Chapter

18/19 Corporate Bonds / Government Bonds

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Bonds

• Our goal in this chapter is to understand the basic types and features of corporate bonds and government bonds (Federal, state and local).

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Corporate Bond Basics

• A Corporate bond is a security issued by a corporation.

• It represents a promise to pay bondholders a fixed sum of money (called the bond’s principal, or par or face value) at a future maturity date, along with periodic payments of interest (called coupons).

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Corporate Bond Basics

• Corporate bonds differ from common stock in three fundamental ways.

Corporate Bonds Common Stock

Represent a creditor’s claim on the corporation

Represents an ownership claim on the corporation

Promised cash flows (coupons and principal) are stated in advance

Amount and timing ofdividends may changeat any time

Mostly callable Almost never callable

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Corporate Bond Basics

• There are several trillion dollars of corporate bonds outstanding in the United States.

• More than half of these are owned by life insurance companies and pension funds.– These institutions can eliminate much of their financial risk via

cash flow matching.– They can also diversify away most default risk by including a

large number of different bond issues in their portfolios.

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Corporate Bond Types

•Bonds issued with a standard, relatively simple set of features are popularly called Plain Vanilla Bonds (or “bullet” bonds).

•Debentures are unsecured bonds issued by a corporation.

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Corporate Bonds Types

• Mortgage bonds are debt secured with a property lien.

• Collateral trust bonds are debt secured with financial collateral.

• Equipment trust certificates are shares in a trust with income from a lease contract.

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Bond Indentures

• A Bond Indenture is a formal written agreement between the corporation and the bondholders.

• This agreement spells out, in detail, the obligations of the corporation, the rights of the corporation, and the rights of the bondholders (with respect to the bond issue.)

• In practice, few bond investors read the original indenture. Instead, they might refer to an indenture summary provided in the prospectus of the bond issue.

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Bond Indentures, Cont.

• The Trust Indenture Act of 1939 requires that any bond issue subject to regulation by the Securities and Exchange Commission (SEC) must have a trustee appointed to represent the interests of the bondholders.

• Trustees are typically arms of commercial banks.

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Bond Indentures, Seniority Provisions

• Different bond issues can usually be differentiated according to the seniority of their claims on the firm’s assets in case of default.– Senior Debentures are the bonds paid first in case of default.– Subordinated Debentures are paid after senior debentures.

• Bond seniority may be protected by a negative pledge clause.

• A negative pledge clause prohibits a new debt issue that would have seniority over existing bonds.

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Tombstone Ad, Equipment Trust Notes Issue

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Bond Indentures, Fixed-Price Call Provisions

• Most corporate bonds have a call provision attached.

• A traditional, fixed-price call provision allows the issuer to buy back all or part of its outstanding bonds at a specified call price sometime before the bonds mature.

• When interest rates fall, bond prices increase.– The corporation can “call-in” the existing bonds, i.e., pay the call

price.– The corporation can then issue new bonds with a lower coupon.– This process is called bond refunding.

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Bond Indentures, Fixed-Price Call Provisions

• Three features are usually attached to restrict an issuer’s call privilege:– Bonds usually have a deferred call provision

– The call price includes a call premium over par value.

– Some have a refunding provision.

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Bond Indentures, Make-Whole Call Provisions

• Make-whole call provisions have recently become common

• Like a fixed-price call provision, a make-whole call provision allows the issuer to pay off the remaining debt early. However,– The issuer must pay the bondholders a price equal to the present

value of all remaining payments.– The discount rate used to calculate this present value is equal to:

• The yield of a comparable maturity U.S. Treasury security

• A fixed, pre-specified make-whole premium

• As interest rates decrease the make-whole call price increases

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Bond Indentures, Put Provisions

• A bond with a put provision can be sold back to the issuer at a pre-specified price (normally set at par value) on any of a sequence of pre-specified dates.

• Bonds with put provisions are often called extendible bonds.

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Bond Indentures, Bond-to-Stock Conversion Provisions

• Convertible bonds are bonds that can be exchanged for common stock according to a pre-specified conversion ratio (i.e., the number of shares acquired).

Conversion Price = Bond Par Value / Conversion Ratio

• Conversion Value = Price Per Share × Conversion Ratio

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Tombstone Ad, Convertible Notes Issue

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Convertible Bond Prices and Conversion Values

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Bond Indentures,Bond Maturity Provisions

• Bond maturity and principal payment provisions - term bonds are issued with a single maturity date, while serial bonds are issued with a regular sequence of maturity dates.

• Term bonds normally have a sinking fund, which is an account used to repay some bondholders before maturity.– Money paid into a sinking fund can only be used to pay

bondholders.– Some bondholders are repaid before the stated maturity of their

bonds, whether they want to be repaid or not.– At maturity, only a portion of the original bond issue will still be

outstanding.

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Bond Indentures,Principal Payment Provisions

• Coupon payment provisions - An exact schedule of coupon payment dates is specified.

• If a company suspends payment of coupon interest, the company is said to be in default, a serious matter.– Bondholders have the unconditional right to timely repayment.– Bondholders have the right to bring legal action to get paid.– Companies in default have the right to seek protection from

inflexible bondholders in bankruptcy court.

• If there is default, it is often in the best interests of the bondholders and the company to avoid court and negotiate a new bond issue to replace the existing one.

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Protective Covenants

• A bond indenture is likely to contain a number of protective covenants.

• Protective Covenants are restrictions designed to protect bondholders.

– Negative covenant (“thou shalt not”) example - The firm cannot pay dividends to stockholders in excess of what is allowed by a formula based on the firm’s earnings.

– Positive covenant (“thou shalt”) example - Proceeds from the sale of assets must be used either to acquire other assets of equal value or to redeem outstanding bonds.

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Event Risk

• Event risk is the possibility that the issuing corporation will experience a significant change in its bond credit quality.

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Bonds Without Indentures

• A private placement is a new bond issue sold privately to one or more parties. That is, this new bond issue is not available to the general public.

• Private placements are exempt from registration requirements with the SEC, although they often have formal indentures.

• Debt issued without an indenture is basically a simple IOU of the corporation.

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Corporate Bond Credit Ratings

• A corporation usually subscribes to several bond rating agencies for a credit evaluation of a new bond issue.

• Each contracted rating agency will then provide a credit rating - an assessment of the credit quality of the bond issue based on the issuer’s financial condition.– The best known rating agencies in the U.S. are Moody’s

Investors Services and Standard & Poors Corporation.– Rating agencies in the U.S. also include Duff and Phelps; Fitch

Investors Service; and McCarthy, Crisanti, and Maffei.

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Corporate Bond Credit Rating Symbols

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The Importance of Corporate Bond Credit Ratings

• Only a few institutional investors have the resources and expertise necessary to evaluate correctly the credit quality of a particular bond.

• Many financial institutions have prudent investment guidelines stipulating that only securities with a certain level of investment safety may be included in their portfolios.

• Can there be a bias in the ratings?

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The Yield Spread

• A bond’s credit rating helps determine its yield spread.

• The yield spread is the extra return (increased yield to maturity) that investors demand for buying a bond with a lower credit rating (and higher risk).

• Yield spreads are often quoted in basis points over Treasury notes and bonds.

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High Yield Bonds("Junk" Bonds)

• High-yield bonds are bonds with a speculative credit rating.

• As a result of this poor credit rating, a yield premium must be offered on these bonds to compensate investors for higher credit risk.

• High-yield bonds are also called junk bonds.

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Bond Market Trading

• An active secondary market with a substantial volume of bond trading exists, thus satisfying most of the liquidity needs of investors.

• Corporate bond trading is characteristically an OTC activity.

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Trade Reporting and Compliance Engine (TRACE)

• At the request of the SEC, corporate bond trades are now reported through TRACE.

• TRACE provides a means for bond investors to get accurate, up-to-date price information.

• TRACE has dramatically improved the information available about bond trades.

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Government Bond Basics

• In 2007, the gross public debt of the U.S. government was more than $5 trillion.

• Today, that debt is closer to $11 trillion.

• The U.S. Treasury finances government debt by issuing marketable as well as non-marketable securities.

• Municipal government debt is also a large debt market. – In the U.S., there are more than 85,000 state and local

governments.– Together, they contribute about $2 trillion of outstanding debt.

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Government Bond Basics

• Marketable securities can be traded among investors.

• Marketable securities issued by the U.S. Government include T-bills, T-notes, and T-bonds.

• Non-marketable securities must be redeemed by the issuer.

• Non-marketable securities include U.S. Savings Bonds, Government Account Series, and State and Local Government Series.

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U.S. Treasury Bills (T-bills)

• T-bills are Short-term obligations with maturities of 13, 26, or 52 weeks (when issued).

• T-bills pay only their face value (or redemption value) at maturity.

• Face value denominations for T-bills are as small as $1,000.

• T-bills are sold on a discount basis (the discount represents the imputed interest on the bill).

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U.S. Treasury Notes (T-notes)

• T-notes are medium-term obligations, usually with maturities of 2, 5, or 10 years (when issued).

• T-notes pay semiannual coupons (at a fixed coupon rate) in addition to their face value (at maturity).

• T-notes have face value denominations as small as $1,000.

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U.S. Treasury Bonds (T-bonds)

• T-bonds are long-term obligations with maturities of more than 10 years (when issued).

• T-bonds pay semiannual coupons (at a fixed coupon rate) in addition to their face value (at maturity).

• T-bonds have face value denominations as small as $1,000.

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U.S. Treasury STRIPS

• STRIPS: Separate Trading of Registered Interest and Principal of Securities

• STRIPS were originally derived from 10-year T-notes and 30-year T-bonds – A 30-year T-bond can be separated into 61 strips - 60

semiannual coupons + a single face value payment

• STRIPS are effectively zero coupon bonds (zeroes).

• The Yield to maturity (YTM) of a STRIP is the interest rates (or return) the investors will receive if the STRIP is held until maturity.

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Inflation-Indexed Treasury Securities

• In recent years, the U.S. Treasury has issued securities that guarantee a fixed rate of return in excess of realized inflation rates.

• These securities are referred to as TIPS (for Treasury Inflation-Protected Securities).

• These inflation-indexed U.S. Treasury securities:– Pay a fixed coupon rate on their current principal, and – Adjust their principal semiannually according to the most recent

inflation rate

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U.S. Treasury, General Auction Pattern

• The Federal Reserve Bank conducts regularly scheduled auctions for T-bills, notes, and bonds.

• 4-week, 13-week, and 26-week T-bills are auctioned weekly.

• 2-year T-notes are auctioned monthly.

• 5-year and 10-year T-note auctions occur about four times per year for each maturity.

• The U.S. Treasury posts auction FAQs, results, and other details at: www.treasurydirect.gov

• You can also buy treasuries directly from this website.

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U.S. Treasury Auctions, Details

• At each Treasury auction, the Federal Reserve accepts sealed bids of two types.

Competitive bids specify a bid price/yield and a bid quantity. Such bids can only be submitted by Treasury securities dealers.

Noncompetitive bids specify only a bid quantity, and may be submitted by individual investors.

• The price and yield of the issue is determined by the results of the competitive auction process.

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U.S. Treasury Auctions, More Details

• All noncompetitive bids are accepted automatically and are subtracted from the total issue amount.

• Then, a stop-out bid is determined. This is the price at which all competitive bids are sufficient to finance the remaining amount.

• Since 1998, all U.S. Treasury auctions have been single-price auctions in which all accepted bids pay the stop-out bid.

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U.S. Savings Bonds

• The U.S. Treasury offers an investment opportunity for individual investors by issuing two types of Savings Bonds:

• Series EE Savings Bonds:– Have face value denominations ranging from $50 to $10,000,– The paper version is sold at exactly half the face value, the

electronic version is sold at face value.

– Treasury guarantees the paper EE bond will double in value in no more than twenty years.

• Fixed interest rate (known at time of purchase)• Earn interest for up to thirty years• Accrue interest semiannually• Must be held at least one year• 3-month interest penalty if held for less than 5 years

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U.S. Savings Bonds

• Series I Savings Bonds:– Have face value denominations ranging from $50 to $10,000.– Are sold at face value.– Earn interest for up to thirty years– Accrue interest semiannually (the interest rate is set at a fixed

rate plus the recent inflation rate), and– Can be redeemed after 12 months– At redemption, the investor receives the original price plus

interest earned– But, investors redeeming Series I bonds within the first 5 years of

purchase incur a three-month earnings penalty

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Federal Government Agency Securities

• Most U.S. government agencies consolidate their borrowing through the Federal Financing Bank, which obtains funds directly from the U.S. Treasury.

• However, several federal agencies are authorized to issue securities directly to the public. Examples include:– The Resolution Trust Funding Corporation– The World Bank– The Tennessee Valley Authority

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Federal Government Agency Securities

• Bonds issued by U.S. government agencies share an almost equal credit quality with U.S. Treasury issues.

• They are attractive in that they offer higher yields than comparable U.S. Treasury securities.

• However, the market for agency debt is less active than the market for U.S. Treasury debt. – Compared to T-bonds, agency bonds have a wider bid-ask

spread.

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Municipal Bonds

• Municipal notes and bonds, or munis, are intermediate- to long-term interest-bearing obligations of state and local governments, or agencies of those governments.

• Because their coupon interest is usually exempt from federal income tax, the market for municipal debt is commonly called the tax-exempt market.

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Municipal Bonds

• The federal income tax exemption makes municipal bonds attractive to investors in the highest income tax brackets.

• However, yields on municipal debt are less than yields on corporate debt with similar features and credit quality.

• The risk of default is also real despite their usually-high credit ratings.

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Municipal Bond Features

• Municipal bonds:– Are typically callable.– Pay semiannual coupons.– Have a par value denomination of $5,000.– Have prices that are stated as a percentage of par value (though

municipal bond dealers commonly use yield quotes in their trading procedures).

– Are commonly issued with a serial maturity structure (hence the term serial bonds, versus term bonds).

– May be putable, or have variable interest rates, or both (variable-rate demand obligation, VRDO), and

– May be strippable (hence creating muni-strips).

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Types of Municipal Bonds

• Bonds issued by a municipality that are secured by the full faith and credit (general taxing powers) of the issuer are known as general obligation bonds (GOs).

• Municipal bonds secured by revenues collected from a specific project or projects are called revenue bonds.– Example: Airport and seaport development bonds that are

secured by user fees and lease revenues.

• Hybrid bonds are municipal bonds secured by project revenues with some form of general obligation credit guarantees.– A common form of hybrid is the moral obligation bond.

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Equivalent Taxable Yield• Suppose you are trying to decide whether to buy:

– A corporate bond paying annual coupon interest of 8%, or

– A municipal bond paying annual coupon interest of 5%

• How do you decide?– If the purchase was for a tax-exempt retirement account, the corporate

bond is preferred because the coupon is higher.

– But, if the purchase is not tax-exempt, the decision should be made on an after-tax basis.

– That is, you must calculate an equivalent taxable yield or

you must calculate an aftertax yield

Rate)Tax Marginal - (1 YieldTaxable ieldAftertax y

RateTax Marginal - 1

YieldExemptTax YieldTaxable Equivalent

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Readings

• All of chapter 18 (except 18.7 and 18.8) and 19 (except T bond and note prices and 19.7, 19.8).