Learning About Bonds

by | March 10, 2009

A bond is a contract to provide payments according to a specific schedule. Bonds are long-term securities with maturities exceeding one year, in contrast to bills, or other short-term debt such as commercial paper, which have maturities of less than one year. The bond universe is huge. There are treasury bonds, agency bonds, junk bonds, corporate bonds, zero coupon bonds, municipal bonds, sovereign bonds, tax-free bonds and so forth. In addition to all of these, there are options on bonds, options on options on bonds, and so on. These will be covered in detail in later sections. In addition, most bonds are highly sensitive to interest rates, so we will have to study the yield curve in some detail. For now we will cover the fundamental financial concepts required in valuation of bonds.

Some things to remember about bonds that distinguish them from equity are that in the contractual agreement of a bond, there is a stated maturity and a stated par value. This is unlike an equity where there is no "maturity" and no "guaranteed" price at maturity. We say that "bonds converge to par value at maturity". This makes the volatility of a bond, generally, lower than an equity especially as maturity draws close. However, don't get the idea that bonds are without risk or uninteresting, as quite the contrary is true. According to a recent article, "Bonds are no longer the stodgy investments they once were. ''What most people don't know is that the 30-year Treasury bond has the same volatility'' as an Internet stock,... " (Business Week Online, "Is the Bond Market Ready for Day Traders?" Feb 28, 2000). Construction of models for valuation of bonds is one of the tougher challenges out there. There are many risks inherent to bonds: default risk, basis risk, credit risk, interest rate risk, yield curve risk, and so on, which may not apply to equity or equity-like securities.

Bonds are generally considered to be less risky than equity, (except for junk bonds), so they can generally be expected to have lower rates of return. In the world of bonds, we are concerned with issuer credit rating. Credit ratings are provided by the major ratings agencies such as Moody's, S&P and Fitch. You may wish to familiarize yourself with these ratings (www.standardandpoors.com, www.moodys.com, www.fitch.com). Very recently, a Goldman Sachs interviewer quizzed me on ratings of corporate bonds and subsidiary liability in case of default. Of course, you may not have to worry about this if you do not have this type of experience listed on your resume, but remember, anything on your resume, no matter how long ago or obscure, is fair game!) The ratings affect the ease and cost of obtaining credit for the corporation issuing the bonds. The higher the rating - AAA is the highest S&P rating, for example -- the lower the cost of credit. As the corporation's credit rating declines, it gets more and more expensive for the corporation to raise new funds. Most corporate treasuries are very concerned with possible ratings downgrades and check frequently with ratings agencies before undertaking something that could potentially result in a downgrade. Downgrades can also affect investors, as many fixed income managers in asset management firms have mandates to hold only corporate-grade bonds and better. If a corporation's bonds fall to "junk" category (see, for example, Xerox, May 2002), the institutional investors may have to sell their holdings to comply with client requirements. This dumping of what could be large holdings of the bonds makes the price of the bonds drop.

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