How to Invest in Bonds - Assignment Example

How to invest in bonds Government s and large corporations issue debentures to finance the gap between revenues and expenditures. They issue several types of debt securities to finance projects for capital expenditures of infrastructures, for government and capital for corporations. One of these is bonds that offer a package of yields along with provisions that protects both seller and buyer in the process. This study will answer some questions of Jill to enlighten her audience as future investors in the bond market. 1. What is the relationship between coupon rates and bond prices? Why do the coupon rates for the various bonds vary so much? What are bonds? Bonds are defined as debt issued for a period of more than one year. Common issuers or debtors are the US government, local governments, water districts, companies and other types of institutions. (Investing, 2005) For instance, the US government is the seller of the bonds. When you buy bonds, you become an investor, and they are practically lending money to the US government. The bond bears a promise of the seller to repay the principal amount of the loan at a specified time. When the US Treasury issues a bond, the government guarantees to pay back your principal known as the face value plus interest on maturity. When the investor buys a bond and waits until it matures, he will know exactly how much he is going to receive at the maturity period of the bond. It also called a fixed-income investment as a steady payout is given annually, or semi-annually. Bonds carries a percentage called coupon rate that remains fixed for the life of the bond issue.(Investing) For example, you purchase a bond at $1,000 with a fixed rate of 6%, with 4 years of maturity, your income ($60/1000) is $60 which is payable to you every year for 4 years, then you receive the face value of the bond. Why do coupon rates vary? The coupon rate in bond is fixed and is carried until the maturity of the bond, but the quoted price of the bonds varies because of the interest rates fluctuation. Fluctuations in interest rates values bonds higher or lower than its original value. So when an investor buys a bond and the interest falls, the value of the bond rises, and when the interest rises, the price of the bond falls. Price changes in bonds occur in choices of bonds. Longer term bond prices are more changeable than short term bond prices and more risky. Longer term bonds are more exposed to interest rate risks because the long stream of interest payments to investors does not match the current market interest rates. (AAII) Coupon interest rates vary and changes because it is caused by the fluctuation of rates of interests. Interests in bonds may be fixed, floating or payable at maturity. Interest rates vary because some sellers and buyers of bond want to have an adjustable interest rate which is related to the prevailing market rates. This is called a floating rate – bond which is adjusted from time to time and reflects the base index. Common rate index of performance is the rate on Treasury Bills. 2. How are ratings of bonds determined? Bond ratings are determined by a group of accredited companies who do the financial investigation on the records of organizations issuing bonds. These companies look on the financial condition, management operations, policies and plans in relation to the economic and political conditions. Their findings are summarized in a bond rating. These companies are Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings. They rate bonds from highest to lowest quality. According to their classification, a high quality bond has a low probability of default, but pays lower rate of interest than the low quality level. (Essortment). Essortment cited the ratings guide of the three companies as follows: “An AAA ratings or an Aaa means it is the safest possible investment with almost no chance of default; B or B2 is speculative choice, and C and D ratings are the issuers that are headed for default, or is a poor choice. Bonds with BBB/Baa and above ratings are usually considered “investment grade.” Bonds with ratings of BB/Ba and below are considered “below investment grade” or “speculative” bonds. These lower-ranked bonds are also called “junk” bonds, reflecting their high credit risk, or “high-yield” bonds, reflecting their potential returns. “ (Essortment) In Jill’s table AAA grade of ABC means a rating of very high quality, and a rating of AA for Transpower and Transco Utilities is lesser quality. It could be assumed that ABC is the safest possible investment, and has very slim chance of default as compared to Transpower and Transco. 3. Why do bonds sell for less than their face value while others sell for a premium. Can you classify discount bonds as a bargain? Discount bonds are not really a bargain. Some bonds are sold at a substantial discount from their face value, but it could not be called bargain bonds. It is a zero coupon bonds which are sold less than the face value, and most common in long term maturity bonds. Let us take the following example: Maturity period 20 years Face value $ 20,000 Coupon rate 0 Bond’s price $ 5,050 As you can see from the example that the quoted value of the bond is offered at a on a discounted price.. It has a long period of maturity which is 20 years and pays the face value of $20,000 at the end of term and does not pay interest at the mean time. In the example above, the investor buys the bond at $5,050, and will receive $20,000 on its maturity. The difference of $14,950.00 is the yield at 7% on maturity, Zero-Coupon Bonds: Zero coupon bonds are long term bonds sold at a low discount from its face value. It does not pay interest during the life the bond, but investor is paid on a lump sum amount of the face value. Because there is no intervening interest, the investment is locked and income is not dependent on the low and high rate of increases. Zero coupon bonds are sold on a term of 10, 20 to 30 years maturity (AAII) The length of time des not however exempt an investor from paying taxes earned from the investment. And this is possibly the reason why some investors choose zero bonds of municipal government which are exempt from taxes. (US SEC. 2008) Zero coupon bonds allow an investor to plan for the future, e.g. college education, retirement plans and other future investments by paying a small amount today. What is a premium bond? A premium bond is a bond that sells for more than its par value. This happens when the interest of the bond becomes higher than the market prevailing rate, The word premium and discounts when referred to bonds, merely tells you that the price of the bond is either above or below its par value. (Investopedia) For example, a bond is called premium when it is sold for more than its par value, say, $1000, and it is sold at a discount when it sold for less than $1,000. Another kind of premium bond is a government bond that bears no interest or capital gains but entitles the holder to lotteries. Holder of premium bonds issued by the government has chances to win government lotteries which are being drawn every month. Minimum purchase is $100 to $30,000 and open to anyone aged 16 and above and no set period of term. Because it a non-bearing interest bond, winnings from bonds entered into lotteries are tax free. Winnings are announced in newspapers and in the internet. (NS&I) 4. What does yield to maturity means, and how it is calculated? Investors are always curious about yield. Yield to maturity is the redemption yield or the yield promised by the issuer to pay to the bondholder on its maturity and a measure to know the return of the bond. Yield is the percentage return your bond investment promises at any given price, and can be expressed in a simple formula: Yield=Coupon/Price. (Answers. 2008) Calculation of YTM in Wikipedia, is based on the following premise: When the bond’s coupon rate is less than its YTM, then it is sold at a discount When the bond’s coupon rate is more than its YTM, then the bond is sold at a premium. When the bond’s coupon rate is equal to its YTM, then the bond is sold at Par The yield to maturity is defined as the percentage rate of return paid on a bond, note, or other fixed income security if the investor buys and holds it to its maturity date. It is based on the coupon rate, length of time to mature and market price. It is assumed that the interest paid over the life of the bond will be reinvested at the same rate.(Wikipedia) Let us take the following example: If you were to buy a bond for $1,000 at 6% coupon rate, the current yield would simply be 6% ($60/$1,000). But if the price drops to $800, the yield rises to 7.5%. Why? Because the guaranteed coupon -- $60 -- is now 7.5% of the $800 you paid for the bond ($60/$800). If the price rises to $1,200, the percentage shifts to 5%. ($60/1200) YTM of the investor in this case is 7.5% as against the 6% original coupon rate, There is a disadvantage in holding bonds to maturity as it locks in the investor’s chances for additional gains The gain is only realized if investor sell the bond, take advantage of the upward price movement, then reinvest on another lower priced bond.. 5. What is the difference between the nominal and effective yields in maturity for each bond listed in Table 1. Which one should the investor use when deciding between corporate bonds and other securities of similar bonds. Table 1. Jill’s Decision Table Issuer Face Value Coupon Rate Rating Quoted Price YTM Sinking Fund Call Period ABC Energy $1000 5% AAA $703.1 20 yrs. Yes 3 years ABC Energy $1000 0% AAA $208.3 20 Yes N/A Trans Power $1000 10% AA $1092.0 20 Yes 6 yrs. Talco Utilities $1000 11% AA $206.04 30 NO 5 yrs. Source: Jill’s table From the table, ABC offers two bond options, the zero rate bonds, and the fixed rate interest bond. ABCs first option has a nominal yield of return on a fixed rate of interest which is payable to buyer yearly. It is sometimes referred to as the current yield as the present rate of interest is used. It has a sinking fund and shorter call period. Sinking fund allows seller to pay periodic payment of principal amount to bondholders until it reaches maturity. By that time, the whole principal is fully paid to bondholder. The second ABC option is an effective yield on maturity because income is received upon maturity. It is a zero rate bond, no interest paid, no call period so an investor has to wait for 20 years to get back his investment and returns.. Note that the quoted price is relatively priced lower, and the lump sum of $1,000 is received at the end. It has also a provision for sinking fund. The yield to maturity tells you how much you will receive when a bond is called or matured. Table 2 in question 8 shows outcome of investments under different bond options, and any decisions of investors would depend on their priorities and purpose of investment. 6. Effects of call provision to bond risk and return potential. Before buying bonds, investors should ask the issuer if there are call provisions attached to it. Buyer of bonds should understand this provision as it has got to do with redemptions of the bonds. For instance, some bonds have “call provisions” that allows the buyer to redeem their bonds at a specific date before maturity. In the case of ABC, their bonds have a call period of 3 years, maturity 20 years. This means that bonds may be called 3 years after purchase, and the issuer has an obligation to repay the buyer the face value of the bond even before it reaches the 20 year maturity term. Bond issuers issue yield to call when there is a significant change in the prevailing interest rates, as when the interest rates have dropped. Investors on the other hand require an option for the issuer to repurchase the bonds when investors need immediate cash, or when the interest rates go very high. Investor may also experience the risk in yield to call when it is timed during a low interest situation, which most likely, a loss would occur. Conversely, investors would like to request for a yield to call to a time when the interest is high. (Investing) 7. Explain the risks of each bond. Rank the bonds in terms of relative riskiness. Who are the bond issuers? Bond issuers are government municipal, corporate and mortgage-backed/asset-backed securities. Each type of bond carries some kind of risks. As a general rule, when the risk is high, the yield is high to compensate for risk taken by the investor. Conversely, when the yield is too low, the price falls to bring the yield to the prevailing interest rates. Following are the risks involved in investing in bonds issued by government entities, corporate and mortgaged-backed and asset backed securities. (Investing) 1. Government agency, corporate and municipal bonds. a. Legislative risk. The risk of legislative change could affect the value of the tax exempt income by the change in the tax code. Income from municipal bonds is tax exempt and may be affected if there is any legislation that calls for reduction. b. Call risk. Some bonds issued by municipal bonds, corporate agencies and government entities have call provisions that entitles them to redeem the bonds at a specified date and price before the bond matures. One of the reasons that triggers redemption of a callable bond is the declining interest rates, in which case, investor’s principal is returned earlier than its maturity. In this case, investor is at a loss because he has to reinvest his principal at a lower interest rate. 2. Asset-backed securities, municipal and corporate bonds. a. Credit risks. It is the risk that a borrower will be having default payments on the interest and capital. However, mortgage-backed securities issued by the government are insured, and in this case, the risk is minimal. b. Default risk. This is similar to credit rishs wherein risks are also minimal because bond insurance guaranties payment of principal and interest to bondholders in case of default of borrower. c. Event risk. It is a risk that pertains more in the corporate bonds as this entails a total overhaul in the financial status of the bond issuer. This means the corporation needs debt restructuring, merger or additional capital needs, buyout, which in turn reduces the value of the bonds to fall. Event risk may also occur when there is regulatory change, industrial or natural calamity and accidents which cannot be predicted. d. Prepayment risk. Borrowers with mortgage-backed securities pay their loans sooner when there is a declining interest in the market or a strong housing market, then principal of the investor is returned sooner than expected. e. Contraction risk is similar to prepayment risk wherein borrowers speed up their mortgage loans returning to the investor the principal sooner than expected. Investor at this point will be disadvantaged as he will invest his money on the prevailing low market interest rate. f. Extension risk. In case of mortgage-related securities, there is a possibility that payment of borrower will slow down because of the increase in the rate of interest In this case, investor loses the opportunity of gain to reinvest his money at higher yields. g. Early amortization risk. The possibility of bankruptcy and insufficiency of funds of borrowers results to early amortization. In this set up, investors are paid on a monthly basis of his principal and interest or on an amortized basis and no longer takes into consideration previous term agreements. Investing in any kind of business transaction has an associated risk that investors must take. Bonds are not an exception as it is exposed to risks associated with fluctuations of market interest rates. The interest rate, reinvestment rate and inflation risks relate to the rise and fall that dictates bonds prices. Table 1 explains the theories of risks associated in bond investment. Table 1. Risks associated to a bond Interest rate risk When interest rates rise, bond prices fall; conversely, when rates decline, bond prices rise. The longer the time to a bond’s maturity, the greater its interest rate risk. Reinvestment risk When interest rates are declining, investors have to reinvest their interest income and any return of principal, whether scheduled or unscheduled, at lower prevailing rates. Inflation risk Inflation causes tomorrow’s dollar to be worth less than today’s; in other words, it reduces the purchasing power of a bond investor’s future interest payments and principal, collectively known as “cash flows.” Inflation also leads to higher interest rates, which in turn leads to lower bond prices. Inflation-indexed securities such as Treasury Inflation Protection Securities (TIPS) are structured to remove inflation risk Market risk The risk that the bond market as a whole would decline, bringing the value of individual securities down with it regardless of their fundamental characteristics. Selection risk The risk that an investor chooses a security that underperforms the market for reasons that cannot be anticipated. Timing risk The risk that an investment performs poorly after its purchase or better after its sale. Risk that you paid too much for the transaction The risk that the costs and fees associated with an investment are excessive and detract too much from an investor’s return. Source: Investing Bonds All bonds have associated risks, but rankings could not be obtained as there is no found formula for risks. Risks are related to interest fluctuation, political events and downturn of economy that could not be easily predicted. Risks can also be brought about by the environmental and legal issues that are not present during analysis and purchase of bonds. 8. If I buy 10 of each of these bonds, reinvest any coupons received at the rate of 5% per year and hold them until they mature, what will my realized return be in each bond investment Table 2 Yield to maturity Issuer FV per bond CR Q. P. Maturity YTM % SF CP Yrs Realized income for 10 bonds at YTM ABC 1000 5% 703.1 20 yrs. 8.020 % yes 3 563.00 ABC 1000 5% 208.3 20 yrs. 24.144% yes n/a 502.00 Trans Power 1000 5% 1092.0 20 yrs. 4.305% yes 6 475.02 Talco Utilities 1000 5% 1206.4 30 yrs. 3.831% no 5 467.17 Terms: FV – face value * CR -coupon rate * QP quoted price* CY current yield YTM yield to mature * SF sinking funds * CP call period Table 3. Realized income Quoted Price Yield to maturity % No. of bonds Income per year Maturity Realized Income 703.10 8.020 10 563.20 20 yrs $11,260 208.30 24.144 10 502.90 20 yrs. $10,058 1092.10 4.305 10 475.02 30 yrs $ 9,504 1206.40 3.831 10 467.17 20 yrs. $14.015 208.30 0 10 (10,000-2,083 0 20 yrs. $7,930 (Yield to maturity has been arrived through the formula provided by Investment Newsletter.) Note in the table that the yield or interest rate at maturity on ABC is higher than the original coupon rate. With Transpower , yield on maturity is lower than the coupon rate. ABC 1 has an option to redeem its bond on the current yield percentage. It can also avail of the sinking fund wherein bond holder can choose redemption period of periodical redemption of the principal. This enables bondholder and issuer to schedule cash flows. On example No. 2 of ABC, the difference of $ 1,000 and 208.30 = $791 represents the interest of 8% which. Zero rate returns to the investor the face value of the bond when it is retired. (791/1000 = 8%) On ABC 2, there is no call period, meaning, investor has to wait for 20 years for maturity of the bond. It has however a sinking fund wherein investors can receive partial payment of the capital if he needs it. Note that the quoted price is very low compared to the face value of the bond. Transpower and Talco Utilities quoted price is higher than the face value of the bond, have a longer call period and a sinking fund. Also, the percentage of its yield to maturity is lesser than the current yield, and at the same time less than the coupon rate. YTM provides the investor options to decide better bond investment. Conclusion Bonds are source of financing most commonly issued by government offices and corporations. Government bonds are less risky as it is secured by government assets in the National Treasury Bonds are sold in the open market similar to the stock market where a Trustee is in charge of operations. Investors must look at the different provisions of each bond offered in the market to be able to decide on which investment matches his financial needs and investment portfolio. Interests may be lower in bonds compared to the stock market, but bonds offer a steady fixed income backed up by secured assets and mortgages. Investing in bonds may be recommended for investors who want future income from their present investment, and make money work for them. List of References AAII. American Association of Individual Investors. Bond Investing: 8 Bond Investing Questions That You Should Know How to Answer[online] Available from http://www.aaii.com/faqs/bonds.cfm#3 21 Nov. 2008 Answers com. Current Yield [online]Available from 06 Nov. 2008 Wikipedia. Yield to maturity. [online] available from http://en.wikipedia.org/wiki/Yield_to_maturity 06 Nov. 2008 Read More