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Bond Basics.ppt

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Siddharth Bipin Mishra
Siddharth Bipin Mishra

This document provides an overview of bond basics, including understanding risk and return characteristics of bonds, bond terminology, major types of bonds, how bonds are valued, and costs of investing in bonds. Key points covered include the risks of bonds like interest rate risk, inflation risk, and credit risk. Major bond types discussed are corporate bonds, treasury securities, municipal bonds, and international bonds. The document also explains how bond prices are determined based on interest rates, maturity, and an investor's required rate of return. Bond valuation metrics like current yield and yield to maturity are also defined.

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BM410 Investments Bond Basics
Objectives A. Understand risk and return for bonds B. Understand bond terminology C. Understand the major types of bonds D. Understand how bonds are valued E. Understand the costs of investing in bonds
A. Understand Risk and Return for Bonds Why Consider Bonds in your portfolio? Bonds reduce risk through diversification. Bonds produce steady current income. Bonds can be a safe investment if held to maturity. Bonds are less risky than stocks, although their returns are lower as well. If interest rates drop, bond prices will rise
Risk and Return (continued) Why be concerned about bonds? Bonds are susceptible to changes in: The domestic and world economy Domestic and world interest rates The business and political environment The growth of bond or fixed income investment is determined by more than just interest rates Bonds are somewhat illiquid, may be called, and are often sold in large denominations Individual bonds can be very risky investments Finding a good investment outlet to invest the interest you receive from bonds may be difficult
Risk and Return (continued) Bonds are susceptible to a number of risks: Interest rate risk Risk that a rise (fall) in interest rates will result in a decline (rise) in the bonds value Inflation risk Risk that a rise (decline) in inflation will result in a decrease (increase) in the bonds value Business risk Risk that the bonds value will decline due to problems with the companys business Liquidity risk Risk that investors will be unable to find a buyer or
Risk and Return (continued) Financial risk How the firm raises money could affect the financial performance of the firm and the value of the bonds Political or regulatory risk Unanticipated changes in the tax or legal environment will have an impact on a companys bonds Exchange rate risk Risk that changes in exchange rates will impact profitability for firms working internationally
Questions Any questions of risk and return for stocks?
B. Understand Bond Terminology Par value The face value or amount returned to the holder of the bond at maturity Coupon interest rate (or interest rate) The percentage of the par or face value that will be paid annually to the holder in the form of interest Maturity date The date when the bond expires and the loan must be paid back Price The price that the bond sells for
Bond Terminology (continued) Call provision Allows the issuer to repurchase the bonds before the maturity date Deferred calls provide more protection. Sinking fund Money set aside annually to pay off the bonds at maturity Indenture A document that outlines the terms of the loan agreement Yield The annual interest on a bond divided by its price
Bond Terminology (continued) Issuer The corporation or government agency that issues the bond Term or Bond Maturity: Short-term Bonds with maturity usually a year or less Intermediate-term Bonds with a maturity of 2 to 10 years Long-term Bonds with a maturity of greater than 10 years
Bond Terminology (continued) Bearer bonds Bonds with coupons attach that pay interest only to the bearer upon surrender of the coupons Book-entry bonds Bonds which are registered and stored electronically, similar to stock purchases Baby bond A bond with a par value of less than $1,000
Bond Terminology (continued) Discount bond A bond that is sold at a discount to its par value. Generally, upon maturity the accrued interest and original investment add to the bonds par value Callable bond A bond that can be redeemed prior to its maturity date at the option of the issuer Redemption The process of redeeming a callable bond before its maturity date
Bond Terminology (continued) Asset backed bonds Asset backed bonds Bonds backed by specific holdings of the issuing company, such as equipment or real estate Debentures Bonds backed by the credit of the issuing company Mortgage-backed bonds Bonds backed up by a pool of mortgages Collateralized mortgage obligations (CMOS) More complex and specialized versions of mortgage backed bonds
Bond Terminology (continued) Bonds with Conditions Subordinated bond Bond that will be paid after the other loan obligations of the issuer are paid Floating rate bond Bond whose interest payments fluctuate according to a specific benchmark interest rate Convertible bond Bond which gives the holder the right to convert the bond to company stock instead of getting the cash repayment
Bond Terminology (continued) Callable bonds Bonds which can be called, i.e. redeemed, before maturity at the option of the issuer. Zero-coupon bond A discount bond which pays no interest until maturity. Junk Bonds Bonds with very low bond ratings, a higher interest rate and default rate, and are almost always callable
Bond Terminology (continued) What are bond ratings? Bond ratings are measures of the riskiness of a company. Ratings run from AAA (Standard & Poors) or aaa (Moodys) for the safest to D for the extremely risky Ratings categorize bonds by default risk, the risk of the company being unable to repay the bond The major rating companies are: Standard & Poors Moodys
Bond Terminology (continued) Bond rating company A private sector company that evaluates the financial condition of the bond issuing company, its revenues, profits, debt, and other critical areas, and gives the company a rating which indicates the relative safety of the bond Generally, the better the bond rating, the lower the interest rate the company will have to pay to sell its bonds Only rate corporate and municipal bonds
Bond Terminology (continued) Downgrade A situation where a bond rating company reduces the bond rating of a bond generally due to a deterioration in the companys financial condition Upgrade A situation where a bond rating company improves the bond rating of a bond due generally to an improving financial condition Risk of Downgrading Should a bonds rating be downgraded, the seller would need to reduce the price of the bond (resulting in a lower yield to the seller and a higher yield to the buyer) to make up for the increased risk
C. Understand the Major Types of Bonds (continued) While there are many different types of bonds, they fall under a few major headings: Corporate Treasury Debt Securities Municipal Agency International Treasury Savings Securities
Major Bond Types (continued) Corporate Bonds Types: Bonds secured corporate debts by collateral or real property liens Secured bond, Mortgage bond Unsecured corporate debts Bonds not secured by collateral, and pay a higher return Debenture Long-term unsecured bond Can have a hierarchy of payment, with unsubordinated and subordinated debentures
Major Bond Types (continued) Issuer: issued by corporations Maturities: Can have many different maturities Short-term: 1 to 5 years Intermediate term: 6 to 10 years Long-term: 11 to 30+ years Taxes: Subject to federal, state and local taxes Risk and Return: More risky than government bonds, but higher returns. Very little risk with highest rated bonds
Major Bond Types (continued) Rated: Yes Trading: By brokers, either OTC or on an exchange Callable: Yes
Major Bond Types (continued) Treasury Debt Securities Types: Treasury Bills A short-term debt obligation issued at a discount and redeemed at face value upon maturity in 3, 6, or 12 months Treasury Notes An intermediate-term debt obligation issued at or near par and interest paid semiannually. Treasury Bonds A long-term debt obligation issued at or near par and interest is paid semiannually. Issuer: government
Major Bond Types (continued) Maturities: 3 months to 30 years Taxes: Exempt from state and local taxes, but not federal taxes Risk and Return: Government securities, so considered risk free. However, with lower risk, returns are lower as well Rated: No Trading: Auction, Outstanding issues by brokers, OTC Callable: Usually not
Major Bond Types (continued) Municipal bonds Types: Revenue bonds: Bonds backed by the revenues of a specific project General Obligation bonds: Bonds backed by the taxing power of the issuer Issuer: Bonds issued by various state and local governments Maturities: Can have many different maturities Short-term: 1 to 5 years Intermediate term: 6 to 10 years Long-term: 11 to 30+ years
Major Bond Types (continued) Taxes: Exempt from federal tax May also be exempt from state and local tax if the investor lives in the state from which the bond was issued Risk and Return: Risk is higher than government bonds, while returns may be lower, due to federal tax exemption. Rated: Yes Trading: Brokers, OTC Callable: Sometimes
Major Bond Types (continued) International Bonds Types: International Bonds Bonds issued by international companies and sold internationally in various currencies Yankee Bonds Bonds issued by international companies and sold in the U.S. in U.S. dollars Euro Bonds Bonds issued by U.S. companies and sold outside of the U.S. in U.S. dollars
Major Bond Types (continued) Issuer: Issued by U.S. or international corporations Maturities: Can have many different maturities Short-term: 1 to 5 years Intermediate term: 6 to 10 years Long-term: 11 to 30+ years Par value: $1,000 and up, may be in different currencies Taxes: Subject to US federal, state and local taxes. May also be subject to foreign taxes Risk and Return: Varies. More risky than government and corporate bonds, but higher returns. May also have currency risk as well.
Major Bond Types (continued) Rated: Generally yes for U.S. and larger international firms Trading: By brokers, either OTC or on an exchange Callable: Generally yes
Major Bond Types (continued) US Treasury Savings Securities Types: US Savings EE Bonds US Savings I bonds Issuer: Bonds issued by the U.S. government, and tax deferred until maturity Are not marketable, but can be redeemed from local banks I bonds sold at face value, with interest paid at maturity EE bonds sold at a discount and interest and principle are paid at maturity
Major Bond Types (continued) Maturity: Generally cannot be redeemed before 5 years without penalty. Can hold for up to 30 years. Par Value/Denomination: $25, $50, $100, $1,000 and $10,000 Taxes: Registered bearer bonds exempt from state and local taxes. May have special tax or interest rate benefits. Interest is tax-free if used for qualified educational expenses (EE and I bonds)
Major Bond Types (continued) Risk and Return: Government securities so little risk. EE bond return is low and variable, and changes every six months to 85% of the value of the 5 year government bond I bond return is low and variable, changes every 6 months, and gives a guaranteed real return of inflation plus a real component Rated: No, as these are government securities Trading: Not traded. Can be purchased over the internet at Treasurydirect.gov Callable: no
D. Understand How Bonds are Valued How are bonds valued? Bonds are valued in many ways. Generally, the value of a bond is determined by the price paid for the bond, and the discounted value of all of its interest payments and the repayment of its par value The three key inputs are: The price and the par value of the bond The maturity and coupon interest payments The discount rate of the investor The price of the bond is the present value of the price, interest payments, and future par value all discounted at the investors discount rate
Valuation Principles (continued) What is the relationship between key inputs? Price and Par Value A bond whose price is less (more) than its par value is trading at a discount (premium) to par Bonds trade at below (above) par when the interest rate of the bond is lower (higher) than prevailing market interest rates Suppose you own a bond with a 6% coupon rate. If market interest rates were 4% now, because your bond has a higher than 4% rate, investors would have to pay you more for that bond, i.e. offer you a higher price
Valuation Principles (continued) Maturity and Price Bonds fluctuate in value, and the longer (shorter) the time to maturity the greater (smaller) the fluctuation. Since bonds take into account current changes in interest rates, and if those rates increase, the longer (shorter) the maturity the greater (smaller) the fluctuation in the price of the bond
Valuation Principles (continued) Investors discount rate and price The value of a bond is related to the investors discount rate Bonds are valued at the discount rate required by the investor. If the discount rate increases (decreases), the investor will require a higher (lower) return on all cash flows, and hence a lower (higher) price Since coupon payments are fixed (generally) for the life of the bond, the only input that can change to adjust for changes in the investors discount rate is the bond price
Valuation Principles (continued) Why would an investors discount rate of return change? The investor perceives a change in the risk associated with the firm issuing the bond As perceived risk increases, the investors discount rate increases The investor perceives a change in general market interest rates As general interest rates in the market increase, investors require a higher discount rate to invest The investor perceives a change in the general risk in the market (the market risk premium) As the perceived riskiness of the market increases, investors require a higher discount rate to invest
Valuation Principles (continued) Note that the discount rate required for an investor to invest in bonds will change depending on each investor However, for bonds with a call feature the call price limits the upward price As a bond approaches its maturity date, its market value approaches it par value If you expect interest rates to increase, buy short- term bonds. If you expect interest rates to decrease, buy long- term non-callable bonds.
Valuation Principles (continued) What is the bond yield? Is the total return on a bond investment Is not the same as the interest rate Is affected by the bond price which may be more (a premium to) or less than (a discount to) face value How you do measure bond yield? Current yield Yield to maturity Equivalent taxable yield on munis
Valuation Principles (continued) Current Yield Ratio of annual interest payments to the bonds market price It is calculated as: Annual interest payments / Market price of the bond Since the interest payments are fixed, the only variable that can change is the price of the bond.
Valuation Principles (continued) Yield to Maturity This is the true yield received if the bond is held to maturity, which assumes that all interest payments can be reinvested at the same rate. It is a cash flow problem, that is best solved by use of a calculator. The approximate yield to maturity is: (AIP + (PV CP)/YM) / (PV-CP)/YM AIP = annual interest payments PV = Par value CP = Current market price YM = Years to maturity
Valuation Principles (continued) Equivalent taxable yield (ETY) The yield that must be offered on a taxable bond to give the same after-tax yield on a tax-exempt bond Equivalent Taxable Yield Equation is: ETY = Tax-free yield / (1 marginal tax bracket) Note: It is critical that you understand the tax implications of each type of bond to calculate after-tax return, i.e. municipal bonds are free from federal tax, treasury debt securities are free from state and local taxes, etc.
Valuation Principles (continued) Remember the principles of investing when investing in bonds: Invest tax-efficiently Its not what you make, but what you keep after taxes. Take into account the tax implications of bonds Invest low-cost Buy a bond when it is first issued, rather than in the secondary market Stay diversified Consider investing in a portfolio of bonds. If buying single bonds, consider only high quality bonds
Valuation Principles (continued) Watch market interest rates Keep the inverse relationship between interest rates and bond price in mind If interest rates are likely to rise (fall), invest in short-term (long-term) bonds Know what you are investing in Avoid bonds that might get called. Stick to large issues which are more liquid Know yourself and your goals Match your bonds maturity to your investment time horizon.
E. Understand the cost of investing in bonds What are the costs of investing in bonds? Explicit Costs Commission costs All bond trades incur commission costs Some newly issued bonds are sold without commission cost as the issuer absorbs the costs Most trades however, incur commission costs, which are paid to the broker who arranged the trade Markup This is the difference between the buying price and the calculated selling price
Cost of Investing in Bonds (continued) Explicit costs (continued) Custody (or annual) fees These are fees the brokerage house charges to hold the bonds in your account. May be a minimum amount for small accounts ($15 per year), a specific charge per holding (8 basis points per security), or a percentage of assets for large accounts (25 basis points on assets under management)
Cost of Investing in Bonds (continued) Implicit costs Taxes: Taxes must be taken into account to get the true return of your portfolio but which are not noted on your monthly reports Interest Interest is the coupon payment received each period. These are taxed at your ordinary income rate. This is an expensive type of income
Cost of Investing in Bonds (continued) Implicit costs (continued) Capital Gains This is the difference between what you paid for the bond and what you sold it for, or the par value if you held the bond to maturity Short-term: Gains made in selling bonds owned less than 1 year. They are taxed at your marginal tax rate Long-term Capital Gains: Gains made in selling bonds held for more than 1 year. These are taxed at 10% depending on how long you have held the asset, and are only on the asset, not coupon payments
Cost of Investing in Bonds (continued) Hidden Costs (at the account level) Beyond the explicit and implicit costs, look for the following hidden costs: Account Transfer Fees Charges for moving assets either into our out of an existing account Account maintenance fees Fees for maintaining your account Inactivity/Minimum balance fees Fees because you did not trade or have account activity during the period or because you failed to keep a minimum balance in your account

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Bond Basics.ppt

  • 2. Objectives A. Understand risk and return for bonds B. Understand bond terminology C. Understand the major types of bonds D. Understand how bonds are valued E. Understand the costs of investing in bonds
  • 3. A. Understand Risk and Return for Bonds Why Consider Bonds in your portfolio? Bonds reduce risk through diversification. Bonds produce steady current income. Bonds can be a safe investment if held to maturity. Bonds are less risky than stocks, although their returns are lower as well. If interest rates drop, bond prices will rise
  • 4. Risk and Return (continued) Why be concerned about bonds? Bonds are susceptible to changes in: The domestic and world economy Domestic and world interest rates The business and political environment The growth of bond or fixed income investment is determined by more than just interest rates Bonds are somewhat illiquid, may be called, and are often sold in large denominations Individual bonds can be very risky investments Finding a good investment outlet to invest the interest you receive from bonds may be difficult
  • 5. Risk and Return (continued) Bonds are susceptible to a number of risks: Interest rate risk Risk that a rise (fall) in interest rates will result in a decline (rise) in the bonds value Inflation risk Risk that a rise (decline) in inflation will result in a decrease (increase) in the bonds value Business risk Risk that the bonds value will decline due to problems with the companys business Liquidity risk Risk that investors will be unable to find a buyer or
  • 6. Risk and Return (continued) Financial risk How the firm raises money could affect the financial performance of the firm and the value of the bonds Political or regulatory risk Unanticipated changes in the tax or legal environment will have an impact on a companys bonds Exchange rate risk Risk that changes in exchange rates will impact profitability for firms working internationally
  • 7. Questions Any questions of risk and return for stocks?
  • 8. B. Understand Bond Terminology Par value The face value or amount returned to the holder of the bond at maturity Coupon interest rate (or interest rate) The percentage of the par or face value that will be paid annually to the holder in the form of interest Maturity date The date when the bond expires and the loan must be paid back Price The price that the bond sells for
  • 9. Bond Terminology (continued) Call provision Allows the issuer to repurchase the bonds before the maturity date Deferred calls provide more protection. Sinking fund Money set aside annually to pay off the bonds at maturity Indenture A document that outlines the terms of the loan agreement Yield The annual interest on a bond divided by its price
  • 10. Bond Terminology (continued) Issuer The corporation or government agency that issues the bond Term or Bond Maturity: Short-term Bonds with maturity usually a year or less Intermediate-term Bonds with a maturity of 2 to 10 years Long-term Bonds with a maturity of greater than 10 years
  • 11. Bond Terminology (continued) Bearer bonds Bonds with coupons attach that pay interest only to the bearer upon surrender of the coupons Book-entry bonds Bonds which are registered and stored electronically, similar to stock purchases Baby bond A bond with a par value of less than $1,000
  • 12. Bond Terminology (continued) Discount bond A bond that is sold at a discount to its par value. Generally, upon maturity the accrued interest and original investment add to the bonds par value Callable bond A bond that can be redeemed prior to its maturity date at the option of the issuer Redemption The process of redeeming a callable bond before its maturity date
  • 13. Bond Terminology (continued) Asset backed bonds Asset backed bonds Bonds backed by specific holdings of the issuing company, such as equipment or real estate Debentures Bonds backed by the credit of the issuing company Mortgage-backed bonds Bonds backed up by a pool of mortgages Collateralized mortgage obligations (CMOS) More complex and specialized versions of mortgage backed bonds
  • 14. Bond Terminology (continued) Bonds with Conditions Subordinated bond Bond that will be paid after the other loan obligations of the issuer are paid Floating rate bond Bond whose interest payments fluctuate according to a specific benchmark interest rate Convertible bond Bond which gives the holder the right to convert the bond to company stock instead of getting the cash repayment
  • 15. Bond Terminology (continued) Callable bonds Bonds which can be called, i.e. redeemed, before maturity at the option of the issuer. Zero-coupon bond A discount bond which pays no interest until maturity. Junk Bonds Bonds with very low bond ratings, a higher interest rate and default rate, and are almost always callable
  • 16. Bond Terminology (continued) What are bond ratings? Bond ratings are measures of the riskiness of a company. Ratings run from AAA (Standard & Poors) or aaa (Moodys) for the safest to D for the extremely risky Ratings categorize bonds by default risk, the risk of the company being unable to repay the bond The major rating companies are: Standard & Poors Moodys
  • 17. Bond Terminology (continued) Bond rating company A private sector company that evaluates the financial condition of the bond issuing company, its revenues, profits, debt, and other critical areas, and gives the company a rating which indicates the relative safety of the bond Generally, the better the bond rating, the lower the interest rate the company will have to pay to sell its bonds Only rate corporate and municipal bonds
  • 18. Bond Terminology (continued) Downgrade A situation where a bond rating company reduces the bond rating of a bond generally due to a deterioration in the companys financial condition Upgrade A situation where a bond rating company improves the bond rating of a bond due generally to an improving financial condition Risk of Downgrading Should a bonds rating be downgraded, the seller would need to reduce the price of the bond (resulting in a lower yield to the seller and a higher yield to the buyer) to make up for the increased risk
  • 19. C. Understand the Major Types of Bonds (continued) While there are many different types of bonds, they fall under a few major headings: Corporate Treasury Debt Securities Municipal Agency International Treasury Savings Securities
  • 20. Major Bond Types (continued) Corporate Bonds Types: Bonds secured corporate debts by collateral or real property liens Secured bond, Mortgage bond Unsecured corporate debts Bonds not secured by collateral, and pay a higher return Debenture Long-term unsecured bond Can have a hierarchy of payment, with unsubordinated and subordinated debentures
  • 21. Major Bond Types (continued) Issuer: issued by corporations Maturities: Can have many different maturities Short-term: 1 to 5 years Intermediate term: 6 to 10 years Long-term: 11 to 30+ years Taxes: Subject to federal, state and local taxes Risk and Return: More risky than government bonds, but higher returns. Very little risk with highest rated bonds
  • 22. Major Bond Types (continued) Rated: Yes Trading: By brokers, either OTC or on an exchange Callable: Yes
  • 23. Major Bond Types (continued) Treasury Debt Securities Types: Treasury Bills A short-term debt obligation issued at a discount and redeemed at face value upon maturity in 3, 6, or 12 months Treasury Notes An intermediate-term debt obligation issued at or near par and interest paid semiannually. Treasury Bonds A long-term debt obligation issued at or near par and interest is paid semiannually. Issuer: government
  • 24. Major Bond Types (continued) Maturities: 3 months to 30 years Taxes: Exempt from state and local taxes, but not federal taxes Risk and Return: Government securities, so considered risk free. However, with lower risk, returns are lower as well Rated: No Trading: Auction, Outstanding issues by brokers, OTC Callable: Usually not
  • 25. Major Bond Types (continued) Municipal bonds Types: Revenue bonds: Bonds backed by the revenues of a specific project General Obligation bonds: Bonds backed by the taxing power of the issuer Issuer: Bonds issued by various state and local governments Maturities: Can have many different maturities Short-term: 1 to 5 years Intermediate term: 6 to 10 years Long-term: 11 to 30+ years
  • 26. Major Bond Types (continued) Taxes: Exempt from federal tax May also be exempt from state and local tax if the investor lives in the state from which the bond was issued Risk and Return: Risk is higher than government bonds, while returns may be lower, due to federal tax exemption. Rated: Yes Trading: Brokers, OTC Callable: Sometimes
  • 27. Major Bond Types (continued) International Bonds Types: International Bonds Bonds issued by international companies and sold internationally in various currencies Yankee Bonds Bonds issued by international companies and sold in the U.S. in U.S. dollars Euro Bonds Bonds issued by U.S. companies and sold outside of the U.S. in U.S. dollars
  • 28. Major Bond Types (continued) Issuer: Issued by U.S. or international corporations Maturities: Can have many different maturities Short-term: 1 to 5 years Intermediate term: 6 to 10 years Long-term: 11 to 30+ years Par value: $1,000 and up, may be in different currencies Taxes: Subject to US federal, state and local taxes. May also be subject to foreign taxes Risk and Return: Varies. More risky than government and corporate bonds, but higher returns. May also have currency risk as well.
  • 29. Major Bond Types (continued) Rated: Generally yes for U.S. and larger international firms Trading: By brokers, either OTC or on an exchange Callable: Generally yes
  • 30. Major Bond Types (continued) US Treasury Savings Securities Types: US Savings EE Bonds US Savings I bonds Issuer: Bonds issued by the U.S. government, and tax deferred until maturity Are not marketable, but can be redeemed from local banks I bonds sold at face value, with interest paid at maturity EE bonds sold at a discount and interest and principle are paid at maturity
  • 31. Major Bond Types (continued) Maturity: Generally cannot be redeemed before 5 years without penalty. Can hold for up to 30 years. Par Value/Denomination: $25, $50, $100, $1,000 and $10,000 Taxes: Registered bearer bonds exempt from state and local taxes. May have special tax or interest rate benefits. Interest is tax-free if used for qualified educational expenses (EE and I bonds)
  • 32. Major Bond Types (continued) Risk and Return: Government securities so little risk. EE bond return is low and variable, and changes every six months to 85% of the value of the 5 year government bond I bond return is low and variable, changes every 6 months, and gives a guaranteed real return of inflation plus a real component Rated: No, as these are government securities Trading: Not traded. Can be purchased over the internet at Treasurydirect.gov Callable: no
  • 33. D. Understand How Bonds are Valued How are bonds valued? Bonds are valued in many ways. Generally, the value of a bond is determined by the price paid for the bond, and the discounted value of all of its interest payments and the repayment of its par value The three key inputs are: The price and the par value of the bond The maturity and coupon interest payments The discount rate of the investor The price of the bond is the present value of the price, interest payments, and future par value all discounted at the investors discount rate
  • 34. Valuation Principles (continued) What is the relationship between key inputs? Price and Par Value A bond whose price is less (more) than its par value is trading at a discount (premium) to par Bonds trade at below (above) par when the interest rate of the bond is lower (higher) than prevailing market interest rates Suppose you own a bond with a 6% coupon rate. If market interest rates were 4% now, because your bond has a higher than 4% rate, investors would have to pay you more for that bond, i.e. offer you a higher price
  • 35. Valuation Principles (continued) Maturity and Price Bonds fluctuate in value, and the longer (shorter) the time to maturity the greater (smaller) the fluctuation. Since bonds take into account current changes in interest rates, and if those rates increase, the longer (shorter) the maturity the greater (smaller) the fluctuation in the price of the bond
  • 36. Valuation Principles (continued) Investors discount rate and price The value of a bond is related to the investors discount rate Bonds are valued at the discount rate required by the investor. If the discount rate increases (decreases), the investor will require a higher (lower) return on all cash flows, and hence a lower (higher) price Since coupon payments are fixed (generally) for the life of the bond, the only input that can change to adjust for changes in the investors discount rate is the bond price
  • 37. Valuation Principles (continued) Why would an investors discount rate of return change? The investor perceives a change in the risk associated with the firm issuing the bond As perceived risk increases, the investors discount rate increases The investor perceives a change in general market interest rates As general interest rates in the market increase, investors require a higher discount rate to invest The investor perceives a change in the general risk in the market (the market risk premium) As the perceived riskiness of the market increases, investors require a higher discount rate to invest
  • 38. Valuation Principles (continued) Note that the discount rate required for an investor to invest in bonds will change depending on each investor However, for bonds with a call feature the call price limits the upward price As a bond approaches its maturity date, its market value approaches it par value If you expect interest rates to increase, buy short- term bonds. If you expect interest rates to decrease, buy long- term non-callable bonds.
  • 39. Valuation Principles (continued) What is the bond yield? Is the total return on a bond investment Is not the same as the interest rate Is affected by the bond price which may be more (a premium to) or less than (a discount to) face value How you do measure bond yield? Current yield Yield to maturity Equivalent taxable yield on munis
  • 40. Valuation Principles (continued) Current Yield Ratio of annual interest payments to the bonds market price It is calculated as: Annual interest payments / Market price of the bond Since the interest payments are fixed, the only variable that can change is the price of the bond.
  • 41. Valuation Principles (continued) Yield to Maturity This is the true yield received if the bond is held to maturity, which assumes that all interest payments can be reinvested at the same rate. It is a cash flow problem, that is best solved by use of a calculator. The approximate yield to maturity is: (AIP + (PV CP)/YM) / (PV-CP)/YM AIP = annual interest payments PV = Par value CP = Current market price YM = Years to maturity
  • 42. Valuation Principles (continued) Equivalent taxable yield (ETY) The yield that must be offered on a taxable bond to give the same after-tax yield on a tax-exempt bond Equivalent Taxable Yield Equation is: ETY = Tax-free yield / (1 marginal tax bracket) Note: It is critical that you understand the tax implications of each type of bond to calculate after-tax return, i.e. municipal bonds are free from federal tax, treasury debt securities are free from state and local taxes, etc.
  • 43. Valuation Principles (continued) Remember the principles of investing when investing in bonds: Invest tax-efficiently Its not what you make, but what you keep after taxes. Take into account the tax implications of bonds Invest low-cost Buy a bond when it is first issued, rather than in the secondary market Stay diversified Consider investing in a portfolio of bonds. If buying single bonds, consider only high quality bonds
  • 44. Valuation Principles (continued) Watch market interest rates Keep the inverse relationship between interest rates and bond price in mind If interest rates are likely to rise (fall), invest in short-term (long-term) bonds Know what you are investing in Avoid bonds that might get called. Stick to large issues which are more liquid Know yourself and your goals Match your bonds maturity to your investment time horizon.
  • 45. E. Understand the cost of investing in bonds What are the costs of investing in bonds? Explicit Costs Commission costs All bond trades incur commission costs Some newly issued bonds are sold without commission cost as the issuer absorbs the costs Most trades however, incur commission costs, which are paid to the broker who arranged the trade Markup This is the difference between the buying price and the calculated selling price
  • 46. Cost of Investing in Bonds (continued) Explicit costs (continued) Custody (or annual) fees These are fees the brokerage house charges to hold the bonds in your account. May be a minimum amount for small accounts ($15 per year), a specific charge per holding (8 basis points per security), or a percentage of assets for large accounts (25 basis points on assets under management)
  • 47. Cost of Investing in Bonds (continued) Implicit costs Taxes: Taxes must be taken into account to get the true return of your portfolio but which are not noted on your monthly reports Interest Interest is the coupon payment received each period. These are taxed at your ordinary income rate. This is an expensive type of income
  • 48. Cost of Investing in Bonds (continued) Implicit costs (continued) Capital Gains This is the difference between what you paid for the bond and what you sold it for, or the par value if you held the bond to maturity Short-term: Gains made in selling bonds owned less than 1 year. They are taxed at your marginal tax rate Long-term Capital Gains: Gains made in selling bonds held for more than 1 year. These are taxed at 10% depending on how long you have held the asset, and are only on the asset, not coupon payments
  • 49. Cost of Investing in Bonds (continued) Hidden Costs (at the account level) Beyond the explicit and implicit costs, look for the following hidden costs: Account Transfer Fees Charges for moving assets either into our out of an existing account Account maintenance fees Fees for maintaining your account Inactivity/Minimum balance fees Fees because you did not trade or have account activity during the period or because you failed to keep a minimum balance in your account