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Fixed Income Fundamentals The following are fundamentals of fixed income security valuation: Face Value (Par) The face value of a bond, also known as par value, is the principal amount (original amount borrowed) that must be returned at maturity. Bonds are issued in various face values although the most common denomination is $1,000. Length-to-Maturity A bond’s length-to-maturity, as the expression implies, is the length of time until the bond matures. At maturity, the issuer of a bond agrees to make a final coupon payment and to repay the principal amount borrowed (equal to face value). Bonds can be issued with various lengths-to-maturity. Lengths-to-maturity are often classified as follows: Short Term (1-5 years), Medium Term (5-10 years), and Long Term (10+ years). Length-to-maturity is an important concept in fixed income investing. All else constant, investors require greater rates of return for bonds with longer lengths-to-maturity because they want to be compensated for committing capital and bearing risk over time. In addition, bonds with longer life spans generally exhibit greater price volatility. Coupon Rate The coupon rate is the annual rate of interest that the issuer of a bond promises to pay the holder. Although coupon rates are annualized, most bonds disperse coupon payments semi-annually. Thus, a semi-annual coupon bond with a $1,000 face value and a 10% coupon rate will pay a $50 coupon every six months. Coupon rates are generally fixed. However, a bond can also be structured to pay a floating rate coupon. A floating rate coupon is generally derived from a market interest rate such as LIBOR. Reference the tutorial, Floating Rate Coupon Structures for a comprehensive review. Premium, Discount, and the Discount Rate Bonds are issued at par value. From that point forward, bonds will generally trade at a greater or lesser amount than par value. A bond trading above its par value is said to be trading at a premium. A bond trading below its par value is said to be trading at a discount. Why does this occur? Investors value bonds by discounting their future cash flows at a discount rate. A bond will sell at a premium or discount to par value depending on the size of the discount rate relative to the coupon rate. If a bond’s discount rate is less than its coupon rate, the bond will sell at a premium to par. A bond with a discount rate larger than its coupon rate will sell at a discount to par. The relationship between the discount rate and market value of a bond is detailed below:
Pricing/Quotes A bond’s price is quoted as a percentage of face value. A bond that is trading at face value is trading at 100% or 100. Partial percentage amounts are typically quoted in 1/32nds. Reference the tutorial, Quotation Conventions, for a comprehensive review. Bid, Ask, and the Market Spread Bonds are quoted and traded using a bid and ask pricing system. The bid price is the highest price a potential buyer is willing to pay for a bond. The ask price is the lowest price offered by sellers of a bond. A bond’s market spread is the difference between its highest market bid price and its lowest market ask price. Consider the following example: Calculate the market spread of a bond using the bid/ask quotes of three potential buyers and three sellers:
The highest bid is 85-4. The lowest ask is 85-6. Thus, the market spread of the bond is 0-2 or 1/16 of 1% of face value. A bond’s market spread is a good measure of its liquidity in the secondary market. A large spread generally indicates that a bond is thinly traded and may be have a degree of liquidity risk, while a small spread generally indicates that a bond is highly traded, liquid, and may not have significant liquidity risk. Accrued Interest Although a bond will generally pay interest every six months, an investor who holds a bond will earn interest every day. Between payments interest accrues to the owner. When a bond is traded in the secondary market, the buyer pays the previous investor the current market value of the bond plus any accrued interest. Reference the tutorial, Calculating a Bond’s Accrued Interest for a comprehensive review. Call Options Some bonds have call options. An issuer of a bond with a call option has the right to redeem the bond at a specified price prior to maturity. Issuers often exercise call options when interest rates fall because they can re-issue new bonds at a lower cost of capital. Call options provide a great advantage to issuers and a disadvantage to investors who become vulnerable to reinvestment risk if a bond is called (See Bonds with Embedded Options). Measuring Investment Return Holding Period Yield is a measurement of a bond’s monetary return earned during the period it is held by an investor (known as in investor’s investment horizon). Holding Period Return is derived from the following formula:
1. Under what circumstances will a bond sell at a premium to par value? 2. Under what circumstances will a bond sell at a discount to par value? 3. Under what circumstances will a bond sell at par? 4. How is the market spread determined for a bond using the bid/ask system? 5. Define accrued interest. Answers:
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