An Introduction to Bonds

Tina Horvath

What is a Bond?

Debt instrument: When one purchases a bond, one essentially lends an organization such as the government or a corporation a specified amount of money which the borrower agrees to repay at a designated time.

Why buy a bond? • In exchange for permission to borrow money from the lender, the

organization agrees to pay annual interest payments on the amount borrowed.

Components: • principal - face value of the bond (typically $1000)

• coupon - rate of interest

• maturity - time till issuer will repay borrower

Different Types of Bonds

Corporate Government (Treasury) Municipal

Corporate Bonds

Corporate bonds are issued so that companies can finance expansion or raise funds for other expenses.

Senior debt - bonds that are backed by specific assets of the company. Debenture - a bond whose issue is secured simply by the promise of

the company to repay the amount borrowed. Default Risk (Ratings)

• Standard & Poor: AAA = good credit, CCC = poor standing

• Moody: Aaa = good credit, Caa = poor standing Special cases:

• “junk bonds” - bonds with high default rating (CCC, Caa or worse)

• convertible bonds - bonds that can be exchanged for other securities

Government Bonds Government, or Treasury bonds, are especially noted for their lack of risk since

they are backed by the US government.• bill - maturity of a year or less

• note - maturity of 1-10 years

• bond - maturity of 10+ years STRIPS - Separate Trading Registered Interest and Principal Securities, or

STRIPS, can be split up into separate interest and principal payments, with each payment trading as a separate security. Example: zero coupon bonds

The Federal Reserve retains some control over the bond market by• open-market operations: buying or selling US Treasuries in order to control the money

supply

• changing the discount rate: raising or lowering the rate which in turn raises or lowers general interest rates

• setting reserve requirements: increasing reserves and thereby raising interest rates or decreasing reserves and thereby decreasing rates

Municipal Bonds

Municipal bonds are state and local government bonds. Tax free, not subject to federal taxes Two types of municipal bonds:

• general obligation bonds - funded by property taxes, sales taxes, and income tax

• revenue bonds - funded by revenue from a particular project; e.g., a government issues a revenue bond in order to build a turnpike and repays these bonds with the tolls collected.

Yields

Coupon yield: the interest paid on the principal based on the coupon rate.

Current yield: yield based on interest payments with respect to the purchase price of the bond (discount, premium).

Yield to maturity (YTM): estimates the total amount that one can earn over the total life of the bond.• YTM = coupon + prorated discount or premium

(face value + purchase price) / 2

What Determines Bond Prices?

Current market interest rates: Bond prices tend to increase when interest rates fall and decrease when rates rise.

Inflation: High inflation will devalue a bond. Liquidity: The ease and cost of trading a particular bond

will affect the price. Political risk: People tend not to invest when the

government seems unstable.

Bonds in the Real World