Chapter 3

Bonds features

type of debt security - it is basically a loan

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 bonds face value or principal

• typically 1000 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 bonds 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

• associated with greater interest rate volatility

Term issuance

• all bonds issued and mature on the same day

  • typical issuers: corporations and government

  • type of quote : price quotes, dollar quotes, percentage of par quotes, and 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 to compensate for risk.

• company will hire an underwriter that will pay them upfront for an entire bond issuance, regardless of how many bonds are sold.

best efforts commitment underwritings

• issuer keeps unsold securities

• riskier for the issuer

• smaller fees for underwriter

Us government bonds

• settles one business day after trade

• settles through the federal funds system

Municipal and Corporate Bonds

• settles one business day after trade

• settles through the clearing house system

Seminannual interest / interest on bond for when sold before next payment date

Bonds are paid semi-annually (twice a year), so if a bond is sold to another buyer before the next payment date, whoever has the bond currently is paid. So if the new owner gets the bond 4 days before the payment date, even though they have had it only for 4 days, they still get the interest payment.

• However, the new buyer pays back the original buyer for whatever amount of days they had the bond before them in that period. This is called accrued interest, so then everyone is equal and then the original buyer gets what they were there for or owe and the new buyer gets the amount they earned from being there for 4 days.

30/360 method

• All months are considered to have 30 days

• used for corporate and municipal bonds

actual/365 method

• every month is considered and counted using their actual amount of days

• Used with US government bonds

secured loan

backed by something of value, such as property or assets, providing the lender assurance that they can recover their funds in the event of default.

• also described as collateralized, meaning the bond is backed by collateral

• mortgages or car loans are a good example —> so if the issuer fails to pay required payments, the collateral can be liquidated (sold) and the proceeds are used to pay bondholders.

• For example, a corporation may do a mortgage bond backed by a factory it owns. If the corporation can’t make the required interest or principal payments, the factory must be sold, and the sale proceeds go to the bondholders.

• MORE SAFE

unsecured loan

backed only by the borrowers promise to repay

• so if the issuer fails to make the required payments, bondholders can still sue, but there’s no specific asset pledged to support repayment. If the issuer has no assets or money left, bondholders can lose their entire investment.

Callable bond

• basically calling off the loan early and paying them back early

Allows the issuer to repay the bond’s principal (par value) before maturity and redeem the bond early. When a bond is called, the issuer must pay bondholders : any accrued interest, the bonds par value, and any call premium

call protection

period during which the bond cant be called.

• for example, if a 20 year bond cant be caled for the 10 years, it has 10 years of call protection

call premium

amount above par (1000$) the issuer must pay to call the bond.

• if the bond is callable at $1030, the call premium is $30

put feature

Allows bondholders to sell the bond back to the issuer before maturity for a par value plus any accrued interest. Puttable bonds are attractive to investors, especially when interest rates rise.

• protects the bondholder from rising interest rates

• This helps when interest rates rise because, to sell to the secondary market, you have to lower the price, which means you incur a loss, but with a put feature you can sell the bond back to the issuer at the original value, which is 100 so you don’t incur any loss.

why do bond prices fall when interest rates rise

imagine buying a bond with par value at a coupon rate of 5%. A year later the annual interest rate rises. Now companies are issuing new bonds that pay at a 8% rate. Now noone wants to buy that bond because they can buy a bond at a better rate. So in order for someone to buy the bond off of you compared to bonds lready in the market, you are forced to lower the price value of the bond

Options when a bonds intererst rate rises

1. Keep the bond: you do nothing and continue to receive the same lower-interest-rate dividends

2. Sell in the secondary market: sell it to another investor for a lower price, and now the new investor is receiving a dividend each year at the same lower interest rate but at a discounted price for the bond

3. Bond has a put feature: instead of selling to another investor, you go straight to the company you bought the bond off of and say you are exercising your put. They pay you the 1000 plus the accrued interest.

4. Now you just buy a bond with the higher interest rate

yield for bonds

Measures the overall return of an investment

• influenced by several factors. including :

  • interest rate (coupon)

  • purchase price

  • length of time until maturity

• if a bond is purchased at a discount or a premium, its yield will differ from the interest rate

interest rate for bonds

annual interest rate the issuer pays based on par value

nominal yield

This is different from yield and is just another name for a bond’s interest rate (coupon).

• Nominal yield = annual income/par

• unlike other yields, market price is not part of the nominal yield calculation

Current yield

Quick but incomplete way to estimate return

• It uses an annual income and the bond’s current market price, but it ignores time

• for discount bonds, current yield > coupon

• for premium bonds, current yield < coupon

bond seesaw

if you know there is a discount then you can assume the current yield will be higher than actual yield eliminating any answers that are lower than the actual yield

yield to maturity

yield that includes time, assuming the investor buys the bond and holds it until maturity

• c = coupon interest payment

• f = face value (par)

• p = price

• n - years to maturity

• denominator averages the price and par

• Discount bonds have yields above the coupon

yield to call

applies only to callable bonds. it is the bonds overall rate of return assuming its called after the first call date.

Discounted bond order

coupon = the lowest 4 % for ex

current yield = 5%

YTM = 6.7%

YTC = 8.9%

premium bond order

Coupon = 4%

current yield = 3.6%

YTM = 2.9 %

YTC = 1.9%

• it gets lower and lower, with YTC as the lowest percentage

Bond purchased at par

all yields equal the coupon rate

Interest income

• primary benefit of bonds

• unlike cash dividends on stock, interest payments don’t require approval from the BOD.

  • this is why bond income is more predictable

Capital appreciation

The value of an investment increases; for example, you buy a bond for 950 and sell it for 1000.

Interest rates are unpredictable, however, so it’s hard to predict.

Most investors buy bonds for predictable interest income, not for price appreciation, since it is hard to predict price fluctuations.

systematic risks of bonds (affect the whole market)

• Interest rate risk: Bonds with long maturities and low coupons tend to move the most when market conditions change

  • biggest driver of bond prices is changes in interest rates.

Inflation (purchasing power) risk

• The Fed tends to raise interest rates when inflation rises. This is why purchasing power risk and interest rate risk are closely connected.

• Short-term investment is best

reinvestment risk

• The risk that future interest payments you receive cannot be reinvested at the same interest rate, so you’re not worried about losing your bond - you are worries about what to do with the interest payments you receive

• occurs when interest rates fall

• when interest rates fall, bond prices rise - but reinvestment focuses on what happens to cash flows you need to reinvest.

default risk / credit risk or repayment risk

• nonsystematic risk

• the risk that an issuer can’t make required interest and/or principal payments. The most common cause is bankruptcy.

investment grade bonds

• have little to no default risk and are rated BBB or higher by credit rating agencies, indicating a good credit quality.

speculative grade bonds (also called junk bonds)

have considerable default risk and are rated BB or lower

Liquidity (marketability) risk

The risk that a security can’t be sold quickly, or can be sold with a deep discount.

• municipal bonds are known for liquidity risk

• the less desirable a bond is to investors, the more liquidity risk it has

• ex. for a company near bankruptcy may be difficult to sell without a steep price discount (or may not be sellable at all

Legislative risk

risk that a new law or regulation negatively affects an investment

ex. Tariffs imposed by the Trump administration (2018) increased the cost of doing business with foreign companies from certain countries.

investors experienced legislative risk when the stock market responded negatively to the trade war

political risk

• Political instability negatively affects an investment.

• ex. military coups, threats or acts of war, and mass riots

Typical bond investor

• older and more conservative

• Involve less risk than stocks, meaning lower expected returns

• those who want safer, more predictable income (low risk)

• Zero-coupon bond is the exception —> pays no interest income, and just has one payout at the end, so if investor wants a predictable payout in the future but doesn’t need income along the way this is the way to go

interest rate risk

• occurs when interest rates rise, which forces the price of all existing bonds lower

• the risk that a bond’s market price will change because interest rates change.

Zero value bond / reinvestment risk

• has no reinvestment risk

• long maturity and small coupon rate is best for reinvestment risk

inflation/interest rate/ bond price relationship

inflation goes up, the interest rate rises, and that means bond prices fall

vice versa - when inflation falls, interest rate falls, and that means bond prices rise

variable rate bond

• have low interest rate risk

• have interest payment that change with current market interest rates

• so if a bond initially pays 5% but the market rate rises to 7%, the bond’s coupon may reset upward to around 7%

zero coupon bond

• low reinvestment risk

• high interest rate risk.

Impact on interest rate risk

• when looking to combat the risk, you should seek. bonds with short maturities and high coupon rates.

• However, if you had to choose one thing, maturity has the bigger impact on exposure to interest rate risk. SO a short maturity lowers interest rate risk

political vs legislative risk

political = foreign (somethinghappens politcally to the government )

legislative = a new law or tax or smtg of that sort is introduced

BB (investment grade)

highest speculative bond rating

BBB (speculative grade)\

lowest investment grade bond rating

all the following entities rate bonds

• standard and Po’s

• fitch’s

• moodys