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Chapter 1

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.

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Chapter 1

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  1. Chapter 1 Introduction to Bond Markets

  2. 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.

  3. 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.

  4. 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.

  5. 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.

  6. 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.

  7. 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.

  8. 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.

  9. 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

  10. 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

  11. 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.

  12. 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.

  13. 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.

  14. 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.

  15. Risks Associated with Bond Investing • Credit risk – risk that issuer will fail to satisfy the terms of the bond. • Default risk: Risk the issuer does not repay part or all of its financial obligation. • Credit spread risk: Risk 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). • 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.

  16. 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.

  17. 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.

  18. 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.”

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