Bonds and Derivatives

Overview

• The notes cover various aspects of bonds, derivatives, and related terminologies relevant to investing and public policy.
• The notes include a coverage of treasury bonds, municipal bonds, agency bonds, as well as rating systems and risk evaluations.

Derivatives

• Financial contracts exist between two or more parties which gains its value from an underlying asset, a group of assets, or a benchmark.
• Derivatives can be traded on an exchange or over the counter.
• Its value is derived from fluctuations in the prices of underlying assets.
• These are typically leveraged instruments, which means potential risks and rewards are amplified.
• Common examples include futures contracts, forwards, options, and swaps.

Futures Contracts

• A contract purchaser agrees to buy a specified quantity of a commodity at contract expiration for a price set in the contract (the futures price).
• The contract seller agrees to deliver the commodity at contract expiration in exchange for the agreed price.
• A futures contract is a commitment to buy or sell in the future at a preset price, whereas options provide the holder the right to buy or sell in the future.
• Forward contracts are similar but are not traded on an exchange.
• Company A buys an oil futures contract for $62.22 per barrel expiring Dec. 19, 2025, on Nov. 6, 2025
• Buying an oil futures contract hedges risk because the seller must deliver oil to Company A for $62.22 per barrel when the contract expires
• Company A can accept delivery of the oil if oil prices rise to $80 per barrel by Dec. 19, 2025. The company can also sell the contract before expiration and keep the profits if it no longer needs the oil

Swaps

• These are utilized to exchange one kind of cash flow for another, which can include switching from a variable to a fixed-interest-rate loan through an interest rate swap
• Company XYZ borrows $1,000,000 at a 6% variable rate and is concerned about rising rates
• Company XYZ can create a swap with Company QRS, where XYZ pays QRS 7% on its $1,000,000 principal, and QRS pays XYZ 6% interest on the same principal
• At the swap's beginning, XYZ pays QRS the 1-percentage-point difference between the two rate swaps.
• Company XYZ must pay Company QRS the 2-percentage-point difference if interest rates fall and the rate on the original loan is now 5%
• QRS pays XYZ the 1-percentage-point difference if interest rates rise to 8%

Bonds

• These reduce risk through diversification.
• They generate steady current income.
• They can be a safe investment when held to maturity.
• While returns are lower, these are less risky than stocks.
• Bond prices will rise if interest rates drop.

Bond Terminology

• Par value: amount returned at maturity, also known as face value.
• Coupon interest rate: percentage of the par or face value paid annually to the holder in interest.
• Maturity date: the date when the loan must be paid back.
• Price: This is what the bond sells for on the market.
• Call provision: This allows issuers to repurchase bonds before maturity, and such bonds are referred to as callable bonds that can be redeemed early.
• Sinking fund: Bonds with a sinking fund carry lower risk as the entity sets aside money annually to pay the bond at maturity.
• Issuer: The corporation or government agency that issues the bond.
• Yield: calculated as the annual interest on a bond divided by its price.
• Book-entry bonds are registered and stored electronically, similar to stock purchases.
• Bearer bonds pay coupon/interest only when surrendered.
• Baby bonds have a par value from $75 to $1,000.
• Discount bonds are sold at a discount to their par value.

How Bonds are Backed

• Secured bonds are backed by specific holdings like equipment or real estate which is otherwise known as asset-backed bonds.
• Debentures are backed by the issuing company's credit without collateral, meaning a higher premium due to higher risk.
• Mortgage-backed bonds (MBBs) are backed by a pool of mortgages.
• Collateralized mortgage obligations (CMOs) are more complex versions of MBBs.

Conditions in Bonds

• Subordinated bond: will be paid after the other loan obligations of the issuer are paid.
• Floating rate bond: has interest payments that fluctuate according to a benchmark interest rate.
• Convertible bonds: gives the holder the right to convert the bonds to company stock rather than receiving cash repayment.
• Zero-coupon bonds: discount bonds with no interest paid until maturity.
• Junk bonds: have very low bond ratings, a higher interest rate and default rate, and are frequently callable.

Bond Rating Companies

• Financial Condition Assessment: Evaluates the financial condition of the bond issuer, covering revenues, profit, debt, and critical areas to give a rating reflecting the bond's relative safety.
• Interest Rate Correlation: The relationship is generally better ratings equate to lower rates to sell their bonds.
• Bond Type Focus: ratings are only for corporate and municipal bonds.

Risks of Bonds

• Interest rate risk: A rise in rates will decrease a bond's value.
• Default risk: Arises from problems with the company's business that leads to a decline in value.
• Liquidity risk: the potential inability to sell a bond when needed.
• Exchange rate risk: changes impacting the profitability of multinational firms.
• Political or regulatory risk: unanticipated shifts in tax/legal environments impacting returns.

Major Risks

• Buying a conventional bond gives you promised fixed payments (coupons) in the future, where you face interest rates risk and default risk
• Interest rate risk affects the value of fixed payments, whereas default risk is where the entity that promised fixed payments is unable to deliver

Interest Rate Risk

• The coupons and face value are fixed at the time of issue, whose value can vary.
• The value of guaranteed cash flows changes if interest rates change after a bond is issued.
• If interest rates go up (down), the present value of cash flows (the bond's price) will go down (up)

Determining Interest Risk Exposure

• The coupon level on the bond: Higher coupon bonds are less exposed to risk than lower coupon bonds.
• The maturity of the bond: The general rule is that longer maturity bonds are more exposed to interest rate risk than shorter maturity bonds.
• Bond Duration: It is a composite measure that incorporates both coupon magnitude and maturity, where the higher the duration, the more sensitive it is to rate movements

Default Risk

• A bond's payments (interest rate) are promised by the entity issuing the bond.
• The ideal case is that payments are received, whereas the worst case is that you will not receive any of the promised cash flows.
• Risk is measured on the downside due to potential for a limited upside, so it is best to measure risk through downside or default risk

Default risk Determinants

• The greater the generated cashflows from operations lower the default risk
• More predictable cashflows correlate with lower default risk
• Higher financial commitments relative to your operating cashflows also results in a higher default risk

Measuring Default Risk

• Credit Risk Scores: The use of both qualitative and quantitative factors to measure the credit risk of borrowers.
• Bond Ratings: Bond ratings provided by ratings agencies that cover publicly traded companies desiring access to the bond market.
• Ratings categories ranging from "Aaa/AAA" to "Caa/CCC+" for investment grade and non-investment grade with default categories
• Risk premiums increases with higher default spreads; investors will incorporate higher return requirement into their investment decision, and drive down the pricing for the low rated credit instruments.

Estimating Synthetic Ratings

• Firms can be rated by using financial characteristics, especially using interest coverage ratio
• Interest coverage ratio = Earnings before interest and taxes (EBIT) / interest expenses
• Ratings relates to interest coverage ratios.
• Interest coverage ratio = 3,500/700= 5.00 example firm with Earnings Before Interest and Taxes of $ 3,500 million and interest expenses of $ 700 million

Bond Types

• Treasury debt securities
• Municipal
• Agency
• Corporate
• International
• Treasury savings securities

US Treasury Debt Securities

• Treasury bills: redeemed at face value either in 3, 6, or 12 months
• Treasury notes: intermediate-term debt, with semiannual interest payments.
• Treasury bonds: long-term debt obligations issued at or near par and interest that ispaid semiannually.
• U.S. Government are the issuers.

US Treasury Bonds

• Maturities range from 3 months to 30 years.
• Par value is $1,000, $5,000 (all) $10,000 to $1 million
• Exempt from state and local taxes, but taxes are not exempted from federal.
• Considered risk free, with lower risk and returns as they are not rated, but traded via auction
• This occurs at the federal reserve while the outstanding issues by brokers is OTC.
• These are usually not callable.

Municipal Bonds

• Revenue bonds: This bonds are supported by revenues from a specific project.
• General obligation bonds: bonds supported by the issuer's taxing power.
• The issuer include state and local governments.
• Maturities: Include different kinds like Short-term (1 to 5 years), Intermediate-term (6 to 10 years), and Long-term (11 to 30+ years)
• The par value is $5,000 and up
• Exempt from the federal tax on the interest income, and can be exempted from state and local levels if the investor lives in the state from which the bond was issued.
• They have higher risk compared to other government bonds but lower returns because these government bonds comes with an exemption on taxation
• They are rated and callable but have no trading brokers which are OTC.

Agency Bonds

• Bonds are issued by Fed Gov. agencies which were authorized by congress, such as Federal National Mortgage Association (FNMA or Fannie Mae)
• Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)
• Federal Home Loan Banks (FHLB)
• Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)
• They can have different kinds of maturities like Short-term (1 to 5 years), Intermediate-term (6 to 10 years), and Long-term (11 to 30+ years)
• The par value for this is $25,000 and up, as these requires higher minimun investment.
• Taxes: Ginnie Mae, Fannie Mae and freddie mac are taxable bonds. The taxation for the other federal agencies varies from state to local levels.
• These have somewhat higher risk with rates rated as OTC and callable
• Ginnie Mae, Fannie Mae and freddie mac are state and local tax exempt agencies

Corporate Bonds

• Issued by U.S. corporations with Short(1-5 yrs), Intermediate(6-10 yrs), Long-term(11-30+ yrs) maturities with $1,000 and up par value
• It has no subject for federal, state and lacal taxes compared to other government bond. Low risk is present with the highest rated bonds
• These are riskier compared to government bonds. Trading is possible with OTC and exchanges
• These are callable bonds

International Bonds

• Consists of bonds sold internationally that is issued by international companies with different currencies.
• These include Yankee bonds (bonds sold in the U.S. by international companies) and Euro bonds, as well as bonds sold outside of the U.S. by U.S. Companies, or by international corporations sold with $1,000 and up par value
• These are riskier than government bonds, with potentially higher returns, but come with extra currency risk.
• Most US and larger international bonds comes with ratings, callable and has exchanges
• Taxation federal, state and local levels but may be required with foreign taxes.

US Treasury Savings Securities

• US savings EE/I bonds with tax deferrment from the U.S. government through EE and I bonds that are marketable and sold at value
• Has different maturities through EE/I bonds, which stops through I and EE bonds can be redeemed before five years
• Par value/denomination available in $25, $50, $100, $1,000 and $10,000
• A maximum purchase of $10,000/year through electronic form ($5,000 through tax refund) with state/local taxation on bonds through interest - taxes can be saved when used for school
• Risk and Returns are based as government levels, where bonds return per six months
• Not traded, but has a trading government (EE/I bonds) can be traded on banks, but they are not callable.

Introduction to Bond Valuation

• A $1,000 US government bond paid three years from now with 4% interest is worth $889
• The bond has a face value of $1,000, and an interest rate of 4%.