COM PART 5 Analysis and Management of Bonds Chapter 17 Bond Fundamentals Chapter 18 The Analysis and Valuation of Bonds Chapter 19 Bond Portfolio Management Strategies 589 WWW.COM 590 For most investors, bonds receive limited attention and very little respect. This is surprising when one considers that the total market value of the bond market in the United States and in most other countries is substantially larger than the market value of the stock market. For example, at the end of 2010 the market value of all publicly issued bonds in the U. was more than $30 trillion, while the market value of all stocks was about $18 trillion.
On a global basis, the values are about $61 trillion for bonds versus $43 trillion for stocks. Beyond the size factor, bonds have a reputation for low, unexciting rates of return. Although this may have been true 40 or 50 years ago, it certainly has not been true during the past 30 years. Specifically, the average annual compound rate of return on government/corporate bonds for the period 1980–2010 was over 8 percent versus almost 11 percent for common stocks.
These rates of return along with corresponding standard deviations (6 percent for bonds versus 16 percent for stocks) and the relatively low correlation between stocks and bonds (about 0.21) indicate that there are substantial opportunities in bonds for individual and institutional investors to enhance their risk-return performance. The chapters in this section are intended to provide (1) a basic understanding of bonds and the bond markets around the world, (2) background on analyzing returns and risks in the bond market, (3) insights regarding the valuation of bonds, including numerous new fixed- income securities with very unusual cash flow characteristics, and (4) an understanding of either active or passive bond portfolio management. Chapter 17 describes the global bond market in terms of country participation and the makeup of the bond market in major countries. Also, we examine characteristics of bonds in alternative categories, such as government, corporate, and municipal.
We also discuss the many new corporate bond instruments developed in the United States, such as asset-backed securities, zero-coupon bonds, high-yield bonds, and inflation protection securities. While the use of these securities globally has generally been limited to the large developed markets, it is certain that they will eventually be used around the world. Finally, we consider sources of price information needed by bond investors. Chapter 18 is concerned with the analysis and valuation of bonds.
This includes a detailed dis- cussion of how one values a bond using a single discount rate or using spot rates. We also evaluate alternative rate of return measures for bonds. Subsequently, we consider what factors affect yields on bonds and what characteristics influence the volatility of bond returns, including the very im- portant concept of bond duration, which is a measure of bond price volatility that is important in active and passive bond portfolio management. We also consider bond convexity and the impact it has on bond price volatility.
Notably, these concepts are examined for option-free securities. We also consider how they apply to a growing set of securities with embedded options. Chapter 19 considers how to use the background provided in Chapter 17 and Chapter 18 to create and manage a bond portfolio. We consider three major categories of portfolio strategies in detail.
The first is passive portfolio management strategies, which include either a simple buy-and-hold strategy or indexing to one of the major benchmarks. The second category in- cludes active management strategies that can involve one of five alternatives: interest rate an- ticipation, valuation analysis, credit analysis, yield spread analysis, or bond swaps. The third category includes matched funding strategies, which include constructing dedicated portfolios, constructing classical or contingent immunization portfolios, or horizon matching. The fact that three fairly long chapters are devoted to the study of bonds attests to the impor- tance of the topic and the extensive research done in this area.
During the past 20 years, there have been more developments related to the valuation and portfolio management of bonds than of stocks. This growth of the fixed-income sector does not detract from the importance of equi- ties but certainly enhances the significance of fixed-income securities. Finally, readers should keep in mind that this growth in size, sophistication, and specialization of the bond market im- plies numerous and varied career opportunities in the bond area, including trading these securi- ties, valuation, credit analysis, and domestic and global portfolio management.COM CHAPTER 17 Bond Fundamentals After you read this chapter, you should be able to answer the following questions: • What are some of the basic features of bonds that affect their risk, return, and value? • What is the current country structure of the world bond market, and how has the makeup of the global bond market changed in recent years? • What are the major components of the world bond market and the international bond market? • How does the makeup of the bond market differ in major countries? • What are bond ratings, and what is their purpose? What is the difference between investment-grade bonds and high-yield (junk) bonds? • What are the characteristics of bonds in the major bond categories, such as governments (including TIPS), agencies, municipalities, and corporates? • What are the important characteristics of corporate bond issues developed in the United States during the past decade, such as mortgage-backed securities, other asset-backed securities, zero-coupon and deep discount bonds, high-yield bonds, and structured notes? • How do you read the quotes available for the alternative bond categories (e., governments, municipalities, and corporates)? The global bond market is large and diverse and represents an important investment opportunity. This chapter is concerned with publicly issued, long-term, nonconvertible debt obligations of public and private issuers in the United States and major global markets.
In later chapters, we consider preferred stock and convertible bonds. An un- derstanding of bonds is helpful in an efficient market because the existence of U. and foreign bonds increases the universe of investments available for the creation of a diversified portfolio. In this chapter, we review some basic features of bonds and examine the structure of the world bond market.
The bulk of the chapter involves an in-depth discussion of the major fixed-income investments. The chapter ends with a brief review of the price information sources for bond investors. The reader may also want to revisit Chapter 5, which contains a detailed description of the major bond indexes and how they relate to one another.1 BASIC FEATURES OF A BOND Public bonds are long-term, fixed-obligation debt securities packaged in convenient, affordable denominations for sale to individuals and financial institutions. They differ from other debt, such as individual mortgages and privately placed debt obligations, because they are sold to the public rather than channeled directly to a single lender.
Bond issues are considered fixed-income 591 WWW.COM 592 Part 5: Analysis and Management of Bonds securities because they impose fixed financial obligations on the issuers. Specifically, the issuer of a bond agrees to: 1. Pay a fixed amount of interest periodically to the holder of record 2. Repay a fixed amount of principal at the date of maturity Normally, interest on bonds is paid every six months, although some bond issues pay in inter- vals as short as a month or as long as a year.
The principal is due at maturity; this par value of the issue is rarely less than $1,000. A bond has a specified term to maturity, which defines the life of the issue. The public debt market typically is divided into three time segments based on an issue’s original maturity: 1. Short-term issues with maturities of one year or less.
The market for these instruments is commonly known as the money market. Intermediate-term issues with maturities in excess of 1 year but less than 10 years. These instruments are known as notes. Long-term obligations with maturities in excess of 10 years, called bonds.
The lives of debt obligations change constantly as the issues progress toward maturity. Thus, is- sues that have been outstanding in the secondary market for any period of time eventually move from long term to intermediate to short term. This change in maturity is important because a major determinant of the price volatility of bonds is the remaining life (maturity) of the issue.1 Bond Characteristics A bond can be characterized based on (1) its intrinsic features, (2) its type, (3) its indenture provisions, or (4) the features that affect its cash flows and/or its maturity. Intrinsic Features The coupon, maturity, principal value, and the type of ownership are im- portant intrinsic features of a bond.
The coupon of a bond indicates the income that the bond investor will receive over the life (or holding period) of the issue. This is known as interest income, coupon income, or nominal yield. The term to maturity specifies the date or the number of years before a bond matures (or expires). There are two different types of maturity.
The most common is a term bond, which has a single maturity date. Alternatively, a serial obligation bond issue has a series of maturity dates, perhaps 20 or 25. Each maturity, although a subset of the total issue, is really a small bond issue with generally a different coupon. Municipalities issue most serial bonds.
The principal, or par value, of an issue represents the original value of the obligation. This is generally stated in $1,000 increments from $1,000 to $25,000 or more. Principal value is not the same as the bond’s market value. The market prices of many issues rise above or fall below their principal values because of differences between their coupons and the prevailing market rate of interest.
If the market interest rate is above the coupon rate, the bond will sell at a dis- count to par. If the market rate is below the bond’s coupon, it will sell at a premium above par. If the coupon is comparable to the prevailing market interest rate, the market value of the bond will be close to its original principal value. Finally, bonds differ in terms of ownership.
With a bearer bond, the holder, or bearer, is the owner, so the issuer keeps no record of ownership. Interest from a bearer bond is obtained by clipping coupons attached to the bonds and sending them to the issuer for payment. In contrast, the issuers of registered bonds maintain records of owners and pay the interest directly to the current owner of record. Types of Issues In contrast to common stock, companies can have many different bond issues outstanding at the same time.
Bonds can have different types of collateral and be either senior, unsecured, or subordinated (junior) securities. Secured (senior) bonds are backed by a legal claim on some specified property of the issuer in the case of default. For example, WWW.COM Chapter 17: Bond Fundamentals 593 mortgage bonds can be secured by real estate assets; equipment trust certificates, which are used by railroads and airlines, provide a senior claim on the firm’s equipment. Unsecured bonds (debentures) are backed only by the promise of the issuer to pay interest and principal on a timely basis.
As such, they are secured by the general credit of the issuer. Subordinate (junior) debentures possess a claim on income and assets that is subordinated to other debentures. Income issues are the most junior type because interest on them is paid only if it is earned. Although income bonds are unusual in the corporate sector, they are very pop- ular municipal issues, where they are referred to as revenue bonds.
Finally, refunding issues provide funds to prematurely retire another issue. The type of issue has only a marginal effect on comparative yield because it is the credit- worthiness of the issuer that determines bond quality. A study of corporate bond price behav- ior by Hickman (1958) found that whether the issuer pledged collateral did not become important until the bond issue approached default.