Introduction to BONDS

What are Bonds? A bond is a form of debt, issued by either a Government or company. Bonds are categorised as ‘Debt Securities’ The holder of a bond is entitled to interest payments called coupons. Coupons can be paid either quarterly, six monthly or annually. Bonds are typically issued from one to thirty years (sometimes even longer).

Can I see it? Well they used to look like this…

Now there more like this… A digital receipt of your purchase.

What purpose do Bonds play? Bonds provide investment banks and financial institutions places to invest large sums of money in a highly liquid market. Traditionally, bonds offer investors a lower deviation or risk profile, in comparison to other investments. Bonds can be found in investment portfolios as ‘cash’, as they provide a better yield than at a conventional bank

So are Bonds safe? Not necessarily, as there is a chance for a capital loss on the investment or a default. That’s why debt securities come with ratings, from AAA (Best) to C or D (Terrible). Bond capital returns are tied closely to the coupon rate and countries cash rate (controlled by the central bank like the RBA). So the longer the bond has to maturity, the more sensitive it is. Also, rating adjustments on bonds can cause price fluctuations and create strong volatility within the traded bond. Bonds are not capital safe!

Terminology of Bonds Face Value – The amount of money the investor will receive when the bond comes to maturity. Coupon – The rate of interest the holder will earn whilst holding the bond. Maturity – The date on which the bond will mature. Par – When the coupon rate matches the interest rate. Premium – When the bond is trading above its face value. Discount – When the bond is trading below its face value. At Par – When the bond is trading at its face value.

Terminology of Bonds Coupon Payments Annually – Every 12 months or once a year Semi-annually – Every six months or twice a year Quarterly – every 3 months or 4 times a year

How do they work? Here is a diagram to explain…

So what are we calculating? We are going to calculate the Present value! YearsCash flowPresent Value Total500

How to calculate the value Here is the present value formula P = Price C = Coupon Amount i = Interest Rate n = Time Period FV = Face Value

Example 1 ABC is looking at issuing a $100 FV bond with a coupon rate of 7% paid annually and maturing in 10 years. Current interest rate is 5%. What is the price? Premium Bond

Example 2 ABC is looking at issuing a $100 FV bond with a coupon rate of 5% paid semi-annually and maturing in 10 years. Current interest rate is 5%. What is the price? At Par

Example 3 ABC is looking at issuing a $100 FV bond with a coupon rate of 3% paid quarterly and maturing in 10 years. Current interest rate is 5%. What is the price? Discount Bond

Calculations

Bonds applied to real life A bond trader in the year 2000 is looking at increasing his 20 year holdings of government debt. The current bond issue is for $1,000, face value with a coupon rate of 7% paid quarterly, interest rates are at 8% per annum respectively. What price would the trader pay for the bond?

Bonds applied to real life In 2005 the bond has 15 years left till maturity, current conditions are as follows, 7% coupon rate paid quarterly, and interest rates are at 10%. What is the price of the bond now? Has the trader made/lost money on the capital value of the bond from his initial purchase? Loss/Gain on position

Bonds applied to real life In 2010, 2 years after the Global Financial Crisis, the bond has 10 years left to maturity. Current conditions are as follows, 7% coupon rate, paid quarterly and interest rates are at 4%. What is the price of the bond now? Has the trader made/lost money on the capital value of the bond from his initial purchase? Loss/Gain on position

Any Questions?