Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1  More on bonds  Calculating yields 30cis Lesson 30:

Advantages of bonds Bonds are one of the main asset classes in investing. They are included in most investment portfolios. The main advantages of bonds are:  The majority of bonds carry a fixed interest rate, giving a regular and certain flow of income  But index-linked bonds will pay a coupon that varies according to the rate of inflation  The majority of bonds have a fixed maturity date  But there are some bonds with no redemption rate (perpetuals)  And there are some bonds which can be repaid between two set dates o This can sometimes be at the investor’s option or the issuer’s option  Bonds have a range of returns to suit different investment and/or tax requirements Source: Barclays Capital Equity Gilt Study 2010 N.B. Gaps due to unavailability of data UK real (i.e adjusted for inflation) asset class returns (% per annum)

Disadvantages of bonds The main disadvantages of bonds are:  The “real” value of the income flow is eroded by inflation  Except for index-linked bonds  Default risk  The risk that the issuer will not be able to make the interest payments when they fall due  The risk that the issuer will not be able to repay the capital sum at maturity Source: U.S. Municipal Bond Fairness Act, 2008 Cumulative Historic Default Rates (in percent) Investment grade corporate bonds (also known as high grade corporate bonds) are the best-quality corporate bonds, as determined by rating agencies such as Moody’s. They are debt securities, issued and redeemed by the strongest companies. Technically, a bond is considered investment grade if its credit rating is judged as BBB- or higher by Standard & Poor’s or Baa3 or higher by Moody’s.

Price risk The biggest risk associated with bonds is price risk:  Price risk  The risk that rising interest rates will render the bond coupon unattractive, forcing down the resale price to restore the yield advantage o But note that the repayment of the capital sum at maturity will not be affected  If interest rates increase, bond prices will decrease  If interest rates decrease, bond prices will increase Remember: there is an inverse relationship between interest rates and bond prices

Flat, or running yields of bonds The interest paid on a bond as a percentage of its market price is referred to as the “flat” or “running” yield Definition of yield: An investment’s yield is the income it provides the investor, stated as a percentage of its purchase price  The Pennsylvania Railroad bond required an initial investment of US$1,000 and paid an annual coupon of US$44  The bond’s flat yield at issue (par) was 4.4%  The bond was issued when bank deposit interest rates were 3.5%  The bond had an attractive yield advantage of 0.9%

If cash deposit interest rates rose by 0.25% to 3.75%, then in order to maintain its 0.9% flat yield advantage compared to the cash deposit market, the resale price of a newly issued US$1,000 bond bearing a US$44 coupon would need to fall by about US$50. If demand for long-term bonds pushed up the price of this bond up from US$725 to US$750, the flat yield would fall by 0.20% Using the example of the Pennsylvania Railroad 30- year, 4.4%, US$1,000 nominal bond… If cash deposit interest rates kept on rising, the resale price would need to keep on falling to keep the bond attractive to buyers

A bond can also offer the opportunity for capital growth  Supposing that two years after issue, the interest rate paid on cash deposits fell from 3.5% to 2.5% The price of a bond in the secondary market is heavily influenced by interest rates  The enhanced value (relative to cash deposits) of all those future earnings would be reflected in a higher asking price for the bond  The resale price of this particular bond would probably have gone up by around 18%  the Pennsylvania Railroad bond would become more attractive to investors, because it was still paying a fixed 4.4% coupon each year for 30 years  The yield advantage over cash deposits would have widened from 0.9% to 1.9%

Can the price of bonds go down as well as up? If a falling interest rate for cash deposits can cause a rise in the asking price for bonds in the secondary market, a rise in cash deposit interest rates can have the opposite effect. Bond prices are inversely correlated with interest rates  If two years after issue the interest rate paid on cash deposits rose to 4.0%:  The yield advantage of the bond would shrink to 0.4%  The bond’s relative attractiveness versus cash deposits would have been lessened  The resale price of the Pennsylvania Railroad bond in the secondary market would have fallen by about 7%

What if cash interest rates exceed bond interest rates? Over the life of a bond, the interest rate paid on cash deposits can rise so much that it exceeds the coupon rate of a bond Bond prices are inversely correlated with interest rates  If after two years cash deposit rates goes up to 5.5%  The attraction of the bond versus cash deposits would have be completely wiped out o The bond now has a yield disadvantage  If the bond-holder wants to find a buyer, he will have to offer a discount to the sum of the future cash flows  The asking price will have to drop by around 25%

Approaching maturity Assuming no default on repayment of the capital sum, the price of the bond should always converge with the amount to be repaid (the nominal sum) As more and more of the annual interest payments are cashed in each year, this leaves fewer and fewer of annual interest rate payments still to come  Yield advantage or disadvantage becomes less and less relevant Bonds trading at a premium: Assuming that interest rates remain stable, the value of a bond will decline steadily over its remaining life, until it reaches the value of the original principal sum borrowed Bonds trading at a discount: Assuming that interest rates remain stable, the value of a bond will rise steadily over its remaining life, until it reaches the value of the original principal sum borrowed Bond price behaviour as maturity approaches (assuming that interest rates remain constant) Bond price

Bond prices in the secondary market To make it easier to compare bond prices in the secondary market, bond prices are typically stated as the price payable to purchase £100 or US$100 of nominal value  It is quite usual to see such bond price quotes as:  78  104 UK Gilt prices European corporate bond prices prices

Other risks associated with holding bonds  Early redemption  The risk that the issuer might invoke a call provision (if the bond is callable) o A call provision is the right to “call in” or redeem the bonds early, if, for instance, the issuer has been able to refinance the borrowing at a cheaper interest rate The other main risks associated with holdings bonds as an investment are:  Seniority risk  The issuer might issue new, additional bonds, which rank higher in seniority o In the event of the issuer’s liquidation, debt with the highest seniority is repaid first  Liquidity risk  Some bonds are more easily sold at a fair market price o Liquidity: the ease with which a security can be converted into cash  Exchange rate risk  The bonds might be denominated in a currency different to that of the investor o The value of the issuer’s currency might have declined relative to the investor’s