Chapter 1 INTRODUCTION TO BONDS 1

Bonds: Definition and Markets A Bond is a debt instrument requiring the issuer (borrower) to repay to the bondholders (lenders/ investors) the principal borrowed amount plus interest over a specified period of time. Bondholders have an IOU (or promissory note) from the issuer. The IOU is evidence of a contractual lending relationship between the bondholder and issuer. 2

U.S. Fixed Income Markets / Sectors (Defined by issuer type) Treasury : issued by the U.S. Government. Agency : includes securities issued by federally related institutions and government-sponsored enterprises. Municipal: issued by state and local governments. General Obligation and Revenue Bonds (tax exempt securities). Corporate: issued by U.S. and non U.S. corporations in the United States. 3

U.S. Fixed Income Markets/Sectors (Defined by issuer type) Emerging Market: issued by governments and corporations of developing and less-developed countries (China, India, Brazil, Argentina, Russia etc). Asset Backed Securities: bonds issued against a collateral pool of assets, e.g., credit cards, auto loans, student loans etc. 7. Mortgage Backed Securities: issued against a collateral pool of residential / commercial mortgages. 4

Bond Indenture Is a contractual agreement between the issuer and the bondholder covering: Bond Features (coupon rate, principal, maturity date). Size of the issue. Any property or asset pledged. Financial Covenants (e.g., restrictions on minimum working capital or debt ratios). Redemption Rights or Call privileges. 5

Features of a Bond: Par or Face Value (FV): Principal amount repaid on maturity of the bond. For most corporate (treasury) bonds the face value is $1000 ($10,000). Bond prices are quoted as a percent of face value, in fractions of 1/32 e.g. Par Quote =Price as %(Par) Price ($) $1000 91 24/32 = 91.7500 $ 917.50 $ 5000 102:11 =102.3438 5,117.19 6

Coupon Payments Periodic payments made to bondholders during the life of the bond. Coupon rate is stated on “nominal” annual basis. Usually fixed, but may be floating or variable (i.e. reset periodically to a pre-determined benchmark, e.g. 6Months London Inter Bank Offered Rate (LIBOR)). Typically, coupon is paid twice a year (coupon payment frequency, m=2). Annual coupon payment is the product of the coupon rate and face value. 7

Coupon Payments(Contd….) Zero-Coupon Bond – interest is paid at the maturity with the exact amount being the difference between the principal value and the price paid for the bond Floating-rate bonds – issues where the coupon rate resets periodically (the coupon reset date) based on the coupon reset formula given by: reference rate + quoted margin

Example: Calculating Periodic Coupon Payments 10%, 30 year Treasury Bond, m=2. Coupon Rate (C) = 10% Annual Coupon Payment = 10% * 10,000 (FV =10,000) = $1000 Periodic Coupon Payment (CPN) = $500. 9

Maturity Maturity crucial for two reasons. Fixed date on which the bond ceases to exist, and the issuer redeems (retires) the bond’s face value to the bondholders. Maturity crucial for two reasons. Calculating remaining number of periods for coupon payments and principal. Determining price volatility of bonds; prices of longer maturity bonds are more sensitive to interest rate changes than shorter maturity bonds. 10

Maturity ( Contd…) Short Term Bonds : 1 to 5 yrs. Medium Term Bonds: 5 to 10 yrs (also called Notes). Long Term Bonds: maturity > 10 yrs. 11

Amortization Amortization Feature – the principal repayment of a bond issue can call for either a. the total principal to be repaid at maturity (or) b. the principal repaid over the life of the bond In the latter case, there is a schedule of principal repayments called an amortization schedule. For amortizing securities, a measure called the weighted average life or simply average life of a security is computed.

Embedded Options Embedded Options – it is common for a bond issue to include a provision in the indenture that gives either the bondholder and/or the issuer an option Call provision - grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date Put provision - gives the bondholder the right to sell the issue back to the issuer at par value on designated dates Convertible bond - provides the bondholder the right to exchange the bond for shares of common stock Exchangeable bond - allows the bondholder to exchange the issue for a specified number of common stock shares of a corporation different from the issuer of the bond

Description Describing a Bond Issue –most securities are identified by a nine character CUSIP number CUSIP stands for Committee on Uniform Security Identification Procedures First six characters of CUSIP identify the issuer The next two characters identify whether the issue is debt or equity and the issuer of the issue The last character is a check character that allows for accuracy checking The CUSIP International Numbering System (CINS) identifies foreign securities and includes 12 characters

Some Dates to remember Trade or Transaction Date: The date on which trade is initiated and ownership changes hands. Settlement Date: The date on which trade is cleared by delivery of securities against funds. Number of settlement days varies from market to market, e.g., settlement period for US Treasuries is one working day after trade date, while that for Japanese Government bonds is three working days. The new owner begins to earn interest from settlement day onwards. 15

Some Dates to remember Coupon or Interest Payment Dates (IPD): Scheduled dates on which the issuer pays the periodic coupon payments to the bondholders. Maturity Date: Scheduled date on which the issuer pays (redeems) the face value of the bond to the bondholders. 16

Risks Associated with Investing in Bonds Interest-rate Risk Reinvestment Risk Call Risk Credit Risk Inflation Risk Exchange Rate Risk Liquidity Risk Volatility Risk Risk Risk

Risks Associated with Investing in Bonds (continued) 1. Interest-Rate Risk Interest-rate risk or market risk refers to an investor having to sell a bond prior to the maturity date. An increase in interest rates will mean the realization of a capital loss because the bond sells below the purchase price. Interest-rate risk is by far the major risk faced by an investor in the bond market.

Risks Associated with Investing in Bonds (continued) 2. Reinvestment Risk Reinvestment risk is the risk that the interest rate at which interim cash flows can be reinvested will fall. Reinvestment risk is greater for longer holding periods, as well as for bonds with large, early, cash flows, such as high-coupon bonds. It should be noted that interest-rate risk and reinvestment risk have offsetting effects.

Risks Associated with Investing in Bonds (continued) 3. Call Risk Call risk is the risk that a callable bond will be called when interest rates fall. Many bonds include a provision that allows the issuer to retire or “call” all or part of the issue before the maturity date; for investors, there are three disadvantages to call provisions: cash flow pattern cannot be known with certainty investor is exposed to reinvestment risk bond’s capital appreciation potential will be reduced

Risks Associated with Investing in Bonds (continued) 4. Credit Risk Credit risk is the default risk that the bond issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and principal. Credit spread is the part of the risk premium or spread attributable to default risk. Credit spread risk is the risk that a bond price will decline due to an increase in the credit spread.

Risks Associated with Investing in Bonds (continued) 5. Inflation Risk Inflation risk arises because of the variation in the value of cash flows from a security due to rises in purchasing power. For all but floating-rate bonds, an investor is exposed to inflation risk because the interest rate the issuer promises to make is fixed for the life of the issue.

Risks Associated with Investing in Bonds (continued) 6. Exchange-Rate Risk Exchange-rate risk refers to the unexpected change in one currency compared to another currency. From the perspective of a U.S. investor, a non-dollar-denominated bond (i.e., a bond whose payments occur in a foreign currency) has unknown U.S. dollar cash flows. The dollar cash flows are dependent on the exchange rate at the time the payments are received. The risk of the exchange rate causing smaller cash flows is the exchange rate risk or currency risk.

Risks Associated with Investing in Bonds (continued) 7. Liquidity Risk Liquidity risk or marketability risk depends on the ease with which an issue can be sold at or near its value. The primary measure of liquidity is the size of the spread between the bid price and the ask price quoted by a dealer. The wider the dealer spread, the more the liquidity risk.

Risks Associated with Investing in Bonds (continued) 8. Volatility Risk Volatility risk is the risk that a change in volatility will adversely affect the price of a bond. The value of an option rises when expected interest-rate volatility increases. For example, consider the case of a callable bond where the borrower has an embedded option, the price of the bond falls when interest rates fall due to increased downward volatility in interest rates.

Risks Associated with Investing in Bonds (continued) 9. Risk Risk Risk risk refers to not knowing the risk of a security. Two ways to mitigate or eliminate risk risk are: Keep up with the literature on the state-of-the-art methodologies for analyzing securities avoid securities that are not clearly understood

Secondary Market for Bonds The secondary market is the market where securities that have been issued previously are traded. Secondary trading of common stock occurs at several trading locations in the United States: centralized exchanges and the over-the-counter (OTC) market.

Secondary Market for Bonds (continued) The secondary markets in bonds throughout the world are quite different from those in stocks. The secondary markets in bonds are not centralized exchanges but are OTC markets, which are a network of noncentralized market makers.