Understanding Bonds: Characteristics and Overview

Bonds Overview

• Bonds are securities issued for borrowing arrangements, obligating the issuer to make payments to the bondholder on specified dates.
• Bonds, also called debt securities, represent a claim on a specified periodic income stream. Debt securities are often termed fixed-income securities due to their fixed income stream promise.
• Bonds are favored for their relative simplicity due to predefined payment formulas with minimal risk consideration.

Key Bond Characteristics

• Face or par value is the principal amount repaid at maturity.
• The coupon rate determines the interest payment amount.
• The bond indenture includes coupon date, maturity date, and par value, and it's the contract between the issuer and bondholder.
• A bond with a 1,000parvalueandan81,000 par value and an 8% coupon rate can be sold for 1,000parvalueandan81,000 and would entitle the holder to 80peryear.Paymentsaretypicallymadeintwosemiannualinstallments,forexample,80 per year. Payments are typically made in two semiannual installments, for example, 80peryear.Paymentsaretypicallymadeintwosemiannualinstallments,forexample,40 each. At the end of a 30-year term, $1,000 par value is paid to the bondholder.
• Bonds are issued with coupon rates high enough to attract investors to pay par value.
• Zero-coupon bonds do not have coupon payments, and investors get par value at maturity. Their return is the difference between the issue price and par value payment at maturity.

Treasury Bonds

• Treasury bonds and notes can be purchased directly from the Treasury.
• Note maturities range from 1-10 years, bond maturities are 10-30 years.
• Treasury bonds have semi-annual coupon payments.
• A par value of £1,000 with a 2.25% coupon rate yields £22.50 annually, paid as two installments of £11.25.

Corporate Bonds

• Corporations, like governments, borrow money by issuing bonds.
• Corporate bonds are traded over the counter, but the bond market may be thin.
• Call provisions allow the issuer to repurchase the bond at a specified price before maturity; this includes call protection.
• Refunding occurs when a firm retires high coupon debt and issues new bonds at lower rates.
• Call protection is an initial period when bonds cannot be called; these are called deferred callable bonds.
• The call option benefits the firm, allowing refinancing at lower rates when market rates decline; however, it burdens the bondholder, who forfeits the bond at the call price.
• To compensate for the risk of callable bonds, investors are issued bonds with higher coupons and yield at maturity, compared to non-callable bonds.

Convertible Bonds

• Convertible bonds allow the bondholder to exchange each bond for a set number of shares.
• Market conversion value is the current value of shares for which bonds can be exchanged.
• The conversion premium is the amount by which the bond's value exceeds its conversion value.
• Convertible bondholders gain when the company's stock price increases.
• A convertible bond issued at 1,000parvalueconvertibleinto40sharesofafirm′sstock,thestockpriceisat1,000 par value convertible into 40 shares of a firm's stock, the stock price is at 1,000parvalueconvertibleinto40sharesofafirm′sstock,thestockpriceisat20 per share and if it rises to 30,eachbondcanbeconvertedinto30, each bond can be converted into 30,eachbondcanbeconvertedinto1,200 worth of stock.
• Convertible bonds offer lower coupon rates and yields to maturity, but the actual return may surpass the stated yield if the option to convert becomes profitable.

Callable and Puttable Bonds

• Callable bonds enable the issuer to extend or retire the bond at the call date.
• Puttable bonds allow the bondholder to extend or retire the bond at the call date.

Floating Rate Bonds

• Floating-rate bonds have interest payments tied to current market rates.
• For example, the rate might adjust annually to the current T-bill rate plus 2%.
• Coupon rates on floaters adjust to changes in general market interest rates, but not to changes in the firm's financial condition.

Amazon Corporate Bond Sale Example

• Amazon secured $16 billion from the debt market to fund its acquisition of Whole Foods.
• This was the year's fourth-largest corporate bond sale.
• The 16billionwasborrowedacrossseventrancheswithmaturitiesfromthreeto40years,andreceivednearly16 billion was borrowed across seven tranches with maturities from three to 40 years, and received nearly 16billionwasborrowedacrossseventrancheswithmaturitiesfromthreeto40years,andreceivednearly49 billion in orders.

Preferred Stock

• Although technically equity, preferred stock is included in the fixed-income universe.
• Preferred stocks typically pay a fixed dividend, providing perpetual level cash flow.
• Adjustable or floating-rate preferred stock has become popular in recent decades, similar to floating-rate bonds.
• The dividend rate on preferred stocks links to current market rates and adjusts at intervals.
• Unlike interest payments on bonds, dividends on preferred stock are not considered tax-deductible expenses, reducing its attractiveness as a capital source.
• Failure to pay dividends on preferred stock does not lead to corporate bankruptcy.
• Common stockholders cannot receive dividends until preferred stockholders are fully paid.

Innovation in the Bond Market

• Inverse floaters are negatively impacted when rates rise; coupon and present value of cash flow fall. Investors benefit when rates fall.
• Coupon rate falls when interest rates rise.
• Walt Disney issued asset-backed bonds with coupon rates tied to the financial performance of films.
• Catastrophe bonds transfer catastrophe risk from the firm to capital markets.
• Switzerland-based Winterthur issued a bond whose payments would be cut if a severe hailstorm in Switzerland caused extensive damage.
• Indexed Bonds have payments tied to a general price index or commodity price.
• Mexico has offered bonds with payments depending on oil prices.
• Some bonds are indexed to a general price level.

Global Bond Market

• Domestic bonds are issued locally by a domestic borrower and are denominated in the local currency.
• Foreign bonds are issued on a local market by a foreign borrower and are denominated in the local currency while foreign bond issues and trading are supervised by local market authorities.
• International bonds are underwritten by a multinational bank syndicate and placed mainly in countries that do not use the bond's denominated currency.

Foreign Bonds and Eurobonds

• Foreign bonds have existed for a long time in national markets and are organized by an international bank (as lead manager).
• Foreign bonds often have colorful names like Yankee Bonds (US), Samurai Bonds (Japan), Matador Bonds (Spain), and Bulldog Bonds (UK).
• Eurobonds are different instruments from bonds issued in Euros.
• Eurobonds avoid national regulations.
• Confusion may arise, since bonds denominated in Euros can be mistaken for Eurobonds.
• Eurobonds were originally named because European banks issued them and "international bond" is now used in place of Eurobond.

Argentina's Eurobond Plan

• Argentina is planning to join Chile, Colombia, and Peru in tapping the euro sovereign bond market.
• Low interest rates are enticing borrowers and investors to search for yield.
• Argentina's bond is expected to be attractive due to low rates in developed nations, and negative rates in the Eurozone and Japan.

Default Risk and Ratings

• Bonds promise fixed income, but they are not riskless.
• Government bonds can be default risk-free, unlike corporate bonds.
• Bond default risk, or credit risk, is measured by ratings from rating companies like Moody's Investor Service, Standard & Poor's, and Fitch.
• Top ratings are AAA or Aaa; only a few firms have this rating.
• Bonds rated BBB or Baa and above are investment grade; lower-rated bonds are speculative/junk bonds.

Determinants of Bond Safety

• Bond rating agencies base their ratings on the issuer's financial ratios.
• Coverage ratios (earnings to fixed costs) signal possible cash flow difficulties if low or falling.
• A high leverage ratio (debt to equity) signals possible inability to meet bond obligations.
• Liquidity ratios (current/acid/quick) indicate the firm's ability to pay bills with liquid assets.
• Higher profitability ratios (ROE/ROI/ROA) suggest better prospects to earn returns on investments.
• The cash flow to debt ratio is the ratio of total cash flow to outstanding debt.

Discriminant Bond Safety Analysis

• Discriminant analysis (e.g., z-scoring) uses data on return on equity and coverage ratios.
• Firms that went bankrupt display a different pattern compared to solvent firms.
• Bankrupt firms are labeled as "X," solvent firms as "O".
• Discriminant analysis determines the line equation that distinguishes X and O.
• If the equation of the line is .75=.9xROE + .4xCoverage, and a firm's z-score is above .75, the firm is safe contrasted to the "z" score below .75
• The Z score calculation:
  • z = 3.3(EBIT/Total assets) + 99.9(Sales/Assets) + 0.6(Market value of equity/Book value of debt) + 1.4(Retained earnings/Total assets) + 1.2(Working capital/Total assets)

Bond Indentures

• Bond indentures are restrictions protecting bondholder rights.
• Restrictions involve collateral, sinking funds, dividend policy, and further borrowing.
• Issuing firms agree to these protective covenants to market bonds to investors concerned about bond safety.
• Sinking funds are established to spread payments over several years.
• The firm can repurchase a fraction of its outstanding bonds in the open market each year or can purchase a fraction of its outstanding bonds at a call price associated with the sinking fund provision.
• Subordination clauses should be included, which restrict additional borrowing.
• Dividend restrictions: Some covenants limit dividend payments and protect bondholders by forcing the firm to retain assets.
• Collateral bonds: Holders receive assets if the firm defaults on the bond.
  • If the collateral is property, it is a mortgage bond.
  • If the collateral is securities held, the bond is a collateral trust bond.
  • If the collateral is equipment held, the bond is an equipment obligation bond.
  • Collateral bonds are safer and offer lower yields.

Bond Pricing

• P = C[1/r – 1/(r(1+r)^t)] + Face value/(1+r)^t
• P = Bond price (Intrinsic value)
• C = Interest or coupon payments
• t = Number of periods to maturity
• r = Discount rate or yield to maturity

Bond Pricing Example

• Price of a 10-year, 8% coupon bond, with a face value of $1,000, can be calculated as:
  • P=40[1/0.03 – 1/(0.03(1+0.03)^20)] + 1000/(1+0.03)^20
  • P = $1,148.77
  • C = $40 (semiannual)
  • Par Value = $1,000
  • Time = 20 periods
  • Rate = 3% (semiannual)

Corporate Bonds and Market Yields

• Corporate bonds are typically issued at par value.
• Underwriters of the bond issue must choose a coupon rate close to market yields.
• In a primary issue, underwriters sell newly issued bonds directly to customers.
• Bondholders trade bonds in the secondary market, bond prices fluctuate inversely with market interest rates.
• The inverse relationship between price and yield is central in the fixed income market.
• Interest rate fluctuations are a primary source of risk in the fixed-income market.

Bond Prices and Yields

• Prices and yields (required rates of return) have an inverse relationship.
• Bond value will be very low when yields are high.
• Bond value approaches the sum of cash flows when yields approach zero.
• The change in bond price is greater for longer times to maturity as any departure of the interest rate of 8%, because if the money is tied longer, the loss is greater if the interest rate rises, which means a greater drop in the bond price.

Yield to Maturity

• An investor isn't provided a rate of return when considering purchasing of the bond.
• Instead, investors must use the price, maturity date, and coupon payment to find infer the return over its life.
• Yield to maturity is the interest rate which makes present bond payment value equivalent to its price.
• The interest rate is often interpreted to be the measure of the average rate of return earned on a bond bought/held until maturity.

Solving Yield to Maturity

• Yield to maturity is the interest rate that makes the present value of a bond's payments equal to its price.
• Solve: P = Σ C / (1+r)^t + Par Value / (1+r)^T

Yield to Maturity Example

• For a 30-year maturity bond with an 8% coupon rate and a price of £1,276.76:
  • 1276.76 = Σ 40 / (1+r)^t + 1000 /(1+r)^t
• Solution: Semiannual rate = 3%

Current Yield

• Current yield is a bond's annual coupon payment divided by its price.
• Premium bonds sell above par value where coupon rate is more than the current yield. Premium bonds sell greater than the current yield, which in turn is greater than yield to maturity.
• Discount bonds sell below par value.

Yield to Call

• The yield to maturity is based on the bond being held until maturity.
• Corporate and government bonds are callable typically after some deferred call period.
• Call price set at a specified percentage of par value, eg, 110% of a £1000, so call price would be £1100
• The YTM calculation is unrealistic for bonds likely to be called.
• To adjust for term of callable bond, alter YTM pricing equation by changing number of periods from maturity to 1st call date/ call price replaces par value and bond prices are calculated on the lowest yield measure.

Bond Prices: Callable Bonds

• After an interest rate falls, the present value of a bond's scheduled payments rises, and the call provision grants the issuer to repurchase bonds at the call price.
• If it falls below present value of scheduled payments, the issuer exercises the option and take back bond from bondholder.
• After high interest rates, the risk of the call is negligible due to present value of scheduled payments being lower than the call price; then the straight and callable values of bonds are converged.
• At lower interest rates, the present value of scheduled payment outvalues the call price; then bonds get called.
• Yield to call is like yielding, but the only difference is the time until call replaces time and call price replaces par value.
• Bond analysts prefer analyzing the value of bond's yield to call for possible calling, given analysts want yield until maturity, and bonds are issued through an initial protection period.

Reinvestment Risk

• YTM assumes all payments will be reinvested at the same rate.
• Interest rates normally change, therefore investors have reinvest their payments to new rates.
• Coupons aren't typically reinvested at the calculated rate.
• If the investor spends the coupons (or reinvests them at different rates), return at retirement date is different.
• Reinvestment risk is considered, and brokers try to give an account for it through calculating bonds duration.
• The final value over two years is the FV of the first coupon added to the second (coupon plus par value).

Reinvestment Risk Example

• An investor invests £1000 for two years into the bond where compound rate of return is 10% at 100 payment. So the final value is:
  • 1st coupon value: 100 x 1.10 = 110
  • Plus, cash payment for coupon and pair makes it 1100 total is 11/210 value.
• Amount is obtained if coupons are reinvested by 10%
  • If the reinvestment is only is 8% then the value can be found thru coupon is (value= 100 X 1.08 = 108) plus 1100, which then means value equals to 1208
  • Vo(1+r)^2: V2 = 9.91)

Yield Curve

• A yield curve is a graphical description of relationship in yield and maturity.
• Key concerns are in value of fixed income and valuation on a bond.
• Allows for those to measure expectations of interest rates and is the starting point when setting an fixed income portfolio.

Holding-Period Return

• Formula: HPR=[I+(P₁−Po)]/Po
  • I = Interest Rate Payment
  • P=1 price
  • P = purchase price

Holding-Period Return Example

• Bond characteristics: CR=8%, YTM=8%, N=10 years
• Semiannual CompoundingPo=$1000
• After six months, the rate falls to 7%, P₁ = $1068.55
• Solving: HPR=[40+(1068.55-1000)]/1000 - HPR+10.85% (semiannual)

Yield to Maturity Versus Holding Period Return

• Return and yield are equal on maturity.
• Holding yield is unchangeable, equals with yield.
• If 80% of annual is paid by one coupon on to 100 price = 8%. 8% equal means remains period is equal-If the yields are below and priced on one another that would suggest the bond could do one of two things either rise/fall, but then they are greater.