The three important elements that an investor needs to know when investing in fixed-income security are :
the bond’s features, which determine its scheduled cash flows and thus the expected and actual returns.
The legal, regulatory and tax considerations that apply to the fixed income security
the contingency provisions that may affect the bond’s scheduled cash flows.
The primary reason why issuers choose to issue callable bonds is to protect themselves against a decline in interest rates. This decline can come either from market interest rates falling or from the issuer’s credit quality improving.
A typical make whole call requires the issuer to make a lump-sum payment to the bondholders based on the present value of the future coupon payments and outstanding principal due to early bond redemption. The discount rate is usually a predetermined spread over the YTM of an appropriate sovereign bond. The typical result is a redemption value that is significantly greater than the bond’s current market price. Issuers, rarely invoke this provision because redeeming a bond that includes a MWC option is costly.
One of the reasons why the distinction between investment grade and high-yield bond markets is because institutional investors may be prohibited from investing in, or restricted in their exposure to, lower quality or lower-rated securities.
Central banks use open market operations to implement monetary policy. Open market operations refer to the purchase or sale of bonds, usually but not always sovereign bonds. Central banks may also purchase and sell bonds denominated in foreign currencies as part of their efforts to manage the relative value of the domestic currency and their country’s foreign reserves.
Fixed income markets are dominated by institutional investors, in part because of the high informational barriers to entry and high minimum transaction sizes. The issuance and trading of bonds very often occurs in OTC markets. Thus, fixed income securities are more difficult to access than equity securities. For these reasons, institutional investors tent to invest directly in bonds, where retail investors prefer to use investment vehicles (e.g. ETFs)
Bid-Ask spread can be as low as 5bps for very liquid issues to no price quoted for illiquid issues. A reasonable spread is of the order of 10 to 12 bps, whereas an illiquid spread may be in excess of 50bps.
There are limits to a government’s ability to reduce the debt burden. As the sovereign debt crises that followed the GFC has shown, taxing citizens can only go so far in paying down debt before the taxation becomes an economic burden.
Although both parties to a repurchase agreement are subject to credit risk, the agreement is structured as if the lender of funds is the most vulnerable party. Specifically, the amount lent is lower than the collateral’s market value. The difference between the market value of the collateral and the value of loan is known as repo margin, although the term “haircut” is more commonly used. The price of a traditional (option free) fixed rate bond at issuance is the present value of the promised cash flows. The market discount rate is used to obtain the present value.
The YTM is the internal rate of return on the cash flows – the uniform interest rate such that when the future cash flows are discounted at that rate, the sum of the present values equals the price of the bond. It is the “implied market discount rate”
The YTM is the rate of return that an investor will receive if and only if
The bond is held till maturity
The investor is able to reinvest the coupon payments at the YTM rate
The borrowers makes timely coupon and principal payment.
Relation between Bond Price and Bond Characteristics
For the same coupon rate and time to maturity, the % price change is greater when the market discount rate goes down than when it goes up. (Convexity effect)
For the same time-to-maturity, a lower coupon bond has a greater % price change than a higher-coupon bond when their market discount rates change by the same amount (Coupon effect)
Generally, for the same coupon rate, a longer term bond has a greater % price change than a shorter-term bond when their market discount rates change by the same amount (Maturity effect)
The primary component of the yield spread for many bonds is compensation for credit risk, not for time-to-maturity, and as a result, the yield spreads reflect the term structure of credit spreads. The term structure of credit spreads is the relationship between the spreads over the benchmark rates and times-to-maturity.
In addition to credit risk the change in spread can arise from liquidity of the bond.
In general, however, it is not possible to directly observe the market’s assessment of components separately – analysts can only observe the total yield spread.
The investor pays a lower price for the callable bond than if it were option-free. If the bond were non-callable, its price would be higher. The option-adjusted price is used to calculate the option-adjusted yield. The option-adjusted yield is the required market discount rate whereby the price is adjusted for the value of the embedded option. The value of the call option is the price of the option-free bond minus the price of the callable bond.
On the run (most recently issued government bonds) bonds typically trade a slightly lower YTM than off-the-run bonds having the same or similar times-to-maturity because of differences in demand for the securities and sometimes, differences in the cost if financing the government security in the repo market.
Isolating credit over varying time-to-maturity give rise to a term structure of credit spreads. An approach to calculate credit spread is to calculate a constant yield spread over a government spot curve. This spread is known as the zero volatility spread (Z-Spread ). The formula is as follows:
The Z Spread is also used to calculate the option adjusted spread (OAS). The formula is as follows:
OAS = Z Spread – Option value
Capital gains arise if a bond is sold above its constant-yield price trajectory and capital losses arise if a bond is sold below its constant-yield price trajectory. This trajectory is based on the YTM when the bond is purchased.
The investment horizon is at the heart of understanding interest rate risk and return. There are two offsetting type of interest rate risk that affect the bond investors
Coupon Reinvestment Risk – The future value of reinvested coupon payment increases when the interest rates rise and decreases when rates fall.
Market Price Risk – The sale price on a bond that matures after the horizon data decreases when the interest rates rise and increases when the rates fall.
(Macaulay) Duration is a useful measure because it represents the approximate amount of time a bond would have to be held for the market discount rate at purchase to be realized if there is a single change in interest rate. If the bond is held for the duration period, an increase from reinvesting coupons is offset by decrease in price if interest rates increase and vice.
When the investment horizon is less than the Macaulay Duration of the bond, the investor’s risk is to higher interest rates as market price of the bond dominates the coupon reinvestment risk.
When the investment horizon is greater than the Macaulay Duration of the bond, the investor’s risk is to lower interest rates as the coupon reinvestment risk dominates the market price risk
When the investment horizon is equal to the Macaulay Duration of the bond, coupon reinvestment risk is offset by the market price risk.
Modified Duration is the estimated change in bond’s market value for a 1% change in the market discount rate
Duration Gap is the difference between the Macaulay Duration and Investment Horizon. As time passes, the investment horizon is reduced and the Macaulay duration of the bond also changes. Therefore, the duration gap changes as well.
Modified Duration is a YIELD statistic whereas Effective Duration is a curve duration statistic.
For Callable Bonds (also for mortgage backed bonds), yield duration statistics do not apply;effective duration is the appropriate duration measure.
A higher coupon rate or a higher YTM reduce the duration measures. A longer time-to-maturity usually leads to a higher duration. It ALWAYS does so for a bond priced at premium or at par value. But if the bond is priced at a discount , a longer time-to-maturity might lead to a lower duration. This situation only occurs if the coupon rate is low (not zero) relative to YTM and the time-to-maturity is long.
The importance of Yield Volatility in measuring interest rate risk is that bond price changes are product of two factors:
the impact per basis point change in the YTM (measured by duration and convexity)
the number of basis point change in the YTM (yield volatility)0
Structural Subordination can arise when a corporation with a holding company has debt both at the parent holding company and operating subsidiaries. Debt at operating subsidiaries will get serviced by the cash flow and assets of the subsidiaries before funds can be passed (“upstreamed”) to the holding company to service debt at that level.
The two key issues for sovereign debt analysis are:
a government’s ability to pay
its willingness to pay.
Willingness to pay is important because of the principle of sovereign immunity, where investors are generally unable to force a sovereign to pay its debts.
The spot curve is a benchmark for the time value of money and is therefore viewed as the most basic term structure of interest rates because no reinvestment risk is involved.; the stated yield equals the actual realized return if the zero is held to maturity.
The trust deed (aka Indenture) is the legal contract that describes the bond, the obligations of the issuer and the rights of the bond holder. Apart from basic bond features(e.g. Coupon Rate, Frequency of Coupon payments), the indenture also identifies:
the funding sources for interest and principal payments
credit enhancement provisions that reduce the credit risk of the bond issue (very often used when creating ABS)
collateral - specific assets that securing the debt obligation above the and beyond the issuer's promise to pay.
covenants - clauses that specify the rights on the bondholders and any actions that the bond issuer is obligated to perform or prohibited from performing.
contingency provisions
Although the issuer is ultimately the source of contractual payments, it is the trustee that ensures timely payments. Doing so is accompanied by invoicing the issuer for interest payment and principal repayments and holding the funds until they are paid.
Bonds are sometimes issued by a holding company rather than by one of its operating companies. A holding company maybe rated differently than the operating companies and the bond holders may lack recourse to assets held by those companies. If the bonds are issued by the holding company with few assets to call on in the event of default, investor may face more credit risk than if the bonds were issued by an operating company in the group.
For ABS, the sponsor transfers the assets to the special legal entity (or SPV in Europe) to carry out the securitization process. A key reason for forming a special entity is bankruptcy remoteness. The transfer of assets by the sponsor is considered a legal sale and therefore the sponsor no longer has ownership rights. Any party making the claims following the bankruptcy of the sponsor would be unable to recover the assets or their proceeds.
Collateral Trust Bonds are backed by the securities like common shares or bonds or other financial assets. These securities are pledged by the issuer and typically held by the trustee.
Equipment trust certificates are bonds secured by a specific types of equipment or physical assets (e.g. Aircraft)
Affirmative Covenants enumerate the list of things that issuer is required to do.
Negative Covenants enumerate the list of things that issuer is prohibited from doing.
The GFC (c. 2008) showed that the putable bonds can often exacerbate liquidity problems,however, because they provide a first claim on the issuer's assets. The put provision gives bondholders the opportunity to convert their claim into cash before other creditors.
The difference in price between a callable bond and an otherwise identical noncallable bond is equal to the value of the call option to the issuer.
To avoid the higher interest rates required on callable bonds but still preserve the option to redeem bonds early when corporate or operating events require it, issuers introduced bonds with make-whole call provisions. With a make-whole bond, the call price is not fixed but includes a lump-sum payment based on the present value of the future coupons the bondholder will not receive if the bond is called early. With a make-whole call provision, the calculated call price is unlikely to be lower than the market value of the bond. Therefore the issuer is unlikely to call the bond except when corporate circumstances, such as an acquisition or restructuring, require it. The make-whole provision does not put an upper limit on bond values when interest rates fall as does a regular call provision. The make-whole provision actually penalizes the issuer for calling the bond. The net effect is that the bond can be called if necessary, but it can also be issued at a lower yield than a bond with a traditional call provision.
Credit Ratings tend to lag the market's pricing of credit risk.
Ratings don't change often while as the bonds are traded frequently which makes the traders focus more on the "loss given default" instead of "default risk". Credit Rating agencies tend to focus more on Default Risk while the Bond Market tends to focus more on "Loss Given Default"
For lower rated (speculative grade) bonds – Bonds of different companies ( having the same rating) - might trade a different valuations because of market's perception of riskiness of one company vs. Another in-terms of recovery rates.
The issuer's credit rating is at Senior Unsecured Level.
Structural Subordination can arise when a corporation with a holding company has debt both at the parent holding company and operating subsidiaries. Debt at operating subsidiaries will get serviced by the cash flow and assets of the subsidiaries before funds can be passed (“upstreamed”) to the holding company to service debt at that level.
Because Debt Obligations (terms of which are listed in the "indenture") are contracts which are enforceable by law, analysts typically assume that the creditor is "willing" to pay the dues and therefore they focus more on the "ability" to pay the dues.
Purchasing floating-rate debt is attractive to some institutions that have variable-rate sources of funds (liabilities), such as banks. This allows these institutions to avoid the balance sheet effects of interest rate increases that would increase the cost of funds but leave the interest income at a fixed rate. The value of fixed-rate bonds (assets)held would fall in the value, while the value of their liabilities would be much less affected.
The lower the coupon rate, the greater the bond's price sensitivity to interest rate changes.
Capital markets have regular rhythms. For instance, the economic cycle is the major determinant of overall corporate spreads. During recessions, the escalation of default risk widens spreads and reduces corporate returns relative to Treasuries. Conversely, economic prosperity reduces bankruptcies, tightens corporate spreads, and boosts corporate returns relative to Treasuries. (https://fred.stlouisfed.org/graph/?g=1tQDW)
Counter to intuition, relative corporate returns often perform best during periods of heavy supply of bonds.
Citing lower expected liquidity, some investors are often reluctant to purchase smaller-sized issues (less than $1.0 Billion). For investment grade issuers, these liquidity concerns frequently are exaggerated.
Interest rates are both the barometer of the economy and an instrument for its control.
The spot rate as a yield concept avoids the need of reinvestment rate assumption for coupon paying securities.
The yield on a zero-coupon expiring in T years is considered as the most accurate representation of a T-year interest rate.
Spot rate for a given security with a maturity T can be expressed as a geometric mean of 1 year spot rate and series of T-1 forwards rates
Bootstrapping
Method to derive spot rates using par rates. Par rates are the YTM on coupon paying government bonds that are priced at PAR.
So, if we have Par Rate then we use that to derive Spot Rate and which in turn can help us to derive the implied forward rate.
The YTM is generally a realistic estimate of expected return only if the yield curve is flat.
The YTM of default risk-free bond can be viewed as an weighted average of spot rates applied to its cash flows.
If the spot curve one year from today reflects the current forward curve, the return on zero-coupon bond for the one-year holding period is x%, regardless of the bond's maturity .
If the trader expects the forward curve to remain static then the return of bond with a duration longer than the investment horizon has a higher return than the bond with a maturity that matches the investment horizon.
The bond's total return with depend on the spread between the forward and the spot rate and the maturity of the bond. The longer the maturity the sensitive its total return is to the spread.
When the yield curve is upward sloping, as a bond approaches maturity or "rolls down the yield curve", it is valued at successively lower yields and higher prices.
Investors expecting the interest rates to fall will generally extend portfolio duration relative to a benchmark to take advantage of bond price increases from falling rates (and vice versa)
To capitalize on curve steepening expectation traders will short long term bonds and buy short terms bonds (and vice versa)
The spread of swap rates over government benchmark rates is a proxy for perceived credit risk relative to the risk-free debt.
During highly uncertain times, investor flock to government bonds in what is termed as "Flight to Quality". A flight to quality is often associated with bullish flattening in which the yield curve flattens as long term rates fall by more than short term rates.
Bond is properly thought of as a package of zero-coupon bonds.
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