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BOND NOTES

 

DEFINITION:  A bond is a commitment by the issuer to pay a fixed rate of interest for a pre-determined period of time. By selling bonds, the issuing company has raised spending power by borrowing. This is called Debt Financing.
 

BOND TERMS

The following is a [very crude] example of a corporate bond.

bulletThe left side of the bond is called the bond's principal.
bulletThe $1000 is the bond's PAR value or the FACE amount.  When the bond is first issued, it is sold for $1,000.  Bond holders are loaning the issuing corporation $1,000 in exchange for 30 years of interest.  At the end of the term [when the bond matures] the bondholder's $1,000 is returned.
bulletThe issuing corporation's name is listed on the face of the bond.  In our example case, the issuer is AT&T.
bullet8% in our example is the coupon rate.  That is the rate of interest (as an annual rate) promised by the issuing corporation for the use of your money.  You are paid 8% of $1,000 per year for as many years as you own this bond.  The payments are made semi-annually.  We will be glad to know that their is no fancy math necessary to make these calculations.  Interest is paid on a simple interest basis.  8% of $1,000 = $80, which will be paid in two $40 installments.
bulletThe date listed on the bond's face is the maturity date.  Typically 30 years, this is the date that the bondholder is paid $1,000 and the date that the bond dissolves.  The debt is paid, this bond issue is over!
bulletThe dashed lines toward the bottom of the bond's principal represent the indenture, where the terms and conditions of the bond issue are listed.  The indenture could be short or 100 pages long, we will see what special circumstances a corporation could include in the indenture as our study of bonds progress.
bulletThe squares to the right of the principal are the bond's coupons. 

         Principal                               Bond's coupons. In a 30-year bond, there are 60 coupons

$1000

☺

AT & T

8%

1/1/33

----------------

Indenture

---------------

$40

1/1/33

     $40

7/1/03
      $40

1/1/04
      $40

7/1/04
 

 

      
 

 

      

 

BOND YIELDS
COUPON RATE/YIELD Stated on the face of the bond. Technically, the coupon rate is derived by dividing the annual income by the par value.
CURRENT YIELD Annual interest income / Price.  Once the bond is issued and is the secondary market (has begun trading), an investor may pay a price for the bond different from par.  In this case, the annual income divided by the price paid, will give the investor a more accurate yield than the coupon yield. The coupon yield will equal the current yield if the bond can be purchased at par.
YIELD TO MATURITY The promised compounded rate of return an investor will receive from a bond purchased at the current market price and held to maturity. It captures the coupon interest to be received on the bond as well as any capital gains or losses realized by purchasing at a discount or premium.

YTM = {Annual Interest+[(Face Value @ Maturity-Price)/# yrs to maturity]} / [(face value @ maturity + price)/2]

 REALIZED COMPOUNDED YIELD: The YTM calculation assumes that the investor reinvests all coupons received from a bond at a rate equal to the computed YTM, thereby earning interest-on-interest over the life of the bond.
PROMISED YIELD: The YTM is referred to as Promised because investors will only earn that rate if the bond is held to maturity and coupon payments are reinvested at the YTM.

The risk that the investor faces with the YTM calculation is REINVESTMENT risk.  The possibility that the coupons CANNOT be reinvested at that YTM.
YIELD-TO-CALL YTC = {Annual Interest+[(Call Price - Price)/# yrs to call]} / [(Call Price + Price)/2]

The Yield-to-Call calculation is identical to the Yield-to-maturity with logical substitutions of elements. The number of years to maturity in the YTM formula is replaced with the number of years to call.  The Face Value @ Maturity is replaced with the Call Price.  These are usually the same, BUT the company may pay a different price from par when the bond is called.  Sometimes referred to as a guilt coupon, the firm may add one coupon to the price on the call date, compensating investors (in some way) for calling the bond before maturity.

 

BOND VALUATION
Bond valuation is the process of calculating the intrinsic value of the bond given changes in market interest rates.  This process describes interest rate risk.

For example, we have an 8%, $1,000, 30 year bond, paying $40 semi-annual coupons.

We know that the bond cost $1,000 new, when issued. It costs $1,000 because that is the face value, it also costs $1,000 because that is the present value of its parts.  If we calculate the present value of the bond's principal (a single sum) and added it to the present value of the coupons (an annuity), we would have $1,000.

$1000  * ( 1+ .08/2)-60                 = $95.06

$40 * [1- ( 1+ .08/2)-60 ] / (.08/2) = $904.94

                       TOTAL                  = $1000

The biggest risk of bond ownership is interest rate risk.  We know that interest rates and bond prices are inversely related.  When interest rates increase, bond prices decrease and vice-versa.

Given our sample bond, let's say that interest rates increase from 8% to 9%.  We know that the price of our bond will decrease, but how much?  Bond valuation will determine the new price of the bond given this change in the market.  The process is the same, we have to take the present value of the bond's principal and add it to the present value of the coupons using the current interest rate of 9%.

$1000 * ( 1+ .09/2)-60                     = $71.28

$40 * [1- ( 1+ .09/2)-60 ] / (.09/2) = $825.52

                       TOTAL                        = $896.80

The same process would be used for decreasing interest rates.

 

 

BOND RATINGS

This table illustrates ratings of the two principal bond rating agencies, Standard & Poors and Moody's. Third agency, Fitch, may be listed in some of the literature that you may read.

QUALITY S&P Moody's Description
High Grade AAA Aaa Bonds judged to be of the best quality. They carry the smallest degree of investment risk.  Interest payments are protected by a large, stable margin. Principal is secure.
  AA Aa Bonds that are judged to be of high quality by all standards. They are rated lower than the best bonds because margins of protection may not be as large.  AAA and AA bonds are referred to as "High Grade."
Medium Grade A A Upper-medium grade obligations. Factors giving security to principal and interest are considered adequate.
Bottom rung of Investment Grade Bonds BBB Baa Bonds that are considered as medium-grade obligations -- they are neither highly protected or poorly secured.
Speculative Grade BB Ba Bonds that have speculative elements. Protection of principal and interest may be moderate.
  B B Bonds that lack the characteristics of a desirable investment. There may be small assurance of principal and interest payments over any long period.
Default CCC Caa Bonds of poor standing. These issues may be in default or there may be elements of danger present with respect to principal and interest.
  CC Ca Obligations speculative to a high degree. These issues are often in default.
    C Lowest rated class in Moody's list.
  C   Rating given to income bonds on which interest is not being paid.
  D   Issues in arrears in interest and/or principal payments.
 

Default Rates on US Bonds

Studies are periodically done on bond defaults.  To illustrate the risk of investing in lower grade bonds, this study tracked default rates up to 10 years after issuance. You can see that bonds rated single B had a 40% default rate 10 years into their term.
Yrs after issuance AAA AA A BBB BB B CCC
1 0% 0% 0% .03% 0% .87% 1.31%
2 0 0 .30 .57 .93 3.22 4.00
3 0 1.11 .60 .85 1.36 9.41 19.72
4 0 1.42 .65 1.34 3.98 16.37 36.67
5 0 1.70 .65 1.54 5.93 20.87 38.08
6 .14 1.70 .73 1.81 7.38 26.48 40.58
7 .19 1.91 .87 2.70 10.91 29.62 NA
8 .19 1.93 .94 2.83 10.91 31.74 NA
9 .19 2.01 1.28 2.99 10.91 39.38 NA
10 .19 2.11 1.28 3.85 13.86 40.86 NA
Source:  Edward Altman "Defaults and Returns on High-Yield Bonds through the First Half of 1991"  Financial Analysts Journal, 47, no 6 (November/December 1991): Table X, pp 74-75

 

BOND RETIREMENT FEATURES & ZERO COUPON BONDS
BOND RETIREMENT FEATURES
Being Paid-off @ maturity. The bond matures naturally.
Retired Serially Serial bonds mature at different dates rather than all at once. A portion of the issue is retired annually throughout the bond's term. Investors can pick maturity dates to meet their needs.
Retired by Sinking Fund Additional protection to bond holders; a sinking fund forces the issuing company to set aside funds during the bond's term. At maturity, the company has saved the money necessary to retire the principal.
Being Called by the issuer before stated maturity.  Corporate Treasurers are no dummies, they install Call Features into the Indenture to protect the company from interest rate risk.  An example being if the company borrows money in a high interest rate environment and interest rates fall, as they have in year 2001; the company can refinance the issue as a person would refinance their house to take advantage of the lower rates.

If the bond is FREELY CALLABLE, the investor has NO CALL PROTECTION.  The company can call the bond at any time.

If the bond is NON CALLABLE, the investor has FULL PROTECTION against the call. The bond will not be retired until it matured.

If the bond has a DEFERRED CALL - The investor has LIMITED CALL PROTECTION.  The bond may be called within the first 5 years or the last half of its life. Those are examples. The company can name its call features, they have to be spelled out in the Indenture.
 

 

ZERO COUPON BONDS

ZERO's Earn interest during the bonds life. They are sold at a "deep discount" from the face amount and mature at face.  For example, a zero may be sold for $200 and mature, 20 years later at $1000.  The owner gets no interest during that time (hence the name, ZERO coupon).

The primary disadvantages of owning Zero's:

•Taxes are paid on earnings annually as if interest was received.  The investor will be billed annually for the 'accreted' or accumulated value of the bond.

•Zero's can experience violent price swings more than a coupon bond due to their having no periodic coupon payments to buffer changes in market interest rates.  These violent price swings could be used as a distinct advantage for the bondholder, zeros could be purchased when there is an expectation of falling interest rates.  When the rates fell, zero prices would rise more than coupon bonds.

 

 

RISKS AND ADVANTAGES OF BONDS

 

RISKS
Interest Rate Risk THIS IS THE BIGGEST RISK OF BOND OWNERSHIP.  Bond prices move inversely with interest rates. Other risks can be avoided or minimized, interest rate risk is more difficult to avoid. Usually bond professionals are the only ones that can sufficiently protect a portfolio against this risk.
Default Risk Second biggest risk, the risk of the issuing corporation filing for bankruptcy protection or otherwise defaulting on their obligation to pay.  Default can come in many forms.  If the company is late on a coupon payment, if they do not contribute to the sinking fund (if required), if they violate the parameters of the call features, any of these plus many more, constitute default, not just failure to pay. Investors probably perceive the failure to pay as the most serious because they are not getting paid for their investment.
Inflation Risk Since bonds are fixed income securities, inflation risk (rising prices) could consume several percentage points if not all of the bond's rate of return.
Reinvestment Risk If interest rates have fallen, coupons would be reinvested at a lower interest rate, thus lowering the yield to maturity. [Discussed in Yield-to-Maturity]
Maturity Risk Risk in investing in long term securities.
Call Risk The risk that a callable bond will be called.
Liquidity Risk This is coupled with quality. Thinly traded bonds may not be quickly sold.

 

ADVANTAGES
Aside from regular cash payments, Bond holders have a senior position over stock holders in event the firm is liquidated or files for bankruptcy. Bond holders get paid first, then preferred stockholders, then common stockholders.

Debenture Bonds: Are backed only by the "full faith and credit" of the issuer. The bonds are unsecured debt.