Analyzing Bonds

In this lesson, you’re expected to learn about:
– the different types of bonds
– bond rates and data
– bond valuation

A wide variety of different types of bonds are available, each with several variables that make it unique. Different bonds have different traits depending on who issues them.

Each issuer can also offer different options for additional features on those bonds, as well as using different underlying assets to generate the returns earned on the bonds or changing the methods by which repayments are made.

A number of different permutations can exist among bonds; for instance, a corporate bond may be a zero-coupon convertible bond (it doesn’t make payments of interest). Zero-coupon bonds are usually issued at a deep discount, meaning it is issued at a price well below its par value and the return to investors will be in the form of capital appreciation.

Additionally, a number of features are unique to each type of bond. However, bonds can’t have more than one issuer or have conflicting features.

Types of bonds

A wide variety of different types of bonds are available, each with several variables that make them unique. Different bonds have different traits depending on who issues them.

Each issuer can also offer different options for additional features on those bonds, as well as using different underlying assets to generate the returns earned on the bonds or changing the methods by which repayments are made.

1) Corporate Bonds

Corporate bonds are the ones that companies issue to raise capital with debt. These types of bonds are particularly important for corporate finance purposes. The role of these bonds is important from the perspective of investors and issuers.

2) Government Bonds

Governments are some of the biggest and most popular issuers of bonds in the world. Like all other organizations, governments issue bonds to incur debt that funds their spending.

Every year the government budgets its revenues and expenditures, and when it spends more than it generates in revenues, the remainder has to be acquired by incurring debt through the selling of government bonds.

In some cases, government bonds are issued to fund a specific project instead of making up for a general spending deficit.

For example, if a government wants to build a power plant, rather than attempting to budget for it out of its usual revenues, it may fund the entire project by selling government bonds and paying them back from the profits generated by selling the energy.

3) Coupon Bonds 

The term coupon bond comes from the old days when bonds were physical pieces of paper. These bonds had a series of paper tickets attached to them, each maturing at a specific date in the future.

Each coupon represented an interest payment and accumulated interest was paid periodically in exchange for the attached coupons.

Now, bonds aren’t pieces of paper anymore but ones that periodically make interest payments are still considered coupon bonds.

4) Zero-Coupon Bonds

Forgoing periodic payments
In contrast to coupon bonds, these bonds don’t make periodic interest payments. They still generate income but instead of making periodic payments, everything is paid out at maturity.

These bonds are sold at a deep discount (at a price much lower than face value) and pay face value at maturity.

5) Deep Discounted Bonds

Deep discounted bonds refer to a security that’s issued at a price well below its face value (either more than 15% in total or at a discount of more than 0.5% per year).

As a consequence, a deep discounted bond has a low coupon rate. Investors who issue deep discount bonds receive much of, if not all, the return in the form of the repayment of the capital amount at redemption when the bond reaches maturity.

6) Asset-Backed Securities

Although not technically bonds, asset-backed securities have been a topic of controversy since the 2007 financial crisis.

Asset-backed securities are securities sold by a company in order to raise capital for an investment and then the securities are repaid using the revenues raised from that investment.

For example, if a bank issues an asset-backed security, the money it raises from the sale can then be used to make a business loan to someone else. While the asset-backed security may pay 5% to the investor, the returns are repaid using part of the 6% interest that the bank earns from the business loan.

In a typical business loan, if the business defaults on the loan, the lender owns whatever assets it can take or sell from the business, provided that the bank has taken security over those assets.

The security of an asset-backed security is repaid using the cash flows from the business loan, so if the business defaults, the assets of the business are sold and the profits used to repay the holders of the asset-back securities first. Only then does whatever’s left over belong to the bank.

7) Convertible Bonds

Convertible bonds work just like normal corporate bonds except that purchasers have the right (at their discretion) to convert the bonds into a predetermined number of shares in the company. If you’re the investor and the company starts doing very well, causing the share price to increase, you can convert your bonds to the more valuable shares. But if the share price drops, you’re still guaranteed returns from your bond purchase, assuming that you don’t exchange perfectly good bonds for falling share prices.
As a corporate finance manager, issuing convertible bonds allows you to raise equity without reducing investor confidence in the price of your shares. You’re giving investors the option to exchange bonds for equity.

8) Callable Bonds  

Issuing bonds can be expensive for a company. For every bond sold, the company must pay back the principal as well as interest. If market interest rate drops below the rates that a company is paying on existing bonds, it would prefer to stop paying the rate on those bonds and issue new bonds at the lower rate.

Callable bonds are bonds that are issued with a contractual clause that allows the issuing company to redeem the bonds before their maturity date at a price equal to the present value plus a premium. This premium, which is paid to the investor, acts like an early repayment penalty in order to reimburse the investor fairly for not extending the debt to its full maturity date.

9) Puttable Bonds

If your company is buying bonds, it may want to protect itself from a change in interest rates. Say that you’re buying bonds at a 5% interest rate and the rates go up to 10%. Puttable bonds allow you to force the issuer to buy back your 5% bonds so that you can use that money to buy 10% bonds.

When your company buys puttable bonds and interest rates increase, you can insist on pre-maturity repayment of the principal, minus a penalty for early withdrawal. You can then use that money to buy higher-rate bonds.

For a company, however, using this strategy to attract investors can be risky. If several of your investors exercise their put option, forcing your company to repay its debts, and your company doesn’t have enough cash to repay them, it has to sell the capital it bought using that debt to make repayments.

This can lead to insolvency, where you simply don’t have money to pay your debts and are forced out of business. This form of potential repayment obligation isn’t measured on the balance sheet and so your company looks like it has more liquid assets than it really does. Therefore, managers watching the company’s liquidity need to use financial data that adjusts for these sorts of puttable bonds when determining the company’s risk of insolvency or illiquidity.

10) Registered Bonds

The majority of bonds in existence around the world today are registered bonds. With these bonds, the owner’s name and contact information is recorded and kept on file with the company who had taken out the bond.

Registered bonds don’t exist as physical entities. Instead they’re electronically registered to individuals and serial numbers connect these bonds to those people as a means of tracking ownership.

11) Catastrophe Bonds 

Bonds that raise capital for companies to limit the risk of an event occurring. The company issues bonds to raise capital with the stipulation that if a specific event occurs, bondholders must forgive repayment of the interest and/or principal.

Any company can issue catastrophe bonds – they’re an alternative to buying insurance to limit the risk of a potential disaster.

[Optional] Types of Bonds
Check out this 9-minute video to learn more:
Bond Rates
Most of the bonds already discussed are frequently fixed-rate bonds. You can however find them in variable-rate forms.

Fixed-rate bonds are very straightforward. The nominal cash flows of a fixed-rate bond are exactly as advertised – repayment of the principal with an added interest payment equal to the percentage rate.

On the other hand, a variable-rate bond is one where the interest rate or the principal payments is variable. So the amount you make by investing in these types of bonds changes over the life of the bond. Thus, the returns are tied to some other measure.

Types of Variable-Rate Bonds   

1) Floating interest rate bonds 

– most common form
– the interest rate on the bonds floats with the market interest rate. If the interest rate offered on bonds for sale on the open market increases, the bond pays more, matching the market interest rate. On the other hand, if the market rate decreases, so do the returns on your floating-rate bond.
– a good option for attracting investors speculating on interest rate increases but benefiting issuing companies when market interest rates decrease.

2) Inverse floating interest rate bonds

– this type offers returns that are the opposite of the market interest rate.
– work just like standard interest rate bonds except that they go in the opposite direction.
– when the market rate goes down, the rate on these bonds goes up, and vice versa.
– investors like these bonds when interest rates are projected to decrease, and issuing companies like them when interest rates are projected to go up.
– also helpful for portfolio risk management: allow bond investors to buy equal amounts of interest floats and inverse interest floats to protect against all interest rate changes and help stabilize interest rate returns.
– many investors feel that this approach minimizes returns because a strategy of using your money to buy only the best investments, instead of using a portion for risk management, decreases potential.

3) Indexed bonds 

– this type of variable-rate bond has its interest rate pegged to any of the many available indexes.
– if you buy or sell a bond pegged to the FTSE 100 and this index increases by 10%, your interest rate also increases by 10%.

Understanding Bond Information

Bond data is designed to help buyer and sellers make effective decisions regarding the potential to invest in bonds or issue their own.

Below are some common terms that you should know:

1) Ask (the offer): the price at which the seller is attempting to sell the bond. If this amount is above the bid price, no sale can be made until the buyer and seller give in and accept the price of the other party. The difference is known as the spread.

2) Bid: the price at which the buyer is attempting to buy a particular bond. If below the ask price, no sale is made until the buyer and seller agree on a compromise.

3) Coupon/Rate: this refers to the interest rate generated on a bond.

4) Credit quality ratings: performed by a credit rating agency on a bond and then provided to the public in order to help prospective buyers assess the risk of the issuing corporation defaulting. When bonds are issued, the issuers are asking others to loan them money through the purchase of the bond. As a result, companies issuing bonds must undergo a credit check. S&P and Moody’s are the two primary rating agencies. Each uses a slightly different rating system but their purpose is generally the same.

Bond Credit Ratings – S&P and Moody’s
5) Face Value / Par Value: the amount of the principal repayment on the bond.

6) Issuer: the organization issuing the bond.

7) Maturity date can be listed in two ways:
– as a duration of time (e.g. 1 year, 10 years). The bond matures in an exact duration of time after the purchase date.
– as a date: the bond matures on the date listed.

8) Price: it isn’t just listed as the nominal face value of the bond, it’s listed as a percentage of the face value. A bond that sells for under face value is selling at a discount, whereas a bond selling above face value is selling at a premium. Bond pricing can also be considered as:
– Dirty: bond price including accrued interest.
– Clean: accounts for just the price and not any accrued interest.

9) Price Change: the amount the price has changed since the last period, which can be anywhere from one day to a year, depending on where you’re getting your information from. It can be expressed in two ways:
– In nominal terms, the price change is expressed in terms of the currency increase or decrease.
– In ratio terms, the price change is expressed as a percentage of the previously reported price.

10) Volume: describes the total value of all bonds of a particular type being sold. So if someone issues and successfully sells ten bonds worth $10 each, the volume is $100 during that time period.

11) Yield: the amount of returns that a bond generates at a given price. It is what you actually get back for what you’ve paid out. Current yield refers specifically to the annual amount of interest paid divided by the market price of the bond.

12) Yield to Maturity: the value of the returns on a bond if it’s held until its maturity date, given the current price. If the price is higher, the yield is lower, because the percentage return on the investment is a lower proportion of the price. Conversely, the yield is higher if the price is lower. YTM assumes not only that the bond is held to maturity, but also that no coupons are collected.

Understanding Bond Valuation

Valuation of bonds refers to the process by which people determine a bond’s value. This information is then used to determine what’s considered a fair price. Valuation allows:

– investors to find out what they’re willing to pay, what they can expect in returns and what their investment portfolio is worth at any given point in time.
– issuing organizations to determine how much capital they can raise using debt, and the interest rates they need to offer in order to attract investors.

Bonds can be valued using the equation below:
where r = the annual interest rate
t = no. of years until maturity

To find the total present value of the bond you need to add up the present values of all the coupons and then add the present value of the end principal payment.

Zero-coupon bonds and other bonds that don’t make periodic interest payments don’t require this sort of calculation. Instead, because they generate all their cash flows at maturity, the bond value is equal to the present value of the single future cash flow after taking accumulated interest into account.

If you’re not holding a bond until maturity or you want to calculate your percentage return on bond investment, you can do so by calculating the holiday period yield, which is the amount of yield that a bond provides while a person is holding it. This figure assumes that the person is selling the bond before maturity.

Holding period yield
= {[Coupon + (Net gain/loss)] ÷ Purchase price} x 100   

In this case, the net gain or loss is the price of selling the bond minus the price of purchasing the bond, i.e. the profits generated from buying and reselling the bond.

[Optional] Overview of Bonds
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