SECTION 5 : BOND VALUATION AND BOND YIELD

Bond Characteristic
The Price of bond The value of a government bond of similar maturity The bond coupon rate and frequency The maturity of the bond the longer the period the riskier the investment The credit rating of the issuer The type of bond straight, callable, puttable, sinking fund, index-linked, zero-coupon etc Whether the bond is registered or in bearer form bearer bonds often have tax advantages The liquidity of the bond the number of market-makers, the cost of transaction, market volatility etc The taxation situation of the bond is the income taxed at source, at what rate and when

Several of the factors influencing bond prices, as with financial instrument in general, involve elements of risk. Each type of risk : Credit Risk is the risk that a counterparty will fail to honour its agreed obligations Market Risk results as a change in the value of a bond caused by any movements in the level or volatility of the current market yields or cost of money Operational Risk covers matters such as : Settlement or Herstatt risk Legal Risk Strategic Risk arises from the way in which trading is carried out by market players operating for their institutions.

Other Bond Characteristic Principal and par The principal is the face amount of a bond bought by an investor. The term of par refers to 100% of the face value. Maturity The maturity of a bond is the length of time elapsing between the issue date and when the bond is due for repayments, that is, when the final interest payment and the principal are returned to the investor. Coupon A coupon is the periodic interest payment during the lifetime of a bond. Accrued Interest The amount of interest that has gathered since the last payment date is known as the accrued interest.

Bond Valuation

Rate of Return Obviously investors are interest in the future value of their investments and need some kind of indication to guide their investment decisions. The simplest guide is return. In effect, the return on an investment is the difference between the cost of buying and selling any financial instrument. An investor hopes that the selling price will be greater than the buying price but there is always an element of risk. Simple and Compound Interest Simple interest rates assume interest is paid at maturity regardless of maturity period. Equivalent Interest Rates These convert an original compound rate into another using a different convention. In order to help investors to compare instruments on a direct basis accurately, equivalent interest rates can be used.

Present Value Present value of a bond is not always equal to its par or face value. A bond can trade at a premium or at a discount. The present value reflects how fixed coupon instrument compares with current market interest rates and the frequency of coupon repayments. Day Count Method Once the maturity and value dates are known, the difference between them determines the exact investment period. The method of determining the length of time between the dates is known as the day count or day basis. It will probably come as no surprise to learn that there are a number of different methods by which days are counted in different bond markets and for different instruments. Accrued Interest The seller is compensated therefore for any interest due which has accumulated since the last coupon payment this is known as accrued Interest. The Concept of Yield The yield or YTM is the annualized interest rate that makes the present value of a bonds future cash flows equal to its market value. Bond Prices A bond price is also affected by its face value. In order to standardize prices and overcome technical fluctuations which arise from coupon payments, the markets use the following prices. Dirty price. This is the full market value of a bond including accrued interest expressed as a percentage of the face value. Clean price. This is the full market value which has been cleansed of the accrued interest expressed as a percentage of the face value.

Bonds Yields
The Relationship Between Bond Price and Yield Yield to maturity is the uniform discount rate at which the present value of a bonds future cash flows equals the bonds dirty price. There is an inverse relationship between bond prices, their PVs and interest rates as one rises the other falls. There is also an inverse relationship

between bond price and yield as prices rise, yields fall and vice versa. In effect the price of a bond in the secondary market depends on the market rate of return on new debt at the time of the trade. Yield Conventions Not all bond markets use the same conventions for expressing yield. You will probably encounter all of the following conventions at sometime. Current Yield Adjusted Current Yield or Japanese Simple Yield YTM or ISMA YTM Greenwell-Montagu (weekend) Yield

Yield Conversions A similar situation exists when comparing YTMs for annual and semi-annual coupon paying bonds. It is usual to quote a semi-annual YTM for a semi-annual bond and annual YTM for an annual bond. Yield Curve In order to compare bond yields over a whole range of maturities a yield curve of benchmark instruments is constructed. This plot displays graphically the relationship between interest rates for government securities at different maturities having the same credit risk and is often called the term structure of interest rates. Total Return Analysis Calculations involving YTM produce expected measures of return whereas the actual rate of return is often termed the total rate of return. Components of Total Return Holding Period Market Value Re-investment Rate

Total Return Measures Historical total return Horizon total return

Yields for Complicated Bonds The bonds covered here are : Callable bonds Puttable bonds Sinking fund bonds - The amount of any future cash flow - The length of time of any future cash flow Index-linked/inflation-indexed bonds Convertible bonds Parity price = Conversion ratio x Current share price Bonds with warrants - The fixed income value of the bond which can be as for a conventional bond - The equity value derived from the value of the warrant

Bond Risk an Yield Analysis

The yield on a bond contains an element of risk premium to reflect the credit and liquidity risks associated with the bond. However, in order to fully manage interest rate risk and market exposure, market risk needs to be assessed thoroughly and separately. There are a number of measures dependent on yield which are used by market players to assess market risk including : Duration Duration is a way of comparing interest rate or market risk between two bonds with different original maturities. Duration is a measure of the weighted average life of a bond which takes into account the size and the timing of each cash flow. In effect it is a weighted average of the PVs of all cash flows. Basis Point Value (BPV) Macaulay duration is dependent on yield and modified duration is based on a 1% change in yield. In term of basis points, a 1% change is 100bp, which is a very large change in markets. It is much more likely that changes will be a smaller and therefore market players need a finer measure to assess risk. This measure is known as Basis Point Value. Convexity Convexity is the change in modified duration for a 1% change in yield.

SECTION 6 : TRADING IN BOND MARKETS

Issuers in the Primary markets

An issuer is the borrower of funds responsible for ensuring that interest and principal payments are made to bond holders usually via a paying agent. Issuers in the primary markets fall broadly into one of four categories : Government and sovereign organization Government bond markets are also the most liquid of the domestic markets. However, many governments now issues Eurobonds in the international markets. Sovereign include states, provinces and municipalities, which may be countries or local/regional governments within a country. Supranationals These are organizations that raise capital for economic growth in developing countries and that have a high credit rating Supranationals include : - International Bank for Reconstruction and Development the World Bank - European Investment Bank - African Development Bank - Asian Development Bank - Council of Europe Corporates Multinational corporations use the debt markets for many reasons to fund their activities. Credit ratings vary from issuer to issuer and can rank as high as governments to below investment grade junk bonds. Banks and Other Financial Institutions These organizations use the bond markets to raise capital to fund their activities just like corporations. In some markets such as Eurobonds, bank and financial institutions form a significant percentage of the issuers.

Credit Rating and Agencies

One of the major considerations in pricing a new issue is the creditworthiness of the organization issuing the bond. In other words, investors have to assess the risks that the issuer

may default on interest payments or principal repayment. Credit ratings are carried out by agencies and include an evaluation of an issuers credit history and capability to repay its obligations. There are a number of credit ratting agencies, some of which are specific to particular types of bond markets. Some of the more well-known agencies include : Moodys Investor Services Standard & Poors Corporation Duff & Phelps Fitch Mikuni

The most widely recognized of the agencies are Moodys and Standard & Poors. Bonds that are classified as speculative grades, that is, non-investment grades, are commonly known as junk bonds. In many cases junk bonds have high yields in order to attract investors. Investment grades Highest quality Excellent Good Medium Speculative grades Questionable Poor Very poor Extremely poor Lowest Moodys Highest Lowest Aaa, Aaa1, Aaa2, Aaa3 Aa, Aa1, Aa2, Aa3 A, A1, A2, A3 Baa, Baa1, Baa2, Baa3 Ba, Ba1, Ba2, Ba3 B, B1, B2, B3 Caa, Caa1, Caa2, Caa3 Ca, Ca1, Ca2, Ca3 C Standard & Poors Highest Lowest AAA, AAA, AA+ AA, AA, A+ A, A, BBB+ BBB, BBB, BB+ BB, BB, BB+ B, B, CCC+ CCC, CCC, CC+ CC, CC, C+ C

The ratings determined by the agencies are an opinion of the issuers ability to repay debt which is dependent not only on the credit risk of the issuer but also on the type of debt instrument. This opinion is based on a number of criteria including : Geographical location of the issuer. Even a top quality issuer will be considered a less safe risk if they are based in an unstable political climate Type of business Future prospects for the issuers industry

Ranking of the organization Management of the organization Profit and loss accounts Liquidity and cash flow Future plans of the organization Type of instrument

Issuing A Bond in the Primary Market

The primary market is concerned with bond issues and as such, the amounts of money are often so large running into even billions of dollars that no single organization could possibility raise the loan by itself. There are five basic steps involved in the issue. Each of the steps are described here as self-contained scenario for clarity, but of course in practice matters are not quite as simple. The five steps are : Step 1 Appoint a Lead Manager and Agree on Fees Step 2 Determine the Deal Structure and Pricing Step 3 Form and Underwriting Syndicate Step 4 Set Up the Administration of the Bonds Step 5 Primary Trading

Intermediaries Involved in the Primary Markets

The role of intermediaries is to bring together issuers and investors. Most governments use a system of primary dealers and brokers to issue their bonds in their domestic markets.

Players in the Secondary Markets

Once a new issue has been placed or sold in the primary market it can be traded in the secondary market. Some secondary markets are illiquid, that is there is little secondary trading. There are six types of people of you will encounter, each with a different role :

Market Makers Market makers act as principals, who use their own capital to buy, sell and hold instruments, trading for their own account. Within the secondary market the greatest volume of trading takes place among the market markers. Agency or Retail Brokers These act as agents who buy and sell on behalf of an investor. They help preserve the anonymity of the investors and issuers. They do not hold a position but earn their income from the commission they charge. Inter Dealer Brokers (IDBs) IDBs operate in a different way to that of brokers. Their role is to bring market makers together in order to preserve anonymity and market efficiency. They do not take positions themselves but earn a small commission for their service. Dealers or Traders These act as principals, taking instruments onto the trading organizations books, hoping to make a profit on their resale. Sales People Sales people are the interface between the client, or the investor, and the dealers. Their job is to provide their client with information about the market, relay prices and pass on orders to the traders to transact. They also try to sell the banks position, such as its underwriting commitments. Financial Analysis and Economistsa These are responsible for the compilation and examination of the detailed information in the market place. The information from these analysts is considered into a set of forecast which are used as guidelines for investment to support sales people.

How Bonds Are Traded

Bonds may be issued in a number of ways different markets have their own conventions. The main methods used are : Registered This is where the current owner is recorded in a register retained by the issuer or the issuers agent. As ownership changes the register is altered accordingly.

Bearer bonds In this case the owner is anonymous in that no investors name is recorded on the bond whoever bears the bond owns it. In some cases bearer bonds are also registered. Book entry These instruments do not have a physical certificate but are registered electronically with custodian banks.

Both clearing houses offer similar services, which broadly cover the following : Clearance This provides buyers and sellers with an efficient and economic means of settling transactions. It covers issues in the primary as well as transactions in the secondary markets. This facilitates swift and efficient settlement and helps to protect the anonymity of investors. These clearing houses will also arrange for the physical delivery of the bond certificate if this is required. Custody This is a safe-keeping facility for securities based on a worldwide network of major banks acting as depositories. Securities Lending and Borrowing This allows participants to lend securities and increase the yield on them. It allows participants to borrow securities in order to settle transactions and so contributes to the overall liquidity of the market. Money Transfer and Banking The purpose of this facility is to provide long- or short- term borrowing for participants.

Investors in Bond Markets

Although some bond issues are designed to attract individual investors, by far the largest group of investors are financial institutions and corporations. There are a number of broad categories of large investors who have funds available from a variety of sources. There are four important categories which are discussed briefly here : Performance Funds These are funds such as unit and investment trusts which have been established to achieve returns for a given level of risk. The funds have no liabilities to meet and are often designed to cater for specific purposes.

Pension Funds, Life Assurance and Insurance Companies These are fund that are designed to meet a set of liabilities. Typically pensions and life insurance policies provide lump sum payments after a specified period. Pension funds for large public and private organizations may have their own registered company in their own right. Other company schemes may use the services of a specialist fund management company. Central Bank Most government central banks hold large amounts of bonds. These comprise the following : - New government issues which can be used for monetary policy control - Foreign government or highly rated corporate bonds which can be used to control government FX reserves Corporate Investors Most large corporations use the bond markets to invest surplus cash and finance schemes such as pensions. Many commercial banks are significant investors in the bond markets using bonds to finance their activities. FRNs are bought by many banks to fill gaps in their borrowing and lending requirements.

Regulations of Markets

There are a number of organization involved with regulating the markets all of which are concerned basically with ensuring the following : Maintenance of high ethical and professional standards among all market participants who deal with each other and individual investors Fair treatment for all investors Prevention of fraud and dishonest practices

There are two major groups of regulatory bodies which operate in the domestic markets and the international markets. Domestic Regulatory Bodies In most countries the government has a range of bodies to regulate the markets. International Regulatory Bodies The two mains organizations are :

The International Primary Market Association (IPMA) This organization has a framework of standards and documentation within which issuing houses in the Eurobond markets are expected to operate. IPMA members are obligated to report any deviations from these standards to each other. International Securities Markets Association (ISMA) The International Securities Markets Association, based in Zurich acts as the regulatory body for the international securities market. ISMA sets a framework of rules and regulations in which its member operate. In order to help regulate the market, ISMA has set up a Transaction Exchange System (TRAX). This is a real-time on-line facility for the comparison and confirmation of transactions between dealers. The system provides the means by which users can see whether their trades will be settled or what details are required for settlement. The system is constantly updated throughout the day and both parties to a transaction are expected to input details within 30 minutes of the deal. If the details match, the trade is good and it can only be cancelled if both parties consent. If the details do not match then the transaction may be cancelled. ISMA also keeps a register of lost and stolen bonds.