Bond basics

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A bond is a debt investment. Investors loan money to corporations or governments for a set term and interest rate. The initial face value of most bonds is $1000. After issuance bonds trade on the over-the-counter market where their principal value fluctuates according to changes in interest rates and any changes in the bond's credit quality. Newly issued corporate bonds are syndicated by consortiums of investment banks who initially buy an offering for resale to investors. Government bonds are offered by auction, where investors tender bids for the issue. Bonds have certain features which include:

  • Coupon rate: the interest rate paid by the bond. The rate may be fixed, floating, or inflation indexed, depending on the specific issue. The coupon date spells out the frequency of interest payments, usually biannually for US bonds.
  • Maturity date: the date at which the bond principal will be repaid. Bonds are usually issued with maturities ranging from 1 year to thirty years.
  • Options: the most common option involving bonds is the existence of a call feature. This feature gives the issuer the right to repay the bond before the maturity date. Since an issuer will call bonds when the interest rate is lower than the coupon rate, this feature is not advantageous to the buyer of the bond, who is then faced with reinvesting the proceeds of the redeemed bond in a lower interest rate environment. Thus it is usual for a callable bond to offer a higher coupon than an uncallable bond as compensation for the risk of early redemption. Alternately, some bonds are issued with a put feature which gives the bond holder the right to force the issuer to repay the bond before the maturity date, usually on prescribed put dates
  • Sinking Funds provide a means of repaying a bond issue. The issuer makes periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market. Sinking funds tend to reduce the risk of default, and thus allow the issuer of a bond to pay a lower interest rate on the bond.
  • Senior vs. Subordinated Debt Senior Debt is given priority over other debt in case of default; Subordinated Debt is unsecured and, in a default, is repayable after other debts have been paid.

Assuming one holds a bond to maturity, a bond's actual return consists of three cash flows:

  • The coupon interest;
  • The reinvestment rate at which the coupon interest is compounded;
  • The return of principal at maturity.

Types of Bonds

There are three main issuers of U.S. bonds.

Treasury Bonds are issued by the US treasury in groups of three maturity ranges

  • Bills have a range up to one year;
  • Notes have a range berween one year and ten years;
  • Bonds have a range greater than ten years.

Treasury bonds are usually not callable. Treasuries also carry the full faith and credit backing of the US government. The interest income is exempt from state tax. Treasuries can be purchased through brokerages and banks as well as through an individual account at Treasury Direct . Government agencies also issue debt, some of which is backed by the full faith and credit of the government and some which is not.

Corporate Bonds are issued by corporations and are often callable. Since a corporation can default on it's debts, corporate bonds are subject to credit risk and usually pay higher coupon interest rates over comparable term treasury maturities as compensation for this risk. Corporate bonds are subject to federal and state income tax. (Refer to Corporate Bond Defaults and Recovery Rates 1920-2006 for data on defaults)

Municipal Bonds are issued by states and localities. These bonds are subject to credit risk. The bonds are generally exempt from federal tax, although some private revenue municipal bonds are subject to the federal alternative minimum tax. A tax exempt bond is also usually state tax exempt for residents of the state issuing the bond. Due to these tax preferences, municipal bonds generally offer lower coupon interest rates than do comparable term treasuries and corporates. (Refer to Moody's US Municipal Bond Rating Scale 1970-2000 for detault and recovery data on municipal bonds.)

Other types of bonds::

Zero coupon bonds are accrual bonds and do not pay current coupon interest. They are issued at a deep discount from par value and compound continuously at the coupon rate. The bond holder receives the full principal amount as well as the value that has accrued from interest on the redemption date. Zero coupon bonds may be created from fixed rate bonds by financial institutions by "stripping off" the coupons. In other words, the coupons are separated from the final principal payment of the bond and traded independently. Individuals are taxed on the annual accrual of income, although the investor receives no current interest payment.

Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), which include GNMA securities backed by the full faith and credit of the US treasury, collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).whose underlying securities are often such assets as auto loans or credit card receivables.

High Yield bonds are corporate bonds with lower credit quality than top credits. These companies are at much greater risk of default than higher quality credits and, as a result, pay higher coupon interest rates than comparable high quality corporate bonds.

Factors Affecting Bond Prices

New Issues

The coupon of a newly issued bond is primarily set by two major factors: the credit quality of the bond and the maturity of the bond. It is axiomatic in the investment markets that if investors are to invest in risky securities higher risk must be compensated by higher expected retum. Thus the US Treasury pays a lower coupon on its debt than do corporate borrowers subject to default risk, Non treasury debt is graded for credit quality by three rating agencies. The following table describes the ratings.

insert table

The longer the maturity of a bond the greater the risk to the bondholder. Longer time horizons increase the likelihood that a bond issuer will become a greater credit risk through bad management decisions, the deterioration of economic conditions, or the company engaging in future merger and acquisition activity which changes the leverage of a company's balance sheet. Longer horizons also increase the likelihood that a bond's coupon income will be eroded by higher than expected inflation. Finance economics defines a bond's expected return to be comprised of three basic building blocks: first, the risk-free rate as defined by the current yield of a treasury bill; a time horizon premium to compensate investors for the risks of longer maturities; and a default risk premium to compensate investors for bearing credit risk. These building blocks can be visualized in the following table:

insert table

Bonds on the Secondary Market

Once a bond has been issued, it trades on the secondary market, and fluctuates in price until it matures. A bond will change in price for two main reasons:

1. The bond's credit rating has changed (either upgraded or downgraded).

2. Interest rates have changed.

Unless a bond is falling into or out of default, price movements associated with changes in credit rating tend to be infrequent, although during periods of economic distress and economic recovery credit rating changes can be significant price factors. The ever present driver of changes in a bond's market value comes from fluctuations in current market interest rates. We can understand this law of bond pricing by considering the following scenario. Let us assume that we purchase at issue a $1000 ten year bond yielding a 5% coupon. This entitles us to $50 of annual income. Assume that one year later, interest rates have risen to 6% and we wish to liquidate the bond. No rational investor will pay $1000 dollars for $50 of income, when he can receive $60 per annum for the same $1000 dollar investment. In this interest rate scenatio, our 5% bond will have to decrease in market value until its current yield approximately produces a 6% return. A simular, yet opposite price movement occurs if interest rates fall. Suppose, in our scenario above, interest rates fall to 4 percent during the year after our purchase. Our $1000 bond produces $50 of annual income in an environment where investors can only receive $40 of annual income from a newly issued bond. Our bond will therefore rise in price until it provides a purchaser with a 4% return. Thus we come to the basic rule of bond price movements in the open market.

insert table when interest rates rise bond prices fall When interest rates fall bond prices rise

A corollary principle to this price movement is the fact that, all things being equal, fluctuations in price are greater for long maturities than it is on shorter maturities. At any given time in the secondary market one is likely to find any number of bonds selling at a discount over par value, or at a premium to par value.