Download Fixed rate bonds

JJ Mois Année
Julie CHAM
ITEC/FIC/TTS/ECN
BONDS & FLOATERS
BONDS
 Definition – Concepts
 Bond Rating Agencies (Moody's and Standard & Poor's)
 Features of Bonds
 Types of bonds
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Fixed Rate Bonds
Zero Coupon Bonds
High Yield Bonds
Convertible Bonds
Step-up (down) Bonds
Floating Rate Notes
 Duration indicators
 Annexe : Main Financial Markets
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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.
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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.
Moody's
S&P
Meaning
Investment Grade Bonds
Aaa
AAA
Bonds of the highest quality that offer the lowest degree of
investment risk.
Aa1, Aa2, Aa3
AA+, AA, AA-
Bonds are of high quality by all standards, but carry a slightly
greater degree of long-term investment risk.
Non Investment Grade Bonds (Junk Bonds)
Ba1, Ba2, Ba3
BB+, BB, BB-
Bonds with speculative fundamentals. The security of future
payments is only moderate.
C
C
Lowest rated class of bonds
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Features of Bonds (1)
 The Issuer :
 Government bonds : issued by a national government and 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.
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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.
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Features of Bonds (3)
 Coupon Rate : 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.
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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.
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Bond Price Formula :
 Price of any financial instrument = the Net Present Value (NPV) of all future cash flows
discounted 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!
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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)
2.3
1Y
2.3
2Y
2.3
3Y
2.3
4Y
102.3
2.3
-----
20Y
98.2
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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.
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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.
1Y
2Y
3Y
1000
4Y
-----
20Y
600
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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.
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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.
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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
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Floating Rate Notes (Floaters)
 Example : a 3-year FRN
 Coupon resets and pays every 6month
 Reference rate : 6month Libor
 Quoted Margin : 52bp semi-annually
FRN issued at par
100
6M
12M
18M
24M
30M
36M
100
Floating coupons of Libor plus 52bp paid semi-annually
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Floating Rate Notes (Floaters)
 Next coupon rate value ?
spot Lag :
Libor 6M fixed
spot Lag :
Libor 6M fixed
Next Coupon fixed
Current Coupon fixed
- 2j
PrevCpnDate
Today
6M
Maturity
- 2j
NextCpnDate
Current Coupon paid
NextCpnDate + 6M
Next Coupon paid
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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%
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Annexe : Main Financial markets
 They facilitate :
 The raising of capital in the Capital markets (Long term)
• Stock markets
• Bond markets
Primary market : new issues
exchanges
Secondary market : aldready issued
Over-the-counter
 The transfert of risk int the Derivatives markets
 The international trade in the Currency markets (Foreign exchange or Forex)
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