The Fixed Income team deals with bonds issued by governments or corporations. This department is usually split into two teams: the Credit team, which focuses on corporations’ bonds; and the Rates team, which focuses on government bonds. Bonds are generally traded over the counter (OTC).
- Over The Counter (OTC): the trading of securities through private dealer networks rather than on a public central exchange (such as the London Stock Exchange).
As mentioned in the General Commercial Knowledge: Methods Of Financing section, bonds are issued with a defined coupon rate (the interest that the bond issuer will pay to the purchasers of the bonds), which is often paid either annually, semi-annually or quarterly. The amount repaid once a bond matures is known as the principal amount (the stated price of the bond at the outset, though it is worthy to note bonds may be purchased at a discount or premium to the stated principle amount).
- Maturity: the time at which an issuer will pay the principal amount to bondholders. After this date, bondholders are no longer entitled to coupon payments from the issuer.
The price of a bond is calculated by summing the present value of all the future cash flows (coupon payments and the principal amount). Firstly, the estimated present value of each yearly coupon payment must be calculated:
As X increases, so does the number by which the coupon payment is divided, which in turn reduces the present value. As such, the further into the future that each cash flow is due to be received, the lower its calculated present value. This continuous reduction in value serves to represent the fact that the set coupon payment may be worth less in the future, partially due to the predicted effect of inflation and the fact that the money paid for the bond could potentially have been invested elsewhere had the bond not been purchased.
To calculate the price of a bond, the present values of each separate cash flow must be calculated then added together. The principal amount (due to be repaid when the bond matures) must then be similarly discounted and added to the calculation. The below example illustrates the price calculation for a bond that matures after 10 years (the ‘…’ signifies that the present values for years 3-9 would also have to be calculated and added together). It is worthy to note that when you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond.
- Yield: in relation to bonds, this refers to the coupon (interest) payments bondholders receive (typically annually) expressed as a percentage of the price at which the bond is currently trading. Therefore, whilst the coupon rate is generally fixed, the yield % will change in line with fluctuations in the price at which the bond is trading. If the bond price increases, the fixed coupon rate will form a lower percentage of the (newly increased) price at which the bond is trading. As such, it can be stated that the yield of a bond moves inversely with price.
- Yield To Maturity: the anticipated return that the bondholder will receive by the time the bond matures (if they do not sell it before it reaches maturity). It is calculated based on its current price, coupon payments, face value and maturity date.
All bonds have credit ratings. The highest ratings denote the lowest perceived risk and are usually awarded to sovereign debt, whilst lower ratings are usually given to more speculative investments. All else being equal, usually the lower the rating, the higher the yield (interest payments), as this compensates investors for the higher risk of issuers defaulting (in which case, investors will not recoup their initial investment).
- Yield Curve: shows the relationship between interest rates and maturities by mapping out the interest rates bonds are paying across different maturities. The curve typically shows that the longer the time period before which the principal amount must be repaid (i.e. the further into the future the date of maturity is set), the higher the yield demanded by investors. This is because investors will likely require additional financial returns to compensate for the fact that they must wait a longer period before receiving the principal amount.
- Callable Bonds: this is a type of bond that has been issued on terms that entitle the issuer, under certain circumstances, to recall the bonds early through paying off all the debt in one early instalment.
- Puttable Bonds: this is a type of bond that has been issued on terms that entitle the bondholder (purchaser of the bond) to force the issuer to buy back the bond at the bondholder’s discretion.
- Perpetual Bond: these pay interest indefinitely, but never mature. Issuers will not have to pay the principal amount to investors after a set time period. Instead, the bondholders expect to make a profit over time as the capital received through interest payments accumulates.
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By Jake Schogger -City Career Series