Bond Basics: What are Bonds?

• A bond represents a loan or debt obligation of an issuer (the borrower)

• Borrower (issuer)
  • Responsible for interest payments and repayment of the principal at maturity
  • Generally fixed over a life of the bond
• Investor (lenders / creditor not owner)
  • Creditors are senior securities to stockholders
  • If corporation is being liquidated, creditors get paid before stockholders (preferred & common)

For investors, what’s the attraction to bonds?

• Greater safety than stocks (bonds are a form of senior security)
• Typically, consistent income in the form of interest and a known maturity 

Terminology:

• 10% – Coupon
  • Interest rate; the fixed percentage of par
  • It is set when the bond is issued
  • Stated annually, but paid semi-annually
• $1,000 Par
  • The par value (face value, or principal of the bond)
  • This is the amount that the issuer agrees to pay its investors when the bond matures (regardless if you pay $980 or $1020 for the bond)
• 10% Debenture
  • Unsecured corporate debt
    • Not pledging any specific asset that’s backing the bond; it’s backed by the corporations full faith & credit
• Due 1/15/20XX
  • The maturity of due date of the bond
  • This is the date on which principal is returned and the last interest payment is made

Coupon rate of Nominal yield:

• The rate of interest is generally fixed at the time the bond is issued and, with some exceptions, remains the same for the life of the bond. Exceptions include bonds that are issued with variable (or floating) rates or as zero-coupons

Term and Serial Maturities:

• Two of the ways that an issuer may structure its loan repayment or maturity are term and serial
• For both types, bonds are issued on the same date and interest is paid each year
• Term maturity: the entire bond offering matures on the same date
• Serial maturity: the bond offering matures over several years (i.e., has a series of maturity dates [1 yr, 2yr])
  • Level debt service: some serial maturities are structured so that principal and interest payments represent approximately equal annual payments over the life of the offering

Terminology:

• Bond
  • Represents a loan or debt obligation of an issuer (the borrower)
• Issuer
  • Responsible for interest payments and repayment of the principal at maturity (also referred to as debt service)
• Debt service
  • Interest payments and repayment of principal
• Face value
  • Amount the issuer agrees to pay the investor when the bond matures
• Coupon rate
  • The rate of interest,which generally states constant throughout the life of the bond
• Term bond issue
  • Entire bond offering matures on the same date
• Serial bond issue
  • Offering matures over several years (the issue has several maturity darts)
• Level debt service
  • Principal and interest payments represents approximately equal annual payments over the life of the offering)

Zero-Coupon Bond:

• Issued: at deep discount
• Maturity: matures at face value (par)
• Interest: considered the difference between the purchase price and par value
• Carrying value: the investor’s carrying value (cost basis) must be accreted yearly
• How it trades: trades flat (without accrued interest)
  • Accrued interest is what a buyer pays the seller when they purchase the bond (price of the bond + accrued interest) 
  • If I buy a bond from X. Last time bond paid interest was 2 months ago. So it’ll pay interest 4 months from now. I will receive a whole 6 month interest payment even though I’ve only held 4 months. When I buy a bond from someone else, I’ll pay the price of the bond + 2 months of accrued interest. 
• Reinvestment risk: not subject to reinvestment risk 
• Suitability: suitable for an investor who is planning for a specific future investment goal

Why Bond Prices Fluctuate from Par:

• The par value of a bond can differ greatly from the price that investors pay to purchase the bond
• Although most bonds are initially sold at par value, as times goes by, these same bonds will trade in the market at prices that are either more than or less than their par value
• A bond that is selling for less than its par value is a discount
• A bond that is selling for more than its par value is a premium
• Interest-rate risk affects bond price
  • New bonds are coming out with higher/lower rates, so previous bonds become less/more attractive
• Credit Risk

Interest-rate Risk:

• Inverse relationship
• Interest-rate risk means that as market interest rates change, a bond’s price will change in the opposite direction

Example:

• If bond was issued at par value $1,000 with a 7% coupon
• Now… interest rates went up to 9%, so now new bonds with this risk and maturity are being issued with 9% coupons at par to give investors a return of 9%. That previous 7% coupon is fixed. To make it attractive with today’s rates at 9%, the price of the 7% coupon bond will trade at a discount 
• If rates drop to 5%, that 7% coupon looks very attractive. Investors will pay a premium to get that higher 7% coupon. 

Scenario:

• A bond quoted at 94 ½ is trading at 94.5% of its $1,000 par value. Which is true?
  • Purchase price of this bond is $945
  • This bond is trading at a discount
  • This bond is trading at a premium
  • Interest rates have risen since the bond was issued

Credit Risk:

• Credit risk is a recognition that an issuer may default and may not be able to meet its obligations to pay interest and principal to the bondholders
• Issuers that are considered high credit risks must pay a higher rate of interest in order to induce investors to purchase their bonds
• Securities issued by the US government have the lowest possible credit risk
• Credit risk is more difficult to evaluate when the bonds are issued by a corporation or a municipality 
• Bonds with higher ratings have lower yields and higher prices
• Bonds with lower credit ratings have higher yield and lower prices

Credit Rating Companies:

• How can investors be sure they will get their interest payments and their principal back?
  • A bond’s credit rating helps determine this
  • S&P
  • Moody’s
  • Fitch

• BBB & above is Investment Grade
• Speculative Grade is BB and below (junk bonds or high yield)

Who do  you think pays for the rating? As it relates to bond ratings, what’s the concern?

• The issuer pays for the rating
• As it relates to bond ratings, rating agency concern is the risk of default

Coupon Rates and Bond Pricing:

• A bond with a price of:
  • 100 is selling at 100% of its par value, or $1,000
  • 90 is selling at a discount equal to 90% of its par value, or $900
  • 110 is selling at a premium which is equivalent to 110% of its par value, or $1110
• For corporate and municipal bonds, a bond’s price may also be expressed in terms of points
  • Each point is equal to 1% of the bond’s par value, or $10
  • Corporate and municipal bonds trade in increments of ⅛ of a point, or $1.25
  • For pricing purposes, convert fractions to decimal
  • Example: ⅛ becomes .125 and ⅝ becomes .625
    • Therefore, a bond quoted at 93 ⅝ can be converted to 93.625% of par, or $936.25

What is the dollar value of each bond?

• 5 ¼ → 5.25 → $52.50
• 92 ½ → 92.50 → $925
• 6 ⅝ → 6.625 → $66.25
• 109 ⅜ → 109.375 → $1093.75

Pricing of Government Securities:

• Government bonds such as T-Notes, T-bonds and agency Securities trade in increments of 1/32 of a point

• T-bills are quoted on a discount yield basis, not dollar
• In a T-bill dealer’s quotation, the bid’s higher yield represents a lower price, while the ask’s lower yield is a higher price 

Bond Yields:

• Yield is the return you get on a bond
• Nominal Yield
  • Same as coupon rate
  • Fixed
• Current Yield
  • Annual interest divided by the current market price 
• Yield to Maturity (YTM) – overall rate of return (interest + principal)
  • Same as basis and yield
  • Includes the reinvestment of annual interest and the gain or loss over the life of the bond
  • Measured to the bond’s maturity 

• Basis point
  • 1.00% = 100 basis points
  • .01% = 1 basis point

Example: ABC Company

• At par value, Nominal Yield, Current Yield, and YTM are equivalent
• If bond is trading at a discount because rates increase, then YTM will be greatest, then CY, then NY
• If bond is trading at a premium because rates decrease, then YTM will be the smallest, then CY, then NY

Retiring Debt Prior to Maturity:

• When a bond reaches its maturity date, the bondholder will redeem it to the issuer and receive the bond’s par value plus the last interest payment
• The issuer’s obligation to the bondholder has ended and the debt is considered retired
• Some bonds are deemed before they mature
  • Call Provision (Callable) 
    • Allows the issuer to redeem bonds prior to maturity, either in whole or partial (lottery call)
    • If called, the investor receives the full return of principal plus any accrued interest
    • Usually used when interest rates are falling
    • Why purchase?
      • Higher yield, call protection (period of time when bonds can’t be called), call premium
  • Put Provision (Puttable)
    • Gives the bondholder the right to redeem (or put back) the bond on a date prior to maturity (opposite of a call provision)
    • It is redeemed when interest rates are rising
    • Allows bondholders to redeem their bonds at values greater than market value as interest rates rise
    • Normally have a lower yield, though

Convertible Debentures and Conversion Parity:

• A convertible bond gives an investor the ability to convert the par value of his bond into a predetermined number of shares of the company’s common stock
• Convertible bonds provide investors with safety of principal and potential stock growth
• They allow the issuer to pay a low coupon rate
• The conversion price is set at a premium at issuance and the bond’s price is influenced by the underlying stock’s price
• The price at which the bond can be converted is referred to as the conversion price and is set at the time that the bond is issued
• Conversion Ratio = Par Value of Bond / Conversion Price 
  • Conversion Ratio: Number of shares that investor will receive at conversion
  • Conversion Price: The price at which the bond can be converted, set at issue

Example: XYZ Corporation

• 6% Debenture
• Market Price $1,100 and Convertible at $20
• Conversion Ratio = $1,000 / $20 = 50 shares of stock
• What bond is trading at does not matter, nor debenture

Conversion parity means equivalent market value 

Price of Convertible Bond = Aggregate Market Value of the Common Stock

Question:

• A bond is purchased at $1,100 and convertible at $40. The market price of the common stock is now $45 per share. What is the parity price of the bond
  • Conversion ratio:
    • $1,000 / $40 = 25 shares
  • Find the value of those shares:
    • 25 shares * $45 = $1,125
  • If converted, what is the stock’s basis
    • $1,100 / 25 shares = $44/share
  • When does an arbitrage opportunity exist? (ability to have a locked-in profit)
    • If the bond is available at a discount to parity
    • Which is how much?
      • Less than $1,125