Bond - Explained
What is a Bond?
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Table of ContentsWhat is a Bond?How Does a Bond Work?Characteristics of BondsBond IssuersVarieties of BondsZero-coupon bond Convertible bonds Callable bonds or puttable bondsAcademic Research on Bonds
What is a Bond?
Bonds are financial instruments representing a loan usually by an investor to a company. The owners of bonds are called debtholders or creditors. Bonds details documents such as I.O.U between the lender and the borrower, the maturity date of the loan, principal amount to be paid back, the time frame of the loan and other necessary details. Bonds are usually used by companies (corporate bonds), municipalities (municipal loan) and government (government bonds) to fund a substantial project.
How Does a Bond Work?
Investors are quite acquainted with three assets: stocks, bonds, and cash equivalents. Bonds are usually known as fixed income securities, the government and corporate bonds are traded openly or between the borrower and the lender privately. There are some bonds that are also traded over-the-counter (OTC)
The inability of a company to fund a large project, an incomplete operation or pay off debts may result in the company's issuance of bonds. This company issues bonds to raise money for such projects while the bondholders earn from the interest payment, this is also referred to as the coupon. The coupon rate determines the interest payment. This is followed by an agreement decided by the bond issuer, this makes up the loan terms, payment of bond principal, bond maturity dates and interest rates. The actual price of a bond is dependent on the issuance credit quality, the time frame of the bond, the coupon rate against the general interest rate. Though, most bonds price are usually fixed at $100 or $1,000 face value per individual bond. The face value refers to the total amount of money paid at the bond's maturity time. The face value is paid to the bondholder. Investors decide whatever happens to the bond in as much as the bond has been issued. Investors may decide to sell the bond to other investors prior to the maturity date of the bond or even repurchase the bond when interest rates/borrowers credit decline or improve respectively.
Characteristics of Bonds
Bond shares similar characteristics which include the following:
- Face value is used in determining interest payments by the bond issuer. It refers to the actual amount that the bondholder will be paid upon the bond's maturity date. For instance, if two investors purchase a bond at $1,090, but the other was offered a trading discount at $980. Both will eventually receive the same face value of $1,000 when the bond matures.
- The coupon rate: This refers to the interest rates paid by the company issuing the bond. It is paid alongside the actual amount of the bond (face value) and it is expressed in percentage. For example, a 5% coupon rate equals 5% x $1000 face value = $50 every year. This is the amount that bondholders will receive.
- Coupon date refers to the date in which a company makes interest payments on the bond issue.
- Maturity date: as the name suggests refers to the date in which the bond matures and the face value is paid.
- Issue price refers to the exact amount the bond is sold.
Credit quality and maturity time are basically the two features of a bond and most essentially the decider of the coupon rate. In terms of credit quality, if the company issuing the bond is known for poor credit evaluation, then there is a huge tendency the bonds will not pay promptly but they offer huge interest. Likewise, the company issuing bonds pay higher interest rates because the investors are liable to high risks such as inflation and others. Furthermore, bonds can be classified into their qualities, the one with the highest quality is the investment grade. This includes debts issued by the U.S government and some companies. The other refers to bonds that are called high yield or junk due to their high risk, they have a higher risk of default in the future. Credit rating agencies like Standard and Poor's, Moody's and Fitch Ratings generate credit ratings for companies and their bonds. Bonds are sensitive to interest rates changes when these changes rise or fall, interest rates also do the same. This sensitivity is what we call duration. The duration here accounts for the rising or falling of bond's price as a result of interest rates changes. Another term to note is convexity. Whenever a bond changes as a result of the rising and falling of interest rates, the rate of change is termed 'convexity'. This rate of change calculation is usually done by a professional because of the complexity involved.
There are three types of bonds: the corporate bond, municipal and government bonds. The corporate bond is offered by private companies, the municipal is offered by states and municipalities, some of the municipal bonds offer tax-free as coupon income. Lastly, the government bonds are issued by the treasury. The U.S treasury offer bonds with a year maturity, called bills, 1-10 years, called notes and more than 10 years referred to as bonds.
Varieties of Bonds
Borrowers issue many types of bonds, those issued to make a coupon payment is referred to as coupon bonds. Others include Zero-coupon bonds, convertible bonds, callable bonds or puttable bonds and others.
A good example of this type of bond is the U.S Treasury bills. For example, they do not pay coupons payment. They are issued at a discounted rate and generates a return on investment when the investor receives the full face value upon maturity of the bond. An investor is paid $100 at a bond maturity if the U.S. Treasury sold 26-week bills with $100 face value for $98.78 on October 18th, 2018. This equals a total annual yield of 2.479%.
This type of bonds allows bondholders to their debt into stock depending on the share price or other conditions. A company needs to borrow $1 million to finance a large project. This could be done by issuing bonds with a 12% coupon that matures in 10 years. However, if this company sees investors who are willing to buy at 8% unlike the 12%, this obviously allows them to convert the bond into stock when stock prices increase. This will ensure the company having a smaller interest payments while their project is ongoing. When an investor changes bonds, thereby converting it into stocks. The company issuing the bond does not need to pay interest or bonds principal. An investor who purchases this bond will earn from the rise in stocks if eventually the company's project becomes realistic, but with a lower coupon payment. In the long run, if the bonds are converted, investors earn more.
Callable bonds or puttable bonds
This is quite different from the convertible bonds. For instance, A company issued $1 million worth of bonds with a 10% coupon maturing in 10years. As a result of interest rates declining or the company credit rate improving, the company can call or buy the bonds back for the principal amount, thereby, offering new bonds at a lower coupon rate. This bond is also referred to as the 'called back'. Note that, this is only possible before the maturity date.
Academic Research on Bonds
- Dobondsspan thefixed incomemarkets? Theory and evidence for unspanned stochastic volatility CollinDufresne, P., & Goldstein, R. S. (2002). Do bonds span the fixed income markets? Theory and evidence for unspanned stochastic volatility.The Journal of Finance,57(4), 1685-1730. Most term structure models assume bond markets are complete, that is, that all fixed income derivatives can be perfectly replicated using solely bonds. How ever, we find that, in practice, swap rates have limited explanatory power for returns on atthemoney straddlesportfolios mainly exposed to volatility risk. We term this empirical feature unspanned stochastic volatility (USV). While USV can be captured within an HJM framework, we demonstrate that bivariate models cannot exhibit USV. We determine necessary and sufficient conditions for trivariate Markov affine systems to exhibit USV. For such USV models, bonds alone may not be sufficient to identify all parameters. Rather, derivatives are needed.
- Liquidity in USfixed incomemarkets: A comparison of the bid-ask spread in corporate, government and municipalbondmarkets, Chakravarty, S., & Sarkar, A. (1999). Liquidity in US fixed income markets: A comparison of the bid-ask spread in corporate, government and municipal bond markets.FRB of New York Staff Report, (73). We examine the determinants of the realized bid-ask spread in the U.S. corporate, municipal and government bond markets for the years 1995 to 1997, based on newly available transactions data. Overall, we find that liquidity is an important determinant of the realized bid-ask spread in all three markets. Specifically, in all markets, the realized bid-ask spread decreases in the trading volume. Additionally, risk factors are important in the corporate and municipal markets. In these markets, the bid-ask spread increases in the remaining-time-to maturity of a bond. The corporate bond spread also increases in credit risk and the age of a bond. The municipal bond spread increases in the after-tax bond yield. Controlling for others factors, the municipal bond spread is higher than the government bond spread by about 9 cents per $100 par value, but the corporate bond spread is not. Consistent with improved pricing transparency, the bid-ask spread in the corporate and municipal bond markets is lower in 1997 by about 7 to 11 cents per $100 par value, relative to the earlier years. Finally, the ten largest corporate bond dealers earn 15 cents per $100 par value higher than the remaining dealers, after controlling for differences in the characteristics of bonds traded by each group. We find no such differences for the government and municipal bond dealers.
- Dynamic asset allocation andfixed incomemanagement Srensen, C. (1999). Dynamic asset allocation and fixed income management.Journal of financial and quantitative analysis,34(4), 513-531. This paper provides the solution to an intertemporal investment problem. The investor has power utility and can invest in stocks and bonds in a complete market setting where the Vasicek term structure model applies. The paper demonstrates that the zero-coupon bond with maturity at the investment horizon is the appropriate instrument for hedging changes in the opportunity set. Implementation issues are discussed and it is shown how the intertemporal investment problem can be recast as a series of mean-variance problems in terms of drift and volatility of the wealth forward price. An application based on a quasi-dynamic programming approach is considered.
- Socially responsiblefixedincomefunds, Derwall, J., & Koedijk, K. (2009). Socially responsible fixedincome funds.Journal of Business Finance & Accounting,36(12), 210-229. The growing importance of SRI in the investment arena has resulted in considerable academic interest in the performance of socially responsible equity mutual funds. Remarkably, no attempts have been made to evaluate the performance of mutual funds that invest in socially responsible fixedincome securities. This study fills that gap by measuring the performance of socially responsible bond and balanced funds relative to matched samples of conventional funds, over the period 19872003. Using multiindex performance evaluation models, we show that the average SRI bond fund performed similar to conventional funds, while the average SRI balanced fund outperformed its conventional peers by more than 1.3% per year. The expenses charged by SRI funds, match those charged by conventional funds and, evidently, do not cause SRI funds to underperform.
- An exactbondoption formula, Jamshidian, F. (1989). An exact bond option formula.The journal of Finance,44(1), 205-209. This paper derives a closedform solution for European options on pure discount bonds, assuming a meanreverting Gaussian interest rate model as in Vasicek . The formula is extended to European options on discount bond portfolios.