Bernardi Securities, Inc.

Example

Issuer: Anytown, USA issues $5,000,000 in bonds to finance a school addition in August 99. The average interest cost for bonds is 6% and the maturities span 20 years with $250,000 of principal due every year. The new issue also has a 10-year par call feature beginning August 1, 2009.

Along comes 2004 and rates are much lower than they were in 1999. The city decides, like many homeowners do, to refinance their outstanding debt at today’s lower interest rates.

The city has already paid down 5 years of principal but they do not have the cash to pay off the remaining 15 years they have left and even if they did, the 1999 bonds are not callable until 2009.

What to do? They decide to lock in these low rates (2004) by floating a “refunding” issue. What this new issue does is borrow enough money by issuing new bonds at the lower rates. The proceeds from the new issue go to buy U.S. debt securities (usually Treasury bonds), which are set aside in an escrow account. The proceeds are then used to pay semi-annual interest and ultimately used to call in the 1999 bonds at the first available call date…in this instance, August 1, 2009.

So, what has happened? The city will save money by paying off the higher interest, 1999 issue early. The holders of the ’99 issue now have bonds, which although originally issued by Anytown, USA, are now secured by U.S. obligations held in an escrow account. In addition, their maturity (assuming they bought the 20 year bond in the original ’99 issue) will now come due 10 years early. Obviously the value of this bond is increased as it is now a high interest bearing, short-term security backed by the U.S. government and hence, is assumed to be of AAA rated quality even if the original issue was not rated.

The new, refunding issue bears today’s market interest rates at lower levels (compared to 1999). The bonds from this issue, let’s say, have an average interest rate of 4.50% and go out 15 years with a 10-year call option. If rates do come down even further between now and the first call date for this new issue, the whole process could be repeated with another refunding issue on the 2004 series, but that’s another story.

Knowing the yield to maturity, coupon and time to maturity, one can merely look in a “basis book” for the correct pricing of any bond. For speedy and accurate pricing configuration, “basis book” data is stored in bond calculators and bond pricing computers that, in turn, can be used to find the price or yield of any bond.

The following example attempts to simplify, as much as possible, the configuration process.

The price of a bond is precisely the sum of the present values of the cash flows, interest and principal, discounted by the yield to maturity*. The following is an example of a 3-year 6% coupon bond having a$1,000 par value and quoted at a 7% yield to maturity.

The price will be the sum of the present values of each semiannual interest payment of $30, plus the present value of $1,000 received in three years, all discounted by 7%. Formulated as follows:

*(Yields are calculated to call or maturity usually based upon best yield to purchaser)

The total cash payments come to $1,180. But the sum of the present values - which is the price of the bond - is only 973.32. The investor would have paid $973.32 per $1,000 par value.

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The measurement of volatility is called “duration”. It is used to gauge the sensitivity of a bond to interest rate changes and is a most important tool in the professional management of fixed income portfolios.

“Duration” is based on the same cash flows as “yield to maturity” i.e., coupon rate, time to maturity and yield to maturity.

However the “duration” gauge, also considers the timing and size of the cash flow and when the cash is received. This is an important distinction since 1) a higher premium bond (high coupons) produces more investment funds than does a lower coupon bond and 2) the high coupon investor is receiving funds back more quickly than the one invested in low coupon bonds who, in turn, will have less to re-invest at the coupon payment date.

Bonds with the same yield to maturity can have different durations. The lower coupon bond will have a longer duration than a bond bearing a higher coupon and will be considerably more volatile and vulnerable to interest rate changes in the market.

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The sensitivity of a bond is the degree of change in a bond’s value as interest rates change.

Price sensitivity is more related to the effective life (taking into consideration all of the cash flow receipts) of a bond than to its actual maturity. The effective life factors (see below) will give a fairly decent idea as to how a particular bond will react to falling or rising interest rates.

Most investors understand when interest rates fall, bond prices rise and when rates rise, bond prices fall. However, it is noteworthy to remember not all bond prices react to the same extent when rates change. Some are more sensitive than others. For example, long maturity bonds and lower coupon bonds are subject to larger changes in price as compared to short-term bonds or higher coupon bearing bonds.

Being “sensitive” to a bond’s price sensitivity is another important concept for our portfolio managers to understand as we make portfolio decisions.

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Three factors determine the effective life of a bond: the bond’s maturity, its coupon rate and current market rates.

The value of money can be calculated by using the concepts of “future value” and “present value”. Future value indicates the value of today’s dollar versus its value at some future date. Present value indicates how much a dollar received at some future date is worth at the present.

To best explain the concept, input the following into your financial calculator:

The discount is the difference between the purchase price of a bond and its stated redemption price at maturity. Investors purchasing a bond in the secondary market or bonds purchased at the original issue date as an original issue discount bond will derive their return from the coupon interest paid and from the difference between the purchase price and the redemption value.

While most discounts are purchased in the secondary market (the after market of a new issue bond) some new issue bonds are issued at a discount. These discounts are termed “original issue discount” (OID).

A market discount generally exists when a bond is purchased on the secondary market at a price below par. For the bond purchased at an original discount (OID), like a Zero-coupon, the discount is the difference between the purchase price and the issue price of the bond plus accreted OID.

There may be tax implications involved in either case. We refer you to your Bernardi Investment Specialist for guidance relating to the de minimis rule and other tax matters to be considered when purchasing a discount bond.

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ZERO BONDS

Only with “zero based” bonds are maturity and lifetime synonymous. “Zeros” derive their entire return from the difference between the purchase price and the redemption value. There are no coupon payments. A “zero bond” promising to pay a yield of $100,000 in 20 years has an effective life of 20 years. No return accrues in the interim years.

For comparison purposes, assume the $100,000 is invested in the 20-year Zero bond at 5%. The dollar price the investor pays would be about $37,000. Compare the zero investment with a $100,000 investment in a coupon bond of the same maturity purchased to yield 5%.

The zero bond costs less to purchase and the promised yield for both bonds would be the same. However, the cash flow is quite different. The coupon bond produces a cash inflow of $5,000 each year for the next 20 years, thereby making the “weighted average” term of its payout much shorter (the investment is being repaid gradually rather than in a lump sum) while the zero bond does not pay the total return promised until the 20th year.

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The investor who takes the time to understand “premium bonds” will be rewarded with higher yields, greater price stability and greater refunding possibilities.

The following table illustrates the income flow of a 5.20% coupon bond purchased at a yield of 3.25% (a dollar price of 110.393). The premium is returned to the investor, with interest on the premium, over the life of the bond. The premium paid, as stated previously, is not a cost factor. It is similar to a homeowner’s mortgage payments; part of the payment is interest on the outstanding principal and the remainder is a payment for principal amount owed.

For the investor living in states with state income taxes, that part of the coupon payment which is premium being return is not taxable.

“Cushion bonds”, sometimes referred to as “kicker bonds”, can be excellent investments for most bond portfolios. “Cushions” are callable, high coupon bonds selling at a premium. “Cushions” often offer higher than available market yields to its call date and considerably higher yields to maturity when compared to bonds with the same maturity.

The risk is that the issuer will call the bond prior to its maturity. The market adjusts for this risk and the investor can earn a higher returns because of the call possibility and because of the uncertainty as to the date the bond could be called. However, we often find that, even if a bond is called at its worst call date, the investor will have earned more than what would have been earned with a comparable non-callable bond. Remember:

It all depends on the investor’s investment parameters. There is no one “best answer” to the question. Remember:

The “escrowed to maturity” or “pre-refunded” bond is born when new securities*, purchased by the issuer, are placed in an escrow account for the sole purpose of meeting all interest and principal payments of a previously issued debt. If the new bonds* are set aside to redeem a bond at the first possible call date, it becomes a “pre-refunded bond”. If the bonds are escrowed to maturity the bonds become an “escrowed to maturity” (ETM) bond issue.
* Usually U.S. Treasury Securities
.
Issuers applying for its refunded issue to be rated automatically receives a AAA rating from both Moody and Standard & Poor if the bonds held in the escrow to pay the interest and principal are U.S. Government bonds. The original issuer becomes the guarantor in name only. The U.S. Government bonds held in escrow are now the security behind the escrowed bonds.

Some escrowed bonds are not rated AAA even if secured by U.S. Government bonds. In fact, some may have no rating whatsoever. Why? Often, because issuers do not want to pay the rating services when they receive no benefit; therefore, they do not apply for a rating. But rated or not, all U.S. Treasury escrowed bonds are of the same quality. Payment is dependent only upon the United States Government’s ability to pay its obligations.

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Analyzing debt is the ongoing, everyday task of our portfolio managers and underwriters. There is no “short course”; no short cuts. Debt analyses covers a broad spectrum of financial interpretation including knowledge of the issuer’s debt history and the issuer’s past, present and future economic situation.

Proper analyses demands professional attention and the more sophisticated the debt instrument, the more professionalism required. See our “Bernardi A* Approved Bonds page for a quick review of a few of the questions we ask about any bond being considered for placement in a Bernardi Managed Portfolio. As a quick read, here are a few basic questions you might ask of a bond you may be considering:

Security behind the debt?
Direct debt (DD)?
Ratio of the DD to AV?
DD per capita and the DD+OD per capita?

Assessed Valuation (AV)?
Overlapping debt(OD)?
Ratio of DD + OD to AV?
Authority for issuing the debt?

Utility Revenue Bonds:

Security behind the debt?	Flow of Funds
Number of Users?	Reserve Accounts & Amounts in Each
Total Amount of Utility’s Debt?	If water, gas, electric ask what is Source of Supply?
Debt per User?	History of Past Debt?
Projected Coverage of Debt?	Population?
Debt Coverage Based Upon Actual Revenues?	Economic Factors?

NON-RATED BONDS AND BOND RATINGS

As underwriters and as portfolio managers we assume the responsibility for the study and analyses of each issue placed with our clients.

While ratings provide an excellent guide for evaluating the quality of a bond, they should not be the sole basis for an investment decision. In fact, we believe “ratings” should be used merely to confirm the strength or weakness of a particular bond based upon our own analyses.

Usually, non-rated bonds are not rated because the issuer is not willing to pay for the rating agency’s opinion. We will often recommend our issuer clients not pay the fees required to attain a rating. It is our own analyses and knowledge that leads us to recommend issues we know and follow.

In order to add value we, at times, place “non-rated” bonds into our managed portfolios.

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BOND RATING AGENCIES

Rating agencies are paid by a bond issuer to rate the issuer’s bonds and they often (but not always) monitor bond issues after their original offering. It is important to remember as an issuer’s financial and/or other conditions change, its’ rating might be lowered or improved depending upon the circumstances. The following table outlines the financial indicators (ratings) used by two of the major bond-rating agencies.

What Does Rating Mean	Moody’s Ratings	Standard & Poor’s Ratings

Highest Possible Rating	Aaa	AAA
Superb Quality	Aa1 Aa2 Aa3	AA+ AA AA-
Excellent Quality	A1 A2 A3	A+ A A-
Adequate Quality (lowest investment grade for banks)	Baa1 Baa2 Baa3	BBB+ BBB BBB-
Speculative to Very Risky	Ba1 down to B3	BB+ down to B-
Verge of Default	Any “C” Rated	Any “C” Rated Bond
In Default	D	D

Links to Rating Agencies’ Web Pages

Using bond ratings as a measurement of a bond’s quality is an excellent tool. However, there are many other factors affecting a bond’s price beyond its’ rating. Factors such as geographical location, the “name” of the issuer and the purpose of the debt affect bond pricing over and above the rating given by a rating agency.

It is important to remember that ratings are approximate guides for analyzing relative bond values. While some investors view “ratings” as absolutes, they are not. Conditions change. Ratings change. Markets change. Values change.

Use the Bernardi links provided below for information about several of the more widely recognized rating agencies:

Standard and Poor’s Corporation

Moody’s Investor Service

Fitch Investors Service, Inc.

Overview

What Are They?

FLOATS are auction products issued by municipal authorities for a wide variety of reasons. Dividend Rates are set via an auction each payment cycle and are based upon current market conditions. Usually the rates are reset weekly, some are reset monthly.

There are about $42 billion in tax-exempt auction market municipal bonds currently outstanding. In 2003, auction market issuance reached a record $24 billion, comprising 227 issues, and an increase in total volume of 71% over 2002.

Reset Cycle:	Investors purchase and sell at par and the investor can tender bonds (Put) on any reset date. Settlement is next business day. Interest is paid after each reset cycle (7,28 or 35 days).
Tax Exempt:	The FLOATS we offer are usually those exempt from federal income taxes and, in some states, exempt from local and state taxes.
Quality/Ratings:	Most FLOAT issues are insured and have an underlying long- range rating of AA or better. There are no short-term ratings.
Advantages:	Holding Period Flexibility Credit Quality Frequent Coupon Payments Liquidity.
Disadvantages:	Dutch Auction Mechanism. If there are more sellers than buyers in any given auction (see following paragraph), the investor may not be able to sell securities until the next successful auction or legal final maturity. Rates are set to compensate investors with enhanced yield to compensate for reduced liquidity. However, although not obligated to do so, the remarketing agent usually inventories unsold securities to ensure a successful auction.
Denomination:	Multiples of $25,000
Minimum:	$100,000

MUNICIPAL BOND CREDIT ENHANCEMENTS

Municipal Bond Insurance:

Very popular with individual investors, “insured” bonds now account for more than 50% of municipal bond issues currently coming to market. This popularity is best measured by the number of new insurers now competing to “insure” bond issues.

The insurance provides an added layer of security

This added security is as strong as is the insurance provider

The investor pays the “insurance premium” through the acceptance of a lower yield than a bond otherwise would have paid without the insurance

A bond rated “AAA” because of insurance does not trade as well as a bond rated AAA on its own merits.

We have our biases:

We want to know the quality of the bond on its own merit

We question the practicality of paying insurance premiums on bonds highly regarded or rated on their own merits

Many of the insuring companies will avoid insuring bonds whose credit is weak or because the size of the issue is small

We want to know the strength of the insurance company providing the insurance

Best-known bond insurers with AAA rating include (click below to access their websites):

American Municipal Bond Assurance Co. (AMBAC)

Financial Guaranty Insurance Company (FGIC)

Financial Security Assurance (FSA)

Municipal Bond Insurance Association (MBIA)

Alternate Revenue Bonds

Often referred to as a “double barreled” source of security, we often recommend alternate revenue bonds. The debt is secured by the issuing entity’s revenue stream and further secured by a pledge from the issuer’s tax base.

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Letter Of Credit (LOC)

“LOCs” are credit enhancements issued normally by banks and insurance companies. They are similar to bond insurance, but with less protection for the investor. The credit enhancer is not obligated to actually make interest payments.

A line of credit is extended so the issuer can borrow and thereby meet interest payments if cash is not available to cover payments. We rarely employ the use of LOCs.

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JUNQUE IS JUNK

Junk bonds or bonds tagged as “non-investment grade” or “speculative” do not belong in conservative bond portfolios. These bonds pay the investor higher rates of interest because of their credit unworthiness. We are not in the “junk” business. They do not belong in any of our portfolios.

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TAXABLE MUNICIPAL BONDS

Taxable bonds are issued when bond issue proceeds are used for a private purpose,
including bonds issued for some housing projects, sports facilities, etc.

Bernardi Securities, Inc. frequently trades/recommends taxable bonds. Taxable municipal bond yields are substantially higher than yields available on US Government bonds and usually are comparable to yields available on investment-grade corporate bonds. Many are general obligation bonds backed by the full and unlimited taxing power of the municipality issuing the bonds.

Also, inasmuch as we are able to fully analyze a taxable municipal bond credit in the same manner as a tax-free* municipal, our portfolio managers regularly use taxable municipal bonds for a variety of portfolios including retirement plans, pension plans and other tax-deferred portfolios.

*Free from current Federal income taxes only.
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FLOATING RATES AND VARIABLE RATE BONDS

These securities often come to market during periods of rising interest rates. Generally, the issuer periodically re-calculates the interest paid the investor. The re-calculation is based upon the then prevailing rates.

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