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BONDS
All rights reserved.
Ula Academics
AN UNDER-DISCUSSED
ASSET CLASS?
Many people know about Equities, less about Bonds..
Bonds have traditionally had high investment
minimums and were traded privately OTC which
makes accessibility more onerous..
But with interest rates at its highest in decades, more
are realizing that there are implications across asset
classes and that the base case risk free rate has
increased tremendously as well.. Accessibility has also
improved over years.. We discuss more..
WELCOME MESSAGE
LETS GET STARTED
LIST OF CONTENT
PRESENTATION
The few terminologies you should
know..
HOW BONDS WORK
01
Defining the concept..
TYPES OF BONDS
02
The Optimal Capital Structure..
CAPITAL STRUCTURE
03
Overview of other fixed income related
products..
OTHER FIXED INCOME PRODUCTS
04
05 Final discussion and next steps..
CONCLUSION
HOW BONDS WORK?
Here are a few terms you should know when discussing Bonds:
Par Value : Bond prices are quoted in terms of Par Value (100%). A Bond is trading at a
discount if it is trading at 85 and it is trading at a premium if it is trading at 104; all
Bonds would revert to its Par Value at maturity provided it has not defaulted.
Coupon Rate: This is the coupon rate the issuer promises to pay you, the creditor.
While a Investment Grade Bond could pay a coupon of say 4% (depending on Risk
Free Rate), a High Yield Bond from the same company could pay a higher coupon of
7% as it has higher risk (more about this..)
Coupon Type: Coupons of Bonds can be fixed or floating.. Fixed means that the 4%
coupon is paid semi-annually (most of the time) while a Floating Rate Bond pays a
reference rate interest (whatever that reference may be) + a Margin so this allows
investors to hedge against Interest Rate Risk as the amount received is in accordance
to market interest rate...
A DUMMY’S GUIDE..
HOW BONDS WORK?
Here are a few terms you should know when discussing Bonds:
Maturity Date: This is the date the Issuer would repay you your investment..
Issuer: The company that is borrowing funds from you..
Credit Rating: This is related to the concept of Investment Grade or High Yield bond
types.. The Big 3 Credit Rating providers are Moody’s, S&P and Fitch and each of
them have their individual credit rating system.. In general, Credit Rating agencies
assess the financial situation of companies, its viability, solvency and assigns a rating
which has a threshold that denotes Investment Grade (good quality credits) from High
Yield (poor quality credits) bonds.. For taking on an increased solvency and credit
risks in riskier companies, investors in High Yield companies are compensated with
higher Interest Rates (Coupon rates..)
A DUMMY’S GUIDE..
HOW BONDS WORK?
Here are a few terms you should know when discussing Bonds:
Seniority: Now, we have to understand where the bond lies in the capital structure of
the company. If it is a Senior Secured Creditor, it has one of the highest claims to the
firm’s cashflows in the event of bankruptcy (higher than Senior Unsecured).. But both
these creditors are senior as compared to Junior Unsecured Creditors (eg: High Yield
Creditors)
A DUMMY’S GUIDE..
TYPES OF BONDS
There are many classifications of bonds and many terminologies.. In general, however, you can
probably assign bond into one of these categories:
(a) Straight Bond: Bonds with the usual characteristics; fixed rate coupon and maturity stated.
(b) Floating Rate Bond: Bonds that pay floating rate coupon tied to some benchmark + Margin.
(c) Convertible Bond: Bonds that can be converted into equities, allows interest rate to be low.
(d) Corporate Bond: Bonds issued by companies.
(e) Sovereign / Quasi-sovereign Bond: Bonds issued by Governments / government-linked entities
And within categories such as Corporate Bond, you can also classify bonds by their Credit Ratings -
either an Investment Grade (usually Senior Unsecured) or High Yield (Junior Subordinated Bond)..
BONDS
CAPITAL STRUCTURE
BETWEEN BONDS AND EQUITIES.. THE OPTIMAL CAPITAL STRUCTURE
We have touched upon this in Equities.. But we are bringing this up again because the
discussion is slightly different when brought up in the context of Bonds.. Plus we will touch
upon the concept of Optimal Capital Structure of firms...
The optimal capital structure of a company is still subject to discussion today although we
generally know:
a) Cost of Debt is cheaper than Cost of Equity: Companies typically prefer internal funds,
followed by Debt and lastly Equity due to signaling effects (also read about the Peking Order
of Capital Structure).. Besides, interest costs incurred for paying on debt is not subjected to
taxes and therefore there is a Tax Benefit of debt...
b) Bankruptcy costs and Optimal Capital Structure: Despite the benefits of debt, there is
increasing bankruptcy costs if too much debt is incurred by the company and therefore the
Optimal Structure cannot be 100% debt..
c) Monitoring function of creditors: There is also a difference between bank loan debt (where
financial institutions are creditors and can assert a monitoring function) from public debt..
OTHER FIXED INCOME RELATED PRODUCTS
Bonds is only one type of fixed income products but in the credit and interest rate space, there are tons
of derivatives all linked to fixed income...
(i) Interest Rate Swaps: This effectively allows one side of the party to pay fixed interest and receiving
floating and vice versa for the counterparty. This is a popular product among institutions.
(ii) Forward Contracts: This allows one to lock in a rate whereby interest rates would be delivered at;
more popular with FX as an underlying..
(iii) Cap and Floor Notes: Basically a structured product that allows an investor to earn a minimum base
interest rate while subjected to a cap of the highest level of interest rates received.
(v) Credit Default Swaps: This is basically an option to buy protection against default of a company. If
such a product is purchased without ownership of the underlying, it is a naked Credit Default Swap.
And there are many many more...
FIXED INCOME AND INTEREST RATE PRODUCTS AND DERIVATIVES
CONCLUSION
Always my favourite; lets recap what we
have learnt about Bonds..
Please visit the next module in this
Investing 101 course.. !
How bonds work, the main
mechanics..
LEARNING ONE:
Types of Bonds..
LEARNING TWO:
Optimal Capital Structure..
LEARNING THREE:
Other types of Fixed Income
Products and Derivatives..
LEARNING FOUR:
UNTIL THE NEXT
TIME!
All Rights Reserved.
Ula Academics.

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Asset Allocation 101 - Bonds.pdf

  • 2. AN UNDER-DISCUSSED ASSET CLASS? Many people know about Equities, less about Bonds.. Bonds have traditionally had high investment minimums and were traded privately OTC which makes accessibility more onerous.. But with interest rates at its highest in decades, more are realizing that there are implications across asset classes and that the base case risk free rate has increased tremendously as well.. Accessibility has also improved over years.. We discuss more.. WELCOME MESSAGE LETS GET STARTED
  • 3. LIST OF CONTENT PRESENTATION The few terminologies you should know.. HOW BONDS WORK 01 Defining the concept.. TYPES OF BONDS 02 The Optimal Capital Structure.. CAPITAL STRUCTURE 03 Overview of other fixed income related products.. OTHER FIXED INCOME PRODUCTS 04 05 Final discussion and next steps.. CONCLUSION
  • 4. HOW BONDS WORK? Here are a few terms you should know when discussing Bonds: Par Value : Bond prices are quoted in terms of Par Value (100%). A Bond is trading at a discount if it is trading at 85 and it is trading at a premium if it is trading at 104; all Bonds would revert to its Par Value at maturity provided it has not defaulted. Coupon Rate: This is the coupon rate the issuer promises to pay you, the creditor. While a Investment Grade Bond could pay a coupon of say 4% (depending on Risk Free Rate), a High Yield Bond from the same company could pay a higher coupon of 7% as it has higher risk (more about this..) Coupon Type: Coupons of Bonds can be fixed or floating.. Fixed means that the 4% coupon is paid semi-annually (most of the time) while a Floating Rate Bond pays a reference rate interest (whatever that reference may be) + a Margin so this allows investors to hedge against Interest Rate Risk as the amount received is in accordance to market interest rate... A DUMMY’S GUIDE..
  • 5. HOW BONDS WORK? Here are a few terms you should know when discussing Bonds: Maturity Date: This is the date the Issuer would repay you your investment.. Issuer: The company that is borrowing funds from you.. Credit Rating: This is related to the concept of Investment Grade or High Yield bond types.. The Big 3 Credit Rating providers are Moody’s, S&P and Fitch and each of them have their individual credit rating system.. In general, Credit Rating agencies assess the financial situation of companies, its viability, solvency and assigns a rating which has a threshold that denotes Investment Grade (good quality credits) from High Yield (poor quality credits) bonds.. For taking on an increased solvency and credit risks in riskier companies, investors in High Yield companies are compensated with higher Interest Rates (Coupon rates..) A DUMMY’S GUIDE..
  • 6. HOW BONDS WORK? Here are a few terms you should know when discussing Bonds: Seniority: Now, we have to understand where the bond lies in the capital structure of the company. If it is a Senior Secured Creditor, it has one of the highest claims to the firm’s cashflows in the event of bankruptcy (higher than Senior Unsecured).. But both these creditors are senior as compared to Junior Unsecured Creditors (eg: High Yield Creditors) A DUMMY’S GUIDE..
  • 7. TYPES OF BONDS There are many classifications of bonds and many terminologies.. In general, however, you can probably assign bond into one of these categories: (a) Straight Bond: Bonds with the usual characteristics; fixed rate coupon and maturity stated. (b) Floating Rate Bond: Bonds that pay floating rate coupon tied to some benchmark + Margin. (c) Convertible Bond: Bonds that can be converted into equities, allows interest rate to be low. (d) Corporate Bond: Bonds issued by companies. (e) Sovereign / Quasi-sovereign Bond: Bonds issued by Governments / government-linked entities And within categories such as Corporate Bond, you can also classify bonds by their Credit Ratings - either an Investment Grade (usually Senior Unsecured) or High Yield (Junior Subordinated Bond).. BONDS
  • 8. CAPITAL STRUCTURE BETWEEN BONDS AND EQUITIES.. THE OPTIMAL CAPITAL STRUCTURE We have touched upon this in Equities.. But we are bringing this up again because the discussion is slightly different when brought up in the context of Bonds.. Plus we will touch upon the concept of Optimal Capital Structure of firms... The optimal capital structure of a company is still subject to discussion today although we generally know: a) Cost of Debt is cheaper than Cost of Equity: Companies typically prefer internal funds, followed by Debt and lastly Equity due to signaling effects (also read about the Peking Order of Capital Structure).. Besides, interest costs incurred for paying on debt is not subjected to taxes and therefore there is a Tax Benefit of debt... b) Bankruptcy costs and Optimal Capital Structure: Despite the benefits of debt, there is increasing bankruptcy costs if too much debt is incurred by the company and therefore the Optimal Structure cannot be 100% debt.. c) Monitoring function of creditors: There is also a difference between bank loan debt (where financial institutions are creditors and can assert a monitoring function) from public debt..
  • 9. OTHER FIXED INCOME RELATED PRODUCTS Bonds is only one type of fixed income products but in the credit and interest rate space, there are tons of derivatives all linked to fixed income... (i) Interest Rate Swaps: This effectively allows one side of the party to pay fixed interest and receiving floating and vice versa for the counterparty. This is a popular product among institutions. (ii) Forward Contracts: This allows one to lock in a rate whereby interest rates would be delivered at; more popular with FX as an underlying.. (iii) Cap and Floor Notes: Basically a structured product that allows an investor to earn a minimum base interest rate while subjected to a cap of the highest level of interest rates received. (v) Credit Default Swaps: This is basically an option to buy protection against default of a company. If such a product is purchased without ownership of the underlying, it is a naked Credit Default Swap. And there are many many more... FIXED INCOME AND INTEREST RATE PRODUCTS AND DERIVATIVES
  • 10. CONCLUSION Always my favourite; lets recap what we have learnt about Bonds.. Please visit the next module in this Investing 101 course.. ! How bonds work, the main mechanics.. LEARNING ONE: Types of Bonds.. LEARNING TWO: Optimal Capital Structure.. LEARNING THREE: Other types of Fixed Income Products and Derivatives.. LEARNING FOUR:
  • 11. UNTIL THE NEXT TIME! All Rights Reserved. Ula Academics.