Bonds

Basic Information Handout

By-Tariq Mumtaz
Definitions
A bond is simply a loan in the form of a security with different terminology: The issuer is equivalent to the
borrower, the bondholder to the lender, and the coupon to the interest.

Bonds enable the issuer to finance long-term investments with external funds. Bonds and stocks are both
securities, but the major difference between the two is that stockholders are the owners of the company (i.e.,
they have an equity stake), whereas bondholders are lenders to the issuing company.
As per “wikipedia.org”
A debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing.
The Federal government, states, cities, corporations, and many other types of institutions sell bonds.
Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date
(maturity).
As per “investorwords.com”
A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows
the funds for a defined period of time at a fixed interest rate. Companies, municipalities, states and U.S. and
foreign governments to finance a variety of projects and activities use bonds.

Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate.
Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals
are typically in the three to 10-year range.
As per “investopedia.com”
When it comes down to it, a bond is simply a
contract between a lender and a borrower by
which the borrower promises to repay a loan
with interest. However, bonds can take on many
additional features and/or options that can
complicate the way in which prices and yields
are calculated. The classification of a bond
depends on its type of issuer, priority, coupon
rate and redemption features.

1) Bond Issuers
As the major determiner of a bond's credit
quality, the issuer is one of the most important
characteristics of a bond. There are significant
differences between bonds issued by
corporations and those issued by a state
government/municipality or national
government. In general, securities issued by the
federal government have the lowest risk of
default while corporate bonds are considered
riskier ventures.

2) CUSIP Number
CUSIP stands for Committee on Uniform
Securities Identification Procedures. Formed in
1962, this committee developed a system that
identifies securities, specifically U.S. and
Canadian registered stocks, and U.S.
government and municipal bonds.
The CUSIP number consists of a combination of nine characters, both letters and numbers, which act as a
sort of DNA for the security - uniquely identifying the company or issuer and the type of security. The first
six characters identify the issuer and are assigned in an alphabetical fashion; the seventh and eighth
characters (which can be alphabetical or numerical) identify the type of issue; and the last digit is used as a
check digit.

3) Par Value
Par value, in finance and accounting, means stated value or face value. In the U.S. bond markets, a bond is
worth its par value when the price is equal to the face value. A Treasury note is denominated in units of
$1,000. The par values for different fixed-income products will vary. Bonds generally have a par value of
$1,000, while most money market instruments have higher par values.

A par value of 100.00 for a note or bond means only that the note or bond is selling for the face value paid
upon maturity of the note or bond. It can (and does) have different absolute values per Note or Bond
depending on the conventions of the particular market and country in which such par value is quoted

4) Annual Interest Rate or Coupon

A coupon is the stated interest rate for a bond. Most bonds have a fixed coupon that does not change during
the life of the bond. Most bonds have two coupon payments per year. For example, a bond with a 5.0%
coupon pays $25 twice per year, for total interest of $50, which is 5.0% of the face value of the bond (almost
all bonds have a face value of $1,000).

5) Maturity Date
The maturity date of a bond is the date on which the bond will be repaid. Note that many bonds have
features such as puts and calls that can cause the principal to be repaid on an earlier date.

6) First Coupon Date

Bonds typically pay interest twice per year on coupon payment dates. The first coupon date is the date on
which the very first interest payment is made for a bond. It is relevant because bonds often have a longer or
shorter than normal first payment period. When the first coupon payment has been made, the bond will
likely pay every 6 months thereafter.

7) Coupon Payment Frequency

The pay frequency refers to the frequency that the bond pays interest. The most common pay frequency is
semi-annually (twice per year), but bonds can also pay interest monthly, quarterly, annually, or at maturity.

8) Trustee & Paying Agent

An agent who makes dividend payments to stockholders or principal and interest payments to bondholders
on behalf of the issuer of those stocks or bonds. Also known as a "disbursing agent." A bank is usually the
paying agent designated to make dividend, coupon, and principal payments to the security holder on behalf
of the issuer.
Characteristics & Features of Bonds
The following chart
outlines these
categories of bond
characteristics

Nominal, Principal or Face Amount

The amount on which the issuer pays interest, and which has to be repaid at the end.

Issue Price
The price at which investors buy the bonds when they are first issued, typically $1,000.00. The net proceeds
that the issuer receives are calculated as the issue price, less issuance fees, times the nominal amount.

Maturity Date
The date on which the issuer has to repay the nominal amount. As long as all payments have been made, the
issuer has no more obligations to the bondholders after the maturity date. The length of time until the
maturity date is often referred to as the term, tenure, or maturity of a bond.

The maturity can be any length of time, although debt securities with a term of less than one year are
generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty
years. Some bonds have been issued with maturities of up to one hundred years, and some even do not
mature at all.

1. Short term (bills): maturities up to one year;

2. Medium term (notes): maturities between one and ten years;
3. Long term (bonds): maturities greater than ten years.

Coupon
The interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the
bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name
coupon originates from the fact that in the past, physical bonds were issued which coupons had attached to
them. On coupon dates, the bondholder would give the coupon to a bank in exchange for the interest
payment.

Coupon Dates
The dates on which the issuer pays the coupon to the bondholders. In the U.S., most bonds are semi-annual,
which means that they pay a coupon every six months. In Europe, most bonds are annual and pay only one
coupon a year.
Indentures and Covenants
An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the
clauses of such an agreement. Covenants specify the rights of bondholders and the duties of issuers, such as
actions that the issuer is obligated to perform or is prohibited from performing.

ƒ Optionality - A bond may contain an embedded option 1 ; that is, it grants option-like features to the
holder or the issuer.
ƒ Callability - some bonds give the issuer the right to repay the bond before the maturity date on the
call dates. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to
repay the bond at par.
ƒ Putability - Some bonds give the holder the right to force the issuer to repay the bond before the
maturity date on the put dates; see put option.
ƒ Convertibility - convertible bond lets a bondholder exchange a bond to a number of shares of the
issuer's common stock.

Call dates and put dates

The dates on which callable and putable bonds can be redeemed early. There are four main categories.

Priority
In addition to the credit quality of the issuer, the priority of the bond is a determiner of the probability that
the issuer will pay you back your money. The priority indicates your place in line should the company
default on payments.

If one holds an unsubordinated (senior) security and the company defaults, you will be first in line to receive
payment from the liquidation of its assets. On the other hand, if you own a subordinated (junior) debt
security, you will be paid out only after the senior debt holders have received their share.

1 An option is a contract written by a seller that conveys to the buyer the right — but not the obligation — to buy (in the case of a call option) or to sell
(in the case of a put option) a particular asset, such as a piece of property, or shares of stock or some other underlying security, such as, among others,
a futures contract. In return for granting the option, the seller collects a payment (the premium) from the buyer.

For example, buying a call option provides the right to buy a specified quantity of a security at a set strike price at some time on or before expiration,
while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote, the option must
fulfill the terms of the contract.
Types of Bonds

Bonds can be classified based on two benchmarks.

A- Issuing Party
B- Classification on Characteristics (Interest Rate, Coupon rate, maturity and Securitization)

(A.1) Corporate Bond

A Corporate Bond is a bond issued by a corporation. The term is usually applied to longer-term debt
instruments, generally with a maturity date falling at least a year after their issue date. Sometimes, the
term "corporate bonds" is used to include all bonds except those issued by governments in their own
currencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of local
authorities and supranational organizations do not fit in either category.

Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its
maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into equity. The
coupon (i.e. interest payment) is usually taxable. Sometimes this coupon can be zero with a high redemption
value.

Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends,
of course, upon the particular corporation issuing the bond, the current market conditions and governments
to which the bond issuer is being compared and the rating of the company. Corporate bondholders are
compensated for this risk by receiving a higher yield than government bonds. Corporate bonds are often
listed on major exchanges and ECNs 2 . However, despite being listed on exchanges, the vast majority of
trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based,
over-the-counter markets.

(A.2) Government Bonds

A government debt obligation (local or national) backed by the credit and taxing power of a country with
very little risk of default. In other words Government bonds are Treasury securities issued government of
the country, these are fixed income security They are the debt financing instruments of the Federal
government, and they are often referred to simply as Treasuries or Treasurys.

The bonds issued by the government are generally considered to be a safe option. The government bonds of
the developed countries are generally regarded as the more secured ones than the developing or the
underdeveloped ones.

Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from ten years to thirty years. They
have coupon payment every six months like T-Notes, and are commonly issued with maturity of thirty years.
Like other securities, individual issues of T-bills are identified with a unique CUSIP number. These too are
of different categories and are differentiated from one another in accordance with their respective time span
for maturity. There are four types of marketable treasury securities:

Treasury Bills - Treasury bills (or T-bills) mature in one year or less. Like zero-coupon bonds, they do not
pay interest prior to maturity; instead, they are sold at a discount of the par value to create a positive yield
to maturity. Many regard Treasury bills as the least risky investment available to U.S. investors.

Regular weekly T-bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91
days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52 weeks,
about 1 year). Treasury bills are sold by single price auctions 3 held weekly.

2
An electronic communication network ('ECN) is the term used in financial circles for a type of computer system that facilitates trading of financial
products outside of stock exchanges. The primary products that are traded on ECNs are stocks and currencies. ECNs came into existence in 1998 when
the SEC authorized their creation. ECNs increase competition among trading firms by lowering transaction costs, giving clients full access to their order
books, and offering order matching outside of traditional exchange hours.

3 Investors making competitive bids specify the rate or yield they are willing to receive for the use of their funds. Successful bidders pay the price
equivalent to the highest accepted rate or yield regardless of the rate or yield they bid. All Treasury securities auctions are now single-price.
Like other securities, individual issues of T-bills are identified with a unique CUSIP 4 number. Banks and
financial institutions, especially primary dealers, are the largest purchasers of T-bills.

Treasury bills are quoted for purchase and sale in the secondary market on an annualized percentage yield
to maturity, or basis. With the advent of TreasuryDirect 5 , individuals can now purchase T-Bills online, have
funds withdrawn from and deposited directly to their personal bank account, and earn higher interest rates
on their savings.

General calculation for yield on Treasury bills is

Treasury Note - Treasury notes (or T-Notes) mature in two to ten years. They have a coupon payment
every six months, and are commonly issued with maturities dates of 2, 3, 5 or 10 years, for denominations
from $100 to $1,000,000.

The 10-year Treasury note has become the security most frequently quoted when discussing the performance
of the U.S. government-bond market and is used to convey the market's take on longer-term macroeconomic
expectations.

T-Notes and T-Bonds are quoted on the secondary market at percentage of par in thirty-seconds of a point.
Thus, for example, a quote of 95:07 on a note indicates that it is trading at a discount: $952.19 (i.e. 95 7/32%)
for a $1,000 bond. The example of 95 and 7/32 points may be written as 95:07, or 95-07, or 95'07, or
decimalized as 95.21875.) Other notation includes a +, which indicates 1/64 points and a third digit may be
specified to represent 1/256 points. Examples include 95:07+, which equates to (95 + 7/32 + 1/64) and 95:073,
which equates to (95 + 7/32 + 3/256). Notation such as 95:073+ is unusual and not typically used.

Treasury Bonds - Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from ten years to
thirty years. They have coupon payment every six months like T-Notes, and are commonly issued with
maturity of thirty years.

As the U.S. government used its budget surpluses to pay down the Federal debt in the late 1990s, the 10-
year Treasury note began to replace the 30-year Treasury bond as the general, most-followed metric of the
U.S. bond market.

However, due to demand from pension funds and large, long-term institutional investors, along with a need
to diversify the Treasury's liabilities - and also because the flatter yield curve meant that the opportunity
cost of selling long-dated debt had dropped - the 30-year Treasury bond was re-introduced in February 2006
and is now issued quarterly. Some countries, including France and the United Kingdom, have begun offering
a 50-year bond, known as a Methuselah.

4 The acronym CUSIP typically refers to both the Committee on Uniform Security Identification Procedures and the 9-character alphanumeric security
identifiers that they distribute for all North American securities for the purposes of facilitating clearing and settlement of trades. The CUSIP distribution
system is owned by the American Bankers Association and is operated by Standard & Poor's. The CUSIP Services Bureau acts as the National
Numbering Association (NNA) for North America, and the CUSIP serves as the National Securities Identification Number for products issued from both
the United States and Canada.

5 TreasuryDirect is a website run by the United States Treasury, allowing individual investors to purchase Treasury securities such as T-Bills and other
directly from the U.S. government. Its website allows money to be deposited from and withdrawn to personal bank accounts, and allows rolling
repurchase of securities as the currently held items mature.

Treasury offers product information and research across the entire line of Treasury Securities, from Series EE Savings Bonds to Treasury Notes. New
TreasuryDirect accounts offer Treasury Bills, Notes, Bonds, Inflation-Protected Securities (TIPS), and Series I and EE Savings Bonds in electronic form
in one account.
Treasury Inflation Protected Securities (TIPS) - Treasury Inflation-Protected Securities (or TIPS) are
the inflation-indexed bonds issued by the U.S. Treasury. These securities were first issued in 1997.

The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon
rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted
principal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 10-year and 20-
year maturities. 30-year TIPS are no longer offered.

In addition to their value for a borrower who desires protection against inflation, TIPS can also be a useful
information source for policy makers: the interest-rate differential to pay additional taxes on the inflation-
adjusted principal. The details of this tax treatment can have unexpected repercussions. (See tax on the
inflation tax.)

By comparing a TIPS bond with a standard nominal Treasury bond across the same maturity dates,
investors may calculate the bond market's expected inflation rate by applying the Fisher equation.

Example: If the annual coupon of the bond was 5% and the underlying
principal of the bond was 100 units, the annual payment would be 5 units. If
the inflation index increased by 10%, the principal of the bond would
increase to 110 units. The coupon rate would remain at 5%, resulting in an
interest payment of 110 x 5% = 5.5 units.

(A.3) Municipal Bonds

A municipal bond is a bond issued by a city or other local
government, or their agencies. Potential issuers of municipal
bonds include cities, counties, redevelopment agencies, school
districts, publicly owned airports and seaports, and any other
governmental entity (or group of governments) below the state
level.

States, cities, and counties, or their agencies (the municipal

issuer) to raise funds issue municipal bonds. The methods and
practices of issuing debt are governed by an extensive system of
laws and regulations, which vary by state. Bonds bear interest at
either a fixed or variable rate of interest, which can be subject to
a cap known as the maximum legal limit.

The issuer of a municipal bond receives a cash payment at the

time of issuance in exchange for a promise to repay the investors
who provide the cash payment (the bond holder) over time.
Repayment periods can be as short as a few months (although
this is rare) to 20, 30, or 40 years, or even longer.
Municipal bonds may be general obligations of the issuer or
secured by specified revenues. Interest income received by
holders of municipal bonds is often exempt from the federal
income tax and from the income tax of the state in which they are
issued, although municipal bonds issued for certain purposes may
not be tax exempt.

One of the primary reasons municipal bonds are considered separately from other types of bonds is their
special ability to provide tax-exempt income. Interest paid by the issuer to bond holders is often exempt from
all federal taxes, as well as state or local taxes depending on the state in which the issuer is located, subject
to certain restrictions. Bonds issued for certain purposes are subject to the alternative minimum tax.
Purchasers of municipal bonds should be aware that not all municipal bonds are tax-exempt.
Because municipal bonds are most often tax-exempt, comparing the coupon rates of municipal bonds to
corporate or other taxable bonds can be misleading. Taxes reduce the net income on taxable bonds, meaning
that a tax-exempt municipal bond has a higher after-tax yield than a corporate bond with the same coupon
rate.

This relationship can be demonstrated mathematically, as follows:

Where :
rm = interest rate of municipal bond, rc = interest rate of comparable corporate bond, t = tax rate

For example if rc = 10% and t = 38%, then

(A.4) Agency Bonds

A bond, issued by a U.S. government-sponsored agency. The offerings of these agencies are backed by the
U.S. government, but not guaranteed by the government since the agencies are private entities. Such
agencies have been set up in order to allow certain groups of people to access low cost financing.

Some prominent issuers of agency bonds are Student Loan Marketing Association (Sallie Mae), Federal
National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).
These bonds are not fully guaranteed in the same way as U.S. Treasury and municipal bonds.

Not all agency bonds are issued by government agencies; indeed, the largest issuers are not agencies per se,
but rather government sponsored entities (GSEs). This is an important distinction, as true agencies are
explicitly backed by the full faith and credit of the U.S. Government (making their risk of default virtually as
low as Treasury bonds), while GSEs are private corporations that hold government charters granted because
their activities are deemed important to public policy.

Although they carry a government guarantee (implicit or explicit), agency bonds trade at a yield premium
(spread) above comparable Treasury bonds. There are a couple reasons why investors should expect this
higher yield in agency bonds over Treasuries:

ƒ There is some additional risk, however slight, stemming from political risk that the government
guarantee of agency debt could be modified or revoked in the future, leaving the bonds more
susceptible to default.

ƒ Treasury bonds are arguably the most liquid financial instrument on the planet, and are used by
central banks and other very large institutions requiring the ability to buy or sell securities in vast
quantities very quickly and efficiently. Agencies, on the other hand, are neither quite as liquid nor as
efficient to trade.

Agency bonds are usually exempt from state and local taxes, but not federal tax. While coupon payments on
debt from the most well known agencies (Fannie Mae and Freddie Mac) are taxable on both the federal and
state level, other agencies are taxable only on the federal level.

Þ How Treasury Auction Work: http://www.treasurydirect.gov/instit/auctfund/work/work.htm

Þ Features and Risks of TIPS: http://www.kc.frb.org/Publicat/econrev/PDF/1q98Shen.pdf
(B.1) Fixed Rate Bond
In finance, a fixed rate bond is a bond with a fixed coupon (interest) rate, as opposed to a floating rate note.
A fixed rate bond is a long term debt paper that carries a predetermined interest rate. The interest rate is
known as coupon rate and interest is payable at specified dates before bond maturity.

(B.2) Floating Rate Bonds

Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate,
like LIBOR or federal funds rate 6 , plus a spread. The spread is a rate that remains constant. Almost all
FRNs have quarterly coupons, i.e. they pay out interest every three months, though counter examples do
exist. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference
rate for that day and adding the spread.

Government sponsored enterprises (GSEs) such as the Federal Home Loan Banks, the Federal National
Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are
important issuers.

Example: Suppose a new 5 year FRN pays a coupon of 3 months LIBOR +0.20%,
and is issued at par (100.00). If the perception of the credit-worthiness of the issuer
goes down, investors will demand a higher interest rate, say LIBOR +0.25%.
Therefore, a dealer would then make a market of 27 / 25.

This means, that he would buy bonds at the equivalent of LIBOR +0.27%, and sell at
the equivalent of LIBOR +0.25%. If a trade is agreed, the price is calculated. In this
example, LIBOR +0.27% would be roughly equivalent to a price of 99.65. This can
be calculated as par, minus the difference between the coupon and the price that
was agreed (0.07%), multiplied by the maturity (5 year).

(B.3) High Yield Bond

A high yield bond (non-investment grade bond, speculative grade bond or junk bond) is a bond that is rated
below investment grade at the time of purchase. These bonds have a higher risk of default or other adverse
credit events, but typically pay higher yields than better quality bonds in order to make them attractive to
investors.

Global issuance of high yield bonds more than doubled in 2003 to nearly $146 billion in securities issued
from less than $63 billion in 2002, although this is still less than the record of $150 billion in 1998.

The holder of any debt is subject to interest rate risk and credit risk, inflationary risk, currency risk,
duration risk, convexity risk, repayment of principal risk, streaming income risk, liquidity risk, default risk,
maturity risk, reinvestment risk, market risk, political risk, and taxation adjustment risk.

A credit rating agency attempts to describe the risk with a credit rating such as AAA. In North America, the
five major agencies are Standard and Poor's, Moody's, Fitch Ratings, Dominion Bond Rating Service and
A.M. Best. Bonds rated BBB- and higher are called investment grade bonds. Bonds rated lower than
investment grade on their date of issue are called speculative grade bonds, derisively referred to as "junk"
bonds.

The lower-rated debt typically offers a higher yield, making speculative bonds attractive investment vehicles
types of financial portfolios and strategies. Many pension funds and other investors (banks, insurance
companies), however, are prohibited in their by-laws from investing in bonds which have ratings below a
particular level. As a result, the lower-rated securities have a different investor base than investment-grade
bonds.

6 The federal funds rate is the interest rate at which private depository institutions (mostly banks) lend balances at the Federal Reserve to other
depository institutions, usually overnight. The federal funds rate target is decided by the governors at Federal Open Market Committee (FOMC) meetings.
The FOMC members will either increase, decrease, or leave the rate unchanged depending on the meeting's agenda and the economic conditions of the
U.S.
(B.4) Zero Coupon Bond
A Zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower
than its face value, with the face value repaid at the time of maturity. It does not make periodic interest
payments, or so-called "coupons," hence the term zero-coupon bond. Investors earn return from the
compounded interest all paid at maturity plus the difference between the discounted price of the bond and
its par (or redemption) value.

Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds,
and any type of coupon bond that has been stripped of its coupons.

Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically
start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets. Short-
term zero coupon bonds generally have maturities of less than one year and are called bills. Pension funds
and insurance companies like to own long maturity zero coupon bonds because of the bonds' high duration.
This high duration means that these bonds' prices are particularly sensitive to changes in the interest rate,
and therefore offset, or immunize the interest rate risk of these firms' long-term liabilities.

STRIPS (Separate Trading of Registered Interest and Principal Securities)

Zero coupon bonds have a duration equal to the bond's time to maturity, which makes them sensitive to any
changes in the interest rates. Investment banks or dealers may separate coupons from the principal of
coupon bonds, which is known as the residue, so that different investors may receive the principal and each
of the coupon payments. This creates a supply of new zero coupon bonds.

The coupons and residue are sold separately to investors. Each of these investments then pays a single lump
sum. This method of creating zero coupon bonds is known as stripping and the contracts are known as strip
bonds. "STRIPS" stands for Separate Trading of Registered Interest and Principal Securities.

Dealers normally purchase a block of high quality and non-callable bonds—often government issues—to
create strip bonds. A strip bond has no reinvestment risk because the payment to the investor only occurs at
maturity.

(B.5) Inflation-Indexed Bonds

Inflation-indexed bonds are bonds where the principal is indexed to inflation. They are thus designed to cut
out the inflation risk of an investment. The Massachusetts Bay Company issued the first known inflation-
indexed bond in 1780. The market has grown dramatically since the British government began issuing
inflation-linked Gilts in 1981. As of 2008, government-issued inflation-linked bonds comprise over $1.5
trillion of the international debt market.

The inflation-linked market primarily consists of sovereign debt, with privately issued inflation-linked bonds
constituting a small portion of the market.

Inflation-indexed bonds pay a periodic coupon that is equal to the product of the inflation index and the
nominal coupon rate. The relationship between coupon payments, breakeven inflation and real interest rates
is given by the Fisher equation. A rise in coupon payments is a result of an increase in inflation expectations,
real rates, or both.

The most liquid instruments are Treasury Inflation-Protected Securities (TIPS), a type of US Treasury
security, with about $500 billion in issuance. The other important inflation-linked markets are the UK
Index-linked Gilts with over $300 billion outstanding

Example: If the annual coupon of the bond was 5% and the underlying principal of
the bond was 100 units, the annual payment would be 5 units. If the inflation index
increased by 10%, the principal of the bond would increase to 110 units. The coupon
rate would remain at 5%, resulting in an interest payment of 110 x 5% = 5.5 units.
(B.6) Asset-Backed Security
A financial security backed by a loan, lease or receivables against assets other than real estate and
mortgage-backed securities. For investors, asset-backed securities are an alternative to investing in
corporate debt. An ABS is essentially the same thing as a mortgage-backed security, except that the
securities backing it are assets such as loans, leases, credit card debt, a company's receivables, royalties and
so on, and not mortgage-based securities.

Assets are pooled to make otherwise minor and uneconomical investments worthwhile, while also reducing
risk by diversifying the underlying assets. Securitization makes these assets available for investment to a
broader set of investors.

These asset pools can be made of any type of receivable from the common, like credit card payments, auto
loans, and mortgages, to esoteric cash flows such as aircraft leases, royalty payments and movie revenues.
Typically, the securitized assets might be highly illiquid and private in nature.

In some cases, it can be used as credit enhancement by creating a security that has a higher rating than the
issuing company, which monetizes its assets. This allows it to pay a lower rate of interest than would be
possible via a secured bank loan or debt issuance. The various types of ABS are:

Home Equity Loans - Securities collateralized by home equity loans (HELs) are currently the largest asset
class within the ABS market.

Mortgage-Backed Security -A mortgage-backed security (MBS) is an asset-backed security whose cash

flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically
made monthly over the lifetime of the underlying loans. However not all securities backed by mortgages are
considered mortgage-backed security (MBS). Housing Bonds (Mortgage Revenue Bonds) are backed by the
mortgages, which they fund, but aren't classified as mortgage-backed security (MBS).

Auto Loans Backed - The second largest subsector in the ABS market is auto loans. Auto finance
companies issue securities backed by underlying pools of auto-related loans. Auto ABS are classified into
three categories: prime, nonprime, and subprime:

Credit Card Receivables Backed - Securities backed by credit card receivables have been benchmark for
the ABS market since they were first introduced in 1987. Credit card holders may borrow funds on a
revolving basis up to an assigned credit limit. The borrowers then pay principal and interest as desired,
along with the required minimum monthly payments. Because principal repayment is not scheduled, credit
card debt does not have an actual maturity date and is considered a nonamortizing loan.

Student Loans Backed - ABS collateralized by student loans (“SLABS”) comprise one of the four (along
with home equity loans, auto loans and credit card receivables) core asset classes financed through asset-
backed securitizations and are a benchmark subsector for most floating rate indices.

Asset-backed securities enable the originators of the loans to enjoy most of the benefits of lending money
without bearing the risks involved. They offer originators the following advantages:

ƒ Selling these financial assets to the pools reduces their risk-weighted assets and thereby frees up
their capital, enabling them to originate still more loans.
ƒ Asset-backed securities lower their risk. In a worst-case scenario where the pool of assets performs
very badly, the owner of ABS would pay the price of bankruptcy rather than the originator.
ƒ The originators earn fees from originating the loans, as well as from servicing the assets throughout
their life.
(B.7) War Bonds
War bonds are a type of savings bond used by combatant nations to help fund a war effort and as a monetary
policy for controlling inflation from an economy over stimulated by a war.

In 1917 and 1918, the United States government issued Liberty Bonds to raise money for its involvement in
World War I. According to the Massachusetts Historical Society, Because the first World War cost the
federal government more than 30 billion dollars (by way of comparison, total federal expenditures in 1913
were only $970 million), these programs became vital as a way to raise funds.

In 1941, in an effort to control inflation, the U.S. Treasury began marketing the new Series E bonds U.S.
Savings Bonds as "defense bonds". The government used the hype of the war to market the bonds to the
country as a way to raise money for the war.

(B.8) Perpetual Bond

A perpetual bond, which is also known as a Perpetual or just a Perp, is a bond with no maturity date.
Therefore, it may be treated as equity, not as debt. Perpetual bonds pay coupons forever, and the issuer does
not have to redeem them. Their cash flows are, therefore, those of perpetuity.

(B.9) Bearer Bond

A bearer bond is different from normal stock in that it is unregistered – no records are kept of the owner, or
the transactions involving ownership. Whoever physically holds the bearer bond papers owns the stock or
corporation. This is useful for investors and corporate officers who wish to retain anonymity. The downside
is that in the event of loss or theft, bearer bonds are extremely difficult to recover.

The bearer bond most possibly has its origins in the post Civil War United States. Their use in avoiding
taxation became more popular after World War I. Europe and the remainder of the Americas adapted the
use of these bonds in their own finance systems for similar reasons of utility.

A bearer bond or bearer security is a certificate that represents a bond obligation of, or stock in, a
corporation or other intangible property. It has been illegal since 1982 to issue bearer bonds in the municipal
or corporate bond markets in the United States.
Yield-Price Relationship

Understanding the price fluctuation of bonds is probably the most confusing part of this lesson. In fact,
many new investors are surprised to learn that a bond's price changes on a daily basis, just like that of any
other publicly traded security. Up to this point, we've talked about bonds as if every investor holds them to
maturity. It's true that if you do this you're guaranteed to get your principal back; however, a bond does not
have to be held to maturity.

At any time, a bond can be sold in the open market, where the price can fluctuate - sometimes dramatically.
We'll get to how price changes in a bit. First, we need to introduce the concept of yield.

Measuring Return with Yield

Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using
the following formula:

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. If
you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). But 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
Of course, these matters are always more complicated in real life. When bond investors refer to yield, they
are usually referring to yield to maturity (YTM). YTM is a more advanced yield calculation that shows the
total return you will receive if you hold the bond to maturity. It equals all the interest payments you will
receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the
bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).

Knowing how to calculate YTM isn't important right now. The key point here is that YTM is more accurate
and enables you to compare bonds with different maturities and coupons.

Example: Consider a 30-year zero coupon bond with a face value of $100. If the bond is priced at a yield-to-maturity of
1 0%, it will cost $5.73 today (the present value of this cash flow, 100 /(1.1)30 = 5.73). Over the coming 30 years, the
price will advance to $100, and the annualized return will be 10%.

But what happens in the meantime? Suppose that over the first 10 years of the holding period, interest rates decline,
and the yield-to-maturity on the bond falls to 7%. With 20 years remaining to maturity, the price of the bond will be
$25.84. Even though the yield-to-maturity for the remaining life of the bond is just 7%, and the yield-to-maturity
b argained for when the bond was purchased was only 10%, the return earned over the first 10 years is 16.26%. This
can be found by evaluating (1+i) = (25.84/5.73)0.1 = 1.1626.

Over the remaining 20 years of the bond, the annual rate earned is not 16.26%, but 7%. This can be found by
evaluating (1+i) = (100/25.84)0.05 = 1.07. Over the entire 30 year holding period, the origi nal $5.73 invested matured to
$100, so 10% annually was made, irrespective of interest rate changes in between.

The Link Between Price And Yield

The relationship of yield to price can be summarized as follows: when price goes up, yield goes down and vice
versa. Technically, you'd say the bond's price and its yield are inversely related.

Here's a commonly asked question: How can high yields and high prices both be good when they can't
happen at the same time? The answer depends on your point of view. If you are a bond buyer, you want high
yields. A buyer wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5%. On the
other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond
goes up. This way you can cash out by selling your bond in the future.

Price in the Market

So far we've discussed the factors of face value, coupon, maturity, issuers and yield. All of these
characteristics of a bond play a role in its price. However, the factor that influences a bond more than any
other is the level of prevailing interest rates in the economy.

When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds
and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall,
the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into
line with newer bonds being issued with lower coupons.
Bond Market
The bond market is a financial market where participants buy and sell debt securities, usually in the form of
bonds. it is also known as the debt, credit, or fixed income market

As of 2006, the size of the international bond market is an estimated $45 trillion, of which the size of the
outstanding U.S. bond market debt was $25.2 trillion. Nearly all of the $923 billion average daily trading
volume (as of early 2007) in the U.S. bond market takes place between broker-dealers and large institutions
in a decentralized, over-the-counter (OTC) market. However, a small number of bonds, primarily corporate,
are listed on exchanges.

Market Structure
Bond markets in most countries remain decentralized and lack common exchanges like stock, future and
commodity markets. This has occurred, in part, because no two bond issues are exactly alike, and the
number of different securities outstanding is far larger.

However, the New York Stock Exchange (NYSE) is the largest centralized bond market, representing mostly
corporate bonds. The NYSE migrated from the Automated Bond System (ABS) to the NYSE Bonds trading
system in April 2007 and expects the number of traded issues to increase from 1000 to 6000.

The Securities Industry and Financial Markets Association classifies the broader bond market into five
specific bond markets.

1. Corporate
2. Government & agency
3. Municipal
4. Mortgage backed, asset backed, and collateralized debt obligation
5. Funding

Bond Market Participants

Bond market participants are similar to participants in most financial markets and are essentially either
buyers (debt issuer) of funds or sellers (institution) of funds and often both.

Participants include:

1. Institutional investors
2. Governments
3. Traders
4. Individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many smaller issues,
institutions like pension funds, banks and mutual funds hold the majority of outstanding bonds. In the
United States, private individuals currently hold approximately 10% of the market. For market participants
who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and
interest are received according to a pre-determined schedule.

But participants who buy and sell bonds before maturity are exposed to many risks, most importantly
changes in interest rates. When interest rates increase, the value of existing bonds fall, since new issues pay
a higher yield. Likewise, when interest rates decrease, the value of existing bonds rise, since new issues pay
a lower yield. The fundamental concept of bond market volatility:

“Changes in bond prices are inverse to changes in interest rates”

Bond Market Index
A bond market index is a listing of bonds or fixed income instruments and a statistic reflecting the composite
value of its components. It is used as a tool to represent the characteristics of its component fixed income
instruments. They differ from stock market indices in their complexity

Bond indices can be categorized based on their broad characteristics, such as whether they are government
bonds, corporate bonds, high-yield bonds, mortgage-backed securities, etc. They can also be classified based
on their credit rating or maturity. Most bond indices are weighted by market capitalization. This results in
the bums problem, in which less creditworthy issuers with a lot of outstanding debt constitute a larger part
of the index than more creditworthy ones.

Global
ƒ Lehman Aggregate Bond Index - a family of global and regional bond indices.

U.S. bonds
ƒ Lehman U.S. Aggregate
ƒ Salomon BIG
ƒ Merrill Lynch Domestic Master
ƒ CPMKTB - The Capital Markets Bond Index

Government bonds
ƒ Salomon Smith Barney World Government Bond Index
ƒ J.P. Morgan Government Bond Index
ƒ Access Bank Nigerian Government Bond Index
ƒ FTSE UK Gilts Index Series

Emerging market bonds

ƒ J.P. Morgan Emerging Markets Bond Index
ƒ JPMorgan GBI-EM Index

High-yield bonds
ƒ CSFB High Yield II Index (CSHY)
ƒ Merrill Lynch High Yield Master II
ƒ Bear Stearns High Yield Index (BSIX)

How to Read A Bond Table

Column 1: Issuer - This is the company, state (or province) or
country that is issuing the bond.
Column 2: Coupon - The coupon refers to the fixed interest rate
that the issuer pays to the lender.
Column 3: Maturity Date - This is the date on which the borrower
will repay the investors their principal. Typically, only the last two
digits of the year are quoted: 25 means 2025, 04 is 2004, etc.
Column 4: Bid Price - This is the price someone is willing to pay
for the bond. It is quoted in relation to 100, no matter what the par
value is. Think of the bid price as a percentage: a bond with a bid of
93 is trading at 93% of its par value.
Column 5: Yield - The yield indicates annual return until the bond
matures. Usually, this is the yield to maturity, not current yield. If
the bond is callable it will have a "c--" where the "--" is the year the bond can be called. For example, c10
means the bond can be called as early as 2010.

Copyright © November 2008

Tariq Mumtaz