Bond Fundamentals

26 March 2014
Bonds are long-term debt instruments used by business firms and governments to raise
money. Most bonds pay interest semiannually at a stated interest rate with an
initial maturity of 10 to 30 years with a face value of $1,000 that must be repaid at
maturity.

A company sells its bonds, in the sense that it gives a promise of future payments in
return for current cash.

Bills (Money Market instruments) - debt securities maturing in less than one year. -
Notes - debt securities maturing in one to 10 years.
Bonds - debt securities maturing in more than 10 years.




Classifications
Mortgage bonds are backed by real assets pledged as security.
Debentures are not backed by any security.
Income bonds are so named because interest payments are only
made if the company generates sufficient income.
Zero coupon bonds pay no coupons, and their return is purely from
purchasing at a discount.
Floating rate bonds are so named because the coupon rate is tied
to some basic rate such as T-bill rates. These provide protection
against inflation and interest rate risk and keep bonds selling close
to their par values.
Junk bonds are high risk, high return bonds. Typically, these are
issued by lower-rated entities and are often tied to mergers or
leveraged buyouts.

2) Priority
In addition to the credit quality of the issuer, the priority of the bond is a determiner of the probability
that the issuer will pay you back your money.
If you hold an unsubordinated (senior)security and the company defaults, you will be first in line to
receive payment from the liquidation of its assets. On the other hand, if you own a subordinated (junior)
debt security, you will get paid out only after the senior debt holders have received their share.

4) Redemption Features
Both investors and issuers are exposed to interest rate risk because they are locked into either receiving
or paying a set coupon rate over a specified period of time. For this reason, some bonds offer additional
benefits to investors or more flexibility for issuers:
Callable, or a redeemable bond features gives a bond issuer the right, but not the obligation, to redeem
his issue of bonds before the bond's maturity.
Convertible bonds give bondholders the right but not the obligation to convert their bonds into a
predetermined number of shares at predetermined dates prior to the bond's maturity.
only applies to corporate bonds.


Puttable bonds give bondholders the right but not the obligation to sell their bonds back to the issuer at
a predetermined price and date. These bonds generally protect investors from interest rate risk. If
prevailing bond prices are lower than the exercise par of the bond, resulting from interest rates being
higher than the bond's coupon rate, it is optimal for investors to sell their bonds back to the issuer and
reinvest their money at a higher interest rate.

Basic Bond Valuation

B
0
= Sum (1 to n) I / (1+i)
n
+ M/ (1+i)
n


B
0
= bond's value at time zero
I= annual interest payments
i= discount rate
n= number of years to maturity
M= par value (payment at maturity)
Nature of corporate bonds. Most bonds state that the issuer (sometimes called the borrower or seller) agrees to pay
the buyer (sometimes called the investor or lender) a series of fixed interest payments. Usually these payments are to
be made every six months (semiannually) until the bond matures. To determine the amount of interest that a bond pays,
simply multiply its coupon rate times the bonds par value (sometimes called its face value or "principal).This par value
is usually $1,000 and is printed on the bond.The coupon rate is also printed on the bond and does not change during the
bonds life.

For example, if General Electric issues a bond whose coupon rate is 10%, this means that the bond pays the buyer 0.10
1,000 or $100 per year. Because the interest payment is made semiannually, the buyer actually receives $50 every six
months. Despite the fact of semiannual payment, the coupon rate is always stated on annual basis.


Example
Suppose Play Now, Inc. issues ten-year bonds (par $1,000) with an annual coupon of
8.6%. Similar ten-year bonds are paying 8.0% interest. What is the value of one of Play
Now's new bonds -- that is, what should be its price?
B
0
= C/(1+i)
n
+ M/(1+i)
n

=$86 x (PV of ten year $1 annuity at 8.0%) + $1,000 x (PV of $1 to be paid in 10 years at
8.0%)
=$86 x 6.710) + ($1,000 x .4632) =577.06 + $463.20 =$1,040.26
Answer (using spreadsheet). You can also use a
spreadsheet:
End of
year Interest Principal Present value
1 $86 $79.63
2 $86 $73.73
3 $86 $68.27
4 $86 $63.21
5 $86 $58.53
6 $86 $54.19
7 $86 $50.18
8 $86 $46.46
9 $86 $43.02
10 $86 $1,000 $503.03
Discount Rate 8.00%
Bond Value $1,040.26
Semiannual interest
Most bonds, although the coupon rate is stated as an annual interest rate, actually pay
interest semiannually. Valuing bonds that pay interest semiannually involves three steps:
Convert bond's annual interest (I) to semiannual interest -- divide I by 2
Convert the years to maturity (n) to semiannual periods -- multiply n by 2
Convert annual required return (i) to semiannual discount rate -- divide i by 2
The bond valuation formula for a bond paying interest semiannually is:
B
0
= Sum (1 to n) I/2 / (1+i/2)
2n
+ M/ (1+i/2)
2n

Example
Returning to our example, suppose Play Now issues ten-year bonds (par $1,000) with an
annual coupon rate of 8.6% that pay interest semiannually. Similar ten-year bonds are
paying 8.0% interest. What is the value of one of Play Now's new bonds -- that is, what
should be its price?
Answer. Use present value and present value annuity tables:
B
0
=C/2/(1+ i/2)
2n
+ M/(1+i/2)
2n

=$43 x (PV of 20-period $1 annuity at 4.0% per period) + $1,000 x (PV of $1 after 20
periods at 4.0% per period
=($43 x 13.590) + ($1,000 x .4564)
=$584.37 + $456.40
=$1,040.77


End of year Interest Principal Present value
0.5 $43 $41.35
1 $43 $39.76
1.5 $43 $38.23
2 $43 $36.76
2.5 $43 $35.34
3 $43 $33.98
3.5 $43 $32.68
4 $43 $31.42
4.5 $43 $30.21
5 $43 $29.05
5.5 $43 $27.93
6 $43 $26.86
6.5 $43 $25.82
7 $43 $24.83
7.5 $43 $23.88
8 $43 $22.96
8.5 $43 $22.08
9 $43 $21.23
9.5 $43 $20.41
10 $43 $19.62
10 $1,000 $456.39
TOTAL $1,040.77
Calculations using spreadsheet.


Notice that this bond is identical to
the bond in the previous example
with the exception that it pays
interest semiannually. The effect of
the semiannual payments is to
increase the price of the bond -- from
$1,040.26 to $1,040.77.



Reasons for bond price fluctuation
Bonds can change in price for essentially two reasons:
(1) the issuer's riskiness changes; and
(2) economic changes cause interest rates to change - most
pronounced for long-term bonds.

Effect of changes in debt rating. What happens if a debt rating
agency (such as Moody's) downgrades AT&T debt? The bonds
now must offer a higher yield, to compensate for the debt's
now perceived higher risk -- the bond's price falls. For example,
if the required return (yield) on the second listed bond
increased to 8.9%, the price would fall from 97.75 to about
$95.08. (The price would rise if AT&T's perceived riskiness fell.)

Effect of changes in interest rates. What happens to the price
of AT&T bonds if the Federal Reserve lowers the prime lending
rate and markets perceive that long-term interest rates will fall?
The bonds now can offer a lower yield, in line with the market's
expectation that long-term debt will pay lower interest rates,
and the bond's price rises. That is, bond prices rise when
interest rates fall. (And bond prices fall, when interest rates
rise.) For example, if the yield on long-term bonds fell to 7.8%,
the price of the third listed bond would rise to $103.30.

Moody\'s vs. Standard & Poors Bond Ratings
Bond Rating
Grade Risk
Moody\'
s
Standar
d &
Poor\'s
Aaa AAA Investment,
Highest Quality
Lowest Risk
Aa AA Investment,
Very High
Quality
Low Risk
A A Investment,
High Quality
Low Risk
Baa BBB MinimumInvest
ment Grade
Medium Risk
Ba BB Junk,
Speculative
High Risk
B B Junk, Very
Speculative
Higher Risk
Caa CCC Junk, Default
Possible
Higher Risk
Ca CC Junk, Default
Probable
Extreme Risk
C D Junk, In actual
or imminent
default
Highest Risk
Yield & YTM
The general definition of yield is the return an investor will receive by holding a bond to
maturity.
So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate
of 5%, this is how you'd calculate its current yield





Bond investors commonly look at yield to maturity (YTM) -- the rate of return the bond
offers at a specified price, if held to maturity. By computing bonds' YTM, it is possible to
compare bonds with different coupon rates and prices.
A bond's YTM can be calculated by using the bond pricing formula and solving for the
discount rate. If you know --
current price (B
0
), annual interest (I), par value (M), years to maturity (n)

YTM is the interest rate an investor would earn by investing every coupon payment from
the bond at a constant interest rate until the bonds maturity date.
A higher yield to maturity will have a lower present value or purchase price of a bond.

So, if you purchased a bond with a par value of $100 for $95.92 and it paid a coupon rate of 5%, this is how you'd calculate its current yield:



Bond trades at discount ...... when its coupon rate is less than the current yield or market
interest rates (its price will be below par).

Bond trades at premium ...... when its coupon rate is more than the current yield or market
interest rates (its price will be above par).

Bond Selling At . . .Satisfies This Condition
Discount: Coupon Rate < Current Yield < YTM
Premium :Coupon Rate > Current Yield > YTM
Par Value: Coupon Rate = Current Yield = YTM



As a bond gets closer to its maturity date, the
bond's price approaches par value. That is, the
shorter the time until a bond's maturity, the
less responsive is the bond's price to interest
rate changes.
For this reason, short-term debt has less
"interest rate risk" than long-term debt.
Examples
An AT&T bond (rated AAA) that pays semi-annual interest has a coupon
rate of 6.75% and 2.5 years until maturity
1. What should be its price where par is 100? Assume the following
current yields?
Answer 1
2. Assume now different maturities for the bond (current yield of 7.5%),
what is the price?
Answer 2
3. Assume now that the bond (maturing in 4.5 years) trades at the
following prices, what is the yield?
Answer 3

Answer 1 Answer 2 Answer 3
Current yield Bond price Maturity Bond price Bond price Yield
4.13% 106.18 2.5 years 98.32 97.18 7.50%
7.50% 98.32 4.5 years 97.18 106.53 5.11%
12.50% 87.97 19.0 years 92.47 94.1 8.35%
The Credit Spread
The credit spread, or quality spread, is
the additional yield an investor receives
for acquiring a corporate bond instead of
a similar federal instrument.

As illustrated in the graph, the spread is
demonstrated as the yield curve of the
corporate bond and is plotted with the
term structure of interest rates.

The term structure of interest rates is a gauge of the direction of interest rates and
the general state of the economy. Corporate fixed-income securities have more risk
of default than federal securities and, as a result, the prices of corporate securities
are usually lower, while corporate bonds usually have a higher yield.

Duration
The term duration has a special meaning in the context of bonds. It is
a measurement of how long, in years, it takes for the price of a bond to be repaid by its
internal cash flows. It is an important measure for investors to consider, as
bonds with higher durations carry more risk and have higher price volatility than bonds
with lower durations.

For each of the two basic types of bonds the duration is the following:


1. Zero-Coupon Bond
Duration is equal to its time
to maturity.

2. Vanilla Bond - Duration will
always be less than its time to
maturity.
Duration of a Vanilla or Straight Bond
Consider a vanilla bond that pays coupons annually and matures in five years. Its cash
flows consist of five annual coupon payments and the last payment includes the face
value of the bond.
The moneybags represent the cash flows you will receive over the five-year period. To
balance the red lever at the point where total cash flows equal the amount paid for the
bond, the fulcrum must be farther to the left, at a point before maturity. Unlike the zero-
coupon bond, the straight bond pays coupon payments throughout its life and therefore
repays the full amount paid for the bond sooner.
Factors Affecting Duration
Macaulay Duration
The formula usually used to calculate a bond\'s basic duration is the Macaulay duration,
which was created by Frederick Macaulay in 1938.
Macaulay duration is calculated by adding the results of multiplying the present value of
each cash flow by the time it is received and dividing by the total price of the security. The
formula for Macaulay duration is as follows:

n = number of cash flows
t = time to maturity
C = cash flow
i = required yield
M = maturity (par) value
P = bond price

Modified Duration
Modified duration is a modified version of the Macaulay model that accounts for changing
interest rates. Because they affect yield, fluctuating interest rates will affect duration, so
this modified formula shows how much the duration changes for each percentage change
in yield.


All three factors affect the degree to which bond price will change in the face of a change
in prevailing interest rates. These factors work together and against each other. Consider
the chart below:

So, if a bond has both a short term to maturity and a low coupon rate, its characteristics
have opposite effects on its volatility: the low coupon raises volatility and the short term
to maturity lowers volatility. The bond's volatility would then be an average of these two
opposite effects.
Properties of Convexity
Convexity is useful for comparing bonds. If two bonds offer the same duration and yield
but one exhibits greater convexity, changes in interest rates will affect each bond
differently. A bond with greater convexity is less affected by interest rates than a bond
with less convexity. Also, bonds with greater convexity will have a higher price than
bonds with a lower convexity, regardless of whether interest rates rise or fall. This
relationship is illustrated in the following diagram:

As you can see Bond A has greater convexity
than Bond B, but they both have the same price
and convexity when price equals *P and yield
equals *Y.
If interest rates change from this point by a very
small amount, then both bonds would have
approximately the same price, regardless of the
convexity. When yield increases by a large
amount, however, the prices of both Bond A and
Bond B decrease, but Bond B's price decreases
more than Bond A's.
Notice how at **Y the price of Bond A remains
higher, demonstrating that investors will have to
pay more money (accept a lower yield to
maturity) for a bond with greater convexity.

What Factors Affect Convexity?

Here is a summary of the different kinds of convexities produced by different types of bonds:

1) The graph of the price-yield relationship for a plain vanilla bond exhibits positive convexity. The price-yield curve will
increase as yield decreases, and vice versa. Therefore, as market yields decrease, the duration increases (and vice versa).

2) In general, the higher the coupon rate, the lower the convexity of a bond.Zero-coupon bonds have the highest convexity.

3) Callable bonds will exhibit negative convexity at certain price-yield combinations. Negative convexity means that as
market yields decrease, duration decreases as well.


Understanding even the most basic characteristics of convexity allows the
investor to better comprehend the way in which duration is best measured
and how changes in interest rates affect the prices of both plain vanilla and
callable bonds.

for callable bonds, modified duration can be used for an accurate estimate of
bond price when there is no chance that the bond will be called. In the chart
above, the callable bond will behave like an option-free bond at any point to
the right of *Y. This portion of the graph has positive convexity because, at
yields greater than *Y, a company would not call its bond issue: doing so
would mean the company would have to reissue new bonds at a higher
interest rate. Remember that as bond yields increase, bond prices are
decreasing and thus interest rates are increasing. A bond issuer would find it
most optimal, or cost-effective, to call the bond when prevailing interest rates
have declined below the callable bond's interest (coupon) rate. For decreases
in yields below *Y, the graph has negative convexity, as there is a higher risk
that the bond issuer will call the bond. As such, at yields below *Y, the price
of a callable bond won't rise as much as the price of a plain vanilla bond.