investing in Bonds Flashcards
purpose of selling bonds
raising money to fund construction, take on new projects, or grow the business
Bonds
- a debt instrument issued by the government or a company
- a promise to repay the principal along with interest (coupons) by a specified date (maturity)
Type of Bonds 1
-By Issuer @Government bonds @Corporate bonds -By Coupon rate @Fixed @Indexed, e.g., iBonds of HKSAR where coupon interest payments are linked to average annual inflation, with a min interest rate of 1%. -By Principal @Fixed as par value @Indexed, e.g., TIPS (Treasury Inflation-Protected Securities) where principal changes with CPI
Par value
With stocks, the par value, which is frequently set at $1, is used as an accounting device but has no relationship to the actual market value of the stock.
But with bonds, par value, usually $1,000, is the amount you pay to purchase at issue and the amount you receive when the bond is redeemed at maturity.
Par is also the basis on which the interest you earn on a bond is figured. For example, if you are earning 6% annual interest on a bond with a par value of $1,000, that means you receive 6% of $1,000, or $60.
While the par value of a bond typically remains constant for its term, its market value does not. That is, a bond may trade at a premium, or more than par, or at a discount, which is less than par, in the secondary market.
The market price is based on changes in the interest rate, the bond’s rating, or other factors.
Type of Bonds 2
By Special features
- Convertible bonds
• Hybrid bonds, with features of both debt and equity
• Have an option to convert the bond to stock
• Usually priced lower than a straight bond
• Advantage to the company: the company does not have to repay the debt obligation, yet gives up some ownership through stock
• Advantage for the bondholder: ability to
participate in the upside of a growing company and increased returns - Callable bonds
-Before the bond matures, issuer has the right
to buy back the bonds at a defined call price on the call date(s). Technically speaking, the bonds are cancelled immediately.
-The call price usually exceeds the par value
-Advantage to the company: If interest rates in
the market have gone down, the company
can refinance its debt at a cheaper level
-Advantage for the bondholder: a higher
coupon than a straight, non-callable bond;
and a higher call price than face value
Coupon Rate
Interest payment paid on the bond as a percentage of the bond’s face value
Yield to Maturity
Rate of return you earn on the bond based on the price you pay for the bond and the principal you receive at maturity, including all coupons
Current yield
Interest payment paid on the bond as a percentage of the bond’s current market price
For example, if a bond is priced at $95.75 and has an annual coupon of $5.10, the current yield of the bond is 5.33%. If the bond is a 10-year bond with nine years remaining and you were only planning to hold it for one year, you would receive the $5.10, but your actual return would depend on the bond’s price when you sold it. If, during this period, interest rates rose and the price of your bond fell to $87.34, your actual return for the period would be -3.5% (-$3.31/$95.75) because although you gained $5.10 in dividends, your capital loss was $8.41.
Called
When a bond is repaid earlier than its maturity date
Yield to Call
Rate of return you earn on the bond based on the price you pay for the bond and the call price at the you receive at the early repayment date, including all coupons.
Why the interest rate tends to have an inverse relationship with the price of the bond?
At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer examination, it makes sense. An easy way to grasp why bond prices move opposite to interest rates is to consider zero-coupon bonds, which don’t pay coupons but derive their value from the difference between the purchase price and the par value paid at maturity.
For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond’s rate of return at the present time is approximately 5.26% ((1000-950) / 950 = 5.26%).
For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his or her satisfaction with this return depends on what else is happening in the bond market. Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn’t be in demand at all. Who wants a 5.26% yield when they can get 10%? To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond’s price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield).
Now that we have an idea of how a bond’s price moves in relation to interest-rate changes, it’s easy to see why a bond’s price would increase if prevailing interest rates were to drop. If rates dropped to 3%, our zero-coupon bond - with its yield of 5.26% - would suddenly look very attractive. More people would buy the bond, which would push the price up until the bond’s yield matched the prevailing 3% rate. In this instance, the price of the bond would increase to approximately $970. Given this increase in price, you can see why bond-holders (the investors selling their bonds) benefit from a decrease in prevailing interest rates.
If I buy a $1,000 bond with a coupon of 10% and a maturity in 10 years, will I receive $100 each year regardless of what the yield is?
Simply put: yes, you will. The beauty of a fixed-income security is that the investor can expect to receive a certain amount of cash, provided the bond or debt instrument is held until maturity (and its issuer does not default). Most bonds pay interest semi-annually, which means you receive two payments each year. So with a $1,000 bond that has a 10% semi-annual coupon, you would receive $50 (5%*$1,000) twice a year for the next 10 years.
Most investors, however, are concerned not with the coupon payment, but with the bond yield, which is a measure of the income generated by a bond, calculated as the interest divided by the price. So if your bond is selling at $1,000, or par, the coupon payment is equal to the yield, which in this case is 10%. But bond prices are affected by, among other things, the interest offered by other income-producing bonds. As such, bond prices fluctuate, and in turn, so do bond yields. You can read more about the factors affecting bond prices in the tutorials “Bond Basics” and “Advanced Bond Concepts”.
To further illustrate the difference between yield and coupon payments, let’s consider your $1,000 bond with a 10% coupon and its 10% yield ($100/$1,000). Now, if the market price fluctuated and valued your bond to be worth $800, your yield would now be 12.5% ($100/$800), but the $50 semi-annual coupon payments would not change. Conversely, if the bond price were to shoot up to $1,250, your yield would decrease to 8% ($100/$1,250), but again, you would still receive the same $50 semi-annual coupon payments.
Yield
The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value.
For example, there are two stock dividend yields. If you buy a stock for $30 (cost basis) and its current price and annual dividend is $33 and $1, respectively, the “cost yield” will be 3.3% ($1/$30) and the “current yield” will be 3% ($1/$33).
Bonds have four yields: coupon (the bond interest rate fixed at issuance), current (the bond interest rate as a percentage of the current price of the bond), and yield to maturity (an estimate of what an investor will receive if the bond is held to its maturity date). Non-taxable municipal bonds will have a tax-equivalent (TE) yield determined by the investor’s tax bracket.
Mutual fund yields are an annual percentage measure of income (dividends and interest) earned by the fund’s portfolio, net of the fund’s expenses. In addition, the “SEC yield” is an indicator of the percentage yield on a fund based on a 30-day period.
Discount bond
price below par value
Premium bond
price above par value
