4 - Bonds (fin) Flashcards
Bond characteristics
NV - far value/face value - amount issue will pay back @ redemption. coupon expressed as % of this
£100, $1000, 100 yuan, 1000 rand
price - quoted as amount investor would have to pay to buy NV
redemption date/maturity date - when issue will repay NV
coupon - interest that issuer pays to holder (usually semi annual, can be quarterly or annual)
can be 0 for ZCB
fixed for vanilla bonds
index (inflation) linked for ILB - linked to RPI with 8 (issued before jul 2005) or 3 month lag - inflation uplift = RPI now/RPI @ issue
maturity
<7yrs = short 7-15 = med >15 = long
yield - measures return on bond incl coupon and principal
what is a bond
a form of debt whereby borrower issues bond and receives price of bond, over the lifetime of bond pays interest in form of coupons and then at maturity repays lender the principal value of the bond
rank ahead of equity in cases of liquidation - so relatively low risk - so generally lower expected returns
traditionally low correlation to equities
bond yield
= return an investor expects to receive each year over its term to maturitY
In financial media - will see flat yield and GRY (aka YTM)
figure shown = annual
markt val of straight will vary as rates vary - because fixe dcoupon will seem more/less attractive relative to rates
yields can be neg = capital loss (cannot be offset as no CGT on gains)
higher yield = higher risk
risk built up of
risk free rate + credit risk + liquidity risk + currency risk (if in another currency) +maturity
for most govis - yield is just risk free rate + maturity as no credit risk/currency risk
currency risk can be taken on by issuer by denominating bond in another currency
bond features: maturity date
single dated/bullet bonds - vast majority of bonds - single redemption date
irredeemable/perpetual/undated
issuer has no obligation to redeem but may have right to do so after particular date
coupon paid in perpetuity
e.g. war bonds UK 5% war loan 1917
no undated UK gilts in issue
also issued by corps - AT1 bonds are perpetual bonds issued by banks to help fulfil cap reqs
most corp perpetuals are convertible
callable bonds - can be redeemed by issuer between call date and maturity date
- if rates fall - call back and refinance at lower rate
higher coupons for investor
e.g. UK double dated gilt - last one redeemed in 2013
putable bonds
can be redeemed early by holder
- if rates rising - redeem and buy new bond @ higher rate
lower coupon
both call and put bonds hard to analyse price - dissuades investors
Coupons
most bonds = fixed rate coupon = ‘straights’
frequency = market driven
semi annual usually- UK, US, Japan, Italy
annual - Germany, France
ILB - coupon and redemption linked to inflation index (currently RPI) via uplift (or down if no deflation floor)
FRN - coupons linked to ref interest rate e.g. SONIA, ESTR, SARON, SOFR
ZCB - no coupon. issued at discount to face val and the gain provides the required GRY - will be subject to income tax as yield is considered to have accrued over life of bond
- UK govs dont issue these but can be created via STRIPS
step up coupons - % increases annually
Credit ratings
Credit rating agencies provide a benchmarking system for government and corporate bonds.
-Moody’s, Fitch, S&P
IG - least likley to default, highest liquidity
speculative/high yield/junk/non IG - more likely to default, compensated for with higher coupons and higher YTM
PostGFC scrutiny - competitive pressure to lower standards, bias towards clients with more issues with ratings agencies
Credit ratings - Moody, fitch, s&p
spreads
difference between yield avail on 1 instrument vs another - usually as bps
e.g.
same instrument different maturities
2yr gilt vs 10 yr gilt
corp vs gov
- 10 yr appl vs 10 year treasury
different countries
10yr gilt vs 10 year treasury
used as indicators of risk sentiment - wider spread vs govi = greater perceived risk
can also be vs rate benchmarks eg SONIA, ESTR, SOFR etc
als bond yields vs equity yields - observed as indicators of changing sentiments and relative val
bond covenants
baso just conditions that protect holders
covenants limiting further debt and priority -
negative pledge clause
- prevent issuer from reducing val of bond by issuing additional debt @ higher priority or
pari passu clause
- only allowing debt to be issued at higher priority is existing bonds are upgraded to have equal priority
covenants restricting divi payment
- excessive divis could negatively impact bond value - covenants frequently restrict payment of cash divi based on earnings and cash
- can also restrict buyback facility
covenants restricting sale of assets
- to prevent val falling due to asset sale - often assets only permitted for sale if proceeds used to buy new fixed assets or retire debt
- can prohibit transfer of whol bis or require new owner to assume all obligations of bond
breach of covenants is a default event - if no solution is found afer engagment period post default - bond becomes immediately repayable
Susuk
Islamic financial instruments - similar to bond s- compliant with Shariah law (interest forbidden)
works on basis of risk sharing -customer and bank share risk of investment and divide profit between them
susuk = instruments of equal val representing common share in ownership of UL
baso - issuer sells investor group a certificate (susuk) and uses proceeds to buy asset -investor group has direct partial ownership in asset
issuer must also promise to buy back certificate at future date @ par
severaldifferent structures
Ijarah Susuk
Ijarah = lease
company owns asset
SPV issues susuk and uses proceeds to buy asset from company
leases asset back to company
lease payments passed back through to investors
@end - comp buys back assets and SPV buys back susuks from investors
Intifa susuk
similar to Ijarah but investors have right to use,own, develop asset over period
issuer divides right sof assets into units and transfers to investors
investors have right to benefit like a time share
salam susuk
similar to forward contract
issuer issues susuk and promises to delivery commodity on future date
price paid in advance via susuk
usually ST finance
perpetual susuk
susuk without specific maturity date
may be redeemed or amortised wholly or partially @ any time @ issuer discretion or within specific period
gov, ministries, instiution and public authorities can issue perpetual susuk
convertible susuk
gives holder right to convert into shares of issuer at future date
price of susuk cannot be below par val of shares
green bonds?
GBP?
conventional debt where proceeds used to finance/refinance new/existing green projects
- w/ positive environmental or climate benefits e.g. energy efficiency, transportation
additional transaction costs - issuer must track, monitor and report on funds
- issuers think this is offset by benefits (diversifying investor base, highlighting greenness etc)
lack of standardization as to what makes a green bond - can lead to greenwashing, green label can confer pricing advantage
GBP - green bonds principal dev by ICMA - completely voluntary recommendation of guidelines + transparency and disclosure, promoting integrity etc
fall from green grace - bonds losing green status -reputational and price damage - could put cap at risk due to downward pressure.
canlead to ‘green default’ - investors seeking penalties for breaking green clauses even if bond is paid in full
green bonds?
GBP?
conventional debt where proceeds used to finance/refinance new/existing green projects
- w/ positive environmental or climate benefits e.g. energy efficiency, transportation
additional transaction costs - issuer must track, monitor and report on funds
- issuers think this is offset by benefits (diversifying investor base, highlighting greenness etc)
lack of standardization as to what makes a green bond - can lead to greenwashing, green label can confer pricing advantage
GBP - green bonds principal dev by ICMA - completely voluntary recommendation of guidelines + transparency and disclosure, promoting integrity etc
fall from green grace - bonds losing green status -reputational and price damage - could put cap at risk due to downward pressure.
canlead to ‘green default’ - investors seeking penalties for breaking green clauses even if bond is paid in full
what is greenwashing
practise of comps making misleading environmental claims for marketing purposes - with aim of improving rep, to attract environmentally aware customers and increase profits
social bonds
bond with proceeds used to fund projects with non environmental but beneficial theme - typically with social objectives in mind
e.g. basic infrastructure, affordable housing, health services - particularly to benefit those livign below poverty line
first ever - Asia 2018 - to provide stable LT housing in Korea
like green bonds - ICMA has issues SBP (social bond principles) - voluntary guidelines where issuers may align framework to market expectations = market confidence
sustainability bonds
funds used to finance or refinance combo of green and social project - ICMA has issued SBG - sustainability bond guidelines - promoting integrity etc, voluntary
sustainability linked bonds (SLBs)
any bond instrument where financial and structural characteristics vary depending on whether issuer has achieved ESG/sustainability objectives
more flexi than green/social/sustainability bonds which can only be used to finance specific projects
- no specific use of proceeds - but issuer must define/commit to sustainability path over years
ICMA has vol SLBP guidelines = sets out best practise for launching credible slb
SLBs are complimentary financing to green/social/sustainability bonds
blue bonds
proceeds used for protection and conservation of marine ecosystems
generally issued by low-income countries that are heavily reliant on oceans and their resources
first sovereign blue bond: 2018 Republic of Seychelles - $15mn to support expansion of marine protected areas, fisherie governance
coupons partically guaranteed by world bank and concessional loan from GEF
social impact bonds
main goal is to achieve social objectives not investmentreturns
very diff from conventional bonds - focus is on social benefit > investment potential
payouts based on specific social criterias being met
dont offer fixed return
used by govt to address issues e.g. homelessness, youth unemployment, children in care etc
BASO
contract with GOV/pub sector issue, whereby it pays for better social outcomes + passes on part of the savings achieved to investors.
factors affecting bond price
rates (up P down) - investors need higher ROR as rates rise
inflation (up price down) - investors need higher ROR as inflation rises, for ILB price tends to rise as higher inflation expected - both prevailing and expected rates impact
liquidity - more liquid = more expensive
exchange rates
issuer specific factors
- credit rating - higher = higher price - lower yield
- structure and seniority of bond - higher = higher price
bond derivs
loan based crowdfunding+ risks?
crowfunding = popularized following GFC - way of financing debt through raising via from a large no. of people
loan based aka P2P
- consumers lend to bis directly for interest payment and repayment of capital over time
- bypasses traditional banks
- returns are financial
-primarily for profitable SMEs, not really suitable for startups
Risks
- no FSCS recourse
- may have difficulty cashing in (some platforms do have 2ndary market tho)
- capital at risk
investment based crowdfunding+ risks
consumers invest in comp by buying shares or debentures
- can also refer to mini/crowd bonds which is a way investors lend directly to bis
Risk
- high risk - potential for loss of capital funding entrepreneurial endeavours
- may have little recourse in case of default/fraud
- dilution risk as likely multiple rounds of funding
- long investment periods
- risk platform could fail or become insolvent
- secs not transferable, most platforms have no 2ndary market - difficult to cash in early
lending platforms for debt crowdfunding
UK = FundingCircle— US=Lending Club
Fudingcircle - 2010
- P2P crowdfunding platform , listed in 2018 on lse
- enables investors to lend to small comps - mechs have changed over time
- used to allow retail investors to pick who they lent to - suspended this in 2017 citing lack of diversification and risk to retail investors
FCA reg of lending platforms
FCA regs both loan and investment based crowdfunding
- banned sale on mini bonds to retail investors in 2020 - substantially decreasing popularity of investment based crowdfunding
- they did this after many mini bond scandals
- e.g. collapse of mini bon dprovider london capital finance - promised 8% interest and risked >£200mili invested by 11k people
bond fintech
capexmove?
bondevalue?
fintech has potential to transform bond markets - large fin instit are experimenting w/ issues on blockchains
capexmove - bond tokenisation platform - digitises tradition debt instruments into smart legal contracts and issues tradable units
bond evalue - breaks down large denomination bonds into smaller denominations suitable for retail investors
approved in 2020 by monetary authority of Singapore as a recognized market operator
gov bonds
govs issue bonds to raise money to cover deficits, fund projects etc - easy for govs like UK with high credit rating
low risk as as government backed - though govs can default
Argentine has defaulted 9 times in history - May 2020 - failed to make $500mn interest payment on foreign debt
dev market gov debt
UK - issued by DMO (executive agency of treasury), also servies and manages gilts
US - US treasury handles secs issued by US gov in form of T bonds, notes and bills, also issues gov sponsored entities which involve ABSs
EU - countries retain control over its own debt - even eurozone
EM debt
historically only a small fraction of global bond market due to
limited issuance, poor data qual, market illiquidity, regular economic crises
Brady bonds - US treasury sec nicholas brady issued first EM gov bond by converting many latin american defaulted bank loans to collateralized ZCBs.
issued in USD to reduce currency risk (political instability etc)
now - improved credit ratings, stronger gov balance sheets, much sovereign debt considered IG
types of gilt
conventional
75% - fixed, semi annual coupon. receive principal + final coupon @ redemption
ILG - approx 1/4 of UK debt
coupon payments and principal adjusted in line with RPI (8 month lag before sep 05, 3 month lag after)
will have no uplift in period of zero deflation
during deflation - depends on if gilt has deflationary floor
STRIPS
practise of stripping coupon and bond apart, so CFs and principal are separated
holder of prin basically has ZCB, which trades at discount to NV
holder of coupons analogous to annuity (if coupons split up they are also baso ZCB)
good for liability matching - no reinvestment risk as usual with coupon paying gilts
only some gilts are designated ‘strippable’ by DMO and stripped by GEMMs
dual dated - none in issue rn
foreign currency debt issues
- issued to finance foreign currency reserves. USD and euro outstanding rn. trade like eurobonds with same conventions for accrued interest
green gilts
first issued in 2020 to mean green obj
Green Gilts issued in Sep 2021. Plan to raise £15bn to fund clean transport, climate change adaption, renewable energy,
energy efficiency, pollution prevention and control and living and natural resources
NSI green savings bonds
fixed term investments where saving contribute to green projects - rate fixed for 3 yrs, taxable but paid gross.
no floating rate or convertible in issue since 01
bid- cover ratio
no. of bids received / no. of bids accepted (or can use £ amount / £ amount)
> 2 = successful auction - strong demand
<1 = failure - amount bid < amount offered
low ratio = disappointing auction - marked by higher yield
gilt issuance
competitive auction - pay the amount bid up to the amount the DMO wishest to raise highest to lowest
non-competitive tender - up to 500k NV where applicants revieve NV they applied for @ weighted avg price of successful competitive bids
PAOF - post auction option facility
successful bidders have option to acquire additional 10% of gilt allocation @ average accepted price
Interim funding/TAPS
issuance of smaller quant of stock to improve liquidity or market efficiency - DMO sells to GEMMs (often tranche of existing stock or result of failed auction )
GEMMs
obligations and privileges
must be vetted by DMO and LSE - then become primary dealers
obligations
- to make effective 2 way prices to customers on demand up to size agree with DMO = provide liquidity (excluding other GEMMS, fixed interest MM or gilt IDB)
- to participate in gilt issuance programme, bidding competitively - baso underwriting gilt auctions
- provide DMO with closing prices, market conditions and GEMMs positions/turnover
privileges
- executive rights to competitive telephone bidding @ gilt auctions and other DMO ops
- exclusive facility to trade as counterparty to DMO
-exclusive access to gilt IDB screen
firm can register to be a GEMM on
- all gilt edged secs
-IL gilts only
- gilts excluding IL
Broker dealers
non GEMM LSE members that can buy/sell gilts as agent (broker) or as principal (dealer)
- as broker - bound by LSEs best ex rules
- must identify with GEMM if deal is a small one from outset i.e. <1mili
Gilt IDB (inter dealer brokers)
arrange deals anonymously between GEMMs
cannot take principal positions
IDB acts as angel - but settles transaction as in it were the principle
can only act as principal between GEMMs
secondary gilt market
supported by GEMMs who must ensure two way quote exists @ all times
secondary market for ILG may be less liquid than straights
relationship between interest rates and gilt price
inverse
rates increase - fixed val of coupon less attractive vs rate on deposited funds - price down
rates decrease - fixed val of coupon more attractive vs rate on deposited funds - price up
gilt repos
repo = sale and repurchase - legally binding
borrower - sells gilts and agrees to buy back @ future date @ set price with interest @ repo rate inferred in the repurchase price
baso ST lending w/ gilt as collateral
If coupon due during repo must be paid back to orig owner - stated in repo agreement
buyer/lender has entered into a reverse repo
borrower = able to raise finance against security of gilts - potentially @ cheaper rate
lender = if lender is bank - benefit of repo is security of gilt vs conventional finance
if lender = GEMM - repo enables GEMM to access gilts it requires to meet settlement obligations
Standing repo facility (SRF)
ensures smooth running of gov bond market
enables GEMMS to enter into reverse repo with DMO to e.g. cover short position in bonds
must first sign the relevant documentation provided by CB
above £5mn NV
next day settlement
can be rolled forward for up to two weeks
other countries also have SRF
in UK DMO charge higher than normal repo rate
Reverse repo and sale
creation of short position in debt instrument - where buyer/lender immediately sells security provided by borrower/seller on open market
on settlement date - buyer acquires gilt in market (hoping to profit from fallen price) and delivers to seller
stock borrowing and lending intermediaries (SBLI)
- pool large blocks of secs from instit investors (pension funds, insurance brokers)
- secs then loaned out to borrowers to cover their short position
- once short position is closed out (borrowers purchased secs elsewhere), bonds returned to instit
- SBLI charges fee 0.5% split between themselves and lenders of secs
- minimal activity in UK since 96 due to intro of repo market
instit investors dont have to do anything - just receive fee
with repo - they would have to invest money paid to make return
gilt settlement
UK - settle T+1 in CREST (certificates registry for electronic share registration) - part of Euroclear UK and Ireland
CREST is the CSD, regulated by the BoE with RCH status
CREST
same day clearing system
allows shareholders/bondholders to hold assets in dematerialized form
clears trades by matching settlement details of buyers and sellers
UPDATES SHAREHOLDER REGISTER - settles when CREST updates the register of relevant company to transfer shares to buyer
ISSUES PAYMENT OBLIGATION - bank to transfer £ to seller
ISSUES RECEIPT NOTIFICATION - to sellers bank to expect payment
ETC (electronic trade confirmation system) - both parties to transaction required to confirm sides of transac via file transfer - submit confirmation details to CREST - if they dont match CREST highlights this
LCH - clearing house for OTC trades (CREST/Euroclear) which is responsible for settling transaction with each CP
other functions
- custodianship
-assisting w/ divi payments
-handing corp actions on behalf of clients it reps
- collects SDRT
CREST members are either
- members - large instits used by sponsored members to provide access
- sponsored members
bond prices and futures
IR and inflation expectations are explicit in bond derivs - these are a driver of bond prices
10 yr treasury note contract - one of most activity traded futures contracts - trades of CBOT
- v good liquidity
- vehicle to hedge exposure to variety of fixed income instruments
- speculation opp (on IR spread between IG and HY bonds vs UST)
bond futures = cash or physically settled (cheapest to deliver bonds)
arbitrage opps will quickly eliminate price discrepancies regarding cheapest to deliver bonds
debenture vs loan stock
debenture = loan with some specified security
loan stock/unsecured loan stock = loan with no security provided
- in UK market tends to be comps with high credit rating or status
loans w/out security have higher coup to compensate for risk
eurobonds
bonds issued outsideof the country whose currency they are denominated in
- allows orgs to issue debt w/out being restricted to domestic market
bearer form (comp doest keep record of holders) - safekeeping is important - so often held in depositories/ CH - ‘immobilisation’
unsecured debt (highly rated comps)
OTC trading
no WH tax (CH keeps register but not avail to gov)
coupons taxable but paid gross + annual
vanilla (annual coupon) or ZCB, FRN, stepped coupon
trades matched through TRAX
ICMA self regulatory system
t+2 settlement
accrued interest 30/360
corp bond issuance
most common method in primary, domestic bond market is via placement
PV of bond long hand (semi annual)
for semi annual bond
HALVE COUPOUNS
HALVE DISCOUNT RATES
DOUBLE TIME PERIODS (TO WHOLE NUMBERS)
PV of bond long hand (NPV)
PV = discounting future values of CF back to today in accordance w/ prevailing IR
(coupons and redemption)
NPV = PV of cash flows - current price
For semi annual = Halve coupons and discount rate. Use FULL NUMBER time periods
annuity discount formula - pricing bonds
r = rate/desired yield
n= no. of period
Use formula to work out PV of coupons and ADD
PV of redemption payment
flat yield
cash return as % of cash price
- ignores cap gain/loss @ redemption = better for ST investors who wont hold to maturity
- good for irredeemables or ST cash returns
- ignores timing of cash flows and time val of $
- useless if coupon isn’t constant
uses clean price
Japanese GRY
good way to estimate GRY -considers returns, income and cap
better than flat yield
useful for non taxpayer who will hold to maturity
ignores timing of CFs and time val of $
assumes linear growth not compoind growth - can overstate effects of cap gain/loss
uses clean price
worse if bond is further from maturity
GRY
basically IRR of the bonds cash flows
more appropriate for LT investors than FY as takes coupons and gain/loss @ maturity into account
- best for LT, non taxpaying investors - pension funds and charities
1) calculate JGRY to give indication of yield
(coupon + gain/loss@maturity / years to maturity) / clean price
2) calculate NPV (N1) using R1 (rate below JGRY) - should be pos
3) calculate NPV2 (N2) using R2 (rate above JGRY) - should be neg
4) calculate GRY by interpolation
net redemption yield simple
JGRY using net coupon as no CGT on gain
convention is to assume 40% rate
GRY of FRNs
can use this formula to work out r = yield
deriving spot rate from bond price
bootstrapping
use 1 yr bond to find 1 yr spot rate (will be same as yield as only 1 CF)
then use 1 yr rate to find 2 year rate - as 2 yr bond is a DCF of 2 CFs - so discount 1yr coupon by 1 year spot rate
how to calculate forward rates
arbitrage - should be no difference between investing for 2 years vs investing for 1 year and rolling over @end
SO calc 1 yr spot rate then 2 year sport rate then rearrange for forward rate
calculating forward rates formula
mac D formula
cannot use annuity formula as it’s the sum of PVxt
modified duration
y = rate
aprox change in price for 1% change in yield
if yield goes up price will go down obvi
only an approximation due to convexity because mod duration implies linear price yield relationship
mod dur and convexity
only an approximation due to convexity because mod duration implies linear price yield relationship
actual relationship isnt linear - increases in yields results in prices dropping at reducing rate
mod dur - will overstate fall in price and understate rise
convexity
measure of curvature in relationship between bond price and yield
- change in mod dur with respect to yields
higher convexity = more curvature
lower coup = lower convexity
mod duration good aprox for small movements in yield - diminishes as yield vol increases
convexity adjustment
amount to add to price to account for convexity (always pos)
BPV - basis point value
finer measure of sensitivity AKA price/dollar value of basis point
represents how much price will change if yield changes by a bp
more sensitive bonds obvs have higher bpv
