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Bonds Explained

Bonds Explained

What is a bond?

When a business uses financial markets to raise debt capital rather than equity, (shares), the instrument or product frequently used is a bond. A bond is a long term debt obligation of the borrower or issuer. The bond purchaser is called the investor.

Bonds allow issuers to increasing balance sheet leverage. In liquidation bond investors normally rank prior to equity holders but are behind or subordinated to secured lenders.

There are certain terms that apply to a bond the main ones include the following:

  • Principal: This is the amount of money the investor will receive on maturity. It is also the amount on which interest payments are calculated.

  • Coupon: The coupon is the regular interest that is paid to the investor by the issuer. The frequency can be annually, semi annually or quarterly. Coupons can be fixed rate or floating rate, (more on this later). From an issuer's perspective coupon payments are normally deductible before tax whereas equity dividends are not.

  • Maturity: This is the date on which the investor will expect to receive repayment of the principal sum invested. Typically bonds have maturities of between 2 and 30 years. However there are bonds with longer maturities and some that never mature, (known as irredeemable or perpetual bonds).

  • Currency: The bond will have a specified currency, the majority of bonds are issued in the major currencies, USD. EUR and JPY.

Why issue a bond?

The main reason for issuing a bond is to arrange cheap long term financing. Bond markets offer issuers one of the cheapest ways of borrowing. This is because capital markets are relatively efficient and this keeps transaction costs and spreads to a minimum. It is also the reason why bond markets have grown at the expense of traditional bank lending.

Are there any other reasons for bond issuance? Yes, many borrowers rely on frequent and diversified access to capital markets. Diversification, (in theory), means they are less reliant on one single source of funding. Issuing bonds with different currencies, coupons and maturities will attract different investors thereby spreading the issuer's source of funds.

Why buy a bond?

Investors buy bonds because they need to obtain a return on their money and their investment horizon is medium or long term. Furthermore they consider the return they get is attractive relative to the risk they are taking. The main risk is not receiving timely repayments of interest and principal.

The demand for and supply of bonds therefore provides you with bond market prices and in this respect bond markets are the same as any other market place.

Two types of bond

Whilst bonds can come in all "shapes and sizes" there are two main types. They are fixed rate bonds, (also known as fixed income) and floating rate bonds, (normally known as floating rate notes). The names are derived from their coupon payments.

Fixed Income Bonds

Fixed income bonds pay an investor regular, known coupons. The frequency of the coupon payments can be quarterly, semi-annually or annually. The interest is often calculated on a 30/360 basis, that is using 12 months with each month containing 30 days.

An investor buying a fixed income security is really buying a series of future cash flows, (the coupons and principal).

Investors and traders judge the value of a fixed income bond by calculating its yield. This is an internal rate of return calculation. It is the rate of interest, that when used, discounts all the bond cash flows to give a net present value of zero; the higher the yield, the higher the rate of return.

But to fully evaluate whether the bond is good value an investor must consider the risk. The main risk is credit risk. Bonds with higher credit risk provide investors with greater yields.

Floating rate notes, (FRNs)

FRNs also pay regular coupons but this time the payment is variable rate. Typically every three or six months the coupon is "refixed" using the prevailing 3 or 6 month Libor rate.

This means that when short term rates rise, on the next interest refixing date, the coupon will increase. When rates go down the coupon falls.

The investment return on a FRN is therefore similar to that on a bank deposit that is rolled over every three months. For this reason many people regard FRNs as money market instruments despite the fact that FRNs typically have maturities of between 2 and 20 years.

The interest calculation for the coupon payment is normally on a money market basis, (actual 360).

Investors and traders judge the value of a floating rate note by calculating its discount margin. For example if a 5 year FRN is priced at 99% and pays a coupon of Libor it will give the investor a 1% capital gain on maturity. If the 1% is spread out over 5 years that is the equivalent of 20 basis points per annum on simple basis and, (using 5%), 23 basis points on a compound basis. The FRN therefore has an implied return of Libor + 23 basis points.

Just like fixed rate bonds the return will be higher for FRNs that are less creditworthy.

What's the main difference between the two bonds?

Fixed rate bonds give you a known interest payment. Some investors prefer this, pension funds for example can use fixed rate bonds to match future liabilities.

But it also means that when interest rates increase the value of a fixed coupon bond falls. This is simple math, the present value of the future cash flows falls as interest rates go up. For longer dated fixed income bonds the effect of rising interest rates on the bond price is greater (this is because there are more cash flows to be discounted).

Floating rate notes give you a return that is dependent on short term Libor rates. Some investors prefer this. Banks for example often buy FRNs because the coupon income matches their funding cost. It also means that FRNs experience lower price volatility in respect of changing interest rates. This is a "good thing" if rates increase but you forgo capital gains should interest rates fall.

How important is liquidity?

Liquidity also plays a part in bond prices. Liquid bonds are those that can be sold easily with the minimum of transaction costs. From a liquidity perspective some bonds are just better than others. In general high quality bonds that have large issuance sizes are the most liquid. Investors will pay relatively more for them.

What is the clean & dirty price?

When dealers buy and sell bonds they agree the price at which the transaction is done. In most bond markets, with a few exceptions, this price is known as the "clean price". The clean price excludes the bond's accrued interest. The accrued interest on a bond is the daily amount of money that accrues to the holder of the bond between the coupon dates.

When the settlements department pays or receives the cash value of the bond the accrued interest is added to the clean price in order to work out the "dirty price" which is also the settlement value. That means if you buy a bond half way through the time period between one coupon and the next you must pay for the interest already accrued, which in this case is half the coupon. The exact calculation for accrued interest will depend on the day count convention that applies to the bond's coupon.

What is a medium term note, (MTN)?

A MTN is a bond that has been issued under a flexible programme. There is an information memorandum that explains the purpose of the programme, the amount of outstanding debt that can be issued and the financial details of the issuer. The information memorandum is provided to investors and is updated annually.

Bonds issued under MTN programmes can have different currencies, coupons, maturities. They may also contain embedded risks like calls and puts. This means that an issuer can use an MTN programme to structure a bond that exactly meets the investor's requirements. For this reason MTNs are very popular with both issuers and investors.

First published by Barbican Consulting Limited 2007

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