Introduction to Debt Markets

1. Introduction to Debt Markets Bonds vs. Stocks In the Rearview Mirror Debt Classes Sources of Risks

2. Bonds vs. Stocks • Sizing Bond (2009) and Stock Markets (Q3 2008) $34.3 T $14.1 T

3. Rearview Mirror

4. Rearview Mirror

5. Source of Risks • Interest Rate Risk (Market Risk) • The major factor affecting bond prices • The price of bond changes in the opposite direction of interest change • All bonds are exposed • Inflation Risk • Inflation reduces purchasing power • Yield changes to reflect the expected inflation • Reinvestment Risk • No guarantees that coupon payments could be reinvested at the same rate

6. Source of Risks • Credit Risk • Inability of issuer to pay coupon and/or principal • Corporate, Emerging market and high-yield bonds • Credit linked debt securities, credit derivatives • Liquidity Risk • Inability to unload position without substantial loss • Municipal, Corporate, and Emerging market bond • FX Risk • The risk of exchange rate fluctuation in reducing the return on a foreign bond

7. Why Bonds? • Bonds form an important asset class • Sources of risk and return in bonds • Interest rate risk • Reinvestment risk • Default risk • When liabilities are fixed in nominal terms, investing in suitably chosen bond portfolios may lead to lower risk • May not be necessary to consider all asset classes and use mean variance optimization methods • Bond mispricing may arbitrage opportunities for an active portfolio manager

8. Issuers of Bonds • U.S. Treasury • Notes and Bonds • Municipalities • Tax-Exempt Bonds • Corporations • Corporate Bonds, Preferred Stock • International Governments and Corporations • Innovative Bonds • Indexed Bonds • Floaters and Reverse Floaters

9. General Bond Characteristics • Price • Face or par value • Coupon rate • Compounding and payment frequency • Indenture, i.e. attached options, covenants, etc.

10. Debt Classes: Definition • Bond (Fixed Income Security) • A security obligating issuer to pay interest and principal to the holder on specified dates. • Coupon Interest rate, e.g. 4%, 5 3/4%, etc. • Face/par value or Principal amount, e.g. $100 MM, $3B. • Maturity, e.g. 3 month, 1 year, 30 years, etc. • Bond can be classified according to its attributes • Payment type, e.g. semi-annual coupon, amortizing, etc. • Issuer, e.g. government, agency, corporate, etc. • Maturity, e.g. short, medium, long, etc. • Security, e.g. secured, unsecured debenture, etc.

11. Debt Classes: Payment Type • Pure Discount or Zero-Coupon Bond • No coupon payments prior to maturity. • Bond’s face value paid at maturity. • Coupon Bond • A stated coupon paid periodically prior to maturity. • Bond’s face value paid at maturity. • Perpetual (Consol) Bond • A stated coupon paid at periodic intervals. • Self-Amortizing Bond • Certain amount paid at each payment period. • No balloon payment at maturity.

12. Debt Classes: U.S.Treasuries • Treasury Bills • maturity  1 year when issued • typically 3 months and 6 months • pure discount bond, no coupon • Treasury Notes • Maturity: 1 year  maturity  10 years when issued • Typically, 2, 3, 5, and 10 year • Coupon: semi-annual • Treasury Bonds • Maturity: >10 years when issued • Typically, 20, 30 (last issued Feb 15, 2001) • Coupon: semi-annual

13. Debt Classes: U.S.Treasuries • Treasury STRIPS are zero-coupon securities that are made by “stripping” coupons or principals from Government Notes and Bonds. • Treasury Strips are issued under the U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) program. • Prices of Notes, Bonds, and STRIPS are quoted as prices per $100 of face value. Prices of Bills are quoted in terms of rate of discount.

14. Example from July 1, 2004 WSJ • U.S. Treasury Notes and Bonds are typically issued with face value of $10,000, and pay semi-annual coupons • The following bond quoted in the July 1, 2004 WSJ: • Matures in February 2026 (2/15/2026) • Coupon rate is 6%. Semi-annual coupon payments are made on 2/15 and 8/15 of each year in the amount of (0.06 x $10,000)/2 = $300 • At maturity (2/15/2026) the payment is the coupon of $300 plus the principal of $10,000 • Quoted decimal price per $100 par is $108 8/32 = $108.25 • Quoted bond price is $10,825.00

15. Debt Classes: Corporate Bonds • Secured Debt (backed by collateral assets) • Secured by real property • Property reverts to bondholder upon default • Subordinate Debenture • General creditors subordinate to secured debt • Higher priority over stockholders • Other Features of corporate bonds • Convertible bonds: convertible to equity • Callable bonds: issuer’s right to buys back bond • Putable bonds: holder’s right to sell bond to issuer • Sinking funds: reduced face amount over time

16. Corporate Bonds – Default Risk • One of the biggest differences between Corporate Bonds and U.S. Treasury Bonds is the default risk on corporate bonds • Corporate bonds are rated on the basis of their default risk by a few rating companies

17. Corporate Bonds – Default Ratings Rating Companies • Moody’s Investor Service • Standard & Poor’s • Fitch Rating Categories • Investment grade • Aaa, Aa, A, Baa by Moody’s ratings • AAA, AA, A, BBB by S&P ratings • Speculative grade or “Junk” bonds • Rated below Baa by Moody’s and BBB by S&P

18. Factors Used by Rating Companies • Coverage ratios • Leverage ratios • Liquidity ratios • Profitability ratios • Cash flow to debt • Effects of bond covenants • Moody’s acquired KMV to use option pricing theory to rate corporate bonds

19. Debt Classes: Corporate Bonds • Credit Rating

20. Average One-Year Credit Loss Rates Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006

21. Ratings and Average Time to Default Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006

22. Mean and Median Recovery Rates Source: “Credit Derivatives” by E. Banks, P. Siegel, M. Glantz; McGraw-Hill, 2006

23. Protection Against Default • Sinking funds • Subordination of future debt • Dividend restrictions • Collateral

24. Promised Return vs. Expected Return Takeaways • Bonds of firms in distress do have high promised yield • Example • TEMBEC INDS INC 8.625% bond maturing in 6/30/2009 • The current yield is 16.121% • YTM is 51.029% • The open question: • What return you expect to get?

25. Comparing Bonds – On the Importance of Fine Print • Yield is useful for comparing similar bonds to see if which bond may be cheaper • Detailed analysis focuses on bonds identified this way: • “Similar” • Cash flows • Duration • Credit risk • Call, Put, Conversion and other provisions

26. “Similar” Bonds Example Two U.S. Treasury bonds of same maturity from July 1, 2004 WSJ: The first bond has a coupon rate of 4.75%, and yields 4.56% The second bond has a coupon rate of 13.25%, and yields only 3.71% (!!!) The difference is that the second bond is CALLABLE!!! It was issued as a 30yr bond in May of 1984, and is callable at par value in 25 years, i.e. in May of 2009 Now it is almost 100% certain that it will be called, hence it now trades as bond maturing in 2009:

27. Bond Provisions • Bond provisions may alter the structure of cash flows, affecting bond prices and yields • Call Provision allows the issuer to repurchase the bond at a specified call price before the maturity date Relationship between Interest Rate and Callable Bond Price

28. Yield to Call • Bonds are most likely to be called when their price exceeds the call price • It implies that premium bonds will be called at the earliest date when the bond becomes callable • Hence yield quoted in WSJ for callable premium bonds is in fact yield to call (recall previous example)!!! • Example of cash flows difference for a callable bond: A 30yr bond with 8% coupon sells for $115, and is callable in 10 years at par

29. Bond Provisions Continued • Put Provision allows a bondholder to reclaim a principal, or to extend bond’s life • Convertible Provision allows a bondholder to exchange a bond for common stock • Typically are callable as well • Secured Bonds have specific collaterals for bonds • Sinking Funds guarantee gradual repurchase of corporate bonds by the issuer • Floating Rate Bonds have interest payments tied to some measure of current market rates

30. Debt Classes: Municipal Bonds • Municipal Bonds • Maturity varies from one month to 40 years • Exempt from federal taxes and state taxes (for residents of issuing state) • Generally two types: • Revenue bonds • backed by the revenue of a particular project • e.g. water bond • General Obligation bonds • backed by the tax revenue of local government • e.g. school bond • Riskier than U.S. Government bonds

31. Debt Classes: Non-US Issues • Investment Grade Bond outside US • Bonds issued by foreign companies and nations • Greater than $7 trillion by 2001 • e.g., U.K. Gilts, Japan’s JGBs, Germany’s Bunds, French’s OATs, etc. • Emerging Market Bond • Bonds issued by governments and companies of emerging economies • $1.2 trillion by 1995 • Denomination in local currency or US$ • Some issues have principal and a few coupon backed by US government (Brady bond)

32. Source of Risks

33. Bond Resources • www.bondmarkets.com • www.investinginbonds.com • bonds.yahoo.com • PIMCO • Lehman Brothers Bond Indices • Bloomberg Bond Rates • Live Market Analysis on Bonds and Related Topics

34. Wrap-up • Debt Classes • Issuer, security, and payment type • Source of Risks • Interest, inflation, reinvestment, credit, liquidity, currency