Bonds 1 Flashcards
What is a bond?
Bonds are debt securities that are issued by governments, companies, and transnational organizations.
How are bonds paid?
Bonds usually have regular periodic fixed coupon payments and repay the face value of the bond at the maturity date of the bond.
What are zero-coupon bonds?
Zero-coupon bonds make no coupon payments and only repay the face value of the bond on the maturity date.
4 type of long-term bonds
- Federal government Bonds
- Corporate Bonds
- Mortgages
- Municipal Bonds
Federal government Bonds
Borrowing of the federal government. They represent the largest percentage of the total debt market and are by far the most liquid. Because they are backed by the government, they are considered default free. They are the simplest to value; they pay interest at a fixed rate and have a stated principal.
Corporate bonds
Corporate bonds are loans made by investors to corporations, which can be bought and sold publicly or privately. The corporation’s ability to make money and meet the debt obligations determines the risk of default. The bond’s price can fluctuate over time. If a bond is callable, the corporation has the right to pay it off early, so investors require a higher return to compensate for this risk.
Mortgage bonds
Mortgages are loans that are secured by real estate and are typically issued by banks or financial institutions. To raise funds, groups of mortgages are pooled together and sold as bonds, which offer investors protection because the principal is secured by the underlying asset. In case of default, the property can be sold to repay the bondholders. As a result of this security, mortgage bonds typically offer lower yields.
Pure expectations theory
The pure expectations theory explains the term structure in terms of expected one-period spot rates. Advocates of the expectations theory believe that the yield on a one-year bond is set so that the return on the one-year bond is the same as the return on a six-month bond plus the expected return on a six-month bond purchased six months hence. If the expectations theory is correct, then an upward-sloping yield curve is an indication that short-term rates are expected to increase. Similarly, a flat yield curve is an indication that short-term rates are expected to remain the same. Finally, a downward-sloping yield curve indicates that short-term rates are expected to decline. The easiest way to understand the expectations theory is to assume that the investors setting prices do not care about risk (are risk neutral). In this case, no matter what their time horizon, they will select the security or securities that give them the highest expected return. This is exactly the opposite of the market segmentation theory.
Liquidity Premium Theory
Liquidity premium theory assumes investors must be offered a higher expected return to hold a bond with a horizon different from their preferred horizon. It is assumed that there is a shortage of longer-term investors so that extra return must be offered on long-term bonds to induce investors to hold them. The assumption is that there is an excess of investors with short-term horizons. If the liquidity premium theory holds, an investor with a long-term horizon can hold a bond matching his horizon and earn the liquidity premium. Thus, such an investor earns an extra return without any extra risk. If the market expects short-term interest rates to remain stable over the next few years, the yield curve will be upward sloping, reflecting the term premium. Even if a declining series of one-period rates, it is still possible to observe an upward sloping yield curve. This would occur if the risk premiums were sufficiently large to overcome the expectations of a decline in one-period rates.
Segmented Markets Theory
The argument here is that bond markets are segmented from one another. Bond issuers and investors have a strong preference of debt with specific maturities. Some investors may prefer short-term bonds because they are less risky and more liquid, while others may prefer long-term bonds because they offer higher yields and better inflation protection. Thus, the supply and demand of long-term funds determine long-term rates, the same applies to short-term bonds. If there is a high demand for short-term bonds, the interest rate for short-term bonds will be lower than that for long-term bonds, and vice-versa. People who believe in market segmentation theory examine flows of funds into these market segments to predict changes in the yield curve.
Preferred habitat theory
Preferred habitat theory rests on the premise that investors who match the life of their assets with the life of their liabilities are in the lowest risk position. If there is a sufficient extra return to be earned on assets of other lives, they will adjust their position to include more of these higher-yielding assets. If this theory is correct, premiums will exist for maturities where there is insufficient demand. These premiums are necessary to induce investors to leave their preferred habitat. If there are many firms issuing long-term debt relative to the number of investors interested in long-term debt, a premium will have to be offered on long-term debt and vice-versa with short-term debt. With the preferred habitat, the premiums can be positive or negative. Without an idea of the sign and size of the premiums, nothing can be concluded about future one-period rates from observing the yield curve.
Default Risk
Unlike government bonds, for corporate bonds and municipal bonds there is a risk that the coupon or principal payments will not be met. Therefore, there is a distinction between promised return and expected return. The difference between promised return and expected return is the default premium. Bond rating agencies like Moody’s and S&P among others provide credit ratings for issued bonds worldwide. Likelihood of loss includes both the probability of a missed, delayed, or partial payment and the size of the loss if a loss occurs. Bond rating agencies divide bonds into different classes.
AAA/AA – Very high quality, A/BBB – High quality, BB/B – Speculative, CCC/D – Very poor quality.
The impact of a credit rating change on the yield and price of a bond depends on the direction and magnitude of the change. An upgrade in credit rating leads to a decrease in yield and price as it is less risky, while a downgrade leads to an increase in yield and price as it is a more risky investment. Investors demand a higher return for taking on greater risk, and a bond’s yield and price are inversely related. When the cost of servicing a government’s debt increases, it means that the government must pay more interest on its outstanding debt. This can make it more difficult for the government to raise new debt finance, as investors may be less willing to lend to the government at the higher interest rates required to compensate for the increased risk of default.
Furthermore, as the cost of servicing a government’s debt increases, it can lead to a situation in which the government’s debt-to-GDP ratio becomes unsustainable. This means that the government is borrowing more than it can realistically pay back, which can lead to a potential fiscal crisis.
Bond rating agencies are private, for-profit companies that are paid by the same issuers they are rating. This creates a potential conflict of interest, as there is a financial incentive for rating agencies to assign higher credit ratings to issuers in order to maintain their business relationships and attract more business.
The conflict of interest in the business model of bond rating agencies was highlighted during the 2008 financial crisis, when many highly rated mortgage-backed securities and collateralized debt obligations (CDOs) experienced significant default rates, leading to widespread losses for investors. The rating agencies were criticized for assigning high ratings to these securities, even though they were backed by subprime mortgages that were at a high risk of default.
Tax Effects
The cash flows on certain bonds may have a tax advantage for certain investors. This is because the interest income from bonds is generally taxable at the federal, state, and local levels, unless the bond is issued by a tax-exempt entity or agency. One example of a bond with a tax advantage is a municipal bond, which is issued by a state or local government to fund public projects such as schools, roads, and bridges. The interest income from municipal bonds is generally exempt from federal income tax and may also be exempt from state and local income tax, depending on the issuer and the state in which the investor resides. This makes municipal bonds particularly attractive to investors in high tax brackets, as they can benefit from the tax-exempt income. Another example of a bond with a tax advantage is a U.S. Treasury bond, which is issued by the federal government to finance its operations. The interest income from Treasury bonds is exempt from state and local income tax but is subject to federal income tax. However, the interest income from certain types of Treasury bonds, such as inflation-protected securities (TIPS), may be tax-deferred until the bond matures or is sold.
Option Features of Bonds
Bond sometimes contain a feature that constitutes on option for either the issuer or the holder of the bond. A call option is a feature of some bonds that gives the issuer the right to redeem the bond before its maturity date. This means that if interest rates have fallen since the bond was issued, the issuer can repay the bond principal to the bondholders earlier than originally planned, which can be beneficial for the issuer. However, from the perspective of the bondholder, the call option represents a risk, as it means that the bondholder may not receive the full amount of interest income they were expecting if the bond is called before maturity.
The presence of a call option can affect the valuation of bonds in a few ways. First, the value of a bond with a call option will generally be lower than the value of a similar bond without a call option, all else being equal.
Another option is sinking fund. Many bond issues require that part of the issue be retired over the life of the bond. The corporation has the option of purchasing bonds directly or of calling the bonds if it needs to meet its sinking fund obligation. The third option is the conversion option, which benefits bondholders. The bondholder has the option of converting the bond into common equity, the bond is used to pay for equity. This can affect the valuation of the bond resulting in a lower yield offered as if used as it allows bondholder to participate in any future growth in the issuer’s stock price.
