Corporate Bonds / Government Bonds

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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 bonds 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 creditors claim on the corporation Represents an ownership claim on the corporation
Promised cash flows (coupons and principal) are stated in advance Amount and timing of dividends may change at 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 firms 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 issuers 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 firms 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 issuers
  financial condition.
• The best known rating agencies in the U.S. are
  Moodys 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 bonds 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

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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).