III.  Bonds and Options

A. Bond Prices and Yields

1.  Bond characteristics

a.  Basic concepts

• A bond is a debt security

• Requires specific payments to the bondholder at specific dates

• Bond (loan) must be repaid at the end of the life of the bond

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b.  Definitions

(1) Par value - face value of the bond, amount that must be repaid

• Usually $1,000

• Bid and ask prices are percentages of par

(2)  Coupon - required interest payment

• Usually semiannually

(3)  Coupon rate - interest per dollar of par value

(4)  Zero coupon bonds - no coupon payment

• Return earned through capital appreciation

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c. Types of bonds

(1) Treasury bonds and notes

• Debt of of U.S. governments

• Note - 1-10 years maturity

• Bond - 10+ years maturity

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• Price paid will include accrued interest between coupon payments 

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(2) Corporate bonds

• Debt of corporations

• Possible features

(a) Callable bonds

• Issuer can repurchase bonds at a specified call price before the maturity date

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(b) Convertible bonds

• Bondholders have option to exchange bonds for a specified number of shares of the issuing company

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• Market conversion value – current value of shares that bond can be converted into 

• Conversion premium - excess of bond value over conversion value

• Allows both a stream on income and participation in appreciation of stock

• Coupon usually lower

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(c ) Puttable bonds

• Same as callable bond, but holder has the option

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(d)  Floating rate bonds

• Interest rate varies, tied to some measure of current interest rates

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(3) Preferred stock

• Equity, but pays a steady stream of dividends

• In bankruptcy, has lower priority than bonds but higher than common stock

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(4) Other issuers

• State and local governments - interest exempt from federal taxes

• Government agencies - Federal Home Loan Bank Board, Ginnie Mae, Fannie Mae, Freddie Mac

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(5) International bonds

(a) Foreign bonds

• Issued by a company in a country other than where it is sold

(b) Eurobonds

• Denominated in currency of issuer, but sold in other markets

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d.  Bond innovations

(1)  Inverse floaters

• Coupon rate falls when interest rates rise

• Betting that interest rates fall

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(2)  Asset-backed bonds

• Income from specific assets used to service debt

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(3)  Pay-in-kind bonds

• Issuer pays either in cash or in additional bonds

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(4) Catastrophe bonds

• Higher coupon rate, but principle reduced if there is a catastrophe

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(5)  Indexed bonds

• Payments tied to general price index or price of a commodity

• Treasury Inflation Protected Securities (TIPS)

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2.  Bond pricing

• Use present value of cash flows

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• Annuity

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a.  Interest rates and bond prices

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b.  Pricing between coupon dates

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c.  Excel

• =PRICE

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3.  Bond yields

a.  Yield to maturity (YTM)

• Interest rate that makes the present value of a bond's payment equal to its price

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• Current yield

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• Coupon rate greater than current yield for premium bonds, less than current yield for discount bonds

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b.  Yield to call

• What is average rate of return for bonds subject to call?

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c.  Realized compound return

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• Horizon analysis - forecasting realized compound yield over various holding periods

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4.  Bond prices over time

• Capital gain or loss if coupon rate is different that market interest rate

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a.  Yield to maturity vs. holding-period return

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b. Zero-coupon bonds

• No coupon, return is all capital gains

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• After-tax returns

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5.  Default risk and bond pricing

 a.  Credit risk

• Risk of bond defaulting

• Measured by Moody's Investor Services, Standard & Poor's Corporation, Fitch Investors

• Investment-grade bonds - BBB / Baa or above

• Speculative-grade or junk bonds - BB / Ba or below

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b.  Junk bonds

• Also known as high-yield bonds

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c.  Determinants of bond safety

(1) Coverage ratios

• Times-interest-earned ratio

• Cash flow difficulties if ratio is low or falling

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(2) Leverage ratio, debt-to-equity ratio

• Excessive indebtedness if too high

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(3)  Liquidity ratios

• Current ratio, quick ratio

• Measures ability to pay bills coming due with most liquid assets

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(4) Profitability ratios

• Return on assets, return on equity

• Indicators of firm's overall financial health

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(5)  Cash flow-to-debt ratio

• Total cash flow to outstanding debt

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d.  Bond indentures

• Contract between issuer and bondholder

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(1)  Sinking funds

• Spread burden of payment of par value over time

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(2)  Subordination of future debt

• Restricts issuance of debt in future

• Future debt that is issued has lower priority

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(3)  Dividend restrictions

• Restricts dividends firm can pay to have more money for debt service

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(4)  Collateral

• Bondholder receives specific asset if firm defaults

• Debenture bonds - unsecured with collateral

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e. Yield to maturity and default risk

• Difference between promised yield-to-maturity and expected yield to maturity due to possibility of default

• Default premium - difference between promised yield and identical government bond

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f.  Credit default swaps

• Insurance policy on the default risk of a bond or loan

• Turns bond into AAA rating

• Premium should be the yield spread between the current rating and AAA

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g.  Collateralized debt obligations

• Establish legally distinct organization (Structured Investment Vehicle)

• Organization raises funds to buy debt, usually with short-term commercial paper

• Debt pooled together and then split into different classes (tranches)

• Each tranche given different seniority level in terms of claims

• Can be sold as stand-alone security

• Senior tranches have higher rating, lower tranches have higher yields

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6.  Yield curve

• Term structure of interest rates - relationship between yield to maturity and terms to maturity

• Yield curve - graph of the term structure

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• Theories:

a.  Expectations Theory

• Yields to maturity determined solely by expectations of future short-term interest rates

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b.  Liquidity Preference Theory

• Investors demand a risk premium on long-term bonds