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bonds - G o a ls B onds F ix e d In c o m e S e c u r itie...

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1 Bonds: Fixed Income Securities Economics 71a: Spring 2007 Mayo chapter 12 Lecture notes 4.3 Goals History Features and structure Bond ratings Bond Returns Interest and capital gains Stock comparison: dividends and cap gains Most income in the form of interest Two Parts = (capital gain) + (Interest) R t + 1 = P t + 1 + I t + 1 ! P t P t R t + 1 = P t + 1 ! P t P t + I t + 1 P t
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2 Annual Historical Returns 0.7% 3.8% TBills 2.8% 5.8% Gov t Bonds 3.2% 6.3% Corp Bonds 9.2% 12.4% Stocks Inflation Adjusted Raw Returns Bonds in the 1990 s 1990-1999 Bonds, 8.7% (nominal, no inflation adjustment) $10,000 -> $23,000 Stocks 18.2% (nominal) $10,000 -> $53,000 1990-2003(June) Bonds, 9.7% (nominal) $10,000 -> $35,000 Stocks, 10.2% (nominal) $10,000 -> $37,000 Bond Return Summary Generally, lower returns than stocks But also, less risk than stocks Bond Risks Interest rate risk Purchasing power risk (inflation) Default or business risk Liquidity risk Call risk
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3 Goals History Features and structure Bond ratings Bond Features Agreement to borrow money Amount of loan Principal, “par value” Paid back at set date in the future “maturity” Interest payments Coupon interest rate Percentage of principal Made on regular schedule Example Bond structure Principal = $1000 Maturity = 10 years Coupon = 5%, semiannual Cashflows Pays $25 in interest every 6 months (Interest payment is fixed.) 10 years from now pays back $1000 + $25 Bond Legal Structure Indenture Specifies rights of bond holders Restrictions often include Requirements on accounting practices Firm should pay taxes Constrain future borrowing Limit dividend payments on stock
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