1. Advanced Bond Concepts: Introduction
  2. Advanced Bond Concepts: Bond Type Specifics
  3. Advanced Bond Concepts: Bond Pricing
  4. Advanced Bond Concepts: Yield and Bond Pricing
  5. Advanced Bond Concepts: Term Structure of Interest Rates
  6. Advanced Bond Concepts: Duration
  7. Advanced Bond Concepts: Convexity
  8. Advanced Bond Concepts: Formula Cheat Sheet
  9. Advanced Bond Concepts: Conclusion

Before we get into bond pricing, let’s first go over various bond characteristics – for example, bonds can be issued by governments or corporations, or, in the case of eurobonds, can be denominated in a currency other than its home country or market where it’s issued.

In their simplest form, bonds are contracts between lenders and borrowers, according to which the borrower promises to repay the loan with interest. Bonds can take on additional features, however, that shape the way their prices and yields are calculated. How a bond is classified depends on its issuer, priority, coupon rate and redemption features. 

Bond Characteristics

This chart shows the categories of bond characteristics. Below, we'll go into details about each one.

Bond Issuer

The bond issuer is one of the most important characteristics of a bond and a major factor in determining a bond’s credit quality. There are four primary types of issuers:

Government

Government bonds generally have the lowest default risk. U.S. Treasuries, for example, are backed by the “full faith and credit” of the U.S. government. Federal government bonds in the U.S. include savings bonds, Treasury bonds and Treasury inflation-protected securities (TIPS).

Municipality

Known as “munis,” municipal bonds are issued by non-profits, private-sector corporations and other public entities. The loan may be used for public projects such as constructing highways, hospitals and schools. Munis typically have more risk than government bonds but less than corporate issues. That’s because most cities don’t go bankrupt but, as we’ve seen in recent years, it can happen (think: Detroit).

Corporate

Companies can issue bonds just as they issue shares of stock. Corporate bonds are considered to have higher risk than either munis and government bonds. As a result, interest rates are nearly always higher on corporate bonds. The company’s credit quality plays an important role: the higher the quality, the lower the interest rate you’ll receive.

International

International bonds are issued in a country by a non-domestic entity. They include Eurobonds, foreign bonds and global bonds:

  • A eurobond is denominated in a currency other than that of its country of issue. Bonds in this market are categorized according to the currency in which they are denominated. A eurobond issued in the U.S. and denominated in Japanese yen, for example, would be classified as a euroyen bond.
  • Foreign bonds are issued in a domestic market by a foreign entity, in the domestic market’s currency. The samurai bond, for example, is a popular yen-denominated bond issued in Japan by an American company. 
  • Global bonds are bonds that are issued and traded in two or more markets and denominated in one market’s currency.

Priority

In addition to the issuer’s credit quality, a bond’s priority factors into the odds that the issuer will repay your money. Similar to priority in a surfing contest (that dictates which surfer in the line-up has first dibs on the next wave), bond priority indicates your place in line if the company were to default. If you hold senior (unsubordinated) debt, you’re first in line to receive payments if the company defaults. Hold junior (subordinated) debt and you’ll be paid only after the senior debt holders are paid.

Coupon Rate

Bond issuers can choose from various types of coupons, or interest payments:

  • Straight, plain vanilla or fixed-rate bonds pay an absolute coupon over a set time period. Upon maturity, the last coupon payment is made, along with the par value of the bond.
  • Floating rate debt or “floaters” pay a coupon rate tied to the movement of an underlying benchmark, such as the three, six or nine-month T-bill, or LIBOR. For example, a floater may have the coupon rate set as “T-bill rate plus 0.5%.”
  • Inverse floaters pay a variable coupon rate that changes in the opposite (inverse) direction of short-term rates. Inverse floaters subtract the benchmark from a set coupon rate: For example, if LIBOR is the underlying benchmark, an inverse floater might pay a coupon rate of 5% minus LIBOR.
  • Instead of paying any coupon, zero-coupon bonds are issued at deep discounts and pay full face value at maturity.

Redemption Features

Both issuers and investors are exposed to interest rate risk. As such, some bonds offer different types of redemption features that can benefit investors and provide more flexibility for issuers.

  • Callable bonds can be redeemed by the issuer at some point before maturity. If interest rates have declined, for example, the company may want to refinance the debt at a lower rate. In this case, the company would call its current bonds and reissue them at a lower interest rate.
  • Convertible bonds apply only to corporate bonds, and give investors the right (but not the obligation) to convert their bonds into a fixed number of shares at some point before maturity.
  • Puttable bonds give investors the right (but not the obligation) to sell their bonds back to the issuer at a specified price before maturity. The repurchase price is set when the bond is issued and is usually par value. 

 


Advanced Bond Concepts: Bond Pricing
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