Lecture 11: Bonds

Characteristics of Bonds

  • Definition of Bonds

    • A bond is a financial security that obligates the issuer (firm) to make specified payments to the bondholder (investor).
    • Essentially, it serves as a financial contract.

  • Key Characteristics of Bonds

    • Face Value

    • The amount that the investor receives at the maturity of the bond.

    • Maturity Date

    • A specified date on which the face value of a bond must be repaid.

    • A bond is a finite life financial contract, meaning it has a defined term till maturity.

    • Coupon Rate

    • The annual interest payment made as a percentage of the face value.

    • Coupon Payments

    • Actual dollar amounts of interest payments made to the bondholder during specified periods (e.g., annually, semi-annually).

    • Secured vs. Unsecured Bonds

    • Secured Debt

      • Gives bondholders rights over specific assets used as collateral in the case of default.

    • Unsecured Debt

      • No collateral backing; typically, these are riskier.

  • Safety of Bonds Compared to Stocks

    • Bonds are generally safer compared to stocks due to their priority during liquidation.
    • In the event of company distress, bondholders are paid before stockholders.

Issuers of Bonds

  • Types of Issuers

    • Federal Government

    • Issues bonds such as treasury securities to borrow money, considered very unlikely to default.

    • Corporations

    • Issue corporate bonds, with U.S corporate debt exceeding $5 trillion.

    • Mortgage Debt

    • Represents roughly $5.5 to $6 trillion in bonds.

    • State and Local Governments

    • Issue municipal bonds, typically riskier than federal government bonds due to limited capacity to generate revenue.

    • Foreign Entities

    • Issues various forms of bonds such as eurobonds.

U.S. Treasury Securities

  • Market Characteristics

    • The U.S treasury market is considered liquid and extensive, with a total debt of approximately $31 trillion.
    • U.S treasuries hold significant risk-free status because the government can print money to meet obligations.

  • Types of U.S. Treasury Securities

    • Treasury Bills (T-Bills)
    • Treasury Notes (T-Notes)
    • Treasury Bonds (T-Bonds)
    • Classification depends on maturity.

  • Market Features

    • Low transaction costs due to a deep market with many buyers and sellers.
    • Nearly constant trading activity means low commissions.

  • Default Risk

    • U.S treasury bonds are issued under strong repayment guarantees unlike state/local debts which may be subject to bankruptcy.

Pricing of Bonds

  • Valuation Process

    • Bonds pay fixed coupon payments and a lump sum at maturity, making valuation critical.

  • Discounting Cash Flows

    • Present value calculations involve discounting future cash flows, continuing through the timeline until maturity.
    • Two common present value strategies:
    • Discount each cash flow to present value individually.
    • Treat coupon payments as an annuity, and calculate the lump sum payout separately.

  • Yield to Maturity (YTM)

    • The average return on a bond if coupons are reinvested at the YTM.
    • YTM can differ from actual realized return due to changing interest rates.

Examples of Bond Valuations

  • Example 1: Calculate YTM from Market Price

    • Coupon: 8% on $1,000 face value
    • Market Price: $1,053.46, maturity in 3 years.
    • Calculation requires use of financial calculator to derive YTM (about 6.0%).

  • Example 2: Semi-annual Bond Payment

    • Similar structure but payments split leading to adjusted calculations for semi-annual discounting.
    • Understand the effects of varying payment schedules.

Bond Pricing In Depth

  • Differentiating Premium vs. Discount Bonds

    • Premium bonds have prices above face value, discount bonds below.
    • Price affects return expectations; higher YTM indicates riskier investment.

  • Understanding Price Movements

    • As bonds approach maturity, their prices converge to face value, leading to predictable price movements.

  • Impact of Coupon Payments

    • Bonds may be affected differently when purchased between coupon payments, leading to adjustments for accrued interest.

Common Mistakes in Bond Calculations

  • Mistaking coupon rates for discount rates can influence valuation results.
  • Ensuring accurate input of financial calculator variables is critical for proper valuation.
  • Understanding the terms that characterize bond features and their implications on pricing is essential for higher-level understanding.

Final Remarks on Bonds

  • Bonds will return to face value at maturity, regardless of interim price changes or market conditions.

  • An inverse relationship exists between bond pricing and yield to maturity due to changing investor demands and risk perceptions.

  • Various factors affect YTM including economic shifts, issuer credit quality changes, and differing cash flow timing.

  • In the next lecture, we will discuss bond risks and delve deeper into the analysis of bond contracts to advance our understanding of this financial security.