BONDS: THE BASICS Study Session 14 THE BASICS The following material offers students with a limited outcome statements in this study session. Those with background in this topic area an overview of some of adequate preparation in this topic area can proceed the basic concepts and definitions necessary to directly to the topic review for the first required understand the material covered by the learning reading in this study session. BOND BASICS The following two study sessions deal with debt (as opposed to equity) securities. In the U.S., corporations raise much more capital by issuing debt securities than by issuing equity securities, and the U.S. Treasury issues large amounts of debt securities on a regular basis. Debt securities are sometimes called fixed income securities, but you will soon realize that much of the complexity in valuing and determining the risk of “fixed income” securities is caused by the fact that the cash flows of many bonds are not really fixed. Your understanding of the material may be improved with an explanation of the terms used when speaking about debt securities. Much of the terminology and some of the conventions for stating yields are based on historical practices. Let’s begin by looking at a simple fixed income (debt) security. Historically, a corporation that wanted to borrow money would issue bonds that were actual certificates. Each certificate (often with a nice engraved image of a factory or locomotive) had a face value (also called par value, maturity value, or principal amount) that was stated on the central portion of the certificate. A $100,000 face value bond issued by the Reading Railroad Corporation on Jan. 15, 1955 with a maturity of 20 years would have a principal portion that would state something like, “The Reading Railroad Corporation will pay $100,000 to the bearer on January 15, 1975.” This represents the repayment in 20 years of the amount borrowed and is referred to as the principal repayment portion of the bond. The Reading Railroad is called the issuer of the security (bond) and is also the borrower of the money. Such a bond was called a bearer bond. If ownership is registered and a lost or destroyed certificate can be replaced, it is called a registered bond instead. The remainder of the certificate (the bond) consisted of the bond coupons. Each coupon was a separate promise to pay a given amount of interest on the $100,000 principal amount, typically every six months from the issue date until the maturity date. If a $100,000 bond were issued with a “6% coupon rate,” each coupon would typically be for one-half of the 6% (annual) coupon rate, or 3% of $100,000. Thus, a 20-year, $100,000, 6% bond issued on Jan. 15, 1955 would have 40 coupons attached to it. These coupons would have dates of July 15 and January 15 each year from July 1955 through the maturity date of January 15, 1975, and each one would be a promise to pay $3,000 on those dates. In order to sell a bond, all coupons with dates later than the date of sale must still be attached. Delivery of a bond that has all such coupons still attached is referred to as good delivery. ©2006 Schweser Study Program Page 1 Study Session 14 Bond Basics The buyer of a bond is the lender of the funds and is also referred to as the owner of the bond (debt security) or the bondholder. If the market rate of interest for a loan to the issuing company is equal to the coupon rate when the bond is issued, the bond will be worth (and trade at) its face value. Since the stream of payments (coupons every six months and the principal or face value on the maturity date) is fixed when the bond is issued, its value can change over time as the (market-determined) required yield (return for lending money for that time period to that issuer) changes. Simply put, when yields go up, the (present) value of those promised payments goes down and vice versa. Bond certificates can be issued with any principal or face value, and for this reason, market values/prices are often expressed as a percentage of face value. “One bond” is usually used to refer to $1,000 of face value so that an order for 100 bonds would be for $100,000 of principal value. If the bonds are trading at 98 ½, the cost of 100 bonds will be $98,500. Since bonds were traded long before calculators were available, simplistic measures of yield, such as current yield, were used and are still with us today. Current yield is the annual interest divided by the bond price and is still given in the bond quotations for corporate bonds published in daily newspapers. Rating agencies give bond purchasers an indication of the relative likelihood of default (default risk). An AAA (or triple-A) rated bond is judged to have the least risk of failing to make its promised interest and principal payments over its life. Bonds with greater risk of defaulting on promised payments have lower ratings such as AA (double-A), A, BBB, BB, etc. So far, we have discussed bonds that are simply a legally binding promise of the issuer to make scheduled interest and principal payments. These bonds are called debentures. When the bond is backed by the pledge of specific collateral that the bondholder has a claim to if the issuer defaults on a promised payment, it is called a collateralized bond. If the collateral is real estate, the bond is referred to as a mortgage bond, and if the collateral is physical assets such as railroad cars, the bond is referred to as an equipment trust certificate. In general, bonds backed by specific collateral get higher bond ratings than debentures of the same issuer, and the “better” the collateral, the higher the bond rating. The term “bond” typically refers to a debt security with 20 or more years to maturity, while the term “note” is a debt security issued with between 2 and 10 years to maturity. While this terminology is often used when referring to bonds (and notes) issued by the U.S. Treasury, these are not hard and fast rules. The term “bond” will often be used to refer to any debt security, while the term “note” may be used for any shorter-term promise to pay. Most often, debt securities issued with maturities of one year or less do not make interest payments prior to maturity, a single payment at maturity is the only promised payment. In the case of U.S. Treasury issues, such securities are referred to as bills, rather than notes or bonds. Some bonds will have a provision that requires the issuer to pay off (redeem) a portion of a bond issue prior to maturity, according to a schedule. The provision to retire these bonds “early” is referred to as a sinking fund provision. If the issuer has the option to pay off the principal prior to maturity (and not honor remaining coupons), the bond has a call feature or provision and is said to be callable. The amount the issuer must pay to bondholders to redeem callable bonds early is referred to as the call price and this is typically greater than or equal to the face value of the bond. One significant change over the years is that certificates are typically no longer issued. The ownership of debt securities is instead recorded by the registrar. Bonds where ownership is not evidenced by a physical certificate are said to be book entry bonds, and the promised payments are made when due by sending the payments to the registered owners or their designated bank or brokerage house. As you read the material in the following study sessions, you will learn about many variations on this basic description of bonds or debt securities. Coupons may not be fixed; principal may be paid at other than the original maturity date for a variety of reasons under different structures; and other options besides call options may be part of the agreement between bond buyers and bond issuers. It may help to remember that essentially any agreement made and agreed to by both the issuer and the security buyers can be legally entered into. The variety of coupon structures and other provisions is driven by the marketplace. Features that bondholders have a preference for will tend to decrease the borrowing Page 2 ©2006 Schweser Study Program Study Session 14 Bond Basics costs of issuers (lower yields), and features that benefit the issuer will require the issuer to promise higher interest payments as compensation to buyers. As we mentioned at the beginning of this section, the amount of debt securities outstanding is huge, and the effort devoted to analyzing and managing portfolios of debt securities is large as well. Evaluating the risk and potential return from debt is complicated, not only by the great variety of debt securities available, but by the number of issuers as well. This presents many opportunities for analysts who understand these securities and the markets they trade in. ©2006 Schweser Study Program Page 3 The following is a review of the Debt Investments: Basic Concepts principles designed to address the learning outcome statements set forth by CFA Institute. This topic is also covered in: FEATURES OF DEBT SECURITIES Study Session 14 EXAM FOCUS Fixed income securities, historically, were promises to You should pay special attention to how the periodic pay a stream of semiannual payments for a given payments are determined (fixed, floating, and variants number of years and then repay the loan amount at of these) and to how/when the principal is repaid the maturity date.