Ch. 3 [debt securities]

Bond Features

• Debt security

• Allows issuers to borrow from investors

principal

• Original loan amount; the face value

• Also known as the par value

interest

• Cost of borrowing money

par value

• Known as a bond’s “face value” or principal

• Typically $1,000 for bonds

• Typical sale price for new issue bonds

• Bond interest payments based on par

• Stays fixed for the life of the bond

maturity date

• Date the issuer pays:

  • One final interest payment

  • Principal (par value)

interest rate (coupon)

• Represents annual interest paid to bondholders

• Based on the bond’s par value

• Largely dependent on market interest rates at the time of issuance

interest payments

• Legal obligation of the issuer

• Typically made semi-annually

bearer bonds

• Owned by whoever physically possesses them

• No longer issued in the US

book entry bonds

• Ownership tracked electronically by a transfer agent

• All modern securities issued in this format

zero coupon bonds

• Do not make regular interest payments

• Issued at a discount and mature at par

• Longer maturities = deeper discounts

short-term maturities

• Safer than long-term bonds

• Lower rates of return

money markets

• Debt securities with one year or less to maturity

long-term maturities

• Riskier than short-term bonds

• Higher rates of return

Term Issuance

• All bonds issued and mature on the same day

• Typical issuers:

  • Corporations

  • US government

• Type of quote:

  • Price quotes

  • Dollar quotes

  • Percentage of par quotes

  • Term quotes

Serial Issuance

• All bonds are issued on the same day, but mature on different days

• Typical issuers:

  • Municipalities

• Type of quote:

  • Yield quotes

  • Basis quotes

  • Serial quotes

Series Issuance

• Bonds are issued on different days, but all mature on the same day

• Typical issues:

  • Construction-related projects

Basis points

• Formal measurement of percent

• 1 basis point = 0.01%

• 100 basis points = 1%

Firm commitment underwritings

• Underwriter keeps unsold securities

• Riskier for underwriter

• Larger fees for underwriters

best effort commitment underwritings

• Issuer keeps unsold securities

• Riskier for the issuer

• Smaller fees for underwriter

Primary market

Where issuers initially sell their securities to the public

Secondary Market

Where investors trade securities after sold in the primary market

Bond Transactions

• IPOs occur in the primary market

• Trade in the secondary market

Bond Market Prices

• Influenced primarily by Interest rates

• Interest rates up, market prices down

• Interest rates down, market prices up

Discount Bond

Trades below par ($1,000)

Premium Bond

Trades above par ($1,000)

Price Volatility

• Measures how fast bond prices move

• Bonds with the most price volatility:

• Long maturities

• Low coupons

US government Bond Trades

• Settle one business day after the trade (T+1)

• Settle through the Federal Funds system

Municipal and corporate bond trades

• Settle one business day after the trade (T+1)

• Settle through the Clearing House system

Accrued Interest

• Paid by the buyer to the seller during a bond transaction

• Interest accrues up to, but not including the settlement date

30/360 method

• Assumes 30 days in each month “counted over”

• Utilized for corporate & municipal bonds

Actual/365 method

• Counts actual days in months

• Utilized for US Government bonds

Trading Flat

• Bonds that trade without accrued interest

• Examples of flat bonds:

  • Zero coupon bonds

  • Bond trades settling on the payment date

secured bonds

• Collateral backs the bond

• Safer investments vs. unsecured bonds

Unsecured bonds

• Also known as full faith and credit bonds

• No collateral backing

• Riskier investments vs. secured bonds

call feature

• Allows issuers to end a bond before maturity

• Requires the payment of accrued interest, par, plus any call premium

• Typically utilized when interest rates fall

call premium

Amount above par ($1,000) issuer must pay to call the bond

call protection

Number of years before a bond may be called

tender offer

Formal offer to buy a security from current investors

put feature

• Allows bondholders to end a bond before maturity

• If exercised, the issuer must pay accrued interest plus par to the bondholder

• Generally utilized when interest rates rise

Nominal Yield

• NY=Par / Annual income​

• Measures the interest paid annually to investor

• Never changes over the life of the bond

• Also known as:

  • Coupon

  • Interest rate

  • Stated rate

Current Yield

• CY=Market price/Annual income​

• Measures overall rate of return based on the current market price

• Discount bonds CY > coupon

• Premium bonds CY < coupon

Yield to Maturity (YTM)

• Measures overall rate of return if the bond is held to maturity

• Discount bonds YTM > coupon

• Premium bonds YTM < coupon

Yield to Call (YTC)

• Measures overall rate of return if the bond is held until called

• Discount bonds YTC > coupon

• Premium bonds YTC < coupon

Discount Bond Yield Relationships

• Current yield, YTM, and YTC are higher than the coupon

• Order of all yields (lowest to highest)

  • Nominal yield (coupon)

  • Current yield

  • Yield to maturity (YTM)

  • Yield to call (YTC)

Premium Bond Yield Relationships

• Current yield, YTM, and YTC are lower than the coupon

• Order of all yields (lowest to highest)

  • Yield to call (YTC)

  • Yield to maturity (YTM)

  • Current yield

  • Nominal yield (coupon)

Par bond yield relationships

All yields are the same

bond benefits

• Primary benefit is interest income

• Interest payments are legal obligations of the issuer

• Capital appreciation may occur, especially if interest rates fall

interest rate risk

• Interest rates rise, forcing bond market prices down

• Type of systematic risk

• Most susceptible bonds:

  • Long maturities

  • Low coupons

• Avoided by variable rate bonds

Inflation (purchasing power) risk

• Prices of goods and services rise, forcing bond prices down

• Typically results in higher interest rates due to Federal Reserve actions

• Avoided by short-term securities

Reinvestment risk

• Market returns reinvested at lower rates

• Occurs when interest rates fall

• High coupon bonds are most susceptible

• Avoided by zero coupon bonds

Call risk

• Bond called when interest rates fall

• The worst form of reinvestment risk

Default risk

• Also known as credit or repayment risk

• Issuer unable to make required interest and/or principal payments

Bond Ratings

• Only consider default risk

• Three bond rating organizations:

  • Standard & Poors (S&P)

  • Moody’s

  • Fitch

Investment grade bonds

• BBB or above

• Low default risk

Speculative (junk) grade bonds

• BB or below

• High default risk

Liquidity (marketability) risk

Security is difficult to sell or requires a large discount to sell

legislative risk

New domestic law or regulation negatively affects a security

political risk

Foreign government instability negatively affects a security

typical investor

• Seeking income

• Generally older, risk-averse (conservative)

systematic risks

• interest rate risk

• inflation risk

• reinvestment risk

non-systematic risk

• default

• liquidity

• legislative

• political