After this session you should be able to understand the various features of a bond and know what the relevant market conventions are for the trading and settlement of bonds and money market securities.
There are five main features of a bond that will be examined in this session:
- issuer
- maturity
- coupon
- face value
- call options
Conventions for trading and settlement will also be discussed.
Issuer
The issuer is the government body, corporation or special purpose vehicle that is actually raising debt and therefore borrowing money by issuing the bond. It is this entity that is making the promise to repay the debt (in some cases the repayment may be guaranteed by another entity).
It is important to understand exactly which entity (legal vehicle) is issuing the bond (and the nature of the guarantee, if any) because ultimately it is they who are promising to repay the bond at maturity and make the regular interest payments associated with the particular issue.
Sometimes there may be a parent company involved in the structure. If that is the case, it is important to understand the nature of the relationship between the issuer and the parent company. It is also essential to understand whether or not there is a guarantee in place from the parent company. If there is no guarantee the investor needs to make an assessment of the willingness of the parent to support its subsidiary that has issued the bond.
Maturity
The maturity is the date on which the issuer promises to repay the face value of the bond and to make the final interest payment. One of the defining features of bonds is that they generally mature on a specific date.
Other fixed income securities, for example perpetual income securities, do not have fixed maturity dates. These securities are discussed in Session 10.
Face value
The face value of a bond represents the principal amount that needs to be repaid by the issuer on the maturity date. Bonds are usually priced assuming a face value of $100. If the bond is pre-payable, then the face value, less pre-payments, will be the amount paid to the investor.
Coupon
Coupons are the periodical interest payments that an investor receives on a bond. The term coupon is derived from the old bearer certificates where, when an investor purchased a bond they actually received a certificate with the coupons attached to the bottom of them. Each time an interest payment was due the investor literally tore off a coupon and physically presented it to receive their interest.
The coupon rate may or may not represent the actual return the investor receives from the bond and this is determined by the purchase price of the bond. The purchase price of a bond can be at par ($100), at a discount to face value (less than $100), or at a premium to face value (more than $100). So, depending on the purchase price of the bond, the actual return to the investor may be higher or lower than the coupon rate. This measure of return is known as yield to maturity.
Floating rate notes and index linked bonds generally pay quarterly coupons whereas fixed rate bonds generally pay a semi-annual coupon. In the case of a semi-annual coupon, the rate is divided by two. There is no adjustment for the number of actual days in the coupon period. So if the coupon is 7% paid on a semi-annual basis, the holder receives $3.50 per $100 of face value every six months.
Call options
Call options allow the issuer to repay the bond prior to the stated maturity date of the bond. Call options normally allow the issuer to repay those bonds at par, which means the issuer will pay the holder back $100 (plus any interest accrued up to or including the call date). A call is usually made on a coupon payment date so investors will get their interest payment in addition to the face value of $100 back.
This feature is called an option because the issuer has the right but not the obligation to repay the debt early. In this instance, the issuer has a call option over their issue. It is important to remember that generally speaking, when it suits the issuer to call a bond, it is not going to suit the investor to have that bond called.
The most standard form of call option would allow an issuer to call a bond if interest rates have fallen so they can refinance at lower rates. In this circumstance, the investor would have seen the capital value of their bond appreciate because they have locked in a higher rate. However, once the issuer calls the bond, the holder loses this ‘locked in’ rate.
Investors should be careful to note the full details of the call option since these details will impact the pricing of the security. Furthermore, if the bond does involve an option to the issuer or another party, it is essential that the yield on the bond reflects an adequate degree of compensation.
Money market conventions for trading and settlement of bonds
1. Bid and offer prices
In the fixed income market, as with other markets, an investor can trade securities by using bid and offer prices. It is important to remember that these prices are made from the perspective of the person making the price, not generally the average investor.
If a dealer makes an investor a bid and an offer for a particular security, these are the prices at which the dealer is prepared to buy or sell. A market has been made for the investor and they must look at the situation from the opposite side. If they wish to sell a security they have to deal at the bid price and if they want to buy they have to deal at the offer price.
The spread (difference between the bid price and offer price) is how the supplier of the price or the provider of the liquidity makes money from the transaction.
Figure 3.1 shows the fluctuations in the bid and offer yields for ten year Commonwealth Government securities over a one month period. These are very liquid instruments as demonstrated by the narrow bid/offer spread. Securities issued by corporations may be less liquid and have wider bid/offer spreads, so that the bid/offer spread is really a function of the liquidity available for that individual security.
2. Ex-interest period and settlement days
The normal ex-interest period for Australian bonds is seven days prior to a coupon date and this is set by the issuer, not the broker. If a bond is purchased in the ex-interest period, the holder does not receive the next coupon as the previous holder receives the coupon instead. Not all bonds have a seven day ex-interest period, but seven days is the market standard.
The normal settlement period for bonds and index linked bonds (ILBs) is three days or trade date plus three days (T+3). These settlement day rules are simply market convention and any investor is able to negotiate with their broker, or whoever is providing the fixed income securities, to settle any day that suits them.
Discount securities settle on the day they are traded.
3. Rounding
The actual pricing of bonds will be explored in Session 4 but for now it is important to understand how the prices are rounded.
The discount formula requires no rounding and prices are calculated to the nearest cent for discount instruments. For bonds and floating rate notes, the gross price is rounded to three decimal places per $100 at face value.
4. Price definitions
The RBA formula, which is discussed in Session 4, calculates the total price of a bond based on the present value of all the future cash flows of the bond. The total price includes the capital price and the accrued interest. The accrued interest may be negative if the bond is in its ex-interest period.
The accrued interest is seen as that portion of the next interest payment that belongs to the seller of the bond for holding the bond over the period from the previous coupon date to the settlement date.
Another term for the capital price is the ‘clean price’, while the ‘dirty price’ or the ‘gross price’ refers to the total price comprising the capital price plus accrued interest. The gross price is the value that is calculated by the Reserve Bank bond pricing formula.
5. Premiums and discounts
Where a bond’s yield is greater than its coupon rate it is said to trade at a discount. This means that the clean price is less than $100. Those bonds with yields less than their coupons are said to trade at a premium, i.e. when the clean price is trading at greater than $100. Where the clean price is equal to $100, the bond is said to be at par and this occurs when the yield and the coupon rate on the bond are identical which is often the case on a new issue. Figure 3.2 below shows a graphical representation of the inverse relationship between price and yield, which is covered in detail in Session 4.
6. Final period pricing
When a bond enters its final coupon period, (i.e. once its second-last coupon payment has been made) it no longer prices off the standard bond formula. The pricing formula switches over to the discount formula where the face value is added to the last coupon payment to get the face value for input into the discount formula. Thus it is priced the same as a bank bill or other discount securities.
Conclusion
You should now have an understanding of the various features of a bond and know what to look for in a bond issue. You should have an appreciation of the market conventions for the trading and settlement of bonds and money market instruments. You should be aware of the five important features of a bond: issuer, maturity, coupon, face value and call options.
Review questions
1. Would the new holder of a bond receive the next coupon if the bond was purchased in the ex-interest period?
- Yes
- No
2. When a bond's yield is less than its coupon rate it is said to be trading at a
- Discount
- Premium
- Par
3. What is yield to maturity?
- The known coupon return set out on purchase of a bond
- The return you can expect if you sell a bond prior to maturity
- The return an investor will receive if they buy a bond and hold it until maturity
- It is useful for direct comparison between different types of securities with various maturities and credit risks.