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  1. THE BOND MARKET A Deeper Understanding of a Major Economic Market Based on presentations by Emma Ricci and Meghan Barnes

  2. WHAT IS A BOND? • A bond is a loan, a `debt security`. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer.

  3. Components • The issuer, similar to a holder of an option • Principal amount, usually $1000 • Specified interest rate; paid to the issuer yearly (also known as the coupon) • Date of maturity

  4. Example • In 2004, Radnor township issued bonds for a total of $50 million, in order to pay for the new Middle School building • The maturity was 20 years • The coupon was 5.5 % • The bond was callable (the township could pay off the bond early)

  5. Corporations Finance Operations Federal Government Treasury Securities Bills, Notes, & Bonds Federal Agencies Government Sponsored Enterprises Municipal Governments and Agencies Munis are “Tax Exempt” General Obligation Revenue Foreign Governments and Corporations Yankee Bonds Issuers of Bonds

  6. Floating Rate Bonds Interest Payments Change Over the Life of the Bond Rate is Tied to a Financial Benchmark such as the LIBOR Convertible Bonds Can be Exchanged for Other Securities Special Types of Bonds

  7. High-Yield / Junk Bonds Speculative Grade Bonds Rated below Baa by Moody’s or BBB by S&P Greater Risk = Higher Yield Asset-Backed Bonds Securitized by Some Financial Asset Zero Coupon Bonds Do Not Pay Coupons Sold at a Large Discount Types of Bonds, Continued

  8. Premium vs. Discount • Premium bonds: price > par value YTM < coupon rate • Discount bonds: price < par value YTM > coupon rate • Par bonds: price = par value YTM = coupon rate

  9. Trading Bonds / Bond Prices • Usually Issued in Par Values of $1,000 • Price is Usually Closest to Par at the Time it is First Issued • Dealers Post Bid and Ask Prices • Prices Listed Daily in the Wall Street Journal Down to 1/8 of a Dollar • Price is Equal to the Present Value of the Expected Future Cash Flows • P= C/(1+r)1 + C/(1+r)2+ C/(1+r)3 +…+ C/(1+r)n + M/(1+r)n

  10. Yield Curve • Shows the Relationship Between Short-Term and Long-Term Yields on Securities • Slope can be Upward, Downward, or Horizontal • Right Now, They are All Upward Sloping • Longer Time to Maturity = Higher Yield

  11. Current Yield Curves 1.) Treasury Yield Curve 2.) Agency AAA Yield Curve 3.) Corporate AAA Yield Curve 4.) Municipal AAA Yield Curve

  12. Price vs. Yield • Prices Continually Fluctuate With Changes in Interest Rates • Interest Rates h, Prices i • Interest Rates i, Prices h • Rates of Older Issues Change to Match Those of New Issues • Longer Maturity Means More Likely Price Will Be Affected By Changes in Interest Rates

  13. Tax Status • Some Offer Special Tax Advantages • No State or Local Income Tax on U.S. Treasury Bonds or Munis • Wanting Taxable or Tax-Exempt Income Depends on: • Your Income Tax Bracket • The Difference Between What Can Be Earned From Taxable Versus Tax Exempt Securities

  14. Nationally Recognized Statistical Rating Organizations Henry Varnum Poor Compiled Financial Data About Canals & Railroads Updated the Directory of Railroads, Canals and Steamship Lines in the United States Poor’s Publishing Successor of Henry, Collaborated with John Moody Later Went Their Separate Ways Bond Ratings – Measuring Default Risk

  15. Ratings, Continued • Moody’s Began Producing “Moody’s Investor’s Manual” • Poor’s Publishing Published its Own Bond Ratings • Then Merged with the Standard Statistical Bureau to Form Standard and Poor’s • Other Rating Agencies Today • Fitch Investor Service • Duff and Phelps

  16. The Rating Process Standard and Poor’s Process as example: • Rating Request • Issuer Meeting • Rating Committee Meeting • Notification and Appeal • Dissemination • Surveillance

  17. Higher Rating Means Less Risk that the Issuer Will Default on Payments Lower Rating Means Higher Risk Purchaser is Compensated with a Higher Yield for Taking on this Additional Risk Definition of the Ratings/Default Risk

  18. Factors Effecting Default Risk • Earnings Variability • More Volatile Earnings Could Mean a Greater Possibility of Losses Exceeding Ability to Raise Funds • Age of the Firm • If a Firm has a Well Established History of No Defaults, Investors Have More Confidence in its Continued Success • Current Leverage • Using Greater Financial Leverage Could Mean Greater P/E Ratio • But Could Also Mean that by Using More Borrowed Funds Rises Relative to Equity, and Risk of Declines in Net Earnings Increases

  19. Risk vs. Yield • Risk and Yield are Directly Related • The Risk Involved in an Investment Includes the Risk Free Rate Plus the Default Risk Premium

  20. Callable Bonds • Call Privileges • Gives the Issuer the Right to Retire a Bond Prior to Maturity • Call Risk • Known as Reinvestment Risk • Bonds Will Be Called When Interest Rates are Falling • Investors May Earn Less Than Their Expected Yield • If an Investor is Long a Callable Bond, then Callable Bond Price = Noncallable Bond Price – Call Option Price

  21. Callable Bonds, Continued • Call Premium • Purchaser is Compensated for Higher Risk • If Rates are High and Going to Fall, there Will Be a Higher Call Premium • If Rates are Low and Going to Rise, there Will Be a Lower Call Premium • Advantage is for the Issuer • Disadvantage is for the Purchaser

  22. Putable Bonds • Purchaser Buys Nonputable Bond and a Put Option from the Issuer • Purchaser has the Right to Sell the Bond to the Issuer at a Certain Predetermined Time and Price • If Investor is Long a Putable Bond, then • Putable Bond Price = Nonputable Bond Price +Put Option Price

  23. Callable Bonds If P>E, intrinsic value is P-E and option is “in the money” If P=E, intrinsic value is 0, option is “at the money” If P<E, intrinsic value is 0 and option is “out of the money” Putable Bonds If P<E, intrinsic value is E-P and option is “in the money” If P=E, intrinsic value is 0 and option is “at the money.” If P<E, intrinsic value is 0 and option is “out of the money.” P=Current Bond Price, E=Strike Price Current Price vs. Strike Price

  24. Bonds Issued by Govt. or Companies Capital Market Not Insured by Govt. CDs Issued by Banks Money Market Insured by Federal Govt. up to $100,000 Bonds vs. Certificates of Deposit • Both could have a Call Option Attached and Expose the Purchaser to Reinvestment Risk

  25. Stocks Capital Gain/Loss Unlimited Upside Potential with Unlimited Downside Risk Part Owner Dividends Company may change it or decide not to pay one at all Bonds Fixed Income Creditor Guarantee of Principal Payment Default Risk Stocks vs. Bonds DIVERSIFICATION: depending on your income and ability to take risk, you will choose a different path.