BONDS & FLOATERS

1. Julie CHAM ITEC/FIC/TTS/ECN BONDS & FLOATERS

2. BONDS • Definition – Concepts • Bond Rating Agencies (Moody's and Standard & Poor's) • Features of Bonds • Types of bonds • Fixed Rate Bonds • Zero Coupon Bonds • High Yield Bonds • Convertible Bonds • Step-up (down) Bonds • Floating Rate Notes • Duration indicators • Annexe : Main Financial Markets

3. Definition - Concepts • A bond (fixed-income security) is a debt security issued by the Federal government, states, cities, corporations, or institutions • All of these entities need money to operate (to fund the federal deficit, to build roads and finance factories, ..) so they borrow capital from the public by issuing bonds. • So when an investor buys a bond, he becomes a creditor of the issuer. • The issuer owes the investor a debt and is obliged to repay the bond’s value and interest at a later date, termed maturity.

4. Bond Rating Agencies (Moody's and Standard & Poor's) • Provide a service to investors by grading fixed income securities based on current research. • The rating system indicates the likelihood that the issuer will default either on interest or capital payments.

5. Features of Bonds (1) • The Issuer : • Government bonds : issued by a national governmentand referred to as risk-free bonds. • Govies : issued in the country's own currency Ex : - in France, OAT are Govies issued by the « Agence France trésor » - in USA, US Treasuries are Govies issued by the « Bureau of Public Debt » • Sovereign bonds : issued in foreign currencies • Corporate bonds : • issued by private and public corporations, as opposed to Govies. • higher yields because there is a higher risk of a company defaulting than a government. • Agency (Quasi-Govies) Bonds : • issued by a U.S. government-sponsored agency. • After Govies, the safest category of bonds. All agency bonds carry an ‘AAA’ credit rating. • Municipal bonds : • issued by any municipal organization • the interest payments are usually exempt from federal taxes and also from state and local taxes in the area bonds are issued.

6. Features of Bonds (2) • Nominal (Principal, Face value, Par value) : amount over which the issuer pays interest, and which has to be repaid at the end. • Price : It fluctuates throughout its life due to the interest rates evolution and variation of the issuer credit quality. • When a bond trades at a price above the Nominal : it’s sait to be selling at a premium • When it sells below the Nominal : it’s said to be selling at a discount • Maturity date : the date that the bond will cease to exist and at which time the issuer will pay the nominal • short term (bills): maturities up to one year; • medium term (notes): maturities between one and ten years; • long term (bonds): maturities greater than ten years. !

7. Features of Bonds (3) • CouponRate : Interest rate that the issuer pays to the bondholder(expressed as a percentage of the bond’s face value). • Coupon Type : The type of interest rate.It can be fixed, variable or floating. • Coupon Dates : Coupons are typically paid semiannually, but some bonds pay annual, quarterly or monthly coupons. • Coupon frequency : The number of times interest is paid per year.

8. Features of Bonds (3) • Optionality (callability / puttability) : it grants option like features to the buyer or issuer • Callable bond : the issuer has the right to redeem the bond prior to its maturity date. He will often call a bond if it’s paying a higher coupon than the current market interest rates. The company can reissue the same bonds at a lower interest rate. • Put bond :allows the bondholder to redeem the bond at a specified price prior to maturity. Investors might choose to do this if interest rates increase after the bond was issued. • How does it work? • Bond issues at a price closed to its par value (exact price determined by market conditions). • The issuer makes fixed periodic interest payments : coupons (a percentage of that par value) • They continue to be paid until the bond's maturity date • At maturity date : one final coupon is paid along with the par value.

9. Bond Price Formula : • Price of any financial instrument = the Net Present Value (NPV) of all future cash flowsdiscounted at a suitable interest rate(s). • To simplify we assume a single rate for all cash flows known as the yield-to-maturity. • Cash flows = { coupon interest payments & the maturity value (par value) } • Fixed rate bond formula : C = coupon payment n = number of payments i = interest rate (yield-to-maturity)M = value at maturity, or par value  • This formula illustrates that, when interest rates go up, the price goes down!

10. Types of bonds (1) • Fixed rate bonds (called straight or plain vanilla bonds ) : a bond paying periodic interest payments at a fixed rate over a fixed period to maturity, with the return of Principal on the maturity date. • Example : a 4.6% 20-year bond (long term bond) • Bond’s par value (Face value) of USD 100 • it issues below par at USD 98.2 (at a discount). • It then makes semiannual coupon payments of USD 2.30. • On the maturity date, a final coupon is paid along with the par value. 102.3 2.3 2.3 2.3 2.3 2.3 1Y 2Y 3Y 4Y - - - - - 20Y 98.2

11. Types of bonds (2) • Zero coupon bonds : • No periodic interest payments (No coupons) • It’s sold at a deep discount to face value and matures at its face value. • The income comes to bondholder from the difference between the par value that he receives when the bond is redeemed and the bond’s price (at a discount) • Ex : investor can buy a bond with a par value of 1000 for a price of 600, so the interest realized is : 1000-600=400. • Example :a 20-year Zero Coupon bond • Bond’s par value (Face value) of USD 1000 • it issues at a discount at USD 600. • On the maturity date, a coupon is paid. 1000 1Y 2Y 3Y 4Y - - - - - 20Y 600

12. Types of bonds (3) • High yield bonds (non-investment grade bonds, junk bonds) : • rated below investment grade by the credit rating agencies. • Relatively risky so investors expect to earn a higher yield. • Convertible bonds (converts): • give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. • Step-up (Step-down) bonds : • The coupon rate increases (decreases) during the life of the bond. • Ex : a 5-year bond can have a coupon rate of 6% for the first 2 years and 6.5% for the last 3 years (step-up bond) • or 9% for the first 2 years and 8% for the last 3 years (step-down bond). • only one change in coupon rate : a single step-up (step-down) bond. • more than one change : a multiple step-up bond.

13. Types of bonds (4) : Floating Rate Notes (Floaters) • Coupon fluctuates with a designated reference rate (Benchmark rate, market index). • 2 commonly-used reference rates : • Libor (London Interbank Offered Rate) • In continental Europe :the euro benchmark is called Euribor • Coupon rate is calculated as the reference rate plus a fixed spread: Coupon rate = Reference rate + Fixed Spread • Ex : 3month USD LIBOR +2.0% (coupon rate = 3month LIBOR + 200 basis points) • Coupon Frequency : periodically, normally every 3month : “quaterly” • Typically, FRN have maturities of about 5 years.

14. Floating Rate Notes (Floaters) • Quoted Margin (in basis points): • Amount added to the reference rate (« fixed spread ») in order to determine the coupon • It depends upon the issuer's credit quality • It is fixed over the bond’s life • Discount Margin (in basis points): • This measure assesses the average margin that an investor can expect to receive over the FRN’s life. • It can be seen as a FRN’s equivalent of a fixed bond’s yield to maturity. • It will change daily, according to market conditions and credit quality of the issuer. • Advantages : • Coupon linked to a variable interest rate index : • has the effect of eliminating most of the interest rate sensitivity of the note • Price is always at or near par value. • the price action of a FRN is driven mostly by the changes in the credit quality of the issuer

15. Floating Rate Notes (Floaters) • Example : a 3-year FRN • Coupon resets and pays every 6month • Reference rate : 6month Libor • Quoted Margin : 52bp semi-annually 100 FRN issued at par 6M 12M 18M 24M 30M 36M 100 Floating coupons of Libor plus 52bp paid semi-annually

16. Floating Rate Notes (Floaters) spot Lag : Libor 6M fixed Next Coupon fixed • Next coupon rate value ? spot Lag : Libor 6M fixed Current Coupon fixed Today - 2j - 2j Maturity PrevCpnDate 6M NextCpnDate NextCpnDate + 6M Current Coupon paid Next Coupon paid

17. Duration Indicators • Duration is a measure of the average (cash-weighted) term-to-maturity of a bond. The bond’s value will vary depending on : • the amount of the cash flows (coupon size) • the timing of the cash flows (term to maturity) • the interest rate used for discounting. • Duration helps to summarize these variables in a single number. • Duration (MacCauley’s duration) : • The weighted-average term to maturity of the cash flows from a bond. • frequently used by portfolio managers who use an immunization strategy. • Modified Duration : • A useful measure of the sensitivity of a bond's price to interest rate movements. • It follows the concept that interest rates and bond prices move in opposite directions. • It’s used to determine the effect « a 100 bp (1%) change in interest rates » will have on the price of a bond. • Ex : a 15 year bond with a Modified Duration of 7 years would fall approximately 7% in value if the interest rate increased by 1%

18. Annexe : Main Financial markets • They facilitate : • The raising of capital in the Capital markets (Long term) • Stock markets • Bond markets • The transfert of risk int the Derivatives markets • The international trade in the Currency markets (Foreign exchange or Forex) Primary market : new issues exchanges Secondary market: aldready issued Over-the-counter