Bonds

Question 1

What is a bond ?

Answer 1

A bond is, very simply, a loan.

A company or government that needs to raise money to finance, for example, an investment project, could borrow money from its bank or, alternatively, it could issue a bond to raise the funds it needs by borrowing from the investing public.
With a bond, an investor lends in return for the promise to have the loan repaid on a fixed date and (usually) a series of interest payments.

Question 2

What is a loan stock?

Answer 2

A corporate bond issue in the domestic bond market without any underlying collateral, or security.

Question 3

What is the difference between a bond and most loans?

Answer 3

A bond is a tradeable instrument with a secondary market, meaning investors can buy and sell bonds without going back to the original borrower.

Question 4

What is the nominal?

Answer 4

This is the amount of stock purchased and should not be confused with the amount invested or the cost of purchase. This is the amount on which interest will be paid and the amount that will eventually be repaid. It is also known as the ‘par’ or ‘face’ value of the bond.

Question 5

What is the Stock?

Answer 5

The name given to identify the stock and the borrower

Question 6

What is the coupon?

Answer 6

This is the amount of interest paid per year, expressed as a percentage of the face value of the bond. The bond issuer will pay the coupon to the bondholder. The rate is quoted gross and will normally be paid in two separate and equal half-yearly interest payments. The annual amount of interest paid is calculated by multiplying the nominal amount of stock held by the coupon; that is, in this case, US$10,000 multiplied by 1.875%.

Question 7

What is Redemption Date?

Answer 7

This is the date at which the issue expires and the borrower will repay the lender the sum borrowed. Repayment of principal will take place at the same time that the final interest payment is made. The amount repaid will be the nominal amount of stock held.

Question 8

What is the Price?

Answer 8

This stock can be freely traded at any time on the New York Stock Exchange (NYSE) and, as mentioned above, it is quoted at US$96.18. The convention in the bond markets is to quote stock per US$100 nominal of stock. In this example, the price quoted is US$96.18 and so each US$100 nominal of stock purchased will cost US$96.18 before any brokerage costs (note: a historic price is used as an example as prices can and do change).

Question 9

What is the value?

Answer 9

The value of the stock is calculated by multiplying the nominal amount of the stock by the current price (allowing for the price being per $100 nominal of stock), and so the holding has a market value of $9,618 – that is, the nominal value of $10,000 multiplied by the price of $96.18.

Question 10

What are the advantages of investing in Bonds?

Answer 10

1. For fixed interest bonds, a regular and certain flow of income
2. For most bonds, a fixed maturity date (but there are bonds which have no redemption date, and others which may be repaid on either of two dates or between two dates – some at the investor’s option and some at the issuer’s option)
3. A range of income yields to suit different investment and tax situations, and
4. The relative security of capital for more highly rated bonds.

Question 11

What are the disadvantages of investing in Bonds?

Answer 11

1. The real value of the income flow is eroded by the effects of inflation (except in the case of index-linked bonds).
2. Bonds carry elements of risk.

Question 12

What are the main risks attached to holding bonds?

Answer 12

1. Default risk, the issuer might be a company that could go out of business and/or will not repay the capital at the maturity risk, and price risk.

Question 13

What is the inverse relationship between interest rate and bond prices?

Answer 13

1. If interest rates increase, bond prices will decrease.
2. If interest rates decrease, bond prices will increase.

Question 14

What other risks are attached to bonds?

Answer 14

1. Early redemption – the risk that the issuer may invoke a call provision and redeem the bond early.
2. Seniority risk – this relates to the seniority with which corporate debt is ranked in the event of the issuer’s liquidation. If the company raises more borrowing and it is entitled to be repaid before the existing bonds, then the bonds have suffered from seniority risk.
3. Inflation risk – the risk of inflation rising unexpectedly and eroding the real value of the bond’s coupon and redemption payment.
4. Liquidity risk – liquidity is the ease with which a security can be converted into cash. Some bonds are more easily sold at a fair market price than others.
5. Exchange rate risk – bonds denominated in a currency different from that of the investor’s home currency are potentially subject to adverse exchange rate movements.

Question 15

Bond issues, subject to credit ratings, can be divided into two categories Name both categories:

Answer 15

1. Those accorded an investment grade rating, and
2. Those categorised as non-investment grade, or speculative. The latter are also known as ‘high-yield’ or – for the worst-rated – ‘junk’ bonds”

Question 16

Government Bonds

Answer 16

Governments issue bonds to finance their spending and investment plans and to bridge the gap between their actual spending and the tax and other forms of income that they receive. Issuance of bonds is high when tax revenues are significantly lower than government spending.

Question 17

What are the four main marketable types of US Bonds?

Answer 17

1. Treasury bills – also known as T-bills, a money market instrument used to finance the government’s short-term borrowing needs. They have maturities of less than a year and are typically issued with maturities of 28 days, 91 days, 182 days and 365 days. They are zero coupon instruments that pay no interest and instead are issued at a discount to their par value. Once issued, they trade in the secondary market and are priced on a yield-to-maturity basis.
2. Treasury notes – conventional government bonds that have a fixed coupon and redemption date. They have maturity dates between one and ten years from their issue date. They are commonly issued with maturities of two, five and ten years.
3. Treasury bonds – again conventional govern­ment bonds, but with maturities of more than ten years from their issue date; most commonly issued with typical maturities of 20 to 30 years.
4. Treasury inflation-protected securities – these are index-linked bonds and are referred to as TIPS. The principal value of the bond is adjusted regularly, based on movements in the consumer price index (CPI) to account for the impact of inflation. Interest payments are paid half-yearly and, unlike the UK version, the coupon remains constant but is paid on the changing principal value.

Question 18

STRIPS

Answer 18

Separate trading of registered interest and principal securities) are also traded based on the stripped elements of Treasury notes, bonds and TIPS. Each bond is broken down into its underlying cash flows – that is, each individual interest payment plus the single redemption payment. Each is then traded as a separate zero coupon bond (ZCB).

Question 19

What is a gilt?

Answer 19

UK government bonds are known as gilts. Historically, when physical certificates were issued, they used to have a gold or gilt edge to them; hence, they are known as ‘gilts’ or ‘gilt-edged stock’. The bonds are issued on behalf of the government by the Debt Management Office (DMO).

Question 20

What is an index linked bond?

Answer 20

Index-linked bonds are bonds where the coupon and the redemption amount are adjusted in line with movements in the General Index of Retail Prices (RPI); they are similar to the US TIPS.

Question 21

What are the main type of German government bonds?

Answer 21

Bunds, Schatz and Bobls. Bunds are longer-term instruments; Schatz are issued with two-year maturities; Bobls are issued with five-year maturities.

Question 22

What are the main type of Chinese government bonds?

Answer 22

1. Sovereign government bonds are issued by the Ministry of Finance and typically have maturities between three months and 50 years.
2. Policy bank bonds are quasi-sovereign bonds issued by the China Development Bank, the Agricultural Development Bank of China and the Export-Import Bank of China. They, typically, have maturities of between six months and 50 years, and carry slightly higher yields than government bonds.
3. The third major sector of the market is local government bonds that are issued by provincial and local governments, which typically have maturities of between one and ten years. These demonstrate greater differentiation based on the credit quality of the issuer and their fiscal position.

Question 23

List the six categories of JGBs:

Answer 23

1. Short-term bonds
2. Medium-term bonds
3. Long-term bonds
4. Super-long-term bonds
5. Individual investor bonds
6. Inflation-indexed bonds.

Question 24

What is a corporate bond?

Answer 24

A corporate bond is a bond that is issued by a company, as the name suggests.
The term is usually applied to longer-term debt instruments with a maturity date of more than 12 months.

Question 25

Bond Security

Answer 25

When a company is seeking to raise new funds by way of a bond issue, it will often have to offer security to provide the investor with some guarantee for the repayment of the bond. In this context, security usually means some form of charge over the issuer’s assets (eg, its property or trade assets) so that, if the issuer defaults, the bondholders have a claim on those assets before other creditors (and so can regard their borrowings as safer than if there were no security).

Question 26

What is a callable bond?

Answer 26

In some cases, a corporate bond will have a call provision which gives the issuer the option to buy back all or part of the issue before maturity. These bonds are known as callable bonds.

Question 27

What is a puttable bond?

Answer 27

Some bonds are issued with put provisions and are known as puttable bonds; these give the bondholder the right to require the issuer to redeem early, on a set date or between specific dates. This makes the bond attractive to investors and may increase the chances of selling a bond issue in the first instance. It does, however, increase the issuer’s risk that it will have to refinance the bond at an inconvenient time.

Question 28

What are Medium-Term Notes (MTNs)

Answer 28

MTNs are standard corporate bonds with maturities up to five years, though the term is also applied to instruments with maturities as long as 30 years. How MTNs differ from other debt instruments is that they are offered to investors continually over a period of time by an agent of the issuer, instead of in a single tranche of one sizeable underwritten issue.

Question 29

What are Floating Rate Notes (FRNs)

Answer 29

Debt securities issued with a coupon that periodically changes based on a benchmark interest rate. An FRN will usually pay interest at the benchmark rate plus a quoted margin or spread.

Question 30

What are convertible bonds?

Answer 30

A bond which can be converted, at the investor's choice, into the same company's shares.

Question 31

Which choices do investors have if they hold a convertible bond?

Answer 31

1. To simply collect the interest payments and then the repayment of the bond on maturity, or 2. To convert the bond into a predefined number of ordinary shares in the issuing company, on a set date or dates, or between a range of set dates, prior to the bond’s maturity.

Question 32

What is attractive for an investor that holds convertible bonds?

Answer 32

1. If the company prospers, its share price will rise and, if it does so sufficiently, conversion may lead to capital gains. 2. If the company hits problems, the investor will retain the bond – interest will be earned and, as bondholder, the investor would rank ahead of existing shareholders if the company goes out of business. (Of course, if the company is seriously insolvent and the bond is unsecured, the bondholder might still not be repaid, but this is a more remote possibility than that of a full loss as a shareholder.

Question 33

What are Preferred Bonds?

Answer 33

Preferred bonds, also known as ‘preferreds’, share the characteristics of shares and bonds and have the potential to offer investors higher yields than holding the company’s ordinary shares or bonds. They are essentially bonds that have equity-like features and are generally issued by large banks and insurance companies. They are usually undated/perpetual and carry callable rights for the issuer within the first five to ten years of issuance. A specific equity-like feature is the fact that these pay dividends as opposed to coupons as with other bonds. Within the issuer’s capital structure, preferreds rank lower than senior debt but higher than equity.

Question 34

What are Zero Coupon Bonds?

Answer 34

Bonds issued at discount to their nominal value that do not pay a coupon, but which are redeemed at par on a pre-specified future date.

Question 35

What is a covered Bond?

Answer 35

A variation on ABSs is covered bonds which are widely used in Europe. These are issued by financial institutions and are corporate bonds that are backed by cash flows from a pool of mortgages or public sector loans. The pool of assets provides ‘cover’ for the loan, hence the term ‘covered bond’. They are similar in many ways to ABSs, but the regulatory framework for covered bonds is designed so that bonds that comply with those requirements are considered as particularly safe investments.

Question 36

What are the main differences between covered bonds and ABS bonds?

Answer 36

1. The assets remain on the issuer’s balance sheet. 2. The asset pool must provide sufficient collateral to cover bondholder claims throughout the whole term of the covered bond. 3. Bondholders must have priority claim on the asset pool in case of default of the issuer.

Question 37

Domestic and Foreign Bonds

Answer 37

Bonds can be categorised geographically. A domestic bond is issued by a domestic issuer into the domestic market, for example, a UK company issuing bonds, denominated in sterling, to UK investors. In contrast, a foreign bond is issued by an overseas of foreign entity into a domestic market and is denominated in the domestic currency.

Question 38

What are eurobonds?

Answer 38

Eurobonds are large international bond issues often made by governments and multinational companies in a currency which is not the currency of the country in which it is issued. Often issued in a number of financial centres simultaneously, the one defining characteristic of eurobonds is that they are denominated in a currency different from that of the financial centre or centres from which they are issued. An example might be a German company issuing either a euro, a dollar or a sterling bond to Japanese investors.

Question 39

What are the advantages of Eurobonds ?

Answer 39

1. A choice of innovative products to more precisely meet issuers’ needs 2. The ability to tap potential lenders internationally, rather than just domestically 3. Anonymity to investors as issues are made in bearer form 4. Gross interest payments to investors 5. Lower funding costs due to the competitive nature and greater liquidity of the market 6. The ability to make bond issues on short notice, and 7. Less regulation and disclosure.

Question 40

What are yields?

Answer 40

Yields are a measure of the returns to be earned on bonds. The coupon reflects the interest rate payable on the nominal or principal amount. However, an investor may have paid a different amount to purchase the bond, so a method of calculating the true return is needed. The return, as a percentage of the cost price, which a bond offers is often referred to as the bond’s yield.

Question 41

What is the flat yield and how is calculated?

Answer 41

The interest paid on a bond as a percentage of its market price is referred to as the flat, or running, yield. The flat yield is calculated by taking the annual coupon and dividing by the bond’s price, and then multiplying by 100 to obtain a percentage.

Question 42

What is the yield curve?

Answer 42

The depiction of the relationship between the yields and the maturity of bonds of the same type.

Question 43

What will be the impact of a fall in interest rates on bond prices?

Answer 43

Bonds have an inverse relationship with interest rates so a fall in interest rates should see bond prices rise.

Question 44

What is the function of a call provision when attached to a bond?

Answer 44

A call provision enables the issue to "call" the bond an repay it early.

Question 45

What options do a convertible bond give to an investor?

Answer 45

An investor holding a convertible bond will have regular opportunities to convert the bond into shares of the underlying company. If they choose not to do so, they can hold the bind until its normal maturity date.

Question 46

What type of bond does not pay interest?

Answer 46

A zero coupon bond pays no interest and instead is issued at a discount to the amount repayable at maturity.

Question 47

You have a holding of $1000 Treasury 1.5% stock 2030 which is priced at $101.15. What is its flat yield?

Answer 47

The flat yield of a bond is the coupon dividend by the current price so the flat yield= 1.5/101.15 x100= 1.48%