Finance Chapter on Bonds and Stocks

Bond Definitions and Terminology

• A bond is a security issued for borrowing arrangements.
• The borrower sells bonds to lenders for cash.
• The issuer agrees to make payments (coupons) to the bondholder.
• At maturity, the nominal value is repaid.

Bond Terminology

• Par value (face or nominal value): The payment to the bondholder at maturity.
• Coupon rate: The bond's interest payments relative to its par value.
• Bond indenture: The contract between the issuer and bondholder.
• Accrued interest: The prorated share of an upcoming coupon payment when a bond is purchased between coupon payments.

Bond Coupons

• A bond with a par value of $1,000 and an 8% coupon rate may sell for $1,000.
• The bondholder is entitled to 8% of the par value (or $80 per year) for the bond's life.
• Payments are usually in two semi-annual installments.
• At maturity, the issuer repays the par value ($1,000).

Bonds as a Form of Debt

• Bonds are a form of debt.
• Interest payments are tax-deductible for firms.
• Issuers are borrowers, while bond buyers are lenders.
• Bonds offer borrowers access to a larger pool of lenders, which leads to better pricing.
• Bonds can easily be traded in the secondary market.
• Bonds have more standardized payment structures compared to bank loans.

Bond Prices

• Bonds are often issued at par (the price equals the par value).
• Zero-coupon bonds are sold at a discount.
• Bond prices depend on market conditions after issuance.

Accrued Interest Example

• Suppose an 8% bond with $40 semi-annual coupon payments has 30 days since the last coupon payment.
• The accrued interest would be $6.59.
• Invoice price = flat price + accrued interest

How Bonds are Traded

• Primary market issuance: Governments and corporations issue bonds to raise capital.
• Secondary market trading: Bonds are typically traded among investors in the over-the-counter (OTC) market after initial issuance.
• Dealers buy and sell bonds from their own inventory, providing liquidity to the market.
• Many bonds are traded OTC, rather than formal exchanges.

Bond Types by Issuer

• Government bonds (US Treasury notes and bonds; other countries have similar bond types.): Government bonds are generally considered safe investments because they are backed by the government.
• Agency bonds: Issued by government agencies or mortgage-related agencies.
• Municipal bonds: Issued by local government institutions; interest payments are often tax-free.
• Corporate bonds: Issued by corporations; Maturity duration is usually a range from 7 to 30 years, but there are also longer term options.

Bond Types by Characteristics

• Callable bonds: Allow the issuer to repurchase the bond at a specific call price before the maturity date.
• Convertible bonds: Allow the bondholder to exchange a bond for a specified number of the firm's shares.
• Puttable bonds: Give bondholders the option to exchange the bond for its par value at a specified date or to extend the bond's life.
• Floating-rate bonds: Adjust the interest rate periodically according to a prevailing market rate.
• Preferred stock: Considered an equity investment, but frequently included within fixed income, as it typically pays a fixed dividend.

International bonds

• Foreign bonds: Issued by a borrower from a country other than where the bond is sold. Denominated in the currency of the country where it's marketed.
• Eurobonds: Denominated in one currency, and sold in other national markets.

Innovation in the Bond Market

• Inverse floaters: Coupon rates move in the opposite direction of general interest rate movements.
• Asset-backed bonds: Income from a specified group of assets is used to service the debt.
• Catastrophe (CAT) bonds: A form of insurance securitization where investors receive higher coupon rates for taking on risk; bondholders lose all or part of their investment in the event of a catastrophe.

Indexed bonds

• Indexed bonds make payments tied to a general price index or a commodity's price.
• Examples include Treasury Inflation-Protected Securities (TIPS).

Credit Risk

• Credit risk (default risk): The risk that a bond will not repay all promised payments.
• Rating companies: Moody's, Standard & Poor's, and Fitch.
• Rating categories: AAA (or Aaa) to lower ratings (speculative-grade bonds or junk bonds)
• Determines of bond safety: Coverage ratios, leverage ratios, liquidity ratios, profitability ratios, and cash flow to debt ratios.
• Bond indentures: Set of restrictions (protective covenants) that safeguard bondholders from default. These may include sinking funds, subordination clauses, dividend limitations, and collateralization.
• Credit spread: The difference between the yield-to-maturity (YTM) of a corporate bond and the YTM of an otherwise identical government bond.

Bond Pricing

• Bond value is the present value of its cash flows.
• Discount rate encompasses the risk-free rate, expected inflation premium, and risk premium; it used to compute the present value.
• Bond pricing and the coupon rate and market interest rate relationship: Bonds sell at par if the coupon rate equals the market interest rate; if the coupon rate is lower, the bond sells at a discount; if higher, the bond sells at a premium.

Bond Profitability Measures

• Total bond return: The overall return from holding a bond over a period. It’s the sum of income component (periodic coupon payments) and capital gains or losses (difference between purchase and sale prices, or face value at maturity).
• Current yield: Annual coupon payment divided by the current bond price; simple measure of profitability, but ignores capital gains and losses.
• Holding period return (HPR): The rate of return over a particular holding period; depends on the bond’s price at the end of the period and is difficult to compare across different bonds with different holding periods and maturities; the rate of return is only forecastable.
• Yield to maturity (YTM): The interest rate that equates the present value of a bond's payments to its price; most commonly used measure of bond profitability; it assumes that coupon payments will be reinvested at the same yield.

Bond Prices Over Time

• Bond prices generally converge to par value at maturity.
• Premium bonds often have higher coupon payments but may result in capital losses if purchased above par and held to maturity.
• Discount bonds offer lower coupon payments, but the potential for capital gains as the price rises to maturity.

Zero-Coupon Bonds

• Zero-coupon bonds only pay a lump sum at maturity.
• US Treasury Bills are an example. Zero coupon's price falls during the time until maturity, owing to the time value of money.

Python Lists and For-Loops

• Lists: Ordered, modifiable collections of mixed datatypes.
• For-loops: Repeatedly execute a block of code for items in sequences or iterables (e.g., lists). They are used to automate repetitive tasks and are useful when dealing with a large number of items.