bond prices and yields

types of fixed income instruments

• loans

• bonds

loans

• private, none tradeable agreements between a borrower and a lender

bonds

• standardized, tradeable securities in which investors lend capital to the issuer of a bond

  • issuer promises to repay the principal borrowed plus interest (aka the coupon)

issuers of bonds

• corporations - corp bonds

• sovereign govts - govt bonds

• non sovereign govts - local govt bonds

• quasi govt entities - freddie ma

• supranational entities - european investment bank

• special purpose entities - asset backed securities

maturity date

• the date the final cash is to be repaid

principal

• par value that will be repaid

coupon rate

• annual % of par value

  • can be annual, semiannual, quarterly, or monthly

zero coupon bonds

• pay no interest/coupons

floating rate notes

• pay coupons at a variable rate

• coupon = market reference rate + fixed margin in bps

basis points

• 100 bps = 1%

seniority

• senior debt ranks ahead of junior (subordinated debt) in a bankruptcy

contingency provisions

• bonds may contain rights for the issuer or the investor

  • callable + putable 

callable bond

• right for the issuer to call in the bond early at a fixed call price

putable

• right for the investor to sell the bond back to the issuer at a fixed put price

bond indenture

• legal contract between the issuer and the bondholder

  • defines obligations and restrictions

sovereign bonds

• repaid from taxes on economic activity/ the ability to create new currency

local government bonds

• repaid from local government taxes or revenue from operational infrastructure

secured bonds

• repaid from issuer’s operating cash flow

  • added security of a legal claim on specific collateral

unsecured bonds

• have no added security in their bond indenture

bond covenants

• specific requirements the issuer must fulfill within the bond indenture

affirmative covenants

• specify requirements the issuer must fulfill

  • provide timely reports to bondholders

  • bondholders right to redeem at par, or at a premium in a merger

• ex: cross default, pari passu

cross default provision

• any issuer defaults also apply to this bond

  • is an affirmative covenant

pari passu clause

• ensure the bond continues to have a senior claim

  • is an affirmative covenant

negative covenants

• place restrictions on the issuer so that the risk of the issuer default does not increase

  • entering into asset sales and leaseback agreements

  • pledges of collateral

• ex: negative pledge clause, incurrence test

negative pledge clause

• issuance of more senior debt, ranking above existing debt

  • is a negative covenant

incurrence test

• additional borrowings, share repurchases, or dividends can only be carried out if financial rations remain within a specified threshold 

  • is a negative covenant

quotes bond price

• does not include interest accruing between coupon payment dates

corporate bonds

• callable

• convertible

• put bonds

• floating rate 

convertible bond

• bonds with an option allowing the bondholder to exchange the bond for a specified number of shares of common stock

put bonds

• bond that the holder may choose to either exchange for par value at some date or extend for a given number of years

floating rate bonds

• bonds with coupon rates periodically reset according to a specific market rate

preferred stock

• considered equity, but included in the fixed income universe

• differ from bonds

  • failure to pay div does not result in corp bankruptcy

  • div owed cumulate

domestic issuers

• state, local govts (muni bonds)

• federal home loan bank board

• government national mortgage association (Ginnie Mae)

• federal national mortgage association (Fannie Mae)

• federal home loan mortgage corporation (Freddie Mac)

• farm credit agencies

foreign bonds

• issued by a borrower from a country other than the one in which the bond is sold

• denominated in the currency it is marketed in

eurobonds

• denominated in one currency, but sold in other national markets

eurodollar market

• dollar denominated bonds sold outside the US

euroyen bonds

• yen denominated bonds sold outside japan

maturity

• bond conventionally issued with maturities up to 30 years

  • recent years = 50-100 yrs

inverse floaters

• coupon rate falls when the general level of interest rates rise

asset backed bonds

• income from a specified group of assets used to service debt

pay in-kind bonds

• issuers can pay interest in cash or additional bonds

catastrophe bonds

• higher coupon rates to investors for taking on risk

indexed bonds

• payments tied to the general price index or the price of a particular commodity

• ex: TIPS

treasury inflation protected securities

• par value of the bond increases with the consumer price index

bond value

• PV of coupons + Present par value

price and yield

• inverse relationship

  • interest rate fluctuations is a main source of risk in the fixed income market

  • convex curve - becomes flatter with higher interest rates

yield to maturity

• discount rate that makes the PV of the bond payments equal to the price

• avg rate of return if the bond is bought now and held until maturity

  • bonds internal rate of return

• base don coupon rate, maturity, and par value (all readily available)

current yield

• annual coupon / price

yield to call

• calculated like YTM - time until call replaces time until maturity

• low interest rates

  • price of callable bonds = flat

  • risk of being called is high

• high interest rates

  • price converges to that of a normal bond

  • risk of call is negligible

realized compound return

• compound rate of return on bond with all coupons reinvested until maturity

horizon analysis

• analysis of bond returns of a multiyear horizon, based on forecasts for the bond’s YTM and reinvestment rate of coupons 

reinvestment rate risk

• uncertainty surround the cumulative future value of reinvestment bond coupon payments

  • reinvestment rate risk offsets price risk

price path of bonds

• bond price approached the par value as the maturity date approaches

holding period return

• rate of return over a particular investment period

• depends on the bonds price at the end of the period, which is an unknown value

separate trading of registered interest and principal of securities (STRIPS)

• the US treasury oversees brokerage firms’ creation of zero coupon bonds from coupon bearing notes and bonds

after tax returns

• built in price appreciation on original issue discount bonds constitutes an implicit interest payment to the holder

• IRS calculates price appreciation schedule 

  • determines taxable interest income for built-in appreciation 

credit risk

• aka default risk

• risk that the bond issuer will fail to make all promised payments

rating companies

• moodys

• standard and poors

• fitch investor service

investment grade bonds

• BBB/Baa or above

speculative / junk bonds

• Below BBB/Baa

determinants of bond safety

• coverage ratios

• leverage ratios

• liquidity ratios

• profitability ratios

• cash flow to debt ratio

coverage ratio

• company earnings to fixed costs

leverage ratios

• debt to equity

liquidity ratios

• current: CA / CL

• quick: CA (excluding invt) / CL

profitability ratio

• measures RoR on assets or equity

cash flow to debt ratio

• total cash flow to outstanding debt

bond indentures

• subordination clause

• collateral

• debenture

• sinking fund

subordination clause

• restrictions on additional borrowing stipulating that senior bondholders are paid first in the event of bankruptcy

collateral

• specific asset pledges against possible default on a bond

debenture

• bond not backed by specific collateral

sinking fund

• indenture calling for the issuer to periodically repurchase some proportion of outstanding bonds prior to maturity

promised ytm

• will be realized if the firm meets the obligations of the bond issue

expected ytm

• must consider the possibility of default

default premium

• differential in promised yield that compensates the investor for the risk inherent in purchasing a corporate bond

credit default swaps

• insurance policy on the default risk of corporate bonds or loans

  • designed to allow lenders to buy protection against losses on large loans

  • risk structure of interest rates and CDs prices are tightly aligned

• used to speculate on the financial health of companies

yield curve

• graphical relationship between yield and maturity

• allows investors to gauge their expectations for future interest rates against those of the market

expectations hypothesis

• theory that yields to maturity id determined solely but the expectations of future short term interest rates

spot rates

• rates starting today for a specified period

• can be used as discount rates for future cash flows to find present values

• zero coupon bonds can be used to infer these

forward rate

• short term rate of interest for a future period

• makes expected total return of a long tern bond = short term bond 

• no arbitrage

  • 3 yr spot rate should be the same as investing for one year in three successive periods

liquidity preference theory

• investors demand a risk premium on long term bonds

liquidity premium

• extra expected return demanded by investors as compensation for the greater risk of long term bonds

  • spread between the forward ROI and expected short sale