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(Page 1 of 40) Copyright © 2010, Investopedia.com - All rights reserved. Advanced Bond Concepts http://www.investopedia.com/university/advancedbond/ Thanks very much for downloading the printable version of this tutorial. As always, we welcome any feedback or suggestions. http://www.investopedia.com/contact.aspx Table of Contents 1) Advanced Bond Concepts: Introduction 2) Advanced Bond Concepts: Bond Type Specifics 3) Advanced Bond Concepts: Bond Pricing 4) Advanced Bond Concepts: Yield and Bond Price 5) Advanced Bond Concepts: Term Structure Of Interest Rates 6) Advanced Bond Concepts: Duration 7) Advanced Bond Concepts: Convexity 8) Advanced Bond Concepts: Formula Cheat Sheet 9) Advanced Bond Concepts: Conclusion Introduction In their simplest form, bonds are pretty straightforward. After all, just about anyone can comprehend the borrowing and lending of money. However, like many securities, bonds involve some more complicated underlying concepts as they are traded and analyzed in the market. The goal of this tutorial is to explain the more complex aspects of fixed-income securities. We'll reinforce and review bond fundamentals such as pricing and yield, explore the term structure of interest rates, and delve into the topics of duration and convexity. (Note: Although technically a bond is a fixed-income security with a maturity of ten years or more, in this tutorial we use the term “bond” and “fixed-income security" interchangeably.) The information and explanations in this tutorial assume that you have a basic understanding of fixed-income securities. Investopedia.com – the resource for investing and personal finance education. This tutorial can be found at: http://www.investopedia.com/university/advancedbond/ (Page 2 of 40) Copyright © 2010, Investopedia.com - All rights reserved. Bond Type Specifics Before getting to the all-important subject of bond pricing, we must first understand the many different characteristics bonds can have. 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. The following chart outlines these categories of bond characteristics: 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 to be riskier ventures. Of course there are always exceptions to the rule. In rare instances, a very large and stable company could have a bond rating that is better than that of a municipality. It is important for us to point out, however, that like corporate bonds, government bonds carry various levels of risk; because all national governments are different, so are the bonds they issue. Investopedia.com – the resource for investing and personal finance education. This tutorial can be found at: http://www.investopedia.com/university/advancedbond/ (Page 3 of 40) Copyright © 2010, Investopedia.com - All rights reserved. International bonds (government or corporate) are complicated by different currencies. That is, these types of bonds are issued within a market that is foreign to the issuer's home market, but some international bonds are issued in the currency of the foreign market and others are denominated in another currency. Here are some types of international bonds:  The definition of the eurobond market can be confusing because of its name. Although the euro is the currency used by participating European Union countries, eurobonds refer neither to the European currency nor to a European bond market. A eurobond instead refers to any bond that is denominated in a currency other than that of the country in which it is issued. Bonds in the eurobond market are categorized according to the currency in which they are denominated. As an example, a eurobond denominated in Japanese yen but issued in the U.S. would be classified as a euroyen bond.  Foreign bonds are denominated in the currency of the country in which a foreign entity issues the bond. An example of such a bond is the samurai bond, which is a yen-denominated bond issued in Japan by an American company. Other popular foreign bonds include bulldog and yankee bonds.  Global bonds are structured so that they can be offered in both foreign and eurobond markets. Essentially, global bonds are similar to eurobonds but can be offered within the country whose currency is used to denominate the bond. As an example, a global bond denominated in yen could be sold to Japan or any other country throughout the Eurobond market. 2) 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 you hold 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 get paid out only after the senior debt holders have received their share. 3) Coupon Rate Bond issuers may choose from a variety of types of coupons, or interest payments. Investopedia.com – the resource for investing and personal finance education. This tutorial can be found at: http://www.investopedia.com/university/advancedbond/ (Page 4 of 40) Copyright © 2010, Investopedia.com - All rights reserved.  Straight, plain vanilla or fixed-rate bonds pay an absolute coupon rate over a specified period of time. Upon maturity, the last coupon payment is made along with the par value of the bond.  Floating rate debt instruments or floaters pay a coupon rate that varies according to the movement of the underlying benchmark. These types of coupons could, however, be set to be a fixed percentage above, below, or equal to the benchmark itself. Floaters typically follow benchmarks such as the three, six or nine-month T-bill rate or LIBOR.  Inverse floaters pay a variable coupon rate that changes in direction opposite to that of short-term interest rates. An inverse floater subtracts the benchmark from a set coupon rate. For example, an inverse floater that uses LIBOR as the underlying benchmark might pay a coupon rate of a certain percentage, say 6%, minus LIBOR.  Zero coupon, or accrual bonds do not pay a coupon. Instead, these types of bonds are issued at a deep discount and pay the full face value at maturity. 4) Redemption Features Both investors and issuers are exposed to interest rate risk because they are locked into either receiving or paying a set coupon rate over a specified period of time. For this reason, some bonds offer additional benefits to investors or more flexibility for issuers:  Callable, or a redeemable bond features gives a bond issuer the right, but not the obligation, to redeem his issue of bonds before the bond's maturity. The issuer, however, must pay the bond holders a premium. There are two subcategories of these types of bonds: American callable bonds and European callable bonds. American callable bonds can be called by the issuer any time after the call protection period while European callable bonds can be called by the issuer only on pre-specified dates. The optimal time for issuers to call their bonds is when the prevailing interest rate is lower than the coupon rate they are paying on the bonds. After calling its bonds, the company could refinance its debt by reissuing bonds at a lower coupon rate.  Convertible bonds give bondholders the right but not the obligation to convert their bonds into a predetermined number of shares at predetermined dates prior to the bond's maturity. Of course, this only applies to corporate bonds. Investopedia.com – the resource for investing and personal finance education. This tutorial can be found at: http://www.investopedia.com/university/advancedbond/ (Page 5 of 40) Copyright © 2010, Investopedia.com - All rights reserved.  Puttable bonds give bondholders the right but not the obligation to sell their bonds back to the issuer at a predetermined price and date. These bonds generally protect investors from interest rate risk. If prevailing bond prices are lower than the exercise par of the bond, resulting from interest rates being higher than the bond's coupon rate, it is optimal for investors to sell their bonds back to the issuer and reinvest their money at a higher interest rate. Unlimited Types of Bonds All of the characteristics and features described above can be applied to a bond in practically unlimited combinations. For example, you could theoretically have a Malaysian corporation issue a subordinated yankee bond paying a floating coupon rate of LIBOR + 1% that is callable at the choice of the issuer on certain dates of the year. Bond Pricing It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. In this section, we will run through some bond price calculations for various types of bond instruments. Bonds can be priced at a premium, discount, or at par. If the bond's price is higher than its par value, it will sell at a premium because its interest rate is higher than current prevailing rates. If the bond's price is lower than its par value, the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond, given the bond's coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates. Fundamentally, however, the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: all we are doing is discounting the known future cash flows. Remember that to calculate present value (PV) - which is based on the assumption that each payment is re-invested at some interest rate once it is received--we have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield. Investopedia.com – the resource for investing and personal finance education. This tutorial can be found at: http://www.investopedia.com/university/advancedbond/ (Page 6 of 40) Copyright © 2010, Investopedia.com - All rights reserved. Here is the formula for calculating a bond's price, which uses the basic present value (PV) formula: C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value The succession of coupon payments to be received in the future is referred to as an ordinary annuity, which is a series of fixed payments at set intervals over a fixed period of time. (Coupons on a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired. The calculation assumes this time is the present. You may have guessed that the bond pricing formula shown above may be tedious to calculate, as it requires adding the present value of each future coupon payment. Because these payments are paid at an ordinary annuity, however, we can use the shorter PV-of-ordinary-annuity formula that is mathematically equivalent to the summation of all the PVs of future cash flows. This PV-of-ordinary-annuity formula replaces the need to add all the present values of the future coupon. The following diagram illustrates how present value is calculated for an ordinary annuity: Investopedia.com – the resource for investing and personal finance education. This tutorial can be found at: http://www.investopedia.com/university/advancedbond/ (Page 7 of 40) Copyright © 2010, Investopedia.com - All rights reserved. Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods one, two and three. Notice how the present value decreases for those coupon payments that are further into the future the present value of the second coupon payment is worth less than the first coupon and the third coupon is worth the lowest amount today. The farther into the future a payment is to be received, the less it is worth today - is the fundamental concept for which the PV-of-ordinary-annuity formula accounts. It calculates the sum of the present values of all future cash flows, but unlike the bond-pricing formula we saw earlier, it doesn't require that we add the value of each coupon payment. By incorporating the annuity model into the bond pricing formula, which requires us to also include the present value of the par value received at maturity, we arrive at the following formula: Investopedia.com – the resource for investing and personal finance education. This tutorial can be found at: http://www.investopedia.com/university/advancedbond/ (Page 8 of 40) Copyright © 2010, Investopedia.com - All rights reserved. Let's go through a basic example to find the price of a plain vanilla bond. Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. In our example we'll assume that coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in six months. Here are the steps we have to take to calculate the price: 1. Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten years, we will have a total of 20 coupon payments. 2. Determine the Value of Each Coupon Payment: Because the coupon payments are semi-annual, divide the coupon rate in half. The coupon rate is the percentage off the bond's par value. As a result, each semi-annual coupon payment will be $50 ($1,000 X 0.05). 3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. If we left the required yield at 12%, our bond price would be very low and inaccurate. Therefore, the required semi-annual yield is 6% (0.12/2). 4. Plug the Amounts Into the Formula: Investopedia.com – the resource for investing and personal finance education. This tutorial can be found at: http://www.investopedia.com/university/advancedbond/ (Page 9 of 40) Copyright © 2010, Investopedia.com - All rights reserved. From the above calculation, we have determined that the bond is selling at a discount; the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. The bond must sell at a discount to attract investors, who could find higher interest elsewhere in the prevailing rates. In other words, because investors can make a larger return in the market, they need an extra incentive to invest in the bonds. Accounting for Different Payment Frequencies In the example above coupons were paid semi-annually, so we divided the interest rate and coupon payments in half to represent the two payments per year. You may be now wondering whether there is a formula that does not require steps two and three outlined above, which are required if the coupon payments occur more than once a year. A simple modification of the above formula will allow you to adjust interest rates and coupon payments to calculate a bond price for any payment frequency: Notice that the only modification to the original formula is the addition of "F", which represents the frequency of coupon payments, or the number of times a year the coupon is paid. Therefore, for bonds paying annual coupons, F would have a value of one. Should a bond pay quarterly payments, F would equal four, and if the bond paid semi-annual coupons, F would be two. Pricing Zero-Coupon Bonds Investopedia.com – the resource for investing and personal finance education. This tutorial can be found at: http://www.investopedia.com/university/advancedbond/ (Page 10 of 40) Copyright © 2010, Investopedia.com - All rights reserved. So what happens when there are no coupon payments? For the aptly-named zero-coupon bond, there is no coupon payment until maturity. Because of this, the present value of annuity formula is unnecessary. You simply calculate the present value of the par value at maturity. Here's a simple example: Example 2(a): Let's look at how to calculate the price of a zero-coupon bond that is maturing in five years, has a par value of $1,000 and a required yield of 6%. 1. Determine the Number of Periods: Unless otherwise indicated, the required yield of most zero-coupon bonds is based on a semi-annual coupon payment. This is because the interest on a zero-coupon bond is equal to the difference between the purchase price and maturity value, but we need a way to compare a zero-coupon bond to a coupon bond, so the 6% required yield must be adjusted to the equivalent of its semi-annual coupon rate. Therefore, the number of periods for zero-coupon bonds will be doubled, so the zero coupon bond maturing in five years would have ten periods (5 x 2). 2. Determine the Yield: The required yield of 6% must also be divided by two because the number of periods used in the calculation has doubled. The yield for this bond is 3% (6% / 2). 3. Plug the amounts into the formula: You should note that zero-coupon bonds are always priced at a discount: if zero- coupon bonds were sold at par, investors would have no way of making money from them and therefore no incentive to buy them. Pricing Bonds between Payment Periods Up to this point we have assumed that we are purchasing bonds whose next coupon payment occurs one payment period away, according to the regular payment-frequency pattern. So far, if we were to price a bond that pays semi- annual coupons and we purchased the bond today, our calculations would assume that we would receive the next coupon payment in exactly six months. Of course, because you won't always be buying a bond on its coupon payment date, it's important you know how to calculate price if, say, a semi-annual bond is Investopedia.com – the resource for investing and personal finance education. This tutorial can be found at: http://www.investopedia.com/university/advancedbond/ (Page 11 of 40) Copyright © 2010, Investopedia.com - All rights reserved. paying its next coupon in three months