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related with the Features and Risks on Bonds Securities. Through this article, I just want to share this knowledge with all of you. I hope it will provide you some information about the Bonds while dealing practically as well as while preparing for any course or studies.
Introduction
1) Debt Obligations Bonds, Mortgage-backed securities, Asset Backed Securities, Bank Loans. 2) Preferred Stock Represents ownership interest and has fixed dividends payment.
Features of Bonds
Par Value is the amount that the issuer agrees to repay the
bondholder at or by the maturity date. When a bond trades below its par value, it is said to be trading at discount. When a bond trades above its par value, it is said to be trading at premium.
Coupon Rate, also called the nominal rate, is the interest rate that
the issuer agrees to pay each year. The annual amount of the interest payment made to bondholders during the term of the bond is called the coupon. The coupon is determined by multiplying the coupon rate by the par value of the bond i.e. Coupon = Coupon Rate X par value. The higher the coupon rate, the less the price will change in response to a change in market interest rates
Zero Coupon Bonds Bonds that are not contracted to make periodic coupon payments are called zero-coupon bonds. The holder of a zero-coupon bond realizes interest by buying the bond substantially below its par value. Interest is then paid at the maturity date, with the interest being the difference between the par value and the price paid for the bond. Step-Up Notes Securities that have a coupon arte increases over time. These securities are called step-up notes because the coupon rate steps up over time. When there is only one change (or step up) the issue is referred to as a Single Step-
up note. When there is more than one change the issue is referred to as a multiple step-up note. Deferred Coupon Bonds Bonds whose interest payments are deferred for a specified number of years. Floating-Rate Securities These securities have coupon payments that reset periodically according to some reference rate. Coupon Rate = Reference Rate + Quoted Margin Maximum Coupon rate is called Cap. Minimum Coupon Rate is called a Floor. Coupon rate increases when reference rate increases, and decreases when reference rate decreases.
Issues whose coupon rate moves in the opposite direction with the change in the reference rate. Such issues are called Inverse Floaters or Reverse Floaters. The coupon Formula is: Coupon Rate = K L X (Reference Rate)
Paying off provisions of bond When the issuer agrees to pay one
lump sum payment at the maturity date, it is termed as Bullet Maturity. 1) Call & Refunding Provisions The right of the issuer to the stated maturity date is referred to as a Call provision. If the issuer exercises this right, the issuer is said to call the bond.
When the issuer exercises an option to call an issue, the call price can be either i. ii. iii. Fixed regardless of the call date the call price is par plus accrued interest. Based on the price specified in the call schedule the call price depends on when the issuer calls the issue. Based on a mark-whole premium provision Provides a formula for determining the premium.
A non-callable issue prohibits the refunding of the bonds for a certain number of years or for the issues life. Non-refundable Bonds prevents redemption from certain sources, namely the proceeds of other debt issues sold at a lower cost of money.
2) Sinking Fund Provision The indenture may require the issuer to retire a specified portion of the issue each year. This is referred to as a sinking fund requirement. If only a portion is paid, the remaining principal is called balloon maturity. Many times issuer has the option to retire more than the sinking fund requirement. This referred to as an accelerated sinking fund provision.
Put Provision It grants the bondholder the right to sell the issue
back to the issuer at a specified price on designated dates.
Embedded Options granted to the Bondholder i. ii. iii. Conversion Privilege Right to put the issue Floor on a floater
1) A bond will trade at a price equal to par when the coupon rate is equal to the yield required by market Coupon Rate = Yield Required by Market 2) Price = Par Value
A bond will trade at a price below par (sell at a discount) or above par (sell at a premium) if the coupon rate is different from the yield required by the market. Specifically, Coupon rate < Yield required by market (Discount) Coupon rate > Yield required by market (Premium) Price < Par Value Price > Par Value
3)
The price of a bond changes in the opposite direction to the change in interest rates. So, for an instantaneous change in interest rates the following relationship holds: If interest rates increase If interest rates decreases Price of the bond decreases Price of the bond increases
1) Impact of Maturity > All others factors constant, the longer the bonds maturity, the greater the bonds price sensitivity to changes in interest rates. 2) Impact of Coupon rate > The lower the coupon rate, the greater the bonds price sensitivity to change in interest rates.
3)
Impact of Embedded Options > For this, let us decompose the price of the callable bond in:Price of Callable Bond = Price of option-free bond Price of embedded call option. When interest rate decline both price components increase in value, but the change in the price of the callable bond depends on the relative price change between the two components. Therefore, a decline in interest rates will result in an increase in the price of the callable bond but not by as much as the price changes of an otherwise comparable option free bond.
4) Impact of the yield level > Higher a bonds yield, the lower the price sensitivity. Price sensitivity is lower when the level of interest rate in the market is high, and the sensitivity is higher when the level of interest rate is low.
5) Floating rate Securities > The price of the floating rate security will fluctuate depending on three factors> a. b. c. The longer the time to the next coupon reset date, the greater the potential price fluctuation. The required margin that investors demand in the market changes. It will typically have a cap. Once the cap is reached, the securities price will react mush the same way to changes in market interest rates as that of a fixed-rate coupon security. It is termed as Cap risk of the floating rate security.
Approximate percentage Price changes for a 100 basis point change in yield is:
Duration =
Price of Years decline Price if yields rise . 2 X (Initial Price) X (Change in yield in decimal)
The approximate dollar price change for a 100 basis point change in yield is sometimes referred to as the dollar duration.
The same disadvantages apply to mortgage backed and asset backed securities where it is termed as prepayment risk.
2)
3)
Liquidity risk > is the risk that the investors will have to sell a
bond below its indicated value, where the indication is revealed by a recent transaction. The wider the bid-ask spread the greater the liquidity risk.
Volatility risk > The greater the expected yield volatility, the
greater the value of an option. The risk that the price of a bond with an embedded option will decline when expected yield volatility changes is called volatility risk. Price of Callable Bond = Price of option-free bond Price of embedded call option Price of Putable Bond = Price of option-free bond + Price of embedded call option