What you should know about Bonds?
Bonds are fixed-income security, with a maturity period of greater than one year. As a dealing representative, your clients will expect you to understand the structure of bonds, and how they can help investors meet their financial goals.
Bonds are fixed-income securities with a maturity of greater than one year. Newly issued bonds typically sell at their par value. Bond issuers promise to pay regular coupon payments to the investor, also referred to as the bondholder. Bonds have a finite life which means they mature on a pre-determined date.
The investment objectives of bonds are regular income and stability of principal.
The risk and return of bonds vary based on a number of factors, including the credit worthiness of the issuer, among other considerations. Bonds issued by corporations with good credit ratings typically involve lower risk. On the other hand, corporations with poor credit ratings involve higher risk and as such, pay higher coupon rates to attract investors and to compensate them for the higher risk.
This is the borrower. The issuer is either a government body or corporation. The issuer is responsible for all the coupon payments and repayment of the principal.
Also known as face value, face amount, or principal, this is the amount that was originally lent to the issuer and is to be repaid at maturity. Par value is usually denominated in multiples of $1,000.
The coupon rate is the rate of interest that will be paid to the bondholder. It is a nominal annual interest rate and is expressed as a percentage of the par value. The coupon payment is the interest payment calculated using the coupon rate and the par value. Although the coupon rate is expressed as an annual percentage, most bonds pay interest semi-annually.
This is the date the bond will expire, at which point the last coupon payment is made and the principal is repaid to the bondholder. When bonds are issued, the maturity date is usually the same day (e.g. May 9) but in a future year. Coupon payments are paid on the anniversary of this day and the semi-annual anniversary day (e.g. May 9 and November 9).
The Bond Market
When governments or corporations want to raise money through a new bond issue, they hire an investment dealer to help them
with the process. This first step where the money raised from investors goes directly to the issuer is known as the primary
Bond prices are quoted in relation to $100. When a bond price is $100, it is referred to as par. Typically primary distributions of bonds are priced at par.
Subsequent to the primary distribution, investors can sell their bonds to other investors in the bond market. Unlike the stock market, which has a central place to trade stocks such as the Toronto Stock Exchange (TSX), the bond market does not have a central trading place. Instead, the majority of bonds trade in the over-the-counter market, a computerized network where investment dealers transact directly with each other. A small number of bonds do trade on an exchange.
In the bond market, the price of a bond can change from par due to a number of factors such as interest rate changes. Bonds that are priced above par are said to be trading at a premium, while bonds that are priced below par are said to be trading at a discount.
Globally, the bond market is significantly larger than the stock market, since this type of security is very important in maintaining well-functioning governments and corporations.
Types of Bonds
There are two classes of bonds: coupon bonds, which provide regular payments to investors, and zero-coupon bonds, also called strip bonds, which make a lump sum payment to investors upon maturity.
Historically, bondholders were given a bond certificate showing they loaned money to the issuer. Attached to each certificate were a number of coupons that entitled the bondholder to receive regular coupon payments. When it was time to receive a coupon payment, the bondholder would cut out the coupon from the bond certificate and redeem it at the bank.
With coupon bonds, there is a built-in contract that states the issuer’s legal obligation to provide coupon payments, usually semi-annually or annually, and return of principal. If the issuer defaults on the coupon payments or principal, the bondholder can force the issuer into bankruptcy to sell their assets and use the proceeds to repay the bondholders.
While bondholders no longer receive physical certificates, coupon bonds are still obligated to make regular coupon payments. At maturity, the issuer must make one final coupon payment and return the bondholder’s principal. The coupon payments for coupon bonds are calculated as follows:
Investment Profile of Coupon Bonds
The investment objective of coupon bonds is the stability of income, with a higher level of return than money market securities. The expected return for coupon bonds is both incomes, and the potential for an additional return in the form of capital gains due to changes in interest rates, if the coupon bonds are traded on the secondary market. The risk level of coupon bonds ranges from low to medium. Regular coupon payments, and the promise to repay the principal, give these bonds a stable quality. However, their price sensitivity to interest rate changes increases the risk level.
Debentures operate the same way as bonds but they differ in how they are secured. Bonds are secured by specific assets of the issuer such as property, inventories, equipment, or other securities. Debentures are not secured by real assets or collateral. Instead, they are backed by the reputation and credit worthiness of the issuer.
Investment Profile of Debentures
Debentures offer a higher level of income than regular secured bonds. Debentures are considered a medium risk because they are not secured by any real assets, and they have a lower priority than bondholders for the company’s assets in the event that the company goes bankrupt.
Convertible bonds are a type of coupon bond that offers investors the option to convert the bonds into common shares, which confer an ownership interest in the company issuing the bonds. This option is at a pre-set price, within a specified time frame. In exchange for the conversion option, the bond issuer usually offers a lower coupon rate than that offered with other bond types.
Cheryl is considering investing in common shares of BIZ Corporation, but she is uncertain about how well the company will perform in the future. She buys a BIZ convertible bond, which offers her the option to convert her bond into common shares at $40 per share at a specific date in the future.
If BIZ common shares rise in value to $45 per share, Cheryl can make the conversion within the allowable time and convert her bond into common shares at the lower price of $40. However, if the common share price falls to $30, she does not have to convert her bond. She can continue to hold the bond and collect the coupon payments until the bond matures.
Investment Profile of Convertible Bonds
Convertible bonds appeal to investors who want the stability offered by bonds and the option to own common shares. Compared to regular bonds, convertible bonds are at higher risk because they have lower priority for the issuer’s assets in the event of bankruptcy.
Bonds with Additional Features
Coupon bonds can also have additional features that may be triggered either at the issuer’s option or the bondholder’s option.
Callable or Redeemable Bonds
With a callable bond, the issuer (borrower) reserves the right to buy back, or call, the bond from the bondholder within a specified time period and at a specified price, usually at a premium to face value. This makes sense if interest rates drop and the borrower can issue bonds at a lower interest rate. Investors demand a higher rate of interest on callable bonds because they may have to sell the bond back at a disadvantageous time.
If a bond has an extendible feature it allows the investor to extend the term of the bond within specified limits. This is an attractive feature if the bond is close to maturity, and is paying higher interest than current rates. Investors accept a lower rate of interest to obtain this feature.
These bonds allow the bondholder to redeem a bond at par before the maturity date. A bondholder may choose to redeem early if the coupon rate is lower than current interest rates, and invest the proceeds elsewhere.
Zero-coupon bonds, also called strip bonds do not provide coupon payments. These bonds are sold at a discount and redeemed at maturity for their face value. The interest income constitutes the difference between the face value of the zero-coupon bond and the purchase price.
|Zero-coupon bonds are created when an investment dealer takes a regular coupon bond and strips its coupon payments. In doing so, the investment dealer creates separate bonds for each coupon payment and the principal.|
Zero-Coupon Bonds Characteristics
With zero-coupon bonds, the face value at maturity is pre-determined so investors know exactly how much interest income they will receive.
Zero-coupon bonds are typically held in registered accounts such as Registered Retirement Savings Plans (RRSPs). Interest income generated by securities is taxed annually. Although strip bonds do not pay interest annually, the interest accrues or builds up, each year. Subsequently, investors are required to pay taxes on the accrued annual interest income even though they do not receive any interest income until the bond matures.
By putting strip bonds in a registered account where interest income is sheltered, investors are not required to calculate the annual accrued interest income or pay taxes on this amount. If a strip bond is held in a non-registered account, investors are required to pay taxes each year on the accrued interest income, which is interest that accumulates but has not been paid.
Investment Profile of Zero-Coupon Bonds
The investment objectives of zero-coupon bonds are income and stability of principal (if held to maturity). Income is derived from interest, as well as the potential for capital gains if the zero-coupon bonds are sold before maturity in the secondary market.
Zero-coupon bonds have a higher risk than coupon bonds because no payments are received until the bonds mature. Generally, payments received sooner are considered to be safer than payments received at a later time because there is greater uncertainty in the future. For example, the issuer can go bankrupt or interest rates may rise.
Mortgage bonds are fixed-income securities that invest in a pool of mortgages. These bonds offer bondholders regular interest income and the safety of principal.
Canada Mortgage Bonds (CMBs) are invested in a pool of mortgage-backed securities, which are a collection of mortgages that are packaged into a security and sold to investors. CMB holders are paid the interest and principal from the mortgage-backed securities.
CMBs are guaranteed by the Canada Mortgage and Housing Corporation (CMHC), a government-owned home insurance provider. They are also backed by the Government of Canada.
Investment Profile of Mortgage Bonds
The investment objectives of mortgage bonds are stable income, and safety of principal (if held to maturity). Income is derived from interest, as well as the potential for capital gains if the mortgage bonds are sold before maturity in the secondary market.
Mortgage bonds are considered to be low risk because they are backed by real assets (buildings and houses) that can be sold to repay the bondholders. In the case of CMBs, they are backed by CMHC and the government of Canada.
Bond Prices and Interest Rates
There is an inverse relationship between bond prices and interest rates. What that means is, that when prevailing interest rates rise, the price of existing bonds generally falls. Conversely, when prevailing interest rates fall, bond prices generally rise.
The relationship between interest rates and bond prices is important for bonds that trade on the secondary market. That is, the bonds have not matured and the bondholder wants to sell them. Since the terms of an existing bond, such as the coupon rate and maturity date are fixed, the only component that can be adjusted is the price. Therefore, bondholders will be subject to the current market conditions, in this case, interest rates, when they sell their bonds.
Bond Return Calculations − Current Yield
As a dealing representative, it is very important that you understand how the return on investment for bonds is calculated. Two common calculations to determine the return or yield of a bond are current yield and yield-to-maturity.
The current yield formula calculates the potential return on investment for bondholders, based on the current market price of the bond and the stated coupon payment. The current yield formula is:
|Current Yield = (Coupon Payment / Market Price) x 100|
|Luther purchases a bond with a par value of $1,000 and a coupon rate of 6%. He pays $980 for the bond, which is the market price. The coupon payment is $60, calculated as (6% x $1,000). The current yield of Luther’s bond is 6.12%, calculated as (($60 ÷ $980) x 100).|
Bond Return Calculations − Yield-to-Maturity
A limitation of the current yield formula is that it provides only the annual yield, and does not calculate the overall return from the reinvestment of interest, called compounding. It also does not take into account any capital gains or capital losses resulting from a discount or premium on the bond price.
Since the current yield is based on the current market price of bonds, the yield may change from year to year, when the market price of a bond changes.
The yield-to-maturity (YTM) is the annual return an investor earns if the bond is held to maturity. This return is considered a more accurate measure of a bond’s return than the current yield because it factors in the coupon and principal payments, the timing of the payments, the bond’s price, and the time to maturity. Unlike the current yield, it assumes all coupons are reinvested at the same rate.
The YTM calculation is complex. Bond tables, calculators, and computer programs have been developed to determine the YTM of a bond. For this course, you are not required to calculate the YTM.
Bond Prices, Interest Rates, and Yields
The reason it is important to understand the inverse relationship between bond prices and interest rates is these factors affect bond yield, or return.
Before delving more deeply into how bond prices and interest rates affect yield, it is essential to understand two characteristics of a rational bond investor. All things being equal:
- Bond investors prefer higher coupon payments.
- Bond investors tend to invest in bonds primarily for the steady coupon payments. Therefore, bond investors will be attracted to bonds that pay higher coupon payments.
- Bond investors prefer lower purchase prices.
- Like any rational investors, bondholders do not want to pay high prices for a bond.
When Bond Prices Fall, the Yield Rises
Remember the bond’s coupon rate and coupon payments are fixed. When interest rates increase, prices of existing bonds decrease. As a result, investors shopping for bonds can buy the bond at a lower price and receive the same coupon payments as those who purchased the bonds at par.
An investor who paid less than par is said to have purchase his or her bond at a discount. Bonds that are purchased at a discount have a higher yield than the coupon rate.
The relationship between bond prices, interest rates and yield looks like this:
James bought a bond at a par value of $1,000 with a coupon rate of 10%, which means that James gets a coupon payment of $100 each year, calculated as ($1,000 x 10%).
A year later, interest rates rise and the market value of James’s bond falls to $800. James sells his bond to Margaret for $800. At a price of $800, Margaret is able to get the same $100 yearly coupon payment at a lower market price, a discount price. Margaret’s yield is 12.5%, which is higher than the return James got on the bond.
James’s current yield is 10%, calculated as (($100 ÷ $1,000) x 100).
Margaret’s current yield is 12.5%, calculated as (($100 ÷ $800) x 100).
Interest rates have increased and the bond price has decreased, therefore the bond yield has increased.
When Bond Prices Rise, the Yield Falls
Now let’s see what happens to the bond’s yield when bond prices go up.
When interest rates decrease, they cause the price of existing bonds to increase. As a result, investors shopping for bonds will pay more for existing bonds because they pay a higher coupon payment than newly issued bonds. This will raise the market price of existing bonds.
An investor who paid more than par value for a bond is said to have purchased his or her bond at a premium. Bonds that are purchased at a premium have a lower yield than the coupon rate.
The relationship between bond prices, interest rates and yield looks like this:
James bought a bond at a par value of $1,000 with a coupon rate of 10%, which means that James gets a coupon payment of $100 each year, calculated at ($1,000 x 10%).
A year later, interest rates fall and the market value of James’s bond rises to $1,200. James sells his bond to Margaret for $1,200. At a price of $1,200, Margaret gets the same $100 yearly coupon payment, but at a higher market price. Margaret’s yield is 8.33%, which is lower than the return that James got on the bond.
James’s current yield is 10%, calculated as (($100 ÷ $1,000) x 100).
Margaret’s current yield is 8.33%, calculated as (($100 ÷ $1,200) x 100).
Relationship Between Bond Prices and Interest Rates
The chart below summarizes the inverse relationship between bond prices and interest rates:
The yield curve is a graph that shows the relationship between the yield-to-maturities of the same class of bonds with different maturities.
Bonds within the same class are those that have the same credit quality.
Yield curves are an important tool in fixed income investing and it is often used in forecasting the direction of interest rates and bond pricing.
To get a better understanding of yield curves, we’ll look at the three types of yield curves:
Yield Curves Types
Portfolio managers will use the shape of the yield curve to develop a bond investing strategy. They can refer to it to select the term to maturity of bonds that will provide the optimal yield.
Inflation and Interest Rate Risk
There are six main types of risk associated with investing in bonds.
Also known as purchasing power risk, inflation risk arises when the return of a bond does not keep up with the inflation rate, representing the increase in the costs of goods and services.The inflation rate reduces the actual rate of return of the bond. As a result, the purchasing power of the bondholder’s coupon payments is eroded. The dollar value of the coupon payments will buy fewer goods, because general prices have gone up.
Clive purchases a bond with a coupon rate of 5%, but the inflation rate is 3%. Therefore, Clive’s purchasing power has only increased by approximately 2%, not 5%.Given the inflation rate, Clive’s real rate of return, also called the actual return, is approximately 2%.
Interest Rate Risk
This is the risk that the price of existing bonds will decline due to a rise in interest rates. Recall that as interest rates rise the price of existing bonds declines, and when interest rates fall bond prices go up.
This is the risk that coupon payments from a bond will be reinvested at a lower interest rate than the rate on the original investment. Bonnie purchased a 10-year bond with a coupon rate of 5%. After two years, the prevailing interest rate fell to 3%. Subsequently, Bonnie’s coupon payment can only be reinvested at 3% and not 5%.
This is the risk that a bond investor cannot find a buyer for his or her bond when he or she wants to sell it. This is often the case in thin bond markets, where demand for bonds may be low due to economic uncertainty.
This is the risk that a government, or an agency backed by the government, may be unable to make interest payments or return the investor’s principal amount. The government may be unable to pay due to unfavorable economic conditions.
Also referred to as credit risk, this is the risk that the bond’s issuer may run into financial problems and will not be able to pay bondholders their scheduled coupon payments. In a worst-case scenario, their principal will not be re-paid. However, in the event the issuer defaults on coupon payments, the investor may still be able to recover some of their investment
Role of Credit Rating Agencies
Credit rating agencies rate the credit quality of bond issuers. These companies use their professional judgment and other analytical tools to create a series of ratings on corporate and government bond issues.
Investors will refer to the rating assigned to a bond issuer to gauge its default risk.
In Canada, credit rating agencies must apply to securities regulators to become designated rating organizations. They are required to abide by the rules regarding conflicts of interest, proper compliance, and reporting requirements.
Standard & Poor’s Rating Services is one of the major global credit rating agencies. According to its rating system, bonds can range from the highest quality, rated AAA, to the lowest quality, rated D. Investment grade bonds, those that have a low risk of default, range from between AAA to BBB-. Conversely, high yield bonds (i.e. high risk bonds) usually have a rating of BB or lower and are commonly referred to as “junk bonds”.
Bonds and Mutual Funds
Since there is a contractual obligation from issuers to pay regular coupon payments, bonds are usually used in mutual fund portfolios to provide an income stream that can be distributed to investors. Furthermore, issuers must repay the principal amount; this offers mutual fund portfolios some stability. Because of this fact, portfolio managers may invest a portion of their portfolio in bonds to lower the overall risk of their mutual fund.
Portfolio managers do need to consider the credit quality of the issuer and the term of the bond since these factors affect the level of risk of the bond. Depending on the investment objective of the mutual fund, portfolio managers will select bonds accordingly.
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