MARKETS AND VOLATILITY - SECTION IV - CHAPTER 24 - Fixed Income - Bonds

1. Fixed Income/Bonds
CMT LEVEL - I

2. What are Bonds?
• A bond is a fixed income instrument that represents a loan made
by an investor to a borrower (typically corporate or
governmental).
• Bonds are used by companies, municipalities, states, and
sovereign governments to finance projects and operations.
• Owners of bonds are debt holders, or creditors, of the issuer.
• Bond details include the end date when the principal of the loan
is due to be paid to the bond owner and usually includes the
terms for variable or fixed interest payments made by the
borrower.

3. What are Bonds?
• Bonds are units of corporate debt issued by companies and
securitized as tradeable assets.
• A bond is referred to as a fixed income instrument since
bonds traditionally paid a fixed interest rate (coupon) to
debtholders. Variable or floating interest rates are also now
quite common.
• Bond prices are inversely correlated with interest rates:
when rates go up, bond prices fall and vice-versa.
• Bonds have maturity dates at which point the principal
amount must be paid back in full or risk default.

4. Components of Bonds
Maturity Secured/Unsecured Coupon Par Value
Yield to Maturity Duration Rating Issuer
Bid/Ask/Last

5. Components of Bonds
• Yield to maturity (YTM) - is the most commonly cited yield
measurement. It measures what the return on a bond is if it is
held to maturity and all coupons are reinvested at the YTM rate.
• Coupon Rate - The coupon amount is the amount of interest paid
to bondholders, normally annually or semiannually.
• Secured or unsecured Bonds - Unsecured bonds are called
debentures; their interest payments and return of principal are
guaranteed only by the credit of the issuing company.
• On the other hand, a secured bond is a bond in which specific
assets are pledged to bondholders if the company cannot repay
the obligation.

6. Components of Bonds
• Maturity - The maturity date of a bond is the date when the
principal, or par, amount of the bond will be paid to
investors, and the company’s bond obligation will end.
• Par value - is the face value of a bond. Par value is important
for a bond or fixed-income instrument because it determines
its maturity value as well as the dollar value of coupon
payments
• A bond rating - is a grade given to a bond by various rating
services that indicates its credit quality. It takes into
consideration a bond issuer's financial strength or its ability
to pay a bond's principal and interest in a timely fashion.

7. Components of Bonds
• Bond Issuers - Bonds are issued as forms of tradable debt. ...
The bond issuer is the borrower, while the bondholder or
purchaser is the lender. At the maturity of the bond, bond
issuers repay the bondholder the principal value.
• Duration - is a measure of the sensitivity of the price of a
bond or other debt instrument to a change in interest rates.
Duration is non-linear and accelerates as time to maturity
lessens.
• Bid/Ask / Last Price – These denoted in units specific to the
bond type. They could be in basis point (0.01) or fractional
representation , such as 1/8 , 1/16 or 1/32

8. Risks of Bonds
Credit/Default
Risk
Prepayment
Risk
Interest Rate
Risk
Inflation Risk

9. Risks of Bonds
• Inflation Risk - This risk refers to an event wherein the rate of price
increases in the economy deteriorates the returns associated with the
bond. This has the greatest effect on fixed bonds, which have a set
interest rate from inception.
• Default /Credit Risk - This risk refers to an event wherein the bond's
issuer is unable to pay the contractual interest or principal on the bond
in a timely manner, or at all.
• Credit rating services such as Moody's, Standard & Poor's and Fitch
give credit ratings to bond issues, which helps to give investors an idea
of how likely it is that a payment default will occur.
• Prepayment Risk - A callable bond is a bond that the issuer may
redeem before it reaches the stated maturity date. In essence, a
callable bond allows the issuing company to pay off their debt early.

10. Risks of Bonds
• Interest-rate risk refers to the inverse relationship between the
price of a bond and market interest rates.
• To explain, if an investor purchased a 5% coupon, a 10-year
corporate bond that is selling at par value, the present value of the
$1,000 par value bond would be $614.
• This amount represents the amount of money that is needed
today to be invested at an annual rate of 5% per year over a 10-
year period, in order to have $1,000 when the bond reaches
maturity.
• Now, if interest rates increase to 6%, the present value of the bond
would be $558, because it would only take $558 invested today at
an annual rate of 6% for 10 years to accumulate $1,000.
• In contrast, if interest rates decreased to 4%, the present value of
the bond would be $676.

11. Yield Curve
• A yield curve is a line that plots the
interest rates, at a set point in time,
of bonds having equal credit quality
but differing maturity dates.
• The most frequently reported yield
curve compares the three-month,
two-year, five-year, 10-year and 30-
year U.S. Treasury debt.
• There are three main types of yield
curve shapes: normal, inverted and
flat (or humped).

12. Yield Curve
• A normal or up-sloped yield curve indicates yields on
longer-term bonds may continue to rise, responding
to periods of economic expansion.
•An inverted or down-sloped yield curve suggests
yields on longer-term bonds may continue to fall,
corresponding to periods of economic recession.
•A flat yield curve may arise from normal or inverted
yield curve, depending on changing economic
conditions.