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Bonds

Bonds. Hana Lee & Maggy Sharobeem. What is a Bond?. A debt security The authorized issuer owes the holders a debt, and depending on the terms of the bond, is obliged to pay interest (coupon) and/or repay the principal at a later date (maturity)

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Bonds

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  1. Bonds Hana Lee & Maggy Sharobeem

  2. What is a Bond? • A debt security • The authorized issuer owes the holders a debt, and depending on the terms of the bond, is obliged to pay interest (coupon) and/or repay the principal at a later date (maturity) • A formal contract to repay borrowed money with interest at fixed intervals

  3. What is a Bond? • A bond is a loan • The issuer is the borrower (debtor), the holder is the lender (creditor) and the coupon is the interest • Bonds and stocks are both considered securities • However, stockholders have an equity stake in the company (they are owners) and bondholders have a creditor stake (they are lenders) • Bonds usually have a defined term whereas stocks do not

  4. What is a Bond? • The bond is made up of: • The nominal, principal/ face amount- the amount on which the issuer pays interest and has to be repaid at the end of the term • Issue price- the price at which the investors buy the bond when it is first issued (usually equal to the principal amount) • Date of Maturity- the date on which the issuer has to repay the nominal amount • Coupon- the interest rate that the issuer pays the bond holder

  5. Types of Bonds • Fixed Rate Bonds • Floating Rate Notes (FRNs) • Zero- coupon bonds • Inflation linked bonds • Asset- backed Securities • Subordinated Bonds • Equity linked notes • Perpetual bonds • Bearer bonds • Registered bond • Municipal bond • Book- entry bond • Lottery bond • War bond • Serial bond • Revenue bond

  6. Fixed Rate Bonds • Bonds with a fixed coupon (interest) rate • A fixed rate bond is a long term debt paper that carries a predetermined interest rate, coupon rate, and interest rate is payable at specified dates before the time of maturity • Risks: Interest Rate Risk • When the market rates rise, the price declines

  7. Floating Rate Note • Bonds with a variable coupon (interest) which is equal to a money market reference rate (LIBOR or federal funds rate) + a spread ( a rate that remains constant) • Most FRNs have quarterly coupons that are paid out every three months • At the beginning of each coupon period, the coupon is calculated by take the fixing of the reference rate for that day and then adding the spread

  8. Floating Rate Note • In the US, government sponsered enterprises are the ones that issue FRNs • Federal Home Loan Banks • Federal National Mortgage Association (Fannie Mae) • Federal Home Loan Mortgage Corporation (Freddie Mac)

  9. Floating Rate Note • Some FRNs have maximum (capped FRNs) or minimum coupons (Floored FRNs) or both minimum and maximum coupons (collared FRNs) • Risk: • FRNs have very little interest rate risk- very low sensitivity to changes in market rates because the coupon is constantly changing • When the market rates rise, the coupon rate also rises, keeping its price constant

  10. Zero- Coupon Bonds • Also known as a discount bond • Bond is bought at a price lower than its face value, with the face value repaid at the time of maturity • Does not have periodic interest payments (zero- coupon) • Investors earn money from the compounded interest all paid at the time of maturity in addition to the difference between the discounted price of the bond and its par (redemption) value

  11. Zero- Coupon Bonds • US Treasury Bills, US Savings Bonds • Risks: Very sensitive to interest rate changes • Pension funds and insurance companies like to own long maturity zero- coupon bonds due to the bonds’ high duration (very sensitive to interest rate changes and offset the interest rate risk of the firms’ long- term liabilities)

  12. Inflation Linked Bonds • Bonds where the principal is indexed to inflation, they are designed to cut out the risk of inflation in an investment • Pay a periodic coupon that is equivalent to the product of the inflation index and the nominal coupon rate • A rise in coupon payments is due to an increase in inflation

  13. Perpetual Bonds • A bond with no maturity date • It is treated as an equity not a debt • Pay coupons forever • The issuer does not have to redeem the bond • Most of these bonds are callable (after 5 years) meaning that the issuer of the bond can redeem the bond on call dates at a defined call price

  14. Municipal Bond • A bond issued by a city or other local government (municipality) • Interest income received by the holders is often exempt from federal income tax of the state in which they are issued • Risk: how likely the issuer is to make all the payments, on time and in full • Default risk

  15. War Bond • Are debt securities issued by a government for purposes of financing military operations in times of war • They generate capital for the government and make civilians feel like they are involved • Also helps control inflation in an over stimulated economy by removing money from circulation until after the war

  16. Interest Rate Risk • Is the risk or variability in value that comes with an interest- bearing asset (ex: loans, bonds, etc.) • Generally, as rates rise, the price of the bond will fall (ex: fixed rate bond) • If the rates fall, the price of the bonds increase (this is a good thing, if you want to sell your bond) • The interest rate risk is usually measured by the bond’s duration (the sensitivity of the asset’s price to interest rate movements)

  17. Interest Rate Risk • Mostly based on simulating movement in one or more yield curves using the Heath- Jarrow- Morton framework to ensure that the yield curve movements are consistent with current market yield values • A general framework that models the evolution of the interest rate curves

  18. Calculating Interest Rate Risk • Market to Market • Calculating the net market value of the assets and liabilities- “market value of portfolio equity” • Stress Testing the market value • Shifting the yield curve • Calculating Value at Risk of the portfolio • Risk measure of the risk loss on a specific portfolio of financial assets

  19. Calculating Interest Rate Risk • Calculating multiperiod cash flow and expense for N periods forward in a deterministic set of future yield curves • Calculating multiperiod cash flow and expenses for N periods forward with random yield curves movements and measuring the probability distribution of cash flows over time • Measuring the mismatch of the interest sensitivity gap of assets and liabilities by classifying by maturity

  20. Bond Rating • Grade on bond indicates credit quality • Affects interest rate applied to bond • Credit rating for an issuer based on issuer’s credit worthiness (ability to pay back loan) • In General: • For investors – credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk • increases the efficiency of the market • lowers costs for borrowers and lenders • increases the total supply of risk capital in the economy, leading to stronger growth

  21. Credit Rating Agencies • CRAs registered with the Securities and Exchange Commission, known as Nationally Recognized Statistical Rating Organizations(NRSROs): • Fitch, Inc (US) • Moody’s Investors Service, Inc (US) • Standard & Poor’s (US) • Egan-Jones Rating Company (US) • A. M. Best Company, Inc. (US)

  22. Yield • nominal yield (coupon yield) = yearly total of coupons (or interest) paid/the face value of bond • current yield = yearly total of coupons paid/the bond's spot market price (actual price at current time) • yield to maturity = the internal rate of return (IRR) on the bond's cash flows: the purchase price, the coupons received and the principal at maturity • required yield: return a bond must offer in order for the investment to be considered worthwhile

  23. Current Yield COUPON RATE: 10% • Value: $1000 Current Yield:10% = (.10*$1000/$1000)*100% • Value (drops): $800 Current Yield: 12.5% = ($100/$800)*100% • Value (rises): $1200 Current Yield: 8.33% = ($100/$1200)*100%

  24. Current Yield • Face Value: $100 • Price: $95.92 • Coupon Rate: 5% Face value

  25. Yield to Maturity • Current yield does not account for  time value of money or the present value of the coupon payments the investor will receive in the future • Yield to maturity = the return that an investor gains by receiving the present values of the coupon payments, the face value and capital gains in relation to the price that is paid

  26. Sources • Ray, Christina I. The Bond Market. Homewood: Richard D. Irwin, Inc., 1993. • Brown, Patrick J. Bond Markets: Structures and Yield Calculations. New York: International Securities Market Association, 1998. • http://www.investinginbonds.com/learnmore.asp?catid=3&id=383 • http://www.investopedia.com/terms/b/bondrating.asp • http://www.investopedia.com/university/advancedbond/advancedbond3.asp • http://www.investopedia.com/university/bonds/bonds3.asp • http://beginnersinvest.about.com/od/savingsbonds/a/history-of-us-savings-bonds.htm • http://en.wikipedia.org/wiki/Bond_credit_rating • http://en.wikipedia.org/wiki/Credit_rating_agency • http://en.wikipedia.org/wiki/Interest_rate_risk • http://en.wikipedia.org/wiki/Heath-Jarrow-Morton_framework • http://en.wikipedia.org/wiki/Yield_curve • http://en.wikipedia.org/wiki/Bond_%28finance%29 • http://en.wikipedia.org/wiki/Fixed_rate_bond • http://en.wikipedia.org/wiki/Floating_rate_note • http://en.wikipedia.org/wiki/Zero-coupon_bond • http://en.wikipedia.org/wiki/Inflation_linked_bond • http://en.wikipedia.org/wiki/Perpetual_bonds • http://en.wikipedia.org/wiki/Municipal_bond • http://en.wikipedia.org/wiki/War_bond

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