Bond Fundamentals

Bond Fundamentals

Basic Features of a Bond

Public bonds: long-term, fixed obligation debt sold to individuals and financial institutions. A bond is an agreement to pay a fixed amount of interest (usually semi-annually) and a fixed amount of principal at maturity. Par value is typically $1,000. The public debt market is typically divided in short-term (money market), intermediate term (notes w/ 1 to 10 years to maturity) and long-term (bonds w/ over 10 years to maturity). As time passes, bonds move from long to intermediate to short-term. (called public because they are sold to the public rather than channeled to a specific lender.)

Also have money market debt instruments (maturity of 1 year or less), notes (maturity of 1 to 10 years), and bonds (maturity greater than 10 years).

Bond Characteristics

Intrinsic Characteristics:

term to maturity: single maturity date

serial obligation: series of maturity dates (i.e., an issue with 30 years may retire 1/5 every 6 years. Munis are like this a lot.

principal, par value: original principal value of obligation (i.e., $1,000 or $5,000)

bearer bond or registered issues

bearer: the holder is entitled to bond, so issue doesn’t keep records of transfers in ownership--coupons are clipped and sent in to receive interest (can bring coupon in to local bank to do this). Bearer bonds can be changed to registered bonds.

registered: issuer keeps record and send interest payment via check. Bearer bonds were once universal, however they have gradually been giving way to registered bonds, some of which pay interest through electronic transfers. Some bearer bonds may be changed to registered bonds and are called interchangeable bonds. A bond can be registered for principal but not for interest.

Types of Issues

senior: secured, backed by legal claim on specified property;

junior (unsecured): backed only by the promise of the issue;

debentures (backed only by the integrity of the borrower)

subordinated debentures (claim is subordinated to other debentures)

Income issues (are the most junior type of bond because interest on them is paid only if the firm earns enough to pay it--very popular in munis where they are called revenue bonds)

Studies have found that the TYPE OF ISSUE only becomes important as the bond approaches default (because that’s when collateral really matters). It is basically the credibility of the issuer that determines bond quality. However, collateral and security characteristics do affect bond quality ratings.

Indenture Provisions: contract between issuer and bondholders specifying the legal requirements. A trustee typically handles making sure the issuing company follows the requirements. The Trustee Act of 1939 requires firms file updates with the SEC to establish that indenture provisions are being met. Bondholder get semi-annual financial reports.

Features Affecting a Bond’s Maturity:

Freely callable bonds: the issuers can retire the bond at any time with a typical notification of 30 to 60 days. [Used to force conversion.] This is a negative feature. A bond selling at (par + one interest payment) faces the risk of being called.

Noncallable: issue cannot be retired prior to its maturity date.

Deferred call feature: it can be called only after a certain length of time has passed (i.e., 5 to 10 years). Then the issue becomes fully callable.

Non-Refunding provision: says the bond can be called and prematurely retired for any reason other than refunding. [However, firms can retire bonds if they do so with cash & don’t refund, per se.]

Sinking fund feature: (specifies how the bond will be amortized over its life) will have a call feature attached so that they can be called in to retire them. SF provision is an obligation that must be carried out regardless of market conditions—most bonds are retired through direct negotiation with institutional holders.

Bond Rates of Return:

Since the 1960s there has been a good bit of price volatility and therefore capital gains/losses have really affected the rate of return on bonds.

OVERVIEW OF THE GLOBAL BOND MARKET SYSTEM

Fixed income securities dominate common stock partly because companies tend to issue bonds with a fixed life rather than common stock (which lasts forever). In 1987 there were about $246 billion in new corporate securities issued. Only $71 billion was equity (C/S & P/S). This is due to several reasons:

Debt is cheaper than stock as a source of capital. Also companies tend to use R/E as equity rather than C/S.

Corporations only issue C/S--the government (both Federal and state and munis) cannot issue C/S, but they can issue debt.

There are some tables on page 348-349 that show which countries had what portion of world debt. Just remember that this book is ‘relatively’ old and the 80s was the decade of credit. Things could have changed a good bit since 1987. [Actually, according to the 1994 edition, the U.S. has dropped slightly along with Japan along with a slight increase in almost all the rest of the countries.]

The Participants (Issuers)

federal governments (i.e., U.S. Treasury) (In 1991 had about 28% of total U.S. bonds outstanding)

government agencies: these securities are issued under the authority of an act of Congress and the proceeds are used to finance many legislative programs. Although the government itself odes not directly issue the bonds, they effectively represent the full faith and credit of the U.S. Treasury (In 1991 had about 23.3% of total U.S. bonds outstanding). Federal governments and government agencies make up approximately 55% of outstanding U.S. bonds.

municipalities: issues by states, school districts, cities, etc. If you purchase a bond issued by a municipality, it interest income is not taxed at the federal level. For the most part, if the purchaser lives in the state where the bond is issued, the issue is not taxed at the state/local level either. (In 1991 munis had about 13.3% of total U.S. bonds outstanding)

corporation: the importance of this sector varies greatly among countries. In the U.S. the % of bonds issued by corporations has gone from 17.6% in 1984 to 12% in 1987 to 26.2% in 1991. There are commonly four major subgroups that corporate issues are divided into:

industrials

public utilities (least risky)

transportation (most risky)

financial

International: consists of both foreign bonds and Eurobonds. This market is growing.

Participating Investors (Investors)

Institutional investors make up 90-95% of the trading because of the high minimum denominations. Institutions have a major impact on the behavior of market yields because they can acquire numerous amounts of a single issue. However, different segments are more institutionalized than others. For instance, the agency market is heavily institutionalized (because the minimum investment is $10,000 to $100,000). The corporate sector is less so. Examples of investors: life insurance companies, commercial banks, pension funds, mutual funds. Which type each institutional tends to buy depends+ on the (1) tax code applied to the institution and (2) the nature of the liability that the institution assumes in relation to its depositors/ clients. For instance, commercial banks tend to buy short to intermediate term bonds because their depositors are relatively short term. Private and government pension funds invest heavily in corporate and agencies bonds. Mutual funds (fixed income MFs) invest across the board as they develop bond funds that meet the needs of individual investors. Also, commercial banks are regulated as to different rating types -- they must choose investment-grade bonds (rate higher than a double BB or Ba).

Investment/Trading Opportunities: The bond market is primarily a primary market--not as much trading in securities market as with common stock. Therefore, before investing in a bond, you should check its trading volume. Some are traded on the NYSE quite often, others quite rarely. Poor liquidity makes transaction costs higher.

Bond Ratings: There are four major rating agencies:

Duff and Phelps
Fitch Investors Service
Moody’s Investors Service, Inc. (popular)
Standard & Poor’s (popular)

Generally all four services agree but if they don’t a "split rating’ occurs. Various studies find that the rating tended to vary directly with profitability, size, cash flow coverage, and inversely with financial leverage, and earnings instability. Other studies find that ratings definitely affect the marketability and effective interest rate.

Seasoned issues are regularly reviewed to ensure that the assigned rating is still valid. If not, revisions are made (either upward or downward) usually only by one rating grade. [However, process could take up to 18 months before bond issue was ‘cycled’ through again.]

Since many people, including mutual fund managers examine bond ratings, the following is a brief summary of the types of questions bond rating agencies are trying to answer when rating a company’s bond.

Primary question: Can the firm service its debt in a timely manner?

Three main areas are examined:

Bond indenture provisions: Is future debt going to be subordinated? Is a sinking fund going to be established? How are the bonds collateralized? Is there a call provision?
Company’s financial resources: How much cash and working capital does the company have? How capable is the firm of riding out a recession without defaulting on interest or sinking fund payments? Will the firm have to finance future improvements with future borrowing? Has the firm’s cash resources been recently depleted? What about current outstanding debt? Does the firm frequently have to borrow from the bank? How much is the firm paying in dividends? If DPR is too high, rating agency may think firm isn’t "saving for a rainy day."
Future earning power (measures firm’s ability to make future interest and sinking fund payments). Examine, not only firm’s, but industry’s life cycle and the current stage of the industry in life cycle. Firms in mature industry are considered riskier. Also, examine demand for firm’s product. Has the firm been increasing its market share, sales and earnings? Company management is questioned about their future vision for the firm. Where does management see firm in next 12 months, next 5 years? Also try to analyze management’s philosophy, experience, maturity, capability and depth. Examine management turnover rates. Does management promote from within? How much does the firm spend on R&D? Does the firm conduct internal audits? If so, it is considered less risky because it is paying closer attention to the "goings on" within the firm.

Where do bond rating agencies get information?

Mostly from published reports (annual and quarterly reports and bond registration statement filed with SEC). Examine current and historical statements.
Talk with firm’s competitors and review trade journals for articles about firm and possible innovations. Want to try and get an unbiased view of firm.
"Interviews" company management. Much of the process is spent interviewing management. One agency said if they relied solely on financial figures, the entire rating process would only take 10 minutes.

Market Rates of Return: There is approximately a 90% correlation between the rates of return on various bonds--in other words, "various market segments tend to move together."

Prior to mid-1960s Interest Rates were less volatile. However, nowadays an aggressive manager could receive good capital gains in the bond market. "This increased volatility also increased the risk in bond portfolio management."

Bond Investment Risks (added a few not listed in book):

Interest rate risk: risk that interest rates will change and affect price of bond

Default risk (same as business risk): failure to pay specified interest payments or principal at specified time.

purchasing power risk: risk that you will lose the purchasing power of the $ (same as inflation risk).

Reinvestment rate risk: risk that interest rates will change and affect the rate that you earn on the reinvestment of your interest receipts.

marketability risk: liquidity of investment and ease of getting rid of it

maturity risk: longer term bonds are affected more by interest rate changes than short-term bonds.

exchange rate risk: if you buy bonds denominated in other currency than your own

event risk: firm may experience an event (either + or -) that can affect price of bond.

Call risk: bond may be called prior to maturity.

Alternative Bond Issues

Domestic Government Bonds

United States: Treasury obligations are very popular because of high quality (little or no risk of default), substantial liquidity and those issued since 1989 are noncallable. Short-term T-bills are sold at a discount, whereas notes and bonds have a semiannual coupon payment. Unusual features of government notes and bonds: deferred call feature is very long and relative to the maturity date rather than the issue date, also ALL issues since 1989 are noncallable.

Government Agency Issues

United States: Issued by various political subdivisions, such as Federal Home Loan Bank, Federal National Mortgage Association Discount Notes, Government National Mortgage Association. Pay interest semiannually. While not direct issues of the U.S. Treasury, are backed by U.S. government. GNMA: bondholders receive month payments of principal and interest, because the agency "passes through" mortgage payments made by the original borrower to Ginnie Mae. The portion of the cash flow to the bondholder that represents principal repayment is tax-free, but the interest portion is taxable. Even though new issues have a maturity of 25-30 years, the average life is only 12 years because: mortgagees refund when interest rates drop, people sell their houses and pay off their mortgage with proceeds. Thus, GNMA bonds’ maturities are very uncertain. Rates of return are relatively attractive, plus most of the return is tax-free in later years because most of the payment represents principal. BHs monthly payment (interest received) can vary depending on whether investors prepay on mortgage.

Municipal Bonds

Municipal bonds are issued by states, counties, cities, etc. Munis are tax exempt from both federal taxes and taxes in the locality and state in which the obligation was issued. Munis attractiveness vary with the investor’s tax bracket. You can convert the tax-free yield of a muni to an equivalent taxable yield by:

equivalent taxable yield = coupon rate of muni/(1 - investor’s marginal tax rate)

Although the interest payment on munis is tax-free, any capital gains are not, which is why the above formula only works if the muni is selling close to par.

Two different types of munis:

General Obligation bonds (GOs) are backed by full faith and credit of the issuer and its entire taxing power; and
Revenue bonds are serviced by the income generated from specific revenue-producing projects of the municipality. These bonds generally provide higher returns because they have a higher default risk.

Municipal bond guarantees: provide that a bond insurance company guarantees to make prin and interest payments if the issuer defaults. The guarantees are irrevocable over the life of the bond. The issuer purchases the insurance for the benefit of the investor; thus the issuer gets to pay a lower rate because the bond is less risky to the investor. In 1994 approximately 30% of all new munis were insured. To qualify for private bond insurance, the issue must initially carry a rating of BBB or better. This is great for smaller municipalities because they can get a good rate.

Corporate Bonds:

Utilities dominate the corporate U.S. market. Industrials are next (this includes mining firms, retails, etc.) then rail, /transport and financials. Mostly everything is similar except the type of collateral offered. Maturities range from 25 to 40 years. Almost all have deferred call provisions. Corporate notes are typically non-callable. Maturities range from 25 to 40 years--utilities generally lie in the 25-30 year range. Most bonds have deferred call features after 5 to 10 years. The deferment period depends on the level of interest rates at the time of the bond issue. If interest rates are high, the deferment period is usually longer 7-10 years, whereas when interest rates are lower, the deferment period is shorter. [Pamela, this goes against what you might think--why is that???? I don’t know. The only thing I can think of is that the shorter the deferment period, the riskier the bond to the investor, so if interest rates are already high, an issuer doesn’t want to tack on a short deferment period because the yield will have to be even higher during a period of high interest rates.]

Types of corporate bonds:

mortgage bonds: bondholder is granted a first-mortgage lien on some piece of property. Provides security to the lender.

Collateral trust bonds: borrower pledges stocks, bonds, or notes as collateral rather than fixed assets or property.

Equityment trust certificates: issued by railroads, airlines and other transportation firms with the proceeds used to purchase equipment that serves as collateral for the debt.

Collateralized mortgage obligations: rather than a regular mortgage bond backed by pools of mortgages that could be paid off early, etc., CMOs have a sequential distribution process that creates a series of bonds with varying maturities to appeal to a wider range of investors. A CMO issue is broken into classes (A, B, C, D, etc. [some have up to 20 classes]) and the cash flows received from the underlying mortgages are applied first to pay interest on the first three classes of bonds. The bonds are retired sequentially. All principal payments are directed first to the shortest-maturity class A bonds until they are completely retired, and so on. CMOs generally have very high ratings because they typically are overcollateralized. They are purposefully structured to ensure that the underlying mortgages will always general enough cash to support the bonds issued.

Other asset-backed securities such as certificates for automobile receivables (CARs), which are essentially bonds issued by financial institutions which are backed by the loans made by individuals to finance the purchase of cars. Investors receive monthly payments typically and actual maturity could be less than stated maturity.

Variable rate notes: interest rate paid fluctuates in tune with market rates. Popular during periods of high interest rates (issuer wants to capitalize on a drop in interest rates). The rate is usually fixed for a certain time frame (say the first 6 to 18 months) and then fluctuates with some standard.

Zero coupon and deep discount bonds: no interim interest payments are made, or the coupon rate is set substantially below the market rate.

High-yield bonds: AKA speculative grade or junk bonds. Corporate bonds that have been assigned a bond rating by the rating agencies that is below BBB (or Baa). Since 1980 the structure of junk bonds has changed. Before 1980, junk bonds were usually fallen angels; however, since 1980 junk bonds have been issued by small firms, relatively new firms, and those firms issuing bonds for a leveraged buy-out. This structure change occured in part because Drexel Burnham Lambert began aggressively underwriting junk bonds. Of all the high-yield bonds sold since 1978, about 94% were sold since 1983. Major owners of junk bonds are mutual funds (about 100 funds invest only in junk bonds or include them in their portfolio).

OBTAINING INFORMATION ON BONDS

Less need for fundamental analysis because many bondholders rely on the credit ratings by Moody’s, etc. Some large investors may have their own ‘In-house’ analysts (to uncover marginal return opportunities, or to confirm ratings by agency).

Several private research firms have been formed to independently appraise bonds. They look at information on:

risk of default
info on market/economic conditions
info on intrinsic bond features (call premiums, sinking funds, etc.)

Utilize such sources as:

Moody’s Bond Record
S&P Bond Guide
Fitch Rating Register
Fitch Corporate Credit Analysis
The Bond Buyer

Sources of Bond Quotes

To obtain current market information (quotes and prices). Some (albeit limited) info in available in the WSJ (but only for some corps, some munis and all treasuries that are publicly traded).

Interpreting Bond Quotes

Either quotes on basis of yield or price. Price: 98½ is 98.5% of par. So if par is= $1,000 then price is= $985.00 If par=$5,000 then price = $4,925.00. Three systems for different types of bonds:

Corporate bond quotes:

ATT	7 1/8	03	8.9	30	79 7/8
Company	Coupon Rate	Maturity Date	Current Yield*	Volume	Close

* Coupon PMT/Market price = 71.25/798.75 = 8.92%

Other things to note:

zr=zero coupon bonds
f = flat (not meeting interest payments)
vj=firm in bankruptcy
cv=convertible
dc=deep discount

All of the quotes ignore any interest that has accrued since the last interest payment date. The prices pertain to principal only.

The actual price will exceed the quotes because you will have to pay accrued interest. For example:

if CR=7 1/8 or 7.125% and 2 months have passed since PMT (pays semi-annually) and the quoted price was 79 7/8 (or 79.875% or $798.75). Then you would have to pay for 2 months of accrued interest: 7.125*1000 par = $71.25 / 2 = $35.625 * (2 / 6) = $11.875.

or:

Interest = 7.125 x 1000 = 71.25 a year / 12 months = 5.9375 a month x 2 months = $11.875

So, you would pay 11.875+798.75=810.625