Bond Features and Markets A Bond Issued by

Bond Features and Markets

A Bond Issued by Macy’s Term Amount of issue $550 million Date of issue 01/15/2012 Maturity 01/15/2022 Face value $2, 000 Annual coupon 3. 875 Offer price (%) 99. 189 Coupon payment dates 01/15, 07/15 Security None Sinking fund None Call provision At any time Call price Treasure rate plus 0. 35% Rating Moody’s Baa 3, S&P BBB-

A Bond Issued by Macy’s •

Security • The issuer may pledge some of their assets for the bond. With these assets, the bondholders are secured when the company cannot repay its obligations Ø Collateral: Financial securities that are pledged as security for payment of bond Ø Mortgage: Real property (real estate, like land or buildings) Ø Debentures: Unsecured bond for which no specific pledge of property is made Ø Notes: Unsecured debt with original maturity less than 10 year • Macy’s bond Security: None Ø The bonds are not secured by specified assets

Sinking Fund • Usually, the bondholders receive the face value at maturity, but sometimes they may be repaid in part or in entirely before maturity • Early repayment is often handled through a sinking fund • A sinking fund is an account managed by the bond trustee for the purpose of repaying the bond Ø The company makes annual payment to the trustee Ø The trustee uses the funds to retire a portion of the bonds: Buying up some of the bonds or calling in a fraction of the outstanding bonds • Macy’s bond Sinking Fund: None Ø The bonds have no sinking fund

Call Provision • A call provision allows the company to repurchase part or all of the bond issue at stated price over specified time Ø Deferred call provision: the company can be prohibited from calling its bonds for the first part of a bond’s life (say the first 10 years) Ø During this period of prohibition, the bond is said to be call protected • Macy’s bond Call Provision: At any time Ø The bonds can be called at any time before maturity Ø The bond do not have deferred call

Call Price • Stated price in call provision • Price the company used to call the bonds from the market • Call price > face value, why? Ø The company would like to call the bond when the market interest rate is lower than the bond’s coupon Ø When the company calls the bond, it hurts bondholders’ benefit, so the bond has to be called at a price greater than face value Ø Call premium = Call price – face value • Macy’s Call Price: Treasury rate plus 0. 35% Ø The discount rate (YTM) used to compute Macy’s call price is treasury rate at calling time + 0. 35%

Protective Covenants • Negative covenants Ø Limit certain actions a company might otherwise wish to take during the term of the loan Ø Example: The firm cannot pledge any assets to other lenders • Positive covenants Ø Specify an action that the company agree to take or a condition the company must abide by Ø Example: The firm must maintain any collateral or security in good condition

Bond Indenture (Deed of Trust) • Contract between issuing company and bondholders • Includes: Ø Basic terms of the bonds Ø Total amount of bonds issued Ø Secured versus Unsecured Ø Sinking fund Ø Call provisions • Deferred call • Call premium Ø Details of protective covenants

Bond Ratings – Investment-Quality • Measure bond default risk • High Grade Ø Moody’s Aaa and S&P AAA: Capacity to pay is extremely strong Ø Moody’s Aa and S&P AA: Capacity to pay is very strong • Medium Grade Ø Moody’s A and S&P A: Capacity to pay is strong, but more susceptible to changes in circumstances Ø Moody’s Baa and S&P BBB: Capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay • Macy’s bond Credit Rating: Baa 3 BBBØ This bond has moderate credit risk at the bottom of investment grade

Bond Ratings – Low Quality • Low and Very Low Grade Ø Moody’s: Ba, B, Caa, C Ø S&P: BB, B, CCC, C Ø Considered speculative with respect to capacity to pay. The “BB” and “Ba” ratings are the lowest degree of speculation Ø Although such bond is likely to have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions • Default Ø Moody’s D and S&P D – in default with principal and interest in arrears

Primary vs. Secondary Market • Primary Market Ø Original sale of securities by governments or corporations Ø Public offerings Ø Private placements • Secondary Market Ø Securities are bought and sold after the original sale Ø Provide the means for transferring ownership of corporate securities Ø Dealer markets and auction markets

Dealer and Dealer Market • Dealers Ø Maintains an inventory Ø Buy and sell for themselves, at their own risk Ø Used car dealer; local college bookstore • Dealer Market Ø Most of buying and selling is done by dealers Ø No central location Ø Most trading in debt securities takes place over the counter (OTC) in old days Ø Many dealers are connected electronically now

Bond Market • Dealer market • Extremely large number of bond issues Ø A corporation typically has only 1 common stock, but could have a dozen or more bond issues Ø Federal, state, and local governments can have a wide variety of bonds outstanding • Little or no transparency Ø Getting up-to-date prices difficult, particularly on small company issues Ø Little centralized reporting of transactions, which are privately negotiated between parties

Corporate Bond Quotations • Corporate bond dealers are now required to report trade information through Trade Reporting and Compliance Engine (TRACE) • One site that provides bond information is www. finra. org/industry/trace/corporate-bond-data • Database that provides bond information is Bloomberg

Treasury Quotations

Treasury Quotations • Maturity Coupon 5/15/2030 6. 250 Bid Asked 150. 7188 150. 7500 Chg. 8906 Asked Yield 2. 713

Treasury Quotations Maturity Coupon 5/15/2030 6. 250 Bid Asked 150. 7188 150. 7500 Chg. 8906 Asked Yield 2. 713 • Ask price goes up by 0. 8906% since the previous day • Two bond prices correspond to two YTM. Asked Yield is the YTM (=2. 713%) used to compute Asked Price (=$1, 507. 5)

Problem 6 -13 Use Treasury Quotes Locate the Treasury issue in Figure 6. 3 maturing in August 2021. Assume a par value of $1, 000. What is its coupon rate? What is its bid price in dollars? What was the previous day’s asked price in dollars? Maturity Coupon 8/15/2021 8. 125 Bid Asked 155. 1094 155. 1563 Chg Asked Yield . 7969 2. 713

Clean Price •

Dirty (Invoice) Price •

Problem 6 -21 Accrued Interest You purchase a bond with an invoice price of $1, 095. The bond has a coupon rate of 9. 9%, semiannual coupons, and there are two months to the next coupon date. What is the clean price of the bond?

Problem 6 -22 Accrued Interest You purchase a bond with a coupon rate of 9 percent, semiannual coupons, and a clean price of $840. If the next coupon payment is due in three months, what is the invoice price?

Real and Nominal Rates • Nominal rate on an investment is the % change in the number of $ • Real rate on an investment is the % change in purchasing power • Difference between nominal and real rate is inflation

Example: Pizzas • Pizzas cost $5 per piece today and will cost $5. 25 in a year • $100 buys 20 pieces of pizza today • If the interest rate is 15. 5%, we can withdraw $115. 50 in a year after depositing $100 today • $115. 50 in a year can buy 22 pieces of pizza • Our buying power goes up by 10% , which is the real interest rate • Inflation is 5% per year

Fisher Effect •

Problem 6 -11 Nominal and Real Returns An investment offers a total return of 14 percent over the coming year. Bill Bernanke thinks the total return on this investment will be only 8. 1 percent. What does Bill believe the inflation rate will be over the next year?

Term Structure of Interest Rates • The graphical representation of the relationship between YTM and maturity of default-free, pure discount bonds is called the time structure of interest rates • Tells the pure time value of money for different length of time • Three components determine the shape of term structure Ø Real rate of interest Ø Inflation Ø Interest rate risk

Normal Case: Upward-Sloping

Inverted Case: Downward-Sloping

Treasury Yield Curve

Risk and Reward for holding Bonds • Anything else that affects the risk of the cash flows (bond payments) to the bondholders will affect the bond yield to maturity (YTM) • Bond YTM is the return required in the market to compensate those risks of investing in bond