Bonds:
long-term debt securities issued by government agencies or corporations that are collateralized by assets
Par value:
for a bond, its face value, or the amount returned to the investor at the maturity date when the bond is due
Debentures:
long-term debt securities issued by corporations that are secured only by the corporation’s promise to pay
Term to maturity:
the date at which a bond will expire and the par value of the bond, along with any remaining coupon payments, is to be paid back to the bondholder
Bonds maturities may vary between 1 and 30 years
background on bonds
Investors provide the issuers of bonds with funds
Issuers are obligated to make interest payments and to pay the par value at maturity
Coupon payments are normally paid semi-annually
Some bonds are issued at a price below par value
Call Feature
a feature on a bond that allows the issuer to repurchase the bond from the investor before maturity
-Offer a slightly higher return than similar bonds without a call feature
Sinking fund
a pool, of money that is set aside by a corporation or government to repurchase a set amount of bonds in a set period of time
-Acts like a mandatory call feature
Convertible bond:
: a bond that can be converted into a stated number of shares of the issuer’s stock at a specified price
-Tend to offer a lower return than non-convertible bonds
Extendible bond:
a short-term bond that allows the investor to extend the maturity date of the bond
-Tend to offer a lower return than non-extendible bonds
Put feature:
a feature on a bond that allows the investor to redeem the bond at its face value before it matures
-Slightly lower return than similar bonds without a put feature
Bond Characteristics
- call feature
- sinking fund
- convertible feature
- extendible feature
- put feature
- yield to maturity
- discount
- premium
Yield to maturity
the annualized return on a bond if it is held until maturity
-If a bond sells at par value, its yield to maturity equals the coupon rate
Discount:
a bond that is trading at a price below its par value
-If a bond sells below par value, its yield to maturity would exceed the coupon rate
Premium:
: a bond that is trading at a price above its par value
-If a bond sells above par value, its yield to maturity would be less than the coupon rate
Bonds Trading in the Secondary Market
- Investors can sell their bonds to other investors before the bonds reach maturity
- Bond prices change in response to interest rate movements and other factors
- Investors buy or sell bonds from a brokerage firm’ bond inventory
Term structure of interest rates:
: a graph that shows the relationship between bond yield to maturity and time to maturity
- Resulting curve is known as a yield curve - Shape of the yield curve reflects the market’s sentiment about the direction for interest rates over time - Yield curve shapes include normal, steep, inverted, and flat
Theories that attempt to explain why the term structure of interest rates is shaped the way that it is:
Liquidity preference theory
pure expectations theory
market segmentation theory
Liquidity preference theory
suggests that investors require a premium for investing in longer-term bonds
pure expectations theory
suggests that the shape of the yield curve is a reflection of the market’s expectation for future interest rate movements
market segmentation theory
suggests that the shape of the yield curve is determined by the supply and demand of bonds for various market players in different segments of the yield curve
Types of Bonds
Government of Canada Bonds Federal Crown Corporation Bonds Provincial Bonds Municipal Bonds corporate bonds
Government of Canada Bonds
debt securities issued by the Canadian government
-Not exposed to the risk of default by the issuer
-Issued with a term to maturity of between 1 and 30 years
-Interest is paid semi-annually
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-Can be sold easily in the secondary market
-marketable bonds –> Government of Canada bonds that can be sold in a secondary market
Federal Crown Corporation Bonds
- -debt securities issued by corporations established by the federal government
- -Not exposed to the risk of default by the issuer
- -Issued with a term to maturity of between 2 and 10 years
- -Interest is paid semi-annually
- -Can be sold easily in the secondary market
Provincial Bonds
-debt securities issued by the various provincial governments
- Risk of default by the issuer will differ depending on the province from which you purchased the bond
- Issued with a term to maturity of between 1 and 30 years
- Interest is paid semi-annually
- Can be sold easily in the secondary market
Municipal Bonds
—long-term debt securities issued by local government agencies
- Provide the funds necessary for municipal projects
- Very low default risk
- Uncommon investments in Canada
- Terms and condition will vary with the needs of the municipality
Corporate Bonds
long-term debt securities issued by large firms
- Subject to default risk
- High-yield bonds
- terms and condition will vary with the needs of the corporation
High-yield bonds:
bonds issue by less stable corporations that are subject to a higher degree of default risk
Other Fixed-Income Products
Short-Term -Debt Securities
-T-Bill’s
-Banker’s aceptances (BAs)-
- Commercial Paper
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T-Bills:
short-term debt securities issued by the Canadian and provincial governments and sold at a discount
-Do not make coupon payments
Banker’s acceptances (BAs):
short-term debt securities issued by large firms that are guaranteed by a bank
Commercial paper:
a short-term debt security issued by large firms that is guaranteed by the issuing firm
Canada Savings Bonds (CSBs):
ten-year debt securities issued by the Canadian government
Fully guaranteed
Can be purchased as a simple interest bond or a compound interest bond
Can be redeemed at any time before maturity
Mortgage backed securities (MBSs):
represent a pool of CMHC-insured residential mortgages that are issued by banks and other financial institutions
A guaranteed flow-through investment Attractive to investors seeking income Can be sold in the secondary market Issued with a term to maturity of between 1 and 10 years Subject to prepayment risk
Strip Bonds
long-term debt securities issued by the Government of Canada (and some provinces) that do not offer coupon payments
Can be sold at a very deep discount
Although not paid, interest must be recognized every year
Very safe investment in terms of default risk and can be sold in the secondary market
Very high interest rate risk
Real Return Bonds
long-term debt securities issued by the Government of Canada that protect you from inflation risk
All other bonds are exposed to inflation risk
The par value of the bond is adjusted for changes in the inflation rate
Coupon payments will increase with each increase in the face value
Return from Investing in Bonds
Your return from investing in a bond depends on the price at the time you sell it
If the bond coupon rate is less than the current coupon rate on similar bonds, you must sell the bond at a discount
If the bond coupon rate is more than the current coupon rate on similar bonds, you can sell the bond for a premium
Default Risk
Investors do not receive all of the coupon payments they are owed and may not receive all or any of the principal they are owed
Risk premium:
the extra yield required by investors to compensate for default risk
Default risk:
the risk that the borrower of funds will not repay the creditors
Call (prepayment) risk:
the risk that a callable bond will be called
Inflation risk:
the risk that the purchasing power of a bond investment will diminish due to a relative increase in inflation
Inflation decreases purchasing power because it reduces the real value of your investments
Reinvestment Risk
the risk that the income earned from a bond cannot be reinvested at the same or a higher rate of interest as was being earned from the bond
Interest rate risk:
the risk that a bond’s price will decline in response to an increase in interest rates
Impact of a Bond’s Maturity on Its Interest Rate Risk
Bonds with longer terms to maturity are more sensitive to interest rate movements
Selecting an Appropriate Bond Maturity
Choose maturities on bonds that reflect your expectations of future interest rates
Consider investing in bonds that have a maturity that matches the time when you will need the funds
Interest rate strategy
selecting bonds based on interest rate expectations
Expect interest rates to decline, invest heavily in long-term bonds
Expect interest rates to increase, shift most of your money to bonds with short terms to maturity
Passive strategy
investing in a diversified portfolio of bonds that are held for a long period of time
Valuable for investors who want to generate stable interest income over time and do not want to incur costs associated with frequent trading
-May reflect a portfolio of bonds with diversified risk levels
Maturity matching strategy:
selecting bonds that will generate payments to match future expenses
Bond investment strategies
- interest rate strategy
- passive strategy
- maturity matching strategy.