Introductory to Bonds 1B

As per the first lesson Introduction to Bonds, we have presented introductory materials relating to bonds. In this subsequent lesson, we will discuss the following topics:

• Coupon vs Yield: The Key Differences
• Key Determinants Of Yield
• Illustration On Bond Coupon Payments
• Types Of Yield
• Types Of Bonds
• Key Risks Of Investing In Bonds
   

Coupon vs Yield: The Key Differences
 

Coupon and yield are important concepts in fixed income investment. Some investors may not be familiar with these two terms and may confuse one with the other. The coupon of a bond refers to the fixed payment of interest made by the issuer to investors. While coupon usually mentioned in per annum term, frequency of coupon payment could differ from bond to bond. The most commonly seen are semi-annual and annual coupon payments. Some fixed income instrument might carry zero coupon, that does not mean investors are earning no return; rather, all interest payment will come at the maturity of the fixed income instrument. Investors who invest in fixed income instruments with the expectation to receive periodic cash flows should avoid zero coupon bonds with long maturities.

Coupon and yield are important concepts in fixed income investment. Some investors may not be familiar with these two terms and may confuse one with the other. The coupon of a bond refers to the fixed payment of interest made by the issuer to investors. While coupon usually mentioned in per annum term, frequency of coupon payment could differ from bond to bond. The most commonly seen are semi-annual and annual coupon payments. Some fixed income instrument might carry zero coupon, that does not mean investors are earning no return; rather, all interest payment will come at the maturity of the fixed income instrument. Investors who invest in fixed income instruments with the expectation to receive periodic cash flows should avoid zero coupon bonds with long maturities.

Key Determinants Of Yield
Bond price and yield typically have an inverse relationship, i.e., the higher the price, the lower the yield, vice versa.

As mentioned in previous section, yield-to-maturity is used as a gauge of average yearly return of a bond. That leads to the question of what determines the yield of a bond (and also the prices).

There are many factors which affect the yield of a bond. That being said, the most pertinent to average investors are macroeconomic condition, credit risk and liquidity risk.

Macroeconomic condition generally refers to the economic performance of a country or market. People typically refer to economic indicators such as inflation, unemployment, economic growth and central policy rates. In general, yields tend to be higher if an economy has higher inflation, lower unemployment, higher economic growth and higher central bank policy rates.

In seeking a higher yield on a bond investment, an investor may consider to invest in bonds that are issued by companies with higher credit risks (i.e., issuers with less favorable financial

metrics). For example, a company that has a higher ratio of debt to net income may have a higher risk of not meeting their financial obligations as compared to a company that has low level of debt to net income. Investors will naturally seek higher yield (return) as a compensation for enduring the higher credit risk whilst for bonds with lower credit risks, the required returns will be generally lower.

Liquidity risk in general refers to how easy/ soon an investor is able to liquidate the bond. Everything else equal, a bond with higher liquidity tends to have lower yield.

Note that bonds with longer maturities, even by the same issuer, tend to have higher yields. This is because everything else equal, longer tenor bonds come with higher uncertainties over issuers’ ability to repay their debts in the future.
 

Last but not least, it is important to remember that all three factors mentioned above are inter-related. For example, a deteriorating economy could cause an increase in credit or default risk of its companies, as corporates will likely earn less income when the economy is not performing. An issuer that is on the brink of bankruptcy might see the liquidity of its bonds vanishes, as investors stop buying its bonds.

Illustration On Bond Coupon Payments:

Coupon Payments:

Calculating coupon payments

Assume a 5-year vanilla bond paying 5% coupon per annum, MYR 250,000 nominal value, you’ll get:

Since coupon payments are usually paid out every semi-annually,
Investor will receive RM 12,500 / 2 = RM 6,250 every 6 months.

Illustration on the Relationship between Price and Yield:

We split the same bond into 3 different scenarios: bond trading at par value, trading at a premium, and trading at discount. All scenarios assume no transaction fees.

Scenario 1:
5-year bond paying 5.00% coupon per annum traded at 100 (par value)

When an investor purchased a bond at 100 and held till maturity.

• Coupon Component: The investor has received a 5.00% coupon for 5 years
• Price Component: No gains or losses by the investor (bought at 100, mature at 100), since all bonds mature at 100 (par value) at maturity.

Yield to maturity= Coupon + Capital Gains / Losses
**Yield to maturity = 5.00% + 0% = 5.00%

**Do note that yield calculations above are rough estimates for better understanding. For better accuracy, it is advisable to use a financial calculator.

Scenario 2:
5-year bond paying 5.00% coupon per annum traded at 105 (traded at premium)

Scenario 3:
5-year bond paying 5.00% coupon per annum traded at 95 (traded at discount)

When an investor purchased a bond at 95 and held till maturity.

• Coupon Component: The investor has received a 5.00% coupon for 5 years
• Price Component: Capital gain of 5% throughout the 5-year period (Investor bought at 95, matures at 100), hence, on average, 1% gain per year on average.

Yield to maturity= Coupon + Capital Gains / Losses
**Yield to maturity= 5.00% + 1% = 6.00%

**Do note that yield calculations above are rough estimates for better understanding. For better accuracy, it is advisable to use a financial calculator.

We can conclude that:

✓ If coupon = yield to maturity, bond traded at par (Scenario 1)

✓ if coupon > yield to maturity, bond traded at premium (Scenario 2)

✓ If coupon < yield to maturity, bond traded at discount (Scenario 3)

Once again, the relationship holds: the more expensive (better value) the bond is, the lesser the returns to the investor, vice versa.

Question: Does investors always have to look for discounted bonds to achieve a better return?

A: As mentioned, yield or yield-to-maturity is a better estimate of a fixed income instrument’s return. Whether a bond is traded below or above par has no bearing on the return of that bond.

 

Out in the fixed income world, bond returns are measured in yields. However, bonds with different features are being measured differently. 

Bond features may range from Callable Bonds to Puttable Bonds whereby: 

Callable Bond: The issuer of the bond has the right to redeem the bonds back before maturity at a specific date and price in the future. 

Puttable Bond: The investors of the bond have the right to sell back the bonds to the issuer before maturity at a specific date and price in the future.
 

Let’s have a look at the type of yields below:

Table 1: Types of bond yields.
 

Types of Bonds:

Table 2: Types of bonds.

[1] Callable Date/s: Specific date/ dates when an Issuer can exercise its rights to redeem the bond at a specific price as per the terms of the bond.
**Note that the types of bonds are not limited to the list above.

Key Risks Of Investing In Bonds
 

Investments come with risk and reward, while we have gone through the rewards on previous topics, we now move to what are the risks when it comes to investing in bonds? 

To understand better, we look further into the risk of investing in bonds: 

a) Credit Risk 
The risk where the yield of a bond increases (hence price decreasing) relative to Government bond yield of similar maturity (this is commonly known as “widening of credit spread”) as a result of adverse events which might impact the financials of the issuer negatively./p>

For example, due to the Covid-19 pandemic, company operations and cash flow have been severely affected, putting pressure on the company’s liquidity and thus weaken the company's debt repaying capabilities. Eventually, the credit risk identified within a company would be higher at the same time, leading to a higher chance of the next risk, default risk. However, it is to note that companies with higher credit risk does not always lead to a default but will definitely have a higher chance of default.
 

b) Default risk

The risk of issuer failing to meet financial obligations, in other words, the borrower is unable to meet the agreed terms. i.e., failing to make coupon payment.

c) Macro Risk

Typically refers to macro-economic conditions that could lead to higher yields (hence lower prices) to the overall bond market such as higher inflation, faster economic growth and tighter monetary policies. Macro risk could also be political in nature, such as sanctions, change of ruling parties etc which could potentially impact the economic condition of a country or region.

To illustrate:
When interest rates are expected to fall (rise) due to lower (higher) inflation, bond prices will increase (decrease). This is due to the existing bond becomes more attractive (unattractive) as newly issued bonds will be unattractive (attractive) at lower (higher) rates.

d) Reinvestment Risk

The risk that investors will not be able to reinvest cash flows at a rate equal to their required return.

Example:
An investor had invested in callable bonds. The issuer has the right to call back the bond at a point in time. If the bond is being redeemed, the investor will receive the bond’s face value and will have the risk of not investing at the same rate as before.

This scenario usually happens when interest rates begin to fall as the issuer has the opportunity to borrow at a lower rate.

e) Liquidity Risk

Liquidity risk occurs when the investor is unable to convert their assets into cash easily due to lack of buyers or an inefficient market. The lack of liquidity is the reason why certain bond’s bid-ask spread is wide.

Example:
A bond holder wishes to liquidate their assets in order to use the funds to reinvest at a higher rate or pay off their children’s education but unable to do so due to the lack of buyers in the market. To sell off the bond, the investor will have to sell at a worse rate.



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