Bonds Flashcards
(30 cards)
Bond Yields Characteristics
yield puts everything on level playing field - enables
comparison of bonds. Higher risk of an investment the
investor requires a higher yield.
risk free rate is first building block of yield (3%)
term risk is next building block (2%)
credit risk is next building block (1%)
liquidity may be next block (0.5%)
currency risk may be next block
Covenants
Conditions that protect bondholders
Covenants limiting further debt and priority
Covenants restricting the payment of dividends
Covenants restricting the sale of assets
if you have debt at the top of the priority order then
covenants stop your debt becoming less prioritised
may restrict higher priority debt being created or if they
do your debt has to be upgraded to same level of priority
restrict excessive levels of dividends, share buy-backs
can sell assets if proceeds are used to buy similar assets or
pay some debt
Islamic Finance
Sukuk
Islamic financial certificate compliant with Sharia law
Securities of equal value representing a common share in the ownership of an underlying asset
Ijarah Sukuk
Establish SPV
Issues Sukuk and sells to investors
Proceeds used to purchase asset from the company for a set period
SPV leases asset back to company
Lease payments made by company to investors via SPV
Company buys asset back and money returned to investors
basically works the same as a bond - get regular payments
receive money back at maturity
technically no interest - rent on property leasing back
intifa’a similar but they get the right to use the asset
they have purchased
Salam Sukuk
Similar to a forward contract
Buy a commodity today for deferred delivery
Good must be clearly defined and easily available for delivery
Price known and paid in advance
NOT tradeable so rare
Green Bonds
Used to fund ‘green’ projects
Additional transaction costs
Lack of standardisation
Potential for ‘greenwashing’
ICMA Green Bond Principles
gives a good image - need to prove they are putting it
towards a green project
can be expensive for issuer - monitering and reporting on
green initiative
danger of greenwashing
set of voluntary guidlines
if break green clause then can be financially punished
falling from green grace - lost its green status
ESG Bonds
Social Bonds
Fund projects with social objectives
Sustainability Bonds
Finance both green and social projects
Sustainability-linked bonds
any type of bond where the issuer meets predefined sustainability/ESG objectives
Blue bonds
Supports marine projects
Social Impact Bonds
pay for success bonds - gov only pays if evidence of positive outcome
Factors affecting bond prices
Interest rates
Inflation
Specific Issuer factors - Credit rating and Structure and seniority of the bond
Liquidity
Exchange rates (if denominated in a foreign currency)
Debt Crowdfunding
Loan-Based
* Consumers lend to
businesses directly
via a platform
* For established,
profitable SMEs
* No FSCS protection
* Delays in cashing-in
* Higher risk
Investment-Based
* Consumers invest directly in the company by buying
shares or debentures
* Higher risk
* Dilution risk
* Long investment periods
* No protection for investors
* No secondary market
Lending Platforms
* E.g. Funding Circle
in the UK and
Lending Club in the
US
* Enables consumers
to lend to small
companies
* Different platforms
carry different levels
of risk
Bond Fintech
Capexmove
* Bond Tokenisation platform
* Digitises traditional debt instructions
into smart legal contracts
* Issues tradeable units for secondary
trading
BondbloX
* Simplifies bond investing by allowing
investors to track and trade bonds
electronically
* Fractional bond exchange - breaks high
denomination wholesale bonds down
into smaller more accessible units
Gilt Issuance
Issued on behalf of the government by the Debt Management Office (DMO)
May be new bonds or tranches of existing stocks
Auctions – competitive, non-competitive
Interim funding (TAPS)
Primary dealers – e.g. GEMMs
Obligations and privileges
Secondary market
primary dealers obligations:
obliged to give two way prices to ensure liquidity, participate in auctions (underwrite kinda), report to DMO what is going on in market
privileges:
exclusive rights to telephone auctions
exclusive access to DMO secondary market
Broker-dealers
Buy/sell as principal or agent
Gilt inter-dealer brokers
Anonymous deals between GEMMs
Gilt Auctions
Weekly auctions
Competitive – buyers pay the price they bid, through GEMM minimum 1 million
Non-competitive – up to £500,000 where buyers pay the weighted average price
Post Auction Option Facility (PAOF) gives successful bidders in auction the option to buy an extra 25% at weighted average price
Bid-cover ratio
>2 denotes a successful auction
<1, auction is considered a failure
UK auction should not be <1 as primary dealers should
ensure there is enough bids
Repurchase Agreement
Cash borrower agrees to immediately sell security to lender and buy it back at the same price on
an agreed date in the future (e.g. 2 weeks)
Cash borrower also pays interest on the future date known as repo interest
Legally binding agreements
Other collateral can be used – not just gilts
Reverse repo
Standing repo facility (SRF) ensures smooth running of the government bond market
Eurobonds
In a currency other than that of the
market in which they are issued:
Trading mechanism is OTC
Issued in bearer form
Unsecured debt
No withholding tax
Coupons taxable but paid gross and
annually
Often immobilised in depositaries
Pricing a bond & semi annual bond
PV coupon = 1/r x (1-1/(1+r)^n x CF
PV redemption = 100/(1+r)^n
add the two together
if coupon = yield then bond must be priced at 100
interest rates rise prices fall
semi annual - double periods and half coupon and yield
Index Linked bond pricing
calculate real yield = (1+rNominal)/(1+rInflation) - 1
discount each cash flow by real yield and sum to get price
Multiply price by index ratio
Accrued interest cum and ex div
dirty price cum div then add on accrued interest from clean price
dirty price ex div then takeaway accrued interest fromclean price
accrued interest = coupon x (accrued days/days in period)
Flat Yield
(annual coupon/clean price) x 100
useful for non-taxpayers, perpetual bond holders
short term investors who focus on income
doesn’t consider tax, capital gain/loss or the time value of
money
cant be used for variable coupon bonds
Japanese Gross Redemption Yield
(coupon + (100 - clean price/number of years to redemption))/clean price
ignores time value of money, tax
always use annual coupon for Japanese GRY
Gross Redemption Yield
Effectively the IRR of the bond’s cash flows
1. Calculate Japanese GRY to give an indication of actual GRY e.g. 2.90%
2. Find N1, the net present value of the bond at a yield below the Japanese GRY e.g. 2.50%.
Name this R1
N1 = Price of bond using R1 – actual price of the bond
N1 should be positive
3. Find N2, the net present value of the bond at a yield above the Japanese GRY e.g. 3.50%.
Name this R2
N2 = Price of bond using R2 – actual price of the bond
N2 should be negative
4. Calculate the GRY by interpolation: 𝐺𝑅𝑌 = r1 + (n1/(n1-n2)) x (r2-r1)
Net Redemption Yield
Flat yield x (100 - tax rate)% + ((100 - clean price/number of years to redemption)/clean price) x 100
useful for tax payers
assume higher rate taxpayer
Floating rate notes price
(next coupon + 100)/(1+r)^n
Index Linked bond yields
- Divide by the index ratio to arrive at the real price
- Use the interpolation method as before to calculate the real GRY using the real price
- Find the nominal yield using the Fisher relationship (1+r)=(1+i)(1+R)
The Yield Curve
Liquidity preference - investors will always go for the lower maturity bond and must be rewarded with higher return for higher maturity
Upward sloping yield curve
Market expectations - expectation theory, spot rates are based on the expectations of future interest rates
i.e. expected future interest rate cuts
Preferred habit theory - different investment firms will have different preference i.e. some banks may only invest in short term bonds if they have liquidity funds or investment firms may only invest in long term bonds to cover pension liabilities. Explains wiggles
Inverted yield curve - recession indicator, short term yields are higher than long term yields, because of expectations of long term cuts
Flat yield - stagflation, short term and long term equal, shifting yield curve either downwards to upwards or vice versa
Upwards sloping - normal yield curve, long term maturities are higher than short this is an economy in normal conditions
Bond Forward Rates
(1 + forward rate)^T-S = ((1+rt)^T)/((1+rs)^S)
S is the start maturity
T is the end maturity
rS is the spot rate on the start date
rT is the spot rate on the end date
Risk Management of bond investments
Interest rate risk
Inflation risk
Credit/Default risk
Liquidity/Marketability risk
Issue specific risk
Fiscal risk
Currency risk
Macro-economic factors
