LCASTOL

CHAPTER 17
BOND FUNDAMENTALS
 LCASTOL
LEARNING OBJECTIVES

Learning Objectives
• Explain the basic features of bonds that affect their risk, return and value
• Explain the current country structure of the world bond market, and how has the
makeup of the global bond market changed in recent years
• Enumerate the major components of the world bond market and the
international bond market
• Explain what bond rates are and their purpose as well as the difference between
investment- grade bonds and high-yield (junk) bonds
• Enumerate the characteristics of bonds in the major bond categories such as
governments (including TIPS), agencies, municipalities, and corporates
• Enumerate the important characteristics of corporate bond issues developed in
the United States during the past decade, such as mortgage-backed securities,
other asset-backed securities, zero-coupon and deep discount bonds, high-yield
bonds, and structured notes
• Explain how to read the quotes available for alternative bond categories (eg.
governments, municipalities and corporates)
COMMON FEATURES OF FIXED INCOME SECURITIES
It is an instrument that allow issuers to borrow money from investors. It pays investors interest on certain
payment dates, and the principal on maturity date

MATURITY PAR VALUE COUPON RATE RIGHTS OF A

The coupon rate is the interest
Maturity is the date The amount the issuer
rate that the bondholder will
BONDHOLDER
when the issuer is agrees to at maturity • The right to receive the
obligated to redeem the date. receive. It can either be fixed or
floating, and the frequency can face value of the bond at
bonds, while tenor is the maturity date.
the time left to maturity. differ per issue
• The right to receive
periodic interest
payments, at a specified
percent of the bond’s
face value.
INDENTURE PROVISION • Priority over company
• The indenture is the contract between the issuer and the bondholder specifying the assets upon default &
issuer’s legal requirements liquidation.

SINKING FUND
• A sinking fund is a fund containing money set aside or saved to pay off a debt
or bond SOURCES OFINCOME
NONREFUNDING PROVISION • Coupon interest
• A provision in a bond indenture that stops or limits the issuer from retiring the • Bond price increase
bonds by using proceeds from another issue. It protects bondholders from resulting from interest
having their bonds called rate/credit changes
 MENU OF FIXED-INCOME SECURITIES
ISSUER TENOR
Natl. Government: T-bills, FXTNs Short-term / Money market: T-bills (91,
LGUs: Municipal Bonds 182 & 364 days) and Commercial Paper
Corporations: CPs, Bonds Long-term: Bonds and Notes.
Banks: Tier 2, LTNCDs Century
Supranational: Example: ADB (2005) Perpetual: Example: Ayala & Petron

LEVEL OF RISK COUPON

Senior secured Coupon bonds: Floaters and Fixed
Senior With step-up provision
Junior (Subordinated) Zeroes
MENU OF FIXED-INCOME SECURITIES
BY PURPOSE BY MANNER OF PRINCIPAL
General – working capital, CAPEX, PAYMENT
acquisition, retirement of debt Amortizing
Sustainable purposes – green and Bullet
social (Example: renewable energy,
waste mgmt., clean transportation –
AC, AEV, MWC, BPI, etc.) BY COUNTRYOF ISSUANCE
Eurobond
Yankee, Samurai, Dimsum, etc.

CURRENCY
Locally-denominated EMBEDDED OPTIONS
Foreign Currency Plain vanilla: no options
Hybrid (GPN) Callable: with a call option
Putable: with a put option
 POP-QUIZ

Statement 1: A non-refunding provision protects bondholders from reinvestment risk.

Statement 2: A senior bond has priority claim over the issuer’s assets compared to junior bondholders

a. Only Statement 1 is correct

b. Only Statement 2 is correct
c. Both Statements are correct
d. Both statements are incorrect

Answer: C
 RATES OF RETURNS ON BONDS
The Computations of Bond Return
• Holding period return
Pi, t 1  Int i, t
HPR i, t 
Pi, t
where:
HPRi,t = the holding period return for bond i during period t
Pi,t+1 = the market price of bond i at the end of period t
Pi,t = the market price of bond i at the beginning of period t
Inti,t = the interest payments on bond i during period t
• The holding period yield (HPY) is
HPY = HPR - 1
 FIXED-INCOME SECURITIES VALUATION
Coupon Interest and Cost
COUPON INTEREST Cash Inflows of a Bond
• Coupon payments are made on a periodic basis until the 105
maturity date
• Coupon payments can be paid annually, semi-annually or 5-yr bond with a 10% coupon rate
quarterly paid semi-annually
• Accrued interest is the amount of coupon interest that a
bondholder earns from the last coupon date to the sale
value date 5 5 5 5 5 5 5 5 5
• 30/360 day rule 1 2 3 4 5 6 7 8 9 10

FORMULAS The general formula for calculating the present value of a bond is as
The formula for calculating the coupon interest of a bond is as shown below:
shown below: PVbond = CPN/(1+YTM)1 + CPN/(1+YTM)2 + …
CPN = FV * CR / n + CPN/(1+YTM)N + FV/(1+YTM)N
Where: Where:
CPN = Coupon Payment per period CPN = Coupon Payment per period
CR = Coupon Rate FV = Face Value of the bond at maturity
YTM = Yield to Maturity
n = Number of Coupon periods annually N = Number of Coupon periods until maturity
For example, the calculation of the coupon interest for a 5-year For example, the calculation of the price for a 5-year bond that pays a 5%
bond, with a face value of 100, that pays a 10% coupon semi- coupon annually when the market rate is 6% would be as follows:
annually would be as follows: PVbond = 5(1+6%)1 +5(1+6%)2 +5(1+6%)3 +5(1+6%)4
CPN = FV * CR / n = 100 * 10% / 2 = 5 +105(1+6%)5
= 4.717+4.450+4.198+3.960+78.462=95.788
 GLOBAL BOND MARKET STRUCTURE
• The market for fixed-income securities is
substantially larger than the listed equity
exchanges (NYSE, TSE, LSE) because
corporations tend to issue bonds rather than
common stock
• For United States during 2010, less than 10
percent of all new security issues were
equity, including preferred as well as
common stock
• For the Exhibit 17.1 shows the size of the
global bond market and the distribution
among countries

a
 GLOBAL BOND MARKET STRUCTURE
Types of Investors
• Individual investors
• Retail investors
• High net-worth investors
• Institutional investors
• Life Insurance Companies
• Commercial Banks
• Property and Liability Insurance Companies
• Pension Funds
• Endowment Funds
• Mutual Funds
• Qualified investors (PH SEC) – Institutional investors
& qualified high net-worth individuals
• Two factors influencing institutions
• The tax code applicable to the institution
• The nature of the institution’s liability structure
 GLOBAL BOND MARKET STRUCTURE

Bond Ratings
• Most corporate and municipal bonds are
rated by one or more of the rating agencies
• The exceptions are very small issues and
bonds from certain industries, such as
bank issues. These are known as non-rated
bonds
• The three major rating agencies (Exhibit
17.3)
• Moody’s
• Standard and Poor’s
• Fitch Investors Service

a
 POP-QUIZ

Statement 1: BBB rated bonds are investment grade.

Statement 2: Three of global credit rating agencies are Moody’s, S&P and Fitch

a. Only Statement 1 is correct

b. Only Statement 2 is correct
c. Both Statements are correct
d. Both statements are incorrect

Answer: C
 MUNICIPAL BONDS
Types of Municipal Bonds
• General obligation (GO) bonds
• Backed by the full faith and credit of the issuer
• In the Philippines, backed by Internal Revenue Allotment (IRA)
• Revenue bonds
• Supported and secured by the revenue from a specific project
• Examples: for wet markets, waste management, sports stadiums, etc.
Features
• Interest payments are exempt from federal income tax
• Convert the tax-free yield of a municipal bond selling close to par to an equivalent taxable yield (ETY)
i
ETY 
(1 - T )

where: i = coupon rate of the municipal obligations

T = marginal tax rate of the investor
 MUNICIPAL BONDS
Municipal Bond Insurance
• Bond insured against default risk
• Insurance is irrevocable for the life of the issue
• Four private bond insurance carriers
• Municipal Bond Investors Assurance (MBIA)
• American Municipal Bond Assurance
Corporation (AMBAC)
• Financial Security Assurance
• Financial Guaranty Insurance Company (FGIC)
• LGUGC (Philippines) – under IISD
• Insured bonds obtain AAA (Aaa) ratings
• Issues with private guarantees have more active
secondary market, and lower required yield

a
 CORPORATE BONDS
U.S. Corporate Bond Market
• Mortgage bonds
• Collateral trust bonds
• Equipment trust certificates
• Mortgage pass-through securities
• Collateralized mortgage obligations (CMOs)
• Asset-backed securities (ABS)
• Certificates for automobile receivables (CARs)
• Credit card receivables
• Variable rate notes
• Collateralized debt obligations (CDOs)
• Zero coupon and deep discount bonds
 CORPORATE BONDS
High-Yield Bonds
• Also known as speculative bonds and junk bonds
• Based on a specification that bonds rated below
BBB make up the high-yield market, that is, non-
investment grade bonds
• The high-yield bond market exploded in size and
activity beginning in the early 1980s (Exhibit 17.6)
• Exhibit 17.7 contains the distribution of ratings for
all the bonds contained in the Bank of America
Merrill Lynch High-Yield Bond Index
• Major owners of high-yield bonds have been
mutual funds, insurance companies, and pension
funds

a
 INTERNATIONAL BONDS
• Foreign bonds are sold in one country and currency by a borrower of a different nationality
• Eurobonds are underwritten by international bond syndicates and sold in several national markets
Sample Countries
• United States
• Yankee bonds are U.S. dollar denominated bonds sold in the U.S. but issued by a foreign firm
• Eurodollar bond market affected by changes in value of U.S. dollar
• Japan
• Samuari bonds: Yen denominated issued by non-Japanese firms in Japan
• Euroyen bonds: Yen denominated, sold outside Japan
• United Kingdom
• Bulldog bonds are sterling-denominated bonds issued by non-English firms and sold in London
• Eurosterling bonds are sterling denominated sold in markets outside London by international
syndicates
• Eurozone
• Market popular among foreign issuers including issuers domiciled in the U.S.
• Impressive growth in Eurobonds issued by non-residents
a
 OBTAINING INFORMATION ON BONDS
• Most bond investors rely on rating agencies for
credit analysis
• Bloomberg

Bond Publications
• Wall Street Journal • Moody’s Bond Survey
• Barron’s, • Fitch Rating Register
• Business Week • Fitch Corporate Credit Analysis
• Fortune & Forbes • Fitch Municipal Credit Analysis
• Federal Reserve Bulletin • Investment Dealers Digest
• Survey of Current Business • Credit Markets
• Treasury Bulletin • Duff & Phelps Credit Decisions
• Standard & Poor’s Bond Guide • The Bond Player
• Moody’s Bond Record
 BOND PRICES & QUOTES
PRICE QUOTES YIELD TO CALL / YIELD TO PUT
• Price per hundred • Sometimes a bond has a call or put option. A call
Cost = (Price * Face Value) + Accrued Interest option gives the issuer the right but not the
• Market rate or Yield to Maturity (YTM). The obligation to redeem the bonds at an earlier date,
YTM will be used as a discount rate to get the while a put option gives the the right to ask for
present value of all future cash flows of the payment for the bonds at an earlier date.
fixed-income security • Yield To Call or Yield To Put instead of YTM
• The call/put date will be used instead of the
maturity date in the computation of the cost

PREMIUM OR DISCOUNT
Fixed-income security prices are subject to change based on the movement of the market rate (YTM) and can
result to a gain or loss
• If the YTM < coupon rate then the bond will sell at a premium
• If the YTM > coupon rate then the bond will sell at a discount
• If the YTC/YTP < coupon rate then the bond will sell at a premium
• If the YTC/YTP > coupon rate then the bond will sell at a discount
 INTERPRETING BOND QUOTES
Corporate Bond Quotes
Last Last EST $ VOL
Company (Ticker) Coupon Maturity Price Yield Spread UST (000’s)
Ford (F) 7.45 July 16, 2031 80.625 9.461 503 30 213,645

Explanations
• Issued by Ford Motor Company with a coupon of 7.45%
• Maturity is July 16, 2031
• The last transaction price was 80.625 percent of par or $806.25, implying an yield to maturity (YTM)
of 9.461%
• The computed yield spread for the Ford bond is 503 basis points (5.03%), in comparison with the
prevailing yield for a U.S. treasury issue with a maturity of 30 years

a
 INTERPRETING BOND QUOTES
Bloomberg Bond Quotes
Explanations
• Issued by the government of Canada
• Coupon is 1.5% • Bid price is 104.422 / Asking price is 104.470
• Last traded YTM is 1.017%
• Maturity is June 2026

a
 INTERPRETING BOND QUOTES

Municipal Bond Quotes

No. of Bonds Special Price/
Offered Municipal Issuer Characteristics Coupon Maturity YTM Broker
150 INDIANA ST TOLL RD M/S/F 11 9.000 01/01/15EST 6.30 DRIZOS
COMMN TOLL
Explanations
• $150,000 Indiana State Toll Road bonds with 9% coupon
• M/S/F: Mandatory sinking fund, effective in 2011
• The maturity is 2015
• EST: Sinking fund is put into escrow until maturity
• The yield to maturity is given as 6.3%

a
 INTERPRETING BOND QUOTES
Philippine Bonds
Treasury Bills
• Pure discount instrument: There is no coupon and they pay par at maturity
• The bid-ask quotes are not the prices but rather discount rates from the par

a
 TREASURY STRIPS
U.S. Treasury Strips
• Treasury STRIPS are bonds that are sold at a discount to
their face value
• The investor does not receive interest payments but is
repaid the full face value when the bonds mature. That is,
they mature "at par."
• STRIPS is an acronym for Separate Trading of
Registered Interest and Principal of Securities. These
types of bonds are generally known as zero-coupon
bonds since they pay no interest or coupon.
• The coupons are sold as separate investments
Treasury Strips Bond Quotes
• “ci” = the coupon interest portion stripped from the
note
• “np” = the principal payment for the treasury note
 TREASURY INFLATION PROTECTED SECURITIES (TIPS)

U.S. TIPS
• Treasury Inflation-Protected Securities (TIPS) are a type of Treasury bond that is indexed to an inflationary
gauge to protect investors from a decline in the purchasing power of their money.
• The principal value of TIPS rises as inflation rises, while the interest payment varies with the adjusted principal
value of the bond.
• The principal amount is protected since investors will never receive less than the originally invested principal.