THE BOND MARKET

A Deeper Understanding of a Major Economic Market

Emma Ricci

WHAT IS A BOND?

• A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer.

• Bonds issued by corporations or the US government are usually taxable

• Bonds issued by state governments or municipalities are usually exempt from tax

Components

• The issuer, similar to a holder of an option

• Principal amount

• Specified interest rate; paid to the bond’s holder yearly (also known as the coupon)

• Date of maturity

Variables that Effect Value

• Maturity

• Redemption Features

• Credit Quality

• Interest Rate

• Price

• Yield

• Tax Status

MATURITY

1.Short-term notes: maturities of up to 4 years;

2.Medium-term notes/bonds: maturities of five to 12 years;

3.Long-term bonds: maturities of 12 or more years.

REDEMPTION FEATURES

• Bond with a redemption provision usually have higher return to compensate for the risk that the bonds might be called early. CALL Option: provisions that allow or require

the issuer to repay the investors’ principal at a specified date before maturity.

PUT Option: option of requiring the issuer to repurchase the bonds, at a specified time, prior to maturity.

CREDIT RATINGS

• Each of the agencies assigns its ratings based on an in-depth analysis of the issuer's financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond.

Credit Risk Moody's Standard and

Poor's Fitch

Prime Aaa AAA AAA

Excellent Aa AA AA

Upper Medium A A A

Lower Medium Baa BBB BBB

Speculative Ba BB BB

Very Speculative B, Caa B, CCC, CC B, CCC, CC, C

Default Ca, C D DDD, DD, D

Credit Ratings

INTEREST RATES

• FIXED: Stays same until maturity; ie: buy a $1000 bond with 8% fixed interest rate and you will receive $80 every year until maturity and at maturity you will receive the $1000 back.

• FLOATING: adjustable to prevailing market rates.

• PAYABLE AT MATURITY: receive no payments until maturity and at that time you receive principal plus the total interest earned compounded semi-annually at the initial interest rate.

PRICE

• The amount you pay for the bond• Newly issued bonds will pay close to their face-

value

• Traded bonds fluctuate in response to changing interest rates

• Bonds traded higher than their face-value are said to be sold at a premium

• Bonds traded lower than their face-value are said to be be sold at discount

YIELD

• Yield is the return you actually earn on the bond--based on the price you paid and the interest payment you receive

Two Types of Yields:Current Yield: annual return on the dollar

amount paid for the bond and is derived by dividing the bond's interest payment by its purchase price

Yield To Maturity: total return you will receive by holding the bond until it matures or is called.

YIELD cont’d

• From the time a bond is originally issued until the day it matures, its price in the marketplace will fluctuate according to changes in market conditions or credit quality. The constant fluctuation in price is true of individual bonds-and true of the entire bond market-with every change in the level of interest rates typically having an immediate, and predictable, effect on the prices of bonds.

YIELD (Linking price and yield)

• Most important thing to remember!!!!

**When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues

**When prevailing prices fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues.

YIELD (Linking interest rate and maturity)

• The longer it takes for a bond to mature, the greater the risk that prices will fluctuate along the way

• By watching a yield curve you can gain a sense of where the market perceives interest rates to be headed

TAXABLE STATUS

• Some bonds offer special tax advantages. There is no state or local income tax on the interest from U.S. Treasury bonds, and no

federal income tax on the interest from most municipal bonds, and in many cases no state or local income tax, as well.

INTEREST RATE-INFLATION

• As a general rule: the bond market, and the overall economy, benefit from steady, sustainable growth rates.

• But steep rises in economic growth can lead to inflation, which raises the costs of goods and services for everyone, leads to higher interest rates and erodes a bond's value.

INTEREST RATE-INFLATION

• Interest rates rise due to:• The Federal Reserve trying to slow economic

growth• through market forces acting in anticipation of

interest rate moves

**Since rising interest rates push bond prices down, the bond market tends to react negatively to reports about strong economic growth.

TYPES OF BONDS

Municipal: issued to raise money for schools, hospitals, highways, etc.

Corporate: debt obligations issued by private and public corporations

Zero-Coupon: Bonds with no periodic interest payments (introduced to the marketplace in 1982)

MARKETABLILITY

• How quickly and easily a bond can be bought or sold

• For a bond to have high marketability, there must be a large trading volume as well as a large number of dealers in the security

Bond Market Tables

• Example of Treasury table would look as follows:

RATE MATURITY BID ASK YLD

7 3/4 Feb. 01 105:12 105:14 5.5

5 3/8 Feb. 01 99:26 99:27 5.44

Bond Market Tables

• Example of Tax-exempt ISSUE COUPON MAT PRICE YLD to MAT

GO bonds 5.00 5-15-28 97 1/8 5.19

Public Power 5.00 1-1-28 97 5.2

District

Bond Market Tables

• Example of Corporate Exchange Traded bonds

BONDS Cur Yld Vol. Close Net chg

BosCel 6s38 9.2 22 65 3/8 +1/4

PacBel 65/8s34 6.7 5 991/8 -1/8

BOND BENEFITS

• Some portion of portfolio should be in bonds• High degree of safety with regular, scheduled,

predictable payments