Bond Analysis 1(4).docx

18Bond Analysis 1 Part 1Bonds as Fixed-income securitiesWhat is a bond?In finance, a bond is a debt security, in which the issuer borrows from the bond holders and, depending on the terms of the bond specified in the indenture (bond contract), is obliged to pay interest (coupon) periodically and/or to repay the principal (at par or face value) on a redemption or maturity date. An amortizing bond is a bond that has periodic coupon and principal repayments.Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of Deposit (CDs) or Commercial paper (CP) are considered to be money market instruments and not bonds. Bonds must be repaid at fixed intervals over a period of time.Bonds and shares are both securities, but the major difference between the two is that (capital) shareholders have an equity stake (ownership) in the company whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas shares may be outstanding indefinitely. An exception is a perpetual bond (i.e., bond with no maturity), i.e. consol bond (UK).Some bond featuresMain characteristics of bonds: par value, coupon rate, coupon frequency, maturity date, Issuer, bond types by security and/or priority claim Bond (or Debenture, UK) is simply a receipt or receipt or promise to repay money on a (log-term) loan, usually with interest. Normally bond is a secured debt. Par Value (Face Value) is the principal amount the issuer has to repay the bondholder on the maturity (redemption) date. Coupon is the promised interest payment of bond, to be paid at a regular interval and at a fixed rate (coupon rate), in proportion to the par (face or nominal) value of the bond.YTM (yield-to-maturity) is the IRR of an investment in a bond that is held to its maturity date. It is the rate of return of bond, which is normally required to be the same as the return rate of other securities at similar risk level. YTM is used as the discount rate to obtain the present value of all expected future cash flows from a bond.Bond (intrinsic) value is considered to be the (theoretical and fair) price of a bond. It is the present value of all expected future cash flows from a bond.Indenture is a formal contract between a bond issuer and a trust company specifying legal requirement. The trust company represents the bond holders and makes sure that the terms of the indenture provisions are enforced. Covenants are clauses in a bond contract that can be negative or positive covenants, ie. limit the issuers from undercutting their ability to repay bonds.Bond Price Quotation Price quotes for corporate and government bonds are represented either by a percentage of the bonds par (face) value. Corporate bonds are quoted in 1/8th increments, so a quote of 99 1/8 represents or 99.125% of par (1,000), or 991.25. US Municipal bonds may be quoted on a dollar basis or on a yield-to-maturity basis. Some bonds (US Government) are typically quoted in 1/32nds.For example, a price of 102-8 on a bond means 102 + (8/32) = 102.25% of par. If the par amount is 1 million, the bond price would be 1.0225 million.Clean price vs. Dirty priceIf bond is traded between the coupon payment date, the quoted price is the clean price which is the bond price net (excluding) of accrued interest. The actual purchase price is the dirty price:Dirty price = quoted price (clean price) + accrued interestBond classificationsby issuer types1. Governments2. Municipal sector 3. State-owned Enterprises (SOEs)4. Corporate sectorby maturity termMaturity term1. Short-term (bills)1-5 years2. Medium-term (notes)6-12 years3. Long-term (bonds)12+ yearsby priority claim1. Senior bonds Have higer priority claim (for payment) than junior bonds in case of liquidation2. Subordinate (or junior) bondsHave lower priority claim (for payment) than senior bonds in case of liquidationby security or collateral1. Secured (senior) bonds Bonds backed by the issuers assets as collateral in case of liquidation2. Unsecured bondsBonds issued without any collaterals as security for payment in case of liquidationby ownership1. Bearer bondIssuer keeps no record of ownership. Bond holders will send coupon document to issuers for payments2. Registered bondIssuer keeps record of bond holders and send payments directly to themby interest (coupon) payment1. Fixed-rate bondsAs stated in the bond indenture (contract)2. 2.1 Floating-rate bonds (FRNs)2.2 Inverse floating-rate bondsVariable coupon rates, generally moving in the same direction as the interest rate change, if moved in the opposite direction called inverse-floating rate bonds, subject to the upper limit (cap) and lower limit (floor) agreed in the contractCoupon rate to be reset periodically (1 or 3 months) based on a formula :reference rate + quoted margini.e. reference rate = 1-month LIBOR 3.5%3.5% + 150 basis points = 3.5% + 1.5% = 5% as a new coupon rate quoted on the coupon reset date3. Zero-coupon bonds No coupon paid but price paid lower than par value, as the interest (coupon) payment*LIBOR = London Interbank Offered Rate LIBOR is a daily reference rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money market (or interbank market).by share conversion1. Convertible bondsBondholders allowed exchange a bond to a number of shares of the issuer.2. Exchangeable bonds Bondholders allowed exchange a bond to a number of shares of a corporation other than the issuer.by embedded option1. Option-free bonds(Straight bonds)Non-callable bonds2. Option-embedded bonds2.1 Callable bonds2.2 Puttable bondsWith right given to issuers to repay (retire) the bond before maturity on the call dates and normally taking place when there is a drop in the market interest rate (rise in bond value) or higher credit rating of issuersWith right given to bondholders to force the issuers to repay (retire) the bonds before maturity on the put datesLife of Bonds1. Freely callable bondsissuer can retire bonds anytime with a notice of 30-60 days2. Non-callable bondsissuer cannot retire bonds before its maturity3. Callable bonds Between (1) & (2) issuer can retire bonds before its maturity issuer normally offers a Call premium so that the amount paid is higher than its par value at maturity, to compensate for pre-maturing retiring the bondsNote that Deferred call provision can be set as the condition, i.e. bonds cannot be called before a certain date, say 5-10 years after issue, after that bonds can be freely callable.Domestic Bonds versus Foreign BondsBonds issued in Foreign CurrenciesA bond issued by a foreign company in a local market and is denominated in the local currency. They are intended for local investors. Note that foreign bonds are regulated by the domestic financial authorities. The main purpose is to provide issuers (foreign company) with the ability to access investment capital (in local currency) available in the local market. Since investors in foreign bonds are usually the residents of the domestic country, investors find them attractive because they can add foreign content to their portfolios without extra exchange rate exposure, ie. Bulldog Bond, Yankee Bond, Matador Bond, Matilda Bond, Samurai Bond etc. Bulldog Bond: A UK sterling-denominated bond that is issued in London by a non-UK company. Yankee Bond: A US dollar-denominated bond issued by a non-US entity in the US market. Samurai Bond: A yen-denominated bond issued in Japan (Tokyo) by a non-Japanese company Matilda Bond: A bond denominated in the Australian dollar and issued on the Australian market by a foreign company. Created in 1994, the market for Matilda bonds is relatively small. Matador Bond: A foreign bond denominated in pesetas and issued in Spain by a non-Spanish company. Maple bond: A Canadian dollar-denominated bond issued by a non-Canadian entity in the Canadian market. Matrioshka bond: A Russian rouble-denominated bond issued in the Russian Federation by non-Russian entities. The name derives from the famous Russian wooden dolls, Matrioshka. Arirang bond: A Korean won-denominated bond issued by a non-Korean entity in the Korean market. Panda bond: A Chinese renminbi-denominated bond issued by a non-China entity in the Peoples Republic of China market.However, there are also Shogun bond: A non-yen-denominated bond issued in Japan by a non-Japanese institution, company or government. Kimchi bond: A non-Korean won-denominated bond issued by a non-Korean entity in the Korean market. Dimsum bond: A Chinese renminbi-denominated bond issued by a Chinese entity in Hong Kong. Enables foreign investors forbidden from investing in Chinese corporate debt in mainland China to invest in and be exposed to Chinese currency in Hong Kong.EurobondA bond issued by a foreign company (not necessarily with European origin) in a local market but is not denominated in the local currency of the (domestic) market where the bond is issued and traded. It is a type of foreign bonds. There is no connection between the physical location of the market on which the bond trades and the location of the issuing company (issuer). Eurobond is denominated in a different currency than the one of the country in which the bond is issued. Dont let the name confuse you! It has nothing to do with Euro currency.For example, a Eurodollar bond is denominated in U.S. dollars and issued in Japan by an Australian company. Note that the Australian company can issue the Eurodollar bond in any country other than the US.Eurobonds are attractive methods of financing as they give issuers the flexibility to choose the country in which to offer their bond according to the countrys regulatory constraints. In addition, they may denominate their Eurobond in their preferred currency. Eurobonds are attractive to investors as they have small par values and high liquidity. For example, Eurodollar bond, Euroyen bond.Eurodollar bondA bond that is denominated in U.S. dollars, issued by a foreign company and held in a foreign institution outside both the U.S. and the issuers home nation. A Eurodollar bond is a type of Eurobond. Eurodollar bonds are advantageous as they face less regulatory restrictions. They are not registered with the SEC (Securities and Exchange Commission) of the US and can be sold at lower than US interest rates. For example, A Chinese bank can hold dollar-denominated bonds issued by a Japanese company.Euroyen bondIt is a Eurobond that is denominated in Japanese yen and issued by a foreign company outside of Japan. For example, if a US bank holds yen-denominated bonds issued by a French company, they are holding Euroyen bonds. These types of bonds are advantageous, as they face less regulatory restrictions. Euroyen bonds also tend to have small par values and high liquidity. These types of bonds have been around since 1984 when Japan started to open its financial markets. Bond Analysis 1 Part 2Some information on bonds: What returns can be obtained from bond investment How to measure the return or yield on bond investment How to value or price a bond Difference between Yield-to-Maturity and Coupon rateReturns of Bond Investment can be in a form of:1. Interest income or Coupon payments2. Capital gain or the difference from selling price and buying price3. Reinvestment return or Interest on Interest from investing the coupons received in other investmentMeasure of Bond Yields MeasurePurpose1. Nominal yieldsCoupon rate2. Current Yield*Current income rate = Annual coupon paymentCurrent market price of bond3. Yield-to-maturity (YTM)Estimated rate of return for bond held until maturityAssumptions: Bond to be held until maturity Coupon reinvestment at YTM rate4. Yield-to-callEstimated rate of return for bond held until the first call5. Realized (horizon) yieldEstimated rate of return for bond likely to be sold before maturity. This estimate takes into account of the specific reinvestment assumption and estimated sale price and the actual rate of return of bond in the past.*Annual coupon bond, Price of Callable Bond PB-callable = PV (all future coupons) + PV (call price)Crossover price = the bond price when YTM = YTCBond ValuationHow to value or price a bondThe intrinsic (or fair) value of a bond is the present value of all future income to be received from holding the bond until maturity, which includes all future coupons and principal (par value) paid on the redemption or maturity date.bond price (PB) = t=1nCt1+rt+Par1+rn (1)Ct = (constant) coupon payment per period (t), coupon rate per period ( c ) x par value (Par); r = yield-to-maturity (YTM) or the rate or return required by the bond market or bond investors; n = the number of periods until maturity.Note that the amount of coupon per period is constant (coupon rate x par value). Hence, the present value of future coupons can be easily obtained by using the present value annuity formula. In this case, the first term in (2) will give the same result as the first term in (1) which is the present value of all future coupons. Eq. (2) should be used particularly when n is large.bond price (PB)= Ct1-1(1+r)nr+Par1+rn (2)Proof: by rewriting Eq. (2), bond price (PB)= Ct1-11+rnr+Par1+rn As Ct = c x Par, when c = coupon rate (per period) and Ct = coupon payment per period:PB= Par c r- c r(1+r)-n+(1+r)-nWhen c = coupon rate willing to be paid by the issuer; r = YTM or the rate of return required/expected from the bond investors/market, hence from Eq.(3)c = r cr= 1PB = Par c rcr 1PB Par c rcr 1PB ParCoupon rate YTM(3) traded at a discount (Discount Bond)PB ParCoupon rate YTMPremium bond & Discount bondCase 1: Par Bond (traded at par)A bond pays the coupon rate at the same rate as its YTM or the bonds required rate of return (normally the same as the rate of return of securities at the same risk level), the bond value will be equal to the bond par value, i.e. c = 10%; y =10%, 3-year maturity.Bond price=10(1+0.10)+ 10(1+0.10)2+10(1+0.10)3+100(1+0.10)3=9.09+8.26+7.51+75.1=100Here, bond price is equal to its par at 100. Case 2: Discount bond (traded below par or traded at a discount)A bond pays the coupon rate less than the required rate of bond return. If the bond pays less than the going rate, investors are willing to lend only if the bonds are sold less than the promised par value of bond at maturity. Because bond sells for less than par (face) value, it is called “Discount bond”.ie. c = 8%, y or r = 10%.At 100 par value per bond, the coupon is 8 per year when bond purchaser would require 10, hence 2 less than expected.Bond price=81+0.10+ 81+0.102+81+0.103+1001+0.103=7.27+6.61+6.01+75.13=95.03Here, bond price is less than its par by 100-95.03 = 4.97 The only way to get the interest rate (or return rate) up to 10% as required is to lower the price to be less than its par value so that the bond purchase, in effect, has a built-in gain. Another way of looking at it is that as the bond holder obtain a loss from the coupon payment, 2 less than expected each year (10-8, from 8% coupon rate and 10% required rate) for 3 years of holding bond to maturity, the present value of a stream of 2 loss for 3 years discounted at the 10% required rate (YTM) is 4.97, which is exactly the same as the gain (of 4.97) from the bond price sold at a discounted price (95.03):Using the PV Annuity formula, the annuity present value (2, for 3 years 10% YTM (or use PVA table)= 2 x (1- 1/1.103)/0.10 = 2 x 2.4869 = 4.9738 4.97Case 3: Premium bond (traded above par or traded at a premium)A bond pays the coupon rate more than the required rate of bond return. It is opposite to the discount bond. In this case, investors are willing to pay extra, more than its par value (or a premium) to get this extra coupon amount. Because bond sells for more than par (face) value, it is called “Premium bond”.ie. c = 14%, y = 10%. At 100 par value per bond, the coupon is 14 per year when bond purchaser would require only 10, hence 4 more than expected.Bond price=141+0.10+ 141+0.102+141+0.103+1001+0.103=12.73+11.57+10.52+75.1=109.95Here, bond value is more than its par by 109.95-100 = 9.95. Total bond value (price) is about 9.95 in excess of its par value. We can verify this amount by noting that coupon is now paid 4 more than expected (14-10, from 14% coupon rate and 10% required rate) each year for 3 years, the present value of a stream of 4 gain each year for 3 years discounted at the 10% required rate (YTM) is 9.95, which is exactly the same as the extra or premium of 9.95 paid for the bond price (of 109.95), in exchange for the extra coupon received more than expected.Using the PV Annuity formula, the annuity present value (4, for 3 years 10% YTM) (or use PVA table)= 4 x (1- 1/1.103)/0.10 = 4 x 2.4869 = 9.9476 9.95Some important bond relationshipsNote: remember that the coupon rate is the rate the bond issuer is willin