Chapter Eleven

1
Chapter Eleven

• Bond and Fixed Income Fundamentals

2
Basic Terms

• A bond (typically) pays a fixed payment (coupon)
  every six months until maturity and then returns
  the par value upon maturity.
• Call Provisions
• Put Provisions
• Convertible Provisions
• Sinking Fund Provisions
• Secured Debt
• Debenture Debt
• Junior vs Senior Debt and the Order of Payments

3
US Government Securities

• Treasury Bills
• 4 week, 13 week, and 26 week
• Treasury Notes
• 2 year, 3 year, 5 year, 10 year
• Treasury Bonds
• Treasury Strips
• Treasury Inflation Protected Securities (TIPS)
• 5 year, 10 year, 20 year
• Interest on Treasury Securities is free from
  state taxation.

4
Agency Securities

• Bonds issued by agencies of the Federal
  Government
• Low Default Risk Small Spread to Treasury Sec.
• Fannie Mae
• Federal National Mortgage Association
• Issues bonds to purchase residential mortgages.
• Freddie Mac
• Federal Home Loan Mortgage Association
• Issues bonds to purchase conventional mortgages
• Ginnie Mae
• Government National Mortgage Association
• Issues bonds to purchase mortgages insured by the
  VHA and FHA

5
Municipal Securities

• Municipal Bonds are bonds issued by state and
  local governments
• Interest on Municipal Bonds is (usually) free
  from federal income taxes
• Interest on Municipal Bonds is (usually) free
  from state income taxes in the state that issued
  the bonds.
• Taxable equivalent yield
• Capital Gains on Municipal Bonds are not free
  from taxation.
• General Obligation Bonds are bonds backed by the
  taxing power of the municipality.
• Revenue Bonds are bonds backed by the revenues
  from the project being financed.
• Some Municipal Bonds are guaranteed by third
  parties.
• Municipal Bonds tend to be relatively illiquid.

6
Corporate Bonds

• Corporate bonds have many different
  characteristics that may vary dramatically from
  one bond to the next
• Credit Risk
• Bond Ratings (See Handout)
• Liquidity
• Special Provisions
• Convertible
• Callable

7
Reading Bond Quotes

• See Handout

8
Homework

• Q 4, 6 9, 11 12
• What are some advantages/disadvantages of
  investing in a junk bond?
• Why might the spread between yields on junk bonds
  vs Treasury bonds narrow when the economy is
  doing well and increase when the economy is doing
  poorly?
• What are the tax implications for Treasury bonds,
  municipal bonds, and corporate bonds?
• I can earn 3.5 on a AA-rated municipal bond
  issued by my home state. My federal tax rate is
  27 and my state tax rate is 6. What rate of
  return must I earn on an AA-rated corporate bond
  in order to better off with the corporate bond?
• A ten-year AA-rated corporate bond is yielding
  6.5 while a ten-year A-rated corporate bond is
  yielding 5.4. Explain how this could happen?
• Price Quotation Handout