Introduction To Bond Math
Introduction To Bond Math
Presentation to CDIAC
Agenda
Agenda
I. What is a Bond?
V. Amortization Structures
What is a Bond?
What is a Bond?
A bond is a debt instrument that allows issuers to finance capital needs. It obligates the issuer to pay
to the bondholder the principal plus interest.
A buyer of the bond is the lender or investor.
A seller of the bond is the borrower or issuer.
When an investor purchases a bond, he is lending money to a government, municipality, corporation,
federal agency or other entity.
In return for buying the bond, the issuer promises to pay the investor a specified rate of interest during
the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes
due.
In addition to operating covenants, the loan documents require issuer to spend the bond proceeds for
the specific projects.
Among the types of bonds an investor can choose from are: U.S. government securities, municipal
bonds, corporate bonds, mortgage and asset-backed securities, federal agency securities and foreign
government bonds, among others.
A bond can also be thought of as a contract between the issuer and investor. This contract specifies,
for example, the terms of the bonds, the funds from which debt service will be paid and any operating
covenants.
What is a Bond?
General Obligation (GO) Bonds are secured by a pledge of the issuers full faith, credit and taxing
power. The full faith and credit backing of a General Obligation bond implies that all sources of
revenue, unless specifically excluded, will be available to pay debt service on the bonds.
Appropriation Bonds are secured by a promise to pay with legislatively approved appropriations.
These are generally supported by the General Fund of issuer, unlike General Obligation bonds where
funds are often not paid from the General Fund.
Examples include Certificate of Participation (COPs) and Leased Revenue Bonds (LRBs).
Revenue Bonds are payable from a specific stream of revenues, such as a user fee or dedicated tax,
and are not backed by the full faith and credit of the issuer. They are issued to finance specific
enterprises or projects and are usually secured solely by revenues from those projects. Revenue bonds
can generally be grouped into the following categories:
Utilities
Higher Education, Healthcare and Other Not-For-Profit
Housing
Transportation
Industrial Development, Pollution Control, and Other Exempt Facility Bonds
Securitized Revenue Bonds
What is a Bond?
Rate Covenants - Under a rate covenant, the issuer pledges that rates will be set at a level sufficient to
meet operation and maintenance expenses, renewal and replacement expenses, and debt service. An
alternative form of rate covenant requires that rates be set so as to provide a safety margin above debt
service, after operation and maintenance expenses are met.
Example: The Board will fix, charge and collect fees so that the Revenues will at all times be
sufficient in each Fiscal Year to pay Operating and Maintenance Expenses and to provide funds at
least equal to 115% of (1.15 times) the Principal and Interest Requirements.
Additional Bonds Test (ABT) - Protects existing bondholders from the risk that their security will be
diluted by the issuance of additional debt. The Additional Bonds Test must be met by the issuer in
order to borrow additional debt secured by the same revenue source as the outstanding bonds.
Example: The Net Revenues in each of the two Fiscal Years immediately preceding the date of
issuance of such proposed Additional Bonds must be equal to at least 130% of the estimated Annual
Debt Service for the year following the proposed issuance.
Debt Service Reserve Fund - Provides a cushion to make timely debt service payments in the event of
temporary adversity. Federal law limits the amount of tax-exempt bond proceeds that can be used to
fund the debt service reserve fund to the lesser of:
10% of the principal amount of the issue;
Maximum annual debt service; and
125% of average annual debt service on an issue.
May also be required for appropriation debt.
Many times a DSRF is not required for highly rated credits (e.g. UC Regents and CSU).
Other Covenants - Additional covenants might include a provision for insuring the project, a review
by an independent auditor, or a prohibition against the sale of the projects facilities prior to repayment
of outstanding debt, among others.
What is a Bond?
Price Insurance
Serial Maturities
1/1/2013 $9,325,000 3.90%
Term Bond
1/1/2016 $10,705,000* 5.25%
Total *
$57,595,000
Coupon - Percentage rate (based on principal/par amount) of annual interest paid on outstanding bonds
Can be fixed or variable
Interest - Cost of borrowing money for the issuer
Usually paid periodically
Interest is calculated by multiplying principal by coupon (adjusted for length of period between
interest payments)
Debt Service - Sum of all principal and interest on a bond
Bond Pricing
Price Discounted present value of debt service on an individual maturity. Debt service is
calculated using the coupon and discounted at the yield.
Price $99.39
Par Amount $8,705,000.00
Purchase Price $8,651,812.45
10
Yield Price
Coupon
11
Coupon
Premium Bonds
Price
Coupon greater than yield
Yield
Purchase price greater than principal amount
Coupon
12
13
14
CABs pay no periodic interest until maturity. The bonds accrete in value as interest accrues.
Usually sold as serial bonds, but can be structured as term bonds.
At maturity an amount equal to the initial principal invested plus the interest earned, compounded
semiannually at the stated yield, is paid.
They are sold in denominations of less than $5000 representing their present value and pay $5000 at
maturity.
Though CABs are often more expensive (sold at a higher yield) than current interest bonds, they are
used to achieve particular debt service patterns.
Example: A CAB maturing in 2011 may have a par amount of $90,595 but will have a value of
$100,000 when it matures. The difference between $100,000 and $90,595 represents the interest on
the bond.
Accreted Value of CAB from Delivery to Maturity
$102,000
$100,000
$98,000
$96,000
$94,000
$92,000
$90,000
1/1/2009 7/1/2009 1/1/2010 7/1/2010 1/1/2011
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Callable Bonds
Callable bonds can be redeemed by an issuer before their actual maturity on and after a specified call
date (an optional redemption provision).
Many times, fixed-rate bonds will be callable 10 years after issuance at a price of par. Historically,
many municipal bonds were sold with 10-year call features where the bond was callable at 102 and
declined to par by the 12th year.
Municipal bonds are sold with embedded call features to provide restructuring flexibility and/or
refinancing savings in the future.
Investors charge the issuers for this flexibility through a higher yield and lower price thereby
increasing the cost of the financing at the time of issuance.
Issuers need to weigh this increased flexibility and the possibility of savings down the road against
this increased cost.
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Bond Insurance
Issuers purchase bond insurance in order that debt service will be paid even if there are insufficient
revenues.
In exchange for this, investors will pay a higher price (lower yield) for an insured bond.
Premium paid upfront, based on original debt service schedule; no credits for refundings or early
repayment of bonds.
The cost of an insurance policy needs to be compared to the observed market spread between
insured and uninsured bonds. It makes sense to only insure those maturities for which the cost of
the policy is less than 'cost' of issuing uninsured bonds.
The market for bond insurance has changed significantly over the last year. For example, several
insurers have been downgraded. Also, it is unclear what the effects of Moodys move to a Global
Scale will be on bond insurance.
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Bond Conventions
Basis Point
Yields on bonds are usually quoted in terms of basis points, with one basis point equal to one one-
hundredth of 1 percent.
.50% = 50 basis points
Day Count
30/360
Usually for tax-exempt fixed rate bonds
Actual/Actual
Usually for tax-exempt variable rate bonds
Pricing
Truncate to 3 decimals
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Yield Curve
Yield Curve
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Maturity (Years)
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Yield Curve
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Maturity (Years)
20
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Maturity (Years)
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$500
453
$450 431
407
365
358
$350 342
79%
314
79%
$300 290
84% 289
85% 76%
259
76%
89% 255
82%
$250 234
88% 226
73%
216
209
195
85%
$200 86%
162
90% 86% 68%
85% 77%
$150 84%
90%
$100
$50
$0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
(YTD)
Fixed Rate
Variable Rate
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Advantages Disadvantages
No Interest Rate Risk - Budget Certainty Higher Initial and Expected Interest Expense
No Ongoing Credit Support Needed Less Flexible Call Feature than Floating Rate
Bonds
Traditional Investors Include: Bond Funds,
Potentially Higher Issuance Costs
Insurance Companies, Arbitrage Accounts,
Trust Departments and Retail Investors
Fixed rate financings remain the most common approach in the current market.
Advantages Disadvantages
Easy to Restructure Interest Rate Risk
Lower Expected Cost of Capital Budgeting Uncertainty
Used to Diversify Debt Portfolio Unpredictable Pricing of Support Costs
Traditional Investors Include: Money Market Additional Administrative Involvement
Funds, Corporations and Retail Investors
Given the Feds recent rate increases, variable rates have increased from their historical lows two years ago, with
SIFMA recently resetting at 1.84%. This compares to a 20-year average of 3.15%.
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Credit enhancement is a means of substituting the credit of the issuer with that of a higher rated third
party guarantor.
Similar to insurance in the case of fixed-rate bond, credit enhancement improves the
Credit enhancement typically takes the form of bond insurance or letters of credit (LOC).
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Amortization Structures
Amortization Structures
Issuers can use amortization structures to shape their overall debt structure pattern.
25
1995
1995 1998
1990 1993 2001
1998 1996 2004
2001 1999
20042002 2007 20102013
20052010
2007 2008 2013
2011 20142016
2016 2017 2019
2019 2020 2022
2022 2023 2025
2025 2026
20282029 2028
20322034
2031 2035
Year
Year
Year
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Debt Service
2005
2008 2010
2013 2015
2018 2020
2023 2025
2028 2030
2033 2035
2038 2040
2043 2008
2005 2013
2010 2018
2015 2023
2020 2028
2025 2033
2030 2038
2035 2043
2040
Ye ar Year
Existing Debt Service New Money Debt Service
Existing Debt Service New Money Debt Service
Debt Service
2008
2005 2013
2010 2018
2015 2023
2020 2028
2025 2033
2030 2038
2035 2043
2040
2008
2005 2013
2010 2018
2015 2023
2020 2028
2025 2033
2030 2038
2035 2043
2040 Year
Year
Existing Debt Service New Money Debt Service New Money Debt Service
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Key Calculations from a Bond Sale
Issuance Expenses
Yield Calculations
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Sources:
Bond Proceeds
Par Amount $57,595,000
Net Premium 1,873,174
Total Sources $59,468,174
Uses:
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Issuance Expenses
Key Calculations from a Bond Sale
30
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Yield Calculations
Yield is the discount rate at which the present value of future debt service payments are equal to the
proceeds of the issue.
The most common measures of the borrowing cost of a bond issue are the arbitrage yield, true interest
cost (TIC) and all-in TIC.
For short or non-callable issues, each is differentiated by which costs it takes account of. For
example
Arbitrage
Yield TIC All-In TIC
32
In this example, the debt service used to calculate the Arbitrage Yield, TIC and All-In TIC are the
same. The difference between them is the 'target' value.
Arbitrage
Yield TIC All-In TIC
33
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