Bonds

In the world of finance, bonds are loans made to large corporations, cities, and governments. These bond issuers owe the holders of the bond a debt obligation and depending on the term of the bond, are obligated to pay them interest which is known as the coupon payment. Bonds pay at fixed intervals, usually semi-annually, unless stated otherwise.  At maturity, the bondholder will receive the principal payment + interest. Bonds are considered an fixed income investment.

Types of Bonds

Federal Bonds

• Federal Bonds are one of the highest rated bonds in terms of credit quality as they’re backed by the federal government. The Federal Government and Government of Canada Crown Corporations issue debt obligations to support government spending, finance projects or day to day operations. These are considered low risk investments and can have terms of one to 30 years.

Provincial Bonds

• Provincial Bonds are issued by Canada’s Provincial Governments. These bonds are of high quality, have better rates than similar federal bonds and can have a term of up to 30 years. These bonds account for about 20% of the bond market. Funds collected by the provincial government are used to fund deficits that may arise from public spending or other expenditures. 
  • Safety – Provincial bonds are direct obligation bonds of the government and are secured by the government’s ability to collect taxes
  • Income – As per other bonds, these pay interest payments twice a year
  • Liquidity – Bonds can be sold at its market value on any business day
  • Price Changes – While the interest portion of the bond will stay the same, the value of your bond will change daily in accordance to supply and demand and interest rates.

Corporate Bonds

• Corporate bonds is a certificate of debt secured by a physical asset on which the corporation promises to pay the holder a stated rate of interest over the life of the bond. At maturity, the investor would receive the principal. Corporate bonds are riskier than government ones and therefore have a higher interest rate.

Corporate Debentures

• Corporate Debentures are similar to a bond except that they are not secured by any specific assets. They’re backed only by the general credit quality of the issuer. Debentures have a higher level of risk and offer a higher rate of return than bonds with similar characteristics.

Zero-Coupon Bonds/Strip Bonds

• Zero Coupon Bond is exactly what the name states. The bond pays no interest payments which are known as coupons because the coupons are stripped and sold separately.  Because the zero coupon bonds do not pay interest, they are sold at a discount. Upon maturity, the bond holders receive the face value of the bond as it gradually increases in value. They’re considered long term investments as they mature in ten or more years. 

Foreign Bonds

• A foreign bond is an investment that is issued by a foreign entity in the local market’s currency. The foreign entity can be a government, municipality or a corporation. Foreign bonds tend to have higher risk than domestic bonds due to their exposure to interest rate risk and currency risk. These are bonds denominated in the local currency of that country.
  • Yankee bond (in the U.S)
  • Rembrandt bond (in the Netherlands)
  • Samurai bond (in Japan)
  • Matador bond (in Spain)
  • Bulldog bond (in the Uk)
  • Maple Bond (in Canada)
  • Kangaroo Bond (in Australia)

Mortgage-Backed Securities (MBS)

• Mortgage Back Securities is when an issuer of MBS buys a portfolio or a pool of mortgages from a certain type of mortgage originator, such as a commercial bank, as an example. The bank essentially sells the stream of income that comes from the payment of the mortgages. These payments are passed to the MBS holders, similar to coupon payments.
  • Mortgage Backed Securities filled with sub-prime loans were one of the main contributors to the 2008 financial crisis. The housing bubble collapse triggered mortgage delinquencies, foreclosures and devaluation of housing related securities. 

Pricing Bonds

• When it comes to pricing, let’s first start with the basics. All bonds have an issue date, a maturity date and a stated face value or par value. Bonds are priced in 100s as a percentage of the par value. A bond with the face value of $1,000 may have a bond price of 100.  For example, a bond trading at 97, means it’s trading at 97% of its par value or $970.
• The coupon rate of a bond is the stated interest rate that is used to calculate the periodic interest paid on each coupon date. Keep in mind that bonds pay interest semi-annually!

Upon maturity, the investor will receive their final interest payment plus the original principal. 

With a basic bond, the issue date, maturity date and the coupon rate never change. The only features that change are the bond’s price and yield.

Price/Yield Relationship

• The yield of a bond is related to the current market interest rates. The price of the bond is determined by discounting the future coupon payments and the par value at the current market interest rates. 

Keep in mind that interest rates and bond prices have an inverse relationship. 💡

• When current market interest rates RISE, bond prices FALL
• When current market interest rates FALL, bond prices RISE

Using the above examples, try changing the interest rate to 5% and then 10%. You’ll notice the inverse relationship mentioned above. As interest rates rise, bond prices fall and vice versa.

Bonds that are priced below $1,000 are said to be trading at a discount. Bonds priced above $1,000 are said to be trading at a premium.  Bonds priced at $1,000 are said to be trading at par.

Calculating a Bond

The quickest and easiest way to calculate a bond is to use a financial calculator. On the financial calculator, you’ll have the following inputs:

FV = Future Value or Principal Value of the Bond
PMT = Periodic Payments (Coupon Rate)
N = Number of Outstanding Interest Payments
I = Interest Rate

Example: Finding the Purchase Price

A $5,000 bond pays interest at 6% semi-annually and is redeemable at par at the end of 10 years. What is the purchase price if the bond pays 10% compounded annually?

A $5,000 bond pays interest at 6% semi-annually and is redeemable at par at the end of 10 years. What is the purchase price if the bond pays 10% compounded annually?

Using a financial calculator, calculate the present value of the redemption price. Note that P/Y/C/Y is 2 as the bond pays interest semi annually.

P/Y = 2
C/Y = 2
FV=$5,000
N= 10 X 2 = 20
I/Y = 10

PV = -1884.44

Step 2 – Calculate the Present Value of the Interest Payments

PMT = 5000 * 0.06/2 = $150
P/Y = 2
C/Y = 2
FV = 0
N = 20
I = 10

PV of interest payments = $1,869.33

Purchase Price = 1884.44 + 1,869.33 = 3,753.77

Since $3,753.77 is less than $5,000 which is the maturity value, you can say that this bond was purchased at a discount.

We’ve broken it down to 2 steps but if you wanted, you can calculate everything in one step using a financial calculator.

P/Y = 2
C/Y = 2
FV=$5,000
PMT = $150 (0.06/2) x $5,000
N= 10 X 2 = 20
I/Y = 10

Purchase Price = $3,753.77

Bond Duration

When you’re reading about fixed income, it’s almost impossible to not come across the word “duration“. What does it mean and how does it affect your portfolio?

Now that we’ve read about bond prices and their inverse relationship with interest rates, we can talk about duration. Duration is measured in years and is the approximate measure of a bond’s price sensitivity to changes in interest rates. It calculates how long it will take an investor to be repaid the bond’s price by the bond’s cash flows (coupons). The higher the duration of a bond, the more its price will drop as interest rates rise. (the greater the interest rate risk)

How Duration Works

For every 1% increase or decrease in interest rates, a bond’s price will change 1% in the opposite direction for every year of duration. For example, if a bond has a duration of five years and interest rates increase by 1%, the bond’s price will decline by 5%.  Alternatively, if a bond has a duration of 5 years and interest rates fall by 1%, the bond’s price will increase by approx. 5%.

How it Helps Your Portfolio 

Duration is a way for you to compare bonds and adjust accordingly in your investment portfolio. 

• For example, if you expect rates to rise, it may make sense to focus on shorter duration investments as they have less interest rate risk.
• If you expect rates to fall, it may make sense to focus on longer duration investments so you can take advantage of price appreciation. 

 Factors That Affect Duration

• Coupon Rate
  • The Higher the Coupon Rate, the Lower the Duration
  • The Lower the Coupon Rate, the Higher the Duration
• Time to Maturity
  • The longer the Time to Maturity, the Higher the Duration
  • The shorter the Time to Maturity, the Lower the Duration

Recap 

• Bonds are just like IOUs.
• Buying a bond means you are lending out your money. 
• They are considered fixed income instruments as their cash flow is fixed.
• A bond is characterized by its face value, coupon rate, maturity, and issuer.
• Yield is the rate of return you get on a bond.
• When price goes up, yield goes down and vice versa.
• When interest rates rise, the price of bonds in the market falls and vice versa.