Bonds

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Bonds

  1. 1. Chapter 1<br />Introduction to Bond Markets<br />
  2. 2. Intro to Fixed Income Markets<br />What is a bond?<br />A bond is simply a loan, but in the form of a security.<br />The issuer of the bond is the borrower and investors (bondholders) are the lenders.<br />Bonds are used to finance a firm’s (usually long-term) investments.<br />Bank loans tend to involve shorter term lending periods.<br />
  3. 3. Recent Bond issuance<br />Yum! Brands<br />$350,000,000 face value<br />3.875% coupon<br />3.89% yield/99.867 price<br />Citigroup, Goldman and JPM/Chase lead<br />10 year bonds maturing November 1st 2020<br />US 10 year bonds<br />Issued 8/16<br />$24 billion<br />2.625% coupon<br />2.730% yield<br />
  4. 4. Bond Market Characteristics<br />Primary market: where new bonds are issued to investors.<br />Secondary market: where previously issued bonds trade.<br />Most secondary market trading occurs in a decentralized (fragmented) OTC market—in part because no two bonds are alike.<br />Size of bond market:<br />Face value of all bonds outstanding worldwide in 2007 was about $65 Trillion.<br />Contrast this with the equities where global capitalization was about $55 Trillion.<br />
  5. 5. Bond Market Sectors<br />Treasury Sector: debt issued by US government:<br />Treasury bills, notes, and bonds.<br />US government is largest issuer of securities in the world.<br />Agency Sector: securities issued by government-sponsored organizations.<br />Municipal Sector: debt issued by state and local governments <br />Also called the “tax-exempt” sector.<br />
  6. 6. Bond Market Sectors<br />Corporate Sector: debt issued by corporations (also called credit sector):<br />Commercial paper, notes, bonds.<br />Subsectors: investment grade and noninvestment grade sectors.<br />Asset-backed Sector – issuer pools loans and receivables as collateral for the issuance of securities.<br />Mortgage-backed Sector – debt backed by pool of mortgage loans:<br />Subsectors: Residential mortgage sector and Commercial mortgage sector.<br />
  7. 7. Summary of Bond Features<br />Bond features are outlined in a contract between the issuer and investors (called the indenture):<br />Term to maturity<br />Principal amount<br />Coupon rate<br />Amortization features<br />Embedded options.<br />
  8. 8. Feature 1: Term to Maturity<br />Term to maturity: # of years until the bond expires. <br />Usually just called “term” or “maturity.”<br />Bond terms:<br />Short term: 1 to 5 years.<br />Intermediate term: 5 to 12 years.<br />Long term: > 12 years.<br />
  9. 9. Features 2 and 3: Principal & Coupon Rate<br />Principal: The amount the issuer agrees to repay to bondholders at the maturity date.<br />Also commonly called: face value, par value, maturity value.<br />Coupon Rate: the annual interest rate the issuer agrees to pay on the face value (principal).<br />The coupon is the annual amount the issuer promises to pay (in $):<br />coupon = coupon rate  principal <br />The coupon is paid semiannually on most bonds.<br />
  10. 10. Coupon Rate, Aside<br />Some bonds pay no coupons (zero-coupon bonds).<br />Zeros are sold at a substantial discount to face value and redeemed at face value at expiration.<br />All interest is therefore received at expiration.<br />Some bonds have floating coupons<br />The coupon resets periodically, according to some formula<br />
  11. 11. Floating Rate Bonds<br />The coupon for a floater is determined by the following general formula:<br />Floater coupon = floating reference rate + fixed margin (in bps)<br />Examples:<br />Floater coupon = 1-month LIBOR rate + 150bps<br />Floater coupon = 3-month T-bill rate + 80bps<br />
  12. 12. Feature 4: Amortization<br />The principal on a bond can be paid two ways:<br />Paid all at once at expiration (“bullet” maturity).<br />Paid little-by-little over the life of the bond according to a schedule (amortizing).<br />One advantage of a bond that amortizes principal is that the issuer won’t have to fund a big “balloon payment” at expiration.<br />
  13. 13. Feature 5: Embedded Options<br />Options are actions that can be taken by either the issuer or the investor.<br />The most common is a call provision: Grants issuer the right to retire bonds (fully or partially) prior to maturity.<br />Put provision: Enables the bondholder to sell the issue back to issuer at par value prior to expiration.<br />
  14. 14. Feature 5: Embedded Options<br />Convertible bond – gives bondholders the right to exchange the bond for a specified number of shares of common stock.<br />This is advantageous to investors if firm’s stock price goes up.<br />Exchangeable bond – allows bondholders to exchange the bond for a specified number of shares of common stock of another firm.<br />Other options exist.<br />
  15. 15. Risks Associated with Bond Investing<br />Interest-rate risk – the risk that interest rates will rise, thereby reducing a bond’s price (also called market risk). <br />The major risk faced by bond investors.<br />Reinvestment risk – the risk that the interest rate at which intermediate cash flows can be reinvested will fall.<br />Call risk – the risk the issuer may “call” or retire all or part of the issue before the maturity date.<br />
  16. 16. Risks Associated with Bond Investing<br />Credit risk – risk that issuer will fail to satisfy the terms of the bond.<br />Default risk: Risk the issuer does not repay part or all of its financial obligation. <br />Credit spread risk: Risk that an issuer’s obligation will decline due to an increase in the credit spread (the part of the risk premium or yield spread attributable to default risk). <br />Credit deterioration risk: Risk that the credit quality of the issuer decreases (closely related to credit spread risk).<br />Credit rating agencies:<br />Standard & Poor’s, Moody’s, and Fitch.<br />
  17. 17. Risks Associated with Bond Investing<br />Inflation risk – the risk that the purchasing power of a bond’s cash flows may decline.<br />Floating rate bonds have a lower level of inflation risk than coupon bonds.<br />Exchange rate risk – if a bond is denominated in a foreign currency (e.g., the euro), the value of the cash flows in US$ will be uncertain.<br />
  18. 18. Risks Associated with Bond Investing<br />Liquidity risk – the risk that the bond cannot be sold with ease at (or near) its current value.<br />Unimportant for investors holding a bond to maturity.<br />Liquidity can be measured by the bid-ask spread. The wider the spread the less liquid a bond is. <br />Sometimes called marketability risk.<br />
  19. 19. Risks Associated with Bond Investing<br />Volatility risk – the value of embedded options is determined partly by the volatility of interest rates.<br />The price of a bond with embedded options will change as interest rate volatility changes.<br />Risk risk – The bond market has been a hotbed of financial innovation. <br />The risk/return characteristics of innovative securities are not always understood. Risk risk is “not knowing what the risk of a security is.”<br />

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