Bonds and Interest rate

Sayed Momin Hashemi & Mohammad Shandy

What Is a Bond?

A bond is a fixed income instrument that represents a loan made by an

investor to a borrower (typically corporate or governmental). A bond could be
thought of as an I.O.U. between the lender and borrower that includes the
details of the loan and its payments. Bonds are used by companies,
municipalities, states, and sovereign governments to finance projects and
operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond
details include the end date when the principal of the loan is due to be paid
to the bond owner and usually includes the terms for variable or fixed interest
payments made by the borrower.
What Is an IOU?

 An IOU is a document that acknowledges a debt owed. In business,

accounts receivable may be informally called IOUs.

 The term IOU has a history dating at least to the 18th century and is
often viewed as an informal written agreement rather than a
legally-binding commitment. However, IOUs are still very much in
use. An IOU between two people conducting business may be
followed up with a more formal written agreement
The Issuers of Bonds

Governments (at all levels) and corporations commonly

use bonds in order to borrow money. Governments need
to fund roads, schools, dams or other infrastructure. The
sudden expense of war may also demand the need to
raise funds
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Similarly, corporations will often borrow to grow their business, to buy

property and equipment, to undertake profitable projects, for research
and development or to hire employees. The problem that large
organizations run into is that they typically need far more money than
the average bank can provide. Bonds provide a solution by allowing
many individual investors to assume the role of the lender. Indeed,
public debt markets let thousands of investors each lend a portion of
the capital needed. Moreover, markets allow lenders to sell their bonds
to other investors or to buy bonds from other individuals—long after the
original issuing organization raised capital
How Bonds Work?

Bonds are commonly referred to as fixed income securities

and are one of three asset classes individual investors are
usually familiar with, along with stocks (equities) and cash
equivalents.

Many corporate and government bonds are publicly

traded; others are traded only over-the-counter (OTC) or
privately between the borrower and lender.
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When companies or other entities need to raise money to finance new

projects, maintain ongoing operations, or refinance existing debts,
they may issue bonds directly to investors. The borrower (issuer) issues a
bond that includes the terms of the loan, interest payments that will be
made, and the time at which the loaned funds (bond principal) must
be paid back (maturity date). The interest payment (the coupon) is
part of the return that bondholders earn for loaning their funds to the
issuer. The interest rate that determines the payment is called the
coupon rate.
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• The actual market price of a bond depends on a
number of factors.

• the credit quality of the issuer.

• the length of time until expiration.

• the coupon rate compared to the general interest rate

environment at the time.

• The face value of the bond is what will be paid back to

the borrower once the bond matures.
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Most bonds can be sold by the initial bondholder to other

investors after they have been issued. In other words, a
bond investor does not have to hold a bond all the way
through to its maturity date. It is also common for bonds to
be repurchased by the borrower if interest rates decline, or
if the borrower’s credit has improved, and it can reissue
new bonds at a lower cost.
Characteristics of Bonds

 Face value is the money amount the bond will be worth

at maturity; it is also the reference amount the bond
issuer uses when calculating interest payments. For
example, say an investor purchases a bond at a
premium $1,090 and another investor buys the same
bond later when it is trading at a discount for $980.
When the bond matures, both investors will receive the
$1,000 face value of the bond.
 The coupon rate is the rate of interest the bond issuer will
pay on the face value of the bond, expressed as a
percentage. For example, a 5% coupon rate means that
bondholders will receive 5% x $1000 face value = $50
every year.

 Coupon dates are the dates on which the bond issuer

will make interest payments. Payments can be made in
any interval, but the standard is semiannual payments.
 The maturity date is the date on which the bond will
mature and the bond issuer will pay the bondholder the
face value of the bond.
 The issue price is the price at which the bond issuer
originally sells the bonds.
Two important features of a bond.

Two features of a bond (credit quality and time to

maturity) are the principal determinants of a bond's
coupon rate. If the issuer has a poor credit rating, the risk of
default is greater, and these bonds pay more interest.
Bonds that have a very long maturity date also usually pay
a higher interest rate. This higher compensation is because
the bondholder is more exposed to interest rate and
inflation risks for an extended period.
Credit Rating Agencies

Credit ratings for a company and its bonds are generated by credit
rating agencies like Standard and Poor’s, Moody’s, and Fitch Ratings.
The very highest quality bonds are called “investment grade” and
include debt issued by the U.S. government and very stable
companies, like many utilities. Bonds that are not considered
investment grade, but are not in default, are called “high yield” or
“junk” bonds. These bonds have a higher risk of default in the future
and investors demand a higher coupon payment to compensate
them for that risk.
Duration

Bonds and bond portfolios will rise or fall in value as interest rates
change. The sensitivity to changes in the interest rate environment is
called “duration”. The use of the term duration in this context can be
confusing to new bond investors because it does not refer to the
length of time the bond has before maturity. Instead, duration
describes how much a bond’s price will rise or fall with a change in
interest rates.
convexity

The rate of change of a bond’s or bond portfolio’s sensitivity to interest

rates (duration) is called “convexity”. These factors are difficult to
calculate, and the analysis required is usually done by professionals.
Categories of Bonds

Corporate bonds are issued by companies. Companies issue bonds

rather than seek bank loans for debt financing in many cases because
bond markets offer more favorable terms and lower interest rates.

Municipal bonds are issued by states and municipalities. Some

municipal bonds offer tax-free coupon income for investors.
Government bonds such as those issued by the U.S. Treasury. Bonds
issued by the Treasury with a year or less to maturity are called “Bills”;
bonds issued with 1 – 10 years to maturity are called “notes”; and
bonds issued with more than 10 years to maturity are called “bonds”.
The entire category of bonds issued by a government treasury is often
collectively referred to as "treasuries." Government bonds issued by
national governments may be referred to as sovereign debt.

Agency bonds are those issued by government-affiliated

organizations such as Fannie Mae or Freddie Mac.
Varieties of Bonds

Zero-coupon bonds do not pay coupon payments and instead are

issued at a discount to their par value that will generate a return once
the bondholder is paid the full face value when the bond matures.
Convertible bonds are debt instruments with an embedded option
that allows bondholders to convert their debt into stock (equity) at
some point, depending on certain conditions like the share price. For
example, imagine a company that needs to borrow $1 million to fund
a new project. They could borrow by issuing bonds with a 12% coupon
that matures in 10 years. However, if they knew that there were some
investors willing to buy bonds with an 8% coupon that allowed them to
convert the bond into stock if the stock’s price rose above a certain
value, they might prefer to issue those.
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 The convertible bond may the best solution for the company
because they would have lower interest payments while the project
was in its early stages. If the investors converted their bonds, the
other shareholders would be diluted, but the company would not
have to pay any more interest or the principal of the bond.

 The investors who purchased a convertible bond may think this is a

great solution because they can profit from the upside in the stock if
the project is successful. They are taking more risk by accepting a
lower coupon payment, but the potential reward if the bonds are
converted could make that trade-off acceptable.
Callable bonds also have an embedded option but it is different than
what is found in a convertible bond. A callable bond is one that can be
“called” back by the company before it matures. Assume that a
company has borrowed $1 million by issuing bonds with a 10% coupon
that mature in 10 years. If interest rates decline (or the company’s credit
rating improves) in year 5 when the company could borrow for 8%, they
will call or buy the bonds back from the bondholders for the principal
amount and reissue new bonds at a lower coupon rate.
Callable bond is riskier for the bond
buyer.
A callable bond is riskier for the bond buyer because the bond is more
likely to be called when it is rising in value. Remember, when interest
rates are falling, bond prices rise. Because of this, callable bonds are
not as valuable as bonds that aren’t callable with the same maturity,
credit rating, and coupon rate.
Puttable bond

A Puttable bond allows the bondholders to put or sell the bond back to the
company before it has matured. This is valuable for investors who are worried
that a bond may fall in value, or if they think interest rates will rise and they
want to get their principal back before the bond falls in value.
Pricing Bonds

 The market prices bonds based on their particular characteristics. A bond's price
changes on a daily basis, just like that of any other publicly-traded security, where
supply and demand in any given moment determine that observed price. But there
is a logic to how bonds are valued. Up to this point, we've talked about bonds as if
every investor holds them to maturity. It's true that if you do this you're guaranteed to
get your principal back plus interest; however, a bond does not have to be held to
maturity. At any time, a bondholder can sell their bonds in the open market, where
the price can fluctuate, sometimes dramatically.

 The price of a bond changes in response to changes in interest rates in the economy.
This is due to the fact that for a fixed-rate bond, the issuer has promised to pay a
coupon based on the face value of the bond – so for a $1,000 par, 10% annual
coupon bond, the issuer will pay the bondholder $100 each year
Inverse to Interest Rates

This is why the famous statement that a bond’s price varies inversely
with interest rates works. When interest rates go up, bond prices fall in
order to have the effect of equalizing the interest rate on the bond
with prevailing rates, and vice versa.
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Another way of illustrating this concept is to consider what the yield on

our bond would be given a price change, instead of given an interest
rate change. For example, if the price were to go down from $1,000 to
$800, then the yield goes up to 12.5%. This happens because you are
getting the same guaranteed $100 on an asset that is worth $800
($100/$800). Conversely, if the bond goes up in price to $1,200, the
yield shrinks to 8.33% ($100/$1,200).
Yield-to-Maturity (YTM)

The yield-to-maturity (YTM) of a bond is another way of considering a bond’s

price. YTM is the total return anticipated on a bond if the bond is held until the
end of its lifetime. Yield to maturity is considered a long-term bond yield but is
expressed as an annual rate. In other words, it is the internal rate of return of
an investment in a bond if the investor holds the bond until maturity and if all
payments are made as scheduled. YTM is a complex calculation but is quite
useful as a concept evaluating the attractiveness of one bond relative to
other bonds of different coupon and maturity in the market
Thank u