Chapter 4: Bonds

Question 1

How are bonds split?

Answer 1

Between government (issued by national governments) and corporate (issued by companies) bonds.

Question 2

How does a bond work?

Answer 2

An investor lends in return for the promise to have the loan repaid on a fixed date plus a series of interest payments. Bonds can be commonly referred to as LOAN STOCK, DEBT or FIXED INTEREST SECURITIES.

Question 3

The 6 features of a bond:

Answer 3

1. Nominal - the amount of stock purchased. The amount on which interest will be paid. Also known as par amount.
2. Stock - name given to identify
3. Coupon - e.g 0.375%, it is the nominal interest rate payable on the stock. Rate is quoted gross will be paid in two separate half yearly interest payments.
4. Redemption date - e.g 2030, it is the year the stock will be repaid, also known as maturity date.
5. Price.- of stock
6. Value

Question 4

UK government bonds are also known as what? Who are they issued by?

Answer 4

Known as gilts. They are issued by the Debt Management Office (DMO).

Question 5

Two types of government bonds:

Answer 5

1. Conventional bonds - instruments that carry a fixed coupon and a single repayment date.
2. Index linked bonds - coupon and redemption amount are increased by amount of inflation over its lifetime (more attractive for long term investments)

Question 6

What is ‘stripping’?

Answer 6

Conventional bonds can be stripped into their individual cash flows - stripping refers to individual cash flows which can be traded separately as zero coupon gilts.

Question 7

Other types of government bonds:

Answer 7

Dual dated - carry a fixed coupon bud show two dates they can be repaid.

Undated.

Question 8

Features of corporate bonds:

Answer 8

1. Bond security: is a form of charge over the issuers assets so that if issuer defaults, the bond holders have a claim on those assets before other creditors. Security can be FIXED or FLOATING.
2. Redemption provisions - issuer has option to buy back all or part of the issue before maturity.

Question 9

What is a sinking fund requirement?

Answer 9

Type of call provision where there may be a requirement for the issuer to redeem a specified amount regular intervals.

Question 10

What’s a puttable bond?

Answer 10

Gives the bondholder the right to require the issuer to redeem early, on a set date or between specific dates.

Question 11

Types of corporate bonds:

Answer 11

1. Medium term notes (MTNs): are standard corporate bonds with maturities up to five years. They are offered to investors continually over a period of time by an agent of the issuer, instead of in a single tranche of one sizeable underwritten issue.
2. Fixed rate bonds: fixed coupons which are paid either half yearly or annually.
3. Floating rate notes (FRNS’s): variable rates of interest. The rate will be linked to a benchmark such as SONIA or SOFR
4. Permanent interest bearing shares (PIBS): they are issued by building societies and carry fixed coupons and are irredeemable.
5. Convertible bonds: gives investor 2 choices - collect interest payments and then the repayment of the bond on maturity AND to convert bond into a predefined number of ordinary shares in the issuing company
   Attractions: 1) if company prospers, share price will rise, capital gains. 2) if company hits problems the investor can retain the bond.
6. Zero-coupon bonds (ZCBs): a bond that pays no interest.

Question 12

What are the two geographic bonds?

Answer 12

1. Domestic bond: issued by a domestic issuer into the domestic market
2. Foreign bond: issued by an overseas entity into a domestic market and is denominated in the domestic currency

Question 13

What are Eurobonds? Where’d they come from? Key factor:

Answer 13

Are large international bond issues often made by governments and multinational companies.

Market devolved in 1970’s to accommodate the recycling of OPEC US dollar revenues from Middle East oil sales.

They are denominated in a currency different from that of the financial centre or centres in which they are issued.

Question 14

What is a ‘negative pledge’ clause?

Answer 14

Prevents company from subsequently making any secured bond issues, or issues which confer greater seniority or entitlement to the company’s assets.

Question 15

Advantages of Eurobonds:

Answer 15

• a choice of innovative products to more precisely meet issuers needs
• the ability to reach potential lenders internationally
• anonymity to investors as issues are made in bearer form
• gross interest payments to investors
• less regulation

Question 16

What are Eurobonds issued as?

Answer 16

Conventional bonds (straights) with a fixed nominal value, fixed coupon and known redemption date.

Question 17

What are asset backed securities?

Answer 17

ABS - these are bundled securities, so called because they are marketable securities that result from the bundling or packaging together of a set of non marketable assets.

The Assets range from mortgages and credit card debt to accounts receivable.

Question 18

What’s the largest ABS market?

Answer 18

It’s for mortgage-backed securities.

Mortgage backed bonds are created by bundling together a set of mortgages and then issuing bonds that are backed by these assets. These bonds are sold on to investors who receive interest payments until they are redeemed - securitisation

Question 19

Advantage of ABS

Answer 19

They bring together a pool of financial assets that otherwise could not easily be traded in their existing form. The pooling together of a large portfolio of these illiquid assets converts them into instruments that may be offered and sold freely in capital markets.

Question 20

What is a covered bond?

Answer 20

A variation of ABS. Issued by financial institutions and are corporate bonds that are backed by cash flows from a pool of mortgages of public sector loans.

Question 21

What’s the differences between asset backed securities and covered bonds?

Answer 21

• They remain on the issuers balance sheet
• The asset pool must provide sufficient collateral to cover bond holder claims throughout the whole term of the covered bond
• Bondholders must have priority claim on the cover asset pool in case of default of the issuer

Question 22

Advantages of investing in bonds:

Answer 22

• For fixed interest bonds you get a regular and certain flow of income
• For most bonds you have a fixed maturity date
• A range of income yields to suit different investment and tax situations

Question 23

Disadvantages of investing in bonds:

Answer 23

• The real value of the income flow is eroded by the effects of inflation
• Bonds carry various elements of risk.

Question 24

Risks of holding bonds:

Answer 24

1. Corporate bonds have default risk and price risk
2. Government bonds are said to have price risk
3. Early redemption - risk that the issuer may invoke a call provision
4. Seniority risk
5. Inflation risk
6. Liquidity risk
7. Exchange rate risk

Question 25

What is a yield?

Answer 25

A measure of the returns to be earned on bonds. The coupon reflects the interest rate payable on the nominal or principal amount.

The return - as a % of the cost price - which a bond offers is often referred to as the BONDS YIELD.

The interest paid on a bond as a % of its market price is referred to as the FLAT or RUNNING YIELD.

Question 26

How is flat yield calculated?

Answer 26

Annual coupon divided by bond price x 100 = …%

Question 27

What is redemption yield?

Answer 27

A measure that incorporates both income and capital return - assuming investor holds bond until maturity

Question 28

Rating agencies

Answer 28

More than 70’agencies throughout the world. Three most prominent: standard and poors, moodys, fitch ratings.

Standard and poors and fitch ratings refine their ratings by adding a plus or minus sign to show relative standing within a category, while moodys do the same by the addition of a 1,2,3.

Assessed by being put on ‘investment grade’ or ‘non investment grade’ categories or ‘speculative’.