B A C K

T O

B A S I C S
By Herman Phua Octant Consulting

BONDS ADDING IT ALL UP

In our last Back To Basics column, we discussed some of the basic concepts behind bond investment and how buying these fixed income instruments can help investors bring a measure of predictability to their investment portfolios. This month, we will consider the relationships between interest rates, maturity and credit quality on a bonds market price.
Firstly, it is important to note that bonds do not have to be held to maturity. Being publicly traded instruments, bonds can be bought and sold in the open market at prices that change daily. In addition, a bonds price is different from its par or face value. As mentioned previously, face value is the principal a bond holder receives on maturity date and remains constant throughout the bonds life. A bonds price, on the other hand, is determined by the market and fluctuates in response to a whole range of variables such as interest rates, credit quality and its remaining lifespan. At any point of time, a bonds market price could be above or below its face value. For example, a bond could have a price of $990 although its face value is $1,000. Such bonds are said to be selling at a discount. Conversely, bonds that have a price above face value are said to be selling at a premium. Generally, newly issued bonds sell at or close to face value. Determining yield Assessing the yield of a bond is different from a stock. For stocks, it is common to use the current yield, which is to divide the dividend (or coupon rate for bonds) by the purchase price. However, that is not enough as current yield only provides the annual return on the amount paid for the bond and does not represent its real value to your portfolio. A more meaningful measure is to use yield-tomaturity (YTM) which is based on the coupon rate, time to maturity, and market price. YTM gives the total return of the bond until maturity by adding up all the interest received from the point of purchase to maturity, plus the gain or loss made from buying the bond at a discount or premium to its face value. As YTM assumes that interest payments will be reinvested at the same rate as the current yield on the bond, doing an exact calculation is a rather complicated and tedious exercise. Fortunately, the following formula can be used to give a simple approximation.

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I Pb n Face value

= = = =

Coupon rate (in dollars) Bond price Years to maturity 1000

I ytm =

1000 - Pb n 1000 - Pb 2

The link between yield and maturity can be depicted through a yield curve. This is the line that joins the yields available on similar securities with different maturity dates, from shortest to longest. The yield curve is most commonly drawn for US Treasury bonds and is a useful tool for predicting interest rate movements. Bonds have risk too Speaking of risk, it was mentioned in the previous column that bonds are issued by either companies or governments. This is important as the assurance that the coupon and face value of a bond will be paid depends on the financial stability or creditworthiness of the issuer. For instance, little risk is associated with governments of economically developed countries, which is why bonds issued by the US or UK governments are usually referred to as risk-free assets. On the other hand, companies must be able to generate profits to service payment of the bonds they issue. To compensate for higher risk, corporate bonds must pay higher yields to attract investors. To be sure, companies too have different levels of credit-worthiness, which is assessed by credit rating agencies such as Moodys, Standard and Poors and Fitch Ratings (see table 1). Bonds with better ratings are assessed to have lower default risk. While blue chips generally have higher ratings, there have been cases when some of these companies run into financial problems. That led to their bonds being downgraded to junk status, causing a decline in the bond price. The lesson here is that not all bonds are safer than stocks. Some might even be riskier. In the next Back To Basics column, we will look further into the concepts of the yield curve and duration to how they help in the bond investment decision. We will also discuss the various options and strategies available to the bond investor.

As it gives total return, YTM allows a fairer comparison between bonds that have differing maturities and coupons. The interest rate link Just like the stock market, interest rates have a significant impact on the bond market. However, unlike stocks, bonds are purchased primarily for interest income, which means movements in market interest rates are a key determinant of bond prices, more so than any other single factor. The price of a bond is inversely related to interest rates. When interest rates rise, bond prices fall to keep in line with the new level of interest rates. To attract investors, bonds that are newly issued, have to offer higher coupon rates compared to older bonds that were issued when interest rates were lower. This will decrease the value of the older bonds and cause their market prices to ease. When interest rates decline, the reverse happens and prices of existing bonds will rise. However interest rate changes do not affect all bonds equally. This is because price is also affected by a bonds remaining lifespan. Bonds with closer maturity dates are relatively more predictable due to better visibility of interest rates over the shortterm. As such, they experience less price fluctuation than long-term bonds, which have to compensate investors with a higher coupon rate for assuming the higher risk of their longer lifespans. Table 1 : Bond Ratings
Bond Rating Moodys Aaa Aa A Baa Ba, B Caa/Ca/C C S&P/ Fitch AAA AA A BBB BB, B CCC/CC/C D

Grade Investment Investment Investment Investment Junk Junk Junk

Risk Highest Quality High Quality Strong Medium Grade Speculative Highly Speculative In Default

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