You've just made an investment in a 25-year bond with a high coupon rate.
It will happen in the first several years.
If the market interest rates go down, you will likely get a notice from the issuer that the bond is being retired before its maturity date.
You don't have anything to do but turn in the bond and invest in something else.
There are three types of call features.
During the deferment period, the issue is noncallable and then becomes freely callable after that.
Bond issuers can take advantage of declines in market interest rates by using call features.
Companies call outstanding bonds and then issue new bonds at lower rates.
Call features work for issuers.
When a bond is called, the investor is left with a lower rate of return than if the bond were not called.
The issuer will pay a call premium to investors if the issue is called.
The issuer of FIXED- INCOME SECURITIES must pay to retire the bond early.
If the bond is called at the earliest possible date, call premiums can be as much as a year's worth of interest payments.
The call premium gets smaller as the bond gets closer to maturity.
The initial call price of a 5% bond could be as high as $1,050 and the call premium could be as low as $50.
These features prohibit the premature retirement of an issue from the proceeds of a lower-coupon bond.
For five years, a bond can be freely callable but non-refundable.
There is a distinction between nonrefundable and noncallable.
A nonre fundable bond can still be called at any time as long as the money that the company uses to retire the bond comes from a source other than a new, lower coupon bond issue.
This provision only applies to term bonds, because serial issues already have a repayment schedule.
Not all term bonds have sinking-fund requirements, but for those that do, the sinking fund specifies the annual repayment schedule that will be used to pay off the issue.
It shows how much principal will be retired each year.
One to five years after the date of issue, the requirements for sinking-fund requirements begin, and continue annually until all or most of the issue is paid off.
The amount not repaid would be retired with a single balloon payment at maturity.
The issuer doesn't have to pay a call premium with sinking-fund calls.
The bonds are usually called par for sinking-fund purposes.
There is a difference between sinking-fund provisions and call or refunding features.
A sinking-fund provision obligates the issuer to pay off the bond over time, unlike a call or refunding provision, which gives the issuer the right to retire a bond early.
The issuer has no choice.
It has to make sinking-fund payments quickly or it will be in default.
A number of different bonds may be issued by a single issuer.
One bond can be differentiated from another by the type of collateral behind the issue.
Junior or senior bonds can be used.
First and refunding bonds are not as secure as straight first-mortgage bonds.
Hewlett-Packard could issue $500 million worth of 20-year bonds.
The bond is completelyUnsecured, meaning there is no recourse other than the good name of the issuer.
Highly regarded firms are able to sell billion-dollar bond issues at competi tive rates.
There is a claim on income secondary to other bonds.
There is no legally binding requirement to meet interest payments on a timely or regular basis if a specified amount of income has not been earned.
Revenue bonds found in the municipal market are similar to these issues.
Fixed-income investors use the ratings that these agencies publish to see how much credit risk is embedded in a bond.
Ratings are an important part of the municipal and corporate bond markets, where issues are regularly evaluated and rated by one or more of the rating agencies.
Moody's and Standard & Poor's are the largest rating agencies.
When a new bond issue comes to the market, a staff of credit analysts from the rating agencies estimates the likelihood that the issuer will default on its obligations.
The issuing organization's financial records are studied by the rating agency.
The firm's financial strength and stability are very important in determining the appropriate bond rating.
A strong relationship exists between the operating results and financial condition of the firm and the rating its bonds receive.
Generally, higher ratings are associated with more profit able companies that rely less on debt as a form of financing, are more liquid, have stronger cash flows, and have no trouble servicing their debt in a prompt and timely fashion.
There are various ratings assigned to bonds by two of the services.
The capacity to pay principal and interest is the highest rating assigned.
"gilt-edge" securities are often called that.
The margins of protection are not strong enough to make high quality bonds rated lower.
There are many investment attributes that may suggest susceptibility to economic changes.
It is possible that there is insufficient capacity to pay principal and interest against adverse economic conditions.
Investment bonds are generally lacking in desirable characteristics.
It may be small to have assurance of principal and interest.
Poor-quality issues can be in default or in danger of default.
Highly speculative issues are often in default.
The issues may be considered poor in investment quality.
Income bonds with no interest are given a rating.
A+ means a strong, high A rating, whereas A- means the issue is on the low end of the scale.
The ratings indicate financially strong, well-run companies.
Companies and governmental bodies that want to raise money by issuing bonds save money if they have an investment grade rating because investors will accept lower yields on these bonds.
The issuers of these bonds don't have the financial strength to back investment grade issues.
Most of the time, when the rating agencies assign ratings to a bond issue, their ratings agree.
An issue might be rated Aa by Moody's but A or A+ by S&P.
The split ratings are viewed asshading the quality of an issue one way or another.
It doesn't mean that a bond will keep its rating for the rest of its life if it gets a certain rating at the time of issue.
Ratings change when the financial condition of the issuer changes.
The assigned rating is reviewed regularly to make sure it is still valid.
An upward revision of junk bonds causes the market yield on the bond to drop, reflecting the bond's improved quality.
If a com's financial condition gets worse, ratings on its bonds may go down.
There is a special name given to junk bonds that used to have a lot of no-name companies issuing them.
It may appear that the firm is always the case.
The issue that gets the rating is listed here.
Some of the company's issues can have different ratings.
The senior securities may have one rating and the junior may have another.
The ratings of General GM are tied to bond yields, so investors pay close attention to them.
The higher the rating, the lower the yield.
An A-rated bond might have a yield of 6.5%, whereas a comparable issue might have a yield of 4%.
A bond's rating has an impact on how sensitive its price is to interest rate movements as well as to changes in the company's financial performance.
These fallen angels are still bonds.
Bond ratings serve to relieve individual investors of the drudgery of evaluating the investment quality of an issue on their own, which is why they've been slapped with low ratings.
Credit analysis is time consuming and costly, and it requires more expertise than the average investor possesses.
Two words of caution are needed.
Bond ratings are only meant to measure the default risk of an issue, which has no bearing on an issue's exposure to interest rate risk.
If interest rates go up, the highest-quality issues will go down in price.
Ratings agencies make mistakes and their mistakes made headlines during the recent crisis.
The rating agencies gave payments on an underlying pool many mortgage-backed securities investment grade of residential real estate mortgages, played a central ratings, and those ratings prompted investors of all role in the financial crisis that began in 2007 and the kinds, including large financial institutions, to pour Great Recession that followed The values of "toxic" mortgage-backed bonds were given ratings by Poor's as real estate prices began to decline.
The ratings of these securities plummeted.
It was more complex than the Lehman Brothers and other large financial rescues because of the fact that institutions.
There are three types of call features.
Our discussion so far has dealt with basic bond features.
We are now looking at the market in which these securities are traded.
The bond market is over-the-counter in nature, as listed bonds represent only a small portion of total outstanding obligations.
This market is more stable than the stock market.
When bond price activity is measured daily, it is remarkably stable, as interest rates and bond prices do move up and down over time.
The bond market has two things that stand out.
The U.S. bond market is larger than the U.S. stock market.
Today's market has bonds available to meet almost any investment objective and to suit just about any type of investor.
The fixed-income market is dominated by treasuries.
There are three popular types of bonds for us to choose from.
All Treasury obligations are backed by the full faith and credit of the U.S. government.
They are very popular with individual and institutional investors both in the United States and abroad.
The U.S. Treasury securities are traded all over the world.
Treasury Bills are not subject to state and local taxes.
The last time the Treasury issued callable debt was in 1984.
Through this process, the Treasury establishes the initial yields and coupons on the securities it issues.
Competitive and noncompetitive bidding options are available to investors in an auction.
The yield that investors specify is the price that they are willing to pay.
Depending on how their bids compare to others, investors may be allocated securities in any given auction.
In a noncompetitive bid, investors agree to accept securities at a certain yield.
The Treasury first accepts all noncompetitive bids and then accepts competitive bids in ascending order in terms of their yield, until the quantity of accepted bids reaches the full offering amount.
The highest accepted bid is the same yield as all other bids.
The financial media follows Treasury auctions.
In this case, only 45% of the competitive bids were accepted and issued bonds, because the number of bids submitted far exceeded the number accepted.
The tenders at lower yields were accepted in full.
In 2008 the yield ment bonds and high-risk junk spreads reflected investors' concerns.
The yield spread set a record in the 1990-1991 failure of Lehman Brothers.
If investors require a 3% interest rate on the growing crisis in Europe, junk bond credit spreads government bonds, then they will demand a 13.5% began climbing again in 2011.
As of early 2015, the junk bond credit spread remained below the level it reached in October of 2011.
The New York University Salomon Center and FRED Economic had a major crisis in the investment banking industry.
They pay interest semiannually and are issued with 5-, 10-, and 30-year maturities.
They offer investors the chance to stay ahead of inflation by periodically adjusting their returns.
The bond's par value is used to calculate the adjustment.
The par value increases at a pace that matches the inflation rate.
The coupon rate is paid on the inflation-adjusted principal.
Suppose you bought a 30-year TIPS with a par value of $1,000 and a 2% coupon rate.
If there is no inflation, you will get $20 in interest per year, paid in two $10 semiannual installments.
The par value of your bond will increase by 3% and your interest payments will increase by 20%.
The inflation that occurred while you held the bond has been compensated by the 3% increase in your interest payments.
Because of this type of bond, investors don't have to guess what the inflation rate will be over the bond's life.
Purchasing power risk is eliminated by TIPS.
TIPS offer lower returns than ordinary Treasury bonds because they are less risky.
These securities are not obligations of the U.S. Treasury and should not be considered the same as Treasury bonds.
They are high-quality securities that have no risk of default.
Despite the similar default risk, these securities usually have higher yields than Treasuries.
They offer a way to increase returns with little or no difference in risk.
The rating was cut by seven steps.
After denying the lender permission to investors became nervous, the government decided to wind down Eksportfi issued by Norway.
The yield on waiving European Union capital requirements to prevent Eksportfinans's benchmark two-year note increased the concentration of loans to single industries.
The events of Moody's remind us that there is a risk of Eksportfinans being downgrade to junk even in countries like Norway.
There are two types of agency issues.
More than two dozen federal agencies offer agency bonds.
The Federal Financing Bank was established to consolidate the financing activities of all federal agencies in order to overcome some of the problems in the marketing of small federal agency securities.
Some of the more popular agency bonds are presented in Table 10.3.
Most of the government agencies support agriculture or housing.
Although agency issues are not direct liabilities of the U.S. government, a few of them carry government guarantees and therefore represent the full faith and credit of the U.S. Treasury.
It's highly unlikely that Congress would allow one of those issues to default, since they are viewed as moral obligations of the U.S. government.
Agency issues can carry long call deferment features.
More than 40% of municipal bonds are directly held by individuals, which is the only segment of the bond market where the individual investor plays a major role.
Municipal bonds are either general obligation or revenue bonds.
Revenue bonds make up 75% to 80% of the new-issue volume of munis.
Municipal bonds are usually issued in $5,000 denominations.
If a sufficient amount of revenue is generated, the issuer of a revenue bond is obligated to pay principal and interest.
The issuer doesn't have to make a payment if the funds aren't there.
Revenue bonds provide higher yields because they involve more risk than general obligations.
The bondholder is assured that payments will be made in a timely manner with these guarantees.
The insurance placed on the bond at the time of issue is nonrevocable over the life of the obligation.
The quality of the bond is improved.
The American Municipal Bond Assurance Corporation is one of the three principal insurers.
If the bond has an S&P rating of BBB or better, these guarantors will usually cover it.
These issues are known as tax-free bonds.
Municipal bonds are usually exempt from state and local taxes in the state in which they were issued.
If the bondholder lives in California, the issue is free of California tax, but if the investor lives in Arizona, the issue is subject to state tax.
Capital gains on municipal bonds are subject to taxes.
Individual investors are the biggest buyers of municipal bonds, and the tax-free interest that these bonds offer is a major draw.
When buying a municipal bond, investors compare the tax-free yield offered by the bond to the after-tax yield that they could earn on a similar bond.
If you are in the 25% tax brackets, each dollar of interest that you earn will cause you to pay 25% in taxes.
A tax-free municipal bond has a yield of 6 percent.
If the municipal bond offers six percent and the taxable bond offers eight percent, then you are indifferent to the choice between the two securities as long as they are similar in terms of risk, and not counting any tax benefit on your state income taxes.
The value is highlighted in Table 10.4.
The tax break that municipal bonds offer is more appealing to investors in higher tax brackets.
If the yields on the bonds are higher than on the municipal bonds, they are not very attractive for these investors.
If yields on municipal bonds are lower than on taxable bonds, investors will chase them even if they have high tax rates.
An investor in the 10% tax brackets would be indifferent to the choice between a municipal bond with a 6% yield and a taxable bond with a slightly higher 6.67% yield.
If the yield on the taxable bond was greater than 9.23%, an investor in the 35% tax brackets would prefer the 6% municipal bond.
The main buyers of municipal bonds are investors with high tax rates.
The benefit of earning tax-free income is offset by the higher yield on taxable bonds for 16.51% of investors.
State and local governments can borrow money at lower rates because of the tax status of municipal bonds.
It is possible to determine the return that a fully taxable bond would have to provide in order to match the return provided by a tax-free bond.
The yield on a municipal bond can be compared to the yield on any number of issues.
The yield on the municipal bond and the investor's tax rate are used to calculate the taxable equivalent yield.
An individual in the 35% tax brackets would have to find a fully taxable bond with a yield of 10.0% to get the same after-tax return.
The computed taxable equivalent yield only applies to certain situations, such as the investor who is looking at an out-of-state bond, or the investor who has no state income tax.
Federal income tax is the only tax that's relevant under any of these conditions.
The in-state bond would be free from both federal and state taxes, but the corporate bond would not.
Equation 10 would not calculate the correct yield.
The inclusion of state taxes means that the denominator of Equation 10.2 is slightly smaller than the denominator of Equation 10.1, which in turn means that the taxable equivalent yield will be higher with state taxes as part of the analysis.
If municipal bonds offer tax advantages at both the federal and state levels, then taxable yields must be even higher to remain competitive.
If you have a marginal federal tax rate of 35%, then your state income tax rate is 3%.
The yield on the municipal bond issued by your state is 6.305%.
If you bought a $1,000 bond, you should be able to confirm that it is correct.
$100 in interest income in the first year is fully taxed at both the state and federal levels.
Remember that taxes paid to state governments may be deducted from your income.
You get to keep $63.05 of the bond's $100 coupon payment after paying $3 in state taxes and $33 in federal taxes.
If you paid $1,000 for the bond, your return is 6.305%.
A 10% yield on a taxable bond is equivalent to a 6.305% yield on a tax-free bond.
If there was no state tax, the yield would have been 9.7%.
The difference would be higher for a higher state tax rate.
In the corporate sector of the bond market investors can promise a yield of 4.8%, which was not remarkable at the find bonds from high-qualityAAA rated issues to junk bonds in or near time.
There is a wide assortment of bonds with different maturities, and it was remarkable about default.