A quick guide to bonds
What is a bond?
When a business uses financial markets to raise debt capital rather
than equity, (shares), the instrument or product frequently used is
a bond. A bond is a long term debt obligation of the borrower or
issuer. The bond purchaser is called the investor.
Bonds allow issuers to increasing balance sheet leverage. In
liquidation bond investors normally rank prior to equity holders but
are behind or subordinated to secured lenders.
There are certain terms that apply to a bond the main ones include
the following:
Principal: This is the amount of money the investor will receive on
maturity. It is also the amount on which interest payments are
calculated.
Coupon: The coupon is the regular interest that is paid to the
investor by the issuer. The frequency can be annually, semi
annually or quarterly. Coupons can be fixed rate or floating rate,
(more on this later). From an issuer’s perspective coupon payments
are normally deductible before tax whereas equity dividends are
not.
Maturity: This is the date on which the investor will expect to
receive repayment of the principal sum invested. Typically bonds
have maturities of between 2 and 30 years. However there are
bonds with longer maturities and some that never mature, (known
as irredeemable or perpetual bonds).
Currency: The bond will have a specified currency, the majority of
bonds are issued in the major currencies, USD. EUR and JPY.
Why issue a bond?
The main reason for issuing a bond is to arrange cheap long term
financing. Bond markets offer issuers one of the cheapest ways of
borrowing. This is because capital markets are relatively efficient
and this keeps transaction costs and spreads to a minimum. It is
also the reason why bond markets have grown at the expense of
traditional bank lending.
Are there any other reasons for bond issuance? Yes, many
borrowers rely on frequent and diversified access to capital
markets. Diversification, (in theory), means they are less reliant on
one single source of funding. Issuing bonds with different
currencies, coupons and maturities will attract different investors
thereby spreading the issuer’s source of funds.
Why buy a bond?
Investors buy bonds because they need to obtain a return on their
money and their investment horizon is medium or long term.
Furthermore they consider the return they get is attractive relative
to the risk they are taking. The main risk is not receiving timely
repayments of interest and principal.
The demand for and supply of bonds therefore provides you with
bond market prices and in this respect bond markets are the same
as any other market place.
Two types of bond
Whilst bonds can come in all “shapes and sizes” there are two main
types. They are fixed rate bonds, (also known as fixed income) and
floating rate bonds, (normally known as floating rate notes). The
names are derived from their coupon payments.
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Fixed income bonds
Fixed income bonds pay an investor regular, known coupons. The
frequency of the coupon payments can be quarterly, semi-annually
or annually. The interest is often calculated on a 30/360 basis, that
is using 12 months with each month containing 30 days.
An investor buying a fixed income security is really buying a series
of future cash flows, (the coupons and principal).
Investors and traders judge the value of a fixed income bond by
calculating its yield. This is an internal rate of return calculation. It is
the rate of interest, that when used, discounts all the bond cash
flows to give a net present value of zero; the higher the yield, the
higher the rate of return.
But to fully evaluate whether the bond is good value an investor
must consider the risk. The main risk is credit risk. Bonds with
higher credit risk provide investors with greater yields.
Floating rate notes, (FRNs)
FRNs also pay regular coupons but this time the payment is
variable rate. Typically every three or six months the coupon is
“refixed” using the prevailing 3 or 6 month Libor rate.
This means that when short term rates rise, on the next interest
refixing date, the coupon will increase. When rates go down the
coupon falls.
The investment return on a FRN is therefore similar to that on a
bank deposit that is rolled over every three months.
For this reason many people regard FRNs as money market
instruments despite the fact that FRNs typically have maturities of
between 2 and 20 years.
The interest calculation for the coupon payment is normally on a
money market basis, (actual 360).
Investors and traders judge the value of a floating rate note by
calculating its discount margin. For example if a 5 year FRN is
priced at 99% and pays a coupon of Libor it will give the investor a
1% capital gain on maturity. If the 1% is spread out over 5 years
that is the equivalent of 20 basis points per annum on simple basis
and, (using 5%), 23 basis points on a compound basis. The FRN
therefore has an implied return of Libor + 23 basis points.
Just like fixed rate bonds the return will be higher for FRNs that are
less creditworthy.
What’s the main difference between the two
bonds?
Fixed rate bonds give you a known interest payment. Some
investors prefer this, pension funds for example can use fixed rate
bonds to match future liabilities.
But it also means that when interest rates increase the value of a
fixed coupon bond falls. This is simple math, the present value of
the future cash flows falls as interest rates go up. For longer dated
fixed income bonds the effect of rising interest rates on the bond
price is greater. (This is because there are more cash flows to be
discounted).
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 Floating rate notes give you a return that is dependent on short
term Libor rates. Some investors prefer this. Banks for example
often buy FRNs because the coupon income matches their funding
cost. It also means that FRNs experience lower price volatility in
respect of changing interest rates. This is a “good thing” if rates
increase but you forgo capital gains should interest rates fall.

How important is liquidity?

Liquidity also plays a part in bond prices. Liquid bonds are those
that can be sold easily with the minimum of transaction costs. From
a liquidity perspective some bonds are just better than others. In
general high quality bonds that have large issuance sizes are the
most liquid. Investors will pay relatively more for them.

What is the clean & dirty price?

When dealers buy and sell bonds they agree the price at which the
transaction is done. In most bond markets, with a few exceptions,
this price is known as the “clean price”. The clean price excludes the
bond’s accrued interest. The accrued interest on a bond is the daily
amount of money that accrues to the holder of the bond between
the coupon dates.

When the settlements department pays or receives the cash value

of the bond the accrued interest is added to the clean price in order
to work out the “dirty price” which is also the settlement value.

That means if you buy a bond half way through the time period
between one coupon and the next you must pay for the interest
already accrued, which in this case is half the coupon. The exact
calculation for accrued interest will depend on the day count
convention that applies to the bond’s coupon.

What is a medium term note, (MTN)?

A MTN is a bond that has been issued under a flexible programme.
There is an information memorandum that explains the purpose of
the programme, the amount of outstanding debt that can be issued
and the financial details of the issuer. The information
memorandum is provided to investors and is updated annually.

Bonds issued under MTN programmes can have different

currencies, coupons, maturities. They may also contain embedded
risks like calls and puts.

This means that an issuer can use an MTN programme to structure

a bond that exactly meets the investor’s requirements. For this
reason MTNs are very popular with both issuers and investors.

William Webster
Barbican Consulting Limited
Financial Markets Training
wwebster@barbicanconsulting.co.uk
00 44 (0)20 79209128

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