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  • Writer's pictureWilliam Webster

How Do Fixed Coupon Bonds Work?

A bond represents a long-term debt agreement. When entities need to raise capital for extended periods, they issue bonds. Generally, bonds mature anywhere from 2 to 20 years. Various entities, like banks, corporations, or governmental bodies, can issue them. Throughout its tenure, a bond offers periodic interest payments to the bondholder, known as "coupons". In a scenario where the issuing entity faces liquidation, bondholders get priority over shareholders, though they rank below secured lenders. For the issuer, the advantage is that these coupon payments are often tax-deductible, a benefit not applicable to dividend payouts. The bond market offers a diverse range of options, and among the most common is the fixed coupon bond, alternatively known as fixed income security or fixed rate bond.

Fixed Coupon Bonds

These bonds guarantee a preset or determined coupon rate to the bondholder. Typically, bondholders receive these interest payments annually or biannually, but some bonds also offer quarterly payments. The interest rate for fixed coupon bonds is established when the bond is first issued, providing investors with a clear projection of their returns. This predictability appeals to many investors, especially those with future financial obligations. Upon reaching its maturity date, the bond's principal amount gets returned to the investor. For detailed specifics about the bond, including coupon rates and repayment schedules, investors can refer to the bond's informational document or term sheet. For instance, the cash flow from a straightforward 5-year bond would appear as follows:

If this bond had a principal amount of $10,000,000 and a 5% coupon then the cash payments would be as follows:

Understanding Bond Transactions

When an investor decides to purchase a bond, they invest an upfront amount - let's say $10,000,000 in this scenario. Over the bond's life, they receive periodic returns, in this case, a $500,000 coupon. At the end of the fifth year, the initial investment of $10,000,000 is returned. Fixed-interest bonds typically use a "bond basis" for their coupons, which assumes every month has 30 days, regardless of the actual number of days in a month. This unique method can complicate accrued interest calculations, especially given the various conventions for addressing accrued interest at month's end.

Deciphering Bond Pricing

In the given example, the bond's price stands at 100%, often termed as "par". However, in the real market, dealers might trade bonds at prices above or below this par value. To simplify: if the bond trades at 102%, the investor shells out $10,200,000 ($10,000,000 x 102%). Conversely, if it trades at 98%, the investment cost is $9,800,000.

The deviation from the par value arises due to various reasons. A bond with a higher coupon rate in a low-interest environment will likely trade above 100%. This is because it promises better returns compared to the prevailing market rates. On the other hand, bonds with lower coupon rates than the prevailing market interest rates often trade below par. Additionally, the bond's credit risk, or the risk associated with the issuer defaulting, plays a significant role. If investors sense an increased risk, the bond price may decline, adjusting for the added risk.

When bonds trade, dealers settle on the "clean price", which doesn't account for any accrued interest. However, during settlement, the operations department adds the accrued interest to the clean price, deriving the "dirty price" or the final amount. This accrued interest represents the interest accumulated since the last coupon payment. In essence, the buyer reimburses the seller for the interest earned up to the sale date and then recoups this amount during the next coupon payment.

For clarity, consider this: if a bond with a $500,000 coupon is traded midway through its coupon period, the accrued interest stands at $250,000:

This would then be added to the clean price agreed between the dealers in order to obtain the settlement price.

Evaluating Bond Value

When an individual purchases a fixed coupon bond, in essence, they're acquiring a series of cash payouts, committed to by the issuer. This arrangement inherently comes with a credit risk regarding the issuer's punctuality in coupon payments and the return of the principal amount.

For those in the investing and trading sectors, the value of a fixed coupon bond is determined by computing its yield to maturity (YTM). This can be thought of as the bond's inherent return rate. Essentially, it's the interest rate that, when applied, discounts all the bond's future cash flows to present a net present value (NPV) of zero.

A critical point to remember is that a higher yield correlates with a higher return rate. To exemplify the correlation between a bond's price and its yield, consider the following:

This bond has a price of 100% and a yield of 5.00%:

This bond has a price of 98% and a yield of 5.47%:

This bond has a price of 102% and a yield of 4.54%:

Assessing Bond Value and Risks

From the given examples, a discernible pattern emerges: when the bond price is lower, its yield is typically higher. This is because the bondholder still receives the predetermined interest payments but has made a smaller initial investment.

However, evaluating a bond's worth doesn't solely hinge on its yield. The associated risks, especially credit risk, play a paramount role. Bonds characterised by a higher credit risk usually offer more attractive yields as a compensatory measure for the added risk.

Dealers predominantly rely on yield for drawing comparisons between bonds. Ideally, two bonds with comparable maturity lengths and risks should possess analogous yields. However, real-world scenarios deviate from this ideal. Certain bonds can be undervalued, resulting in a higher yield, while others might be overvalued, leading to a diminished yield. Traders are always on the lookout for such disparities, aiming to purchase undervalued bonds and offload overvalued ones—a strategy colloquially known as "relative value trading".

Navigating Interest Rate Risks

Fixed coupon bond prices are intrinsically tethered to interest rate fluctuations. A rise in interest rates usually precipitates a decline in fixed-income bond prices, as the future cash flows associated with these bonds are discounted at this heightened rate.

The adverse effects of rising interest rates are more pronounced for bonds with extended maturity dates and lower coupons. Such bonds expose investors to heightened interest rate risks. Consequently, anyone considering an investment in fixed coupon bonds should be acutely aware of potential interest rate vulnerabilities. To measure and manage this risk, investors can employ various quantitative methodologies like duration, basis point value, and value at risk.

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