The underwriter buy bond from issuer & sell to the public
Institutional investor are largest players
After selling, underwriter have nothing to do with the bond – another fiduciary agent handles day to day payment (usually bank as trustee for bonds)
Indenture
Also includes where the money to pay debt comes from
Also some condition to redeem bond in full before maturity date – “call”
Prospectus
Printed before sale, called “preliminary prospectus” / “red herring” / “official statement” (OS)
Who issue the bonds
Treasury / corporate / municipal
Some bond has high liquidity for secondary market, others don’t
Chap-2 Basics
Bond not traded on exchange, but OTC
Independent brokers
Big dealers: banks/pension fund etc.
Primary dealer – buy bond from Fed/Treasury and sell to public
Big size in bond wholesale market
US gov bond min lot $1M, common trade $100M
For individual investor, higher commission
Bid/ask spread – liquidity
Higher Liq lower spread
Dealer vs. Broker
Dealer have inventory, brokers don’t
Dealer put their own money at risk
E-platform
4 dominant: bond desk, municenter, knight bond point, trade web.
Terminology
Par – $1K
Discount vs. Premium
CUSIP – UID (nine digit number, equivalent to ticker)
CINS – international bonds’ CUSIP
Coupon – default – paid semiannually
Say 5.25% coupon means $26.25 interest income every half year.
Maturity – 15 means 2015. Usually maturity < 30 years.
Price: 97, means $970
Accured interest
Bond earns interest every day, when buying bond, sellers have accured interest which means higher actual price for buyer
Call risk – prepayment risk
Good for issuer of bond, bad for buyer
If bond purchased at premium, calling means directly losing money!
If bond rate higher than current interest
Conservatively assume it’ll be called
Evaluate based on yield-to-call instead of yield-to-maturity
Form of bond – certificate / registered / book entry
Basis point – 10bps is big diff for yield
Chap-3 Volatility
Two primary factors for price movement of bond
1. Interest rate risk
2. Credit risk
Interest rate risk / Market risk
Example: you buy treasury when yield=4%, now interest becomes 10%, you will sell at discount such that buyer’s yield is 10%. In this situation: sell at 30 cents on a dollar for treasury.
Ways to protect: shorter maturity bonds (< 7 year)
Maturity length related to interest rate volatility
The reason why shorter term bond are considered cash equivalents is because the price change little w.r.t. interest rate
Rule of thumb: 1% increase in yield make 10% principle loss for 30-year bonds
How interest rate change in 50/100/200bps will change price for different maturity, assuming 7% interest currently
As bond approach maturity, their value approach par.
Price changes will be lower than this if it’s less than 6%.
The degree it’s affected by interest rate is increasing at a decreasing rate. (i.e. for 10-year bond vs. 30-year bond).
Convexity – second order Adj
Decrease interest rate has a bigger magnitude of price increase than the magnitude if interest rate increase.
Buy long term bond to bet interest rate will be lower – capital gain
Held to maturity – sell at par, regardless of interest rate path
不同利率下旧债换新债 – swap – no gain/loss but can generate tax loss!
Credit Risk
Credit rating – risk of default
Default measures both principal & interest
US gov considered zero default risk
How credit rating assessed?
Revenue over debt life vs. cost of debt service
Price change: upgrade price rise
Magnitude of price change from credit rating is less than interest rate (unless company truly likely to default)
Not every downgrade is equal
Below investment grade / drop more than one notch / series of downgrades in close succession is more important
Salvage value of defaulted bonds – can be purchased 10-30 cents on a dollar
Credit quality spreads, narrower when econ is good, wider when econ recession.
Maybe 10-20 bps between diff=1 notch for bonds maturity < 5 years.
2008 GCF – mortgage backed bond market
Credit rating AAA – suddenly collapsed
In municipal bond market – spread between AAA- & A-
Normally 50~70 bps (prior to GFC) suddenly becomes 300bps!!
Short history of interest rates
1950-1982 – principle declined by more than their interest for bond
1970s – coupon 4-6% principle declined 50% or more
Nominal return & real return
TIPS & I-bonds
Fed
Control Fed Fund Rate & Discount rate
Shortest: overnight rates
Fed Fund Rate: Fed’s interest for bank borrow overnight money to satisfy capital requirements
Discount rate: Between banks (similar to fed fund rate)
These directly affect short-term rates & 2-5 year bonds. But longer term may not be affected.
Purchase/sell treasury via Primary dealer to increase/decrease money supply.
Chap 4 – Basic bond math
Three sources of income
Simple interest + Capital Gain + Compound interest
Power of compound interest
7% interest rate w\o compounding 30 year is 2.1x par of interest. With compounding, it’s 6.8x par of interest.
Yield
Coupon yield – denom is par.
Current yield – coupon / purchase price.
Yield to maturity
Include interest-on-interest + capital gain
金融计算器
assume coupon income reinvested at YTM rate
assume hold bond till maturity
reinvestment risk – zero coupon bond no reinvestment risk
Longer maturity bond – less accurate YTM, because reinvestment is bigger portion of bonds’ return
Yield to Call
When multiple call dates
Yield to worst – lowest yield on all call dates
Same calc as YTM
Total return (a posterior)
Actual earning after you redeem/sell the bond
user for “marking to market” calcs
Duration
Gauge sensitivity to interest rate
Considers the timing of cashflows
Weighted average term-to-maturity of cashflow (def of duration)
Duration correlated to maturity length, but adjusted for size/timing of cashflows.
Lower coupon, longer duration.
Except zero-coupon bond, duration always < Time to maturity.
Duration can be used to calculate approximate interest rate volatility.
When interest rate goes up/down 100bps, price go by (approximately) duration of the bond.
Duration can also be calculated for a portfolio of bonds (weighted avg duration of all bonds in portfolio)
Duration works more accurately for smaller change of interest rate.
Convexity – duration的二阶修正
Chap-5 买之前需要知道的
Treasury
基石
Treasury notation
“Minus .01” means (-1/32 * 1%)
“99.29” means 99 + (29/32)
Yield curve
Change continuously thru-out the day
Steep: if long term & short term diff by more than 2%.
Flat: if long term & short term diff by < 1%
Reason behind yield curve
If expect inflation & rate hike – 涌入short term bonds (导致short term yield 下降)
If expect lower econ growth/降息, lock-in longer term bonds for high yields (long term yield下降).
策略 – Riding the yield curve
Buy a longer term bond and sell it in shorter term
Higher yield + price movement because maturity towards par
If interest rate increase, it will backfire (because you take a higher duration bond)
Yield curve – market consensus – predict econ
Additional ret for interest rate risk
2-7年可能比三十年收益率少30-50 bps 但interest rate risk少
Municipal bond往往更upward sloping
Spread table example:
Yield spreads & Benchmarks
Spread def – diff of yield between treasury and other bonds
When Econ bad – spread worsen
Junk bond price decrease & treasury price increase
Benchmark – Bond ETF
Chap 6 – Treasury, Saving bonds & Fed Agency Paper
Fed has either:
1. Treasury Bills / bonds or
2. Zero coupon bonds (zeros)
3. Saving bonds (EE&I)
4. Bonds from Fed Agencies
Treasury
Tolerance for interest rate risk
Flight to quality buying – 股票不好时把钱放进国债
issued periodically by Treasury & Sold thru auctions, most of which to “primary dealers”. In theory you can purchase treasury directly for $5-10MM
No state/local tax
T-bill 一年之内 – no coupon, discounted from par instead
Very short-term so interest rate risk can be ignored
T-notes (2-10 years)
Typically 50-150bps higher than T-bills
T-bonds (10-30 years)
Significant interest rate risk
TIPS (treasury inflation indexed securities)
Face value adjusted by CPI-U
Interest rate never changed but face value does
Interest rate is fixed per auction
High volatility – lower coupon – higher duration
Inflation Expectation Changes
Higher interest rate risk
Big drawback – taxed annually for phantom income
i.e. the capital gain from TIPS because of inflation
Comparing TIPS vs. T-bond etc.
Breakeven inflation rate
Zero coupon bonds (a.k.a. “strips”)
Tax: need to pay imputed interest (phantom interest) every year
Used to speculate
Municipal zero might be more tax-friendly
Warren Buffet buy 30-year zero for speculation
Series EE & Series I
Deferred tax on all interest until redeemed
Education Tax Exclusion
Series EE: accural bonds, no interest until redeem
Series I: 收益公式较复杂
Federal Agency
Credit quality slightly worse than treasury
usually 50-150 bps
Example: Fannie Mae, Ginnie Mae, Freddie Mac
Under conservatorship of Gov.
FHLBs/TVA
Tennesse Valley – 美国power system (国企)
CDs
Insured CDs – sold by some brokerage
Offers Buyback (floating principal) options for early liquidation
