Julie CHAM ITEC/FIC/TTS/ECN BONDS & FLOATERS

BONDS Definition – Concepts Bond Rating Agencies (Moody's and Standard & Poor's) Features of Bonds Types of bonds Fixed Rate Bonds Zero Coupon Bonds High Yield Bonds Convertible Bonds Step-up (down) Bonds Floating Rate Notes Duration indicators Annexe : Main Financial Markets

Definition - Concepts A bond (fixed-income security) is a debt security issued by the Federal government, states, cities, corporations, or institutions All of these entities need money to operate (to fund the federal deficit, to build roads and finance factories, ..) so they borrow capital from the public by issuing bonds. So when an investor buys a bond, he becomes a creditor of the issuer. The issuer owes the investor a debt and is obliged to repay the bond’s value and interest at a later date, termed maturity.

Bond Rating Agencies (Moody's and Standard & Poor's) Provide a service to investors by grading fixed income securities based on current research. The rating system indicates the likelihood that the issuer will default either on interest or capital payments. Moody's S&P Meaning Investment Grade Bonds Aaa AAA Bonds of the highest quality that offer the lowest degree of investment risk. Aa1, Aa2, Aa3 AA+, AA, AA- Bonds are of high quality by all standards, but carry a slightly greater degree of long-term investment risk. Non Investment Grade Bonds (Junk Bonds) Ba1, Ba2, Ba3 BB+, BB, BB- Bonds with speculative fundamentals. The security of future payments is only moderate. C Lowest rated class of bonds

Features of Bonds (1) The Issuer : Government bonds : issued by a national government and referred to as risk-free bonds. Govies : issued in the country's own currency Ex : - in France, OAT are Govies issued by the « Agence France trésor » - in USA, US Treasuries are Govies issued by the « Bureau of Public Debt » Sovereign bonds : issued in foreign currencies Corporate bonds : issued by private and public corporations, as opposed to Govies. higher yields because there is a higher risk of a company defaulting than a government. Agency (Quasi-Govies) Bonds : issued by a U.S. government-sponsored agency. After Govies, the safest category of bonds. All agency bonds carry an ‘AAA’ credit rating. Municipal bonds : issued by any municipal organization the interest payments are usually exempt from federal taxes and also from state and local taxes in the area bonds are issued.

Features of Bonds (2) Nominal (Principal, Face value, Par value) : amount over which the issuer pays interest, and which has to be repaid at the end. Price : It fluctuates throughout its life due to the interest rates evolution and variation of the issuer credit quality. When a bond trades at a price above the Nominal : it’s sait to be selling at a premium When it sells below the Nominal : it’s said to be selling at a discount Maturity date : the date that the bond will cease to exist and at which time the issuer will pay the nominal short term (bills): maturities up to one year; medium term (notes): maturities between one and ten years; long term (bonds): maturities greater than ten years. !

Features of Bonds (3) Coupon Rate : Interest rate that the issuer pays to the bondholder (expressed as a percentage of the bond’s face value). Coupon Type : The type of interest rate. It can be fixed, variable or floating. Coupon Dates : Coupons are typically paid semiannually, but some bonds pay annual, quarterly or monthly coupons. Coupon frequency : The number of times interest is paid per year.

Features of Bonds (3) Optionality (callability / puttability) : it grants option like features to the buyer or issuer Callable bond : the issuer has the right to redeem the bond prior to its maturity date. He will often call a bond if it’s paying a higher coupon than the current market interest rates. The company can reissue the same bonds at a lower interest rate. Put bond :allows the bondholder to redeem the bond at a specified price prior to maturity. Investors might choose to do this if interest rates increase after the bond was issued. How does it work? Bond issues at a price closed to its par value (exact price determined by market conditions). The issuer makes fixed periodic interest payments : coupons (a percentage of that par value) They continue to be paid until the bond's maturity date At maturity date : one final coupon is paid along with the par value.

Bond Price Formula : Price of any financial instrument = the Net Present Value (NPV) of all future cash flows discounted at a suitable interest rate(s). To simplify we assume a single rate for all cash flows known as the yield-to-maturity. Cash flows = { coupon interest payments & the maturity value (par value) } Fixed rate bond formula : C = coupon payment n = number of payments i = interest rate (yield-to-maturity) M = value at maturity, or par value  This formula illustrates that, when interest rates go up, the price goes down!

Types of bonds (1) Fixed rate bonds (called straight or plain vanilla bonds ) : a bond paying periodic interest payments at a fixed rate over a fixed period to maturity, with the return of Principal on the maturity date. Example : a 4.6% 20-year bond (long term bond) Bond’s par value (Face value) of USD 100 it issues below par at USD 98.2 (at a discount). It then makes semiannual coupon payments of USD 2.30. On the maturity date, a final coupon is paid along with the par value. 102.3 2.3 2.3 2.3 2.3 2.3 1Y 2Y 3Y 4Y - - - - - 20Y 98.2

Types of bonds (2) Zero coupon bonds : No periodic interest payments (No coupons) It’s sold at a deep discount to face value and matures at its face value. The income comes to bondholder from the difference between the par value that he receives when the bond is redeemed and the bond’s price (at a discount) Ex : investor can buy a bond with a par value of 1000 for a price of 600, so the interest realized is : 1000-600=400. Example : a 20-year Zero Coupon bond Bond’s par value (Face value) of USD 1000 it issues at a discount at USD 600. On the maturity date, a coupon is paid. 1000 1Y 2Y 3Y 4Y - - - - - 20Y 600

Types of bonds (3) High yield bonds (non-investment grade bonds, junk bonds) : rated below investment grade by the credit rating agencies. Relatively risky so investors expect to earn a higher yield. Convertible bonds (converts) : give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. Step-up (Step-down) bonds : The coupon rate increases (decreases) during the life of the bond. Ex : a 5-year bond can have a coupon rate of 6% for the first 2 years and 6.5% for the last 3 years (step-up bond) or 9% for the first 2 years and 8% for the last 3 years (step-down bond). only one change in coupon rate : a single step-up (step-down) bond. more than one change : a multiple step-up bond.

Types of bonds (4) : Floating Rate Notes (Floaters) Coupon fluctuates with a designated reference rate (Benchmark rate, market index). 2 commonly-used reference rates : Libor (London Interbank Offered Rate) In continental Europe : the euro benchmark is called Euribor Coupon rate is calculated as the reference rate plus a fixed spread : Coupon rate = Reference rate + Fixed Spread Ex : 3month USD LIBOR +2.0% (coupon rate = 3month LIBOR + 200 basis points) Coupon Frequency : periodically, normally every 3month : “quaterly” Typically, FRN have maturities of about 5 years.

Floating Rate Notes (Floaters) Quoted Margin (in basis points): Amount added to the reference rate (« fixed spread ») in order to determine the coupon It depends upon the issuer's credit quality It is fixed over the bond’s life Discount Margin (in basis points): This measure assesses the average margin that an investor can expect to receive over the FRN’s life. It can be seen as a FRN’s equivalent of a fixed bond’s yield to maturity. It will change daily, according to market conditions and credit quality of the issuer. Advantages : Coupon linked to a variable interest rate index : has the effect of eliminating most of the interest rate sensitivity of the note Price is always at or near par value. the price action of a FRN is driven mostly by the changes in the credit quality of the issuer

Floating Rate Notes (Floaters) Example : a 3-year FRN Coupon resets and pays every 6month Reference rate : 6month Libor Quoted Margin : 52bp semi-annually 100 FRN issued at par 6M 12M 18M 24M 30M 36M 100 Floating coupons of Libor plus 52bp paid semi-annually

Floating Rate Notes (Floaters) Next coupon rate value ? spot Lag : Libor 6M fixed Next Coupon fixed spot Lag : Libor 6M fixed Current Coupon fixed Today - 2j - 2j Maturity PrevCpnDate 6M NextCpnDate NextCpnDate + 6M Current Coupon paid Next Coupon paid

Duration Indicators Duration is a measure of the average (cash-weighted) term-to-maturity of a bond. The bond’s value will vary depending on : the amount of the cash flows (coupon size) the timing of the cash flows (term to maturity) the interest rate used for discounting. Duration helps to summarize these variables in a single number. Duration (MacCauley’s duration) : The weighted-average term to maturity of the cash flows from a bond. frequently used by portfolio managers who use an immunization strategy. Modified Duration : A useful measure of the sensitivity of a bond's price to interest rate movements. It follows the concept that interest rates and bond prices move in opposite directions. It’s used to determine the effect « a 100 bp (1%) change in interest rates » will have on the price of a bond. Ex : a 15 year bond with a Modified Duration of 7 years would fall approximately 7% in value if the interest rate increased by 1%

Annexe : Main Financial markets They facilitate : The raising of capital in the Capital markets (Long term) Stock markets Bond markets The transfert of risk int the Derivatives markets The international trade in the Currency markets (Foreign exchange or Forex) Primary market : new issues exchanges Secondary market : aldready issued Over-the-counter