Bond Analysis and Management

A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bond Analysis is used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debt-holders, or creditors, of the issuer.

On this page, we will talk about the basic fundamentals of bonds. Then, we get into the analysis and valuation of these ‘Rodney Dangerfield’ of assets. Finally we discuss how to manage them in portfolios.

Basic Fundamentals

The bond market is large and diverse, larger than the stock market. Thus, it represents an important investment opportunity.

In this section, we present some of their features and types. Then, talk markets around the world. Finally, we get into the entities who issue the.

Bond Features

Public bonds are long-term, fixed payout debt assets. They are packaged in useful, easy to manage sizes for sale to you and big firms.

The issuer agrees to pay a fixed amount of cash over time to the holder of record. Also, they agree to pay a fixed amount of par at the date of when they end.

Public Debt Segments Based on Term
  • Short-term issues with terms of one year or less known as near cash or money market
  • Intermediate-term issues have terms from one to ten years known as notes
  • Long-term issues with terms over a year are bonds
Intrinsic Features

The coupon of a bond states the income a bond investor receives over the life of the bond. Also, the term to maturity gives the date or the number of years before a bond ends.

Most bonds are term bond with a single end date. However, a serial bond has multiple end dates. They are small issues with different coupons and end dates.

The principal or par value of an issue is the original value of the debt. However, par value is not the same as the bond’s value.

Issue Types

Unlike common stock, bonds can have many issues outstanding at the time. In addition, they have different types of collateral and be either senior, unsecured or subordinated. Muni are divided into general obligation or revenue bonds. Also, refunding issues provide funds to end another issue early.

The type of issue only has a little effect on yields.The credit worthiness signals bond quality. Whether an issuer pledged collateral or not is not key unless the issue gets near default.

Factors Affecting Maturity

Call options affect the life and value of bonds. Callable bonds have a call premium which is the amount above par value the issuer must pay the holders for ending the bond early.

Call options
  • Freely callable allows issuer to recall the bond at any time with a common grace time frame of 30 to 60 days
  • Non-callable means issuer cannot retire the bond prior to maturity
  • Deferred call means the issue cannot be called for a certain time after issue. Then, they are called freely

A non-refunding feature stops a call and early recall of an issue from the proceeds of a lower-coupon refunding bond. A sinking fund feature says a bond must be paid off over its life.

Market Structure

The market for fixed-income debt is much larger than the listed stock market because firms tend to issue more bonds than common stock.

Many single buyers and big firms with diverse goals trade in the bond market. Big firms account for 90 to 95 percent of trading although the mix varies among the segments.

Bond ratings are a major part of the bond market because most corp and muni bonds are rated by one or more of the rating firms .Bond ratings provide the basic review for thousands of issues.

The main question is whether the issuer can service its debt in a timely manner over the life of a given issue. The rating firms have done a decent job except in the last cycle. They have a habit of overestimating the rate of default.

Issuers

Global Bond Markets

The US fixed income market is loaded with US Treasury debt.The US government issues their bonds backed by the full faith and credit of the US government. The interest income is subject to fed income tax but exempt from state and local taxes. These bonds are popular because of their high credit rating, highly liquid trait and non-call feature.

The second largest bond market in the world is Japan. It is controlled by the Japanese government and the Bank of Japan. These bonds are an attractive asset because their rating is equal to the US.

The third largest bond market in the world is the German market, although the government segment is somewhat small. The German market is led by banks because firms mainly finance through bank loans.

Government Agency Issues

The federal government in each country can issue agencies which can issue their own bonds.They are a large and growing segment in the US, a much smaller segment in Japan and Germany and don’t exist in the UK.

They are not direct Treasury but carry an implied full faith and credit backing of the federal government. The most popular in the US is GNMA, issued by Dept of Housing and Human Services.

Muni Issues

Muni bonds are issued by states, counties, cities, and other political subdivisions. Interestingly, they represent about 10% of the bond market in most countries and do not exist in the UK.

GO bonds are mainly backed by the full faith and credit of the issuer and its entire taxing power. Also, revenue bonds are serviced by the income thrown off from single revenue-producing projects of the muni.

The key feature of munis is the income is exempt from fed income tax as well as from local and state taxes.

Corporate Bonds
  • Mortgage Bonds– has lien on real estate
  • Equipment Trust Certificates– issued by railroads and airlines to buy rolling stock and planes
  • Collateralized Trust Bonds– secured by financial assets
  • Collateralized Mortgage Obligations (CMOs)– backed by pools of home loans
  • Asset-Backed Securities (ABS) secured by cars or credit cards
  • High-Yield Bonds- junk bonds of less than stellar credit firms

Bond Analysis and Valuation

The value of bonds can be described in terms of dollar values or the rates of return they promise under a set of factors. The value of the bond equals the present value of expected cash flows. The cash flows from the bond are the periodic interest payments and the repayment of par. However, the only factor which affects its value is the market discount rate- its required rate of return.

Relationship of Market Yield and Price
  • The bond is priced at premium if the yield is below coupon rate
  • The bond is priced at discount if the yield is above the coupon rate
  • Also, a link between yield and price is convex- as yields decline the price goes up at an increasing rate, same in declining case

In this section, we start by talking about the various bond yield measures. Then we talk about theories of bond prices. Finally, we get into the reasons and measure of volatility.

Bond Yields

Bond Yield Measures
  • Nominal yield- coupon rate
  • Current yield- current income rate
  • Yield to maturity– expected rate of return held to end
  • Yield to call- expected return for bond held to first call date
  • Realized yield- expected rate for likely bond sold before end considering reinvestment rates

Future Bond Prices

Dollar bond prices are worked up when dealing with realized yield and when issues are quoted on a promised yield basis, such as munis. Therefore the right market price is based on the current market YTM.

Term Structure Theories
  • Expectations Hypothesis– shape of yield curve results for the interest expectations of market traders
  • Liquidity Preference– long-term assets should provide a higher return than short-term ones because you are willing to give up some yield to invest in short-term to avoid long-term ups and downs
  • Segmented Market – big firms have different maturity needs which leaves them to confine their bond picks to certain market segments

You can look at yield expectations by simply observing the shape of the yield curve. Thus, if the curve is declining sharply, it suggests rates will be decline.

Yield Spread Differences
  • Segments, i.e. Treasuries vs corps
  • Sectors of same segments, i.e. industrials vs. utilities
  • Coupons or seasonings
  • End dates within a given segment or sector

The strength of the direction of a spread can change over time.

Bond Volatility

There is an inverse link between changes in yields and the price of bonds. Importantly, interest rate sensitivity is one factor which affects the amount of price change for a yield change.

Bond Market Price Factors
  • Par value
  • Coupon
  • Number of years to end
  • Current market rates
Link between Yield and Price Change
  • Prices move inversely to yields
  • For a given change in yield, longer-term bonds post larger price changes
  • Price volatility increases at a smaller rate as term  increases
  • Price movements from equal absolute increases in yield are not square
  • Also, higher coupon issues lose smaller percent price changes

Interest rate changes trigger different strategies. Thus, bond prices increase during a major decline in rates. Therefore, you want you bonds to have the max rate sensitivity.

The most common measure of rate sensitivity is its duration. As such, it is a composite measure of the timing of a bond’s cash flows traits taking into account its coupon and term to maturity.

Duration Types
  • Macaulay– oldest measure, the time flow of cash from a bond
  • Modified- makes small change to Macaulay
  • Effective– direct measure where price changes are figured with a value model
  • Empirical– measures the real price changes for real changes in rates

Bond Management

Prior to 1960, bonds were managed by simply buying and holding bonds in a group. At the time, purchases were made based on rate guesses and value models.

The early 1970s were hit by record-breaking inflation and rates. The intro of new finance types were in response to increased return risk. As a result, techniques such as matching funds or contingent portfolio were offered to meet the changing needs of big clients.

In this section, we describe passive ways to manage bonds. Then, we talk about a more active approach where we wring out more return and control risk.There are matching Funds techniques and contingent procedures. Finally, we talk about theoretical implications.

Passive Strategies

The simplest strategy is to buy and hold. Thus, these clients do not use active trading to get better returns. Also, a modified version starts with the purchase but still actively looks for ways to trade for stronger holdings.

Some traders opted to build their holdings to match the track record of a major bond index.Therefore, the manager is judged not on risk and return factors but how close the portfolio tracks the index.

Active Strategies

  • Interest Rate Anticipation– probably the riskiest strategy involves relying on unclear forecasts of future rates
  • Valuation Analysis– manager attempts to select bonds based on their intrinsic value
  • Credit Analysis– involves detailed analysis of the bond issuer to determine expected changes in its default risk
  • Yield Spread Analysis– looks for abnormal spreads within a normal sector spreads and makes swap
  • Bond Swaps– involves liquidating a current position and simultaneously buying a different issue in ts place with similar attributes

Matched Funds Techniques

  • Dedicated Portfolio, exact match- used to service a prescribed set of liabilities by lining up maturities to liabilities
  • Dedicated Portfolio, optimal cash match and reinvestment– matches liability cash flows with interest payments and maturities
  • Immunization Strategies– attempts to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates
  • Horizon Matching- is a combination of cash-matching dedications and immunization

Contingent Procedures

  • Contingent Immunization- allows managers to pursue the highest returns available through active strategies while relying on classical bond immunization to ensures a given floor return over the time horizon
  • Other Immunization Procedures– includes requires an investor to accept a cushion spread and then engaging in various portfolio strategies to increase the ending-wealth value

Theoretical Implications

The performance of bonds offers total diversification benefits. In an efficient market, neither stocks nor bonds should dominate a portfolio but some combo should provide a superior risk-adjusted return.

Bond returns are linked directly to risk of default and interest rate risk. Although interest rate risk for investment-quality bond is non-diversifiable, some evidence exists default risk is also largely non-diversifiable because default experience is closely related to the business cycle.

On this page, we talked about the basic fundamentals of bonds. Then, we got into the analysis and valuation of these ‘Rodney Dangerfield’ of assets. Finally we discussed how to manage them in portfolios.

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