This is all About the Fixed Income Securities and its terminologies
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Contents
1. Learning Objectives
- Identify the features of fixed income securities
- Who are bond issuers
- Identify coupon types
- Coupon calculations
- Understand what a discount paper is
- Debt vs equity
- Understand the principle of risk vs return
- Explain bond trading and valuation
2. Content
Debt instruments (bonds) are securities
issued by institutions as a means of raising money. They are an alternative to
bank loans. The investor loans money to
an entity (company or government) for a defined period of time at a specified
interest rate, known as the coupon rate. The riskier the bond, the higher the
rate of interest that must be offered on the bond.
The bond-holder is a creditor of the bond
issuer and has no control over the decision making within that
organization. Bonds are known as fixed
income securities because you know the exact amount of cash you'll get back if
you hold the security until maturity.
The primary reason an investor would
purchase a bond is to earn the coupon interest over the duration of the bond.
The principal is viewed to be quite secure. Except for cases of default, the
bond issuer will repay the principal on the maturity date of the bond.
2.1. Bond Issuers
The two main issuers of bonds are;
2.1.1.
Corporations
Companies issue bonds to raise funds to
expand into new markets, upgrade equipment, fund research and development or for
whatever reason the Board of Directors decide is prudent. Corporate bonds
usually offer slightly higher interest rates than government bonds because of
their perceived higher risk.
2.1.2.
Governments
Governments need money for everything from
infrastructure improvements to social programs. Whenever their tax receipts are
not sufficient to cover their expenses, governments issue bonds to make up the
difference.
2.2. Coupon Types
2.2.1.
Fixed rate
A fixed rate means that the interest rate remains the same for the
entire life of the bond. On each coupon
payment date, usually every six months, a coupon interest payment is paid by
the bond issuer to the investor based on the quantity (nominal value or face)
of the bond
Each day, a bond accrues a portion of its next coupon. This is accrued interest. When the bond is bought or sold, the accrued
interest is also bought or sold.
2.2.2.
Floating rate
A floating rate (also referred to as a variable rate) is an interest
rate that moves up and down over the life of the bond. With this type of coupon, the rate is re-set
at each coupon payment date. The rate is set with reference to either the Fed Rate
or the LIBOR (London Inter-Bank Offer Rate) plus a spread e.g. LIBOR + 250 bps.
When LIBOR is 2%, then this coupon will be 4 ½ %. On each coupon payment date,
a coupon interest payment is paid by the bond issuer to the investor based on
the quantity (nominal value or face) of the bond at the prevailing rate of
interest
Each day, a bond accrues a portion of its next coupon. This is
accrued interest. When the bond is
bought or sold, the accrued interest is also bought or sold.
2.3. Calculating Interest
How the coupon is spread over its coupon period is determined by a
day-count method. There are 3 main methods:
I) 30/360
II) Actual/actual
III) Actual/365
Example:
A $1,000,000 4% US Treasury 2/15/14 will pay a coupon of $40,000 (A)
each year, payable each year on Feb 15 and Aug 15 (B = 2) and uses a ACT/ACT
day count method.
At each coupon date the coupon interest amount = 1,000,000 x 0.04 /
2 = $20,000.00
The amount of accrued interest on any day can also be calculated. Counting
begins from the last coupon payment date
For example. to calculate the interest to May 7th, the last coupon
payment date would be the 15th Feb. Using ACT/ACT as the day count
method the days accrued are 13 days in Feb, 31 days in Mar, 30 days Apr, and 7
days May totaling 81 days (D). The coupon of $20,000 is receivable on Aug 15
and there are 181 days (C) in the coupon period (13+31+30+31+30+31+15).
The accrued interest as at May 7th = 20,000 x 81/181 = $8,950.28
2.4. Discount Paper
These are short term debt instruments which
are issued and traded at a discount and mature at par. This means that rather than paying interest
coupons like bonds the appreciation of the discount paper value provides the
return to the holder. The most common type of discount paper are the United
States Treasury Bills.
With discount paper the issuer will never
pay a coupon. The implied interest component is included in the price.
Example:
We purchased a discount paper in April that
matures three months later. The quantity (or “face” amount) is 1,000,000 and
the cost is $988,852.50.
Upon maturity, we will receive
$1,000,000.00 from the issuer. The $11,147.50 gain is reclassified as interest
income for tax purposes.
2.5. Debt vs Equity
Bonds are debt, whereas stocks are equity. This is the important
distinction between the two security types. By purchasing equity (stock) an
investor becomes an owner of a corporation. Ownership comes with voting rights
and the right to share in any future profits. By purchasing debt (bonds) an
investor becomes a creditor to the corporation (or government).
The primary advantage of being a creditor is that you have a higher
claim on assets than shareholders do. That is, in the case of bankruptcy, a
bondholder will get paid before a shareholder. However, the bondholder does not
share in the profits if a company does well – bondholders are entitled only to
the principal plus interest. There is generally less risk in owning bonds than
in owning stocks.
2.6. Risk vs Return
Yield is a figure that shows the return you
get on a bond. The simplest version of yield is calculated using the following
formula:
Yield is the effective rate of interest
paid on a bond. When you buy a bond at par, yield is equal to the interest
rate. When the price changes, so does the yield.
Example:
If you buy a bond with a stated interest
rate of 10% at par $100, the yield is 10% ($10 / $100).
If the price goes down to $93, then the
yield goes up. This happens because you are getting the same guaranteed coupon
of $10 on an asset that has depreciated in value to $93 ($10 / $93 = 10.75%).
However if the bond price appreciates to
$104 the yield shrinks to 9.615% ($10 / $104).
When bond investors refer to yield, they
are usually referring to yield to maturity (YTM). YTM is a more advanced yield
calculation that shows the total return you will receive if you hold the bond
to maturity. It equals all the interest payments you will receive (and assumes
that you will reinvest the interest payment at the same rate as the current
yield on the bond) plus any gain (if you purchased at a discount) or loss (if
you purchased at a premium).
The level of prevailing interest rates in
the economy influences the price of a bond. When interest rates rise, the price
of bonds in the market falls. This
raises the yield of the older bonds and brings them into line with newer bonds
issued with higher coupon rates.
When interest rates fall, the price of
bonds in the market rises. This lowers
the yield of the older bonds and brings them into line with newer bonds issued
with lower coupons.
2.7. Accounting & Valuation
A bond’s price changes on a daily basis,
just like any publicly traded security.
A bond does not have to be held to maturity. At any time a bond can be bought or sold in
the open market. For accounting purposes, bonds have to be treated ‘clean’.
This means stripping out the accrued interest from the cost (principal amount)
of the bond. In line with best practice, most accounting systems now do this. If interest is included in the price of the
bond this is referred to as a ‘dirty price’ (ie interest = 1,500 bond value =
1,000,000 x 101.25 = 1,012,500 when priced dirty the price would be priced at
101.4 (1,012,500 + 1,500 / 1,000,000 x 100)).
It is important that when pricing bonds that we use the clean price.
The seller is entitled to the accrued interest amount up to the
settlement date of the trade. This accrued interest is added to the agreed upon
price to arrive at the net cash flow. However it’s very important to categorize
the price and the interest separately. The price is part of the principal
amount which is used to calculate your capital gain or loss. The interest is
classified as ordinary income. This is a very important distinction.
2.7.1.
Calculating cost:
Ticket
Type
|
Buy
|
Quantity
|
1,000,000
|
Instrument
|
US
Treasury 4% 2/15/14
|
Trade
Date
|
4-May-07
|
Settlement
Date
|
7-May-07
|
Execution
Broker
|
Bear
Stearns
|
Settlement
Broker
|
Morgan
Stanley
|
Price
|
USD
96-18
|
Cost (principal) = 1,000,000 x 96.5625 /100
= 965,625.00
The accrued interest up to the settlement date is added to the
principal to calculate the total net cash flow that appears on the broker
statement.
Net Cash Flow = 965,625.00 + 8,950.28
= 974,575.28
GL
Entries
Trade date
Dr Bond
Long Cost 965,625.00 (Asset)
Dr Acq
Bond Int 8,950.28 (Asset)
Cr A/P
Prime Broker 974,575.28 (Liability)
Settlement date
Dr A/P
Prime Broker 974,575.28 (Liability)
Cr Prime
Broker Cash 974,575.28 (Asset)
2.7.2.
Calculating unrealized:
On each
NAV date (May 2007), all securities must be priced. For bonds, the price is
quoted per Par value (face value):
For example a price of $95.078125 is per $100 of the bond
A quantity (or face) of $1,000,000 at a price of $95.078125 gives a
valuation of:
$1,000,000
x 95.078125 / 100 = $950,781.25
Once again, for accounting purposes, bonds have to be treated
‘clean’. This means stripping out the accrued interest from the market value of
the bond. Therefore, at valuation date, we must also do a separate interest
accrual using the method shown earlier in this manual. For your convenience we
have repeated the calculation below.
Unrealized =
Mkt Value – Base Cost (Base Principal)
=
$950,781.25 - 965,625.00
=
(14,843.75) Unrealized loss
Interest Accrual (see above)
=
1,000,000 x 4%/2 x 105/181
=
11,602.21
This figure represent the amount the bond
has accrued since the last payment date.
Out of the 11,602.21, we account 2,651.93 has bond income for the month
of May.
GL
Entries
Dr Unrealized
Bond Long 14,843.75
(Revenue)
Dr Bond
Accrual 2,651.93 (Asset)
Cr Unrealized
Bond Long 14,843.75
(Asset)
Cr Bond
Interest Income 2,651.93 (Revenue)
2.7.3.
Calculating realized:
Ticket
Type
|
Sell
|
Quantity
|
500,000
|
Instrument
|
US
Treasury 4% 2/15/14
|
Trade
Date
|
18-Jun-07
|
Settlement
Date
|
19-Jun-07
|
Execution
Broker
|
Bear
Stearns
|
Settlement
Broker
|
Morgan
Stanley
|
Price
|
USD
96-28
|
Proceeds =
Quantity Sold x Price Sold /Par
=
500,000 x 96.875/100
=
484,375
Accrued Interest
=
500,000 x 4%/2 x 124/181
=
6,850.83
New Cash Flow = Proceeds + Accrued Interest
=
484,375 + 6,850.83
=
491,225.83
Realized =
Proceeds – Base Cost
=
484,375 – 482,812.50
=
1,562.50 Realized Gain
GL
Entries
Dr A/R
Prime Broker 484,375
(asset)
Dr Unrealized
Bond Long 7,421.88 (asset)
Cr Bond
Long Cost 482,812.50
(asset)
Cr Realized
Bond Long 1,562.50 (revenue)
Cr Unrealized
Bond Long 7,421.88 (revenue)
Settle Date
Dr Cash 491,225.83
(asset)
Cr A/R
Prime Broker 484,375
(asset)
Cr Acq
Bond Interest 4,475.14
(asset)
Cr Accrued
Bond Interest 1,325.97
(asset)
Cr Bond
Income 1,049.72 (revenue)
