What exactly is a bond?

Discussion in 'Economics' started by Alsacien, Dec 13, 2011.

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  1. Alsacien

    Alsacien LE Moderator

    Bonds, or more correctly, fixed income securities can be a bit confusing to fathom out due to all the jargon, so I'll try and give a basic heads up so that it hopefully makes a bit more sense.

    Government bonds - issued by governments, but are called different things - Treasuries, Gilts, Bunds - all the same thing
    Corporate bonds - issued by big companies and corporations including banks
    There are others such as Municipal Bonds in the US, but I'll keep it simple for now.

    Coupon - so called because they used to have a physical tear off. These pay interest at fixed points in the year depending on the issuers preference, the interest rate is called the coupon. There will be a face value (also called par value) against which the interest is calculated, and a maturity date when it can be redeemed for its face value. Thus fixed income securities as the exact value can be calculated exactly:
    You buy a 10 year $1000 US treasury at issue, and the rate was 10% at the time, you would have made $2000 at maturity.
    Zero-coupon - This type of bond makes no coupon payments but instead is issued at a discount to par value.
    e.g. a zero-coupon bond at issue with a $1,000 par value and 10 years to maturity may trade for $700, you will pay $700 today for a bond that will be worth $1,000 in 10 years.

    What can be confusing is that the par value is not the price of the bond, which will fluctuate throughout its life. When a bond trades above the face value, it is at a premium, below face value it is at a discount.
    Even more confusing is bonds can be fixed rate interest or floating rate interest.
    A bond that matures in one year is much more predictable than a bond that matures in 10 years. Normally the longer the time to maturity, the higher the interest rate. A longer term bond will also fluctuate more than a short term bond.

    Yield is what a bond is currently offering. It can be calculated as: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
    e.g. You buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). If the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

    Yield To Maturity
    Normally markets refer only to Yield To Maturity. YTM shows the total return until maturity. Including all the interest payments, plus any gain (if purchased at a discount) or loss (if purchased at a premium). That is a high level view, a reality software is needed to compare apples to pears.

    Up and Down
    When the price goes up, yield goes down and vice versa.
    If you are bond buyer, you want high yields. If you are bond owner, you want the price of the bond to go up.

    Corporate Bonds
    Any company can issue any amount of bonds just like stocks. The limit is whatever you can actually sell.
    Corporate bonds normally have higher yields because there is a higher risk of a company defaulting than a government.
    Convertible bonds are Corporate Bonds which the holder can convert into stock, Callable Bonds (can be "called" back) allow the company to pay off the face value before maturity.

    So basically, for any bond issue you have to look at what type or types are being offered, what the maturity is - and most importantly what external factors are driving the price and what may change during the time you intend to hold it.

    Bonds are auctioned by issuers against a calendar that is known to investors. Often the type and duration is not fixed until close to the date to consider prevalent market conditions. Only rarely are they cancelled as this raises questions, although long term date changes or combining of auctions is not unusual.

    This is word often picked up by the press and sometimes used out of context. Probably because it is not so easy to explain and sounds interesting.
    What it means is that the interest rate which is settled on for a new issue at auction via bids, will not be possible to to maintain indefinitely for that type and maturity of bond. The rate at which something becomes unsustainable varies between countries, is dependent on the amount and type of debt issuance scheduled, their economic indicators and a number of other things.
    For example.
    Financial market analysts are able to forecast the behaviour of a bond under different scenarios, this helps to decide on a bid. It can also be used to see what is possible.
    Last week Italy could have sold all its forecast debt for the next 2 years at about a 7.5% yield, and even 9% for most of 2012. For Greece the tipping point was around 7%.
    The difference is the debt ratio at that rate, the additional cost related to GDP, the duration etc etc etc - counterbalanced by the key economic indicators such as growth forecasts.
    More important as a general indicator is the take up tracked over several auctions, this shows the underpinning sentiment.

    What makes the current situation so volatile is the difficulty in predicting the timelines of the impact of political decisions.
    The market overvalued many Eurozone bonds (the difference between the prices are called spreads), with a too narrow spread between economies that had bigger differences in economic performance. Now it is generally thought that we have an over correction, but until the political dimension is stable, nobody knows where the reality will end up.
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  2. I think explaining the reason for price moves in lay terms is useful. I normally skip yield curve, nuances etc and say: confidence in the issuer repaying the debt.
  3. Sightly off thread but what happens to Corporate Bonds you may hold in a company if it fails and ordinary shareholders lose their investment .... I suppose I am asking where do they rank in the pecking order for creditors ?
  4. You are referring to the "capital structure" of the company. Bond holders get first dibs on the recovery assets of a defaulted company before the shareholders. The corollary of this is the risk-reward pay-off. Senior Secured debt is least risky but unlikey to yield much whereas common equity is the most risky but has huge potential upside.

    Senior Secured debt
    Senior Unsecured debt "bonds"
    Subordinated debt
    Preference shares
    Common shares "equities/shares"
  5. Thanks ... every day is a learning day .