I-Bonds and Bond Valuation

Bonds and Bond Valuation

• Bonds function as long-term debt securities, representing a promise to repay borrowed funds plus interest.
• Bonds typically feature interest-only payments with principal repaid at maturity; known as level-coupon bonds.

Bond Features

• Maturity Date: The date the principal is paid back alongside the last interest payment.
• Time to Maturity: Reduces over time until the bond matures.

Bond Values and Yields

• Cash flows from bonds remain constant; however, market interest rate changes impact their present value.
• An inverse relationship exists between interest rates and bond prices.
• Bond value is calculated as the present value of future coupon payments and the principal, discounted at the yield to maturity (YTM).
• YTM reflects the market-required return and the bond's current price.
• Current yield equals the annual coupon divided by the market price of the bond.

Bond Pricing Relationships

• YTM = Coupon Rate: Bond price equals face value.
• YTM > Coupon Rate: Bond price is below face value (discount bond).
• YTM < Coupon Rate: Bond price is above face value (premium bond).
• A par value bond's price equals its face value and YTM matches the coupon rate.

Interest Rate Risk

• Defined as the risk associated with fluctuating interest rates affecting bond prices.
• Longer time to maturity leads to greater interest rate risk.
• Lower coupon rates also increase interest rate risk.

More on Bond Features

• Bonds denote liabilities for the borrower and do not confer ownership rights to creditors.
• Differences between debt and equity include tax-deductibility of interest versus dividends and legal recourse for missed payments.

Repayments

• Bonds may be repaid at maturity or partially before maturity, often via a sinking fund.
• A Sinking Fund is an account for redeeming bonds early.
• Call provisions allow issuers to repurchase bonds at predetermined prices before maturity.

Protective Covenants

• Protective covenants limit a firm's actions, such as dividend payments and issuance of additional long-term debt.

Bond Ratings

• Major rating agencies include Moody's and Standard & Poor's (S&P).
• Bonds are rated based on default risk; AAA rating is best, while lower ratings indicate higher risk (junk bonds).

Government Bonds

• Treasury Securities: Include T-bills, T-notes, and T-bonds with different maturities and default risk.
• Treasury securities are exempt from state taxes but subject to federal income taxes.
• Municipal Securities: Issued by state and local governments with tax-exempt coupon payments appealing to high-income investors.

How Bonds are Bought and Sold

• Most transactions occur over-the-counter (OTC) with dealers connected electronically; trades are less frequent than in stocks.

Bond Price Reporting

• The bid price is what a dealer pays to buy a bond, while the asked price is what they sell it for.
• The bid-ask spread is the dealer's profit.

Bond Price Quotes

• The clean price excludes accrued interest, while the dirty price includes it, being the total amount paid by the buyer.

Real versus Nominal Rates

• Real interest rates are adjusted for inflation, indicating the actual purchasing power changes.
• Nominal rates reflect the stated interest before inflation adjustment.

Term Structure of Interest Rates

• Explains the relationship between prevailing interest rates on default-free securities and time to maturity.
• Components include the real rate of return, inflation premium, and interest rate risk premium.
• The Treasury yield curve depicts yields across different maturities, using graphical representation for clarity.

Bonds and Their Valuation

• Bonds are long-term debt instruments issued by various entities, including corporations and governments, with a promise to repay the principal and interest.
• Usually considered interest-only loans, bonds feature consistent interest payments and principal repayment at maturity.

Key Bond Features

• Maturity Date: The specified date when the bond's principal is repaid and the final interest payment is made.
• Time to Maturity: The remaining years until the bond matures, decreasing over time.

Bond Values and Yields

• Bond cash flows remain constant, but fluctuating market interest rates affect the present value of bonds.
• There is an inverse relationship between interest rates and bond prices; higher rates decrease bond value and vice versa.
• The bond's value equals the present value of future coupon payments plus the principal payment, discounted using the Yield to Maturity (YTM).
• YTM is the market interest rate for bonds of similar characteristics, and it reflects the bond's implied return based on current price.
• Current yield is calculated as the annual coupon payment divided by the market price of the bond.

Bond Price and Yield Relationships

• If YTM equals the coupon rate, bond price is at par (face value).
• If YTM exceeds the coupon rate, bond price is below par (discount bond).
• If YTM is less than the coupon rate, bond price is above par (premium bond).
• Terms:
  • Par Value Bond: Market price equals face value.
  • Discount Bond: Sells below par with YTM greater than the coupon rate.
  • Premium Bond: Sells above par with a coupon rate exceeding YTM.

Interest Rate Risk

• Interest rate risk refers to the impact of fluctuating interest rates on bond prices.
• Longer maturity and lower coupon rates increase interest rate risk.

Differences Between Debt and Equity

• Debt: No ownership interest, fixed interest payments, tax-deductible interest, and legal recourse for missed payments.
• Equity: Ownership interest, voting rights, non-deductible dividends, and no legal claim on unpaid dividends.

Long-Term Debt Overview

• Long-term debt instruments have maturities greater than one year, while short-term debt has shorter maturities.
• Types of corporate debt include notes, debentures, and bonds, with debentures being unsecured and bonds often secured by specific assets.

Indenture Agreement

• The indenture is the contract detailing bond terms, including:
  • Basic terms and total amount of bonds issued.
  • Description of secured property and repayment arrangements.
  • Call provisions and protective covenants.

Government Bonds

• Treasury Securities: Include T-bills (maturity ≤ 1 year), T-notes (maturity 1-10 years), T-bonds (maturity > 10 years).
• U.S. Treasury securities carry no default risk and are exempt from state taxes.
• Municipal Bonds: Issued by state/local governments; coupon payments are exempt from federal taxes, making them attractive to high-income investors.

Other Bond Types

• Zero Coupon Bonds: Bonds sold at a discount, no periodic interest payments.
• Floating Rate Bonds: Pay interest tied to a benchmark interest rate, adjusting periodically.

Bond Transactions

• Most bond trades occur in the over-the-counter market, which operates electronically, with lower volume compared to stocks.

Bond Price Reporting

• Bid Price: Price a dealer pays to buy a bond.
• Ask Price: Price a dealer charges to sell a bond.
• Bid-Ask Spread: Difference which represents the dealer's profit.

Bond Price Quotes

• Clean Price: Price excluding accrued interest; the quoted price.
• Dirty Price: Total price including accrued interest, typically paid by the buyer.

Real vs. Nominal Rates

• Real Rates: Adjusted for inflation, reflecting actual purchasing power changes.
• Nominal Rates: Stated rates before adjustments for inflation.

Term Structure of Interest Rates

• The term structure reflects the relationship between nominal interest rates and time to maturity for default-free securities, represented graphically by the yield curve.
• The yield curve captures components like real rates, inflation premium, and interest rate risk premium.
• Additional premiums:
  • Default Risk Premium: Compensation for potential non-payment.
  • Taxability Premium: Extra yield demanded for corporate bonds over municipal bonds.
  • Liquidity Premium: Compensation for the inability to readily sell the bond.