Bonds are classified in several ways. A short quick list follows. In the next section, we discuss some aspects of specific issuers.
Fixed-Rate Bonds
The most common type of coupon is the same for each payment in time, defining a fixed-rate bond. The amount of the coupon is determined by the credit rating of the issuer*, along with conditions in the market at the time of issuance. Although
'
Bond Land: There is no way that the world of bonds can be described in detail while keeping this book portable. The reader is referred to any bookstore with a finance section where you can spend hundreds of dollars to learn the details.Credit Ratings: Credit rating agencies (e.g. S&P and Moody's) rate the credit of issuers through a highly specialized procedure. Naturally, there are different credit notations. Investment grade credits are defined as BBB or higher (S&P), and Baa or higher (Moody's). Non-investment grade (also called high-yield or junk) is defined as BB or lower (S&P), and Ba or lower (Moody's). The credit ratings are regularly reviewed
1 1 1
the coupon does not change, the price of the bond can change with the market through the yield, defined below.
Floating-Rate Bonds
Some coupons change with time as determined by a rule, involving a changing rate or floating rate index. There are many such indices. The most common is Libor. Typically, a floating-rate bond will be issued at Libor plus a spread (e.g.
Libor
+
1%, or Libor+
100bp). Other floating-rate instruments are short-term money market notes based on, for example commercial paper (CP) 'I. Floating rate bonds stay near par, as discussed in the previous chapter.Zero-Coupon Bonds
If no coupon exists, the bond unimaginatively is called a zero-coupon (ZC or OC) bond. We call
Pi:)
the price of a ZC bond with maturity dateT .
Clearly, since he gets no coupon payments, the investor X will pay much less than the notional for one of these bonds (X buys the bond at a "discount"). Sometimes issuers do not want to pay coupons for cash-flow reasons. It is possible to decompose or"strip" a set of coupon bonds into zero-coupon bonds. There are government bond traders that look at and try to cash in on the (small) mispricings using this technique.
Callable Bonds and Puttable Bonds
Many bonds are "callable". This means that at certain dates the issuer ABC can, for prices, which are known up-front, demand that investors X sell back the bond.
A few bonds are "puttable". This means that at certain dates, investors X can make the issuer ABC buy back bonds for pre-determined prices. Generally, puttable bonds are also callable. The call and put features mean that the bonds contain embedded options. The quantitative analysis of such bonds is complicated; we shall examine some of the features in this book. Some derivative products, notably swaptions, are connected with these bonds.
Deterministic Coupon Changes: Step- Up Bonds
Some bonds have coupons that change according to a rule. If the coupons increase with time, the bond is called a "step-up". Step-ups appeal to bearish investors who believe rates will increase and want increasing coupons that keep pace without having to sell existing bonds and buy new ones. Usually step-ups and changed if deemed necessary by the rating agencies. Traders have their own view on credit that may or may not agree with the rating agencies, especially on a short-term basis when a rating seems suspicious. Agency credit ratings generally change over a longer time frame, except when an issuer is clearly in difficulty.
Bonds: An Overview 113
are callable, so the investor loses price appreciation in bull markets when rates drop and the bonds are called”’.
Bonds Depending on Other Markets
Some bonds have coupons that depend on other markets besides interest rates.
For example, equity-linked bonds pay more if a given stock or index increases.
Some structured notes pay a lower coupon in return for a potential equity gain.
Other possibilities include bonds whose coupon depends on a commodity (e.g.
gold), or on the value of an
FX
exchange rate (e.g. Japanese Yen vs. USD), etc.Convertible Bonds
Convertible bonds (“converts”) combine both interest-rate coupons and potential equity’”.
’.
Converts can be exchanged for (or “converted into”) equity. Converts have a wide array of complex side conditions. Lower-credit issuers often use convertibles. Simple versions called PERCS, DECS, etc. also exist. We will look at some possibilities in Ch. 14.Mortgage-Backed Securities
Mortgage-backed securities (MBS) are the repackaging of homeowner mortgages of various sorts into securities. MBS have non-deterministic coupons. This is because the coupons progressively disappear as homeowners increasingly prepay their mortgages, thus removing the underlying collateral. The determination of expected prepayments along with their uncertainties is extremely complicated and involves many variables4. Complex mortgage products called CMOS
Convertible Bonds: Convertible bonds have a lower coupon than ordinary bonds of the same credit. To compensate the investor receiving this low coupon, convertibles contain the implicit option to be converted to shares of stock under certain conditions. A simple but potentially misleading picture is to think of a convertible as an ordinary bond plus a stock option. This is because the conversion option value requires analysis on each possible stock price path at each time in the future.
Mortgage Prepayment Modeling: The subject of prepayment modeling is best thought of to first approximation as a complicated mix of phenomenological wizardry, accompanied by fitting large amounts of data. The goal of a prepayment model is a parameterization of the historical behavior of people regarding the financing of their most valuable asset (their homes), and human behavior is not easy to model. Moreover, when pricing mortgage products, the parameters of a prepayment model are often changed from historical values to “implied values”, thus producing “implied prepayments”. These implied parameters are chosen such that the pricing model fits the market prices for the mortgage products.
(collateralized mortgage obligations) generally have many “tranches” with different characteristics and complicated payment logic5.
This book does not cover MBS. There are many excellent references, to which we refer the reader
”.
Asset- Backed Securities
Asset-Backed Securities”’ (ABS) are the repackaging of anticipated cash flows from different sorts of assets into securities. These include auto loans, credit cards, home equity loans, equipment leases, etc. Theoretically, any potential set of cash flows with enough certainty could be repackaged.
Munis
Municipal or “muni” bonds are issued in a large variety of types, short and long term, with different funding goals by local and state entities, depending on their capital needs. The interest is generally exempt from federal tax and may be exempt from state and local tax6.
Non USD Bonds
Bonds can be issued in different currencies besides the US dollar (USD), for example British pound GBP, Euro EUR, Japanese yen JPY, etc. The choice of the currency depends on the markets and the appetites of investors in various countries to buy the bondsvii.
Guaranteed bonds; Bradys
Some bonds have guarantees (e.g. Brady bondsViii for emerging-market countries that have partial guarantees on some of their coupons). Some mortgage and muni bonds are also guaranteed. The investor pays an extra premium to cover the guarantee.
CMO Logic: There are entire systems to analyze the cash-flow rules for the different tranches in CMOS. This must be done painstakingly from the contracts. Prepayments affect different tranches in very different ways. Rules include the relative amounts of interest or principal and the ordering of the cash-flow payments into the various tranches.
Muni Bond Land: This is a complex zoo. Muni bonds include General Obligation (GO) Bonds, Revenue Bonds (housing, utility, health care transportation, industrial), Municipal Notes (TANS, RANs, GANs), etc. Some bonds called private activity bonds are not tax exempt but are subject to the alternative minimum tax AMT.
Bonds: An Overview 115
Type of Issuance U.S. Treasury Federal Agencies Municipal Comorate Loans
Banks make loans to clients. Bonds are generally riskier than loans. This is due to the generally longer maturity of bonds relative to the loans that the banks are willing to make, and due to the often-lower credit rating of the bond issuers relative to those corporations to which banks are willing to lend. Loans can also be repackaged into securities.
Amount Issued ($B)
$250 B
$450 B
$200 B
$400 B