JJ Mois Année Julie CHAM ITEC FIC TTS ECN BONDS

JJ Mois Année Julie CHAM ITEC/FIC/TTS/ECN BONDS & FLOATERS

BONDS n Definition – Concepts n Bond Rating Agencies (Moody's and Standard & Poor's) n Features of Bonds n Types of bonds 4 4 4 Fixed Rate Bonds Zero Coupon Bonds High Yield Bonds Convertible Bonds Step-up (down) Bonds Floating Rate Notes n Duration indicators n Annexe : Main Financial Markets 2

Definition - Concepts n A bond (fixed-income security) is a debt security issued by the Federal government, states, cities, corporations, or institutions n All of these entities need money to operate (to fund the federal deficit, to build roads and finance factories, . . ) so they borrow capital from the public by issuing bonds. 4 So when an investor buys a bond, he becomes a creditor of the issuer. n The issuer owes the investor a debt and is obliged to repay the bond’s value and interest at a later date, termed maturity. 3

Bond Rating Agencies (Moody's and Standard & Poor's) n Provide a service to investors by grading fixed income securities based on current research. n The rating system indicates the likelihood that the issuer will default either on interest or capital payments. Moody's S&P Meaning Investment Grade Bonds Aaa AAA Bonds of the highest quality that offer the lowest degree of investment risk. Aa 1, Aa 2, Aa 3 AA+, AA- Bonds are of high quality by all standards, but carry a slightly greater degree of long-term investment risk. Non Investment Grade Bonds (Junk Bonds) Ba 1, Ba 2, Ba 3 BB+, BB- Bonds with speculative fundamentals. The security of future payments is only moderate. C C Lowest rated class of bonds 4

Features of Bonds (1) n The Issuer : 4 Government bonds : issued by a national government and referred to as risk-free bonds. • Govies : issued in the country's own currency Ex : - in France, OAT are Govies issued by the « Agence France trésor » - in USA, US Treasuries are Govies issued by the « Bureau of Public Debt » • Sovereign bonds : issued in foreign currencies 4 Corporate bonds : • issued by private and public corporations, as opposed to Govies. • higher yields because there is a higher risk of a company defaulting than a government. 4 Agency (Quasi-Govies) Bonds : • issued by a U. S. government-sponsored agency. • After Govies, the safest category of bonds. All agency bonds carry an ‘AAA’ credit rating. 4 Municipal bonds : • issued by any municipal organization • the interest payments are usually exempt from federal taxes and also from state and local taxes in the area bonds are issued. 5

Features of Bonds (2) n Nominal (Principal, Face value, Par value) : amount over which the issuer pays interest, and which has to be repaid at the end. n Price : It fluctuates throughout its life due to the interest rates evolution and variation of the issuer credit quality. ! 4 When a bond trades at a price above the Nominal : it’s sait to be selling at a premium 4 When it sells below the Nominal : it’s said to be selling at a discount n Maturity date : the date that the bond will cease to exist and at which time the issuer will pay the nominal 4 short term (bills): maturities up to one year; 4 medium term (notes): maturities between one and ten years; 4 long term (bonds): maturities greater than ten years. 6

Features of Bonds (3) n Coupon Rate : Interest rate that the issuer pays to the bondholder (expressed as a percentage of the bond’s face value). n Coupon Type : The type of interest rate. It can be fixed, variable or floating. n Coupon Dates : Coupons are typically paid semiannually, but some bonds pay annual, quarterly or monthly coupons. n Coupon frequency : The number of times interest is paid per year. 7

Features of Bonds (3) n Optionality (callability / puttability) : it grants option like features to the buyer or issuer 4 Callable bond : the issuer has the right to redeem the bond prior to its maturity date. He will often call a bond if it’s paying a higher coupon than the current market interest rates. The company can reissue the same bonds at a lower interest rate. 4 Put bond : allows the bondholder to redeem the bond at a specified price prior to maturity. Investors might choose to do this if interest rates increase after the bond was issued. n How does it work? 4 Bond issues at a price closed to its par value (exact price determined by market conditions). 4 The issuer makes fixed periodic interest payments : coupons (a percentage of that par value) 4 They continue to be paid until the bond's maturity date 4 At maturity date : one final coupon is paid along with the par value. 8

Bond Price Formula : n Price of any financial instrument = the Net Present Value (NPV) of all future cash flows discounted at a suitable interest rate(s). 4 To simplify we assume a single rate for all cash flows known as the yield-to-maturity. n Cash flows = { coupon interest payments & the maturity value (par value) } n Fixed rate bond formula : C = coupon payment n = number of payments i = interest rate (yield-to-maturity) M = value at maturity, or par value n This formula illustrates that, when interest rates go up, the price goes down! 9

Types of bonds (1) n Fixed rate bonds (called straight or plain vanilla bonds ) : a bond paying periodic interest payments at a fixed rate over a fixed period to maturity, with the return of Principal on the maturity date. n Example : a 4. 6% 20 -year bond (long term bond) 2. 3 1 Y 2. 3 2 Y 2. 3 3 Y 2. 3 4 Y 102. 3 - - - 20 Y 98. 2 4 Bond’s par value (Face value) of USD 100 4 it issues below par at USD 98. 2 (at a discount). 4 It then makes semiannual coupon payments of USD 2. 30. 4 On the maturity date, a final coupon is paid along with the par value. 10

Types of bonds (2) n Zero coupon bonds : 4 No periodic interest payments (No coupons) 4 It’s sold at a deep discount to face value and matures at its face value. 4 The incomes to bondholder from the difference between the par value that he receives when the bond is redeemed and the bond’s price (at a discount) 4 Ex : investor can buy a bond with a par value of 1000 for a price of 600, so the interest realized is : 1000 -600=400. n Example : a 20 -year Zero Coupon bond 4 Bond’s par value (Face value) of USD 1000 4 it issues at a discount at USD 600. 4 On the maturity date, a coupon is paid. 1 Y 2 Y 3 Y 1000 4 Y - - - 20 Y 600 11

Types of bonds (3) n High yield bonds (non-investment grade bonds, junk bonds) : 4 rated below investment grade by the credit rating agencies. 4 Relatively risky so investors expect to earn a higher yield. n Convertible bonds (converts) : 4 give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. n Step-up (Step-down) bonds : 4 The coupon rate increases (decreases) during the life of the bond. 4 Ex : a 5 -year bond can have a coupon rate of 6% for the first 2 years and 6. 5% for the last 3 years (step-up bond) 4 or 9% for the first 2 years and 8% for the last 3 years (step-down bond). 4 only one change in coupon rate : a single step-up (step-down) bond. 4 more than one change : a multiple step-up bond. 12

Types of bonds (4) : Floating Rate Notes (Floaters) n Coupon fluctuates with a designated reference rate (Benchmark rate, market index). n 2 commonly-used reference rates : 4 Libor (London Interbank Offered Rate) 4 In continental Europe : the euro benchmark is called Euribor n Coupon rate is calculated as the reference rate plus a fixed spread : Coupon rate = Reference rate + Fixed Spread 4 Ex : 3 month USD LIBOR +2. 0% (coupon rate = 3 month LIBOR + 200 basis points) n Coupon Frequency : periodically, normally every 3 month : “quaterly” n Typically, FRN have maturities of about 5 years. 13

Floating Rate Notes (Floaters) n Quoted Margin (in basis points): 4 Amount added to the reference rate ( « fixed spread » ) in order to determine the coupon 4 It depends upon the issuer's credit quality 4 It is fixed over the bond’s life n Discount Margin (in basis points): 4 This measure assesses the average margin that an investor can expect to receive over the FRN’s life. 4 It can be seen as a FRN’s equivalent of a fixed bond’s yield to maturity. 4 It will change daily, according to market conditions and credit quality of the issuer. n Advantages : 4 Coupon linked to a variable interest rate index : • has the effect of eliminating most of the interest rate sensitivity of the note • Price is always at or near par value. • the price action of a FRN is driven mostly by the changes in the credit quality of the issuer 14

Floating Rate Notes (Floaters) n Example : a 3 -year FRN issued at par 4 Coupon resets and pays every 6 month 4 Reference rate : 6 month Libor 4 Quoted Margin : 52 bp semi-annually 6 M 12 M 18 M 100 24 M 30 M 36 M 100 Floating coupons of Libor plus 52 bp paid semi-annually 15

Floating Rate Notes (Floaters) n Next coupon rate value ? spot Lag : Libor 6 M fixed spot Lag : Libor 6 M fixed Next Coupon fixed Current Coupon fixed - 2 j Prev. Cpn. Date Today 6 M Maturity - 2 j Next. Cpn. Date Current Coupon paid Next. Cpn. Date + 6 M Next Coupon paid 16

Duration Indicators n Duration is a measure of the average (cash-weighted) term-to-maturity of a bond. The bond’s value will vary depending on : • the amount of the cash flows (coupon size) • the timing of the cash flows (term to maturity) • the interest rate used for discounting. 4 Duration helps to summarize these variables in a single number. n Duration (Mac. Cauley’s duration) : 4 The weighted-average term to maturity of the cash flows from a bond. 4 frequently used by portfolio managers who use an immunization strategy. n Modified Duration : 4 A useful measure of the sensitivity of a bond's price to interest rate movements. 4 It follows the concept that interest rates and bond prices move in opposite directions. 4 It’s used to determine the effect « a 100 bp (1%) change in interest rates » will have on the price of a bond. 4 Ex : a 15 year bond with a Modified Duration of 7 years would fall approximately 7% in value if the interest rate increased by 1% 17

Annexe : Main Financial markets n They facilitate : 4 The raising of capital in the Capital markets (Long term) • Stock markets • Bond markets Primary market : new issues exchanges Secondary market : aldready issued Over-the-counter 4 The transfert of risk int the Derivatives markets 4 The international trade in the Currency markets (Foreign exchange or Forex) 18