Bond Markets Flashcards
Government bond market
- Governments issue bonds to cover gaps between government expenditure and tax income
- Normally are very safe assets; reputation and political career, raise tax, government can print money
Maturity
Time remaining to maturity
- Shorts 5 yrs
- Medium 5-15
- Long 15-30
Default risk and trading gains and losses
- Low default risk does not guarantee one does not lose money by trading the gilt
- Low default risk means one receives all promised coupon payments and get back the principle at maturity
- Bond prices fluctuate
Gilts
- Bond issued by UK government
- Low default risk
- Face value of £100
- Coupon rate; paid semi annually
- EG treasury 4.5pc42
Coupon rate 4.5%
Coupon payment 2.25 every 6 months
Mature 2024 - Other names of gilts; exchequer, treasure or funding
Dated gilts - specific date of redemption or
- time range for redemption
- financing flexibility for the government
Undated gilts - few
Markets for gilts
- Quote driven market
- Bid price, ask price, dealer’s spread, potential profit
Index linked gilts
Bonds given fixed income:
- because the coupons and principles is fixed in minimal terms
- Value of a normal of a normal gilt is subject to the influence of inflation, low real value certainty
- coupons and principles are adjusted for RPI
- Normally adjustment is upward because inflation rate is positive
- e.g. initial coupon 2%, inflation 4%, new coupon rate = 2x1+(0.04) = 2.08%
Corporate bond market
Issued by companies
- major type of source of funds for companies
- Higher default risk than government bonds
- Secondary market is active; traded on stock exchange, OTC markets. Bond holders can cash out before maturity by selling to other investors
- normally institutional investors buy corporate bonds rather than individual
Types of Bonds
- Straight bond; pays both coupon and principle
- Zero coupon bond; selling at a discount to the face value
Debentures (loan stock)
- Bonds secured by company assets
- Debenture is the most safe type of corporate bond
- Secure means, in the event of insolvency, corporate assets are sold and proceeds are used to pay back bond holders
- Fixed charge debentures: debenture is secured by specific company assets
- Floating charge: Debenture is secured by general charge on all company assets
- Company given freedom to choose
Receiver
- Appointed when debt contract is signed
- Has the power to dispose assets in the event of insolvency
- Distribute proceeds to creditors
Caution
- Debentures have different meanings in various countries
Trust deeds
- A trust deed is a contract between bond holders and the borrowing company
Covenants
Risk-reducing restrictions put on companies
- make debt holders safer
- reduce borrowing costs
- often voluntary
- affirmative covenants
Restrictive covenants (negative)
- limit on further borrowing; limit on borrowing types
- Restrict the level of dividend ; bond holders against the idea of borrowing to pay dividend
- limit on disposal of assets
- required financial ratio
Credit rating
- Evaluation of company or governments credit worthiness made by credit rating agencies; benefits of credit rating: overcomes asymmetry, encourages investment in bonds, reduce borrowing costs
- Companies pay to get a credit rating
Determinants of credit rating
- Probability of default
- Extent to which lenders are protected in the event of default
Credit rating agencies consider both qual and quant factors
Quant- leverage ratio, cash flows
Qual - market share, management quality
AAA - best possible rating, extremely strong debt service capacity
D - lowest rating, effectively insolvent
Investment grade
- BBB or above
Credit rating agencies issue credit rating to individual bond securities
Credit rating agencies also issue rating for company as a whole
Governments also have credit rating
Bond values and risks
- Same as equity : present value of all future cash flows associated with a bond
- Cash flows associated with a bond; coupon, regular payment, principal, straight bonds, zero coupon bonds
How does a bond pay interest?
- Coupons
- Price at discount to face value
- Coupon rate specifies the interim cash flows but is not interest rate
Yield to maturity
The return to a bond holder from the moment a bond is bought to maturity
- YTM is the effective interest rate if a bond is held to maturity
Po = C/(1+Y) + C+P/(1+Y)^2
Current yield
- The gross (before tax) annual cash flow dividend by the current market price of the bond expressed as a percentage
C/Market price
Interest rate risk
Interest rate risk is reflected in the sensitivity of bond price changes in YTM.
The higher the sensitivity of a bond’s price to changes in YTM (interest rate), the higher the interest rate risk
Zero rate coupon = FV/(1+r)^t
