FIXED INCOME SECURITIES – BOND PRICES & YEILDS (CH14)
Note: always know the current repo and prime rate
INTRODUCTION TO BONDS
WHAT IS A BOND?
Bond → long term debt instrument used for raising long term finance
Two parties:
- borrower/issuer
▪ pays interest & the principal amount
- lender/investor
▪ receives coupons & the principal amount
BOND TRANSACTION
Borrower/issuer Lender/investor
At bond issuance date
Bond selling price
In need of finance Bond certificate Has cash & is seeking an
investment opportunity
Subsequent periods
Coupon/interest payments
Selling/issuing bonds Buying bonds
Principal is repaid at end of
bond term
BOND FEATURES
Bond features = details relating to the bond
Face value:
- set by company & fixed
, - paid/received when bond matures
- determine coupon payment
- function of how much company want to raise
Coupon rate & coupon payments:
- rate determines the payments
- coupon payment = coupon rate x face value
- set by company & fixed
Time to maturity:
- set by the company & fixed
- shows lifespan of the bond
- function of company’s financial position to pay the face value
Yield to maturity (YTM):
- represents the return required by investors on the bond
- used as a discount rate
- fluctuates with market conditions
Where do you get the YTM or how do investors come up with it?
- similar instruments
▪ similar maturity, risk profile, interest bearing
Why is YTM always fluctuating?
- driven by the level of interest rates & interest rate changes
▪ interest rates , YTM also (vice versa)
▪ bonds are int bearing instruments affected by int rate changes
- key drivers of int rate changes aren’t constant
▪ drivers: repo rate changes by central bank, inflation, economic conditions,
default risk, political risk, etc.
Note: repo rate is that rate at which central bank lends money to commercial banks.
Price:
- what you pay to buy the bond
- used as a discount rate
- fluctuates
- price not always = to face value
▪ but issuer will always try ensure that it is by setting coupon rate = to YTM
- PV of coupon payments and face value
- aka. intrinsic value, fair value, etc.
, BOND MARKET PARTICIPANTS
Participants:
- rating agencies
▪ evaluate issuer
• controversial → paid by the issuer
▪ investors use ratings to decide on YTM & whether to invest or not
• poor rating = higher YTM
- issuers/borrowers
- investors/lenders
- intermediaries (will be a question in test 1)
▪ investment banks & security houses/brokers
▪ most important when bonds issued for the 1st time
▪ hired by issuer to be the middleman
▪ hired to: market bond, advise issuers (coupon rate, YTM, etc), deal with all
documentation, underwrite the bond
Major issuers/borrowers:
- governments
▪ budget deficits, projects
- parastatals & municipalities
▪ to fund investments
▪ e.g. Transnet, Eskom, etc.
- corporates
▪ to fund investments
▪ e.g. Barloworld, Anglo American
- banks
▪ To fund their lending portfolio
▪ E.g. ABSA, FNB, Investec
Major investors/lenders:
- pension funds
- hedge funds
- asset managers
▪ e.g. unit trusts, Old Mutual, etc.
- banks
▪ market-making, trading accounts and liquid asset requirements
▪ e.g. ABSA, FNB
Note: always know the current repo and prime rate
INTRODUCTION TO BONDS
WHAT IS A BOND?
Bond → long term debt instrument used for raising long term finance
Two parties:
- borrower/issuer
▪ pays interest & the principal amount
- lender/investor
▪ receives coupons & the principal amount
BOND TRANSACTION
Borrower/issuer Lender/investor
At bond issuance date
Bond selling price
In need of finance Bond certificate Has cash & is seeking an
investment opportunity
Subsequent periods
Coupon/interest payments
Selling/issuing bonds Buying bonds
Principal is repaid at end of
bond term
BOND FEATURES
Bond features = details relating to the bond
Face value:
- set by company & fixed
, - paid/received when bond matures
- determine coupon payment
- function of how much company want to raise
Coupon rate & coupon payments:
- rate determines the payments
- coupon payment = coupon rate x face value
- set by company & fixed
Time to maturity:
- set by the company & fixed
- shows lifespan of the bond
- function of company’s financial position to pay the face value
Yield to maturity (YTM):
- represents the return required by investors on the bond
- used as a discount rate
- fluctuates with market conditions
Where do you get the YTM or how do investors come up with it?
- similar instruments
▪ similar maturity, risk profile, interest bearing
Why is YTM always fluctuating?
- driven by the level of interest rates & interest rate changes
▪ interest rates , YTM also (vice versa)
▪ bonds are int bearing instruments affected by int rate changes
- key drivers of int rate changes aren’t constant
▪ drivers: repo rate changes by central bank, inflation, economic conditions,
default risk, political risk, etc.
Note: repo rate is that rate at which central bank lends money to commercial banks.
Price:
- what you pay to buy the bond
- used as a discount rate
- fluctuates
- price not always = to face value
▪ but issuer will always try ensure that it is by setting coupon rate = to YTM
- PV of coupon payments and face value
- aka. intrinsic value, fair value, etc.
, BOND MARKET PARTICIPANTS
Participants:
- rating agencies
▪ evaluate issuer
• controversial → paid by the issuer
▪ investors use ratings to decide on YTM & whether to invest or not
• poor rating = higher YTM
- issuers/borrowers
- investors/lenders
- intermediaries (will be a question in test 1)
▪ investment banks & security houses/brokers
▪ most important when bonds issued for the 1st time
▪ hired by issuer to be the middleman
▪ hired to: market bond, advise issuers (coupon rate, YTM, etc), deal with all
documentation, underwrite the bond
Major issuers/borrowers:
- governments
▪ budget deficits, projects
- parastatals & municipalities
▪ to fund investments
▪ e.g. Transnet, Eskom, etc.
- corporates
▪ to fund investments
▪ e.g. Barloworld, Anglo American
- banks
▪ To fund their lending portfolio
▪ E.g. ABSA, FNB, Investec
Major investors/lenders:
- pension funds
- hedge funds
- asset managers
▪ e.g. unit trusts, Old Mutual, etc.
- banks
▪ market-making, trading accounts and liquid asset requirements
▪ e.g. ABSA, FNB
