Understanding Bonds
Note: the following reading is adapted from a variety of sources including Bloomberg, U.S. Treasury sites and http://www.investopedia.com/articles/bonds/07/price_yield.asp. This reading specifically deals with long term coupon issues. For U.S. Treasuries that would be debt with maturities of greater than one year. Recall, Treasury Bills (maturities of one year and less) are zero coupon issues (i.e., they sell at a discount of their par value). U.S. Treasuries with maturities of over one year to ten years are commonly referred to as Treasury Notes and those ten years and over are referred to as Treasury Bonds. Throughout this reading, the term Government Bonds will be used for all bonds with maturities over one year.
U.S. Government Bond Quotes
Bond prices are quoted in two ways. When you look at a bond quote, you will frequently see both the dollar price and the yield. The chart below is taken from Bloomberg.com, a provider of U.S. Treasury data. We will refer to information shown in this chart throughout the article. Notice that in the chart, both bond dollar prices and yields are quoted.
U.S. Treasuries (February 7, 2011)
COUPON / MATURITY / PRICE/YIELD / PRICE/YIELD CHANGE2-Year / 0.625 / 01/31/2013 / 99-23 / 0.77 / -0-01½ / 0.024
3-Year / 1.000 / 01/15/2014 / 99-08+ / 1.25 / -0-02 / 0.022
5-Year / 2.000 / 01/31/2016 / 98-22 / 2.28 / -0-03 / 0.020
7-Year / 2.625 / 01/31/2018 / 97-16+ / 3.02 / -0-03½ / 0.018
10-Year / 2.625 / 11/15/2020 / 91-21½ / 3.65 / -0-02+ / 0.010
30-Year / 4.250 / 11/15/2040 / 92-23 / 4.71 / 0-10 / -0.021
U.S. Government Bond Prices
A bond's dollar price represents a percentage of the bond's principal balance (recall that in the U.S., this is $1,000), otherwise known as par or face value. Look at the 2 year Treasury above. It has a quoted price of 99-23. What does this mean in U.S. dollars?
To begin, note that U.S. Government Bonds are quoted in 32nds of a dollar.
A U.S. Treasuries price consists of a "handle" (the numbers to the left of the -) and "32nds". The two-year Treasury's handle is 99, and the 32nds are 23. We must convert those values into a percentage to determine the market price for this bond. To do so, we first divide 23 by 32. This equals .71875. We then add that amount to 99 (the handle), which equals 99.71875. So, 99-23 equals 99.71875% of the par value of $1,000, which equals $997.1875.
Some very active issues may be quoted in 64ths of a point. To reflect this in the quote, a plus sign (+) would follow the price. The 3 year bond quote of 99-08+ means 99 and 8/32 plus 1/16 or 99 and 17/64. The 17/64 equals .265625 which we add to the handle for a price of 99.265625% of par, or $992.65625.
Also note that the 2 year Treasury is trading at a discount, which means that it is trading at less than its par value. If it were "trading at par", its price would be 100. If it were trading at a premium, its price would be greater than 100.
Price and Yield Change
The price and yield change data for U.S. Treasuries presented in the Bloomberg illustration show the price change (handle and "32nds") from the close the trading day before. Thus the 3 year bond’s price is down 2 "32nds", and the yield is up 0.022 percentage points (or basis points).
Corporate and Foreign Government Bond Quotes
Only the market for U.S. Treasuries prices securities using thirty-seconds of a dollar. All other markets (foreign and corporate) use decimal notation.
German Government Bonds (February 8, 2011)
Maturity Coupon Maturity Date Current Price/Yield
3-Month / 0.000 / 05/11/2011 / 99.84 / .686-Month / 0.000 / 08/10/2011 / 99.6 / .80
1-Year / 1.250 / 12/16/2011 / 100.19 / 1.03
2-Year / 1.000 / 12/14/2012 / 99.22 / 1.44
The above quotes for German government bonds are priced in decimal form as a percent of par value. Thus, the 1 year is 100.19% of par, or €100.19 and the 1 year 99.22% of par or €99.22 (Note: German Government bonds have a minimum par value of €100).
U.S. Corporate Bonds (February 8, 2011)
Issuer Name / Coupon / Maturity / RatingMoody's/S&P/
Fitch / Price / Yield %
GENERAL ELECTRIC CAPITAL CORP / 6.000% / Aug 2019 / Aa2/AA+/-- / 110.222 / 4.536%
ABBOTT LABORATORIES / 5.300% / May 2040 / A1/AA/A+ / 97.338 / 5.483%
The above quotes for GE and Abbott are priced in decimal form as a percent of par value (note: par values on U.S. corporate bonds are $1,000). Thus the GE bond is 110.222% of par value, or $1102.22 and the Abbott bond is 97.338% of par value, or $973.38.
Coupon Payments
When you buy a bond, you buy more than principal balance; you alsobuy coupon payments. Different types of bonds make coupon payment at different frequencies (annually or semi-annually). Coupon payments are made in arrears. Thus, when you buy a bond, you are entitled to the percentage of a coupon payment due from the date that the trade settles until the next coupon payment date, and the previous owner of the bond is entitled to the percentage of that coupon payment from last coupon payment date to the trade settlement date.
Since you will be the holder of record when the actual coupon payment is made and will receive the full coupon payment,you must pay the previous owner his or her percentage of that coupon payment at the time of trade settlement. In other words, the actual trade settlement amount will consist of the purchase price plus accrued interest.
Discounts and Premiums on Bonds
When would someone pay more than a bond's par value? The answer is simple: when the coupon rate on the bond is higher than current market interest rates. In other words, the investor will receive interest payments from a premium priced bond that are greater than what they could earn in the current market environment. The same holds true for bonds priced at a discount; they are priced at a discount because the coupon rate on the bond is below current market rates.
Yield to Maturity on a Bond
A yield relates a bond's dollar price to its future cash flows. A bond's cash flows consist of (1) coupon payments and (2) return of principal (par or maturity value). Principal is usually returned at the end of a bond's term, known as its maturity date.
A bond's yield to maturity is the discount rate that can be used to make the present value of all of the bond's cash flows equal to its market price. In other words, a bond's market price is the sum of the present value of each cash flow. Each cash flow is present valued using the same discount factor. This discount factor is the yield to maturity.
In reality, there are several different yield calculations for different kinds of bonds. For example, calculating the yield on a callable bond is difficult because the date at which the bond might be called (the coupon payments go away at that point) is unknown. As a general rule, for bonds callable prior to maturity, yields are computed to the earliest call date for issues quoted above par and to the maturity date for issues below par.
However, for non-callable bonds, such as U.S. Treasury bonds, the yield calculation used is a yield to maturity. In other words, the exact maturity date is known and the yield can be calculated with certainty (almost). But even yield to maturity has its flaws. A yield to maturity calculation assumes that all the coupon payments are reinvested at the yield to maturity rate, although this is highly unlikely because future rates can't be predicted.
In the Bloomberg illustrations, the yield to maturity on the 30 year U.S. Treasury bond is 4.71%, the yield to maturity on the 2 year German government bond is 1.44% and the 2019GE is yielding 4.536%.
A Bond's Yield Moves Inversely to Its Price
Remember that a bond's yield is the discount rate (or factor) that equates the bond's cash flows to its current dollar price. So what is the appropriate discount rate or, conversely, what is the appropriate price?
When inflation expectations rise, interest rates rise or, in terms of bond pricing, the discount rate used to calculate the bond's price increases and, therefore, the bond's price drops. It's that simple. The opposite scenario would be true when inflation expectations fall.
How to Determine the Appropriate Discount Rate
We've established that inflation expectation is the primary variable that influences the discount rate investors use to calculate a bond's price, but you'll notice in the Bloomberg data that each Treasury bond has a different yield and that the longer the maturity of the bond, the higher the yield. This is because the longer a bond's term to maturity, the greater the risk that there could be future increases in inflation and the larger the current discount rate that is required/used by investors to calculate the bond's price will be. By this time, you should recognize this higher discount rate as being a higher yield.
The credit quality (the likelihood that a bond's issuer will default) is also considered when determining the appropriate discount rate (yield); the lower the credit quality, the higher the yield and the lower the price.
Daily Bond Price and Yield Quotes
Refer to the following web site:
Treasuries: http://online.wsj.com/mdc/public/page/2_3020-treasury.html
Corporate Bonds: http://www.marketwatch.com/tools/bonds/
Bonds and Types of Risks
Credit (Ratings) Risk: Although Government Bonds are usually considered high quality credit, not all Government Bonds are rated the same. Consequently, investors face credit (ratings) risk in investing in Government bonds, since the ratings could be downgraded. Some Government Bonds such as German Bunds, US Treasuries and UK gilts have been considered virtually free from credit (ratings) risk, as the bonds are backed by the authority and taxing authority of the German, U.S. or UK government and these governments are unlikely to default on their bonds.
Default Risk (Also referred to as credit risk): The risk that companies or governments will be unable to make the required payments (coupons and principals) ontheir debt obligations. Bonds with default risk trade in the market at a price that is lower than comparable U.S. Treasury securities, which are considered free of default risk. Default risk is gauged by quality ratings assigned by recognized rating companies such as Moody’s Investor Service, Standard & Poor’s corporation, Morningstar and Fitch IBCA. Another factor that correlates to default is the bond’s length to maturity. The longer a bond hangs out there the higher the risk of default.
Interest rate risk: While investors are effectively guaranteed to receive interest and principal as promised, the underlying value of the bond itself may change depending on the direction of interest rates. As with all fixed-income securities, if interest rates in general rise after a Government security is issued, the value of the issued security will fall, since bonds paying higher rates will come into the market. Similarly, if interest rates fall, the value of the older, higher-paying bond will rise in comparison with new issues. Interest rate risk is also known as market risk.
Inflation risk: In a period of low inflation and moderate shifts in interest rates, investors often are content to hold their bonds to maturity, ignoring the changes in market value of their bonds. However, some investors strive to structure their bond holdings to minimize market risks and take advantage of market opportunities. One such technique is called “laddering,” in which the portfolio is structured so that bonds mature at regular intervals, allowing the investor to make new choices with available cash.
Call Risk: If a corporate bond is callable, then the issuing company has the right to purchase (or pay off) the bond after some minimum time period. If you hold a high-yielding bond and prevailing interest rates decline, a company with a call option will want to call the bond in order to issue new bonds at lower interest rates (in effect, to refinance its debt). Not all bonds are callable, but if you buy one that is, it is important to note the terms of the bond. It is important that you be compensated for the call provision with a higher yield.
Event Risk: The risk that a corporate transaction, natural disaster or regulatory change will cause an abrupt downgrade in a corporate bond.
Currency/exchange rate risk: Investors who invest in a government bond that is not in his/her home currency also face currency/exchange rate risk since the value of his/her investment could go down as well as up depending on what happens to the currency exchange rate.
Page | 1