A PRIMER ON BONDS

KIRAN KUMAR K V

A Bond is a contractual agreement between the issuer and the bondholders. There are three elements that an investor needs to know about when investing in a bond:
ü  The bond’s features, including issuer, maturity, par value, and coupon rate and frequency, and currency denomination. These features determine the bond’s cash flows and therefore are key determinants of investor’s expected and actual return
ü  The legal, regulatory and tax considerations that apply to the contractual agreement between the issuer and bondholders
ü  The contingency provisions the may affect the bond’s scheduled cash flows. These contingency provisions are options; they give the issuer or bondholders certain rights affecting the bond’s disposal or redemption

Who issues Bonds?

It is important to understand the issuer of a bond, as it is a measure of credit risk. A bond can be an investment grade bond or a non-investment or junk bond.
ü  Supranational Organisations – World Bank, European Investment Bank
ü  Sovereign (national) Governments – GOI, Federal Govt. of USA
ü  Non-Sovereign (local) Governments – State Govt. of Karnataka, Region of Catalonia in Spain
ü  Quasi-Government Entities – Post Office, NABARD
ü  Companies – Financial & Non-Financial
ü  Special Legal Entities – Formed to create ABS

What is a Bond’s Maturity?

Maturity date of a bond refers to the date when the issuer is obligated to redeem the bond by paying the outstanding principal amount. The tenor is the time remaining until bond’s maturity date

What is a Bond’s Par Value?

The principal of a bond is the amount the issuer agrees to repay the bondholders on the maturity date. This amount is also called the par value, face value, nominal value, redemption value or maturity value

What is a Bond’s Coupon?

The coupon rate of a bond is the interest rate that the issuer agrees to pay each year until the maturity date. The annual amount of interest payments made is called the coupon. Coupon payments can be made annually, semi-annually, quarterly or monthly.
A plain vanilla bond pays a fixed rate of interest. The coupon payment does not change during the life of the bond. A Floating Rate Notes (FRNs) or Floaters pay a floating rate of interest. The coupon rate of a FRN includes two components – a reference rate plus a spread. The spread is typically constant and expressed in bips(basis points). A bip (basis point) is equal to 0.01%. For example, an Indian FRN may have the rate specified as MIBOR + 0.50%, which means that the coupon rate for this bond would be prevailing Mumbai Inter Bank Offer Rate plus 0.50%. MIBOR is a collective name for a set of rates covering different lending offers among banks for different maturities ranging from overnight to one year. A Zero-Coupon Bond do not pay interest, instead they are issued at a discount to par value and redeemed at par value.

What are Bond’s Yield Measures?

The current yield is equal to bond’s annual coupon divided by the bond’s price, expressed as a percentage.
The Yield to Maturity (YTM) or Yield to Redemption or Yield to call is the internal rate of return on a bond’s expected cash flows – that is the discount rate that equates the present value of bond’s expected  cash flows until maturity with the bond’s price.
There is an inverse relationship between a bond’s price and its YTM, all else being equal. That is, the higher the bonds YTM, the lower its price. Thus, investors anticipating a lower interest rate environment (in which investors demand lower YTM) hope to earn a positive return from price appreciation

What are Legal or Regulatory Features of a Bond?

A Bond is a contractual agreement between the issuer and the bondholders; it is subject to legal considerations.
A Trust Deed or Bond Indenture is the legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders. A Collateral is an asset or financial guarantee underlying the debt obligation above and beyond the issuer’s promise to pay. Credit Enhancements are provisions that may be used to reduce the credit risk of the bond issue. Covenantsare clauses that specify the rights of the bondholders and any actions that the issuer is obligated to perform or prohibited from performing.
Secured Bonds are backed by collaterals to ensure debt repayment in case of default. Collateral Trust Bonds are secured by securities such as common shares, other bonds and other financial assets. Equipment Trust Certificates are bonds secured by specific types of equipment or physical assets, such as aircrafts, oil rigs etc. A Covered Bond is a debt obligation backed by a segregated pool of assets called a cover pool.
Credit Enhancements refer to a variety of provisions that can be used to reduce the credit risk of a bond issue. They are meant to increase the credit quality of the issue. They can be internal or external credit enhancements. Internal Credit Enhancements include the below:
ü  Subordination or Credit Tranching is an arrangement where it creates more than one bond class or tranche and orders the claim priorities for ownership or interest in an asset between the tranches. The cash flows generated with different priority to tranches of different seniority.
ü  Overcollateralization refers to the process of posting more collateral than needed to obtain or secure financing.
ü  Reverse Accounts or Reserve Funds come in two forms – a cash reserve fund and an excess spread account. A cash reserve fund is a deposit of cash that can be used to absorb losses. An excess spread account involves the allocation of any amounts left over after paying out the interest to bondholders.
External Credit Enhancements include the following:
ü  Bank Guarantees and Surety Bonds are arrangements with financial institutions, where the latter reimburse bondholders for losses incurred due to issuer’s default.
ü  ALetter of Credit is an arrangement with a financial institution where the latter provides the issuer with a credit line to reimburse any cash flow shortfalls from the assets backing the issue.
ü  A Cash Collateral Account is an arrangement where the issuer borrows the credit enhancement amount from the financial institution and then invests the amount, usually at a high rated commercial paper.
Covenants are legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue. A covenant can be positive or negative covenant. A positive covenanttell what issuers are required to do and administrative in nature. E.g., usage of issue proceeds, promise to make timely payments, complying with laws and regulations, maintain the current line of business, insure and maintain its assets, and pay taxes on time. A negative covenant specify what the issuer is prohibited from doing. E.g., restrictions on further debt, negative pledge ( for non-issuance of a senior debt), restrictions on prior claims (non-collateralizing assets), restrictions on distribution to shareholders, restrictions on asset disposals, restrictions on investments, restrictions on M&A.
A bearer bond is a bond for which ownership is not recorded; only the clearing system will know who the bond owner is at a given time. A registered bond is a bond for which ownership is recorded by either name or serial number.

What are the Principal Repayment Structures of Bonds?

ü  Bullet bond simply refers to plain vanilla bond
ü  Amortizing Bond has a payment schedule that calls for periodic payments of interest and repayments of principal. A bond that is fully amortized is characterized by a fixed periodic payment schedule that reduces the bond’s outstanding principal amount to zero by the maturity date. A partially amortized bondalso makes fixed periodic payments until maturity, but only a portion of the principal is repaid by the maturity date. Thus, a balloon payment (large payment) is required at maturity to retire bond’s outstanding principal amount.

What are the Coupon Payment Structures of Bonds?

ü  Fixed Rate structure promises a fixed rate of coupon paid on due date
ü  Floating Rate structure will not have a fixed coupon, instead their coupon rate is linked to an external reference rate, such as MIBOR
ü  Step-up Rate structures may be fixed or floating, but increases by specified margins at specified dates.
ü  Credit-linked Rate structure has a coupon that changes when the bond’s credit rating changes
ü  Payment-in-Kind structure allows the issuer to pay interest in the form of additional amounts of the bond issue rather than as a cash payment.
ü  Deferred Coupon Rate structure or Split Coupon Rate structure pays no coupons for its first few years but then pays a higher coupon than it otherwise normally would for the remainder of its life.
ü  Index-linked Rate structure has its coupon payments and/or principal repayment linked to a specified index, like inflation (called inflation-linked bonds, also called linkers)

What are Bonds with Contingency Provisions?

A contingency refers to some future event that is possible but not certain. A contingency provision is a clause in legal document that allows for some action if the event does occur. In case of bonds, these contingency provisions are referred to as embedded options. The options embedded in the bonds grant either the issuer or the bondholder certain rights affecting the disposal or redemption of the bond.
ü  Callable Bonds gives the issuer the right to redeem all or part of the bond before the specified maturity date. An American-Style call or continuously callable refers to bonds where the issuer has the right to call a bond at any time starting on the first call date. A European-Style call refers to options where the issuer has the right to call a bond only once on the call date. A Bermuda-Style call refers to options where the issuer has the right to call bonds on specified dates following the call protection period.
ü  Puttable Bonds gives the right to sell the bond back to the issuer at a pre-determined price on specified dates. They are beneficial for the bondholder by guaranteeing a pre-specified selling price at the redemption dates. Puttable bonds can be American-Style, European Style or Bermuda-Style
ü  Convertible Bonds are hybrid securities with both debt and equity features. They give the bondholders the right to exchange the bond for a specified number of common shares of the issuing company.
ü  Warrants are similar to convertible bonds, but, they are not embedded options, instead they are attached options. They give the holder a right to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date.

How are Bonds issued?

Different bond issuing mechanisms are used depending on the type of issuer and the type of bond issued. A bond can be issued via a public offering, in which any member of the public may buy the bonds, via a private placement, in which only a selected investor, or group of investors, may buy the bonds. A public offering can be made in three ways:
ü  Underwritten Offering – where the investment bank guarantees the sale if the bond issue at an offering price that is negotiated with the issuer. Thus, the investment bank (called the underwriter) takes the risk associated with selling the bonds. Usually corporate bonds, local government bonds and few ABS are issued under this method. It is more common for larger bond issues, however, to be underwritten by a group. Or syndicate, of investment banks. This is called syndicated offering. A shelf registration allows certain authorized issuers to offer additional bonds to the general public without having to prepare a new and separate offering circular for each bond issue.
ü  Best Effort Offering – where the investment bank only serves as a broker. It only tries to sell the bond issue at the negotiated price if it is able to for a commission.  Thus, the investment bank has less risk and correspondingly less incentive to sell the bonds in a best effort offering than in an underwritten offering.
ü  Auctioning – where a bond is issued using bidding mechanism. Government bonds are generally issued under this approach.

What are the types of Corporate Debt?

ü  A bilateral loan is a loan from a single lender to a single borrower.
ü  A syndicated loan is a loan from a group of lenders, called the syndicate, to a single borrower
ü  A commercial paper (CP) is a short-term, unsecured promissory note issued in the public market or via a private placement that represents a debt obligation of the issuer.
ü  A bridge financing is an interim financing that provides funds until permanent financing can be arranged.
ü  An interbank funding is a source of short term financing between banks
ü  A certificate of deposit (CD) is an instrument that represents a specified amount of funds on deposit for a specified maturity and interest rate issued by financial institutions.
          A repurchase agreement (REPO) is the sale of security with a simultaneous agreement by the seller to buy the security back from the purchaser at an agreed-on price and future date.

How to Value a Bond?

On a traditional (option-free) fixed rate bond, the promised future cash flows are a series of coupon interest payments and repayment of the full principal at maturity. The coupon payments are on regularly scheduled dates, for example, an annual payment bond might pay an interest on 15 June of each year for 5years. The final coupon is typically paid together with full principal on the maturity date. The price of bond at issuance is the presented value of promised cash flows. The market discount rate is used in the time-value-money calculation to obtain the present value. The market discount rate is the rate of return required by investors given the risk of the investment in the bond. It is also called the required yield or the required rate of return.
Price of Bond = PV of all coupons at market discount rate + PV of maturity at market discount rate

What is the relation between market discount rate and price of the bond?

ü  When the coupon rate is less than the market discount rate, the bond is priced at a discount below par value
ü  When the coupon rate is greater than the market discount rate, the bond is priced at a premium above par
ü  When the coupon rate is equal to the market discount rate, the bond is priced at par value

What is the relation between bond price and bond characteristics?

The price of a fixed-rate bond will change whenever the market discount rate changes. Four relationships about the change in the bond price given the market discount rate are:
1.     The bond price is inversely related to the market discount rate. When the market discount rate increases, the bond price decreases (the inverse effect)
2.     For the same coupon rate and time-to-maturity, the percentage price change is greater (in absolute value) when the market discount rate goes down than when it goes up (the convexity effect)
3.     For the same time-to-maturity, a lower coupon bond has a greater percentage price change than a higher coupon bond when their  market discount rates change by the same amount (the coupon effect)
4.     Generally, for the same coupon rate, a longer-term bond has a greater percentage price change than a shorter-term bond when their market discount rates change by the same amount (the maturity effect)

What are Spot Rates?

When a fixed rate bond is priced using the market discount rate, the same discount rate is used for each cash flow. A more fundamental approach to calculate the price of a bond is to use a sequence of market discount rates that correspond to the cash flow dates. These market discount rates are called spot rates. Spot rates are yields-to-maturity on zero-coupon bonds maturing at the date of each cash flow. Sometimes these are called zero rates.

What are the risks in Bonds?

Interest Rate Risk, Inflation Risk, Real Interest Rate Risk, Default Risk, Call Risk, Liquidity Risk, Event Risk, Sovereign Risk, Reinvestment Risk, Foreign Exchange Risk

What is the Duration of a Bond?

The duration of a bond measures the sensitivity of the bond’s full price (including accrued interest) to changes in the bond’s YTM or more generally, to changes in benchmark interest rates. Duration estimates changes in the bond price assuming that variables other than the YTM or benchmark rates are held constant. Duration measures the instantaneous change in the bond’s price. Duration is a measure of the weighted average life of a bond, which considers the size and timing of each cash flow. It represents the length of time that elapses before the ‘average’ rupee of present value from the bond is received
Duration = D = [PV(C1) X 1 + PV(C2) X 2 +……+ PV(Cn) X n]/P0
Duration reflects coupon, maturity and yield, the three key variables that determine the response of price to interest rate changes. Hence, duration can be used to measure interest rate exposure, using modified duration
Modified Duration = MD = D/(1+YTM)
For small changes in YTM, the price change is proportional to MD as below:
% change in Price = – MD X % change in YTM

What is Bond Convexity?

MD measures the primary effect on a bond’s percentage price change given a change in YTM. A secondary effect is measured by the convexity statistic. The true relationship between the bond price and the YTM is curvilinear (convex). The convexity statistic for the bond, developed using this relationship, is used to improve the estimate the percentage price change provided by MD alone. While  MD measures the sensitivity of bond prices to change in yield, convexity measures the sensitivity of MD to changes in yield.
% change in Price = [ – MD X % change in YTM ] + [ ½ X Convexity X (change in YTM)2 ]

References:

Chandra, P. (2017). Fixed Income Securities. In P. Chandra, Investment Analysis and Portfolio Management (pp. 11.3-12.23). McGraw Hill Education.
Hayes, A. (2017, March 27). Bond Basics Tutorial. Retrieved from INVESTOPEDIA: https://www.investopedia.com/university/bonds/
Reilly, F. K., & Brown, K. C. (2012). Analysis and Management of Bonds. In F. K. Reilly, & K. C. Brown, Investment Analysis and Portfolio Management (pp. 646-801). Cengage Learning.

 

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