Bonds Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A form of debt issued by corporations, federal agencies, and local, state, and national governments, a bond is a financial security designed to pay back the bondholder on particular dates. Payments received by the bondholder typically consist of the repayment at the time of maturity of the principal amount borrowed as well as coupon payments (interest payments) made during the life of the bond (most commonly semi-annually, but often quarterly, monthly, or even once at the time the bond matures and the debt is retired). Because most bonds have a fixed interest payment that the bondholder receives, this form of debt security is also referred to as a fixed income security.

Interest rates paid by the issuers of bonds can be fixed, can be paid at maturity, or can be variable as is the case with a step-up bond or a floating coupon level bond. The step-up coupon bond is the least complex of the variable rate bonds whereas a derivative bond (derivatives can be tied to an index such as an equity index or a consumer price index or determined by a mathematical equation that links the level of interest payments to an economic variable including market indices, single equities, or even commodity prices) can range from a simple structure to a very complex structure. An example of a fixed-coupon bond would be a bond with a $1,000 denomination (par value) that had a seven percent coupon paying semi-annually with a final stated maturity date of January 15, 2020. In this example, every January 15th and every July 15th until and including January 15, 2020, the investor holding the bond would receive $35 such that his or her annual income from the bond would be $70 (7 percent of $1,000 par value or face value of the bond). In addition, upon maturity of the bond on January 15, 2020, the investor would receive not only the last interest payment of $35, but also the principal par value of the bond, which is typically $1,000.

Some bonds are issued without regular interest payments such that all of the interest is paid at the time the bond matures. These bonds are called zero-coupon bonds; they are issued (or sold) at a deep discount to their face value and they mature at par. The difference between the discounted price and the par value of the bond at maturity is considered accreted interest and represents the return to the investor over a specific time period. Consider the example of a zero-coupon bond that matures January 15, 2020. If the investor bought the bond when it was first issued on January 15, 2010, at a price of $300, then the investor would stand to gain $700 in accreted interest over 10 years’ time, or $70 a year. Comparing the zero-coupon bond to the previous 7 percent fixed-coupon bond shows that both bondholders would earn $70 per year. The advantage of the 7 percent coupon bond is that the bondholder actually receives current income of $70

each year throughout the life of the bond, whereas the zero-coupon bondholder has to wait to receive his or her income until the bond matures or until he or she sells the zero-coupon bond in the marketplace. The advantage of the zero-coupon bond is that it requires a much smaller initial investment, in this case $300 for the zero-coupon bond versus $1,000 for the 7 percent coupon bond.

Variable Interest Bonds

Examples of variable interest bonds include a simple step-up coupon that will pay a certain coupon or interest rate for a specified period and then increase the coupon payments at a specific point in time. The simplest form of a step-up bond is called a one-time step-up in which the interest rate is fixed for a period of time and then steps-up once to a higher level. The number of times a bond may step-up typically varies from once to five or six times. As an example, the coupon of a one-time step-up bond might have the following characteristics: 4 percent from July 15, 2008, to January 15, 2010, 8 percent thereafter until maturity in January 15, 2020. Typically the step-up bond will be callable at par on the dates on which it is scheduled to have its coupon increased (step-up). When a bond is called by the issuer, the interest due to that point of time along with the principal of the bond at par value is paid to the bondholder in return for the debt being retired.

A step-up bond with several step-ups in coupons might have a coupon schedule that looks like the following: 3 percent from July 15, 2008, to January 15, 2009; 4 percent January 15, 2009, to January 15, 2010; 5 percent January 15, 2010, to January 15, 2012; 7 percent January 15, 2012, to January 15 2014; 9 percent thereafter. As is typically the case with a single step-up bond, the multiple step-up will be callable by the issuer at par on the dates at which the coupon is scheduled to increase. Because the step-up bond is callable, the yield to maturity for the bondholder is typically higher for a step-up then a fixed coupon bond. However, this higher yield will only be realized by the investor if the prevailing interest rate and the borrowing opportunities of the issuing entity are such that the step-up bond is not called.

Another common form of variable (floating) interest rate bonds are bonds issued with coupons tied to a specific interest rate or index including but not limited to examples such as the U.S. Treasury Bill, the 3or 6month London Inter-bank Overnight Rate (LIBOR), or the Consumer Price Index (CPI). Many of these types of floating interest rate bonds have coupons that adjust and pay as frequently as monthly such that, for example, the coupon paid for a given month will be 200 basis points (200 bps = 2 percent, pronounced “bips”) above the current 3-month LIBOR. So if the 3-month LIBOR is at 3 percent then the coupon for the bond in that month will be 3 percent + 2 percent = 5 percent. The advantage of owning floating interest rate notes is that in the event that interest rates or inflation increases dramatically, then the investors holding these floating rate notes will enjoy increasing coupon payments.

Many more complex forms of floating coupon bonds exist and are typically referred to as structured products or derivatives. A structured product’s coupon can be linked to just about any economic variable including but not limited to interest rates, commodity prices, equity indices, single equities, yield curves, inflation indices, or even to other derivatives. In addition, structures may include caps on coupons, be based on averages or weighted averages, and range from a fairly simple one-to-one relationship to a more complex mathematical computation. One example of a derivative would be a bond that paid a fixed 11 percent coupon for one year and then converted to a floating coupon that paid 10 times the difference between the 30-year interest rate and the 10-year interest rate for the duration of the bond until maturity. A derivative like this would likely have a cap on its interest rate (20 percent, for example) and be callable by the issuer in case the difference (spread) between the 30-year and 10-year rates were significant.

Bond Ratings

Bonds are rated by several credit rating agencies including Standard & Poor’s (S&P), Moody’s, and Fitch. These rating agencies focus on evaluating the credit worthiness of the bond issuers and publish their ratings. Criteria such as the issuer’s asset protection, management capabilities, quantity and type of existing debt and its ability to pay the associated interest and principal due, as well as the overall stability of the issuer’s cash flow are all assessed to determine the creditworthiness and financial strength of the bond issuer. The best known of the credit rating agencies are S&P and Moody’s, each having similar rating scales that range from high-quality investment-grade bonds with little risk through the midrange investment grade and speculative bonds all the way down to the defaulted bonds that have been issued by organizations that have failed to stay current in the payment of interest and/or principal of their debt.

Typically the defaulted bonds are associated with an organization that is in bankruptcy and going through a process of restructuring. In the process of restructuring, bondholders are treated as general creditors, although bonds have a hierarchy in which secured bonds provide the bondholder with a higher level of claim on the assets of the organization, followed by debentures, subordinated debentures, and finally income bonds.

Ranging from the highest quality ratings to the lowest by S&P/Moody’s, the ratings are (1) AAA/Aaa indicates the highest investment-grade rating in which capacity to repay principal and interest is assessed as being very high; (2) AA/Aa indicates a very high quality bond only slightly less secure than the AAA/Aaa ratings; (3) A/A indicates a bond that is slightly more susceptible to adverse economic conditions; (4) BBB/ Baa indicates the issuers of these bonds are judged to have reasonable capacity to repay principal and interest, yet they are slightly speculative; (5) BB/Ba indicates that the investment in these bonds is speculative and that there is a significant chance the issuer could miss an interest payment; (6) B/B indicates the issuer has or is likely to miss one or more interest and or principal payments; (7) C/Caa indicates that there is a very high likelihood that the issuer will miss interest and principal payments and go into default, some even consider this rating to mean a technical default; (8) D/D indicates the issuer is in default and that the payment of interest and principal is in arrears.

Each of the above ratings by S&P can be qualified further by a plus sign (+) or a minus sign (–) to indicate relative strength within each rating category. Likewise, Moody’s qualifies its rating categories with the numbers 1, 2, and 3. The most positive ratings being “+” and “1,” moderate ratings within category being a lack of qualifier for S&P and “2” for Moody’s, and the lowest quality rating being a minus sign “–” for S&P and the number “3” for Moody’s.

One additional important consideration when judging the creditworthiness of a particular bond issuer is the credit rating trend. The credit rating agencies will issue positive or negative outlooks that indicate potential direction of future credit watches or credit rating changes. Credit watches issued by the rating agencies are a stronger statement of trend and can be either negative or positive. Although a negative credit watch issued by S&P or Moody’s indicates a potential future downgrade in the credit rating of a particular issuer, a credit rating downgrade does not always follow the negative credit watch as economic conditions and the financial strength of an issuer is subject to positive changes over time.

The last important aspect of assessing credit rating trend is to analyze the empirical credit ratings over time. It is more common for a troubled firm to undergo a series of downgrades spanning years than for a highly rated investment-grade bond to suddenly become speculative and default, although there are exceptions such as Enron, for example, in which its investment-grade senior secured debt rated Baa3 with a negative credit watch on November 27, 2001, defaulted rapidly and within six days became a Ca rated “junk” bond on December 3, 2001, as evidence of accounting fraud became known.

Bond Yields

The return to an investor in bonds is referred to as yield. There are three important yield calculations for bonds: current yield, yield to maturity, and yield to call. Current yield (CY) is equal to the annual income received from the bond divided by the current market price. For example, a $1,000 face-value bond with a 7 percent coupon trading at a discount of $800 would equal a current yield of 8.75 percent, whereas if the same 7 percent coupon bond was trading at a premium of $1,120 the current yield would be 6.25 percent.

Yield to maturity (YTM) is the annualized rate of return the investor receives if the bond is held to maturity. To calculate YTM, divide either the premium amount paid or the discount by the number of years until the bond’s final stated maturity, then subtract this amount from the annual interest paid, and divide the remainder by the price of the bond. Considering the example above, the YTM of a $1,000 face value, 7 percent coupon bond, maturing in 10 years, offered at the discounted price of $800 would be 11.25 percent. Likewise considering the premium priced bond above, the YTM of a $1,000 face value, 7 percent coupon bond, maturing in 10 years, offered at the premium price of $1,120 would be approximately 5.18 percent. In both of these examples, it is important to understand that an inverse relationship between bond price and bond yield exists such that the higher the price of a bond goes, the lower its yield will be and vice versa.

Calculating yield to call (YTC) is similar to calculating YTM in that the only alteration in the formula is that the “number of years to call” is substituted for “the number of years until the bond’s final stated maturity.” When comparing YTC and YTM, notice that discount and premium prices for bonds will have a greater impact on the YTC because the number of years to a potential call is always less than the number of years to maturity, thus the amount of discount has fewer years to accrete or in the case of a premium, the amount has fewer years for amortization in the event of the bond being called by the issuer. In the bond market, it is important to make distinctions among the various kinds of yields and to be aware of what the yield in the worst-case scenario will be, which is commonly referred to as yield to worst (YTW). This is of particular importance when callable bonds are being sold at a premium.

The yield curve can be represented by a graph that displays time until a bond’s maturity on the x-axis and bond’s yield on the y-axis. A “normal” yield curve is upward sloping such that the bonds with longer maturities will tend to yield more than the bonds of the same quality with shorter maturities. A “normal” spread between short-term bonds and long-term bonds is approximately 3 percent or 300 basis points, although spreads between the short end and long end of the yield curve may vary dramatically. An ascending yield curve typically occurs when the economy is growing and tends to predict future increases in interest rates. An inverted, or downward sloping yield curve in which the shorter-term yields are higher than the longer-term yields can occur when the Federal Reserve Board raises short-term interest rates in order to tighten credit and prevent inflation. The inverted curve tends to foretell future decreases in interest rates.

Although a single yield curve depicts bonds of the same quality and type (for instance AAA corporate bonds) it can be informative to view the differences among yield curves representing different types of bonds. For example, as the spread in yields between corporate AAA and U.S. government bonds (AAA) widens, it indicates that there is a “flight to safety” and that investors in the marketplace believe the economy is worsening and that corporate profits will be decreasing, thus in order to be induced to buy corporate bonds investors require a greater differential yield over the lower yield of U.S. Treasuries that are considered to be close to achieving the status of a “riskless” investment.

Bond Pricing

Bond pricing is based on the perceived risk of the bond relative to the risk and return of alternative investments. The majority of investment-grade corporate bonds and agency bonds are priced among bond trade desks based on a negotiated yield spread to the U.S. Treasuries. The lower the investment-grade credit rating for the corporate bond, the greater the negotiated spread will be. For example, a high-quality corporate bond may offer 50 basis points (one-half percent) more yield to the investor when compared to a similar duration U.S. Treasury. As the quality of the corporate bond decreases through the investment-grade spectrum from AAA to the BBB category, the spread of the offered yield to the Treasuries will increase in order to entice investors to take on the additional risk of lending money to a corporation that may be slightly susceptible to variance in economic conditions. So instead of offering a spread of 50 basis points or less, the trade desk may offer a spread of 200 to 300 basis points.

It is important to note that corporate spreads are not only dependent on the bonds’ credit ratings, but also on the sector to which the corporation belongs. For instance during the financial sector’s troubles of 2008, the spreads were much higher for the bonds issued by financial institutions as compared to corporate bonds of the same quality rating issued by firms within the industrial sector. Corporate bonds that are speculative (rated below BBB) are traded among bond desks based on a dollar price. For instance, a 7 percent coupon bond rated B would be offered for sale at a dollar price such as 95 ($950 per $1,000 face bond) that is expressed in terms of percentage of par value. In general the price will be lower (and the yield higher) the lower the rating of the bond and the longer the period until the bond matures. This lower price and higher yield is meant to compensate the investor for taking on the risk associated with lower creditworthiness and the uncertainty associated with the passage of time.

Similar to investment-grade corporate bonds, agency bonds issued by the Farm Credit System, Federal Home Loan Bank, Federal Home Loan Corporation (Freddie Mac), and Federal National Mortgage Association (Fannie Mae) are offered based on a spread to U.S. Treasuries. In contrast, municipal bonds are offered among trade desks based on yields, although some consideration may be given to the municipal bonds yield as a percentage of similarly maturing U.S. Treasuries.

Bibliography:

J. Fabozzi, The Handbook of Fixed Income Securities, 7th ed. (McGraw-Hill, 2005);
Passtrak Series 7: General Securities Representative License Exam Manual, 15th ed. (Dearborn Financial Publishing, Inc., 2004);
Florian Schmidt and Adam Harper, A Guide to Asian High Yield Bonds: Financing Growth Enterprises (Wiley, 2008);
Securities Industry and Financial Markets Association, www. investinginbonds.com (cited March 2009);
Shop4Bonds, www.shop4bonds.com (cited March 2009);
Timothy Sinclair, The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness (Cornell University Press, 2008);
Tuckman, Fixed Income Securities: Tools for Today’s Markets, 2nd ed. (John Wiley & Sons, 2002).

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