top of page

Bonds

Bonds are a very good long-term investment that doesn't require much work or attention.

Key vocab

Basic Bond Vocab Terms

Bond - A debt requiring the Issuer(the borrower) to pay the lender the borrowed amount plus interest over some specified period of time. 

Maturity date The date in which the principle is required to be paid back.

Term of maturity - The number of years in which the issuer(borrower has promised to meet conditions of the obligation

the-lifecycle-of-a-bond.webp

Coupon rate - Interest rate that the issuer agrees to pay each year. Other term for coupon rate; Nominal rate.

Principal - The amount the issuer(borrower) agrees to repay the bond holder at the maturity date. Other terms for principle; Redemption value, maturity value, par value, or face value. 

Coupon-Rate-Formula-960x300.jpg

Indenture - The contract between the issuer(borrower) and the bondholder.

Basic Cash Flow
Example

mig with logo demonstration demonostartioon.jpg

Issuers of Bonds

1. Federal Government and it agencies
2. Municipal Governments
3. Corporations (domestic or foreign)

Basic names of bonds

Short Term - Bonds with a maturity between 1-5 years

Intermediate Term - Bonds with a maturity between 5-12 years

Long Term - Bonds with a maturity more than 12 years

Deferred-coupon bonds

Deferred-coupon-bond: It lets the issuer avoid using cash to make interest payments for a specified period of time. 
Typically, the issuer would pay all of its interest that has accrued in the form of a single payment made at a later date rather than in periodic increments.

Three types of deferred-coupon structures

1. Deferred interest bonds
2. Step-up bonds
3. Payment-in-kind bonds

Deferred interest: Allows the issuer to pay all accrued interest in the form of one payment at a later date than the periodic payments.

deffered interest model number 1 mig.jpg

Step-up: A bond that pays a lower starting interest rate but has a feature that allows for the interest rate to increase at periodic intervals. 

step up bonds model 1 mig.jpg

Payment-in-kind: Allows the use of a good or a service to be the payment method instead of cash. 

services-607031685-d7441cbdfb25437991c68a0d6d590aa1.jpg

Risks with  investing in bonds

1. Interest rate risk
2. Reinvest risk
3. Call risk
4. Default risk
5. Inflation risk
6. Exchange rate risk
7. Liquidity risk
8. Volatility risk

 

Interest-rate risk

As interest rates rise, the value of a bond will fall. If an investor has to sell a bond before the maturity date, the investor will see a capital loss. (The major risk faced by investors in the bond market.)

interest-rate-risk.webp
Bond-Price-Interest-Rate-Seesaw.png

Reinvest risk

The risk in which the interest rate interim(accrued) cash flows can be reinvested will fall.

This is a greater risk for those who have a longer holding periods. Also for the investors with large, early cash flow.

Interest rate risk and reinvest risk have offsetting effects.

Immunization - When reinvest risk and interest risk offset.

DedicatedInternet_Icons-10.png
reinvest risk.png

Call risk

Call-Risk.jpg

Many bonds include a provision that allows the issuer to retire/call all or part of the issue before the maturity date. The issuer usually has this right in order to have flexibility to refinance the bond in the future is the market interest rate drops below the coupon rate.

3 disadvantages of call provisions

1. The cash flow pattern of a callable bond is not known in certainty. 
2. The issuer will call the bonds when the interest rates have dropped, the investor is exposed to reinvest risk, the investor will have to reinvest the proceeds when the bond is called at a lower interest rate. 
3. The capital appreciation potential of a bond will be reduced, because the price of a callable bond may not rise much above the price in which the issuer will call the bond. 

Call risk is so pervasive in bond portfolio management that many market participant consider it second only to interest rate risk.

Default risk

Risk that the issuer of a bond may default(they will not be able to make the principal payments and interest payments.)

Bonds with default risk trade at a lower rate compared to US treasury securities. Us treasury securities are "risk free". Junk Bonds: High-yield, risky for issuer to pay back. 

Assessing-Default-Risk.jpg
default-1-getty.jpg

Inflation risk

Risk that inflation exceed the coupon rate.

saupload_10yr_breakeven_082420.png

Inflationary risk refers to the risk that inflation will undermine the performance of an investment, the value of an asset, or the purchasing power of a stream of income. Looking at financial results without taking into account inflation is the nominal return. The value an investor should worry about is the purchasing power, referred to as the real return.

Exchange-rate risk

The risk that a company's operations and profitability may be affected by changes in the exchange rates between currencies.

Exchange-Rate-Risk.jpg

Liquidity Risk

The issue of which a bond can be sold at or near its value. Not as risky for investors that hold on until the maturity date.

download (7).jpg
eopfnewoifneiowf.png

The most popular and crudest measure of liquidity is the bid-ask spread

Volatility risk

The risk is that a change in volatility will affect the price of a bond adversely. one of the factors is the volatility of interest rates. 

Bond-and-Volatility-Risk-Premiums.png
fredgraph (2).png

You made it! This is the end of chapter 1, more is coming soon...

bottom of page