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Bonds - (financial)
In Finance , a bond is a promise from a company (or government) to pay interest and principal in the future. A bond is simply a loan, but in the form of a security.
The purpose of bonds is to raise money for a company or government, to enable them to finance long-term investments with external funds.
In addition to public debt issued as bonds, others may be privately held with a private lending institution.
Most public -issued bonds have a face value of $1000 (principal, par value)
Table of contents:
Maturities
Bonds are generally issued for a fixed term (the maturity) longer than ten years. The Maturity is simply the length of time of the bond.
Bond: 10+ years
Note: 1-10 years
Bill: less than 1 year
U.S Treasury securities issue debt with life of ten years or more, which is a bond. New debt between one year and ten years is a "note", and new debt less than a year is a "bill". Note: CDs (certificates of deposit) or commercial paper are considered money market instruments, and not bonds.
When comparing bonds, you can either look at the "time to maturity", or (preferably) at the "duration", which is like a weighted average that tells you how long until the bond comes due. Duration is important in comparing two bonds, or mortgages against each other. It is also very important when hedging interest rate risk, and for matching the maturities of assets and liabilities on the balance sheet.
Types of Bonds
1. Pure "Discount" bonds = "zero coupon" bonds = bullet bond.......all names for the same thing - a bond that pays no cash payments until maturity (all payments at end, in one lump sum). For this type of bond, the PV = Future payment / (1+r) ^t, where r is the market interest rate, and t is the number of periods (years) of the life of the bond.
2. Coupon bonds - pay off some of the principal (denomination) + interest during the life of the bond. The present value of this bond can be figured out either (a) by considering it as a whole bunch of individual "discount" bonds, in which case you just make many individual PV calculations, and add them up., or (b) using an excel spreadsheet, or financial table...find the annuity factor for time = T, and rate = r, and plug into this formula: PV = C * annuity factor + Future payment / (1+r)^t.
3. Consols: a unique type of bond that pays a coupon payment forever, but never pays back the face value (no lump sum at the end). You can value this just like a perpetuity (PV = C/r).
4. Perpetual Bonds: perpetual bonds, which allow companies to repay principal at their discretion. Perpetual bonds, which have no set maturity, are typically have an option to be called after the first five years. Perpetual bonds should pay about 150 basis points to 200 more than notes due in 10 years to compensate investors for the risk that they won’t be called, according to Eric Ollom, chief emerging-markets strategist with Jefferies & Co. in New York. Read more here
Yield to Maturity on a Bond
The YTM of a bond is simply the IRR of its expected future cash flows. It is the discount rate that will make the present value of all of its future cash flows equal to the bond price. Think about the IRR as the discount rate when NPV is =0, and realize that all stocks and bonds are NPV=0, so the yield to maturity of a bond is just that...the IRR of the bond when NPV = 0.
Example:
During the Credit Crisis, the "yield" on Treasuries dropped to record lows. This happens when everyone wants to buy these assets, which drives up the price, and has an inverse effect of driving down the "yield to maturity".
Example:
If a bond is selling at $1050.00, and the face value is $1000, with a 2 year life, and a coupon rate of 10%, then what is the YTM on this bond?
$1050 = $100 + $1000 + $100
1 + y (1+y) ^2
the YTM is the yield (the discount) rate that makes this true. So, if you solve for y, you find that the YTM of this bond is approximately 7.23%. And since it is selling for more than its face value, then it is selling at a premium. The offered coupon rate is more than the going market rate of just 7.23%, so the price of the bond gets bid upward from $1000 to $1050.
Current Yield
Current Yield = current coupon / current price
Be careful, this is not the same thing as the YTM (which is more important) listed above.
The "current yield" is often quoted, but is not as useful as the YTM.
see also, yield curve
Market Price of bond
Bonds are traded publicly in exchanges. The market price of the bond will not be solely based upon the PV of the future cash flows (plus the coupon interest rates). It is not that simple. Because in the market of trading, there are other factors that might bid up or down the market price of the bond, such as:
1. Expectations about future interest rate changes
2. Expectations about the future ability of the firm to pay fixed income (bond) payments
3. Expectations about the possibility of bankruptcy in the future.
4. Expectations about potential future competition .....etc, etc.....
The key point is that if a firm issues a 30 year bond...will they still be around in 30 years to pay off their principal value? For many newer companies, investors can not say for certain if they will...so, they often demand a higher coupon payment every 6 months.
Also, this explains why people pay such close attention to the bond ratings agencies. (AAA, AA, A, BBB, BB, B, CCC,CC,C, D). If a bond gets rated as D, it means that they are in default, and that they will not pay. The safest bonds have an AAA rating. But, with safety comes lower returns. With risk comes higher expected returns.
Sensitivity to interest rates:
if rates are expected to fall....then the EXISTING bonds with HIGHER rates will be in high demand...so the price of these bonds will be bid up...
as the price goes up, the "yield to maturity" goes down.
thats why you see headlines like this: "local currency bond yields fell after economists in a weekly central bank survey said the benchmark interest rate will fall more that previously estimated as economic growth slows."
Sensitivity to Interest rates
Bond values have an inverse relationship with market interest rates. If market interest rates go down, then the value of existing bonds will go up. If market interest rates go up, then the value of existing bonds goes down.
Why?
There are two ways to look at it. (1) think of a bond as a series of future cash flows. In order to find the present value of those cash flows (and the price of the bond), you first need to discount the cash flows to the PV. To do so, you must divide the expected cash flow by the discount rate....so, the higher the interest rate, the lower the expected present value of the bond.
Another way to think about it (2): Think about the coupon % offered on the bond. If the bond is offering 10% interest (fixed over 30 years)...what do you think will happen to the value of that bond if the market interest rates jumped up to 15%? That means that normal investors could invest in other investments that could result in 15% interest rates...so, do you think they will value a bond that only pays out 10%? Of course not, and so the value of the bond will fall if market interest rates rises. If, on the other hand, the market interest rates were to fall to just 5%, then the 10% interest being paid by this bond will suddenly look very attractive, so investors will want it, and that demand will bid up the price.
Result: Either way you look at it....bond values have an inverse relationship with interest rates.
Inflation: effect of inflation on Bonds:
inflationary in the long run, inevitably driving bond yields higher....why? well, with inflation....investors no longer want fixed-income bonds (because money is worth less in the future).....so they will demand yesterdays fixed income bonds LESS.....less demand leads to lower prices....which makes YIELD to maturity higher.
In other words...if investors think there will be inflation....they will demand higher returns to compensate them for that inflation!
Government Bonds:
Government bonds are effectively loans, made by investors to countries. The higher the yield of a bond at auction, the riskier investors think that loan is, so the government has to offer them a higher rate of return to ensure it attracts enough buyers.
Government Bonds - Q&A: an overview:
What is a government bond?
Governments borrow money by selling securities known as bonds to investors. In return for the investor's cash the government promises to pay a fixed rate of interest over a specific period - say 4% every year for 10 years. At the end of the period the investor is repaid the cash they originally paid, cancelling that particular bit of government debt. Government bonds have traditionally been seen as ultra-safe long-term investments and are held by pension funds, insurance companies and banks, as well as private investors.
What is a bond market?
Once a bond has been issued - and the government has the cash - the investor can hold it and collect the interest every year until it is repayable. But investors can also sell the bond on the financial markets. The price of the bond will fluctuate as the outlook for interest rates changes. So, for example, if the markets think that interest rates are going to rise sharply, then the value of a bond paying a fixed rate of 4% for the next ten years will fall. Bond prices will also fall if investors think that there is a risk of the government that issued the bond not being able to make the annual interest payment or repay it in full on maturity - and these are the fears which have been pushing down Irish bond prices.
What is a bond yield?
This sounds complicated, but isn't! The yield is the return received by an investor who buys the bond at today's market price. Let's take an example. A bond is sold by a government for 100 euros, paying an annual interest rate of 4%, or 4 euros per year. The yield is 4%. But then the market price of the bond falls to 50 euros. The interest payment (the coupon) is still 4 euros per year. So for a 50 euro investment the investor can get a 4 euro annual payment, which is a return or "yield" of 8%. Market commentators usually quote bond yields, rather than prices. The key thing to remember is that bad news drives down bond prices, which pushes up bond yields.
Why do bond markets matter?
Because they determine what it costs a government to borrow. When a government wants to raise new money it issues new bonds. But those bonds have to pay an annual interest rate which is close to the current yield for bonds which it has issued earlier and are now being traded in the market (see above). So if a crisis of confidence drives up market yields the government has to pay more for new borrowings - possibly a lot more. (But remember that it does not affect the cost of paying the annual interest of existing bonds, because the interest rate is fixed for the life of the bond).
source: read more from BBC here: http://www.bbc.co.uk/news/business-11743952
Investing Tips
Thinking of Stocks and Bonds as Call options
The stock (equity) of a company can be thought of as a "call option" on the firm. The value of the call option increases with volatility, and a rise in volatility will increase the value of the stock of the firm. This means that the value of the stock equity will increase as the firm selects riskier projects. But, on the other hand, the value of the bond holders will decrease as riskier projects are selected. This can also be seen in terms of Options. The value of a risky bond can be seen as the difference between the value of the firm and the value of the call option on the firm. So, as the value of the call option increases (value of the stock increases), this means that the value of the bonds decreases. The bondholders are therefore hurt when the firm selects riskier projects.
Treasury Bonds:
When the U.S. government sells a Treasury bond, they are borrowing money that they pay interest on until the bond comes due - and they pay back the original amount borrowed. For example: Let's say they sell a bond (which they do in increments of $1,000) for $10,000 that pays interest of 1%, or $100. Once issued however, the bond’s price and yield are based on the demand for bonds and the current interest rate. If demand is high, buyers may pay more than $10,000 for the bond. Let's say that happens (like it did in mid-December) and the price goes up to $12,000.
The individual who buys this bond is going to receive $100 in interest payments regardless of the price they paid. This means they will earn a lower percentage that the original coupon or yield. Instead of 1%, they will receive .8%. The reverse is true as well. If interest rates drop, the yield could grow larger than the original yield. These fluctuations occur daily and can be affected by interest rates, demand and equities performance. Think of the yield and the price as sitting on opposite ends of a seesaw. When one goes up the other comes down, and contrary-wise. If China continues to buy Treasuries, they will increase demand, drive up bond prices and depress treasury yields.
read more: Treasury Bonds
How to issue a bond
for a public offering, first need an indenture (a written agreement) between the company and a trust company. The trust company will represent the bondholders. They will make sure that the terms of the indenture are obeyed by the company. this document will outline the terms of the bond, if the bond has any securitization (asset-backed?), if there are any covenents to protect the bondholders (see discussion above), how the "sinking fund" will be set up, and any notes about call provisions.
Credit Ratings
Junk Bonds:
Bonds < "investment grade" (according to ratings agencies)
If yields rise, it makes new debt too expensive for companies (with ratings below "investment grade"to raise money.
In 2008, junk bonds account for 17% of S&P500 index, and nearly 50% of all corporate bonds.
Index Fund: Merrill Lynch US high-yield index
Links:
Finance
return
risk
External Links
Wikipedia article for more info
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