Bonds - Features and Risks

Based on my studies and the relevant points from the CFA

study material, I have complied some points related with the Features and Risks
on Bonds Securities. Through this article, I just want to share this knowledge w
ith all of you. I hope it will provide you some information about the Bonds whil
e dealing practically as well as while preparing for any course or studies.
Introduction
Fixed Income Security is a financial obligation of an entity that promises to pa
y a specified sum of money at specified future dates. The entity that promises t
o make the payment is called the issuer of the security. It falls under two gene
ral categories >
1) Debt Obligations – Bonds, Mortgage-backed securities, Asset Backed Securit
ies, Bank Loans.
2) Preferred Stock – Represents ownership interest and has fixed dividends pa
yment.
Features of Bonds

► Indenture - The promises of the issuer and the rights of the bondholders are s
et forth in great detail in a bond’s indenture.
► Covenants - As part of the indenture, there are affirmative covenants and nega
tive covenants.
1) Affirmative covenants set forth activities that the borrower promises to
do.
2) Negative covenants set forth certain limitations and restrictions on the
borrower’s activities.
► Maturity of a bond is the number of years the debt is outstanding or the numbe
r of years remaining prior to financial payment. It is important because
1) Indicates the time period over which the bondholder can expect to receiv
e interest payment and principal at the end.
2) Yield offered on a bond depends on the term to maturity.
3) The price volatility of the bond is the function of maturity. The longer
the maturity of the bond, the greater the price volatility resulting from a cha
nge in interest rates.
► Par Value is the amount that the issuer agrees to repay the bondholder at or b
y the maturity date. When a bond trades below its par value, it is said to be tr
ading at discount. When a bond trades above its par value, it is said to be trad
ing at premium.
► Coupon Rate, also called the nominal rate, is the interest rate that the issue
r agrees to pay each year. The annual amount of the interest payment made to bon
dholders during the term of the bond is called the coupon. The coupon is determi
ned by multiplying the coupon rate by the par value of the bond i.e. Coupon = Co
upon Rate X par value.
The higher the coupon rate, the less the price will change in response to a chan
ge in market interest rates
Zero Coupon Bonds – Bonds that are not contracted to make periodic coupon payment
d zero-coupon bonds. The holder of a zero-coupon bond realizes interest by buyin
g the bond substantially below its par value. Interest is then paid at the matur
ity date, with the interest being the difference between the par value and the p
rice paid for the bond.
 Step-Up Notes – Securities that have a coupon arte increases over time. These sec
called step-up notes because the coupon rate “steps up” over time. When there is on
ly one change (or step up) the issue is referred to as a Single Step-up note. Wh
en there is more than one change the issue is referred to as a multiple step-up
note.
Deferred Coupon Bonds – Bonds whose interest payments are deferred for a specifie
years.
Floating-Rate Securities – These securities have coupon payments that reset perio
ording to some reference rate. Coupon Rate = Reference Rate + Quoted Margin
Maximum Coupon rate is called Cap. Minimum Coupon Rate is called a Floor.
Coupon rate increases when reference rate increases, and decreases when referenc
e rate decreases.
Issues whose coupon rate moves in the opposite direction with the change in the
reference rate. Such issues are called Inverse Floaters or Reverse Floaters. The
coupon Formula is:
Coupon Rate = K – L X (Reference Rate)
► Accrued Interest – It refers to the amount of interest that will be received by
the buyer even though it was earned by the seller. The bond buyer must pay the b
ond seller the accrued interest.
The bond in which the buyer must pay the seller accrued interest is said to be tr
-coupon.
If the buyer forgoes the next coupon payment, the bond is said to be trading ex-c
► Paying off provisions of bond – When the issuer agrees to pay one lump sum payme
nt at the maturity date, it is termed as Bullet Maturity.
1) Call & Refunding Provisions – The right of the issuer to the stated maturi
ty date is referred to as a Call provision. If the issuer exercises this right,
the issuer is said to “call the bond”.
When the issuer exercises an option to call an issue, the call price can be eithe
i. Fixed regardless of the call
date – the call price is par plus accrued interest.
ii. Based on the price specified
in the call schedule – the call price depends on when the issuer calls the issue.
iii. Based on a mark-whole premium
provision – Provides a formula for determining the premium.
A non-callable issue prohibits the refunding of the bonds for a certain number of
for the issue’s life.
Non-refundable Bonds prevents redemption from certain sources, namely the proceed
r debt issues sold at a lower cost of money.
2) Sinking Fund Provision – The indenture may require the issuer to retire a
specified portion of the issue each year. This is referred to as a sinking fund
requirement. If only a portion is paid, the remaining principal is called balloo
n maturity. Many times issuer has the option to retire more than the sinking fun
d requirement. This referred to as an accelerated sinking fund provision.
► Conversion Privilege – The issue grants the bondholder the right to convert the
bond for a specified number of shares of common stock. It allows the bondholder
to take advantage of favorable movements in the price of the issuer’s common stock
.
► Put Provision – It grants the bondholder the right to sell the issue back to the
issuer at a specified price on designated dates.
► Currency Denominations – There are some issues whose coupon payments are in one
currency and whose principal payment is in another currency. An issue with this
characteristic is called a dual-currency issue.
► Embedded Options – The provision that gives the issuer or the bondholder an opti
on to take some action against the other party are referred to as embedded optio
ns, because the option is embedded in the issue.
Embedded Options granted to issuers.
i. Right to call the issue.
ii. Right to prepay principal
iii. The accelerated sinking fund provisi
on
iv. The cap on a floater.
Embedded Options granted to the Bondholder
i. Conversion Privilege
ii. Right to put the issue
iii. Floor on a floater
► Borrowing Funds to Purchase Bonds
1) Margin Buying – In this the broker provides the funds borrowed to buy the
securities and in turn the broker gets the money from a bank. The interest rates
banks charge from brokers for these transactions is called the call money rate.
The broker charges the investor the call money rate plus a service charge.
2) Repurchase Agreement – It is a sale of security with a commitment by the s
eller to buy the same security back from the purchaser at a specified price at a
designated future date.
Risk Associated with investing in Bonds
► Interest Rate Risk – Change in interest rate over the period of maturity is refe
rred to as Interest rate risk.
When interest rate rise, a bond’s price falls, when interest rates fall, a bond’s pr
ice will rise.
Reasons for inverse relationship >
1) A bond will trade at a price equal to par when the coupon rate is equal
to the yield required by market
Coupon Rate = Yield Required by Market Price = Par Value
2) A bond will trade at a price below par (sell at a discount) or above par
(sell at a premium) if the coupon rate is different from the yield required by
the market. Specifically,
Coupon rate < Yield required by market Price < Par Value (Discount)
Coupon rate > Yield required by market Price > Par Value (Premium)
3) The price of a bond changes in the opposite direction to the change in i
nterest rates. So, for an instantaneous change in interest rates the following r
elationship holds:
If interest rates increase Price of the bond decreases
If interest rates decreases Price of the bond increases
Bond Features that effect interest rates
1) Impact of Maturity > All others factors constant, the longer the bond’s ma
turity, the greater the bond’s price sensitivity to changes in interest rates.
2) Impact of Coupon rate > The lower the coupon rate, the greater the bond’s
price sensitivity to change in interest rates.
3) Impact of Embedded Options > For this, let us decompose the price of the
callable bond in:-
Price of Callable Bond = Price of option-free bond – Price of embedded call option
.
When interest rate decline both price components increase in value, but the chan
ge in the price of the callable bond depends on the relative price change betwee
n the two components.
Therefore, a decline in interest rates will result in an increase in the price o
f the callable bond but not by as much as the price changes of an otherwise comp
arable option free bond.
4) Impact of the yield level > Higher a bond’s yield, the lower the price sen
sitivity.
Price sensitivity is lower when the level of interest rate in the market is high
, and the sensitivity is higher when the level of interest rate is low.
5) Floating rate Securities > The price of the floating rate security will
fluctuate depending on three factors>
a. The longer the time to the next coupon reset date, the greater the poten
tial price fluctuation.
b. The required margin that investors demand in the market changes.
c. It will typically have a cap. Once the cap is reached, the securities p
rice will react mush the same way to changes in market interest rates as that of
a fixed-rate coupon security. It is termed as “Cap risk” of the floating rate secur
ity.
Measuring interest rate risk
Approximate percentage Price changes for a 100 basis point change in yield is:
Duration = Price of Years decline – Price if yields rise
.
2 X (Initial Price) X (Change in yield in decimal)
The approximate dollar price change for a 100 basis point change in yield is som
etimes referred to as the dollar duration.
► Yield Curve Risk
The graphical depiction of relationship between yield and maturity is called the
yield curve. When interest rate changes they do not change by an equal number o
f basis points for all maturities. The portfolios have different exposures to ho
w the yield curve shifts. This risk exposure is called yield curve risk.
► Call and Prepayment Risk > From investor’s perspective, there are 3 disadvantage
s to call provisions>
1) The cash flow pattern of a callable bond is not known with certainty
2) Because the issuer is likely to call the bonds when interest rates have
declined below the bond’s coupon rate, the investor is exposed to reinvestment ris
k.
3) The price appreciation potential of the bond will be reduced.
The same disadvantages apply to mortgage backed and asset backed securities wher
e it is termed as prepayment risk.
► Reinvestment risk > is the risk that the proceeds received from the payment of
interest and principal that are available for reinvestment must be reinvested a
t a lower interest rate than the security that generated the proceeds. While dea
ling with amortizing securities (i.e. securities that repay principal periodical
ly), reinvestment risk is greater. In Zero-coupon Bonds there is no reinvestment
risk, because there is no coupon payments to reinvest.
► Credit Risk > An investor who lends fund by purchasing a bond issue is exposed
to credit risk. There are 3 types of credit risk >
1) Default Risk > It is defined as the risk that the issuer will fail
to satisfy the terms of the obligation with respect to the timely payment of in
terest and principal.
2) Credit Spread Risk > The risk premium on a bond is referred to as
Yield Spread. The part of the risk premium or yield spread attributable to defau
lt risk is called credit spread. If the credit spread increases, investors say t
hat the spread has “widened” and the market price of the bond issue will decline. Th
e risk that the issuer’s debt obligation will decline due to an increase in the cr
edit spread is called credit spread risk.
3) Downgrade Risk > There are 3 rating agencies in US > Moody’s Investo
rs Service Inc., Standard & Poor’s Corporation, and Fitch ratings. Bond issues tha
t are assigned a rating in the top four categories are referred to as investment
-grade bonds. An unanticipated downgrading of an issue or issuer increases the c
redit spread and results in a decline in the price of the issue or the issuer’s bo
nds. This risk is referred to as a downgrade risk and is closely related to cred
it spread risk.
► Liquidity risk > is the risk that the investors will have to sell a bond below
its indicated value, where the indication is revealed by a recent transaction.
The wider the bid-ask spread the greater the liquidity risk.
► Exchange rate or currency risk > The risk of receiving less of the domestic cu
rrency when investing in a bond issue that makes payments in a currency other th
an managers’ domestic currency is called exchange rate risk or currency risk.
► Inflation or purchasing power risk > arises from the decline in the value of a
security’s cash flow due to inflation, which is measured in terms of purchasing p
ower.
► Volatility risk > The greater the expected yield volatility, the greater the v
alue of an option. The risk that the price of a bond with an embedded option wil
l decline when expected yield volatility changes is called volatility risk.
Price of Callable Bond = Price of option-free bond – Price of embedded call option
Price of Putable Bond = Price of option-free bond + Price of embedded call optio
n

► Event Risk > Risk caused by natural disaster, takeover or corporate restructur
ing, or regulatory change.
► Sovereign Risk > When an investor acquires a bond issued by a foreign entity,
the investor faces sovereign risk. This is the risk, that as a result of the act
ions of the foreign government, there may be either a default or an adverse pric
e change even in the absence of a default.
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