Sun Hung Kai Financial


			29/07/2010 21:28 HKT

Bonds

What are Bonds

1.What are Bonds?
2.What are the different types of bonds?
3.How to calculate the price of a bond?
4.What are the different types of risks involving bonds?
5.What is the yield curve?
6.What is bond indenture?
7.Why should I diversify the investment portfolio?

What are Bonds?

Bond is a debt security. It is the loan agreement between bond issuer (borrower) and bond investor (lender). When you purchase a bond, you are lending money to a Government, corporation, or other entities known as issuer. In return for the loan, issuer promises to pay you a specified interest rate during the life of the bond and the principal returned to the bondholders upon maturity of the bonds.

What are the different types of bonds?

You can find two typical types of bonds categorized by issuer:

Government Bond
When a Government needs to raise funds to finance its expenditures, funds can be borrowed from the market by issuing bonds such as Treasury Bond (US Government) and Exchange Fund Notes (HK Government).

Corporate Bond
It is one of the financial instruments issued by private and public corporations. Companies use the funds raised for various purposes including building facilities, purchasing equipment and expanding the business. For example, MTRC, KCRC, and Hutchison Whampoa.

You can find four typical types of bonds categorized by par interest rate:

Fixed rate bond
Fixed rate bond is issued with a specified coupon rate, which is mainly determined by market conditions at the time of the bond's primary offering. Once determined, it is set contractually for the life of the bond. The coupon rate multiplied by the bond principal provides the dollar amount of the coupon. Investors usually receive interest payment quarterly, semiannually, and yearly whilst investors receive the face value of the bond upon maturity.

Zero-coupon bond
Zero-coupon bond is issued with no periodic interest at all, but the bonds are issued at a discount of par value. As the market value approaches the par value over time, investors will earn the differential value.

Floating-rate bond
Floating-rate bond is issued with a variable interest rate. Interest adjustments are made periodically during the life of the bond. In general the coupon rate is tied to a money market index like Treasury bills. This instrument provides a protection to the bondholder against the interest rate rises. The yield of floating rate bond is always lower than those of fixed-rate bonds with the same maturity.

Convertible bond
It is a type of corporate bond, which allows bondholder to convert the bond into a common stock of the bond issuer. In other words, it is a structured product, linking a bond and with a call option. Therefore, bondholders have the right to convert their bond to a common stock under the predetermined number of shares (conversion ratio) and price (conversion price). Two typical types of features are:

Call features
Call features allow issuer to re-purchase the bond at a specified call price before the bonds expires. When the market interest rate is sliding down, issuer of a corporate bond with high coupon rate is likely to retire the high coupon debt and issue the new one at a lower coupon rate to reduce interest payment. Some bonds have "call protection" which guarantees the bond is non-callable for a specified period before their call date.

Put Features
Allows the bondholder has the right to redeem the bond to the issuer at a designated price and time. The bondholder will do this only if the money can be reinvested elsewhere at a higher rate of return.

How to calculate the price of a bond?

The basic value of bond price is an application of the discounted cash flow techniques. The price of a bond equals to the present value of all future cash flow, including expected coupon (C) (interest income) and the final redemption amount (F) by the discount factor. The discount rate used is the yield to maturity (YTM) which is simply the geometric average of the one-year forward rate for the life of the bond.
If the YTM is not known, but the market price is available, the calculation can proceed in reverse.


Bond price	=

Example:

Issuer		ABC Limited
Coupon		7%
Coupon Frequency (Per Year)		1 (annual)
Rating		A3
Issue Date		Jun 1, 2001
Maturity Date		Jun 1, 2006
Currency		HKD
Redemption amount		100%

Assumption:
The expected yield to maturity (discount factor) is 8% per annual
The yield of a 5 years Exchange Fund Notes is 5% per annum.

What is the price of the above bond if you buy it at new issue for HK$100,000?


Bond price	=

	=	96.007%

Illustration:


Day	Date	Cash Received	Cash flow (Present value)
1st coupon date	01/ 06/ 2002	+$7000	+$6,481.48
2nd coupon date	01/ 06/ 2003	+$7000	+$6,001.37
3rd coupon date	01/ 06/ 2004	+$7000	+$5,556.83
4th coupon date	01/ 06/ 2005	+$7000	+$5,145.21
5th coupon date and final redemption date	01/ 06/ 2006	+$107,000	+$72,822.40
	Total:	+$135,000	$96,007.29

If the coupon rate = yield to maturity (discount factor)

the bond will be priced at par.

If the expected yield to maturity goes up or down, what will happen to the bond price?
If the yield to maturity goes up, the price of the bond will goes down. When the yield to maturity 8%, which is higher than the coupon rate (7%), the bond will be priced at discount. When the yield to maturity goes down (drops to 6%), which is lower than the coupon rate (7%), the bond price will then be priced at premium.
The calculation is shown as follows:


Bond price	=

	=	104.21%

Bond price	=

	=	92.22%

The bond prices shown in the financial pages are not actually the price that investors pay for the bond. This is because the price does not include the interest accrued between the coupons payment dates.
If 50 days have passed since the last coupon payment, and there are 365 days in the coupon period, the bond seller is entitled to a payment of accrued interest of 50/365. Referring to the above example the coupon is 7% per annum, the accrued interest will be $7000 x 50/365 = $958.90.

What are the different types of risks involving bonds?

Default Risk
Although bond issuer promises to pay an interest to the bondholder, but this interest income is not risk-less unless the investor can ensure that bond issuer will not default their obligation. While US government bond may be treated as free of default risk, this is not true for corporate bonds. Therefore, US Treasuries are used as a benchmark in the bond market.
High-yield bonds are classed purely by credit risk. That is, the risk that a debt holder won't receive the interest payment and principal in full and on time.

Credit Risk
How can you determine the repayment ability of a bond issuer? Many investors place a great deal of reliance on the ratings provided by the major rating agencies. There are several credit rating agencies assign rating to bonds. The most prominent of which are: Standard and Poor's (S&P), Moody's Investor Service and Fitch IBCA. They will follow their rigorous methodology to determine the ability of the issuers to repay their debts.
The top rating is the AAA by S&P and Aaa by Moody's. S&P applies on each rating class a suffix "+" or "-" (e.g. AA+) to provide a finer gradation of those rating. Moody's also applies numerical modifiers 1,2 and 3 (with descending order of its generic rating category) in each rating classification from Aa to Caa.
e.g. (1) For a MTRC bond, (coupon: 7.5%, maturity: November 8, 2010), it is rated "A3" by Moody's, "A+" by S&P but Fitch IBCA applies no rating on it.
e.g. (2) For a Bank of East Asia, (coupon:7.5%, maturity: 1February,2011), it is rated "Baa2" by Moody's, "BBB" by S&P and "BBB+" by Fitch IBCA.

The following table listed the rating used by the rating agencies:


CREDIT RATINGS - LONG TERM DEBTS
Credit Risk	Moody's	Standard & Poor's	Fitch IBCA
INVESTMENT GRADE
Highest quality	Aaa	AAA	AAA
High quality (very strong)	Aa1	AA+	AA+
High quality (very strong)	Aa2	AA	AA
High quality (very strong)	Aa3	AA-	AA-
Upper medium grade (strong)	A1	A+	A+
Upper medium grade (strong)	A2	A	A
Upper medium grade (strong)	A3	A-	A-
Medium grade	Baa1	BBB+	BBB+
Medium grade	Baa2	BBB	BBB
Medium grade	Baa3	BBB-	BBB-
NON - INVESTMENT GRADE
Lower medium grade (somewhat speculative)	Ba	BB	BB
Low grade (speculative)	B	B	B
LOW GRADE
Poor quality (may default)	Caa	CCC	CCC
Highly speculative	Ca	CC	CC
Extremely poor prospects	C	C	C
In default	C	D	D

	Interest Rate Risk Bond prices and yield are inversely related. When the interest rate goes up, the bond price will fall. The bondholder will therefore be suffered by the interest rate rise. Long-term bonds are tended to more sensitivity to interest rate change than the short-term bonds. In other words, long-term bonds tend to have more interest rate risk. The relationship between the price and yield of bonds is as follows Interest Rate Yield of Bonds Price of Bonds Interest Rate Yield of Bonds Price of Bonds
	Reinvestment Risk A bondholder may only be able to reinvest his coupons at a lower rate than originally planned. If yields fall, his reinvestment income and consequently his total return from holding the bond will fall relative to the original yield. Conversely, if yields rise, total return will also rise.
	Events Risk The risks come from the bond issue down grade from bond rating agencies, merger or takeover or some unpredictable event. That will cause the bond price to fall.
	Liquidity Risk An active secondary market is important in the debt market. It provides the exit for the bondholders who want to sell back the bond. It is reflected by the bid/ask spread of the bond quote. For some active bond issue, like US Treasuries, the bid/ask spread is talking within 1%. For some illiquid bond issue, the bid/ask spread can jump up to 2% or even higher.
	Currency Risk When the bond denominated in foreign currency, it is subjected to currency risk. The bondholder will be suffered if the exchange changes adversely resulting in less domestic currency.

What is the yield curve?

Yield curve is the graph showing the term structure of interest rates. Yields on bonds with different maturities but same qualities are plotted. If short-term interest rates are lower than long-term interest rates, it is called a Positive Yield Curve. If short-term rates are higher than long-term interest rate, it is called Inverted (or Negative) Yield Curve. If there is a little difference between short-term and long-term interest rates, it is called a Flat Yield Curve.

	When the economy shows a positive the yield curve, this means that buying bonds with longer maturities can enjoy higher return than the short-dated one.
	When the economy shows an inverted yield curve, the market expected the long-term interest rates to decline. Investors can purchase the short-dated bonds to replace the long-dated issues and it may imply the recession is coming.
	When the economy shows a flat yield curve, this means that the reward on extending maturities is relatively small. Investors will choose to stay in the short-dated end of the maturity range.

What is bond indenture?

This is a contract binding the bondholders and bond issuers into the bond issue for a specified term. Generally, the document provides the following information:

	Description of the bonds
	Terms and conditions of the bonds
	Business Overview of the issuer
	Financials of the issuer
	Use of Proceeds

Investors are recommended to pay attention to the above information before. Key parts of the notes have been stated in this document. Also, in case of events, the arrangement will be followed according to the bond indenture.

Why should I diversify the investment portfolio?

No matter what is the investment objective, it makes good sense to diversify the portfolio. If one sector class is in the midst of a downturn, the rising value of another sector class may help to offset the negative impact.
For example, an investor holds a variety of speculative grade and investment grade bonds. The speculative grade bonds can generate greater returns than the investment grade bonds, but they have relatively higher risk. The investment grade bonds are capable to weather economic downturns.