Friday, 20 January 2012

Bond Analysis

Bond Definition:
A bond is a corporate or government debt instrument. It represents a loan to the company (in the case of a corporate bond) from the investing public. In this case, the company is the borrower and the investor is the lender. Companies issue bonds to raise money for business investments.

A bond has a
par value, a maturity date, and a coupon rate. The maturity date is the date the company must repay the investor an amount equal to the par value. The par value is the amount the lender will receive at the maturity date. The coupon rate is the interest rate on the bond. A coupon is typically semi-annually. So if the bond has a coupon rate of 8%, the investor will receive two payments per year, each equal to 4% of the bond’s par value.

Rating agencies rate the creditworthiness of bonds. High quality bonds are considered investment grade. Low quality bonds are considered noninvestment grade, or junk bonds.

Par Value of Bonds:
The par value of a bond refers to the principal – the amount of money the bondholder receives when the bond matures. Par value is also called face value or nominal value. It is the amount stipulated in the bond contract. Par value does not include interest payments. Bond interest rates are quoted as a percentage of the par value of the bond. While bond prices can fluctuate, the bond always matures at par value. However, if the bond issuer defaults, the bondholder may only receive a portion of the par value or nothing at all.

A bond priced above par value is selling at a premium and a bond priced below par value is selling at a discount.

Par values for corporate bonds, municipal bonds, and federal government bonds are usually $1,000, $5,000, and $10,000, respectively.

Bond Face Value:
The face value of a bond is the same as the par value of a bond. It is the principal amount.

Nominal Value, Bond:
The nominal value of a bond is the same as the par value of a bond. It is the principal amount.

 Bond Coupon:
A bond coupon refers to the interest payments the bond issuer pays to the bondholder periodically until the bond matures. Bond coupon rates are quoted as annual rates, but the coupons are typically paid semi-annually. The term “coupon” stems from the days when bondholders would actually tear detachable coupons from the bond certificate and turn them in to the bond issuer on certain dates to redeem the interest payments.

The coupon rate of a bond is the annual interest rate the issuer pays to the bondholder. The rate is expressed as a percentage of the bond’s face value. Bond coupon rates are quoted as annual rates, but the bond coupons are typically paid semi-annually.

For example, an investor holding a bond with a $1,000 face value and a 10% annual bond coupon will receive $100 in interest yearly until the bond matures. At maturity the investor will receive the principal, also called the face value or the par value, plus the final coupon payment. Similarly, an investor holding a bond with a $1,000 face value and a 10% semi-annual coupon will receive $50 in interest every six months until maturity. 

Maturity Date:
In finance, a maturity date is the date on which a debt instrument is due. For example, when a bond reaches maturity, the issuer must pay the bondholder the principle and the final interest payment. A debt instrument’s maturity is one of the factors that determine the price and yield of the instrument. Because of the time value of money and the increased risk of volatility, debt instruments with longer maturities often have higher yields. 

Covenant Definition (Restrictive Covenant):
A covenant is a restrictive clause in a bond contract. The purpose of the clause is to protect the lender (the party that invests in the bond) by imposing restrictions on the borrower (the party that issues the bond). Essentially, the covenant amounts to the lender agreeing to lend money to the borrower as long as certain financial performance criteria are met and maintained throughout the duration of the loan contract. Covenants may cover criteria such as levels of working capital, debt-equity ratios, dividend payments, and other factors that can affect the borrower’s ability to repay loans. 

Zero-Coupon Bonds:

A zero coupon bond is a debt security that does not have periodic interest payments. The bond is issued at a deep discount from par value, to compensate for the lack of interest payments, and then redeemed at par value at maturity.

Stripped Bond:
Strip bonds are synthetic zero-coupon bonds created by banks or dealers. The principal amount (the corpus) is separated from the interest payments (the coupon payments) and the two parts are sold separately to investors. This creates zero-coupon bonds. The investors then receive a lump sum at the maturity date, equal to the value of corpus or the coupon payments, depending on their contract. The contracts are known as
STRIPS (Separate Trading of Registered Interest and Principal of Securities).

Imputed Interest:
According to the IRS, the holder of a zero-coupon bond owes income tax on the bond’s imputed interest. Imputed interest refers to the implied periodic interest payments that the bondholder does not actually receive until maturity. Imputed interest on zero-coupon bonds issued by municipalities is tax exempt.

High Yield Debt (Junk Bonds) :A non-investment grade bond, also called a speculative bond, a high yield bond, an unsecured debenture, or a junk bond, is a bond that is considered a low quality investment because the issuer may default. Rating agencies have systems for rating bonds as investment grade or non-investment grade. Non-investment grade bonds offer higher yields than investment grade bonds to compensate for the greater risk.

High Yield Bond Ratings :

Credit rating agencies rate bonds based on the creditworthiness of the issuer. A bond is given a grade, and the grades are ranked like this: AAA, AA, A, BBB, BB, B, CCC, CC, C, and at the bottom is D.

The highest quality corporate bonds will have a rating of AAA. (US government bonds are considered risk-free and are ranked above AAA.) The lowest quality bonds are rated D, or already in default. Anything rated BBB or above is investment grade. Anything rated BB or below is non-investment grade. Different rating agencies may use different variations of the above rating system. For example, an agency may include plus (AA+) and minus (BBB-) signs to add levels to the rating system.

Junk Bond Yields:
Junk bonds return higher yields than high-quality bonds. The higher yield compensates the investor for the greater risk associated with the lower quality investment.

Junk Bond Index:
A junk bond index tracks the performance of non-investment grade bonds.

Junk Bond Trader:
A junk bond trader is an individual who trades non-investment grade bonds in the marketplace.

Junk Bond Fund:
A junk bond fund is a mutual fund or an exchange-traded-fund (ETF) comprised of non-investment grade bonds. Junk bond funds are convenient financial instruments for investing in high yield bonds.

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