- Based upon the content in Topic 3, what is the current shape of the yield curve for Treasury securities and what does it tell you about the current view of economic growth and inflation in the U.S.?
- Has the spread on corporate bonds and Treasury securities narrowed or widened over the past year?
- What events or apparent changes in market conditions triggered such a change in the spread between the yields on corporate bonds and treasury securities?
Key Features of Bonds Introduction A bond is a form of long-term debt (loan). However, not all bonds are the same. As you read this section, identify what entities raise capital by selling bonds and take note of the key features of bonds. © Ingram Publishing/Thinkstock Loaning small amounts of money to your friends might take no more than a word or a handshake, but when dealing with large amounts of money with complete strangers, we tend to require a bit more formality. Banks are the first place we tend to consider when we think about these more formal loans, but there are other avenues for governments, municipalities, corporations, and other borrowers to raise funds. Bonds and Interest Rates We will focus on bond instruments, which are one way to securitize (to make a series of cash flows into a tradable instrument) a loan. A bond is a loan packaged as a tradable security. It typically has a periodic interest payment and a repayment of principal at maturity. Who Issues Bonds? There are many different entities that will issue bonds, and often bonds will behave differently based upon the type of issuer. At an investment bank, bond traders will often specialize in trading one type of bond. Here are some of the more common types: · Corporation = Corporate bonds or “Corporates” · U.S. government = Government bonds or “Govies” · Smaller government entities (e.g., cities or states) = Municipal bonds or “Munies” · Other governments = Sovereign bonds or “Sovereigns” Bonds originally were pieces of paper, stating all the necessary information in the center with coupons around the edge (yes, just like the Sunday paper). The owner of the bond would cut off the coupon and turn it in to receive each periodic interest payment. The terminology stuck, so even with today’s electronic bonds, the periodic payments are called coupon payments. Most bonds pay these coupon payments twice a year (semiannually), though once a year (annual) payments are not uncommon. These coupon payments typically occur until the maturity date, at which time the final coupon payment and the principal of the bond would be due. This principal amount is called the par value. Currently, the most common par value for corporate bonds in the United States is $1,000. When describing a bond, we typically list the coupon rate, which is the annual total of the coupon payments expressed as a percentage of the par value. For example, a bond that pays $50 semi-annually would be paying a total of $100 ($50 x 2) every year. If the par value of the bond is $1,000, then we say that the bond has a coupon rate of $100 / $1,000 = 10%. Coupon Rates annual coupon payments ÷ par value = coupon rate coupon rate × par value = annual coupon payments Coupon Rate Versus Interest Rate It is easy to confuse the coupon rate with the interest rate. The key is to remember that the interest rate can change over time (as the price of the bond fluctuates), but the coupon rate for most bonds is established at the time of issue and typically doesn’t change over the life of the bond. To make things more confusing, companies typically like to issue bonds with the coupon rate being close to the prevailing interest rate. Just remember that, once the coupon rate is set at the time of issue, it doesn’t change. There are bonds that have “floating” coupon rates that can change, but they are the exception and not the rule. In this competency, we will always assume that bonds are standard bonds with fixed coupons. All bonds are governed by a bond indenture, which is the contract that stipulates all the details of the bond. This includes the conditions for repayment and default, when bondholders can usually seek legal recourse for greater control of the company. Specific items in the bond indenture are referred to as covenants. Key Takeaway · Bonds make coupon payments until the maturity date, at which point the final coupon payment and the par value are due. · The coupon rate is the annual coupon payments of the bond divided by the par value of the bond. · Coupon rates don’t change over the life of the bond for almost all bonds. Why Are Bonds Risky? Introduction What factors account for bond risk? As you read this section, think about what makes a bond risky and what factors contribute to its risk. Credit Risk Not all bonds are created equal. For example, which seems like the safer investment: loan $1,000 to the U.S. government, or loan $1,000 to a small company that hasn’t paid interest to its current investors for over a year? Investing in the world’s largest economy probably seems like the better bet, all other things being equal. But what if the small company offered you three or four times the return on your investment? Now the decision is not so straightforward. The major difference between our government bond and the small company’s bond is our expectation of the borrower’s creditworthiness. We label the uncertainty in future cash flows due to possibility that the borrower will not pay credit risk. The most common credit risk is default risk, which in the extreme occurs when the company doesn’t have the cash to pay the necessary scheduled payment (or chooses not to). Bonds can also be in default for breaching specific covenants (for example, a covenant specifying that certain liquidity ratios be maintained), even if all payments are made. Since, as of the time of this writing, the U.S. government is the largest government on Earth with the largest potential revenue stream, it is considered the borrower with the least amount of credit risk. While not truly without credit risk, as a proxy, we consider U.S. government bonds to be a “risk-free” asset, in terms of credit risk. Sometimes, credit risk is reduced through the use of collateral, or assets, pledged to secure repayment. The most familiar collateral arrangement is the standard home mortgage, where the property itself is collateral against the amount borrowed. Corporations can also pledge certain assets when they choose to issue bonds, with the anticipation that the lower credit risk will correspond to a lower cost of borrowing. To guide investors in their assessment of the credit risk of bond issuers, there are ratings agencies that attempt to qualify the creditworthiness of each bond issue. Some of the larger agencies include: Standard and Poor’s (S&P), Moody’s, and Fitch. Ratings range from AAA (or Aaa, as different agencies have slightly different scales) for the most creditworthy debt, to D for debt that is already in default. Bonds rated at least BBB− (or Baa3) are considered “investment grade”, which is an important distinction for many mutual funds that invest in bonds. Any bonds that are rated lower (BB+/Ba1 or below) are not considered investment grade, or “speculative.” These bonds are sometimes called “junk bonds” (though it would be important to remember that even “junk bonds” have a higher claim on a company’s assets than any shares of stock). The table below displays the different bond ratings. Table 2.1 Bond Ratings Moody’s S&P Fitch High Grade Aaa to Aa3 AAA to AA− AAA to AA− Medium Grade A1 to Baa3 A+ to BBB− A+ to BBB− Speculative Ba1 to B3 BB+ to B− BB+ to B− Very Risky or In Default Caa1 to C CCC+ to D CCC to D There have been concerns over the accuracy of the ratings from these providers, especially after the credit crisis of 2008. Some highly rated securities ended up having default rates much higher than would have been expected, given their assigned ratings. One argument is that these securities were so complex that the ratings agencies couldn’t accurately evaluate them. Another claim was that, because ratings agencies earn their revenues by charging for assigning a rating to a security’s issue, there is a potential conflict of interest that encourages the agencies to give higher ratings than they otherwise should. Regardless of the cause, confidence in ratings agencies has been shaken, and, while the information provided by such companies is undoubtedly useful, an investor is wise to not blindly take ratings as absolute truth, especially when more complex instruments are involved. Yield Curve Introduction The yield curve (term structure of interest rates) accounts for the variability of bond returns (bond yields) attributable to differing maturities. As you read this section, think about why yields on short-term treasury bonds are typically lower than returns or yields on long-term treasury bonds and why the yield curve is normally sloping upward. Now we are going to hold the risk structure of interest rates—default risk, liquidity, and taxes—constant and concentrate on what economists call the term structure of interest rates, the variability of returns due to differing maturities. Even bonds from the same issuer, in this case, the U.S. government, can have yields that vary according to the length of time they have to run before their principals are repaid. Note that the general postwar trend is upward followed by an equally dramatic slide. Sometimes short-term treasury bonds have lower yields than long-term ones, sometimes they have about the same yield, and sometimes they have higher yields. To study this phenomenon more closely, economists and market watchers use a tool called a yield curve, which is basically a snapshot of yields of bonds of different maturities at a given moment. The current yield curve can also be viewed many places online, including Bloomberg, the Wall Street Journal, and the U.S. Treasury itself. What observers have discovered is that the yields of bonds of different maturities (but identical risk structures) tend to move in tandem. They also note that yield curves usually slope upward. In other words, short-term rates are usually lower than long-term rates. Sometimes, however, the yield “curve” is actually flat—yields for bonds of different maturities are identical, or nearly so. Sometimes, particularly when short-term rates are higher than normal, the curve inverts or slopes downward, indicating that the yield on short-term bonds is higher than that on long-term bonds. And sometimes the curve goes up and down, resembling a sideways S (sometimes tilted on its face and sometimes its back) or Z. What explains this? Figure 2.22 shows treasury yield curves. Figure 2.22 Treasury Yield Curves Bond Valuation Introduction Read this section and take notes on how to calculate the value of a bond given the coupon rate and yield to maturity (YTM). The financial value of any asset is the present value of its future cash flows, so we already have the tools necessary to start valuing bonds. If we know the periodic coupon payments, the par value, and the maturity of the bond, then we can use our time value of money skills to solve for either price or YTM (yield to maturity), given the other