Structure of the book
The first seven chapters of this book provide an introduction to the bond markets, followed by four chapters describing the different money markets. Only when you have a firm grasp of the nature of these instruments do we look at the mathematical structures required for bond and money valuations.
Thus maths is reserved for Chapters 12 to 14.Then, in Chapters 15 and 16, we examine some of the more unusual securities that have evolved from the markets, such as bonds where the interest paid to investors depends on monthly mortgage payments from thousands of home owners, or the trading of agreements to notionally deposit money and notionally receive interest at a future date.
Finally, we consider the importance of central banks to the workings of these markets and how the authorities try to control inflation through altering interest rates in the money and bond markets.
Bonds
The concept of governments, companies and other institutions borrowing funds to invest in long-term projects and operations is a straightforward one, yet in today's sophisticated capital markets, with their wide variety of financial instruments and forms of debt, the borrowing and lending decision can be bewildering. Is the domestic bond market or the Eurobond market the better choice? On what terms, fixed- or floating-rate interest, with collateral or unsecured? And what about high-yield bonds or convertibles? The variety of methods of providing long-term finance is almost infinite.
A bond is a long-term contract in which the bond holder lends money to the bond issuer.[1] Basically, bonds may be regarded as merely IOUs with pages of legal clauses expressing the promises made. In return for the loan of money, the issuer promises to make predetermined payments in the future which consist of an interest component, known as the coupon (usually regularly, once or twice a year), and the payment of a capital sum, the face value (par value or nominal value) of the bond, at the end of the bond's life.
Straightforward bonds like this are known as plain vanilla bonds (or conventional bonds), but bonds come in a variety of types. Some do not promise a capital repayment, they just keep paying the coupon in perpetuity. Others do not offer a regular coupon, just a lump sum at the end of a period of time; these are known as zero coupon bonds. Some bonds have features such as floating rates of interest, ‘bullet' or ‘balloon' payments (all explained later).Primary and secondary markets
Bond issuers obtain funding by issuing new bonds on the primary market, where the sale is usually handled by one or a syndicate of dealers and/or brokers, who earn commission by selling the issue to investors. After this initial sale, the bonds may be traded on the secondary market between investors, either through stock exchanges for listed bonds or, more likely, over the counter. Over the counter (OTC) trading is trading carried out between two parties directly (dealer-to-dealer or dealer-to-investor) as opposed to exchange trading which is carried out on a highly regulated public market. Bonds may change hands several times before their maturity.
The secondary markets are sometimes very liquid; that is, those organisations lending their surpluses to borrowers by buying bonds are able to get at their capital (turn it into cash) by selling quickly to other investors without the risk of reducing the price significantly, and the transaction costs of releasing the cash are low. But most corporate bonds have pretty poor liquidity, with most primary market investors buying them and then holding until maturity, resulting in very few secondary market trades.
Shorts, mediums and longs
Bonds with up to five years left until they mature and pay their principal (the amount that the issuer agreed to pay the owner at the maturity date) are generally known as shorts, but the boundary lines are often blurry; medium-dated (intermediate) bonds generally have remaining maturities of between 5 and 12 or 15 years; longs are bonds with remaining maturities of over 12 years.
An alternative classification is ultra-shorts, up to 3 years; shorts, 3-7 years; mediums, 7-15 years; and longs, over 15 years. The time to maturity for bonds when they are first issued is generally between 5 and 30 years, but it should be noted that a bond is classified during its life according to the time remaining to maturity, not the maturity when it was issued, so a 30-year bond which has only 4 years left until it matures, is a short.A number of firms have issued bonds with a longer than usual maturity date - IBM and Reliance of India have issued 100-year bonds, as have Coca-Cola and Walt Disney (Disney's was known as the ‘Sleeping Beauty bond'). There are even some 1,000-year bonds in existence - Canadian Pacific Corporation is paying a dividend of 4% on a 1,000-year bond issued in 1883 by the Toronto Grey and Bruce Railway and due to be repaid in 2883.
Bonds, equity, bank loans and overdrafts compared
Both bonds and equities (shares in companies) are generally negotiable securities, i.e. they can be traded on financial markets. The advantage a bond possesses over a share is that the investor is promised a return. Bond investors are exposed to less risk than share investors because the promise is backed up by a series of legal rights, e.g. the right to receive the annual interest before the equity (share) holders receive any dividend. So in a bad year (e.g. no profits) bond investors are far more likely to receive a payout than shareholders. This is usually bolstered by rights to seize company assets if the company reneges on its commitment to pay coupons or redeem bonds at maturity. If things go very badly for the firm, there is a greater chance of saving the investors' investments if they are holding its bonds rather than its shares, because on liquidation the holders of debt-type financial securities are paid from the proceeds raised by selling off the assets first, before shareholders receive anything.
Offsetting these plus points are the facts that bond holders do not (usually) share in the increase in value created by an extraordinarily successful business, and there is an absence of any voting control over the management of the company. For a company, bonds offer the advantage of long-term borrowing, often with a constant interest rate for, say, 15 years; the original lenders cannot withdraw the capital they lent from the company or increase the interest rate (this is the most common case, but, given the potential for innovation here, there are bonds that allow these things).
An overdraft may have a variable interest rate and can be withdrawn at short notice, leaving the company in need of finance. It also has to be renewed, maybe every six months, and there is a real danger that the lender will refuse to ‘roll over' (continue) the debt at a future renewal date, or may demand a much higher interest rate to continue the lending.Term loans from banks are often more difficult to obtain in the size required by larger companies, and they frequently cost more over the lifetime of the loan. Of course, bank overdrafts and loans have the advantage that they are available even to the smallest firms, whereas the bond market is generally open for large firms only.
Fixed-interest securities
Bonds are often referred to collectively as fixed-interest securities. Most bonds are indeed fixed rate, offering regular coupon amounts agreed at the outset, but some are variable, with the interest rising or falling every few months depending on a benchmark interest rate (e.g. Libor, the London Interbank Offered Rate - discussed in Chapter 8). Other bonds vary the interest paid for a particular three or six months depending on all sorts of factors, e.g. the rate of inflation or the price of copper. Nevertheless they are all lumped together as fixed interest to contrast these types of loan instrument with equities that do not carry a promise of a return.
Fluctuating values
The value of a bond - the price at which it is trading between investors on the secondary market - may fluctuate considerably during its life, and this value reflects the changes in the prevailing interest rate. Bonds are usually issued, but not always, with a nominal value of £100 or $1,000 (or ˆ1,000, etc.). They may have any nominal value, but typical ‘lots' are 100, 1,000, 10,000 and 50,000 of, say, pounds, euros or dollars. A five-year £100 bond issued with a coupon of 5% means that it will pay £5 per year, which is 5% of its nominal value of £100. After five years have expired, the issuer will have made five payments of the £5 coupon to the current holder, or ten of £2.50 if it pays semi-annual (every six months) interest, and the eventual holder receives the nominal value of £100 at the end of the term.
If, during those five years, the interest rate that investors demand for bonds of a similar risk class and time to maturity rises, the market value of the bond will fall to compensate for its coupon rate of only 5%, so that its rate of return reflects the prevailing interest rate.
To put it simply, if a five-year £100 bond is issued with a coupon of 5% and market interest rates for bonds with similar risk and length of time to maturity remain at 5% for the five-year life of the bond, its value will remain at £100 throughout its life. However, this is unlikely to be the case, as the value of a bond will fluctuate throughout its life to take into account the prevailing rate of interest. Interest rates may change daily and the value of bonds changes accordingly. If interest rates on alternative, equally risky bonds rise to 6% when the bond has three years left to maturity, the bond will be a less attractive investment were it still to be offered for sale at £100. It is offering the following deal: in one year receive £5, in two years another £5, and in three years £100 plus the final £5 coupon, i.e. 5% at a time when other bonds offer 6% for the same risk and maturity.
For investors to obtain the current going rate of 6%, the bond must offer secondary market traders £5 per year plus a capital gain over the next three years. This will occur if the price of the bond drops to £97.327 (take this on trust for now, you will be able to calculate this yourself after reading Chapter 13). At this price, investors gain £2.673 by buying at £97.327 and receiving £100 on maturity three years later.
The capital gain is worth £2.673 ÷ £97.327 = 2.746% over three years, or 0.915% per year. Add that to the coupon of £5 per year on an investment that cost £97.327, which in percentage terms works out at 5.137% per year, £5 ÷ £97.327 = 5.137%, and you obtain (approximately) the 6% that investors in bonds of this risk class and maturity are now requiring.
These are rough calculations to give you the gist, precision comes in Chapter 13 - then you'll see how the overall rate of return does work out at exactly 6% once we take into account the timing of compounding (interest received on the interest in the three years).So the bond selling in the secondary market is rather like a bank account that offers the following deal: you put £97.327 into the bank account and the bank pays you 6% interest per year. Each year you withdraw £5. At the end of three years your bank account contains £100. However, while a bank account might produce this type of deal if you agree to hold your money there for the full three years, the bond has the advantage that you can choose to sell the bond to another investor at any point during the three years.
Conversely, if general interest rates that investors are now accepting for this risk class fall to 2% when the bond has three years to maturity, then it will seem an attractive investment at £100, because it is offering a better rate of interest than is current, and its price will rise to £108.652. Investors are accepting a capital loss of £8.652 over the three years but being compensated with three lots of £5.
In both these cases, the bond will still be worth its face value (£100) at the end of its life.