ratings Most corporate and municipal bonds are rated by one or more of the rating agencies The exceptions are very small issues and bonds from certain industries, such as bank issues. These are known as non-rated bonds The three major rating agencies (Exhibit 17.3) Moody�s Standard and Poor�s Fitch Investors Service

13. 17-13 Alternative Bond Issues Domestic Government Bonds United States (support by U.S. Treasury) T-bills, notes, bonds TIPS (Treasury Inflation-Protected Securities) Japan: 2nd largest govt. bond market in the world, supported by Govt. of Japan & Bank of Japan (Japanese Central Bank) Medium term (2,3 or 4 years, issued monthly through auction, similar to US treasury bonds) Long term, (10 years, authorized by MOF, issued by the BOJ) Super long term (15 � 20 years, through private placement to a few financial institutions)

14. 17-14 Alternative Bond Issues Domestic Government Bonds United Kingdom: Gilts are issued through the Bank of England (the British central bank), using the tender methods. Price can�t be less than the minimum tender price stated in the prospectus. Short gilts (less than 5 years), Medium gilts (5 to 15 years), Long gilts (15 years and longer) Eurozone: includes several relatively significant market (Germany, France, Italy), issue process differs from country to country but denominated in Euros Government bonds

15. 17-15 Alternative Bond Issues Government Agency Issues United States: Govt. agencies or a Govt. sponsored enterprise (GSE). Six govt. sponsored enterprises & over 2 dozen federal agencies issue these bonds. Not direct issues, but backed by �full faith and credit� of the U.S. government GNMA(Govt. National Mortgage Association) pass-through certificates (Ginni Mae) Federal Home Loan Mortgage Federal Home Loan Bank Japan: referred as Govt. Associate Organizations Account for about 7 percent of the total Japanese yen bond market This agency market includes public agency debt that is issued like Govt. debt.

16. 17-16 Alternative Bond Issues Government Agency Issues United Kingdom about 13 percent of the pound sterling market is agency and foreign government debt Eurozone Agency bonds and foreign government bonds are less than 8 percent of the Euro bonds outstanding

17. 17-17 Alternative Bond Issues Municipal Bonds: ssued by states, cities & other political subdivisions 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) where: i = coupon rate of the municipal obligations T = marginal tax rate of the investor

18. 17-18 Alternative Bond Issues Municipal Bond Insurance Bond insured against default risk Insurance is irrevocable for the life of the issue Six private bond insurance carriers Municipal Bond Investors Assurance (MBIA) American Municipal Bond Assurance Corporation (AMBAC) Financial Security Assurance (FSA) Financial Guaranty Insurance Company (FGIC) Capital Guarantee Insurance Company (CGIC) Conni Lee Insurance Company Insured bonds obtain AAA (Aaa) ratings Issues with private guarantees have more active secondary market, and lower required yield

19. 17-19 Corporate Bonds U.S. Corporate Bond Market Mortgage bonds: a first mortgage lien on some piece of property or possibly all the property Collateral trust bonds: borrower can pledge financial assets, such as stocks, bonds or notes as collateral Equipment trust certificates: issued by railroads, airlines & other transportation firms with the proceeds used to purchase equipment (freight cars, railroad engines & airplanes), which serve as a collateral for the debt Mortgage pass-through securities: Pass-through monthly payments are necessarily both interest and principal and the bond holder is subject to early retirement if the mortgages prepay because the house is sold or the mortgage refinanced. Therefore the holder of this bonds would be uncertain about the size and timing of the payments

20. 17-20 Corporate Bonds U.S. Corporate Bond Market Collateralized mortgage obligations (CMOs): CMO investors own bonds that are serviced with the cash flows from mortgages; but, rather than the straight pass through arrangement, the CMO substitutes a sequential distribution process that creates a series of bonds with varying maturities to appeal to a wider range of investors. several classes of bonds are floated (referred as tranches) against a pool of mortgages, which are the collateral. For example, assume a CMO issue with four classes of bonds. In such case the first three classes (e.g. classes A,B,C) would pay interest at the stated rates beginning at their issue date and the fourth class would be an accrual bond (Z bond) Asset-backed securities (ABS): commercial mortgages, car loans, credit card debt, student loans etc.

21. 17-21 Corporate Bonds U.S. Corporate Bond Market Certificates for automobile receivables (CARs): securities collateralized by loans made to individuals to finance the purchase of cars. Credit card receivables Variable rate notes Collateralized debt obligations (CDOs): part of asset backed securities market Zero coupon and deep discount bonds: also known as original issuue discount (OID) bonds

22. 17-22 Corporate Bonds High-Yield Bonds Also known as speculative bonds and junk bonds Based on a specification that bonds rated below BBB make up the high-yield market, that is, non-investment grade bonds The high-yield bond market exploded in size and activity beginning in the early 1980s (Exhibit 17.6) Exhibit 17.7 contains the distribution of ratings for all the bonds contained in the Lehman Brothers High-Yield Bond Index Major owners of high-yield bonds have been mutual funds, insurance companies, and pension funds

23. 17-23 Corporate Bonds 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

24. 17-24 Corporate Bonds U.K. Corporate Bond Market Three Forms Debentures Unsecured loans Convertible bonds The maturity structure of the corporate bond market is fairly wide The coupon structure of corporate bonds is also broad with high-coupon bonds in the 10 to 14 percent range Almost all U.K. corporate bonds are callable term bonds

25. 17-25 Corporate Bonds Eurozone Corporate Bond Market Pure corporate bonds that include industrial and utility firms (about 15 percent) Securitized/collaterlized bonds that include indirect corporate borrowing (about 12 percent)

26. 17-26 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

27. 17-27 International Bonds United States Yankee bonds register with SEC Eurodollar bond market affected by changes in value of U.S. dollar Japan Samuri bonds: Yen denominated issued by non-Japanese firms in Japan Euroyen bonds: Yen denominated, sold outside Japan

28. 17-28 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 Eurozone Market popular among foreign issuers including issuers domiciled in the U.S. Impressive growth in Eurobonds issued by non-residents

29. 17-29 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 Barron�s, Business Week Fortune & Forbes Federal Reserve Bulletin Survey of Current Business

30. 17-30 Obtaining Information on Bonds Bond Publications Treasury Bulletin Standard & Poor�s Bond Guide Moody�s Bond Record Moody�s 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

31. 17-31 Obtaining Information on Bonds Interpreting Bond Quotes Treasury Bulletin Standard & Poor�s Bond Guide Moody�s Bond Record Moody�s 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

32. 17-32 Interpreting Bond Quotes Corporate Bond Quotes Last Last EST EST $ VOL Company (Ticker) Coupon Maturity Price Yield Spread UST (000�s) Ford (F) 7.45 July 16, 2031 80.625 9.461 503 30 213,645 Explanations Issued by Ford Motor Company with a coupon of 7.45% Maturity is July 16, 2031 The last transaction price was 80.625 percent of par or $806.25, implying an yield to maturity (YTM) of 9.461% The computed yield spread for the Ford bond is 503 basis points (5.03%), in comparison with the prevailing yield for a U.S. treasury issue with a maturity of 30 years

33. 17-33 Interpreting Bond Quotes 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

34. 17-34 Interpreting Bond Quotes The Quotation Fri. Ask Rate Mo/Yr Bid Asked Chg. Yld. 3 Feb 09n 100:24 100:25 +8 2.22 Explanations This is a 3 percent Treasury note due in Feb 2009 The bid quote is 100:14, implying a bid price equal to 100.4375% of par. The same applies to ask quote If one buys at the asked price, the yield to maturity would be 2.22%

35. 17-35 Interpreting Bond Quotes U.S. Treasury Strips �ci� = the coupon interest portion stripped from the note �np� = the principal payment for the treasury note Treasury Bills Pure discount instrument: There is no coupon and they pay par at maturity The bid-ask quotes are not the prices but rather discount rates from the par

36. 17-36 Interpreting Bond Quotes Municipal Bond Quotes No. of Bonds Special Price/ Offered Municipal Issuer Characteristics Coupon Maturity YTM Broker 200 INDIANA ST OFFICE MBIA 0.000 07/01/10 5.60 BEARSTER BLDG COMMN Explanations $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% The dealer offering the bonds is Bear Sterns To determine the price you compute the discount value

37. 17-37 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