You are on page 1of 17

PartFour

InvestinginFixedIncomeSecurities
PartFourIncludes
Chapter10

FixedIncomeSecurities

Chapter11

BondValuation

Chapter12

PreferredStocksandConvertibleSecurities

179Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Chapter10
BondInvestments
.1

Outline

Learning Goals
I.

WhyInvestinBonds?
A) PuttingBondMarketPerformanceinPerspective
1. HistoricalReturns
2. BondsversusStocks
B) ExposuretoRisk
1. InterestRateRisk
2. PurchasingPowerRisk
3. Business/FinancialRisk
4. LiquidityRisk
5. CallRisk
ConceptsinReview

II.

EssentialFeaturesofBonds
A) BondInterestandPrincipal
B) MaturityDate
C) PrinciplesofBondPriceBehavior
D) CallFeaturesLettheBuyerBeware!
E) SinkingFunds
F) SecuredorUnsecuredDebt
ConceptsinReview

III. TheMarketforDebtSecurities
A) MajorMarketSegments
1. TreasuryBonds
a. InflationProtectedSecurities
2. AgencyBonds
3. MunicipalBonds
a. TaxAdvantages
b. TaxableEquivalentYields
4. CorporateBonds
B) SpecialtyIssues
1. ZeroCouponBonds
2. MortgageBackedSecurities
3. CollateralizedMortgageObligations
4. AssetBackedSecurities
5. JunkBonds
C) AGlobalViewoftheBondMarket
1. U.S.PayversusForeignPayBonds
a. DollardenominatedBonds
b. ForeignpayBonds
ConceptsinReview
IV. TradingBonds
A) BondRatings
1. HowRatingsWork
2. WhatRatingsMean
B) ReadingtheQuotes
1. CorporateBondQuotes
2. GovernmentBondQuotes
3. QuotesonZeroCouponBonds
ConceptsinReview

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
10.1. MaxandHeatherDevelopaBondInvestmentProgram
10.2. TheCaseoftheMissingBondRatings
ExcelwithSpreadsheets

181Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.2

Key Concepts

1.

Historicalreturnsinthebondmarketandcomparisontostockreturns.

2.

Currentincomeandcapitalgainscomponentsofbondreturns,includingthefixednatureofcoupon
paymentsandinverserelationshipbetweenbondreturnsandinterestrates.

3.

Thetypesofriskstowhichbondinvestorsareexposed.Callfeaturesmayresultintheearlyexercise
ofbondswithrelativelyhighcouponpaymentstreams.

4.

Thebasicfeaturesofbondsandtheprinciplesofbondpricebehavior,includingtheimpactofcoupon
paymentsandbondmaturityontheinverserelationshipbetweeninterestratesandbondprices.

5.

Themanytypesofbondvehiclescurrentlyavailableandthewidearrayofinvestmentobjectivesthey
canfulfill.Treasurybonds,agencybonds,municipalbonds,andcorporatebondsareexamined.

6.

Aglobalviewofthebondmarket,includingdollardenominatedandforeignpaybonds.

7.

Bondratingsandthewaytheywork.

8.

Readingbondmarketquotations.

.3

Overview

Bondsareanimportanttypeofinvestmentvehicleduetotheattractiveinvestmentopportunitiestheyoffer
toinvestorsandthesizeofthebondmarket.Thischapterexaminesvariousfeaturesofbondsandbond
ratings.
1.

Whyinvestinbonds?Becausebondsprovideinterestincomeandanopportunityforcapitalgains.
Theinstructorshouldindicatetotheclassthat,duetoacertaininterestincomefrombonds,many
investorsperceivegreatersafetyinbondinvestmentsthaninstockinvestments.This,however,isnot
theonlyreasonforinvestinginbonds.

2.

Toputbondreturnsintoperspective(andtoclearuppossiblemisconceptionsalongtheway),some
timeshouldbespentreviewingthehistoricalperformanceofbondyieldsandbondreturns;Table10.1
canbeusedforthispurposeasitshowsyieldsandreturnsforthe35yearperiodfrom1961to2003.
Takesometimetocontrastbondyieldswithbondreturns.Inthisregard,itsimportanttodrivehome
thepointthatbondyieldisnotthesamethingasbondreturn.Whiletheformerisameasureoftheyield
promisedonabond,thelatterisameasureofthereturnactuallyrealizedoveragivenholdingperiod,
anditincludesbothinterestincomeandcapitalgains(orloss).Finally,youmightwanttoclosethis
discussionbycontrastingstockreturns(Table6.1)withbondreturns(Table10.1),emphasizingnot
onlydifferencesinreturns,butalsodifferencesinrisk.TheMarketsDiarysectionoftheWallStreet
Journalorsimilarpublicationwillhelpupdatethevaluesfoundinthetext.

Chapter10BondInvestments182

3.

Fixedincomesecuritiesarealsoexposedtovarioustypesofrisks.Theinstructorshouldoutlinethe
fivemajortypesofriskstowhichbondsareexposed:Interestraterisk,purchasingpowerrisk,
business/financialrisk,liquidityrisk,andcallrisk.Itshouldbeemphasizedthateventhough
TreasuryBondsareissuedbytheU.S.Governmentandarefreeofdefaultrisk,theyareverymuch
subjecttointerestraterisk,thesinglemostimportantforceinthebondmarket.

4.

Featuresthatcharacterizebondsincludeprincipal,interest,maturitydate,andcallandsinkingfund
provisions.Itmightbehelpfultomakethefollowingdistinctionbetweenbondsandstocksinclass:
owningacompanysbondsdoesnotconstituteanownershipinthecompany,whereasowningstock
inacompanyliterallymeansowningpartofthefirm.Buyingacompanysbondsislikemakinga
loantoacompany,exceptthatbondsmaybetradedinthemarket,andtheirvaluesfluctuate.Itmay
alsobepointedoutthatbondholdershaveclaimsthattakepriorityovertheclaimsofthestockholders
ontheassetsofthecompany.

5.

BondtradingtakesplacemainlyintheOTCmarket.BondsissuedbytheU.S.Treasury,agenciesof
theU.S.Government,anddifferentmunicipalitiesusuallyhaveeithertaxfreeorsometaxexempt
status.Corporatebondsarenottaxexempt.Thebenefitsoftaxfreeandtaxexemptbondsfor
differentinvestorsshouldbediscussed.

6.

Likethestockmarket,thebondmarketisalsoglobalized.ThishelpsU.S.investorsincreasetherisk
diversificationoftheirbondportfolios.Whenexplainingtheforeignbondmarket,theinstructor
shoulddifferentiatebetweenU.S.payandforeignpaybonds.

7.

Bondratingsarepresentednext.Differentbondratingsshouldbementioned.Adetailedexplanation
ofwhattheseratingsimplytotheinvestormightalsobeexplored:alowerbondratingmeansthata
particularbondisriskierthanahigherratedbond,sotheinvestorrequiresagreaterreturn(yield)
fromalowerratedbond(foragiventype,maturity,andcoupon).Studentsmaybeshownhowto
readbondpricequotationsfromtheWSJorothersources.

.4

Answers to Concepts in Review

1.

Bondsareappealingtoindividualinvestorsbecausetheyprovideagenerousamountofcurrent
incomeandtheycanoftengeneratelargecapitalgains.Thesetwosourcesofincometogethercan
leadtoattractiveandhighlycompetitiveinvestorreturns.
Bondsmakeanattractiveinvestmentoutletbecauseoftheirversatility.Theycanprovidea
conservativeinvestorwithhighcurrentincomeortheycanbeusedaggressivelybyinvestorswho
prefercapitalgains.Giventhewideandfrequentswingsininterestrates,investorscanfindavariety
ofinvestmentopportunities.Inadditiontotheirversatility,certaintypesofbondscanbeusedto
shelterincomefromtaxes.Whilemunicipalbondsareperhapsthebestknowntaxshelters,some
Treasuryandfederalagencybondsalsogiveinvestorssometaxadvantages.

2.

Table10.1showsthatoverthepast40yearsbondreturnsandmarketinvestmentratesmovein
oppositedirection.Forexample,1987bondyieldsrosefrom9.02to10.33.Thetotalrateofreturn
during1987was1.47percent,duetothedeclineinbondprices.
Swingsinmarketinterestrateshaveadefiniteimpactonannualbondreturns,asshowninTable
10.1.Inparticular,wheninterestratesrise,bondpricesfallandsuchcapitallossesdragbondreturns
down(unlikemarket,orpromisedyields,bond/totalreturnsaremadeupofbothinterestincomeand
capitalgainsorlosses).Whenmarketinterestratesfall,justtheoppositeoccurs:i.e.,bondpricesrise
andsodobondreturns.

183Gitman/JoehnkFundamentalsofInvesting,NinthEdition

3.

Bondsareexposedtothefollowingfivemajortypesofrisk:
(1) Interestraterisk:Thisaffectsthemarketasawholeandthereforetranslatesintomarketrisk.
Whenmarketinterestratesrise,bondpricesfall,andviceversa.
(2) Purchasingpowerrisk:Thisistheriskcausedbyinflation.Wheninflationheatsup,bondyields
lagbehindinflationrates.Abondinvestorislockedintoafixedcouponbondeventhough
marketyieldsarerisingwithinflation.
(3) Business/financialrisk:Thisreferstotheriskthattheissuerwilldefaultoninterestand/or
principalpayments.Businessriskisrelatedtothequalityandintegrityoftheissuer,whereas
financialriskrelatestotheamountoftheissuersleverage.Treasurysecuritiesarefreeofthis
risk,althoughitisanimportantconsiderationforcorporateandmunicipalbonds.
(4) Liquidityrisk:Thisistheriskthatabondwillbedifficulttoselliftheinvestorwishestodoso.
Thebondmarketisprimarilyoverthecounterinnature,andmuchoftheactivityoccursinthe
primary/newissuemarket.WiththeexceptionoftheTreasurymarketandmostoftheagency
market,thereisnotmuchofasecondarymarketformostbonds.
(5) Callrisk:Thisreferstotheriskthatabondwillberetiredbeforeitsscheduledmaturitydate.
Whenabondiscalled,thebondholdersarecashedoutoftheirinvestmentandmustthenfind
alternativeinvestmentoutletsthatmayhaveloweryields.
Themostimportantsourceofriskforbondsingeneralisinterestraterisk.Itisthemajorcause
ofpricevolatilityinthebondmarket.Asinterestratesbecomemorevolatile,sodobondprices.

4.

Issuecharacteristics(suchascallfeatureandcoupon)doindeedaffecttheyieldandpricebehavior
ofabond.Forexample,highcouponbondshavehigheryieldsthanlowcouponbonds;bondswhich
arefreelycallableprovidehigheryieldsthanbondsthatarenoncallable;usually(althoughnot
always)longmaturitiesyieldmorethanshortmaturities.Withrespecttopricevolatility,bondswith
lowercouponsand/orlongermaturitieswillrespondmorevigorouslytochangesinmarketinterest
ratesandthereforehavegreaterpricevolatilitythanshortmaturityand/orhighcouponbonds.

5.

Withacallfeature,theissuerpaysacallpremiumgenerallyequaltooneyearsinterestattheearliest
dateofcall.Ontheotherhand,sinkingfundsisaprovisionthatstipulatestheamountofprincipal
thatwillberetiredannuallyoverthelifeofabond.Therearenocallpremiumswithsinkingfund
provisions.
Thethreedifferenttypesofcallfeaturesare:
(1) Freelycallable:Theissuecanbeprematurelyretiredatanytime.
(2) Noncallable:Theissuerisprohibitedfromretiringthebondissuepriortomaturity.
(3) Deferredcallable:Theissuecannotbecalleduntilafteracertainlengthoftimehaspassedfrom
thedateofissue.
Abondcanbefreelycallablebutnonrefundableforacertainnumberofyears.Inthiscase,a
nonrefundingoradeferredrefundingissuecanstillbecalledandprematurelyretiredforanyreason
otherthanrefunding.

Chapter10BondInvestments184

6.

Thedifferencebetweenapremiumandadiscountbondillustratestheinverserelationshipbetween
bondpricesandmarketinterestrates.Apremiumbondsellsformorethanitsparvalue,whichoccurs
whenmarketinterestratesdropbelowthebondscouponrate.Incontrast,adiscountbondsellsfor
lessthanparandistheresultofmarketratesrisingabovethecouponrate.
Thefactorsthataffectabondspricesvolatilityareinterestrates,couponandmaturityoftheissue.
Thegreaterthemovesininterestrates,thegreatertheswingsinbondprices.Bondswithlower
couponsand/orlongermaturitiesrespondmorevigorouslytochangesinmarketratesandtherefore
undergosharperpriceswings.

7.

Bondsaresecuritiesthatpromisetopayastatedamountofannualinterestoverthelifeofanissue,
thenrepaytheprincipalvalueofthebondatmaturity.Bondissueshavecertainadvantagesand
disadvantages,someofwhichdependontheissuingentity.
(a) TreasurybondsaredebtsecuritiesissuedbytheU.S.FederalGovernmenttomeettheever
increasingneedsoftheFederalbudget.Advantages:Highqualityorlowdefaultrisk(backedby
thefullfaithandcreditoftheU.S.Government);verypopularinstrumentsthathaveawell
developedsecondarymarket;exemptfromstateandlocaltaxes;manycouponsandmaturities
available;someautomaticallyadjusttheirpar(maturity)valuetoprotectinvestorsfromthe
impactofinflation(TIPS).Disadvantages:Duetotheirlowrisk,theseissuesbearlowyields;
makeapoorinflationhedge;andmanyhavelongmaturitiesandthereforetheyaresubjectto
widepriceswings.
(b) AgencybondsaredebtsecuritiesissuedbyvariousagenciesandorganizationsoftheU.S.
GovernmentliketheGovernmentNationalMortgageAssociation(GNMA).Typically,agency
bondsofferyieldsabovethemarketratesforTreasuries.Advantages:Lowrisk(whilenotapart
oftheU.S.GovernmentthemarketexpectstheFederalGovernmenttosupportitsindependent
agencies);manyareexemptfromstateandlocaltaxes;somepayinterestmonthly.
Disadvantages:Thesecondarymarketisnotwelldevelopedforallagencyissues;lowyielddue
tolowrisk(thoughtheiryieldisabovethatofTreasurybonds);somehaveveryhighunitcosts
(likeGNMApassthroughs:$25,000).
(c) Municipalbondsaredebtsecuritiesissuedbystates,counties,cities,andotherpolitical
subdivisionslikeschooldistrictsandwaterandsewerdistricts.Advantages:Interestonmost
municipalsisexemptfromfederalincometaxandusuallythestateorlocaltaxoftheissuing
governmentbody;manycarryamunicipalbondguaranteethatlowersrisk;ratedbyMoodys
andS&P.Disadvantages:Lowyieldforindividualsinlowtaxbrackets;mostissuesarenot
widelytradedandsohavepoorliquidity;requireslargecapitalinvestment($5,000).
(d) Corporatebondsaredebtsecuritiesissuedbycorporations.Thecorporatebondmarketis
customarilysubdividedintotheindustrial,publicutility,transportation,andfinancialbond
segments.Advantages:Widevarietyofissues;relativelyattractiveyields;ratedbyMoodysand
Standard&Poors;relativelygoodliquidityinthesecondarymarket.Disadvantages:Higherrisk
thangovernmentbackedbonds;longlifetomaturity.

185Gitman/JoehnkFundamentalsofInvesting,NinthEdition

8.

(a) Zerocouponbondshavenointerest,orcoupon,payments.Theyaresoldatadeepdiscountfrom
theirparvalues,andthentheyincreaseinvalueovertimeatacompoundrateofreturnsothatat
maturitytheirvalueisequaltopar.Thereisnoreinvestmentriskofcouponpaymentswiththese
bonds.However,theIRSdoesrequirethatinterestbereportedonanaccrualbasis.Thismakes
thesebondsmostattractiveforuseintaxshelterinvestmentslikeIRAs.
(b) CMOs,orcollateralizedmortgageobligations,areobligationsdesignedtoreducetheproblems
causedbythepassthroughofprincipalpaymentsonmortgagebackedbonds.Normally,all
bondholdersreceiveaproratedportionoftheprincipalpayments,butwithCMOsinvestors
selectashortterm,intermediate,orlongtermposition.Allprincipalpaymentsarethenmadeto
theshortterminvestorsfirst.Oncetheyarepaid,thenextgroupbeginsreceivingprincipal
payments.Suchissuesareusedbyinvestorsseekingthehigheryieldsofmortgagebackedissues.
(c) Junkbondsarelowrated,highyielding,speculativevehiclesissuedprimarilybycorporations
(theresalsoasmaller,butstillsizable,marketforhighyieldjunkmunicipals).Inthepast
theseissueswereinitiallyofhighqualitybutdeterioratedasthecompanyfacedtroubledtimes.
Today,thetermappliestoyoung,rapidlygrowingfirmsthatusesuchissuesforcapitalgrowth
and/ortofinancemergersandtakeovers.Theseissuesshouldonlybeusedbyinvestorswhocan
accepthighlevelsofrisk.Theirhighyieldsandhighriskmaketheminappropriatefor
conservativeinvestors.
(d) Yankeebondsarebondsissuedbyforeigngovernmentsorcorporationsorbysocalled
supernationalagenciesliketheWorldBankandtheInternationalMonetaryFund.Thesebonds
aredenominatedindollarsandregisteredwiththeSEC.Thebondsareissuedandtradedinthe
UnitedStates(onU.S.exchangesandtheOTCmarket).AlltransactionsareinU.S.dollars,
eliminatinganycurrencyexchangerisk.Thesebondsaregenerallyveryhighinqualityandoffer
competitiveyieldstoinvestors.

9.

Bondholdersdislikeinflationasincreasesininflationincreasenominalinterestrates,thusreducing
bondprices.So,theU.S.Governmentissuedbonds(i.e.TIPS),whichareprotectedagainst
unexpectedinflation,thusmakingitmoreattractivetoinvestors.TheU.S.Governmentlikesthese
securitiesbecauseitneednotcompensateinvestorsforinflation.Henceitsborrowingcostsarelower.
ThebiggestadvantageofTIPSforinvestorsistheprotectionagainstunexpectedchangesininflation.
Iftheinvestorisriskaverse,hemightpreferTIPSoverconventionalbonds,whicharenotprotected
againstinflation.ButTIPSarenotveryusefulduringperiodswheninflationstaysdormantasinterest
ratesonTIPSaremuchlowerthanconventionalbonds.AnotherbigdisadvantageofTIPSisthat
investorshavetopayataxontheincreasingfacevalueoftheirbondseachyear,whiletheyget
compensatedforinflationatmaturity.Hencetheyenduppayinginterestonincometheydonthave
onhand.
Thetaximplicationsofvariousgovernmentbondsdiffer.Treasuryissuesaresubjecttofederal
incometax,butexemptfromstateandlocaltaxes.Agencyissuesareallsubjecttofederaltax.Some,
however,areexemptfromstatetaxes.Theinterestonmostmunicipalissues,ontheotherhand,is
exemptfromfederalincometaxesand,usually,thestateandlocaltaxesofthegovernmentalunit
issuingthem;capitalgainsonmunicipalbondsaresubjecttonormalfederal,state,andlocaltaxrates
andmustbepaidonanysuchprofitsearned.

Chapter10BondInvestments186

10. Assetbackedsecurities(ABS)aredebtissuessecuredbyapoolofbankloans,leases,andother
assets.Theseotherassetsincludecreditcardbills,computerleases,truckrentals,androyaltyfees.
Whereasthefederalgovernmentcreatedthreeprimaryagenciestohandlemortgagebackedsecurities
(MBS),assetbackedsecuritiesarecreatedbyinvestmentbankersassistingcorporations.ABShave
shortermaturitiesthanMBSs.BothABSsandMBSsprovidemonthlyinterestpayments.
Securitization(i.e.formingMBSandABS)istheprocesswherebymanylendingvehiclesare
transformedintomarketablesecurities.Anindividualcreditcardloanmightbeveryriskybutapool
ofsimilarloanshasamuchlowerriskofdefaultbecauseitisquiteimprobablethatallloansinthe
poolwoulddefaultatthesametime.Hencetheconceptofsecuritizationissimilartothetraditional
conceptofriskdiversificationofaportfolio.
11. Bymid2003,theworldbondmarketreachedavalueof$33trillion.TheU.S.hasthebiggestshare
(52%).ThefourlargestbondmarketsbehindtheU.S.,inorderofsize,areEuroland(20%),Japan
(16%),theUnitedKingdom(3%)andCanada(2%).Togetherthesemarketsaccountforover90%of
theworldsbondmarkets.Variousformsofgovernmentbondsaccountfor55%ofthetotal.
AlthoughtheU.S.accountsforjustoverhalfoftheworldbondmarket,asforeignmarketscontinue
togrowthispercentageissuretodecline.Foreignpaybondscanpayofffromboththebehaviorof
thesecurityandthebehaviorofcurrency.Investinginforeignpaybondsalsohassomepositive
diversificationeffectsbeyondthatavailablefrominvestinginpurelydollardenominatedbonds.
12. Dollardenominatedbondshavetheircashflows(interestpaymentandprincipalrepayments)
denominatedindollars.Ontheotherhand,foreignpaybondshavetheircashflowsdenominatedin
someforeigncurrency.
Thetwomajortypesofforeign,U.S.paybondsareYankeebondsandEurodollarbonds:
Yankeebondsareissuedbyforeigngovernmentsorcorporations,registeredwiththeSEC,andissued
andtradedintheU.S.AlltransactionsareinU.S.dollars.Theyaregenerallyveryhighinqualityand
offerinvestorsverycompetitiveyields.
EurodollarbondsareissuedandtradedoutsidetheU.S.Theyaredollardenominatedbutarenot
registeredwiththeSEC.ThismeansthatunderwriterscannotsellnewissuestoU.S.investors.Only
seasonedEurodollarissuescanbesoldinthiscountry.
BecauseU.S.paybondsaredollardenominated,thereisnocurrencyexchangeriskforanU.S.
investor.Butforeignpaybondsaredenominatedinsomecurrencyotherthandollars,traded
overseas,andnotregisteredwiththeSEC.Thesebondsarethereforesubjecttochangesincurrency
exchangerateswhichinturncandramaticallyaffecttotalreturnstoU.S.investors.Therearealso
positivediversificationadvantagesarisingfromholdingbothdomesticbonds,andforeignpay
foreignbonds.
13. Bondratingsaregradesthatareassignedtobondissuesonthebasisofextensive,
professionallyconductedfinancialanalysistodesignateinvestmentquality.Ratingsbasicallypointto
thedefaultriskofanissue.Higherratingsmeanthatissuesareinvestmentgrade.Lowerratingsmean
thatissuesareinthejunkcategoryandmorespeculative.Thehighertherating,thelowerthedefault
riskand,hence,thelowertheyieldofanobligation.Alowerratingmeansthattheinvestormust
assumemoreofthedefaultriskandhastobecompensatedwithahigheryield.Further,investment
gradesecuritiesarefarmoreinterestsensitiveandtendtoexhibitmoreuniformpricebehaviorthan
junkbondsandotherlowerratedissues.
Foraparticularbondissue,ifMergentandS&Passigndifferentratings(calledsplitratings)theissue
isthensaidtobesplitrated.

187Gitman/JoehnkFundamentalsofInvesting,NinthEdition

14. Fromanindividualinvestorperspective,bondratingsrelievethedrudgeryofevaluatingthequalityof
thebond.Individualscandependonagencyratingsasaviablemeasureofthecreditworthinessofthe
issuerandtheissuersdefaultrisk.Overtime,theratingagencieshavedoneanexcellentjobof
assessingbondquality;hencetheseratingsareobjectiveandreliable.
Bondratingsareintendedtoonlymeasureanissuersdefaultrisk,andassuch,ratingsprovideno
indicationoftheamountofmarketriskimbeddedinabond.Eventhehighestqualityissueswillgo
downinpricewheninterestratesincrease,subjectinginvestorstocapitallossandmarketrisk.
15. Apercentofparquotationindicatesthattheissueistradingatthequotedpercentoftheparvalueof
theobligation.Forexample,apercentofparquotationof98ona$1,000parvalueobligationmeans
thebondistradingat98%of$1000$980.
Corporatebondquotesareinthousandthsofapercentage,whichessentiallyresultsincorporatebond
pricesbeinginpennies.Forinstance,aquoteof98.167,wouldbeapriceof$981.67.
Governmentbondsarequotedin32ndsofapoint,whichisonepercentofparvalue.Hence,abond
quotedat102:8,ispricedat102%and8/32ofapercent,or102.25%.Agovernmentbondwithapar
valueof$1000,wouldcost$1,022.50(e.g.,1.0225$1000)plustransactioncosts.
16. Tradingvolumeisimportanttoactivebondinvestorswhoaggressivelytradeinandoutofissues,and
whoneedtoexecutetradesonshortnotice.Forexample,whenratesstarttorise,thesetraderswantto
beabletoselloutinahurrytheydonotwanttobeleftholdingtheissueduetolackofliquidityin
thesecondarymarketandwatchthemarketmoveawayfromthem.Inessence,suchinvestorsneedan
issuewithanactivesecondarymarket.Thisactivityismeasuredbytradingvolume.Asecuritywitha
lowvolumecancauseaninvestortosellthesecurityatapricewellbelowthatwhichexistedwhen
theorderwasplaced.
Tradingvolumeisanindicationofliquidityrisk(highervolumeimplieslowerrisk).Highertrading
volumeindicateshigherliquidity;lowertradingvolumeindicateslowerliquidity.

.5

Suggested Answers to Investing in Action Questions

Some Tips on TIPS (p. 427)


(a) WhywouldinvestorsandtheTreasurybeinterestedinTIPS?
(b) WhatistheprimaryadvantageanddisadvantageofTIPS?
Answers:
(a) TIPSareTreasuryinflationprotectedsecuritiesthatadjusttheirparvaluetocompensate
bondholdersforthedeclineintheirpurchasingpower.Hence,theTIPSvaluewillnotdeclineas
inflationheatsup.TheTreasuryDepartmentiswillingtoissueinstrumentswhereittakestheinflation
raterisk,becauseitisabletoissueTIPSwithinterestratesthatarehalfthoseofnormalTreasury
bonds.Thefederalgovernmentalsocollectstaxoftheincreaseinparvalue,eventhoughthegainwill
notbeactuallyrealizeduntilmaturity.
(b) InvestorsinTIPSdonothavetoworryaboutinflation,butearnareturnthatisonlyabouthalfofthe
yieldonotherTreasurybonds.

Chapter10BondInvestments188

At Last Bonds for the Little Guy (p. 436)


SummarizetheadvantagesanddisadvantagesofDANs?
Answer:
Advantagesofdirectaccessnotes(DANs)includeawiderangeofmaturities,nobrokeragefee,afixed
$1,000purchaseprice,possibilityofmonthlypayments,andabilitytoredeemaninheritedbondatpar.
Disadvantagesincludealimitedsecondarymarket,interestrateriskandcreditrisk.YieldsonDANsare
higherthanTreasuryyields,butsotooistherisk.Whethertheyareagoodchoiceforonesportfoliois
dependentupononesneedforgreatercontrolovertheirfixedincomeportfolio.

.6

Suggested Answers to Discussion Questions

1.

(a) Thedifferencebetweenthetwodecadesisduetotheriseintheinterestratesduringtheearly
1980swhichinturnincreasedtheyieldsforbonds.
(b) Duringthe1990s,interestratesfelltolevelsnotseeninover30years.Byearly1999,longterm
Tbondswereyieldinglessthan5%.Themarketwasconsideredbullishascomparedtothe
bearishmarketsofthe1970sand1980s.
(c) Sinceitishighlyunlikelythatthehighinterestratesofthe1980swillreturninthenextdecade,it
wouldappearthatafairrateofreturntoexpectfrombondsisverycomparabletothelate1990s.
Infact,inearly2004,theyieldontenyearTreasurynoteswas4.05%.

2.

(a) Thestockmarketdefinitelyisthemorevolatileofthetwomarketsmostoften.
Duringthe1970scumulativetotalreturnsweregreaterinthebondmarketswhenwecompareits
83.1tothe67.9ofthestockmarketsreturn.
Duringthe1980scumulativetotalreturnsinthestockmarket(390.5)exceededthebondmarket
(240.2)
Duringthe1990scumulativetotalreturnsinthestockmarketagaindominatedthebondmarket
(438.9v.130.2).
(b) Becausestockmarketsaremorevolatileandthusmorerisky,therelativelystablebondmarket
offerstheveryriskaverseinvestoranalternative.Ontheotherhand,ifinterestratesreturntothe
levelsofthevolatile1980speriod,bondsmayagainprovemoreriskythanhistoricalexperience
indicates.
(c) Apromising,wellpayingjobwouldgiveyouthecapitaltotakeamoreaggressivepositioninthe
financialmarkets.Assuch,bondswouldnotplayamajorroleinyourportfolio.Onlyasyounear
retirementandarelativelyfixedincomewouldyouincreasetheallocationofbondsinyour
portfolio.

3.

(a) Agencybonds:bondsissuedbygovernmentagenciesthatarehighqualitysecurities
(b) Municipalbonds:bondsthataretheissuesofstates,counties,citiesandotherpolitical
subdivisions.
(c) Zerocouponbonds:bondsthatpaythecouponatthetimeofmaturity.
(d) Junkbonds:highyieldbondsthathavereceivedlow,subinvestmentgraderatingsusuallyBaorB.
(e) Foreignbonds:bondsthatareissuedinaforeigncountryandpricedinthatcountryscurrency.
(f) CollateralizedMortgageObligations:paymentsarebasedontranchesthatareshort,mediumor
longtermandarederivativesecuritiescreatedfromtraditionalmortgagebackedbonds,which
areplacedintrust.

189Gitman/JoehnkFundamentalsofInvesting,NinthEdition

4.

Therearenoinvestmentproductsintheworldthatarepurelyriskfree,yetthemarketsliketothink
ofariskfreeassetforcomparisonpurposesespeciallytodeterminetheriskpremiumforriskyassets.
TheclosestthingthemarketshavetoapurelyriskfreeassetarethedebtsecuritiesoftheU.S.
FederalGovernmentwhichhasnevermissedacouponpaymentoramaturitydateinhistory.Given
thishistoricalrecordofzerovariance,theguaranteeoftheU.S.Governmenthasagreatdealof
credibilityinthefinancialmarkets.Noonecanpredictthefuture,butthereappearstobenothingin
theshorttermthatindicatestheGovernmentwillnotliveuptoitsguarantee.

5.

(1)
(2)
(3)
(4)
(5)

6.

(a) 7328/32percentofpar,$738.75per$1000offacevalue,whichwillbepaidinNovember2010.
(b) 4.18%
(c) SprintBondPrice:$1097.55,U.S.TreasuryAugust20:1390.62;
TheU.S.Treasurybondcarrieslessriskandhenceahigherprice
(d) 13616/32%ofpar;itispricedsohighbecausethecouponrateishigh
(e) TheGE5%,2013hasoverseventyfivepercentmorevolume.
(f) Citigroupsyield:3.8%,Treasuryyield:3.48%,U.S.Treasurystrip:3.72%;soCitigroupshas
thehighestyield.
TheU.S.Treasurywouldprovide$132.50per$1,000,versus$35fortheCitigroupbondand
nothingfortheU.S.Treasurystrip.

.7
1.

f
b
a
d
e

(6)
(7)
(8)
(9)

c
g
i
h

Solutions to Problems
Currentyield

Annualinterestincome
Currentmarketpriceofbond

$60
7.06%
$850
Note:Anissuescallfeaturedoesnotaffectitscurrentorpromisedyield.
Currentyield

2.

Annualinterest$120.
Currentyield

3.

Interest

$120/$1,2500.096or9.6%.

0.1$1,000$100

$100/Price0.06$100/0.06Price$1,666.67

Chapter10BondInvestments190

4.

Aninvestor,comparingmunicipalstocorporates,mustconvertthemunicipalyieldtoitsfullytaxable
equivalent:
Yieldonmunicipalbond
1 federaltaxrate
0.0525

7.29%
1 0.28

Fullytaxableequivalentyield
(FTEY)

Sincethefullytaxableequivalentyieldof7.29%islessthanthe7.5%returnonthecorporatebond,
thecorporateissueoffersahigherreturnandisthebetterbuy.
Yes,thedecisionverylikelywouldchangeifthiswereaninstatebondandtheinvestorlivedina
statewithhighincometaxes.Thisbondwouldnotonlyshieldtheinvestorfromfederaltaxesbutalso
fromhighstateincometaxes.Sincethefullytaxableequivalentyieldformula(atleasttheone
presentedinthetext,whichisthemostwidelycitedversionoftheFTEY)considersonlyfederal
taxes,theresultinganswermustberaisedsomewhattoaccountforthestatetaxshield.Usingthehigh
endofthetopercentrangecitedinthetext(sincethisissupposedtobeahightaxstate),the
netresultisaFTEYofaround7%forthemuni(i.e.,7.29%0.50%)versus7%forthecorporate
issue.Underthesecircumstances,themunicipalbondisthehigheryieldinginvestment.
5.

Aftertaxyieldbeforetaxyield[1(ftrstr(1ftr))]
Where:ftrfederaltaxrateandstrstatetaxrate
0.07[1(0.330.08(10.33))]0.07[1(0.330.0536)]
0.07[10.3836]0.07[0.6164]0.043or4.3%

6.

BondA:

AArated,instatemuniwith6.375%coupon;exemptfrombothfederalandstateincome
taxes
BondB: AAratedoutofstatemuniwith7.125%coupon;exemptfromfederalincometaxes
BondC: Corporatebondyielding9.75%;notaxadvantages
BondD: LongtermTreasurybondyielding9%;exemptfromstateincometaxesonly
Calculationsforfullytaxableequivalentyields(FTEY):
BondA
BondYield
1 [Federaltaxrate Statetaxrate(1 FTR)]
6.375
6.375

1 [0.35 0.115(1 0.35)] 1 (0.35 0.0748)


11.08%

FTEY

BondB
FTEY

BondYield
7.125

10.96%
1 (Federaltaxrate) 1 0.35

BondC
TheFTEYisthesameasthestatedyield:9.75%
BondD
BondYield
9.00
FTEY

10.17%
1 (Statetaxrate) 1 0.115
Note:BecausetheTreasurybondisexemptfromstatetaxesonly,theyieldisadjustedtocalculatethe
fullytaxableequivalentyieldusingtheaboveformula.

191Gitman/JoehnkFundamentalsofInvesting,NinthEdition

SheshouldbuyBondA,theAARatedinstatemunicipalbond;itsaftertaxreturnishighest.
(b) Rankingonthebasisoffullyequivalenttaxableyield,besttoworst:
Bond

Coupon

FTEY

63/8 %

11.08%
10.96

3.LongtermTreasurybond

77/8
9

4.Corporatebond

9 /4

9.75

1.AAratedinstatemunicipal
2.AAratedoutofstatemunicipal

7.

10.17

TreasurytaxableequivalentyieldTreasuryyield/(1Statetaxrate)
0.05/(10.08)0.05/0.920.05435.43%
MunicipaltaxableequivalentyieldMunirate/[1(FTRSTR(1FRT))]
0.04/[1(0.330.08(10.33))]0.04/[1(0.330.08(0.67))]
0.04/[1(0.330.0536)0.04/[10.3836]0.04/0.61640.0649or6.49%.
Robshouldpurchasethemunicipalbondasthetaxadjustedyieldis6.49%,whichisbetterthanthe
taxadjustedyieldof5.43%ontheTreasurybond.

8.

Currentyield

Annualinterestincome
Currentmarketpriceofbond

Coupon

Interest

MarketPrice

CurrentYield

a. 91/2 %

$95.00

973/4 97.75%1,000

b.16

160.00

1645/8 164.625%1,000

c. 51/4

52.50

5454%1,000

95
9.72%
977.50
160
9.72%
1, 646.25
52.50
9.72%
540

Alloftheabovebondshaveacurrentyieldof9.72%and,assuch,areidentical.
9.

(a)

Beginningofyear
Endofyear

Coupon

Interest

MarketPrice

71/2 %

$75

$850.00

71/2

75

$962.50

CurrentYield
$75
8.82%
$850
$75
7.79%
$962.50

Asthepriceofthebondwentup,thecurrentyielddroppedto7.79%.
Annualinterestincome Capitalgains
(b) HPR
Purchaseprice
$75 $962.50 $850 $75 $112.50

$850.00
$850.00
$187.50

22.06%
$850.00

Chapter10BondInvestments192

10. Priceat7%yield($100/0.07)$1,428.57
Priceat7%yield($100/0.06)1,666.67
Lossonsale
238.10
InterestIncome
100.00
NetLoss
$138.10
Charlielost$138.30onthisinvestmentbecauseinterestrateswentup.
11. (a) HPR

Annualinterestincome+Capitalgains
Priceatbeginningofyear
(1)

Year
1998
1999
2000
2001
2002

Ending
Price
$1006.25
1020.00
1046.25
1102.50
1211.25

(2)
Beginning
Price
(1)(2)
$941.25
1006.25
1020.00
1046.25
1102.50

(3)
Capital
Gain
$65
13.75
26.25
56.25
108.75

(4)
Annual
Income
(3)(4)
$88.75
88.75
88.75
88.75
88.75

(5)
Total
Return
(5)(2)
$153.75
102.50
115.00
145.00
197.50

(6)
HPR
16.33%
10.19
11.28
13.86
17.91

(b) Evaluationofreturnperformance:
AnnualHPR(%)
Year
1998
1999
2000
2001
2002
Average

ARatedCorporate
16.33%
10.19
11.28
13.86
17.91
13.91

BondMarket
9.16%
5.76
9.18
12.16
11.95
7.34

LookingattheaverageHPRsoverthefiveyearperiod,wecanconcludethattheArated
corporatebondhasoutperformedthemarket:13.91%versus7.34%.AlsonotethattheArates
corporatebondreturnswerelessvolatile(Minimum10.19&Maximum17.9)comparedto
thevolatilityofthebondmarket(Minimum5.76&Maximum12.16).
12. $20,000.Azerocouponbondtradesatadiscounttofacevalueandpaysnointerestduringits
lifetime.Atmaturity,itpaysfacevalue,whichrepresentstheprincipalandaccruedinterestonthe
bondduringitslifetime.
13. Archieprobablypurchasedanassetbackedsecurity.Thesesecuritiespayaportionofprincipalwith
theinterestpaymentsastheunderlyingcollateralisrepaid.

193Gitman/JoehnkFundamentalsofInvesting,NinthEdition

14. (a) TotalReturninSwissFrancs:


EndingValueofBondinCHF+DividendsinCHF
1
BeginningValueofBondinCHF
11, 750CHF+950CHF

1
11, 000CHF
15.45%

TotalReturn=

(b) TotalReturninU.S.Dollars:
TotalReturn=

EndingValueofBondinCHF+DividendsinCHF

BeginningValueofBondinCHF
ExchangeRateatEndofHoldingPeriod
1
ExchangeRateatBeginningofPeriod

(11,750CHF+950CHF) 0.8000
1
11,000CHF 0.6329
1.4594 1
45.94%

TotalReturn=

15

(a) Ifyoubuyeachfor$10,000andselleachfor$10,000,theprofitwillbetheinterestyouearn
whichisequalto$600ontheEurobondand$500ontheUSbond.
(b) Theoriginalpurchasewillbe$10,000/1.119,009Euros.
9,0091.069,549.5Euros.
9,549.50.98(thenewexchangerate)$9,358.51.
$10,600$9,358.51$1,241.49isthecurrencyimpact.
Ratherthanmakingmoneyonthisinvestment,theinvestorwouldlose
money.Thelosswouldbeequalto$10,000$9,358.51$641.49.
Alternativemethod:
Thecurrencychangeis0.98/1.110.882883.
$10,6000.882883$9,358.56

.8

Solutions to Case Problems

Case 10.1Max & Heather Develop a Bond Investment Program


Thissimplecaserequiresthestudenttochooseafixedincomeinvestmentstrategyforacouplewhohope
toinvestonalongtermbasis.Inparticular,thestudentmustreviewandconsidertheapplicabilityof
severalkindsofissuesastheyrelatetotheinvestmentneedsofthiscouple.
(a) MaxandHeatherdontrelyontheincomefromtheirinvestmentsfortheirdaytodayneeds.They
haveanadequateincome,sotheirbondportfoliocanbeusedprimarilytomaximizetotalincomeona
longer termbasis(capitalappreciationandhighcurrentincome).Theyshouldinvestwithaview
towardmaximizingthetotalreturnovertheirholdingperiod,ratherthaneitherinterestorcapitalgains
alone.Thisimpliesamiddleoftheroadapproachthatinvolvessomecurrentincome(thatcanbe
reinvested)andsomecapitalgains.

Chapter10BondInvestments194

(b) MaxandHeathercouldconsideravarietyofissues.Forexample,Treasuryobligationsmaturingin
twentyyearsormorewouldbeoneoption.Treasuryobligationshavelowrisk,arenoncallableor
haveverylongcalldefermentperiods,andareexemptfromstateandlocaltaxes.Agencyissuesare
anothergoodchoiceforthem,sincemosthavelowriskbutofferhigheryieldsthanTreasuries.Many
agencyissuesarealsoexemptfromstateandlocaltaxes.Mostmunicipalbondsareexemptfrom
federalincometaxes,providingahighfullytaxableequivalentyieldgiventhePeterstaxbracket.
Corporatebondsmayalsobeattractivebecauseoftheirhighyields.Also,theymightgiveserious
considerationtodeepdiscountedbondsfortheircapitalgainspotential;thelowcouponsalsoreduce
reinvestmentproblems.
(c) Studentsanswerswillvary.
(d) Studentsanswerswillvary.
(e) Studentsanswerswillvary.

Case 9.2The Case of the Missing Bond Ratings


Inthiscase,thestudentrelatesvariousfinancialratiostobondratingsinordertoassignabondratingtoa
particularissue.ThestudentshouldreviewthefinancialratiospresentedinChapter6beforesolvingthis
case.
(a) BondsissuedbyCompanies2,3,and6areinvestmentgradeissues.Thebondsissuedbytheother
three(1,4,and5)areinthejunkbondcategory.Comparingthevariousfinancialratios,weseethat
Company3ranksatthetopismostratios.Companies2,3,and6havefairlygoodliquiditypositions,
rankwellintermsofprofitability,andhavesufficientcashflowtocoverinterestandprincipal.Also,
theirdebttototalcapitalratioislowercomparedtotheotherthreefirms.Companies1,4,and5have
poorliquidityratiosandverylowinterestcoverage.Thehigherleverageatthesecompaniesmakes
theirbondsveryspeculative.
(b) AAAisthehighestratingforabond,whileBisthelowestratingforspeculative
(noninvestment)gradeissues.Company3easilyhasthebestratiosandshouldbetheAAArated
firm.Company4,ontheotherhand,hasthepoorestratiosandshouldreceivetheBrating.
(c) Company6rankssecondintermsoffinancialratios;itscurrentratioisslightlybetterthanCompany2
buthasalowerquickratio.ItsreturnontotalcapitalishigherthanCompany2,andithaslower
leverageandbetterinterestcoverage.Therefore,onthebasisoffinancialratiosCompany6shouldbe
ratedAAandCompany2,A.
Companies1and5arefairlysimilarwithrespecttothefinancialratios.EventhoughCompany5has
abetterprofitabilitymargin,itisalsoveryhighlyleveragedcomparedtoCompany1.These
companiesshouldbeassignedBBratings.