What are the Basics of Bond?

October 28, 2014

Bonds are often referred to as the poor, unglamorous cousins of stocks. Stock markets are frequently in the news. They are more sensational as one hears about the wealth generated by investing in stock markets. But it takes a bear market to remind us of the importance of stability and regular income which only bonds can offer.

Bonds are issued by corporations, governments, municipals for raising capital with a promise to pay interest at regular intervals (except zero coupon) and repay the principal on maturity. The investors in these securities could be individuals, corporations, mutual funds etc. Investors here are seeking an additional return on their surplus funds.

Bonds are mainly classified as fixed rate, floating rate, zero coupon, callable and puttable bonds

Fixed rate, as the name suggests, pays a fixed rate of interest throughout the life of the security.

Floating rate bonds are indexed to a particular benchmark and pay a return that is equal to the benchmark, in some cases there could be a spread over the benchmark rate. Some of the popular benchmarks are LIBOR, Treasury, Inflation Index etc.

Zero coupon securities are issued at discount and the final redemption happens at par value. E.g. a one-year bond with an interest rate of 5% will be issued at $952.38 and redeemed at $1,000 after a year. The difference between the par and the discounted value is the interest.

Callable bonds can be redeemed by the issuer of the bond before the maturity of the bond. Companies issue callable bonds to protect themselves in case the interest rate drops. This feature is very important for long term bonds –  if not, issuers can find themselves locked into a high interest rate for a number of years. Companies are willing to pay a premium to redeem the bonds before maturity.

Puttable bonds provide the option of redeeming the bonds before maturity to the investor. This helps investors in the event the interest rates increase in the market.

US MarketsBonds vs. Equities

Bonds are more widely traded than equities. The below graph of US markets clearly indicates that the investment in bonds is much higher compared to equities.

Source – Learning Bonds (http://www.learnbonds.com/how-big-is-the-bond-market)

Risk of Investing in Bonds

One cannot assume that all bonds are risk free. Treasury bonds issued by the US Government are considered the safest as they are backed by “full faith and credit” of the US Government. Corporate bonds, on the other hand, carry the highest risk. Government and municipal bonds are less risky as compared to corporate bonds.

The bonds risk can be measured in two dimensions:

  1. Default risk of the issuer – This can be measured with the help of ratings provided by credit  rating agencies like Standard and Poor’s, Fitch and Moody’s. Bond ratings are report cards issued for companies. Blue chip and companies with strong fundamentals have high ratings whereas riskier companies have low ratings.
  2. Interest rate risk – Plays a role if you don’t intend to hold the bond till maturity and want to sell the bond in the secondary market. The problem is interest rates could have increased from the time the bond was bought and the bond is no longer attractive to the buyer.

Eg: – An investor has bought a 7% $1,000 bond for three years. At the end of year one, the interest rates in the market stand at 8%. Market is paying $80 and bond holder is offering $70. In order to incentivise the buyer, an adjustment has to be made to the value of the bond. The bond will be offered at a price of $980, this adjustment makes the bond equivalent to other bonds in the market.

How do you measure the sensitivity of the bond to the change in the market interest rates?

Duration measures sensitivity of the bond to changing market interest rates. Simply put, duration is measured in terms of years. Higher the bond’s duration, greater  is the impact of changing interest rate on the bond. The duration is shorter for interest paying bonds as compared to zero coupon bond.

 

Factor’s affecting duration of a bond

  • Bond Price: Higher the price of the bond, lower the duration and vice versa.
  • Coupon: Higher the coupon rate, the greater is the income generated by the bond early on and shorter the duration.
  • Maturity : Longer maturity bonds have a higher duration.
  • Callability : In case of a callable bond the duration is shorter because the principal is repaid earlier as compared to a normal bond.

With the help of what we have read, let us now interpret a recent bond issue by Apple Corporation.

Details of the issue

Issue Amount (US$ bn) Type Coupon Issue Price Maturity
1.0 Floating rate Libor + 7 bps 100.00% May 6, 2017
1.0 Floating rate Libor + 30 bps 100.00% May 5, 2019
1.5 Fixed rate 1.05% 99.947% May 6, 2017
2.0 Fixed rate 2.10% 99.962% May 5, 2019
3.0 Fixed rate 2.85% 99.754% May 9, 2021
2.5 Fixed rate 3.45% 99.916% May 6, 2024
1.0 Fixed rate 4.45% 99.459% May 6, 2044
The issue is rated “AA+” by Standard and Poor’s, and “Aa1” by Moody’s. Both agencies have given “high security” ratings to the issue.The 12 billion dollar issuance is a 7 part bond offering with 2 floating rate tranches and 5 fixed rate tranches maturity ranging between 3-30 years.

 

The floating rate bonds are indexed to Libor with some spread (7 – 30 bps) and the fixed rate bonds are offered at discount in comparison to “on the run” comparable treasury yields.

As per the prospectus filed by Apple Corp., they intend to use the proceeds from the sale of bonds for repurchase of common stock to return capital to the shareholders, pay dividend and other general corporate purposes.

You can learn much more about bonds in our investment banking course called CIBOP (Certified Investment Banking Operations Professional).

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