BOND PRINCIPLES

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 27

BOND FUNDAMENTALS

BOND PRINCIPLES:

Special conventions are used to identify and to classify bonds.

1. Identification of Bonds:

We identify a bond by citing the issuer, the bond's coupon, and its maturity. The coupon

rate is the fixed interest rate that is the basis for the quantity of dollars the bond pays. For

instance, an investor might instruct a broker to buy 5 of the "Hertz sevens of 03." This order

calls for a purchase of $5,000 face value of the Hertz bonds carrying a 7% stated interest

rate and a maturity in the year 2003. The face value of a bond is also called its par value.

The 7% coupon rate, coupled with the $5,000 par value, means an investor would receive

$350 per year from this investment. In the financial press, this bond is listed as Hertz 7s03.

The s does not stand for anything, but is pronounced when the bond is identified, Hertz

might issue another bond paying 81/2% per year and maturing in 2010. These would be the

"eight and one-halves of ten": Hertz 81/2s l0.

Bonds are identified by issuer, coupon, and maturity.

2. Classification of Bonds:

A legal document called the indenture contains the details of a bond issue. This pamphlet

describes the terms of the loan, to include the issuer, security for the loan, and the term of

repayment.

Issuer:

One method of classifying bonds is by the nature of the organization selling the bond.

Corporations; federal, state, and local governments; government agencies; and foreign

corporations and governments all issue bonds. (A bond sold by a state or local government

is a municipal security.) These broader groups are divided into subcategories.

Security:

The security of a bond refers to the collateral that backs the bond.

Unsecured Debt:

All debt of the U.S. Treasury department is secured by the ability of the federal government

to make principal and interest payments from general tax revenues. No specific assets are

ever listed as collateral for federal debt.

State and local governments can also issue debt without specific assets pledged against it.

These are full faith and credit issues or general obligation bonds. Like obligations of the

federal government, these bonds are backed by the taxing power of the issuer.

Financially sound corporations frequently issue debentures, which are really just signature

loans backed by the good name of the company. If a company subsequently issues a second

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unsecured bond, it would be a subordinated debenture. These bonds have a claim on the

company's assets after those of the original debenture holders.

Secured Debt:

There are a great many ways in which companies provide security for a risky debt issue. A

municipal bond might be a revenue bond used to finance a turnpike or a bridge across a

river, with user fees being the principal source of debt repayment. An assessment bond is

typically used to pay for a project that benefits a specific group of people. The installation

of streetlights in a residential area is an example. People who directly and routinely

benefited from this improvement would be assessed a higher property tax.

Corporate secured debt comes in many forms. A mortgage is a well-known security using

land and buildings as collateral. Mortgages are especially popular with public utilities. Their

power lines, poles, and the land on which they sit frequently back a debt issue. Other

securities such as investment assets or the stock of a subsidiary back a collateral trust bond.

An equipment trust certificate provides physical assets such as a fleet of trucks as collateral

for the loan. Airlines frequently use these to finance the purchase of new airplanes; railroads

use them to finance boxcars. In each case the collateral may be easily transported to a new

purchaser if the bondholder wishes to liquidate the collateral in the aftermath of a

bankruptcy.

Term:

Another common debt classification is by term, or the original life of the security. Short-

term securities are those with an initial life of less than one year. U.S. Treasury bills are a

good example. Intermediate-term securities like U.S. Treasury notes have lives ranging

from two years to ten years. A long-term security (such as a U.S. Treasury bond) has a

maturity greater than ten years. Table 4-2 provides some details on the characteristics of

Treasury securities.

Loan arrangements may also be open-ended, as with a corporate line of credit at a

commercial bank or a private citizen's home equity loan. These loans, however, are seldom

readily marketable and usually cannot be resold to another lender.

Some bonds are part of a larger debt obligation known as a serial bond. Such a bond issue

has a series of maturity dates for specific portions of the debt rather than one single date for

the entire issue.

3. Terms of Repayment:

A potential bond investor is interested in knowing the structure of the cash flows promised

in the bond indenture. Several repayment patterns are common.

Interest Only:

Most marketable debt is structured such that the periodic payments are entirely interest. The

principal amount of the loan is repaid in its entirety at maturity.

Sinking Fund:

In some circumstances lenders may require that the borrower provide for the eventual

retirement of the debt by setting aside a portion of the debt principal each year. Such a fund

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is called a sinking fund. For instance, a $10-million, 20-year debt issue might provide that

after five years, the borrower must deposit $1 million into a special escrow account and

another $1 million every third year to partially offset the eventual burden of debt repayment.

Alternatively, the indenture might provide that after a period of time the borrower must

retire a certain number of the bonds each year. This format means that a portion of the debt

must be paid off early according to a schedule outlined in the bond indenture.

Balloon Loan:

A balloon loan may involve a partial amortization of the debt with each payment, but with

the bulk of the principal due at the end of the loan term. Frequently all of the principal is

due at the end of a balloon loan. These bonds are rarely found in marketable form; they are

most often used in commercial banking.

Income Bond:

The key characteristic of an income bond is that the interest is payable only if it is earned.

An income bond might be used to finance some type of income-producing property such as

a parking garage. If the facility is unprofitable in the first few years, the interest does not

have to be paid. It may or may not accumulate depending on the specifications of the bond

indenture. Income bonds are a relic from a bygone age and are no longer common.

4. Bond Cash Flows:

Relative to other types of securities, bonds produce cash flows that an analyst can predict

with a high degree of accuracy. The cash flow patterns fall into four categories: annuities,

zero coupon bonds, variable rate bonds, and consols.

Annuities:

Most bonds are annuities plus an ultimate repayment of principal. An annuity promises

payments of a fixed amount on a regular periodic schedule for a finite length of time. In the

United States and Japan, virtually all bonds pay interest twice per year. In Europe, the

tradition is to pay interest once annually.

Zero Coupon:

A zero coupon bond has a specific maturity date when it returns the bond principal, but it

pays no periodic income. In other words, the bond has only a single cash inflow the par

value returned at maturity. An investor might pay $450 for a bond that promises to return

$1,000 in 7.5 years. The investor's return comes from the $550 increase in value over the

seven-and-one-half years. These types of bonds are still relatively new in the United States.

The retail department store JCPenney (JCP, NYSE) issued the first publicly offered zero

coupon bond in 1982. Chase Manhattan Bank (CMB, NYSE) and McDonald's (MCD,

NYSE) followed suit later that year.

Variable Rate:

Some securities do not carry a fixed interest rate, but allow the rate to fluctuate in ac-

cordance with some market index. Such a bond is a variable rate bond, also called an

adjustable rate bond. U.S. savings bonds are a good example. The interest paid on these is

90 percent of the prevailing rate on five-year Treasury securities, with a 4 percent

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minimum. If market rates move higher, the income earned on these bonds increases, and

vice versa.

A special type of variable rate bond is the step-up bond, one whose coupon increases

according to a predetermined schedule. In February 1995 the Federal Home Loan Bank

issued a three-year step-up bond10 with a coupon that began at 7.25%. Every six months

thereafter the coupon increases, eventually settling at 9.25%.'

Most bonds are composed of an annuity plus a single sum at maturity.

Consols:

With a consol, a level rate of interest is paid perpetually; the bond never matures, and the

interest is paid forever. Bonds of this type are traded in Europe and in Canada, but they are

rare in the United States. Two examples are the Lehigh Valley Railroad 4'/2% and 6%

issues. Issued in 1873, these bonds were "due only on default of interest." A mortgage on

one of the company's main railroad lines secured them. Bondholders agreed to a

modification of the indenture in 1949 giving the bonds a definite maturity of 1989. They are

now gone and part of history.

U.S. companies do occasionally issue very long-term bonds, however. In fact, on January 1,

1937, of the 4,425 U.S. corporate bonds outstanding, 88 (2.7 percent of the total) had a

maturity in excess of 99 years." Long-term bonds seem to be returning to favor with

corporate issuers. Walt Disney Company issued $150 million par value of a 100-year, 7.5%

coupon bond in July 1993. The offering was an enormous success, although one analyst

predicted that the bond would become a "historic artifact, a curiosity."

Earlier in 1993 five other companies issued 50-year bonds. In 1992 there was only one 50-

year bond issued, and prior to that none had been issued in decades. The last 100-year bond

issued prior to the Disney bond was a Chicago & Eastern Illinois Railroad bond in 1954.

Inflation-Indexed Treasury Bonds:

Beginning the end of January, 1997, investors have been able to purchase Treasury Inflation

Protected Securities (TIPS) from the U.S. Treasury department. The securities are

obligations of the federal government with a maturity and coupon, but with an added feature

to provide protection against inflation.

The bonds have a face value of $1,000 and a semiannual coupon that so far has ranged

between 3% and 4% per year. Every six months the government adjusts the principal value

of the bond according to changes in the Consumer Price Index. If, for instance, the CPI rises

4%, the par value of the bond rises to $1,040 and the coupon rate is applied to this higher

rate.

5. Convertible and Exchangeable Bonds:

Some debt instruments have a valuable conversion option. The bondholder has the right, but

not the obligation, to exchange the debt instrument fqr another security or for some physical

asset. A convertible bond may be exchanged for common stock in the company that issued

the bond. An exchangeable bond may be exchanged for shares in a different firm. At one

time International Business Machines (IBM, NYSE) owned a substantial chunk of Intel

(JNTC, NASDAQ). IBM issued a 63/8% bond exchangeable into 26.143 shares of Intel. An

investor in this bond had the security of IBM and the market potential of Intel.

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The conversion is a one-way street. Once conversion occurs, the security holder cannot elect

to reconvert and regain the original debt security. Chapter Twelve of this book provides

detailed coverage of convertible securities.

6. Registration:

Bond registration refers to how the ownership interest is recorded. There are three methods:

bearer bonds, registered bonds, and book entry bonds.

Bearer Bonds:

A bearer bond is one that does not have the name of the bondholder printed on it, Like a

hundred dollar bill, the bond belongs to whomever legally holds it. These bonds have actual

coupons around the perimeter that must be physically clipped with scissors as interest

payment dates arrive. Because of this characteristic, bearer bonds are also called coupon

bonds. Each coupon bears a date and a dollar amount. Once clipped, the coupons can

usually be deposited into the bondholder's bank account at any teller window. New debt

may no longer be issued in this form in the United States.

Bearer bonds are popular outside the United States, however. The Internal Revenue Service

is largely responsible for this fact, as bearer bonds have for years been popular among those

interested in evading taxes on their interest income. Interest earned on a bearer bond is

difficult for the IRS to trace, and much of it was (and probably still is) unreported on

individual income tax returns. They are also popular with international embezzlers and drug

cartels. Ironically, the principal source of bearer bonds has historically been the U.S.

Treasury department.

Registered Bonds:

Bonds that do show the bondholder's name are registered bonds. Rather than clipping

coupons, holders of registered bonds receive an interest check in the mail from the issuer of

the debt.

Book Entry Bonds:

The U.S. Treasury issues new bonds in book entry form only, meaning that ownership is

reflected only in the accounting records. No actual bond certificate changes hands. Until a

few years ago an investor could buy a Treasury note or bond and actually take delivery of

the security. Now, however, a person who wants to buy these securities on their own must

open a Treasury Direct Account (TDA) at any of the 35 Federal Reserve banks or branches.

The Treasury department issues no certificates; instead, they open an account on an

investor's behalf, crediting interest as it is earned and principal as it is repaid. The principal

may also be reinvested m a new Treasury security.

Opening a Treasury Direct Account is a simple matter. Most local banks have the one-page

application available from a customer service representative. Investors generally submit

noncompetitive bids, meaning they agree to accept the average price and yield prevailing at

the next Treasury auction. Figure 4-1 shows the application forms.

It used to be that investors interested in a TDA had to get a certified check from their bank

and mail it in. Now, an investor can make arrangements with the U.S. Treasury authorizing

a direct transfer from his or her checking or savings account. If an investor chooses to sell a

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Treasury security before its maturity, he or she can easily do so via the Sell Direct option.

For a flat fee of $34 regardless of the size of the transaction, the government will take three

bids and sell your bonds to the highest bidder within 24 hours.

You can check your TDA balance either by phone or over the Internet. The Treasury

charges an annual custodial fee of $25 for accounts greater than $100,000, but nothing for

smaller accounts. Given that interest on treasury securities is exempt from state and local

tax, it is odd that more investors do not choose these investments.

Your local bank offers certificates of deposit backed by treasury securities, but CD interest

is fully taxable, while the underlying assets are not. It would make much more sense to do

the investing directly rather than going through the intermediary.

Investors also commonly buy Treasury securities through a brokerage firm, thereby

eliminating the need to open a TDA. The brokerage firm lets investors use their account, but

they pay a commission for the purchase or sale of bonds traded this way. Trading $10,000

par value of Treasury securities might cost as much as $200 at a full-service brokerage

house. Another disadvantage of buying through a broker is that the newspaper price for a

Treasury security is based on a $l-million purchase. Buying a smaller quantity probably

adds about 0.5 percent to the-bond price. This "premium" reflects the cost of the brokerage

firm handling the "small" order. Depending on the bond term, this higher price lowers the

yield by 7 to 10 basis points. A basis point is 0.01%. By using the TDA, an investor would

not give up any of the yield.

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