Chapter 4: Bonds

Question 1

what are the characteristics of a bond?

Answer 1

company’s take loans from investors to raise money for the firm. the loan from the investor will then be paid back on a fixed date along with interest rates biannually until the bond is repaid (fixed interest securities). bonds are tradeable, so investors can buy and sell them without the need to refer back to the original issuer.

Question 2

what is the terminology relating to bonds?

Answer 2

nominal: the value of the bond that is purchased (the amount that interest will be paid back on)
coupon: the nominal interest rate paid on the bond, calculated gross and repayable in two equal half-year payments
redemption/maturity date: the date where the bond will be paid back, will take place on the same date as the final interest payment

Question 3

what is the general convention in the bond market?

Answer 3

to quote prices for bonds per £100 of nominal stock

Question 4

how is the value of the bond calculated

Answer 4

taking the price per £100 of nominal stock and scaling up based on the nominal stock held e.g., is the total nominal value of the bond is £10,000 and the price per £100 nominal value is £100.70, the total value is £10,070 i.e., (10,000/100)x£100.70

Question 5

why do govts issue bonds?

Answer 5

to finance their investment plans, known as gilts (gilt-edged stocks), issued on behalf of the govt by the office of debt management which is an executive agency of HM Treasury

Question 6

what are conventional bonds?

Answer 6

carry a fixed coupon and a single repayment date, they typically represent around 75% of bonds on issue.

Question 7

what are index linked bonds, and why are they attrictive?

Answer 7

bonds where coupon and redemption amount for index linked bonds are increased by the amount of inflation over its lifetime, they are uplifted by inflation at each interest payment
Index linked bonds are attractive in periods when the govt control of inflation is uncertain as this provides better cover for the investor, attractive as long-term investments

Question 8

how can conventional bonds be stripped and sold?

Answer 8

Conventional bonds can be stripped (broken down into their individual cash flows which can then be traded as zero-coupon gilts) into their individual cash flows (the coupon payments and the final repayment of the bond). E.g., a three-year gilt will have seven individual cash flows (the 6 coupon payments biannually throughout the 3 years and the final maturity payment). These will each be known as ‘gilt STRIPS’

Question 9

what is a corporate bond and some of its features?

Answer 9

A bond that is issued by a company
Applied to longer-term debt instruments with a maturity date of more than 12 months
Most corporate bonds are listed on stock exchanges but most of the trading in most developed markets takes pace OTC

Question 10

what is bond security and how is guaranteed?

Answer 10

Security in terms of bonds is when the investor is provided with some backing for the repayment of loans, usually tied with some sort of charge to the issuer’s assets
Security may take form in some sort of third-party guarantee such as a bank saying they will repay the bond if the issuer defaults
Greater the security, the lower the cost of borrowing should be

Question 11

what are the type of bond security?

Answer 11

Security can be fixed or floating (fixed details that the security will be in the form of fixed assets within the company e.g., buildings and floating is when the security lies in the general assets of the company e.g., cash in the bank or trade debtors

Question 12

what is a call provision?

Answer 12

gives the issuer the option to buy back part of all of the bond before the maturity date. attractive to issuer as it gives them an opportunity to refinance the bond. disadvantage to the investor when interest rates are lower than the coupon that is paid and the call provision is used.

Question 13

what is a sinking fund requirement?

Answer 13

when there is a call provision for the issuer to redeem a specified amount of bonds at regular intervals

Question 14

what are ‘puttable bonds’

Answer 14

give the bondholder the capability to require the issuer to redeem the bond early, on a specific date or between two specific dates. makes it easier for the bond to be sold in the first instance but also puts the issuer at a disadvantage as they may be inconvenienced by the time when the investor is asking for the bond to be redeemed

Question 15

what are medium-term notes (MTNs)

Answer 15

standard corporate bonds with maturities up to 5 years, they are released continualy over a period of time rather than all at once in a single tranche of underwritten issue by an agent of the bond issue

Question 16

what are fixed rate bonds?

Answer 16

bonds with fixed coupons which are paid either bi-annually or yearly and have predetermined redemption rates

Question 17

what are floating rate notes (FRNs)?

Answer 17

bonds that have variable rates of interest. rates of interest will be linked to benchmark rate e.g., SONIA (sterling overnight index average) in the UK and SOFR (secured overnight reference rate)

Question 18

what are permanent interest-bearing shares (PIBS)?

Answer 18

bonds peculiar to the UK sterling market, issued by building societies, carry fixed coupons and are irredeemable e.g., if the maturity date is 90 years in the future, then the bond qualifies are irredeemable

Question 19

what are convertible bonds?

Answer 19

bonds issued by companies that have the option, at date prior to the maturity date, to be converted into a set number of ordinary shares by the investor. looks good to the investor as if the company prospers, and the bond is converted then there is an opportunity for capital gains if the share price raises, if the company doesn’t do well then, the investor can retain the bond and keep on getting interest payments and the bondholder would rank above regular shareholders if the company goes bust

Question 20

what are zero coupon bonds and what are the benefits of them?

Answer 20

these are bonds that do not pay any interest (coupon), but they redeem their par value so if the investor was able to purchase the bond at a price below it’s par value then when the maturity date comes, they can get a return for their investment. treated differently for tax purposes as it is provided in the form of capital growth rather than income

Question 21

what are domestic and foreign bonds?

Answer 21

domestic bonds are bonds that are issued by a domestic company into the domestic market. a foreign bond is when a foreign entity issues bonds into a domestic market in that domestic currency e.g., a UK company issuing bonds into the German market for German investors in the euro

Question 22

what are eurobonds?

Answer 22

large international bond issues made by govts and MTCs, most of the activity is concentrated in London. denominated in a country different from that where they are issued. not restricted to those out in Europe despite the name. often don’t provide any underlying collateral/security, but are credit rated by rating agencies. companies will make ‘negative pledge’ clauses in the bond which denotes that they won’t make any secured bond issues that will give seniority to those new bondholders in terms of the company’s assets. must be in any currency other than USD

Question 23

what are the advantages of eurobonds?

Answer 23

choice of innovative products to meet issuers needs for capital raising, reach potential lenders internationally, anonymity to investors, gross interest payments to investors, lower funding costs due to competitiveness and greater market liquidity, ability to make bond issue at short notice, less regulation and disclosure.

Question 24

what are asset-backed securities (ABSs)?

Answer 24

large group of bonds, consisting of bundled securities (packaged set of non-marketable assets). range from mortgages and credit card debt to accounts receivable (money woed to companies by a customer for goods and services provided). largest market of ABS is in the mortgage-backed securities (created by bundling a set of mortgages and then issuing bonds that are backed by these assets (the buildings that the mortgages are on) which is backed principal and interest payments of mortgages.

Question 25

what are covered bonds?

Answer 25

a variation of asset-backed bonds, widely used in Europe. issued by financial institutions and are corporate bonds that are backed by cash flows from a pool of mortgages or public sector loans (pool of assets provides cover for the loans). similar to ABSs but the regulatory framework is different so that they are particularly safe investments. important part of the financing of mortgage and public sector markts and a vital source of term funding for banks

Question 26

what are the main differences between covered bonds and ABSs?

Answer 26

regulatory requirements for covered bonds: remain on the issuers balance sheet, asset pool must provide sufficient collateral to cover the bondholder claims throughout the whole term, bondholders must have priority to claim on the cover asset pool in case of default of the issuer

Question 27

what are some of the advantages/disadvantages of bonds?

Answer 27

fixed-interest rate bonds provide a regular and certain flow of income, most have a fixed maturity rate, range of income yields to suit different investment tax solutions, capital is relatively secured with highly rated corporate bonds. the real value of the income flow is eroded by the effects of inflation, carry risks

Question 28

what are the risks associated with bonds?

Answer 28

default (issuer defaults on the payment of coupons or capital at the maturity date), prices of the bond may fall significant if impacted by external events which has a significant impact on the value of holdings, if the interest rates increase then the prices of bonds will decrease (if the interest rate increases greater than the coupon on the bond then they will seem less attractive to investors and vice versa). seniority risk (seniority at which corporate debt is ranked in the event of the issuers liquidation), bonds denominated in a currency different from that of the investors home currency are potentially subject to adverse exchange rate movements

Question 29

what is a flat yield and how is it calculated?

Answer 29

measure of the returns earned on bonds (expressed as a percentage of the cost price) calculated by taking the annual coupon and dividing it by the bnds price and then multiplying this value by 100 to get a percentage. the coupon is expressed as a price e.g., a 1% annual coupon will be expressed as £1

Question 30

what is a redemption yeild?

Answer 30

this is where it is looked at the total amount of capital gain or loss that is made on a bond by an investor if they retain the bond until it’s maturity date. incorporates both the income generated from the bond as well as the capital return generated wzinto one figure.

Question 31

what is the role of credit rating agencies?

Answer 31

they asses the probability of an issuer defaulting on their payment’s obligations and the extent of the resulting loss. most prominent credit rating agencies are: standard&poors, Moody’s and fitch ratings.

Question 32

what are the different grades that can be given to bonds in their credit ratings?

Answer 32

they can be classed as investment grade or non-investment grade/speculative. investment grade issues offer the greatest liquidity and certainty repayment. bond’s credit rating will be reassessed if circumstances change