Bonds

Bonds
• A bond is a fixed income instrument that represents a loan made by an investor to
a borrower 
• Bonds are used by companies, municipalities, states, and sovereign governments
to finance projects and operations.
• Owners of bonds are debtholders, or creditors, of the issuer
• Bonds are units of corporate debt issued by companies and securitized as
tradeable assets.
• A bond is referred to as a fixed-income instrument since bonds traditionally paid a
fixed interest rate (coupon) to debtholders.
• Variable or floating interest rates are also now quite common.
• Bond prices are inversely correlated with interest rates: when rates go up, bond
prices fall and vice-versa.
• Bonds have maturity dates at which point the principal amount must be paid
back in full or risk default.
 Characteristics of Bonds
• Face value (par value) is the money amount the bond will be worth at maturity; it is
also the reference amount the bond issuer uses when calculating interest payments.
• For example, say an investor purchases a bond at a premium of $1,090, and another
investor buys the same bond later when it is trading at a discount for $980. When the
bond matures, both investors will receive the $1,000 face value of the bond.
• The coupon rate is the rate of interest the bond issuer will pay on the face value of the
bond, expressed as a percentage. For example, a 5% coupon rate means that
bondholders will receive 5% x $1,000 face value = $50 every year.
• Coupon dates are the dates on which the bond issuer will make interest payments.
Payments can be made in any interval, but the standard is semiannual payments.
• The maturity date is the date on which the bond will mature and the bond issuer will
pay the bondholder the face value of the bond.
• The issue price is the price at which the bond issuer originally sells the bonds. In
many cases, bonds are issued at par.
 Types of Bonds
Fixed Rate Bonds
The interest remains fixed through out the tenure of the bond. Owing to a constant
interest rate, fixed rate bonds are resistant to changes and fluctuations in the market.
Floating Rate Bonds
Floating rate bonds have a fluctuating interest rate (coupons) as per the current
market reference rate.
Zero Interest Rate Bonds
Zero Interest Rate Bonds do not pay any regular interest to the investors. In such
types of bonds, issuers only pay the principal amount to the bond holders.
Inflation Linked Bonds
Bonds linked to inflation are called inflation linked bonds. The interest rate of Inflation
linked bonds is generally lower than fixed rate bonds.
Perpetual Bonds
Bonds with no maturity dates are called perpetual bonds. Holders of perpetual bonds
enjoy interest throughout.
 Types of Bonds
Subordinated Bonds
Bonds which are given less priority as compared to other bonds of the company in
cases of a close down are called subordinated bonds. In cases of liquidation,
subordinated bonds are given less importance as compared to senior bonds which are
paid first.
Bearer Bonds
Bearer Bonds do not carry the name of the bond holder and anyone who possesses
the bond certificate can claim the amount. If the bond certificate gets stolen or
misplaced by the bond holder, anyone else with the paper can claim the bond amount.
War Bonds
War Bonds are issued by any government to raise funds in cases of war.
Serial Bonds
Bonds maturing over a period of time in installments are called serial bonds.
Climate Bonds
Climate Bonds are issued by any government to raise funds when the country
concerned faces any adverse changes in climatic conditions.
 Types of Bonds
• Treasury bonds
These are government debt securities issued by the U.S. Federal government that have
maturities greater than 20 years. 
• GSE bonds
U.S. government agency bonds are debt obligations issued by government-sponsored
enterprises (GSEs) or U.S. government agencies. GSEs are independent organizations
sponsored by the federal government and established with a public purpose. Agency bonds
usually are issued in $1,000 denominations
• Investment-grade bonds
• High-yield bonds – Junk bonds are corporate debt securities that pay higher interest rates
than investment-grade bonds. 
• Foreign bonds – A bond issued in a domestic market by a foreign entity in the domestic
market's currency as a means of raising capital (Bulldog - UK, Samurai - Japan, Matilda -
Australia)
• Mortgage-backed bonds - Mortgage-backed securities, called MBS, are bonds secured
by home and other real estate loans. 
• Municipal bonds
 Bond Valuation
• Bond valuation is the process of determining the fair price, or value, of a bond.
• Typically, this will involve calculating the bond's cash flow—or the present
value of a bond's future interest payments
• A bond’s interest payments and face value are fixed.
• This allows an investor to determine what rate of return a bond needs to provide to be
considered a worthwhile investment.

Important points for valuation of Bonds:

• Arrive at present value of yearly cash flows

• Arrive at present value of maturity value = Face Value ÷ (1+r)t

Sum of all these cash flow value and the final face value is the value of the bond.

• The price of a bond is inversely related to the interest rate. When interest rates go up, the price of a bond goes
down, and vice versa.
• When the price of the bond is beneath the face value, the bond is "trading at a discount." When the price of the
bond is above the face value, the bond is "trading at a premium."
 Bond Duration
• Bond duration is a way of measuring how much bond prices are likely to change if and when
interest rates move.
• Bond duration is measurement of interest rate risk.
• Duration can measure how long it takes, in years, for an investor to be repaid the bond’s price
by the bond’s total cash flows.
• Duration can also measure the sensitivity of a bond's or fixed income portfolio's price to
changes in interest rates.
• Time to maturity and a bond's coupon rate are two factors that can affect a bond's duration.
• Modified duration measures the price change in a bond given a 1% change in interest rates.
• A fixed income portfolio's duration is computed as the weighted average of individual bond
durations held in the portfolio.
• As a bond's duration rises, its interest rate risk also rises because the impact of a change in
the interest rate environment is larger than it would be for a bond with a smaller duration.
• Bond has 2 risks – Interest Rate risk and Credit Default risk