Basic Information Handout

8/14/2019 Basic Information Handout

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Bonds

B a s i c I n f o r m a t i o n H a n d o u t

B y - T a r i q M u m t a z


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Definitions

A bond is simply a loan in the form of a security with different terminology: The issuer is equivalent to theborrower, the bondholder to the lender, and the coupon to the interest.

Bonds enable the issuer to finance long-term investments with external funds. Bonds and stocks are bothsecurities, but the major difference between the two is that stockholders are the owners of the company (i.e.,they have an equity stake), whereas bondholders are lenders to the issuing company.

As per wikipedia.orgA debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing.The Federal government, states, cities, corporations, and many other types of institutions sell bonds.Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date(maturity).

As per investorwords.com

A debt investment in which an investor loans money to an entity (corporate or governmental) that borrowsthe funds for a defined period of time at a fixed interest rate. Companies, municipalities, states and U.S. andforeign governments to finance a variety of projects and activities use bonds.

Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate.Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipalsare typically in the three to 10-year range.

As per investopedia.com

When it comes down to it, a bond is simply acontract between a lender and a borrower bywhich the borrower promises to repay a loanwith interest. However, bonds can take on manyadditional features and/or options that cancomplicate the way in which prices and yieldsare calculated. The classification of a bonddepends on its type of issuer, priority, couponrate and redemption features.

1) Bond Issuers As the major determiner of a bond's creditquality, the issuer is one of the most importantcharacteristics of a bond. There are significantdifferences between bonds issued bycorporations and those issued by a stategovernment/municipality or nationalgovernment. In general, securities issued by thefederal government have the lowest risk ofdefault while corporate bonds are considered

riskier ventures.

2) CUSIP NumberCUSIP stands for Committee on UniformSecurities Identification Procedures. Formed in1962, this committee developed a system thatidentifies securities, specifically U.S. andCanadian registered stocks, and U.S.government and municipal bonds.


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The CUSIP number consists of a combination of nine characters, both letters and numbers, which act as asort of DNA for the security - uniquely identifying the company or issuer and the type of security. The firstsix characters identify the issuer and are assigned in an alphabetical fashion; the seventh and eighthcharacters (which can be alphabetical or numerical) identify the type of issue; and the last digit is used as acheck digit.

3) Par ValuePar value, in finance and accounting, means stated value or face value. In the U.S. bond markets, a bond is

worth its par value when the price is equal to the face value. A Treasury note is denominated in units of$1,000. The par values for different fixed-income products will vary. Bonds generally have a par value of$1,000, while most money market instruments have higher par values.

A par value of 100.00 for a note or bond means only that the note or bond is selling for the face value paidupon maturity of the note or bond. It can (and does) have different absolute values per Note or Bonddepending on the conventions of the particular market and country in which such par value is quoted

4) Annual Interest Rate or CouponA coupon is the stated interest rate for a bond. Most bonds have a fixed coupon that does not change duringthe life of the bond. Most bonds have two coupon payments per year. For example, a bond with a 5.0%coupon pays $25 twice per year, for total interest of $50, which is 5.0% of the face value of the bond (almostall bonds have a face value of $1,000).

5) Maturity DateThe maturity date of a bond is the date on which the bond will be repaid. Note that many bonds havefeatures such as puts and calls that can cause the principal to be repaid on an earlier date.

6) First Coupon DateBonds typically pay interest twice per year on coupon payment dates. The first coupon date is the date onwhich the very first interest payment is made for a bond. It is relevant because bonds often have a longer orshorter than normal first payment period. When the first coupon payment has been made, the bond willlikely pay every 6 months thereafter.

7) Coupon Payment FrequencyThe pay frequency refers to the frequency that the bond pays interest. The most common pay frequency issemi-annually (twice per year), but bonds can also pay interest monthly, quarterly, annually, or at maturity.

8) Trustee & Paying AgentAn agent who makes dividend payments to stockholders or principal and interest payments to bondholderson behalf of the issuer of those stocks or bonds. Also known as a "disbursing agent." A bank is usually thepaying agent designated to make dividend, coupon, and principal payments to the security holder on behalfof the issuer.


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Characteristics & Features of Bonds

The following chartoutlines thesecategories of bondcharacteristics

Nominal, Principal or Face AmountThe amount on which the issuer pays interest, and which has to be repaid at the end.

Issue PriceThe price at which investors buy the bonds when they are first issued, typically $1,000.00. The net proceedsthat the issuer receives are calculated as the issue price, less issuance fees, times the nominal amount.

Maturity DateThe date on which the issuer has to repay the nominal amount. As long as all payments have been made, theissuer has no more obligations to the bondholders after the maturity date. The length of time until thematurity date is often referred to as the term, tenure, or maturity of a bond.

The maturity can be any length of time, although debt securities with a term of less than one year aregenerally designated money market instruments rather than bonds. Most bonds have a term of up to thirtyyears. Some bonds have been issued with maturities of up to one hundred years, and some even do notmature at all.

1. Short term (bills): maturities up to one year;

2. Medium term (notes): maturities between one and ten years;

3. Long term (bonds): maturities greater than ten years.

CouponThe interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the

bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The namecoupon originates from the fact that in the past, physical bonds were issued which coupons had attached tothem. On coupon dates, the bondholder would give the coupon to a bank in exchange for the interestpayment.

Coupon DatesThe dates on which the issuer pays the coupon to the bondholders. In the U.S., most bonds are semi-annual,which means that they pay a coupon every six months. In Europe, most bonds are annual and pay only onecoupon a year.


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Indentures and CovenantsAn indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are theclauses of such an agreement. Covenants specify the rights of bondholders and the duties of issuers, such asactions that the issuer is obligated to perform or is prohibited from performing.

Optionality -A bond may contain an embedded option1; that is, it grants option-like features to theholder or the issuer.

Callability -some bonds give the issuer the right to repay the bond before the maturity date on the

call dates. These bonds are referred to as callable bonds. Most callable bonds allow the issuer torepay the bond at par.

Putability - Some bonds give the holder the right to force the issuer to repay the bond before thematurity date on the put dates; see put option.

Convertibility - convertible bond lets a bondholder exchange a bond to a number of shares of theissuer's common stock.

Call dates and put datesThe dates on which callable and putable bonds can be redeemed early. There are four main categories.

PriorityIn addition to the credit quality of the issuer, the priority of the bond is a determiner of the probability thatthe issuer will pay you back your money. The priority indicates your place in line should the companydefault on payments.

If one holds an unsubordinated (senior) security and the company defaults, you will be first in line to receivepayment from the liquidation of its assets. On the other hand, if you own a subordinated (junior) debtsecurity, you will be paid out only after the senior debt holders have received their share.

1An option is a contract written by a seller that conveys to the buyer the right but not the obligation to buy (in the case of a call option) or to sell(in the case of a put option) a particular asset, such as a piece of property, or shares of stock or some other underlying security, such as, among others,a futures contract. In return for granting the option, the seller collects a payment (the premium) from the buyer.

For example, buying a call option provides the right to buy a specified quantity of a security at a set strike price at some time on or before expiration,while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wr ote, the option mustfulfill the terms of the contract.


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Types of Bonds

Bonds can be classified based on two benchmarks.

A- Issuing PartyB- Classification on Characteristics (Interest Rate, Coupon rate, maturity and Securitization)

(A.1) Corporate Bond A Corporate Bond is a bond issued by a corporation. The term is usually applied to longer-term debtinstruments, generally with a maturity date falling at least a year after their issue date. Sometimes, theterm "corporate bonds" is used to include all bonds except those issued by governments in their owncurrencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of localauthorities and supranational organizations do not fit in either category.

Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before itsmaturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into equity. Thecoupon (i.e. interest payment) is usually taxable. Sometimes this coupon can be zero with a high redemptionvalue.

Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends,

of course, upon the particular corporation issuing the bond, the current market conditions and governmentsto which the bond issuer is being compared and the rating of the company. Corporate bondholders arecompensated for this risk by receiving a higher yield than government bonds. Corporate bonds are oftenlisted on major exchanges and ECNs2. However, despite being listed on exchanges, the vast majority oftrading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based,over-the-counter markets.

(A.2) Government BondsA government debt obligation (local or national) backed by the credit and taxing power of a country withvery little risk of default. In other words Government bonds are Treasury securities issued government ofthe country, these are fixed income security They are the debt financing instruments of the Federalgovernment, and they are often referred to simply as Treasuries or Treasurys.

The bonds issued by the government are generally considered to be a safe option. The government bonds ofthe developed countries are generally regarded as the more secured ones than the developing or theunderdeveloped ones.

Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from ten years to thirty years. Theyhave coupon payment every six months like T-Notes, and are commonly issued with maturity of thirty years.Like other securities, individual issues of T-bills are identified with a unique CUSIP number. These too areof different categories and are differentiated from one another in accordance with their respective time spanfor maturity. There are four types of marketable treasury securities:

TTrreeaassuurryy BBiillllss

- Treasury bills (or T-bills) mature in one year or less. Like zero-coupon bonds, they do notpay interest prior to maturity; instead, they are sold at a discount of the par value to create a positive yield

to maturity. Many regard Treasury bills as the least risky investment available to U.S. investors.

Regular weekly T-bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52 weeks,about 1 year). Treasury bills are sold by single price auctions3 held weekly.

2 An electronic communication network ('ECN) is the term used in financial circles for a type of computer system that facilitates trading of financial

products outside of stock exchanges. The primary products that are traded on ECNs are stocks and currencies. ECNs came into existence in 1998 whenthe SEC authorized their creation. ECNs increase competition among trading firms by lowering transaction costs, giving clients full access to their orderbooks, and offering order matching outside of traditional exchange hours.

3 Investors making competitive bids specify the rate or yield they are willing to receive for the use of their funds. Successful bidders pay the priceequivalent to the highest accepted rate or yield regardless of the rate or yield they bid. All Treasury securities auctions are now single-price.


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Like other securities, individual issues of T-bills are identified with a unique CUSIP 4 number. Banks andfinancial institutions, especially primary dealers, are the largest purchasers of T-bills.

Treasury bills are quoted for purchase and sale in the secondary market on an annualized percentage yieldto maturity, or basis. With the advent of TreasuryDirect5, individuals can now purchase T-Bills online, havefunds withdrawn from and deposited directly to their personal bank account, and earn higher interest rateson their savings.

General calculation for yield on Treasury bills is

TTrreeaassuurryy NNoottee --Treasury notes (or T-Notes) mature in two to ten years. They have a coupon paymentevery six months, and are commonly issued with maturities dates of 2, 3, 5 or 10 years, for denominationsfrom $100 to $1,000,000.

The 10-year Treasury note has become the security most frequently quoted when discussing the performanceof the U.S. government-bond market and is used to convey the market's take on longer-term macroeconomic

expectations.

T-Notes and T-Bonds are quoted on the secondary market at percentage of par in thirty-seconds of a point.Thus, for example, a quote of 95:07 on a note indicates that it is trading at a discount: $952.19 (i.e. 95 7/32%)for a $1,000 bond. The example of 95 and 7/32 points may be written as 95:07, or 95-07, or 95'07, ordecimalized as 95.21875.) Other notation includes a +, which indicates 1/64 points and a third digit may bespecified to represent 1/256 points. Examples include 95:07+, which equates to (95 + 7/32 + 1/64) and 95:073,which equates to (95 + 7/32 + 3/256). Notation such as 95:073+ is unusual and not typically used.

TTrreeaassuurryy BBoonnddss --

Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from ten years tothirty years. They have coupon payment every six months like T-Notes, and are commonly issued withmaturity of thirty years.

As the U.S. government used its budget surpluses to pay down the Federal debt in the late 1990s, the 10-year Treasury note began to replace the 30-year Treasury bond as the general, most-followed metric of theU.S. bond market.

However, due to demand from pension funds and large, long-term institutional investors, along with a needto diversify the Treasury's liabilities - and also because the flatter yield curve meant that the opportunitycost of selling long-dated debt had dropped - the 30-year Treasury bond was re-introduced in February 2006and is now issued quarterly. Some countries, including France and the United Kingdom, have begun offeringa 50-year bond, known as a Methuselah.

4The acronym CUSIP typically refers to both the Committee on Uniform Security Identification Procedures and the 9-character alphanumeric securityidentifiers that they distribute for all North American securities for the purposes of facilitating clearing and settlement of trades. The CUSIP distributionsystem is owned by the American Bankers Association and is operated by Standard & Poor's. The CUSIP Services Bureau acts as the NationalNumbering Association (NNA) for North America, and the CUSIP serves as the National Securities Identification Number for products issued from boththe United States and Canada.

5TreasuryDirect is a website run by the United States Treasury, allowing individual investors to purchase Treasury securities such as T-Bills and otherdirectly from the U.S. government. Its website allows money to be deposited from and withdrawn to personal bank accounts, and allows rollingrepurchase of securities as the currently held items mature.

Treasury offers product information and research across the entire line of Treasury Securities, from Series EE Savings Bonds to Treasury Notes. NewTreasuryDirect accounts offer Treasury Bills, Notes, Bonds, Inflation-Protected Securities (TIPS), and Series I and EE Savings Bonds in electronic formin one account.


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TTrreeaassuurryy IInnffllaattiioonn PPrrootteecctteedd SSeeccuurriittiieess ((TTIIPPSS)) --

ot be tax exempt.

minimum tax.urchasers of municipal bonds should be aware that not all municipal bonds are tax-exempt.

Treasury Inflation-Protected Securities (or TIPS) arethe inflation-indexed bonds issued by the U.S. Treasury. These securities were first issued in 1997.

The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The couponrate is constant, but generates a different amount of interest when multiplied by the inflation-adjustedprincipal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 10-year and 20-year maturities. 30-year TIPS are no longer offered.

In addition to their value for a borrower who desires protection against inflation, TIPS can also be a usefulinformation source for policy makers: the interest-rate differential to pay additional taxes on the inflation-adjusted principal. The details of this tax treatment can have unexpected repercussions. (See tax on theinflation tax.)

By comparing a TIPS bond with a standard nominal Treasury bond across the same maturity dates,investors may calculate the bond market's expected inflation rate by applying the Fisher equation.

Example: If the annual coupon of the bond was 5% and the underlyingprincipal of the bond was 100 units, the annual payment would be 5 units. Ifthe inflation index increased by 10%, the principal of the bond wouldincrease to 110 units. The coupon rate would remain at 5%, resulting in aninterest payment of 110 x 5% = 5.5 units.

(A.3) Municipal Bonds A municipal bond is a bond issued by a city or other localgovernment, or their agencies. Potential issuers of municipalbonds include cities, counties, redevelopment agencies, schooldistricts, publicly owned airports and seaports, and any othergovernmental entity (or group of governments) below the statelevel.

States, cities, and counties, or their agencies (the municipalissuer) to raise funds issue municipal bonds. The methods and

practices of issuing debt are governed by an extensive system oflaws and regulations, which vary by state. Bonds bear interest ateither a fixed or variable rate of interest, which can be subject toa cap known as the maximum legal limit.

The issuer of a municipal bond receives a cash payment at thetime of issuance in exchange for a promise to repay the investorswho provide the cash payment (the bond holder) over time.Repayment periods can be as short as a few months (althoughthis is rare) to 20, 30, or 40 years, or even longer.Municipal bonds may be general obligations of the issuer orsecured by specified revenues. Interest income received byholders of municipal bonds is often exempt from the federal

income tax and from the income tax of the state in which they areissued, although municipal bonds issued for certain purposes maynOne of the primary reasons municipal bonds are considered separately from other types of bonds is theirspecial ability to provide tax-exempt income. Interest paid by the issuer to bond holders is often exempt fromall federal taxes, as well as state or local taxes depending on the state in which the issuer is located, subjectto certain restrictions. Bonds issued for certain purposes are subject to the alternativeP


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Because municipal bonds are most often tax-exempt, comparing the coupon rates of municipal bonds tocorporate or other taxable bonds can be misleading. Taxes reduce the net income on taxable bonds, meaning

at a tax-exempt municipal bond has a higher after-tax yield than a corporate bond with the same coupon

This relationship can be demonstrated mathematically, as follows:

thrate.

Where :

terest rate of comparable corporate bond, t = tax rate

For example if rc = 10% and t = 38%, then

rm = interest rate of municipal bond, rc = in

(A.4) Agency BondsA bond, issued by a U.S. government-sponsored agency. The offerings of these agencies are backed by the

.S. government, but not guaranteed by the government since the agencies are private entities. Such

ae), Federalational Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).

Government (making their risk of default virtually asw as Treasury bonds), while GSEs are private corporations that hold government charters granted because

(implicit or explicit), agency bonds trade at a yield premium

pread) above comparable Treasury bonds. There are a couple reasons why investors should expect thishig

al risk, however slight, stemming from political risk that the governmentguarantee of agency debt could be modified or revoked in the future, leaving the bonds more

ther very large institutions requiring the ability to buy or sell securities in vastquantities very quickly and efficiently. Agencies, on the other hand, are neither quite as liquid nor as

t not federal tax. While coupon payments onebt from the most well known agencies (Fannie Mae and Freddie Mac) are taxable on both the federal andtate level, other agencies are taxable only on the federal level.

tm

U

agencies have been set up in order to allow certain groups of people to access low cost financing.

Some prominent issuers of agency bonds are Student Loan Marketing Association (Sallie MNThese bonds are not fully guaranteed in the same way as U.S. Treasury and municipal bonds.

Not all agency bonds are issued by government agencies; indeed, the largest issuers are not agencies per se,but rather government sponsored entities (GSEs). This is an important distinction, as true agencies areexplicitly backed by the full faith and credit of the U.S.lotheir activities are deemed important to public policy.

Although they carry a government guarantee

(sher yield in agency bonds over Treasuries:

There is some addition

susceptible to default.

Treasury bonds are arguably the most liquid financial instrument on the planet, and are used bycentral banks and o

efficient to trade.

Agency bonds are usually exempt from state and local taxes, buds

How Treasury Auction Work: http://www.treasurydirect.gov/instit/auctfund/work/work.h

Features and Risks of TIPS: http://www.kc.frb.org/Publicat/econrev/PDF/1q98Shen.pdf
http://www.kc.frb.org/Publicat/econrev/PDF/1q98Shen.pdfhttp://www.kc.frb.org/Publicat/econrev/PDF/1q98Shen.pdf


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(B.1) Fixed Rate BondIn finance, a fixed rate bond is a bond with a fixed coupon (interest) rate, as opposed to a floating rate note.

A fixed rate bond is a long term debt paper that carries a predetermined interest rate. The interest rate isnown as coupon rate and interest is payable at specified dates before bond maturity.

riod, the coupon is calculated by taking the fixing of the reference

(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) areportant issuers.

ts, but typically pay higher yields than better quality bonds in order to make them attractive to

es issued

isk, default risk,

ent grade on their date of issue are called speculative grade bonds, derisively referred to as "junk"onds.

ar level. As a result, the lower-rated securities have a different investor base than investment-grade

k

(B.2) Floating Rate BondsFloating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate,like LIBOR or federal funds rate6, plus a spread. The spread is a rate that remains constant. Almost all

FRNs have quarterly coupons, i.e. they pay out interest every three months, though counter examples doexist. At the beginning of each coupon perate for that day and adding the spread.

Government sponsored enterprises (GSEs) such as the Federal Home Loan Banks, the Federal NationalMortgage Associationim

Example: Suppose a new 5 year FRN pays a coupon of 3 months LIBOR +0.20%,and is issued at par (100.00). If the perception of the credit-worthiness of the issuergoes down, investors will demand a higher interest rate, say LIBOR +0.25%.

coupon and the price thatwas agreed (0.07%), multiplied by the maturity (5 year).

Therefore, a dealer would then make a market of 27 / 25.

This means, that he would buy bonds at the equivalent of LIBOR +0.27%, and sell atthe equivalent of LIBOR +0.25%. If a trade is agreed, the price is calculated. In thisexample, LIBOR +0.27% would be roughly equivalent to a price of 99.65. This canbe calculated as par, minus the difference between the

(B.3) High Yield BondA high yield bond (non-investment grade bond, speculative grade bond or junk bond) is a bond that is ratedbelow investment grade at the time of purchase. These bonds have a higher risk of default or other adversecredit even

investors.

Global issuance of high yield bonds more than doubled in 2003 to nearly $146 billion in securitifrom less than $63 billion in 2002, although this is still less than the record of $150 billion in 1998.

The holder of any debt is subject to interest rate risk and credit risk, inflationary risk, currency risk,duration risk, convexity risk, repayment of principal risk, streaming income risk, liquidity rmaturity risk, reinvestment risk, market risk, political risk, and taxation adjustment risk.

A credit rating agency attempts to describe the risk with a credit rating such as AAA. In North America, thefive major agencies are Standard and Poor's, Moody's, Fitch Ratings, Dominion Bond Rating Service and

A.M. Best. Bonds rated BBB- and higher are called investment grade bonds. Bonds rated lower thaninvestmbThe lower-rated debt typically offers a higher yield, making speculative bonds attractive investment vehiclestypes of financial portfolios and strategies. Many pension funds and other investors (banks, insurancecompanies), however, are prohibited in their by-laws from investing in bonds which have ratings below aparticulbonds.

6 The federal funds rate is the interest rate at which private depository institutions (mostly banks) lend balances at the Federal Reserve to otherdepository institutions, usually overnight. The federal funds rate target is decided by the governors at Federal Open Market Committee (FOMC) meetings.The FOMC members will either increase, decrease, or leave the rate unchanged depending on the meeting's agenda and the economic conditions of theU.S.


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(B.4) Zero Coupon BondA Zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lowerthan its face value, with the face value repaid at the time of maturity. It does not make periodic interestpayments, or so-called "coupons," hence the term zero-coupon bond. Investors earn return from thecompounded interest all paid at maturity plus the difference between the discounted price of the bond and

ings bonds, long-term zero-coupon bonds,

the interest rate,lities.

its par (or redemption) value.

Examples of zero-coupon bonds include U.S. Treasury bills, U.S. sav

and any type of coupon bond that has been stripped of its coupons.

Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typicallystart at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets. Short-term zero coupon bonds generally have maturities of less than one year and are called bills. Pension fundsand insurance companies like to own long maturity zero coupon bonds because of the bonds' high duration.This high duration means that these bonds' prices are particularly sensitive to changes inand therefore offset, or immunize the interest rate risk of these firms' long-term liabi

SSTTRRIIPPSS ((SSeeppaarraattee TTrraaddiinngg ooffRReeggiisstteerreedd IInntteerreesstt aanndd PPrriinncciippaall SSeeccuurriittiieess))

may receive the principal and each

f the coupon payments. This creates a supply of new zero coupon bonds.

nown as striponds. "STRIPS" stands for Separate Trading of Registered Interest and Principal Securities.

bonds. A strip bond has no reinvestment risk because the payment to the investor only occurs ataturity.

8, government-issued inflation-linked bonds comprise over $1.5illion of the international debt market.

ts of sovereign debt, with privately issued inflation-linked bondsonstituting a small portion of the market.

er equation. A rise in coupon payments is a result of an increase in inflation expectations,

ther important inflation-linked markets are the UKndex-linked Gilts with over $300 billion outstanding

Zero coupon bonds have a duration equal to the bond's time to maturity, which makes them sensitive to anychanges in the interest rates. Investment banks or dealers may separate coupons from the principal ofcoupon bonds, which is known as the residue, so that different investors

oThe coupons and residue are sold separately to investors. Each of these investments then pays a single lumpsum. This method of creating zero coupon bonds is known as stripping and the contracts are kbDealers normally purchase a block of high quality and non-callable bondsoften government issuestocreate stripm

(B.5) Inflation-Indexed BondsInflation-indexed bonds are bonds where the principal is indexed to inflation. They are thus designed to cutout the inflation risk of an investment. The Massachusetts Bay Company issued the first known inflation-indexed bond in 1780. The market has grown dramatically since the British government began issuinginflation-linked Gilts in 1981. As of 200trThe inflation-linked market primarily consiscInflation-indexed bonds pay a periodic coupon that is equal to the product of the inflation index and thenominal coupon rate. The relationship between coupon payments, breakeven inflation and real interest ratesis given by the Fishreal rates, or both.

The most liquid instruments are Treasury Inflation-Protected Securities (TIPS), a type of US Treasurysecurity, with about $500 billion in issuance. The oI

Example: If the annual coupon of the bond was 5% and the underlying principal ofthe bond was 100 units, the annual payment would be 5 units. If the inflation indexincreased by 10%, the principal of the bond would increase to 110 units. The couponrate would remain at 5%, resulting in an interest payment of 110 x 5 % = 5.5 units.


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(B.6) Asset-Backed Security A financial security backed by a loan, lease or receivables against assets other than real estate andmortgage-backed securities. For investors, asset-backed securities are an alternative to investing incorporate debt. An ABS is essentially the same thing as a mortgage-backed security, except that thesecurities backing it are assets such as loans, leases, credit card debt, a company's receivables, royalties and

nderlying assets. Securitization makes these assets available for investment to aroader set of investors.

yments and movie revenues.ypically, the securitized assets might be highly illiquid and private in nature.

of interest than would benk loan or debt issuance. The various types of ABS are:

so on, and not mortgage-based securities.

Assets are pooled to make otherwise minor and uneconomical investments worthwhile, while also reducing

risk by diversifying the ubThese asset pools can be made of any type of receivable from the common, like credit card payments, autoloans, and mortgages, to esoteric cash flows such as aircraft leases, royalty paTIn some cases, it can be used as credit enhancement by creating a security that has a higher rating than theissuing company, which monetizes its assets. This allows it to pay a lower ratepossible via a secured ba

HHoommee EEqquuiittyy LLooaannss -- ties collateralized by home equity loans (HELs) are currently the largest assetlass within the ABS market.

Securic

MMoorrttggaaggee--BBaacckkeedd SSeeccuurriittyy --

ds) are backed by thea fund, but aren't classified as mortgage-backed security (MBS).

A mortgage-backed security (MBS) is an asset-backed security whose cashflows are backed by the principal and interest payments of a set of mortgage loans. Payments are typicallymade monthly over the lifetime of the underlying loans. However not all securities backed by mortgages areconsidered mortgage-backed security (MBS). Housing Bonds (Mortgage Revenue Bonmortg ges, which they

AAuuttoo LLooaannss BBaacckkeedd --pools of auto-related loans. Auto ABS are classified into

subprime:

The second largest subsector in the ABS market is auto loans. Auto financecompanies issue securities backed by underlyingthree categories: prime, nonprime, and

CCrreeddiitt CCaarrdd RReecceeiivvaabblleess BBaacckkeedd --

t scheduled, creditard debt does not have an actual maturity date and is considered a nonamortizing loan.

Securities backed by credit card receivables have been benchmark for

the ABS market since they were first introduced in 1987. Credit card holders may borrow funds on arevolving basis up to an assigned credit limit. The borrowers then pay principal and interest as desired,along with the required minimum monthly payments. Because principal repayment is noc

SSttuuddeenntt LLooaannss BBaacckkeedd --nanced through asset-

nefits of lending moneyithout b

isk-weighted assets and thereby frees up

erforms

ators earn fees from originating the loans, as well as from servicing the assets throughouttheir life.

ABS collateralized by student loans (SLABS) comprise one of the four (alongwith home equity loans, auto loans and credit card receivables) core asset classes fibacked securitizations and are a benchmark subsector for most floating rate indices.

Asset-backed securities enable the originators of the loans to enjoy most of the bew earing the risks involved. They offer originators the following advantages:

Selling these financial assets to the pools reduces their r

their capital, enabling them to originate still more loans.

Asset-backed securities lower their risk. In a worst-case scenario where the pool of assets pvery badly, the owner of ABS would pay the price of bankruptcy rather than the originator.

The origin


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(B.7) War BondsWar bonds are a type of savings bond used by combatant nations to help fund a war effort and as a monetary

olicy for controlling inflation from an economy over stimulated by a war.

federal expenditures in 1913

rnment used the hype of the war to market the bonds to theountry as a way to raise money for the war.

ns forever, and the issuer doesot have to redeem them. Their cash flows are, therefore, those of perpetuity.

anonymity. The downside

r of the Americas adapted the

en illegal since 1982 to issue bearer bonds in the municipalr corporate bond markets in the United States.

p

In 1917 and 1918, the United States government issued Liberty Bonds to raise money for its involvement inWorld War I. According to the Massachusetts Historical Society, Because the first World War cost thefederal government more than 30 billion dollars (by way of comparison, total

were only $970 million), these programs became vital as a way to raise funds.

In 1941, in an effort to control inflation, the U.S. Treasury began marketing the new Series E bonds U.S.Savings Bonds as "defense bonds". The govec

(B.8) Perpetual Bond A perpetual bond, which is also known as a Perpetual or just a Perp, is a bond with no maturity date.Therefore, it may be treated as equity, not as debt. Perpetual bonds pay coupon

(B.9) Bearer BondA bearer bond is different from normal stock in that it is unregistered no records are kept of the owner, or

the transactions involving ownership. Whoever physically holds the bearer bond papers owns the stock orcorporation. This is useful for investors and corporate officers who wish to retainis that in the event of loss or theft, bearer bonds are extremely difficult to recover.

The bearer bond most possibly has its origins in the post Civil War United States. Their use in avoidingtaxation became more popular after World War I. Europe and the remaindeuse of these bonds in their own finance systems for similar reasons of utility.

A bearer bond or bearer security is a certificate that represents a bond obligation of, or stock in, acorporation or other intangible property. It has beo


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Yield-Price Relationship

Understanding the price fluctuation of bonds is probably the most confusing part of this lesson. In fact,many new investors are surprised to learn that a bond's price changes on a daily basis, just like that of anyother publicly traded security. Up to this point, we've talked about bonds as if every investor holds them to

aturity. It's true that if youm do this you're guaranteed to get your principal back; however, a bond does not

etimes dramatically.e'll get to how price changes in a bit. First, we need to introduce the concept of yield.

ows the return you get on a bond. The simplest version of yield is calculated using

($100/$800). Conversely, if the bond goes up in price tonks to 8.33% ($100/$1,200).

ent yield on the

ere is that YTM is more accuratend enables you to compare bonds with different maturities and coupons.

p, yield goes down and vice

yields. A buyer wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5%. On the

have to be held to maturity.

t any time, a bond can be sold in the open market, where the price can fluctuate - somAW

Measuring Return with Yieldield is a figure that shY

the following formula:

YIELD = COUPON AMOUNT / PRICE

When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield. Ifyou buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). But if the price

goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the sameuaranteed $100 on an asset that is worth $800g

$1,200, the yield shri

Yield To MaturityOf course, these matters are always more complicated in real life. When bond investors refer to yield, theyare usually referring to yield to maturity (YTM). YTM is a more advanced yield calculation that shows thetotal return you will receive if you hold the bond to maturity. It equals all the interest payments you willeceive (and assumes that you will reinvest the interest payment at the same rate as the currr

bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).

nowing how to calculate YTM isn't important right now. The key point hKa

Example:Consider a 30-year zero coupon bond with a face value of $100. If the bond is priced at a yield-to-maturity of0%, it will cost $5.73 today (the present value of this cash flow, 1001 /(1.1)30 = 5.73). Over the coming 30 years, the

return earned over the first 10 years is 16.26%. This

nal $5.73 invested matured to

$100, so 10% annually was made, irrespective of interest rate changes in between.

price will advance to $100, and the annualized return will be 10%.

But what happens in the meantime? Suppose that over the first 10 years of the holding period, interest rates decline,and the yield-to-maturity on the bond falls to 7%. With 20 years remaining to maturity, the price of the bond will be$25.84. Even though the yield-to-maturity for the remaining life of the bond is just 7%, and the yield-to-maturity

argained for when the bond was purchased was only 10%, thebcan be found by evaluating (1+i) = (25.84/5.73)0.1 = 1.1626.

Over the remaining 20 years of the bond, the annual rate earned is not 16.26%, but 7%. This can be found byevaluating (1+i) = (100/25.84)0.05 = 1.07. Over the entire 30 year holding period, the origi

The Link Between Price And Yieldhe relationship of yield to price can be summarized as follows: when price goes uT

versa. Technically, you'd say the bond's price and its yield are inversely related.

Here's a commonly asked question: How can high yields and high prices both be good when they can'thappen at the same time? The answer depends on your point of view. If you are a bond buyer, you want high


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other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bondgoes up. This way you can cash out by selling your bond in the future.

Price in the MarketSo far we've discussed the factors of face value, coupon, maturity, issuers and yield. All of thesecharacteristics of a bond play a role in its price. However, the factor that influences a bond more than anyother is the level of prevailing interest rates in the economy.

When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bondsand bringing them into line with newer bonds being issued with higher coupons. When interest rates fall,the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them intoline with newer bonds being issued with lower coupons.


16/17

Bond Market

The bond market is a financial market where participants buy and sell debt securities, usually in the form ofbonds. it is also known as the debt, credit, or fixed income market

As of 2006, the size of the international bond market is an estimated $45 trillion, of which the size of theoutstanding U.S. bond market debt was $25.2 trillion. Nearly all of the $923 billion average daily tradingvolume (as of early 2007) in the U.S. bond market takes place between broker-dealers and large institutions

in a decentralized, over-the-counter (OTC) market. However, a small number of bonds, primarily corporate,are listed on exchanges.

Market StructureBond markets in most countries remain decentralized and lack common exchanges like stock, future andcommodity markets. This has occurred, in part, because no two bond issues are exactly alike, and thenumber of different securities outstanding is far larger.

However, the New York Stock Exchange (NYSE) is the largest centralized bond market, representing mostlycorporate bonds. The NYSE migrated from the Automated Bond System (ABS) to the NYSE Bonds tradingsystem in April 2007 and expects the number of traded issues to increase from 1000 to 6000.

The Securities Industry and Financial Markets Association classifies the broader bond market into fivespecific bond markets.

1. Corporate

2. Government & agency

3. Municipal

4. Mortgage backed, asset backed, and collateralized debt obligation

5. Funding

Bond Market ParticipantsBond market participants are similar to participants in most financial markets and are essentially either

buyers (debt issuer) of funds or sellers (institution) of funds and often both.

Participants include:

1. Institutional investors

2. Governments

3. Traders

4. Individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many smaller issues,institutions like pension funds, banks and mutual funds hold the majority of outstanding bonds. In theUnited States, private individuals currently hold approximately 10% of the market. For market participantswho own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal andinterest are received according to a pre-determined schedule.

But participants who buy and sell bonds before maturity are exposed to many risks, most importantlychanges in interest rates. When interest rates increase, the value of existing bonds fall, since new issues paya higher yield. Likewise, when interest rates decrease, the value of existing bonds rise, since new issues paya lower yield. The fundamental concept of bond market volatility:

CChhaannggeess iinn bboonndd pp rriicceess aarree iinnvveerrssee ttoo cchhaannggeess iinn iinntteerreesstt rraatteess


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Bond Market IndexA bond market index is a listing of bonds or fixed income instruments and a statistic reflecting the compositevalue of its components. It is used as a tool to represent the characteristics of its component fixed incomeinstruments. They differ from stock market indices in their complexity

Bond indices can be categorized based on their broad characteristics, such as whether they are governmentbonds, corporate bonds, high-yield bonds, mortgage-backed securities, etc. They can also be classified basedon their credit rating or maturity. Most bond indices are weighted by market capitalization. This results in

the bums problem, in which less creditworthy issuers with a lot of outstanding debt constitute a larger partof the index than more creditworthy ones.

GGlloobbaall Lehman Aggregate Bond Index - a family of global and regional bond indices.

UU..SS.. bboonnddss Lehman U.S. Aggregate Salomon BIG Merrill Lynch Domestic Master CPMKTB - The Capital Markets Bond Index

GGoovveerrnnmmeenntt bboonnddss Salomon Smith Barney World Government Bond Index J.P. Morgan Government Bond Index Access Bank Nigerian Government Bond Index FTSE UK Gilts Index Series

EEmmeerrggiinngg mmaarrkkeett bboonnddss J.P. Morgan Emerging Markets Bond Index JPMorgan GBI-EM Index

HHiigghh--yyiieelldd bboonnddss CSFB High Yield II Index (CSHY) Merrill Lynch High Yield Master II Bear Stearns High Yield Index (BSIX)

How to Read A Bond Table

CCoolluummnn 11:: Issuer - This is the company, state (or province) orcountry that is issuing the bond.

CCoolluummnn 22::Coupon - The coupon refers to the fixed interest ratethat the issuer pays to the lender.

CCoolluummnn 33:: Maturity Date - This is the date on which the borrowerwill repay the investors their principal. Typically, only the last twodigits of the year are quoted: 25 means 2025, 04 is 2004, etc.

CCoolluummnn 44::Bid Price - This is the price someone is willing to pay

for the bond. It is quoted in relation to 100, no matter what the parvalue is. Think of the bid price as a percentage: a bond with a bid of93 is trading at 93% of its par value.

CCoolluummnn 55: Yield - The yield indicates annual return until the bondmatures. Usually, this is the yield to maturity, not current yield. Ifthe bond is callable it will have a "c--" where the "--" is the year the bond can be called. For example, c10means the bond can be called as early as 2010.

Copyright November 2008Tariq Mumtaz

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