Today we try and understand the relationship between Bond Prices and Yield.
Bonds or Fixed Income products per say have been a great area of interest for investors and specially traders globally. Investment banks have always relied heavily on FICC (Fixed Income Currency Commodities) business to make profits. FICC has always been the major contributor to the banks profits.
Now let’s understand how the Fixed Income product really works and what the determining factor is for investors and traders to invest in a type of bond.
The two major components of a Bond is principal and interest. Interest component is primarily known as Coupon. But bond investment is primarily decided by calculating the Yield. Now what is Yield. Not delving into the bookish definition much, It is anticipated rate of return.
So let’s take an example now and understand how it works in a practical scenario.
A Bond say XYZ is issued on 1st Jan 2012.
- Face Value-$1000
- Coupon-6% Semi Annually
Mr. A purchased this bond on the issue date. So he would receive $60 as yearly interest in two shapes of $30(paid semi annually). Owing to the huge demand of bond the price of the bond has gone up to $1100 after one year. Mr. B who is interested in buying this bond is willing to pay $1100 to Mr. A. Mr. A is happy to sell this off as he is making $160 ($100 due to increase in bond price and $60 as coupon) which is 16% return on investment. The bond is now sold to Mr. B on 1st Jan 2013 at $1100. But the question now is will Mr. B get 6% on Face value or the price he purchased the bond. It is important to understand that bond is a debt instrument and no issuer will want to increase the liability by paying coupon on $1100.Hence coupon will be always paid on $1000 irrespective of the price the bond is purchased in the secondary market. But is that the real rate of return for Mr. B. No is the answer. Reason being he purchased the bond at $1100 and is getting coupon of 6% on FV.
Then how does Mr. B calculate is real rate of return. Well, he does this by calculating Yield.
Let us now calculate the yield of both Mr. A and Mr. B and determine the relation between Bond price and Yield. Going by the above formula.
Yield of Mr. A = 6/1000 = 0.006
Yield of Mr. B = 6/1100 = 0.005
Hence we can now deduce that bond price is inversely linked to the yield. Meaning, if bond price goes up, yield goes down and above calculation can be used to demonstrate the same.
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Some links to learn more about IB :
The other half of traditional Investment Banking, Financing or Corporate Financial Advisory, comprises of structuring and executing a variety of transactions including equity offerings and debt issuances to help companies raise money to fund both organic and inorganic growth. Banks also act as intermediaries between investors like Private Equity firms and companies.
Private Financing can be in the form of straight equity, mezzanine- a mixture of debt and equity, and also structure customized solutions using a host of derivative instruments. This should not be confused with the Derivatives desk that sells hedging instruments to corporate as part of their own risk management strategy or proprietary trading. Corporate financial advisory is a pure service and the team acts as a middleman even if the derivative is being sold is by another team in the same company. The conflict of interest that arises when you have to recommend your own firm’s product has been widely debated. Chinese walls have been set up for this reason and many banks have strict communication protocols in place to make sure the client is protected.
Public market financing is the way companies raise money through the primary and secondary public offerings and debt issuances. Investment banks take up the role of a Book Running Lead Manager. The Book Running Lead Manager undertakes the due diligence of the company ensuring it meets all the criteria for listing, creates the IPO Offer Document, markets the offering through road shows and carefully planned analyst meets and finally sells the issue sometimes offering to underwrite. Here again, the underwriting to buy a percentage of shares is not done by the Investment Banking team but by the Securities desk of the same bank.
Going back to our example of Company ABC. Company ABC requires funding to complete its acquisition of XYZ. Sometimes the same team or in larger banks a different team will set about choosing the appropriate method of finance. Private financing in terms of Private Equity, Mezzanine or Debt or say an IPO or a public debt issuance. In this case it is decided that it is time for ABC to go to the markets and do an Initial Public Offering (IPO). The Equity Capital Advisory team then does a due diligence, puts together the offer document and finally sells the issue.
The Buy-Side Sell Side confusion
This is the general line of thought. On the sell-side, you pitch products such as stocks, bonds, or entire companies in the case of M&A, and you persuade investors to buy them. On the buy-side, you raise capital from investors and then make your own decisions (or in the case of mutual fund analysts make recommendations) on where to invest it and what to buy.”
This is perhaps the worst way to categorize financial firms for the following reason. Large financial firms like ICICI have both buy and sell side divisions. If we go back to our earlier blog post, everyone does everything these days. ICICI has a mutual fund and ICICI has a Equity Capital Markets team.
How does this relate to you as an analyst starting off in a firm? Where should you go? We will look at this in a more detailed manner in a later post relating to Careers in Investment Banking.