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the current yield. The trading volume column shows that 300 bonds traded on that day. The
change from yesterday™s closing price is given in the last column. Like government bonds,
corporate bonds sell in units of $1,000 par value but are quoted as a percentage of par value.
Although the bonds listed in Figure 9.2 trade on a formal exchange operated by the New
York Stock Exchange, most bonds are traded over-the-counter in a loosely organized network
of bond dealers linked by a computer quotation system. (See Chapter 3 for a comparison of
exchange versus OTC trading.) In practice, the bond market can be quite “thin,” in that there
are few investors interested in trading a particular bond at any particular time. Figure 9.2
shows that trading volume of many bonds on the New York exchange is quite low.
Bonds issued in the United States today are registered, meaning that the issuing firm keeps
records of the owner of the bond and can mail interest checks to the owner. Registration of
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




299
9 Bond Prices and Yields




F I G U R E 9.2
Listing of corporate
bonds
Source: The Wall Street
Journal, September 7, 2000.
Reprinted by permission of
Dow Jones & Company, Inc.
via Copyright Clearance
Center, Inc. © 2000 Dow
Jones & Company, Inc. All
Rights Reserved Worldwide.




bonds is helpful to tax authorities in the enforcement of tax collection. Bearer bonds are those
traded without any record of ownership. The investor™s physical possession of the bond cer-
tificate is the only evidence of ownership. These are now rare in the United States, but less
rare in Europe.

Call provisions on corporate bonds While the Treasury no longer issues callable
bonds, some corporate bonds are issued with call provisions. The call provision allows the is-
suer to repurchase the bond at a specified call price before the maturity date. For example, if
a company issues a bond with a high coupon rate when market interest rates are high, and in-
terest rates later fall, the firm might like to retire the high-coupon debt and issue new bonds at
a lower coupon rate to reduce interest payments. The proceeds from the new bond issue are
used to pay for the repurchase of the existing higher coupon bonds at the call price. This is
called refunding.
Callable bonds typically come with a period of call protection, an initial time during which
the bonds are not callable. Such bonds are referred to as deferred callable bonds.
The option to call the bond is valuable to the firm, allowing it to buy back the bonds and
refinance at lower interest rates when market rates fall. Of course, the firm™s benefit is the
bondholder™s burden. Holders of called bonds forfeit their bonds for the call price, thereby
giving up the prospect of an attractive rate of interest on their original investment. To com-
pensate investors for this risk, callable bonds are issued with higher coupons and promised
yields to maturity than noncallable bonds.


<
1. Suppose that General Motors issues two bonds with identical coupon rates and Concept
maturity dates. One bond is callable, however, while the other is not. Which bond
CHECK
will sell at a higher price?

Convertible bonds Convertible bonds give bondholders an option to exchange each
bond for a specified number of shares of common stock of the firm. The conversion ratio
gives the number of shares for which each bond may be exchanged. To see the value of this
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




300 Part THREE Debt Securities


right, suppose a convertible bond that is issued at par value of $1,000 is convertible into 40
convertible bond
shares of a firm™s stock. The current stock price is $20 per share, so the option to convert is not
A bond with an
profitable now. Should the stock price later rise to $30, however, each bond may be converted
option allowing the
profitably into $1,200 worth of stock. The market conversion value is the current value of the
bondholder to
exchange the bond shares for which the bonds may be exchanged. At the $20 stock price, for example, the bond™s
for a specified conversion value is $800. The conversion premium is the excess of the bond value over its
number of shares
conversion value. If the bond were selling currently for $950, its premium would be $150.
of common stock
Convertible bonds give their holders the ability to share in price appreciation of the com-
in the firm.
pany™s stock. Again, this benefit comes at a price; convertible bonds offer lower coupon rates
and stated or promised yields to maturity than nonconvertible bonds. At the same time, the ac-
tual return on the convertible bond may exceed the stated yield to maturity if the option to con-
vert becomes profitable.
We discuss convertible and callable bonds further in Chapter 16.

Puttable bonds While the callable bond gives the issuer the option to extend or retire
the bond at the call date, the extendable or put bond gives this option to the bondholder. If the
put bond
bond™s coupon rate exceeds current market yields, for instance, the bondholder will choose to
A bond that the
extend the bond™s life. If the bond™s coupon rate is too low, it will be optimal not to extend; the
holder may choose
bondholder instead reclaims principal, which can be invested at current yields.
either to exchange for
par value at some
date or to extend for Floating-rate bonds Floating-rate bonds make interest payments that are tied to
a given number of
some measure of current market rates. For example, the rate might be adjusted annually to the
years.
current T-bill rate plus 2%. If the one-year T-bill rate at the adjustment date is 4%, the bond™s
coupon rate over the next year would then be 6%. This arrangement means that the bond al-
floating-rate
ways pays approximately current market rates.
bonds
The major risk involved in floaters has to do with changing credit conditions. The yield
Bonds with coupon spread is fixed over the life of the security, which may be many years. If the financial health
rates periodically
of the firm deteriorates, then a greater yield premium would be required than is offered by the
reset according to a
security. In this case, the price of the bond would fall. While the coupon rate on floaters ad-
specified market rate.
justs to changes in the general level of market interest rates, it does not adjust to changes in
the financial condition of the firm.


Preferred Stock
Although preferred stock strictly speaking is considered to be equity, it often is included in the
fixed-income universe. This is because, like bonds, preferred stock promises to pay a speci-
fied stream of dividends. However, unlike bonds, the failure to pay the promised dividend
does not result in corporate bankruptcy. Instead, the dividends owed simply cumulate, and the
common stockholders may not receive any dividends until the preferred stockholders have
been paid in full. In the event of bankruptcy, the claim of preferred stockholders to the firm™s
assets has lower priority than that of bondholders, but higher priority than that of common
stockholders.
Most preferred stock pays a fixed dividend. Therefore, it is in effect a perpetuity, providing
a level cash flow indefinitely. More recently, however, adjustable or floating-rate preferred
stock has become popular. Floating-rate preferred stock is much like floating-rate bonds. The
dividend rate is linked to a measure of current market interest rates and is adjusted at regular
intervals.
Unlike interest payments on bonds, dividends on preferred stock are not considered tax-
deductible expenses to the firm. This reduces their attractiveness as a source of capital to is-
suing firms. On the other hand, there is an offsetting tax advantage to preferred stock. When
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




301
9 Bond Prices and Yields


one corporation buys the preferred stock of another corporation, it pays taxes on only 30% of
the dividends received. For example, if the firm™s tax bracket is 35%, and it receives $10,000
in preferred dividend payments, it will pay taxes on only $3,000 of that income: Total taxes
owed on the income will be 0.35 $3,000 $1,050. The firm™s effective tax rate on pre-
ferred dividends is therefore only 0.30 35% 10.5%. Given this tax rule, it is not surpris-
ing that most preferred stock is held by corporations.
Preferred stock rarely gives its holders full voting privileges in the firm. However, if the
preferred dividend is skipped, the preferred stockholders will then be provided some voting
power.

Other Domestic Issuers
There are, of course, several issuers of bonds in addition to the Treasury and private corpora-
tions. For example, state and local governments issue municipal bonds. The outstanding fea-
ture of these is that interest payments are tax-free. We examined municipal bonds and the
value of the tax exemption in Chapter 2.
Government agencies, such as the Federal Home Loan Bank Board, the Farm Credit agen-
cies, and the mortgage pass-through agencies Ginnie Mae, Fannie Mae, and Freddie Mac also
issue considerable amounts of bonds. These too were reviewed in Chapter 2.
As the Federal government ran large budgetary surpluses in the late 1990s, it was able to
retire part of its debt. If this trend were to continue, the stock of outstanding Treasury bonds
would fall dramatically; with fewer such bonds traded, the depth and liquidity of the Treasury
market would be reduced. Some observers predict that in this event, Federal agency debt, par-
ticularly that of Fannie Mae and perhaps Freddie Mac, would replace Treasury bonds as the
“benchmark” assets of the debt market.


International Bonds
International bonds are commonly divided into two categories: foreign bonds and Eurobonds.
Foreign bonds are issued by a borrower from a country other than the one in which the bond
is sold. The bond is denominated in the currency of the country in which it is marketed. For
example, if a German firm sells a dollar-denominated bond in the U.S., the bond is considered
a foreign bond. These bonds are given colorful names based on the countries in which they are
marketed. For example, foreign bonds sold in the U.S. are called Yankee bonds. Like other
bonds sold in the U.S., they are registered with the Securities and Exchange Commission.
Yen-denominated bonds sold in Japan by non-Japanese issuers are called Samurai bonds.
British pound-denominated foreign bonds sold in the U.K. are called bulldog bonds.
In contrast to foreign bonds, Eurobonds are bonds issued in the currency of one country but
sold in other national markets. For example, the Eurodollar market refers to dollar-denominated
bonds sold outside the U.S. (not just in Europe), although London is the largest market for
Eurodollar bonds. Because the Eurodollar market falls outside of U.S. jurisdiction, these bonds
are not regulated by U.S. federal agencies. Similarly, Euroyen bonds are yen-denominated
bonds selling outside Japan, Eurosterling bonds are pound-denominated Eurobonds selling out-
side the U.K., and so on.


Innovation in the Bond Market
Issuers constantly develop innovative bonds with unusual features; these issues illustrate that
bond design can be extremely flexible. Here are examples of some novel bonds. They should
give you a sense of the potential variety in security design.
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




302 Part THREE Debt Securities


Reverse floaters These are similar to the floating-rate bonds we described earlier, ex-
cept that the coupon rate on these bonds falls when the general level of interest rates rises. In-
vestors in these bonds suffer doubly when rates rise. Not only does the present value of each
dollar of cash flow from the bond fall as the discount rate rises but the level of those cash
flows falls as well. (Of course investors in these bonds benefit doubly when rates fall.)

Asset-backed bonds Walt Disney has issued bonds with coupon rates tied to the fi-
nancial performance of several of its films. Similarly, “David Bowie bonds” have been issued
with payments that will be tied to royalties on some of his albums. These are examples of
asset-backed securities. The income from a specified group of assets is used to service the
debt. More conventional asset-backed securities are mortgage-backed securities or securities
backed by auto or credit card loans, as we discussed in Chapter 2.

Pay-in-kind bonds Issuers of pay-in-kind bonds may choose to pay interest either in
cash or in additional bonds. If the issuer is short on cash, it will likely choose to pay with new
bonds rather than scarce cash.

Catastrophe bonds Electrolux once issued a bond with a final payment that depended
on whether there had been an earthquake in Japan. Winterthur has issued a bond whose pay-
ments depend on whether there has been a severe hailstorm in Switzerland. These bonds are a
way to transfer “catastrophe risk” from the firm to the capital markets. They represent a novel
way of obtaining insurance from the capital markets against specified disasters. Investors in
these bonds receive compensation in the form of higher coupon rates for taking on the risk.

Indexed bonds Indexed bonds make payments that are tied to a general price index or
the price of a particular commodity. For example, Mexico has issued 20-year bonds with pay-
ments that depend on the price of oil. Some bonds are indexed to the general price level. The
United States Treasury started issuing such inflation-indexed bonds in January 1997. They are
called Treasury Inflation Protected Securities (TIPS). By tying the par value of the bond to the
general level of prices, coupon payments, as well as the final repayment of par value, on these
bonds will increase in direct proportion to the consumer price index. Therefore, the interest
rate on these bonds is a risk-free real rate.
To illustrate how TIPS work, consider a newly issued bond with a three-year maturity, par
value of $1,000, and a coupon rate of 4%. For simplicity, we will assume the bond makes an-
nual coupon payments. Assume that inflation turns out to be 2%, 3%, and 1% in the next three
years. Table 9.1 shows how the bond cash flows will be calculated. The first payment comes
at the end of the first year, at t 1. Because inflation over the year was 2%, the par value of
the bond is increased from $1,000 to $1,020; since the coupon rate is 4%, the coupon payment
is 4% of this amount, or $40.80. Notice that principal value increases in tandem with inflation,
and because the coupon payments are 4% of principal, they too increase in proportion to the
general price level. Therefore, the cash flows paid by the bond are fixed in real terms. When
the bond matures, the investor receives a final coupon payment of $42.44 plus the (price-level-
indexed) repayment of principal, $1,061.11.2
The nominal rate of return on the bond in the first year is
Interest Price appreciation 40.80 20
Nominal return 6.08%
Initial price 1000


2
By the way, total nominal income (i.e., coupon plus that year™s increase in principal) is treated as taxable income in

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