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Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later. Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra-longterm bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century) are virtually perpetuities from a financial point of view, with the current value of principal near zero. The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the creditworthiness of the issuer. These factors are likely to change over time, so the market price of a bond will vary after it is issued. This price is expressed as a percentage of nominal value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but bond prices converge to par when they approach maturity (if the market expects the maturity payment to be made in full and on time) as this is the price the issuer will pay to redeem the bond. This is referred to as "Pull to Par". At other times, prices can be above par (bond is priced at greater than 100), which is called trading at a premium, or below par (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000 in the United States, or in units of £100 in the United Kingdom. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, in the US, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal form.) Some short-term bonds, such as the U.S. Treasury Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond. The market price of a bond is the present value of all expected future interest and principal payments of the bond discounted at the bond's redemption yield, or rate of return. That relationship defines the redemption yield on the bond, which represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices fall and vice versa. Thus the redemption yield could be considered to be made up of two parts: the current yield (see below) and the expected capital gain or loss: roughly the current yield plus the capital gain (negative for loss) per year until redemption. The market price of a bond may include the accrued interest since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "full" or "dirty price". (See also Accrual bond.) The price excluding accrued interest is known as the "flat" or "clean price". The interest rate adjusted for (divided by) the current price of the bond is called the current yield (this is the nominal yield multiplied by the par value and divided by the price). There are other yield measures that exist such as the yield to first call, yield to worst, yield to first par call, yield to put, cash flow yield and yield to maturity. The relationship between yield and maturity for otherwise identical bonds is called a yield curve. A yield curve is essentially a measure of the term structure of bonds. Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter markets. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.

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It's also true that investors demand higher yields for longer maturities. but many others -. consider what happens when the price goes up or down. This is often an excellent time to buy bonds. the prospectus will indicate whether a bond is callable and give you a "yield-to-call" figure. Risk Inflation risk.a harbinger of an impending period of slowly rising consumer prices. A lot of people do just that. Standard & Poor's and Moody's. While it's certainly better than not being paid back at all. What you or I might consider good news. Why is inflation such a problem for bondholders? Think about it this way: Rising prices make today's dollars worth less in the future than they're worth today. And the more downward pressure on bond prices. seriously eroding the purchasing power of that $1." or 100% of its face value. a once-healthy corporation can go bankrupt and suddenly lose the ability to pay its obligations. etc. a rising rate of inflation can have a particularly corrosive effect. cities and counties occasionally In fact. All this explains why bond traders live in a hall of mirrors. It's the percentage return your bond investment promises at any given price. the higher the yield. prices fall and yields -.000 you're supposed to get back in 30 years. Reward: How Bonds Behave y JUST BECAUSE BONDS have a reputation as conservative investments doesn't mean they're always safe.buy and sell them on the open market before they reach maturity. economists label the yield of the shortest-term U. You've probably heard the mantra at least once before: When yield goes up. the worse the threat. you haven't the faintest clue why. Any time you lend money.and thus the yield -.is a figure that captures this change in value.) Paradoxically. The same holds true if the bond's market price jumps to $1. but for now. So far. But if you're like most people. you run the risk it won't be paid back." (See Types of Bonds. That means it's unlikely you'll ever be able to sell a bond for "par. Aa.) -. The credit quality of companies and governments is closely monitored by the two major debt-rating agencies. If the price falls to $800. The reason for that is obvious -. Yield vs. The bond market itself is a minute-by-minute referendum on the threat of inflation. it forces you to find another. we might as well dive right into the yield and price mess.help determine the interest rate that a company or government has to pay when it issues bonds. here goes. If you have a choice. A. Price Goes Down y ALL RIGHT. If the threat is high.Risk vs. you're stuck. They assign credit ratings based on the entity's perceived ability to pay its debts over time. the more at-risk it is statistically. you'll still get $60 each year in interest and $1. Inflation By far. y y y y y y When Yield Goes Up. Since a bond can lock up your money for as long as 30 years. These things are unlikely or you'd never invest in the first place. or "called. The market determines the price -. the bond markets often take it as a bad sign -.000 and a 6% ($60) coupon. Consider a 30-year bond with a face value of $1. a bond's periodic coupon and its ultimate payout never change once the bond is issued. then.000 when the bond matures. So What Does 'Yield' Mean? Yield -. buy a bond without the call option. When the economic news is good. Companies. The more risk. the $800 bond is a much better deal -you're getting the same payout for $400 less. price goes down.a bondspeak standard -. we've discussed bonds as if investors always buy and hold them until they mature. But if you own them already. they often consider bad. As you already know.given enough time. We'll explore what drives price changes in the next lecture. Obviously. and vice versa. But the longer you tie your money up in a bond. place to put your money." This is known as prepayment risk. Those ratings -.S. possibly less lucrative. Well. it's the thing that has most confused beginning investors. Since the first bond hit Wall Street.200. bonds "the risk-free rate of return. the greatest danger for a buy-and-hold bond investor is a rising inflation rate. after all.. y y y y y . When you buy a bond.sometimes wildly. credit risk and prepayment risk are all figured into the pricing of bonds. OK. another source of risk for certain bonds is that your loan may be paid back early. The hotter the economy.expressed as letters (Aaa. Inflation could run rampant.rise.including the pros -.or interest rates -.after that.. Nothing spooks bond traders more than cheerful headlines about full employment or strong economic growth. the price of a given bond can fluctuate -. Consequently.

And although they can carry plenty of risk (we'll discuss why in our How Bonds Behave lecture). All of these entities need money to operate -. Why? Because the guaranteed coupon -$60 -.000 and walk away. a 5% coupon and a 10-year maturity. A key difference between stocks and bonds is that stocks make no promises about dividends or returns. a bond is a loan and you are the lender. You would collect interest payments totaling $50 in each of those 10 years.going the other way.to fund the federal deficit.it can be expressed with this formula: Yield = Coupon/Price. the current yield would simply be 6% ($60/$1. That's why bonds are also known as "fixed-income" investments -. a state. Let's look at that 6% bond again." This represents the total return you can expect if you buy a bond at a given price and hold it until it matures.5%. anyway.so they borrow capital from the public by issuing bonds. the company guarantees to pay back your principal (the face value) plus interest. the issuer promises to pay you back on a particular day -. for instance.the "maturity date" -. the yield grows or shrinks to compensate in either direction. but the company is under no obligation to pay it." Once you buy it. it's either the U. General Electric's dividend may be as regular as a heartbeat. But when the price fluctuates. you add that $200 difference and the effects of reinvested coupons. You've already locked in your yield.they assure you a steady payout or yearly income. government." Say. Who's the borrower? Usually.y y y y y y In its most simple incarnation -. If you were to buy it for $1. this regular income is what makes them inherently less volatile than stocks.the "coupon. however. Yield to maturity includes the fact that the bond you bought for $800 will pay you $1. If you're a bond buyer. because you want to pay $800 for that $1.000 when it's due. Once you've grasped the inverse relationship between price and yield. a local municipality or a big company like General Motors. When the decade was up. it has been known to spend months -. If the price rises to $1. it gets even more complicated.especially if you need cash someday and want to sell the bond to get at it. In the real world. or interest rate.S.73% -. What is a Bond? y TECHNICALLY SPEAKING.a significantly better deal than the original coupon of 6%. you know exactly how much you're going to get back (in most cases. for instance. in the above example. the price you pay is known as its "face value.5% of the $800 you paid for the bond ($60/$800). the percentage shifts Yield to Maturity Unfortunately. called "yield to maturity. you're ready to take on the bond market's next puzzler: If yields and prices move in opposite directions. Now for a little bond-speak. It also assumes you reinvest the coupons at the same rate and figures in the compounding effect. you're rooting for price. When a bond is issued. When you buy a bond for face value.000 face value. the yield rises to 7. If you buy the bond and hold it to maturity. the yield to maturity calculates out to 7. however. And while GE stock spends most of its time moving upward.000 bond.200. or to build roads and finance factories -.000). When GE issues a bond. when people talk about yield. and if the price rises. high yields are what you're after. it can only be a good thing -. you'd get back your $1. how come both high yields and high prices are considered good things? The answer depends on your perspective. We'll discuss some exceptions later).is now 7.at a predetermined rate of interest -. you buy a bond with a $1.known as "current yield" -.even years -. But if the price drops to $800. they're really talking about another figure. the yield is simply the coupon. Once you own the bond. y y y . If.000.

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