Bonds

the conversion feature of a corporate bond

-available in convertible bonds -allows bondholders to exchange their bonds for a specified number of shares of common stock -bondholders exercise this option when the market price of stock is greater than the conversion price A bond that can be converted into a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity anyway should the company continue to do well. From the investor's perspective, a convertible bond has a value-added component built into it; it is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock. usually issued by companies and they give the investor holding the bond 2 different choices: - collect the interest payments and then the repayment of the bond on maturity or -convert the bond into predefined number of ordinary shares in the issuing company on a set date prior to bond's maturity

Theories of term structure

-expectation theory where yield curve reflects market expectation -liquidity theory where market perceives that longer term lending/borrowing to be riskier and requires higher return compensation

benefits of fixed income securities

-for fixed interest bonds, a regular and certain flow of income -for most bonds, a fixed maturity date -a range of income yields to suit different investment and tax situations -relative security of capital for more highly rated bonds

Types of Debt Securities (refer to all of them as bonds or fixed income securities)

-gov bonds -corporate bonds -municipal bonds -mortgage bonds -annuities

call premium

-issuers must pay higher rates to investors for bonds with call features compare to those without -compensates bond holders for having it called before maturity -call premium equal to one year coupon interest

bonds

-long term fixed income securities traded in the capital market -promise to pay fixed income -offers a series of regular smaller claims (coupons which are annually or semi-annually) followed by a terminal payment -maturity of fixed income security may be as small as a few hours or indefinite -returns on bonds help in determining the structure of interest rates on different types of loans -bonds carry some risk of default, providing a role for rating agencies to rate the risk of a bond -even risk-free bonds are not entirely risk-free as there is always some risk due to inflation being unpredictable

Duration

-measure of the effective maturity of a bond -weighted average of the times until each payment is received with the weights proportional to the PV of payment -duration is shorter than maturity for all bonds except zero coupon bonds -duration is equal to maturity for zero coupon bonds

Conclusions

-price of bond inversely related to interest rate -longer maturity, more sensitive to changes in interest -the higher the coupon rate, the less sensitive the value of the bond is to interest rate changes

fixed income securities

-provides return in the form of fixed periodic payments + eventual return of principal at maturity the payments are known in advance

cons of fixed income securities

-real value of income flow eroded by effects of inflation except for index-linked bonds -bonds carry elements of risk n European governments might be unable to meet their obligations on these loans, and the prices of their bonds fell significantly as a result

Credit risk and Collaterised Debt Obligations (CDOs)

-structured investment vehicle (SIV) often used to create CDO -loans are pooled together and split into tranches with different levels of default risk -mortgage-backed CDOs were an investment disaster in 2007 CDOs emerged in the last decade as a major mechanism to reallocate credit risk in the fixed income securities market. To create a CDO, a financial institution commonly a bank, first would establish a legally distinct entity to buy and later resell a portfolio of bonds or other loans.

bonds sold at premium

A bond that is trading above its par value. A bond will trade at a premium when it offers a coupon rate that is higher than prevailing interest rates. This is because investors want a higher yield, and will pay more for it. For example, if a bond has a 7% coupon at a time when the prevailing interest rate is 5%, investors will "bid up" the price of the bond until its yield to maturity is in line with the market interest rate of 5%. As a result of this bidding up process, the bond will trade at a premium to its par value A bond premium will reduce the yield to maturity of the bond, while a bond discount will enhance its yield. The size of the premium will decline as the bond approaches maturity. The premium will dwindle to zero at maturity, since bond issues are generally redeemed at par.

domestic bond

A domestic bond is issued by a domestic issuer into the domestic market, for example, a UK company issuing bonds, denominated in sterling, to UK investors.

money market

A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. short term liquidity purpose

bond sold at par

A term that refers to a bond, preferred stock or other debt obligation that is trading at its face value. The term "at par" is most commonly used with bonds A bond that trades at par will have a yield equal to its coupon, and investors will expect a return equal to the coupon for the risk of lending to the bond issuer. Bonds are quoted at 100 when trading at par. Due to ever-changing interest rates, financial instruments almost never trade exactly at par. A bond will likely not trade at par when interest rates are above or below its coupon rate. For example, if a company issues a bond with a 5% coupon and interest rates increase to 10%, investors will pay less than par for the bond to compensate them for the difference in rates. In the same vein, if interest rates drop, investors will be willing to pay more than par for the bond.

SIV

An SIV raises funds often by issuing short term commercial paper and uses the proceeds to buy corporate bonds or other forms of debt such as mortgage loans, or credit card debt. These loans are first pooled together and then split into a series of classes known as tranches. Each tranche is given a different level of seniority in terms of its class on the underlying loan pool and each can be sold as a stand alone security.

corporate bonds characteristics

Most corporate bonds are listed on stock exchanges, but the majority of trading in most developed markets takes place in the OTC market - that is directly between market counterparties

Credit risk- why bond to choose? -same maturity -same coupon rate -same principal only diff: gov bond and corporate bond

The first way of comparing bonds is to look at ratings. Bonds have some chance of default. This varies across bonds. Government bonds tend to be the safest, while some corporate bonds can be very risky. There are agencies who produce ratings of the riskiness of bonds. Bonds are rated according to the likelihood of default. For corporate bonds, better ratings are associated with: • Lower financial leverage • Smaller intertemporal variation in earnings • Larger asset base • Profitability The top ratings including As are investment grade. Those with Bs are speculative grades. Informally, the lowest category of bonds are known as junk bonds. These have a very high probability of default. Credit risk plays an important role in the assessment of investment in emerging countries Political risk Economic risk The pattern of default premiums offered on risky bonds is sometimes called as the risk structure of interest rates. The greater the default risk, the higher the default premium.

expectations theory

The hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Expectations theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today. This theory is sometimes used to explain the yield curve but has proven inaccurate in practice as interest rates tend to remain flat when the yield curve is normal. In other words, expectations theory often overstates future short-term interest rates.

liquidity theory

The idea that investors demand a premium for securities with longer maturities, which entail greater risk, because they would prefer to hold cash, which entails less risk. The more liquid an investment, the easier it is to sell quickly for its full value. Because interest rates are more volatile in the short term, the premium on short- versus medium-term securities will be greater than the premium on medium versus long-term securities. For example, a three-year Treasury note might pay 1% interest, a 10-year treasury note might pay 3% interest and a 30-year treasury bond might pay 4% interest. This theory is based on the idea that investors prefer, all things equal, short term securities to long-term securities. This can be justified by assuming that investors place an intrinsic value on liquidity. For example, consider making an investment for a two-year period. This can be done using two different strategies. i. Maturity Strategy - hold a two-year asset ii. Rollover Strategy - hold two one-year assets. An investor who values liquidity would prefer the rollover strategy. They might need cash at end of period 1 and with maturity strategy, price of asset at end of year 1 is not known. Using the rollover strategy eliminates this price risk. Consequently, in order to make them attractive, longer term securities must have a risk premium

bond rating agencies

There are more than 70 agencies throughout the world, and preferred agencies vary from country to country. The three most prominent credit rating agencies are: • Standard & Poor's (S&P) • Moody's • Fitch Ratings

corporate bonds

a debt security issued by a corporation and sold to investors backing for the bond is usually the payment ability of the company, which is typically money to be earned from future ops the company's physical assets may be used as collateral riskier than gov bonds

principal upon maturity

amount originally borrowed by company par value or face value maturity or redemption is the time at which a bond becomes due

full or dirty price

amount that the buyer pays the seller is agreed upon price plus an accrued interest

Credit Default Swap

an insurance policy on the default risk of a corporate bond or loan instututional bondholders used CDS to enhance creditworthiness of their loan portfolios to manufacture AAA debt CDS used to speculate that bond prices will fall this means that there can be more CDS outstanding than there are bonds to insure Originally they were designed to allow lenders to buy protection against default risk. The natural buyers of CDS, would then be large bondholders or banks that wished to enhance the creditworthiness of their outstanding loans. An investor holding a bond with a BB rating could in principle raise the effective quality of the debt to AAA by buying a CDS on the issuer.

'Fixed income'

any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule else, issuer is in default if payment missed/bankruptcy

mortgage bonds

bond secured by a mortgage on one or more assets backed by real estate holdings or real property ie equipment mortgage bondholders have a claim to the underlying property and could sell it off to compensate for the default

why do investors like convexity?

bonds with greater curvature gain more in price when yields fall than they lose when yields rise the more volatile interest rates, the more attractive this asymmetry bonds with greater convexity tend to have higher prices and/or lower yields, all else equal

issuer

borrows money by issuing bond

how are fixed income securities issued?

by domestic and foreign governments, public authorities and private corporations -likelihood of default for corporate fixed income securities varies widely

Bond Features and Prices

feature: -face value -coupon or coupon rate -maturity -yield

annuities

financial product issued by financial institutions designed to accept and grow funds from an individual upon annuitization, pay out a stream of payments to the individual at a later point in time they are primarily used as a means of securing a steady cash flow for an individual during their retirement

call feature

gives the chance to repurchase the bond prior to maturity at the call price

Government bond

gov issues bonds to finance their spending and investment plans to bridge the gap between their actual spending and the tac and other forms of income they receive issuance of bonds is high when tax revenues are lower than gov spending

bond prices and yields

have an inverse relationship bond price curve is convex the longer the maturity, the more sensitive the bond's price to changes in market interest rates The yield curve, is a way of illustrating the different rates of interest that can be obtained in the market for similar debt instruments with different maturity dates The rationale for this is that the longer an investor is going to tie up capital, the higher the rate of interest they will demand to compensate themselves for the greater risk, and opportunity cost, on the capital they have invested.

commercial paper

instruments with a shorter maturity. Only companies with high credit ratings can issue bonds with a maturity greater than ten years at an acceptable cost

municipal bonds

issued by a state, municipality or county to finance its capital expenditures exempt from federal taxes and from most state and local taxes

foreign bond

issued by an overseas entity into a domestic market and is denominated in the domestic currency. Examples of a foreign bond are a German company issuing a sterling bond to UK investors or a US dollar bond issued in the US by a non-US company.

eurobonds

large international bond issues often made by governments and multinational companies. This market has grown exponentially into the world's largest market for longer-term capital, as a result of the corresponding growth in world trade and even more significant growth in international capital flows. one defining characteristic of eurobonds is that they are denominated in a currency different from that of the financial centre or centres from which they are issued. An example might be a German company issuing either a euro, a dollar or a sterling bond to Japanese investors. In this respect, the term eurobond is a bit of a misnomer as eurobond issues and the currencies in which they are denominated are not restricted to those of European financial centres or countries. Eurobonds issued by companies often do not provide any underlying collateral, or security, to the bondholders but are almost always rated by a credit rating agency. To prevent the interests of these bondholders being subordinated, or made inferior, to those of any subsequent bond issues, the company makes a 'negative pledge' clause.

bond indenture

legal and binding contract between a bond issuer and bondholders specifies all imp features of a bond (maturity date, timing of interest payments, method of interest calculation, callable or convertible features if applicable to the bond issue) also contains terms and conditions critical info: financial covenants that govern the issuer and the formulas for calculating whether the issuer is within the covenants

principal of a bond

maturity value, par value, face amount issuer borrows which must be repaid to the lender

clean price

price of bond without accrued interest

yield

rate of interest implied by future payment structure of the bond and the current price different types of yield

term structure

relates the interest rate to the time to maturity for securities with common default risk profile -treasury securities are used to construct yield curves since they all have zero risk default The relationship between interest rates or bond yields and different terms or maturities. The term structure of interest rates is also known as a yield curve and it plays a central role in an economy. The term structure reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions. In general terms, yields increase in line with maturity, giving rise to an upward sloping yield curve or a "normal yield curve." One basic explanation for this phenomenon is that lenders demand higher interest rates for longer-term loans as compensation for the greater risk associated with them, in comparison to short-term loans. Occasionally, longterm yields may fall below short-term yields, creating an "inverted yield curve" that is generally regarded as a harbinger of recession. The following question are raised by the term structure: i. Why do rates vary with time? ii. Should the term structure slope up or down

money market instruments

short term fixed income securities traded in money market

When is a bond priced at principal?

since coupon and discount rate same

Yield to Maturity or redemption yield

single rate of interest equating the present value of the income stream with current price also the same as the internal rate of return and would be the approximate return on the bond if was held maturity and all coupon payment were invested at that rate One measure of return is the promised yield-to-maturity. The word "promised" is important here since the bond may be called or go into default. In either case, the full set of promised payments will not be made. The yield-to-maturity is calculated on the basis that neither of these events will occur. The yield-to-maturity is the most common measure of a bond's return and allows for comparisons between bonds with different structures of payments. The general definition is given by comparing the payments offered by a bond with the payments on an alternative investment at a fixed rate of interest. The Yield to Maturity is defines as the interest rate that makes the Present value (PV) of the bond's payments equal to its price. The interest rate is often interpreted as a measure of the average rate of return that will be earned n a bond if it is bought now and held until maturity.

what is a coupon

specific amount of periodic interest over specified period of time not all bonds pay coupon including the zero coupon bonds or pure discount bonds

bond sold at discount

stated rate > market rate bond that is issued for less than its par (or face) value, or a bond currently trading for less than its par value in the secondary market. The "discount" in a discount bond doesn't necessarily mean that investors get a better yield than the market is offering, just a price below par. Depending on the length of time until maturity, zero-coupon bonds can be issued at very large discounts to par, sometimes 50% or more. Because a bond will always pay its full face value at maturity (assuming no credit events occur), discount bonds issued below par - such as zero-coupon bonds - will steadily rise in price as the maturity date approaches. These bonds will only make one payment to the holder (par value at maturity) as opposed to periodic interest payments. A distressed bond (one that has a high likelihood of default) can also trade for huge discounts to par, effectively raising its yield to very attractive levels however, is that these bonds will not receive full or timely interest payments at all; because of this, investors who buy into these issues become very speculative, possibly even making a play for the company's assets or equity

how the cost of a corporate bond varies

the longer the bond's maturity, the higher the int cost to the firm the larger the size of the offering, the lower the cost of the bond will be the greater the risk of the issuing company, the higher the cost of the issue

accrued interest

when an investor purchases a bond between coupon payments, the investor must compensate the seller of the bond for the coupon interest earned from the time of the last coupon payment to the settlement date of the bond ie accrued interest To understand the idea of the accrued interest, consider a coupon bond (a corporate bond r a treasury bond) that pays coupons every six months. So it maybe a coupon is paid on January 1 st for example, the holder of the bond will have to wait six months to July the 1st to receive the next coupon. The buyer and seller come together to transact in the meantime and typically they will do that somewhere in between the coupon payments. The seller will sell the bond to the buyer at the full price which needs to include the interest that is being accrued between this last coupon and the settlement date If you think the time between the coupons, the seller of the bond is being holding the bond until this period in the middle (between coupon and settlement date - (a)) and the interest accrues to the seller. The buyer then is going to have the bond and the interest in the segment between after settlement date and the coupon -(b))and it is going to accrued to the buyer.

attraction of convertible bonds

• If the company prospers, its share price will rise and, if it does so sufficiently, conversion may lead to capital gains. • If the company hits problems, the investor will retain the bond - interest will be earned and, as bondholder, the investor would rank ahead of existing shareholders if the company goes out of business. (Of course, if the company is seriously insolvent and the bond is unsecured, the bondholder might still not be repaid, but this is a more remote possibility than that of a full loss as a shareholder.) The main cause of a call is a decline in interest rates. If interest rates have declined since a company first issued the bonds, it will likely want to refinance this debt at a lower rate of interest. In this case, company will call its current bonds and reissue them at a lower rate of interest. In other words, on the call date(s), the issuer has the right, but not the obligation, to buy back the bonds from the bond holders at a defined call price. Technically speaking, the bonds are not really bought and held by the issuer but are instead cancelled immediately. The call price will usually exceed the par or issue price. In certain cases, mainly in the high yield debt market, there can be a substantial call premium. With a callable bond, investors have the benefit of a higher coupon than they would have had with a non-callable bond. On the other hand, if interest rates fall, the bonds will likely be called and they can only invest at the lower rate. This is comparable to selling (writing) an option — the option writer gets a premium up front, but has a downside if the option is exercised.

benefits of eurobond over domestic bond

• a choice of innovative products to more precisely meet issuers' needs • the ability to tap potential lenders internationally, rather than just domestically • anonymity to investors as issues are made in bearer form • gross interest payments to investors • lower funding costs due to the competitive nature and greater liquidity of the market • the ability to make bond issues at short notice • less regulation and disclosure.