Fixed Income Security Bonds

Bonds are debt securities In which an investor lends money to an issuer (such as a corporation or government), in exchange for interest payments and the future repayment of the bonds face value.

A Bond issue is a contractual promise between a borrower (the bond issuer) and a lender (the bondholder) over the term of the bond. Certain bonds are risk-free (many are low-risk), and bonds generally offer predictable income and better returns than other short-term investments but can be Ø exposed to default and liquidity risks.

Basic Features:

Global bonds market is generally classified by the following characteristics features

1. The issuer of the bond

2. The maturity date of the bond

3. The par value (principal value to be repaid)

4. Coupon rate and frequency

5. Credit quality

6. Geography

7. Indexing

Type of Issuers of Bonds:

There are several types ·of entities that issue bonds Sovereign bonds are issued by a National Government or their treasuries backed by the tax power of the government. A sovereign country can issue bonds in its own currency or ·that of another. Non-sovereign government bonds are issued by states, provinces, and sometimes by entities created to fund/provide services such as for the construction of hospitals, airports and municipal services. ·

Corporations bonds are issued by highly rated entities with very good track records, most blue- chip companies/multinational corporations with pedigree spanning several years.

·Quasi-government or Agency bonds are issued by entities created by national government for specific purposes such as financing small businesses or providing mortgage financing.

·Supranational bonds are issued by multilateral agencies that operate globally e.g. the World Bank, IMF, The European Investment Bank etc. These type of bonds are typically of high credit quality and can be very liquid.

2. Credit quality:

Standard & Poor, Moody’s and Fitch all provided credit ratings on bonds. For S&P and Fitch, the highest bond ratings are AAA, AA, A and BBB are considered investment grade bonds. Moody’s equivalent ratings are Aaa, Baa3. Bonds of BB+ or lower (Ba1 or lower) are termed high-yield, speculative, junk bonds.

3. Original maturities:

The maturity date on bond is the date on which the principal is to be repaid. Once a bond has been issued, the time remaining until maturity is referred as the term to maturity or tenor of the bond. Securities with maturities of one year or less, are classified as money market securities and maturities of greater than one year are referred to as capital market securities.

4. Coupon structure:

Coupon rate on a bond is the annual percentage of its par value that will be paid on maturity to bond holders. Coupon on bonds could be paid annually, semi-annually, quarterly or monthly depending on the indenture. Bonds are classified as either floating-rate or fixed-rate bonds, depending on whether their coupon interest payments are stated in the bond indenture/trust deeds. A bond with a fixed coupon rate is called plain vanilla bond.

5. Geography:

Bonds maybe classified by the market in which they are issued i.e. domestic (National) Bond market, foreign bonds, Eurobonds, developed or emerging markets bonds. Eurobonds are issued outside the jurisdiction of any one country and denominated in a currency different from the currency of the countries in which they are sold. Eurobonds are referred to by the currency they are denominated in. Eurodollar Bonds are denominated in dollar and Euroyen bonds are denominatedin yen.

6. Indexing:

A typical bond has a bullet structure, periodic interest, while some depends on current market rates or indexed to i.e. inflation. Variant of inflation-indexed bonds include indexed-annuity, indexed zero-coupon, interest-indexed, capitalindexed bonds etc. ØHow to calculate a bond’s price using the basic present value (PV) formula: Where C= coupon payment i = interest rate, or required yield M= value at maturity (par value) n= number of payments Key Accounting Entries: Bond issued at Par When a bond is issued at par, the bond’s yield at issuance is equal to the coupon rate. In this case the Present Value (PV) of the coupon payment plus the PV of the face amount is equal to the par value. The effect on the financial statements are ·

On the Balance Sheet, assets and liabilities increase by the bond proceeds (face value). The book value of the bond liability will not change over the term of the bond. ·On the income statement, interest expense for the period is equal to the coupon payment, because the yield at issuance and the coupon rate are the same.

Bond issued at a Discount or Premium When a bond’s yield at issuance is not equal to the coupon rate, the proceeds received (the PV of the coupon payments plus the PV of the face value) are not equal to the par value. In this case the bond is issued at either a premium or a discount ·For Premium bond, interest expenses is less than the coupon payment (i.e. yield coupon rate).

The difference between interest expense and the coupon payment is the amortization of the discount. The amortization of the discount each period is added to the bond liability on the balance sheet. Thus the interest expense will increase over time as the bond liability increases. A discount bond is reported on the balance sheet at less than its face value, as the discount is amortized, the book value of the bond liability will increase until it reaches the face value of the bond at maturity.

ØContingency provisions affecting timing and nature of cash flows:

A bond that do not have contingency provisions are referr·ed to as straight or option free bonds. Call Option gives the issuer the right to redeem all or part of a bond issue at a specific price (call ·price) if they choose to. Puttable Bonds gives the bondholders the right to sell the bond back to the issuing ·company at a pre-specified price, typically par. Convertible bonds gives bondholders the option to exchange the bond for a specific number of shares of the issuing corporation’s ·common stock. Warrants gives bond holders an opportunity for additional returns when the firm’s common shares increase by giving rights to buy the firm’s shares.

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