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Bonds: Fixed Income Securities. Economics 71a: Spring 2007 Mayo chapter 12 Lecture notes 4.3. Goals. History Features and structure Bond ratings. Bond Returns. Interest and capital gains Stock comparison: dividends and cap gains Most income in the form of interest. Two Parts.

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bonds fixed income securities

Bonds:Fixed Income Securities

Economics 71a: Spring 2007

Mayo chapter 12

Lecture notes 4.3

goals
Goals
  • History
  • Features and structure
  • Bond ratings
bond returns
Bond Returns
  • Interest and capital gains
    • Stock comparison: dividends and cap gains
  • Most income in the form of interest
two parts
Two Parts

= (capital gain) + (Interest)

bonds in the 1990 s
Bonds in the 1990’s
  • 1990-1999
    • Bonds, 8.7% (nominal, no inflation adjustment)
    • $10,000 -> $23,000
    • Stocks 18.2% (nominal)
    • $10,000 -> $53,000
  • 1990-2003(June)
    • Bonds, 9.7% (nominal)
    • $10,000 -> $35,000
    • Stocks, 10.2% (nominal)
    • $10,000 -> $37,000
bond return summary
Bond Return Summary
  • Generally, lower returns than stocks
  • But also, less risk than stocks
bond risks
Bond Risks
  • Interest rate risk
  • Purchasing power risk (inflation)
  • Default or business risk
  • Liquidity risk
  • Call risk
goals9
Goals
  • History
  • Features and structure
  • Bond ratings
bond features
Bond Features
  • Agreement to borrow money
  • Amount of loan
    • Principal, “par value”
    • Paid back at set date in the future “maturity”
  • Interest payments
    • Coupon interest rate
    • Percentage of principal
    • Made on regular schedule
example
Example
  • Bond structure
    • Principal = $1000
    • Maturity = 10 years
    • Coupon = 5%, semiannual
  • Cashflows
    • Pays $25 in interest every 6 months
      • (Interest payment is fixed.)
    • 10 years from now pays back $1000 + $25
bond legal structure
Bond Legal Structure
  • Indenture
    • Specifies rights of bond holders
  • Restrictions often include
    • Requirements on accounting practices
    • Firm should pay taxes
    • Constrain future borrowing
    • Limit dividend payments on stock
current bond price
Current Bond Price
  • Discount
    • Price < Par
  • Premium
    • Price > Par
  • Depends on interest rates
  • Bond yield = coupon/price
call provisions
Call Provisions
  • Issuer (firm) can buy back the bonds (call) at a specified price (call premium)
  • Call provisions specify the price, and time period in which this can happen
  • Most corporate bonds are callable
  • Similar to refinancing for individuals
  • Important risk component for investors
sinking funds
Sinking Funds
  • Schedule to pay back principal over time
  • Different from call
    • Option versus requirement
secured debt
Secured Debt
  • Backed by some kind of property
    • Mortgages: real estate
    • Plant and equipment
    • Financial assets
    • Income streams (Mass. turnpike)
  • Unsecured debt (junior bonds, debentures)
    • No asset backing
    • Ok for large reliable firms
difference between debt bonds and equity stock
Difference Between Debt (Bonds) and Equity (Stock)
  • Voting rights
    • D: none, E: yes
  • Claims on firm assets
    • D: senior to equity, E: subordinate to debt
  • Maturity
    • D: fixed, E: none
  • Taxes
  • Trading/liquidity
borrower costs
Borrower Costs
  • What affects the interest rate borrowers pay?
    • Maturity (length of bond)
    • Size (total loan)
    • Default risk
    • Market interest rates
market segments trillions of u s
Market SegmentsTrillions of U.S. $
  • U.S. treasury bonds: 2.2
  • Agency securities: 2.1
    • Federal home loan, Student loan marketing association
  • Municipal bonds: 1.5
  • Corporate bonds: 5.2
  • Mortgage backed securities: 2.9
  • Foreign issues (eurodollar): 3.3
special bond types
Special Bond Types
  • Treasury bonds
  • Municipal bonds
  • Zero coupon bonds
  • Floating rate bonds (floaters)
  • Inflation adjusted bonds
  • Junk bonds
  • Mortgage backed securities
  • Asset-backed securities
  • Convertible bonds
  • Foreign bonds
u s treasury bonds
U.S. Treasury Bonds
  • Borrowing of the U.S. federal government
  • Very low risk/High liquidity
  • $1,000 denominations
  • Maturities
    • 2, 3, 5, 10 years (notes)
    • 20, 30 years (bonds)
  • Interest income exempt from state and local taxes, but not federal taxes
municipal bonds
Municipal Bonds
  • Local state, county, city bonds
  • Interest
    • Exempt from federal taxes
    • Usually free from state tax if you reside in the state the bond was issued by
  • Capital gains
    • Not exempt
zero coupon bonds
Zero Coupon Bonds
  • Zero coupon (interest) payments
  • Principal only
  • Trade at discount
    • Example: $1040 in 1 year
    • Price today = $1000
    • Yield (return) = 4%
  • Constructed zero coupon bonds: Strips
floating rate bonds floaters
Floating Rate Bonds(Floaters)
  • Coupon payments tied to current interest rates
  • Coupon might be principal*(T-bill rate)
    • 1000*(2.5%)
  • Similarities to adjustable rate mortgages
inflation adjusted bonds
Inflation Adjusted Bonds
  • Treasury inflation-indexed obligation TIPS
  • Par value adjusted up with inflation
    • $1000 bond, 3% inflation
    • In one year goes to $1030
  • Coupons are a percentage of par and rise too
junk bonds
Junk Bonds
  • High yield
  • High risk (default likely)
  • Unsecured
  • Famous in the 1980’s
    • Leveraged buyouts
  • Are they a good investment?
mortgage backed securities mortgage bonds
Mortgage Backed Securities(Mortgage Bonds)
  • Pool of mortgages
  • Pay off principal over time
  • Some pools high risk
    • Subprime
  • Tricky refinancing questions
asset backed securities
Asset-backed Securities
  • Bonds backed by revenue streams
    • Car loans/credit cards (large pool)
    • Mass turnpike bonds (tolls)
  • David Bowie bonds
    • Backed by revenue stream for albums
    • IP Securitization
convertible bonds
Convertible Bonds
  • Bonds that can be converted into a fixed number of shares of common stock
  • Value moves with stock price (and interest rates)
  • Difficult valuation
foreign bonds
Foreign Bonds
  • Yankee bonds
    • Dollar bonds issued in U.S. by foreign or international corporations
  • Euro bonds
    • Dollar bonds issued outside the U.S.
goals32
Goals
  • History
  • Features and structure
  • Bond ratings
bond ratings
Bond Ratings
  • Agencies rate the riskiness of a bond
    • Essentially the chance that it will default
  • See page 257
  • Bond ratings (Standard and Poor’s)
    • AAA, high-grade
    • A, medium-grade
    • >=BBB, Investment grade
    • <BBB, speculative grade or “junk” bonds
    • C, No interest paid
    • D, In default
rating agencies
Rating Agencies
  • S&P
    • Rates $30 trillion in debt
  • Moody’s
  • Fitch
problems for raters
Problems for Raters
  • Missed Enron, WorldCom, Parmalat
  • Lack of competition
  • Should there be more official oversight
  • Firms starting consulting businesses
    • Help firms that they are rating
    • Serious conflict of interest
ratings taken seriously
Ratings Taken Seriously
  • Many investment funds having ratings requirements
    • “No junk bonds”
    • Ratings triggers : loans called back if ratings fall
goals38
Goals
  • History
  • Features and structure
  • Bond ratings