Based on my studies and the relevant points from the CFA study material, I have
complied some points related with the Features and Risks on Bonds Securities. Through
this article, I just want to share this knowledge with all of you. I hope it will
provide you some information about the Bonds while dealing practically as well as
while preparing for any course or studies.
Introduction
Fixed Income Security
is a financial obligation
of an entity that promises to pay a specified sum of money at specified future dates.
The entity that promises to make the payment is called the issuer of the security.
It falls under two general categories >
1)
Debt Obligations
Bonds, Mortgage-backed securities, Asset Backed Securities, Bank Loans.
2)
Preferred Stock Represents
ownership interest and has fixed dividends payment.
Features of Bonds
Indenture
- The promises of the
issuer and the rights of the bondholders are set forth in great detail in a bonds
indenture.
Covenants
- As part of the indenture, there are affirmative covenants and negative covenants.
1)
Affirmative covenants
set forth activities that the borrower promises to do.
2)
Negative covenants
set forth certain limitations and restrictions on the borrowers activities.
Maturity
of a bond is the number
of years the debt is outstanding or the number of years remaining prior to financial
payment. It is important because
1)
Indicates the time
period over which the bondholder can expect to receive interest payment and principal
at the end.
2)
Yield offered on
a bond depends on the term to maturity.
3)
The price volatility
of the bond is the function of maturity. The longer the maturity of the bond, the
greater the price volatility resulting from a change in interest rates.
Par Value
is the amount that the
issuer agrees to repay the bondholder at or by the maturity date. When a bond trades
below its par value, it is said to be trading at discount. When a bond trades above
its par value, it is said to be trading at premium.
Coupon Rate,
also called the nominal rate, is the interest rate that the issuer agrees to pay
each year. The annual amount of the interest payment made to bondholders during
the term of the bond is called the coupon. The coupon is determined by multiplying
the coupon rate by the par value of the bond i.e.
Coupon = Coupon Rate X par value.
|
The higher
the coupon rate, the less the price will change in response to a change
in market interest rates |
Zero Coupon Bonds
Bonds that are not contracted to make periodic coupon payments are called zero-coupon
bonds. The holder of a zero-coupon bond realizes interest by buying the bond substantially
below its par value. Interest is then paid at the maturity date, with the interest
being the difference between the par value and the price paid for the bond.
Step-Up Notes
Securities that have a coupon arte increases over time. These securities are called
step-up notes because the coupon rate steps up over time. When there is only one
change (or step up) the issue is referred to as a Single Step-up note. When there
is more than one change the issue is referred to as a multiple step-up note.
Deferred Coupon Bonds
Bonds whose interest payments are deferred for a specified number of years.
Floating-Rate Securities
These securities have coupon payments that reset periodically according to some
reference rate.
Coupon Rate = Reference
Rate + Quoted Margin
|
Maximum Coupon
rate is called Cap. Minimum Coupon Rate is called a Floor.
Coupon rate
increases when reference rate increases, and decreases when reference rate
decreases. |
Issues whose coupon rate moves in the opposite direction with the change in the
reference rate. Such issues are called Inverse Floaters or Reverse Floaters.
The coupon Formula is:
Coupon Rate = K L
X (Reference Rate)
Accrued Interest
It refers to the amount of interest that will be received by the buyer even though
it was earned by the seller. The bond buyer must pay the bond seller the accrued
interest.
The bond in which the buyer must pay the seller accrued interest is said to be trading
cum-coupon.
If the buyer forgoes the next coupon payment, the bond is said to be trading ex-coupon.
Paying off provisions of bond
When the issuer agrees to pay one lump sum payment at the maturity date, it is termed
as Bullet Maturity.
1)
Call & Refunding Provisions The right of the issuer to the stated maturity date
is referred to as a Call provision. If the issuer exercises this right, the issuer
is said to call the bond.
When the issuer exercises an option to call an issue, the call price can be either
i.
Fixed regardless of the call date the call price is par plus accrued interest.
ii.
Based on the price specified in the call schedule the call price depends on when
the issuer calls the issue.
iii.
Based on a mark-whole premium provision Provides a formula for determining the premium.
A non-callable issue prohibits the refunding of the bonds for a certain number of
years or for the issues life.
Non-refundable Bonds prevents redemption from certain sources, namely the proceeds
of other debt issues sold at a lower cost of money.
2)
Sinking Fund Provision The indenture may require the issuer to retire a specified
portion of the issue each year. This is referred to as a sinking fund requirement.
If only a portion is paid, the remaining principal is called balloon maturity. Many
times issuer has the option to retire more than the sinking fund requirement. This
referred to as an accelerated sinking fund provision.
Conversion Privilege
The issue grants the bondholder the right to convert the bond for a specified number
of shares of common stock. It allows the bondholder to take advantage of favorable
movements in the price of the issuers common stock.
Put Provision
It grants the bondholder the right to sell the issue back to the issuer at a specified
price on designated dates.
Currency Denominations
There are some issues whose coupon payments are in one currency and whose principal
payment is in another currency. An issue with this characteristic is called a dual-currency
issue.
Embedded Options
The provision that gives the issuer or the bondholder an option to take some action
against the other party are referred to as embedded options, because the option
is embedded in the issue.
Embedded Options granted to issuers.
i.
Right to call the issue.
ii.
Right to prepay principal
iii.
The accelerated sinking fund provision
iv.
The cap on a floater.
Embedded Options granted to the Bondholder
i.
Conversion Privilege
ii.
Right to put the issue
iii.
Floor on a floater
Borrowing Funds to Purchase Bonds
1)
Margin Buying In this the broker provides the funds borrowed to buy the securities
and in turn the broker gets the money from a bank. The interest rates banks charge
from brokers for these transactions is called the call money rate. The broker charges
the investor the call money rate plus a service charge.
2)
Repurchase Agreement It is a sale of security with a commitment by the seller to
buy the same security back from the purchaser at a specified price at a designated
future date.
Risk Associated with investing in Bonds
Interest Rate Risk
Change in interest rate over the period of maturity is referred to as Interest rate
risk.
|
When interest
rate rise, a bonds price falls, when interest rates fall, a bonds price
will rise. |
Reasons for inverse relationship
>
1)
A bond will trade at a price equal to par when the coupon rate is equal to the yield
required by market
Coupon
Rate = Yield Required by Market Price = Par Value
2)
A bond will trade at a price below par (sell at a discount) or above par (sell at
a premium) if the coupon rate is different from the yield required by the market.
Specifically,
Coupon
rate < Yield required by market Price < Par Value (Discount)
Coupon
rate > Yield required by market Price > Par Value (Premium)
3)
The price of a bond changes in the opposite direction to the change in interest
rates. So, for an instantaneous change in interest rates the following relationship
holds:
><If
interest rates increase Price of the bond decreases
If interest
rates decreases Price of the bond increases
Bond Features that effect interest rates
1)
Impact of Maturity
> All others factors constant, the longer the bonds
maturity,
the greater the bonds price sensitivity to changes in interest rates.
2)
Impact of Coupon rate
> The lower the
coupon rate,
the greater the bonds price sensitivity to change in interest rates.
3)
Impact of Embedded Options
> For this, let us decompose the price of the callable bond in:-
Price of Callable
Bond = Price of option-free bond Price of embedded call option.
|
When interest
rate decline both price components increase in value, but the change in
the price of the callable bond depends on the relative price change between
the two components. |
Therefore, a decline in interest rates will result in an increase in the price of
the callable bond but not by as much as the price changes of an otherwise comparable
option free bond.
4)
Impact of the yield level
> Higher a bonds
yield,
the lower the price sensitivity.
|
Price sensitivity
is lower when the level of interest rate in the market is high, and the
sensitivity is higher when the level of interest rate is low. |
5)
Floating rate Securities
> The price of the floating rate security will fluctuate depending on three factors>
a.
The longer the time to the next coupon reset date, the greater the potential price
fluctuation.
b.
The required margin that investors demand in the market changes.
c.
It will typically have a cap. Once the cap is reached, the securities price will
react mush the same way to changes in market interest rates as that of a fixed-rate
coupon security. It is termed as Cap risk of the floating rate security.
Measuring interest rate risk
Approximate percentage Price changes for a 100 basis point change in yield is:
Duration
= Price of Years decline Price
if yields rise .
2 X (Initial Price)
X (Change in yield in decimal)
The approximate dollar price change for a 100 basis point change in yield is sometimes
referred to as the
dollar duration.
Yield Curve Risk
The graphical depiction of relationship between yield and maturity is called the
yield curve. When interest rate changes they do not change by an equal number of
basis points for all maturities. The portfolios have different exposures to how
the yield curve shifts. This risk exposure is called yield curve risk.
Call and Prepayment Risk
> From investors perspective, there are 3 disadvantages to call provisions>
1)
The cash flow pattern of a callable bond is not known with certainty
2)
Because the issuer is likely to call the bonds when interest rates have declined
below the bonds coupon rate, the investor is exposed to reinvestment risk.
3)
The price appreciation potential of the bond will be reduced.
The same disadvantages apply to mortgage backed and asset backed securities where
it is termed as prepayment risk.
Reinvestment risk
> is the risk that the proceeds received from the payment of interest and principal
that are available for reinvestment must be reinvested at a lower interest rate
than the security that generated the proceeds. While dealing with amortizing securities
(i.e. securities that repay principal periodically), reinvestment risk is greater.
In Zero-coupon Bonds there is no reinvestment risk, because there is no coupon payments
to reinvest.
Credit Risk
>
An investor who lends fund by purchasing a bond issue is exposed to credit risk.
There are 3 types of credit risk >
1)
Default Risk
> It is defined as the risk that the issuer will fail to satisfy the terms of the
obligation with respect to the timely payment of interest and principal.
2)
Credit Spread Risk
> The risk premium on a bond is referred to as Yield Spread. The part of the risk
premium or yield spread attributable to default risk is called credit spread. If
the credit spread increases, investors say that the spread has widened and the market
price of the bond issue will decline. The risk that the issuers debt obligation
will decline due to an increase in the credit spread is called credit spread risk.
3)
Downgrade Risk
> There are 3 rating agencies in US > Moodys Investors Service Inc., Standard &
Poors Corporation, and Fitch ratings. Bond issues that are assigned a rating in
the top four categories are referred to as investment-grade bonds. An unanticipated
downgrading of an issue or issuer increases the credit spread and results in a decline
in the price of the issue or the issuers bonds. This risk is referred to as a downgrade
risk and is closely related to credit spread risk.
Liquidity risk
> is the risk that the investors will have to sell a bond below its indicated value,
where the indication is revealed by a recent transaction. The wider the bid-ask
spread the greater the liquidity risk.
Exchange rate or currency risk
> The risk of receiving less of the domestic currency when investing in a bond issue
that makes payments in a currency other than managers domestic currency is called
exchange rate risk or currency risk.
Inflation or purchasing power risk
> arises from the decline in the value of a securitys cash flow due to inflation,
which is measured in terms of purchasing power.
Volatility risk
> The greater the expected yield volatility, the greater the value of an option.
The risk that the price of a bond with an embedded option will decline when expected
yield volatility changes is called volatility risk.
Price of Callable
Bond = Price of option-free bond Price of embedded call option
Price of Putable Bond
= Price of option-free bond + Price of embedded call option
Event Risk > Risk caused by natural disaster, takeover or corporate restructuring, or regulatory change.
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