Chapter 1 Introduction to Bond Markets

Intro to Fixed Income Markets What is a bond? A bond is simply a loan, but in the form of a security. The issuer of the bond is the borrower and investors (bondholders) are the lenders. Bonds are used to finance a firm’s (usually long-term) investments. Bank loans tend to involve shorter term lending periods.

Bond Market Characteristics Primary market: where new bonds are issued to investors. Secondary market: where previously issued bonds trade. Most secondary market trading occurs in a decentralized (fragmented) OTC market—in part because no two bonds are alike. Size of bond market: Face value of all bonds outstanding worldwide in 2007 was about $65 Trillion. Contrast this with the equities where global capitalization was about $55 Trillion.

Bond Market Sectors Treasury Sector: debt issued by US government: Treasury bills, notes, and bonds. US government is largest issuer of securities in the world. Agency Sector: securities issued by government- sponsored organizations. Municipal Sector: debt issued by state and local governments Also called the “tax-exempt” sector.

Bond Market Sectors Corporate Sector: debt issued by corporations (also called credit sector): Commercial paper, notes, bonds. Subsectors: investment grade and noninvestment grade sectors. Asset-backed Sector – issuer pools loans and receivables as collateral for the issuance of securities. Mortgage-backed Sector – debt backed by pool of mortgage loans: Subsectors: Residential mortgage sector and Commercial mortgage sector.

Summary of Bond Features Bond features are outlined in a contract between the issuer and investors ( called the indenture): Term to maturity Principal amount Coupon rate Amortization features Embedded options.

Feature 1: Term to Maturity Term to maturity: # of years until the bond expires. Usually just called “term” or “maturity.” Bond terms: Short term: 1 to 5 years. Intermediate term: 5 to 12 years. Long term: > 12 years.

Features 2 and 3: Principal & Coupon Rate Principal: The amount the issuer agrees to repay to bondholders at the maturity date. Also commonly called: face value, par value, maturity value. Coupon Rate: the annual interest rate the issuer agrees to pay on the face value (principal). The coupon is the annual amount the issuer promises to pay (in $): coupon = coupon rate  principal The coupon is paid semiannually on most bonds.

Coupon Rate, Aside Some bonds pay no coupons (zero-coupon bonds). Zeros are sold at a substantial discount to face value and redeemed at face value at expiration. All interest is therefore received at expiration. Some bonds have floating coupons The coupon resets periodically, according to some formula

Floating Rate Bonds The coupon for a floater is determined by the following general formula: Floater coupon = floating reference rate + fixed margin (in bps) Examples: Floater coupon = 1-month LIBOR rate + 150bps Floater coupon = 3-month T-bill rate + 80bps

Feature 4: Amortization The principal on a bond can be paid two ways: Paid all at once at expiration (“bullet” maturity). Paid little-by-little over the life of the bond according to a schedule (amortizing). One advantage of a bond that amortizes principal is that the issuer won’t have to fund a big “balloon payment” at expiration.

Feature 5: Embedded Options Options are actions that can be taken by either the issuer or the investor. The most common is a call provision: Grants issuer the right to retire bonds (fully or partially) prior to maturity. Put provision: Enables the bondholder to sell the issue back to issuer at par value prior to expiration.

Feature 5: Embedded Options Convertible bond – gives bondholders the right to exchange the bond for a specified number of shares of common stock. This is advantageous to investors if firm’s stock price goes up. Exchangeable bond – allows bondholders to exchange the bond for a specified number of shares of common stock of another firm. Other options exist.

Risks Associated with Bond Investing Interest-rate risk – the risk that interest rates will rise, thereby reducing a bond’s price (also called market risk). The major risk faced by bond investors. Reinvestment risk – the risk that the interest rate at which intermediate cash flows can be reinvested will fall. Call risk – the risk the issuer may “call” or retire all or part of the issue before the maturity date.

Risks Associated with Bond Investing Credit risk – risk that issuer will fail to satisfy the terms of the bond. 1. Default risk: Risk the issuer does not repay part or all of its financial obligation. 2. Credit spread risk: R isk that an issuer’s obligation will decline due to an increase in the credit spread (the part of the risk premium or yield spread attributable to default risk). 3. Credit deterioration risk: Risk that the credit quality of the issuer decreases (closely related to credit spread risk). Credit rating agencies: Standard & Poor’s, Moody’s, and Fitch.

Risks Associated with Bond Investing Inflation risk – the risk that the purchasing power of a bond’s cash flows may decline. Floating rate bonds have a lower level of inflation risk than coupon bonds. Exchange rate risk – if a bond is denominated in a foreign currency (e.g., the euro), the value of the cash flows in US$ will be uncertain.

Risks Associated with Bond Investing Liquidity risk – the risk that the bond cannot be sold with ease at (or near) its current value. Unimportant for investors holding a bond to maturity. Liquidity can be measured by the bid-ask spread. The wider the spread the less liquid a bond is. Sometimes called marketability risk.

Risks Associated with Bond Investing Volatility risk – the value of embedded options is determined partly by the volatility of interest rates. The price of a bond with embedded options will change as interest rate volatility changes. Risk risk – The bond market has been a hotbed of financial innovation. The risk/return characteristics of innovative securities are not always understood. Risk risk is “not knowing what the risk of a security is.”