3.1 Bonds

3.0 Asset Types – General Introduction

This next section introduces and discusses the main types of assets used by investors to store and transfer wealth across states (possible outcomes) and time. As we know, investors face a huge array of choices of assets, each with its own risk and expected return. Check out this graph showing the annual returns to various asset types. Note, these returns are adjusted for inflation (the return to a dollar is negative) and the vertical scale is logarithmic, meaning the differences would appear substantially larger using a regular scale.

Later in the course we will talk about building portfolios of assets and asset allocation. Assets also vary in many other ways including price, liquidity, ease of transfer, contractual rights and obligations and tax treatment, just to name a few. The topics to follow in Section 3 are introductions, not comprehensive guides. The first category of asset we consider is debt, or bonds.

3.1. Asset Types: Bonds

james bond 007 34 logo

+ Describe a bond in general
+ Identify various types of bonds
+ Learn features of Corporate bonds and Government bonds
+ Understand how the bond market works and the relationship between bond prices and interest rates

Lecture:  Bonds

Part I – What are bonds?

1. As we saw in the previous topic, bonds are debt instruments. They all have the following features:
~ A par or face value, usually written on the bond. The most common value is $1000, although the US government issues savings bonds in many different values
~ A coupon rate, which is the rate of interest the bond will pay on a regular basis, usually every six months, but sometimes annually, quarterly, etc
~ A term, which is the period of time before the principal has to be repaid. This can vary from one year to 30 years, or longer.
2. In addition, some bonds are convertible to stock, others do not pay interest, and many are traded on the open market (they are negotiable securities, like shares in public companies.)
3. While the coupon rate of a bond is fixed, the yield is the return on the bond. The simple yield is the current coupon divided by the current price (more below.) The yield to maturity can also be calculated and varies depending on the current market price and the time to maturity. It is essentially the internal rate of return of the bond.
4. Bonds are generally lower risk than equities, and give the lender a favored legal standing if the company goes bankrupt ahead of other creditors, in particular shareholders.

Risk of holding bonds
Bonds have risks. The usual risks associated with bonds include:
a) interest rate risk – as the interest rate varies, the value of a fixed-coupon bond varies. More on this below.
b) call risk – the risk that the issuer pays off the principle before the maturity date, so not paying all the scheduled interest payments.
c) inflation risk – higher inflation lowers the real rate of return (real yield) to all assets, but bonds have a fixed face value.
d) default risk – the risk that the bond issuer will default on interest payments or repaying the principle.
e) liquidity risk – bond markets can have few buyers and sellers, and those wishing to sell bonds may have difficulty finding buyers, which produces a “thin” market.

Types of bonds
There are very many types of bonds. Some of the more common include:
Convertible bonds
Perpetual bonds
Zero-coupon bonds
Scroll down on this Wikipedia page to the section Types just to see how many different types of bonds there are!
Some bonds are callable, which means the issuer can replay the principle before the maturity date. This can sometimes cause problems for investors who planned on not getting the principle back until the maturity date. Hence there is an additional risk, called “call risk.”
Money market instruments are generally not considered bonds.

Quality of bonds
All bonds are rated by agencies, such as Moody’s, S&P and Fitch. The highest rating is usually AAA or Aaa (Investment Grade,) and anything below Baa or BBB is considered junk. Ratings generally reflect the risk associated with the security and are similar to credit ratings for an individual (FICO score basis.)

Part II – Corporate and Government bonds

Corporate Bonds
1. Issued by companies, both public and private, to raise capital to purchase assets.
2. Used to fund medium to long term capital investments. Can also be used to buy back stock (see recent Apple loan.)
3. Usually sold by syndicate of securities firms and banks who buy the entire issue and sell directly to investors.
4. Generally more risky than government bonds.

Government Bonds
1. Issued by the Federal Government called Treasuries, State and Local Governments called Munis.
2. Used to fund current account deficits. Accumulate to produce account debt (hence the difference between the Federal deficit and the National Debt.)
3. Usually sold by auction.
4. US (Federal) government debt is issued using three broad categories of bond instruments:
a) short term bills: up to five years to mature
b) medium term notes: between six and 12 years to mature
c) long term bonds: greater than 12 years to mature
5) Interest on US savings bonds is tax deductible, as is interest on Municipal bonds.
6) Federal government bonds are generally considered riskless for the main reason that the Federal government has taxing authority to back its debts. Most state and local governments generally cannot raise taxes to pay off their debt, although local governments raise (with the support of voters) property taxes to fund particular bond issues tied to specific projects. Although the risk of default on Federal government debt is practically zero, history is marked by occasions when federal governments defaulted on their debts. These governments usually have bigger problems than debt service…

Part III – The Market for bonds

1. Because bonds are generally negotiable securities, they can be bought and sold on a bond market. Unlike stock markets which tend to be actual physical, or virtually physical, places (New York Stock Exchange for example), bonds are traded by dealers in over-the-counter markets. Remember that a market is an institution (a set of rules for trading or exchanging) rather than a physical thing, so it’s acceptable to call the bond market a market.
2. Bond prices are determined by the demand for, and supply of, bonds.
3. There is an INVERSE relationship between bond prices and interest rates. Consider the following example:
A $1000 bond A is issued for 10 years at a coupon rate of 5%. It pays $50 in interest every year (usually $25 twice a year.)
After one year and a day, the general interest rate in the economy rises to 8% and new bonds are issued at that rate: Bond B has face value $1000, 10 years to maturity and pays $80 per year in interest. Although many factors determine the rate at which bonds must be offered to attract buyers (including the riskiness of the company issuing the bond,) coupon rates generally follow the economy-wide interest rates.
An investor wishing to buy a bond now has two alternatives: buy bond A or buy bond B. Bond B is “worth more” because it pays $80 a year for 10 years, whereas bond A only pays $50 a year for 9 years. If the investor has to pay $1000 for bond B, what would bond A be worth? Less than $1000 for sure! The market will determine what the price for bond A will be. (Can you guess, or calculate, what bond A will sell for?)
I calculate the clean price to be about $811, based on the yield to maturity of A compared to B.
The example shows that the price (value) of a bond falls as the interest rate rises. The converse is true–a fall in the interest rate will increase the value of a bond.
4. This result highlights one very general feature of bonds, and securities in general: investors make money if prices or values change. It is the change in price/value that matters, not the level of prices.
5. If a bond is currently selling at a price above par (face value) it is said to be selling at a premium. If below, at a discount.
6. Some bonds don’t pay interest, and sell at a discount on issue. They return the face value on maturity, so the increase in value over time is an equivalent return to the interest not paid.

Take the Quiz on the Learn website.

Aside: The yield curve
Both Government and corporate debt is issued for various terms ranging from 90 days to 30 years. Each type of bill/note/bond has a yield associated with it. That yield changes daily, and is calculated that frequently. (Check out this video of monthly changes in the yield curve since 2002.) The US Treasury Dept publishes the yield curve data on its website here. These data for Government securities can be plotted with the yield on the vertical axis and debt term on the horizontal axis.
The yield curve has both a shape and a location. This means that it moves up and down between higher and lower yields, as well as shows a difference between the yields of short term and long term bonds. Normally the higher the level of inflation, and inflation expectations, the higher the overall yields will be. Also, normally, the yields on long term bonds will be greater than the yields on short term bonds. The yield curve will be up-sloping. Sometimes, as displayed in the dynamic yield curve demonstration, the yield curve becomes inverted, and long term bond yields are lower than short term bond yields. This is usually interpreted as reflecting concern among bond investors that an economic downturn, or recession, is impending.

In recent years the yield on bonds has fallen, to the point that some government bonds, and corporate bonds have negative yields. A negative yield means that rather than paying to borrow money, companies are being paid by lenders to borrow money. This (almost) defies logic, yet the explanation lies in a comparison of these bonds to the alternatives. If an investor is looking for the least risky option, a bond that pays a negative return might be more attractive than a more risky investment paying a slightly higher, and positive, return. Still, the world appears to have reached a stage where investors can’t give away money… This article from the Financial Times is very informative.

Additional Resources/links
1. Investopedia’s introduction to bonds.
2. No audio video of the yield curve next to the S&P 500 Index since 1999:
. Just look at what Yahoo Finance shows on their home page when you enter bonds:
4. Interesting webpage about how to buy and sell bonds. Not that easy…
5. Here is an interesting article about really long-term (118 year) returns to various assets.

(There is no homework for this topic – this is for the 16-week course)
Write a one page, typed (single spacing is fine) essay on the following question:
What is the general relationship between the Treasury yield curve and the state of the economy (boom, recession, recovery, etc.) in recent years (since 2000)? Does the yield track the economy, or does the economy track the yield? Or, put even another way, is the yield curve a leading indicator? (It would probably be necessary to draw a recent yield curve to illustrate your answer.)

Discuss the following question.
1. After watching the dynamic yield curve video, consider these questions: Why would the “normal” yield curve be upsloping – meaning shorter term debt offers lower returns than longer term debt? Why would it ever be reversed?

(These topics are for the 16-week course only:)
2. Read the Financial Times article about negative bond yields. Why would any investor accept a negative return?
3. Read this article from The Economist about quantitative easing. The US, and many other countries used QE actively for many years following the recession of 2008. Do you think it’s a good idea, and did it achieve the goals of the policy?

Next Topic –>