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:: What are Bonds? ::

The bond or fixed income market is composed of securities represent loans or bonds made by investors to borrowers. The borrowers that issue the bonds can be governments, states, agencies or corporations. The investors who buy the bonds are individuals, banks, insurance companies and pension plans.

Bonds pay a rate of interest, known as coupon, periodically for a fixed period. When the bond matures at the end of the term the principal is repaid to the lender or owner of the bond.

Typically the interest rate and the amount of principal is fixed at the time the bond is offered for sale, which is why bonds are also known as fixed-income securities.

Buying Bonds

When bonds are issued, they are sold at par, or face value, usually in units of $1,000 in United States. In UK, government bonds (known as gilt-edged securities or gilts) are issued in units of £100. After issue, bonds are traded in the secondary market, where they are bought and sold through brokers similar to the way shares are. Bonds traded freely in the open market may change hands several times at different prices between the time the bond is first issued and when it matures.

Bonds are usually identified by quoting the interest rate it pays, the organisation that issued it and its maturity date.  In U.S., bond prices are quoted in points where each point is equal to $10. Partial points are usually quoted in 1/8th, 1/10th or 1/32nd of a point depending upon the market conventions for that particular type of bond. Therefore if a bond is priced at 93 7/8 points, it is worth $938.75 (7/8 x $10 = $8.75).

Bond prices are determined primarily by two factors:

1. Interest Rates:

If new bonds issued are paying 8% of interest because interest rates have fallen, then investors would be willing to pay a premium, i.e. a price above the bond's par value for bonds that pay above-market rate of interest, say 10%. The price would rise until it offered an overall return, i.e. yield to maturity (YTM) that was competitive with news bonds being issued.

If interest rates rise, and new bonds issued are paying 12% of interest, the value of bonds that pays only 10% will decline. The price will decline to a level where its overall return (YTM) becomes competitive with new bonds.

2. Credit Ratings:

Rating companies investigate the financial condition of a bond issuer in order to determine how safe a particular issue is, i.e. how likely will a borrower be able to meet its interest and principal payments in full and on time. All kinds of corporate and international bonds are rated. The only exception is U.S. Treasury bonds since they are obligations of the federal government, which has the authority to raise taxes to pay off its debts.

The best known services are Standard & Poor's and Moody's. The table below shows the rating systems of the two services. Credit ratings influence the interest rate an issuer must pay to attract investors, typically for bonds with the same maturity, the lower the bond's rating the higher the interest it pays and the higher its yield, since it has higher chance of not paying interest on time or repay investors their principals at all (in default).

Lowest-rated bonds typically pay the highest rates to attract investors. These bonds, also known junk bonds or high-yield bonds, were widely used to finance mergers and acquisitions of the 1980s.

Pricing Bonds

Before we look at how to price bonds, one need to understand how to calculate present and future cashflows. Please refer to the note “How to Calculate Present and Future Values” for explanation. Take an investor invest in a U.S. Treasury bond which matures in 5 years’ time, with a coupon rate of 8% percent and par value of $1,000, i.e. an interest payment of $80 will be received by the investor every year for 4 years, plus the final $80 and the face value $1,000 in the fifth year.

1. Finding the Price for given Yield

To determine the present value of these payoffs, or the current price of the bond, one need to look at the return offered by similar securities. If other medium-term U.S. Treasury bonds offered a return of 4.2%, then the price of the 8% bonds can be determined by discounting the cash flows at 4.2%:

Bond prices are usually expressed as a percentage of the face value, in this case, the price of the 8% bond is worth 116.822%.

2. Finding the Yield to Maturity for given Price

If the price of the above bond is $1,100, the value of r that solves the equation below is called the bond’s yield to maturity:

In this case, the yield to maturity is around 5.65%.

Reading the Bonds Table

Table below shows the gilt prices for a number of UK government bonds with different maturity dates.

First column shows the name, coupon rate and redemption (maturity) date of the bonds. The second column are composed of Interest and Redemption yields (or YTM). The rest of the columns show the closing prices from the previous day, price changes from the day before previous day, and 52-week highs and lows. The par value of each bond is £100.

A few points to note here:

1. The Interest yield is simply Coupon divided by the Closing Price. The interest yield and price of bonds are always in inverse relationship; since coupon is by definition fixed, when interest rates rises, to maintain a competitive yield, the price has to fall.

2. The Redemption yield is calculated using the formula in part 2 of Pricing Bonds (see above). Therefore it represents the total return on the bond when the bond is held till maturity, including any captital gains or losses and income from coupon. Redemption yields are always higher than the interest yields if prices of bonds are below par/face value (£100 for U.K. gilts).

3. Long-dated gilt prices move most in response to expectation of interest rate changes compared to short-dated gilts. This is because investors expect higher rates of return the longer the term of investments.

Next time, we will look at what a yield curve is and what economic outlook the market is telling from yield curves.

Written by Henry Tang

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