Bonds

What is a Bond?:

• a bond is a fixed-income investment issued by governments or corporations to raise funding
  • individuals lend money to a government or company at a specified interest rate for a predetermined period
• the entity repays individuals with interest in addition to the original face value of the bond

How Bonds Work?

• bonds are debt instruments - represent loans made to the issuer
• borrower issues a bond that includes the loan terms, interest payments that will be made, and the maturity date by which the bond principal must be repaid
• the interest payment is part of the return that bondholders earn for loaning money to the issuer
• the interest rate that determines the payment is the coupon rate
• initial price of most bonds is typically the par value, or the face value of a bond
  • face value: what is paid to the lender upon maturity

Characteristics of Bonds:

Face Value or Par Value	value of the bond at maturity and the reference amount the bond issuer uses when calculating interest payments
Coupon Rate	rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage
Coupon Dates	dates on which the bond issuer will make interest payments
Maturity Date	date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond
Issue Price	the price at which the bond issuer originally sells the bonds. in many cases, bonds are issued at par

Bond Categories:

Corporate Bonds	companies issue corporate bonds rather than seek bank loans for debt financing because bond markets offer more favorable terms and lower interest rates
Municipal Bonds	issued by states and municipalities. some municipal bonds offer tax-free coupon income
Government Bonds	• the US treasury issues several types of bonds. those with a year or less to maturity are bills, while notes have one to 10 years until maturity.
• government bonds issued with more than 10 years to maturity are called “bonds”. all bonds issued by the treasury are collectively referred to as “Treasuries”
Agency Bonds	issued by government-affiliated organisations such as Fannie Mae or Freddie Mac

Bond Prices and Interest Rates:

• if an investor holds a bond to maturity, they will get their principal back plus interest
• however a bondholder can sell their bonds in the open market, where the price can fluctuate
  • bond’s price varies inversely with interest rates: when rates go up, bond prices fall to equalise the interest rate on the bond with prevailing rates, and vice versa

Yield-to-Maturity (YTM):

• the total return anticipated on a bond if it is held until the end of its lifetime
• considered a long-term bond yield but is expressed as an annual rate
• is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled
• evaluates the attractiveness of one bond relative to other bonds of different coupons and maturity in the market

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• investors can measure the anticipated changes in bond prices given a change in interest rates with the duration of a bond
• duration represents the price change in a bond given a 1% change in interest rates
  • modified duration of a bond
• bonds with long maturities, as well as bonds with low coupons, have the greatest sensitivity to interest rate changes

Bond Variations:

| Zero-Coupon Bonds (Z-bonds) | • do not pay coupon payments and instead are issued at a discount to their par value that will generate a return once the bondholder is paid the full face value when the bond matures. • US treasury bills are zero-coupon bonds | | --- | --- | | Convertible Bonds | debit instruments with an embedded option that allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions like share price | | Callable Bonds | • have an embedded option, but it is different than what is found in a convertible bond • can be “called” back by the company before it matures • riskier for the bond buyer because the bond is more likely to be called when it is rising in value | | Puttable Bonds | • allows the bondholders to put or sell the bond back to the company before it was matured • valuable for investors who are worried that a bond may fall in value or if they think interest rates will rise, and they want to get their principal back before the bond falls in value • usually trades at a higher value than a bond without a put option but with the same credit rating, maturity and coupon rate because it is more valuable to bondholders |

What Determines a Bond’s Coupon Rate?

• credit quality and time to maturity are the principal determinants of a bond’s coupon rate.
• If the issuer has a poor credit rating, the risk of default is greater, and these bonds pay more interest.
• Bonds that have a very long maturity date also usually pay a higher interest rate.
  • This higher compensation is because the bondholder is more exposed to interest rate and inflation risks for an extended period.

How Are Bond’s Rated?

• A company’s and its bonds’ credit ratings are generated by credit rating agencies like Standard and Poor’s, Moody’s, and Fitch Ratings.
• The highest quality bonds are called “investment grade” and include debt issued by the U.S. government and very stable companies, such as utilities.
• Bonds that are not considered investment grade but are not in default are called “high yield” or “junk” bonds.
  • These bonds have a higher risk of default in the future, and investors demand a higher coupon payment to compensate them for that risk.6

What Is Duration?

• Bonds and bond portfolios will rise or fall in value as interest rates change. The sensitivity to changes in the interest rate environment is called “duration.”
• Duration describes how much a bond’s price will rise or fall with a change in interest rates.