Call Options on Bonds

Posted April 1st, 2011 by admin. 0 Comments

Many bonds include a call feature that allows the issuer to redeem or “call” all or part of the issue before the maturity date.

The call option has value to the issuer for several reasons. In the future the borrower may wish to remove restrictions placed on him by the bond indenture. For a corporation these might be restrictions on merger, the sale of assets, or the payment of dividends. Without the call provision, the bondholders by hard bargaining might be able to utilize their monopoly position to extract a large premium from the issuer before selling back the bonds or agreeing to change these clauses.

A second source of value is that the borrower may find that he wants to decrease the amount of his borrowing before the bonds mature. Essentially the same effect as retiring his own bonds could be obtained by buying on the market similar bonds issued by someone else. However, because of the transaction costs involved in making interest payments, the cost of bonds to the issuer will always be somewhat greater than their value on the market. There will therefore be some saving to the issuer in retiring his own bonds rather than buying someone else’s.

The third and probably most significant source of value of the option to the issuer is the ability it gives him to refinance the issuer in the future if interest rates should fall. This implies three risks from the investor:
(a) The cash flow pattern becomes uncertain;
(b) The investor becomes exposed to reinvestment risk because the issuer will call the bond when interest rates drop;
(c) The capital appreciation potential of a bond will be reduced, because the price of a callable bond may not rise much above the price at which the issuer will call the bond.

Option writing for bonds is used both for risk and hedge purposes. Bond call options provide liquidity with little cash requirement. Bond options also have a finite life and can be expensive to purchase and hold until maturity.

Mechanics of Bond Option Writing

The seller of the contract must have on account securities or funds equal to the amount of the potential sale until the contract expires. The seller is also called the writer of the contract. The incentive for writing a bond call option is the premium payment reflecting the risk of loss of the bonds. The premium payment is in addition to the strike price. The strike price is the market value the bond call option must reach in order to be exercised, or called.

Trading on an Exchange

For a stated par, or maturity value, the bond call writer initiates a contract through his broker on a nationally recognized exchange. The exchange provides a uniform bond option contract detailing the responsibilities of both the bond call option buyer and seller, including the length of the call and what bonds constitute good value for delivery. Rarely are bonds ever delivered. Instead contracts are offset by cash payments at maturity. The contract also denotes an exercise price. The fee received, the premium, is determined by market conditions. This includes the current level of interest rates, the price volatility of the bonds and the number of business days the bond option seller is at risk.

Leverage

Rather than incur the price volatility and cash payment for bonds, traders often use bond call options. Traders know from the beginning of the trade the absolute amount of loss they may incur while freeing up cash for other trading purposes. The cost of a bond option varies depending on the premium charged, but a one month bond call option may cost as little as 2 percent of the face value of the bonds. This implies that a 1 percent increase in bond values on a $1 million call would increase bond option values by nearly $10,000.

Hedging

Bond options are popular as hedging vehicles to reduce risk. Traders can buy options and use them to hedge, or offset, an equal amount of futures contracts, bonds and other options, such as bond put options. Bond call options are also used like stock options in a variety of mathematical strategies. By buying and selling different bond call and bond put options, income can be derived from the time to maturity, the difference in coupon or even bond prices. Bond call options, with their liquidity, and known maximum loss, provide traders many opportunities to employ profitable, leveraged, strategic portfolio outcomes.

Posted in Business in Switzerland Tagged as bond indenture, bond option writing, bondholders, call options on bonds, call the bond, callable bonds, cash flow, face value, face value of the bonds, hedging, interest payments, interest rates, investors, issue Swiss bonds, liquidity, maturity, maturity date, maturity value, premium, premium payment, reinvestment risk, strike price, Swiss Financial Company & Trust SA, traders, writer of the contract

Bonds: Maturity and Redemption

Posted March 23rd, 2011 by admin. 0 Comments

Ai = number of accrued days for the ith, or last, quasi-coupon period within odd period counting forward from last interest date before redemption.
DCi = number of days counted in the ith, or last, quasi-coupon period as delimited by the length of the actual coupon period.
NC = number of quasi-coupon periods that fit in odd period; if this number contains a fraction it will be raised to the next whole number.
NLi = normal length in days of the ith, or last, quasi-coupon period within odd coupon period.

Bonds often are referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium or intermediate-term bonds generally are those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years. Whatever the duration of a bond, the borrower fulfills its debt obligation when the bond reaches its maturity date, and the final interest payment and the original sum you loaned (the principal) are paid to you.

Not all bonds reach maturity, even if you want them to. Callable bonds are common: they allow the issuer to retire a bond before it matures. Call provisions are outlined in the bond’s prospectus (or offering statement or circular) and the indenture – both are documents that explain a bond’s terms and conditions. While firms are not formally required to document all call provision terms on the customer’s confirmation statement, many do so.

Bond maturities usually range from one day up to 30 years or even more. But this maturity date must be seen as the last future date (except if the borrower is in default) on which the investor will receive the principal amount from to the issuer. Depending on redemption features, the real reimbursement date can be very different (much shorter). These redemption features usually give the right to the investors and/or the issuer to advance the maturity date of the bond:

Call

This is a provision that allows or require the issuer to repay the bond before the maturity date. The issuer will ‘call’ his bond if the interest rate index is lower than when he issued the bond. On the investor point of view, it means that the bond will be prepaid if the bond brings him too much interest compared to the current market conditions. If you purchase a bond with a ‘call option’, you have to pay less (get a premium) than without call because if the bond is prepaid, you will reinvest the money at a lower rate.

Put

The put is a provision that gives to right to the investors to require from the issuer to redeem the bond before the maturity date. Investors usually exercise this option when the current market rates are higher so that he can reinvest his money at a higher rate. The put feature is a protection for the investor against an increase of the interest rate on the market and, consequently, should pay more (pay a premium) for a bond with a put than without.

Conversion

Some corporate bonds, known as convertible bonds, contain an option to convert the bond into common stock instead of receiving a cash payment. Convertible bonds contain provisions on how and when the option to convert can be exercised. Convertibles offer a lower coupon rate beacuse they have the stability of a bond while offering the the potential upside of a stock.

Partial Prepayment (Paydown)

This kind of feature is usually seen with mortgage-backed securities. Without entering into details, a mortgage-backed security is anything else but the securitisation of a pool of mortgage loans. In mortgage loans, you have a regular (often monthly or quarterly) payment of principal and also the ability for the borrower the prepay the loan before maturity. Mortgage-backed securities prepay the principal to the investors in parallel the underlying mortgage loans. That’s the reason why mortgage-backed securities are traded on the basis of their ‘average life’.

Mortgage-backed bonds prices are more volatile than fixed rate bonds because the speed of redemption increases when the interests go down (when you have to reinvest at a lower rate) but decreases when interests go up. An increase in interest rates will increase the average life (the real maturity date) of your investment.

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Fixed-Rate Capital Securities

Posted February 10th, 2011 by admin. 0 Comments

In the early 1990s, a product called fixed-rate capital securities was introduced to meet the needs of income-oriented investors and provide a cost efficient source of capital for issuers.

These securities combine the features of corporate debt securities and preferred stock: generous yields compared with other investment vehicles, regular income disbursement, predictable investment time frames, liquidity and investment grade quality (in almost every case).

Fixed-rate capital securities (aka hybrids) are like preferred stock, but with a few peculiarities. There is no DRD tax advantage; thus, they pay a higher yield than preferred stocks or bonds from the same issuer. The have a lien status that is higher than preferreds but below creditors, and they carry the credit rating of the issuer. They are traded in the OTC market and most are also listed on the NYSE and AMEX stock exchanges. Most are priced at $25 per share, they have a stated maturity, and are callable after 5 to 10 years. Most issuers are utilities, industrial companies, and financial institutions.

FRCS are also classified based on how they are issued:
1.Junior subordinated debentures are issued directly by the parent company.
2.Trust preferred FRCS are issued by a trust.
3.Partnership preferred FRCS are issued by a partnership.

Specific FRCS are known by acronyms and names which describe the frequency of the payments, or how they are issued, such as:
•MIDS – Monthly Income Debt Securities
•QUICS – Quarterly Income Capital Securities
•QUIDS – Quarterly Income Debt Securities
•QUIPS – Quarterly Income Preferred Securities
•SKIS – Subordinated Capital Income Securities
•TOPrS – Trust Originated Preferred Securities
•TruPS – Capital Trust Pass-through Securities

The main difference between preferreds and FRCS is that FRCS pay interest—not dividends—monthly, quarterly, or semi-annually, but can be deferred if the company is in financial trouble. However, payments can be deferred only if no dividends are being paid for the issuer’s common or preferred stock, and if the interest payments are deferred, then interest continues to accumulate until it is paid. Sometimes FRCS are issued as zero coupon bonds, which are original issue discount (OID) instruments.

However, these securities can have tax complications, either because of interest payment deferral or because they are OIDs. In these cases, interest accrues, and if it is not paid in the year earned, then the investor in these securities must pay taxes on the accrued interest, which is calculated according to complex laws and formulas.

Besides the deferral risk mentioned above, there is also a special event risk, which allows the issuer to redeem the FRCS, at any time, for face value, if the tax law changes that disallows the tax deduction for the interest payments for the issuer’s parent company.

Features and Benefits

Priority of Claims
• FRCS typically offer a higher security claim than preferred and common stock, but rank junior and are subordinate in right of payment to all senior debt of the issuer.

Potential for Attractive Yields
• FRCS typically provide yield advantages relative to preferred stock and corporate bonds of the same issuer, partly to compensate investors for claims with a lower priority in addition to payment deferral risk.

Liquidity
• Certain FRCS trade on the OTC and listed markets, and generally have easily attainable quotes. Many FRCS are also listed on the NYSE®.

Credit Ratings
• FRCS may be rated by investment rating agencies such as Moody’s® and Standard & Poor’s® to assist investors in their evaluations of the securities.

Low Investment Minimum
• Many FRCS are issued at $25 a share (although some are issued with a $1000 par value). This feature enables investors to buy and sell in smaller increments. The actual price paid by the investor may be more or less than $25, particularly when the security is purchased in the secondary market.

Risks

While it may seem appealing to look at securities that offer higher yields, investors should consider those higher yields to be a sign of potentially greater risk.

Market Risk
• FRCS are subject to price fluctuation due to material events affecting the issuer or the market. Additionally, FRCS prices typically decline on ex-dividend days (the dates that buyers of FRCS are not entitled to receive the dividend).

Interest Rate Risk
• FRCS tend to rise in value when interest rates fall, and decline in value when interest rates rise.

Credit and Default Risk
• Investors should consider the possibility of risk that a corporation might default on its payments of interest or principal. Purchasing top–rated securities from companies with a stable or good credit history may help reduce credit risk.

Call Risk
• FRCS generally have a call provision which entitles the issuer to redeem the shares prior to maturity. Typically an issuing corporation will call its securities when interest rates fall, leaving the investor with potentially less favorable reinvestment possibilities. When evaluating FRCS, an investor should know whether call options exist and when these options may be exercised by the issuer.

Special Event Risk
• Many FRCS include a “special event” redemption option, allowing the issuer to redeem the securities at the liquidation value if a tax law change disallows the deductibility of payments by the issuer’s parent company, or subjects the issue to taxation separate from the parent company.

Deferral Risk
• FRCS permit the deferral of payments without declaring default, if the issuer experiences financial difficulties. Payments may be deferred or suspended for some stipulated period. If the issuer defers payments on a cumulative FRCS issue, the deferred income typically continues to accrue for tax purposes, even though the investor does not receive cash payments. Investors should consult with a tax professional regarding the tax treatment of investment income.

Inflation Risk
• FRCS are subject to the risk that the rate of the yield to call or maturity of the investment may not provide a positive return over the rate of inflation for the period of the investment.

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Taxation of Bond Income

Posted December 18th, 2010 by admin. 0 Comments

Bonds provide an important component of many financial plans. Most investors buy bonds for two basic reasons: safety and/or income. Bonds can provide some stability for your portfolio to counter the volatility of stocks while generating current or future income.

Every year, bondholders receive their annual 1099-INT forms and dutifully report the numbers that are listed there on their tax returns. However, there is often more to what appears on these forms than the income that is generated from the stated rate of interest. Many fixed income investors are unaware of a number of factors that can impact the amount of taxable interest that they must report at the end of the year.

The interest earned from bonds is taxed as ordinary income. However, if the bond is sold before maturity, or if the bond was bought in the secondary market for other than par value, then there will also be a capital gain or loss, depending on whether the sale or redemption price was greater or less than the purchase price. The capital gain is not recognized until the sale or the redemption of the bond.

However, taxes on interest must be paid in the year earned, whether it is received or not. For bonds that make regular coupon payments, taxable interest for the year is the interest received or payable for that year.

Nevertheless, for original issue discount (OID) bonds, the bondholder must pay interest that was earned, but not received, which is based on the imputed interest — the interest that the OID bond earns based on a constant yield method, or straight-line amortization. For a zero-coupon bond, which is issued at a deep discount, but pays no interest, the imputed interest rate, which is simply the yield to maturity, is determined by the purchase price, the par value, and the term of the bond, so the IRS requires the use of this rate regardless of changes in the bond’s price in the secondary market.

Some OID bonds do pay regular interest periodically, but the coupon rate was below prevailing interest rates when issued, and so was sold at a discount to its par value. Thus, these bonds pay a stipulated amount of interest, but also have an imputed interest that must be added yearly to determine taxable income. The coupon rate and the imputed interest rate will equal the yield to maturity for the bond. The imputed interest will be proportional to the original issue discount.

Original Issue Discount = Redemption Value – Purchase Price

When a bond with imputed interest is sold, the capital gains or loss is determined by adding the imputed interest to the purchase price of the bond, and subtracting this value from the sale or redemption price.

The major exceptions to reporting OID as interest includes:

debt securities with a term of 1 year or less;
United States savings bonds;
most tax-exempt securities.

De Minimis OID

The interest can be treated as zero if the discount is less than the de minimis OID:

De Minimis OID = 0.0025 x Redemption Value x Number of Years from Issue to Maturity

The de minimis OID will, however, have to be reported as a capital gain if held to maturity.

Example — calculating the De Minimis OID

The de minimis OID for a 10-year bond with a face value of $1,000 = 0.0025 x 1,000 x 10 = $25. If the OID is less than $25, then it does not have to be reported as interest, but it must be reported as a capital gain at maturity.

Form 1099-OID

If the imputed interest is greater than $10 for the year, then you should receive Form 1099-OID either from the issuer or your broker, if you kept the securities in a brokerage account, which will show the interest that must be reported. However, if the issue was purchased in the secondary market for a premium, or if the issue is stripped bond or coupon, then the OID interest must be refigured.

Market Discount Bonds

A market discount bond is any bond having market discount except:

Short-term obligations (those with fixed maturity dates of up to 1 year from the date of issue);
Tax-exempt obligations that you bought before May 1, 1993;
U.S. savings bonds;
Certain installment obligations.

Market discount arises when the value of a debt obligation decreases after its issue date, generally because of an increase in interest rates. If you buy a bond on the secondary market, it may have market discount.

When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.

You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount;
You must treat any partial payment of principal on the bond as ordinary interest income, up to the amount of the accrued market discount;
If you borrow money to buy or carry the bond, your deduction for interest paid on the debt is limited.

Market discount

Market discount is the amount of the stated redemption price of a bond at maturity that is more than your basis in the bond immediately after you acquire it. You treat market discount as zero if it is less than 1/4 of 1% (.0025) of the stated redemption price of the bond multiplied by the number of full years to maturity (after you acquire the bond). If a market discount bond also has OID, the market discount is the sum of the bond’s issue price and the total OID includible in the gross income of all holders (for a tax-exempt bond, the total OID that accrued) before you acquired the bond, reduced by your basis in the bond immediately after you acquired it.

Bonds Acquired At Original Issue

Generally, a bond that you acquired at original issue is not a market discount bond. If your adjusted basis in a bond is determined by reference to the adjusted basis of another person who acquired the bond at original issue, you are also considered to have acquired it at original issue.

Exceptions

A bond you acquired at original issue can be a market discount bond if either of the following is true.

Your cost basis in the bond is less than the bond’s issue price;
The bond is issued in exchange for a market discount bond under a plan of reorganization (this does not apply if the bond is issued in exchange for a market discount bond issued before July 19, 1984, and the terms and interest rates of both bonds are the same).

Accrued Market Discount

The accrued market discount is figured in one of 2 ways:

ratable accrual method;
constant yield method.

Ratable Accrual Method

Treat the market discount as accruing in equal daily installments during the period you hold the bond. Figure the daily installments by dividing the market discount by the number of days after the date you acquired the bond, up to and including its maturity date. Multiply the daily installments by the number of days you held the bond to figure your accrued market discount.

Ratable Accrual=

Market Discount
─────────────────────────────
(Maturity Date – Purchase Date) in Days

Number of Days Actually Held

Constant Yield Method

Instead of using the ratable accrual method, you can choose to figure the accrued discount using a constant interest rate (the constant yield method). Make this choice by attaching to your timely filed return a statement identifying the bond and stating that you are making a constant interest rate election. The choice takes effect on the date you acquired the bond. If you choose to use this method for any bond, you cannot change your choice for that bond.

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Convexity

Posted December 12th, 2010 by admin. 0 Comments

Convexity means a measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes. Convexity is used as a risk-management tool, and helps to measure and manage the amount of market risk to which a portfolio of bonds is exposed.

In the example above, Bond A has a higher convexity than Bond B, which means that all else being equal, Bond A will always have a higher price than Bond B as interest rates rise or fall.

As convexity increases, the systemic risk to which the portfolio is exposed increases. As convexity decreases, the exposure to market interest rates decreases and the bond portfolio can be considered hedged. In general, the higher the coupon rate, the lower the convexity (or market risk) of a bond. This is because market rates would have to increase greatly to surpass the coupon on the bond, meaning there is less risk to the investor.

Convexity is the rate that the duration changes along the price-yield curve, and, thus, is the 1^st derivative to the equation for the duration and the 2^nd derivative to the equation for the price-yield function, and is calculated by the following equation:

Convexity Formula

P = bond price

y = yield to maturity in decimal form

T = maturity in years

CF_t= cash flow at time t

The equation for duration can be improved by adding the convexity term:

Calculating the Change in Bond Prices with Interest Rates Using Duration + Convexity Adjustment

duration convexity formula Convexity

∆y = yield change

∆P = bond price change

Convexity can also be estimated with a simpler formula, similar to the approximation formula for duration:

Convexity Approximation Formula

Convexity = P₊ + P_- – 2P₀
─────────────
2 x P₀(Δy)²

P₀ = bond price
P_- = bond price when interest rate is incremented
P₊= bond price when interest rate is decremented
∆y = change in interest rate in decimal form

However, that this convexity approximation formula must be used with this convexity adjustment formula, then added to the duration adjustment:

Convexity Adjustment Formula

Convexity Adjustment = Convexity x 100 x (Δy)²

∆y = change in interest rate in decimal form

Hence:

Bond Price Change Formula

Bond Price Change = Duration x Yield Change + Convexity Adjustment

Convexity is usually a positive term regardless of whether the yield is rising or falling, hence, it is positive convexity. However, sometimes the convexity term is negative, such as occurs when a callable bond is nearing its call price. Below the call price, the price-yield curve follows the same positive convexity as an option-free bond, but as the yield falls and the bond price rises to near the call price, the positive convexity becomes negative convexity, where the bond price is limited at the top by the call price. Hence, similar to the terms for modified and effective duration, there is also modified convexity , which is the measured convexity when there is no expected change in future cash flows, and effective convexity , which is the convexity measure for a bond for which future cash flows are expected to change.

Posted in Business in Switzerland Tagged as bond price change, bond prices, bond yields, Bonds, call price, callable bond, cash flow, convexity, convexity adjustment, convexity adjustment formula, convexity approximation formula, convexity formulas, convexity measure for a bond, coupon rate, coupons, derivative, duration, duration of a bond, Interest rate, investors, market risk, maturity, measured convexity, modified convexity, negative convexity, option-free bond, portfolio of bonds, positive convexity, risk-management tool, yield change

CMO’s: Plain Vanilla Bonds

Posted December 5th, 2010 by admin. 0 Comments

A plain vanilla bond is a bond with no unusual features, paying a fixed rate of interest and redeemable in full on maturity. The term derives from vanilla or ‘plain’ flavoured ice-cream.

Out of all high yield bond securities, plain vanilla securities are the most widely used. They are exactly as they sound; they pay a cash interest payments at a fixed rate. These securities typically have a term to maturity of 7 to 12 years and have a callable option built in within the first 3 to 5 years to allow for a company to pay off expensive debt as their revenues and credit ratings improve. The corporation can then issue more lower yield debt as a substitute due to their improved position. Plain vanilla bonds have prepayment and extension risk.

Plain-vanilla are collateralized mortgage obligations.

Collateralized Mortgage Obligations or CMO’s are a series of bonds backed by an agency and their mortgage backed securities. These investments are AAA rated and pay monthly principal and interest.

Various Types of CMOs

The most basic CMO structure has tranches that pay in a strict sequence. Each tranche receives regular interest payments, but the principal payments received are made to the first tranche alone, until it is completely retired. Once the first tranche is retired, principal payments are applied to the second tranche until it is fully retired, and the process continues until the last tranche is retired. The first tranche of the offering may have an average life of 2-3 years, the second tranche 5-7 years, the third tranche 10-12 years, and so forth. This type of CMO is known as a “sequential pay,” “clean,” or “plain vanilla” offering.

The CMO structure allows the issuer to meet different maturity requirements and to distribute the impact of prepayment variability among tranches in a deliberate and sometimes uneven manner. This flexibility has led to increasingly varied and complex CMO structures. CMOs may have 50 or more tranches, each with unique characteristics that may be interdependent with other tranches in the offering. The types of CMO tranches include:

Planned Amortization Class (PAC) Tranches

PAC tranches use a mechanism similar to a “sinking fund” to establish a fixed principal payment schedule that directs cash-flow irregularities caused by faster- or slower-than-expected prepayments away from the PAC tranche and toward another “companion” or “support” tranche. With a PAC tranche, the yield, average life, and lockout periods estimated at the time of investment are more likely to remain stable over the life of the security.

PAC payment schedules are protected by priorities which assure that PAC payments are met first out of principal payments from the underlying mortgage loans. Principal payments in excess of the scheduled payments are diverted to non-PAC tranches in the CMO structure called companion or support tranches because they support the PAC schedules. In other words, at least two bond tranches are active at the same time, a PAC and a companion tranche. When prepayments are minimal, the PAC payments are met first and the companion may have to wait. When prepayments are heavy, the PAC pays only the scheduled amount, and the companion class absorbs the excess.

“Type I PAC” tranches maintain their schedules over the widest range of actual prepayment speeds—say, from 100% to 300% PSA. “Type II” and “Type III PAC” tranches can also be created with lower priority for principal payments from the underlying loans than the primary or Type I tranches. They function as support tranches to higher-priority PAC tranches and maintain their schedules under increasingly narrower ranges of prepayments.

PAC tranches are now the most common type of CMO tranche. Because they offer a high degree of investor cash-flow certainty, PAC tranches are usually offered at lower yields.

Targeted Amortization Class (TAC) Tranches

TAC tranches also provide more cash-flow certainty and a fixed principal payment schedule, based on a mechanism similar to a sinking fund, but this certainty applies at only one prepayment rate rather than a range. If prepayments are higher or lower than the defined rate, TAC bondholders may receive more or less principal than the scheduled payment. TAC tranches’ actual performance depends on their priority in the CMO structure and whether or not PAC tranches are also present. If PACs are also present, the TAC tranche will have less cash-flow certainty. If no PACs are present, the TAC provides the investor with some protection against accelerated prepayment speeds and early return of principal. The yields on TAC bonds are typically higher than yields on PAC tranches but lower than yields on companion tranches.

Companion Tranches

Every CMO that has PAC or TAC tranches in it will also have companion tranches (sometimes called support bonds), which absorb the prepayment variability that is removed from the PAC and TAC tranches. Once the principal is paid to the active PAC and TAC tranches according to the schedule, the remaining excess or shortfall is reflected in payments to the active companion tranche. The average life of a companion tranche may vary widely, increasing when interest rates rise and decreasing when rates fall. To compensate for this variability, companion tranches offer the potential for higher expected yields when prepayments remain close to the rate assumed at purchase. Similar to Type II and Type III PACs, TAC tranches can serve as companion tranches for PAC tranches. These lower-priority PAC and TAC tranches will in turn have companion tranches further down in the principal payment priority. Companion tranches are often offered for sale to retail investors who want higher income and are willing to take more risk of having their principal returned sooner or later than expected.

Z-Tranches (also known as Accretion Bonds or Accrual Bonds)

Z-tranches are structured so that they pay no interest until the lockout period ends and they begin to pay principal. Instead, a Z-tranche is credited “accrued interest” and the face amount of the bond is increased at the stated coupon rate on each payment date. During the accrual period the principal amount outstanding increases at a compounded rate and the investor does not face the risk of reinvesting at lower rates if market yields decline. Typical Z-tranches are structured as the last tranche in a series of sequential or PAC and companion tranches and have average lives of 18 to 22 years. However, Z-tranches can be structured with intermediate-term average lives as well. After the earlier bonds in the series have been retired, the Z-tranche holders start receiving cash payments that include both principal and interest.

While the presence of a Z-tranche can stabilize the cash flow in other tranches, the market value of Z-tranches can fluctuate widely, and their average lives depend on other aspects of the offering. Because the interest on these securities is taxable when it is credited, even though the investor receives no interest payment, Z-tranches are often suggested as investments for tax-deferred retirement accounts.

Principal-Only (PO) Securities

Some mortgage securities are created so that investors receive only principal payments generated by the underlying collateral. These Principal-Only (PO) securities may be created directly from mortgage pass-through securities, or they may be tranches in a CMO. In purchasing a PO security, investors pay a price deeply discounted from the face value and ultimately receive the entire face value through scheduled payments and prepayments.

The market values of POs are extremely sensitive to prepayment rates and therefore interest rates. If interest rates are falling and prepayments accelerate, the value of the PO will increase. On the other hand, if rates rise and prepayments slow, the value of the PO will drop. A companion tranche structured as a PO is called a “Super PO.”

Interest-Only (IO) Securities

Separating principal payments to create PO mortgage securities necessarily involves the creation of Interest-Only (IO) securities. CMOs that have PO tranches will therefore also have IO tranches. IO securities are sold at a deep discount to their “notional” principal amount, namely the principal balance used to calculate the amount of interest due. They have no face or par value. As the notional principal amortizes and prepays, the IO cash flow declines.

Unlike POs, IOs increase in value when interest rates rise and prepayment rates slow; consequently, they are often used to “hedge” portfolios against interest rate risk. IO investors should be mindful that if prepayment rates are high, they may actually receive less cash back than they initially invested.

The structure of IOs and POs exaggerates the effect of prepayments on cash flows and market value. The heightened risk associated with these securities makes them unsuitable for certain investors.

Floating-Rate Tranches

First offered in 1986, “floating-rate CMO” tranches carry interest rates that are tied in a fixed relationship to an interest rate index, such as the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT), or the Cost of Funds Index (COFI), subject to an upper limit, or “cap,” and sometimes to a lower limit, or “floor.” The performance of these investments also depends on the way interest rate movements affect prepayment rates and average lives.

Sometimes the interest rates on these tranches are stated in terms of a formula based on the designated index, meaning they move up or down by more than one “basis point” (1/100 of one percent) for each basis point increase or decrease in the index. These so-called “superfloaters” offer leverage when rates rise. The interest rates on “inverse floaters” move in a direction opposite to the changes in the designated index and offer leverage to investors who believe rates may move down. The potential for high coupon income in a rally can be rapidly eroded when prepayments speed up in response to falling interest rates. All types of floating-rate tranches may be structured as PAC, TAC, companion, or sequential tranches, and are often used to hedge interest rate risks in portfolios.

Residuals

CMOs also contain a “residual” interest tranche, which collects any cash flow remaining from the collateral after the obligations to the other tranches have been met. Residuals are not classified as regular interest and may be structured as sequential, PAC, floating-rate, or inverse-floater tranches, and differ from regular tranches primarily in their tax characteristics, which can be more complex than other CMO tranches. CMOs issued as non-REMICs also have residuals which are sold as a separate security such as a trust certificate or a partnership interest.

Collateralized Mortgage Obligations are generally meant for institutional investors or wealthy bond investors. The money invested, while earning monthly income – can take a while if interest rates rise. When interest rates rise, these bonds will pay slower. The refinancing that normally can happen with mortgage pools will slow down or stop when interest rates or bond yields rise.

Posted in Business in Switzerland Tagged as AAA bonds, accretion bonds, accrual bonds, accrued interest, basis point, bond maturity date, bondholders, callable option, cash flow, cash interest payments, CMO's, CMT, COFI, collateral, collateralized mortgage obligations, companion tranches, coupon rate, coupons, defined rate, excess, extension risk, face value, fixed principal payment, fixed rate, fixed rate of interest, flexibility, floating-rate CMO tranches, floating-rate tranches, hedge interest rate risks, hedge portfolios, high yield bond securities, index, institutional investors, interest rate risk, interest-only securities, inverse floaters, investment, investor, issue lower yield debt, issuer, leverage, LIBOR, lockout periods, maturity, monthly income, mortgage, mortgage loans, mortgage-backed securities, PAC schedules, partnership interest, plain vanilla bonds, plain vanilla offering, planned amortization class tranches, prepayment, principal, principal of a bond, principal payments, principal-only securities, redeemable bonds, regular interest payments, residual interest tranche, residuals, securities, sequential pay offering, sinking fund, super PO, superfloaters, support tranches, targeted amortization class tranches, tax, tax-deffered retirement accounts, tranches, trust certificate, wealthy bond investors, yield, Z-tranches

Callable and Non-Callable Bonds

Posted November 29th, 2010 by admin. 0 Comments

In fact, callable bonds are more risky for investors than non-callable bonds because an investor whose bond has been called is often faced with reinvesting the money at a lower, less attractive rate. As a result, callable bonds often have a higher annual return to compensate for the risk that the bonds might be called early.

Fixed income investors and financial advisors face a dilemma in the current environment; either invest in short-term bonds and earn virtually nothing in return, or invest in longer-term bonds and risk significant losses in the event that future interest rates rise substantially. The cushion bond – a callable bond trading at a premium to par value – offers the potential for higher return in a low rate environment, while providing protection against the potentially damaging consequences of future rate increases.

Most investors know that bond prices move inversely to changes in interest rates (i.e. when rates increase, bond prices fall). Most investors may also be aware that long-term bonds are more sensitive to changes in rates than short-term bonds. However, most investors do not fully appreciate one of the biggest factors that may reduce a given bond’s sensitivity to changes in interest rates – an embedded call option.

The investor has to determine the value of the option and the level of compensation required for the associated risks in a callable security.

Three forms of embedded options

The type of embedded option in a callable security affects the option’s value.

American options are continuously callable at any time after the lockout period expires.
Bermudan options give the issuer the right to call the bond on specified dates after the lockout period that typically coincide with coupon dates.
European options have a one-time call feature coinciding with the expiration of the lockout period.

Importance of lockout periods

Coupled with the time to maturity, the lockout period also affects the option’s value. For example, the embedded option in a 10-year noncallable for six months (10nc6M) can be likened to a 6-month European option on a 9.5-year security. The embedded option in a 10nc3 European callable is the same as a 3-year option on a 7-year security. The uncertainty or risk associated with 7-year rates three years from now is higher than the uncertainty of 9.5 year rates 6 months from now, so the first option should have a higher value.

The call option feature of a bond is the most significant characteristic that may reduce interest rate sensitivity because it is the only feature that can actually accelerate the maturity date of a given bond. The call option allows the issuer of a bond – a corporation or municipal agency – the right to call back the bond at a fixed price, typically at par value or slightly more. Thus, if interest rates decline after original issuance, the issuer may repurchase the bonds at a fixed price and subsequently reissue new bonds at lower prevailing market rates. Obviously, the call option embedded in such bonds is a benefit to the issuer, not the investor.

A callable bond can therefore be viewed as a combination of a non-callable bond, plus a call option. Yet, while the investor owns the bond, the issuer owns the call option. In other words, the investor has effectively sold the call option to the issuing agency, and therefore the call option has negative value to the bondholder as it reduces the overall market value of the callable bond. Formulaically, this can be expressed as follows:

Value of Callable Bond = Value of Noncallable Bond – Value of Call Option

So, why do callable bonds represent an opportunity in the current market environment? Well, over the past couple of years as interest rates have declined, investment-grade bonds have generally appreciated in value, but much less so for callable bonds. As rates declined, it became more likely that many such bonds would be called by their issuers at or near par value, so these bonds simply could not appreciate in price to any meaningful degree. Referring back to our formula, this means that the value of the call option increased significantly as interest rates fell, dampening any overall increase in the value of the bond itself.

For the same reason, if rates begin to rise in the coming year or two, these callable bonds are less likely to lose much value because they are already trading at levels that are relatively close to par. Such callable bonds, which have coupon rates that are higher than current market rates and trade at slight premiums to par value, are known as “cushion bonds” – the name being derived from the fact that these bonds are not as sensitive to overall changes in interest rates; they do not appreciate very much when rates fall, nor do they depreciate very much when rates rise. Thus, these bonds can cushion, or buffer, a fixed income portfolio against the affects of changing interest rates.

Posted in Business in Switzerland Tagged as american options, annual return, Bermudan options, callable bonds, coupon, embedded call option, European options, fixed income investors, interest rate sensitivity, interest rates, investment-grade bonds, investors, issuer, lockout periods, long-term bonds, maturity, non-callable bonds, option value, original issuance, security, short-term bonds

Discount and Zero Coupon Bonds

Posted November 27th, 2010 by admin. 0 Comments

Discount Bonds

Discount bonds are bonds that sell for less than the face value of the bond. In many cases, a discount bond will also be a zero-coupon bond. Like many bond issues, a discount bond normally pays the original purchase price plus a fixed or variable amount of interest over the life of the bond.

Understanding how a discounted bond functions is not difficult. Assuming that a bond has a face value of $2,000.00 and is sold for $1,800.00, it can be said that the bond sold for a discount of $200.00. The new owner of the bond can look forward to earning a return on both the principal and any interest that is generated according to the terms and conditions surrounding the bond issue.

Discount bonds could trade for less than the face value for a number of reasons. In some cases, discount bonds can be very attractive to investors because they provide an opportunity to increase the yield on the investment.

Interest Rates

One of the reasons that a bond could be trading for a discount is fluctuations in interest rates in the market. Bonds have an inverse relationship to interest rates in the market. If interest rates increase above the interest rates that are paid by the bonds, the bond values will decrease. This happens because investors will try to sell the bonds in order to get locked into bonds that pay a higher rate of interest. This concept also works in reverse, as the value of bonds will increase if interest rates in the market go down.

Default

Another reason that a bond could potentially trade for a discount is that the company is close to defaulting on the debt. If the company is close to default, investors may be trying to get anything that they can of the bonds that were issued by the company. Many investors will like to purchase these bonds at a deep discount because that provides them with a huge upside. If the company does not go into default, the bond would provide them with a great return on investment.

While many examples of the discount bond do pay interest, that is not always the case. When there is no interest involved, the investment is known as a pure discount bond. In this scenario, the buyer purchases the bond for less than the face value, but ultimately earns a return by eventually receiving the face value of the bond.

Zero Coupon Bonds

Zero coupon bonds also trade at a discount to the face value of the bond. With a zero coupon bond, the investor does not receive any regular interest payments, as he would with a traditional bond. Instead, he purchases the bond for a deep discount at the beginning of the bond term. He can then hold the bond until maturity and cash it in for the full face value. This gives him all of the interest that he would have earned at once. The bonds are called zero coupon because the interest is paid at maturity.

Benefit of Zero Coupon Bonds

The main benefit of zero coupon bonds is that you can invest for specific goals in the future. If you want to invest a certain amount of money and know exactly what you will get back in the future, this could be a great tool. For example, if you were investing so that you could purchase a home or pay for a child’s education at a certain point, this could be a very valuable tool to use.

Tax Implications

One thing that you will have to consider about zero coupon bonds is the tax implications that come with them. With this type of bond, you are actually responsible for the interest payments on your taxes, even though you receive no payments. This is referred to as “phantom interest” and it has to be accounted for along the way. This requires you to come up with money to pay the taxes from other sources besides the bond. Then when you get to cash in the bonds, you will not have to pay any taxes on the money.

Ways to Minimize Taxes

Retirement accounts- Coupon bonds can be a great addition to a retirement account. When you buy them with your retirement account funds, you do not have to worry about taxes on the bonds. Your account is allowed to grow tax free. Then when you retire, you can worry about paying the taxes for them.
Education savings- When you use zero coupon bonds for education, you can actually put the bonds in the children’s names. This will allow make the interest taxable at the child’s rate, which will usually be much less than what your tax rate would be.

Posted in Business in Switzerland Tagged as bond issue, bond term, bond values, Bonds, buy bonds, deep discount, default, discount bonds, education savings, face value, hold bonds, interest payments, interest rates, investment, investors, market, maturity, pure discount bond, retirement accounts, return, sell bonds, yield, zero coupon bonds

Fixed Income Bonds

Posted November 24th, 2010 by admin. 0 Comments

Investments that yield fixed-periodic returns and repay the principal on maturity are called fixed income bonds. These bonds are preferred by investors seeking fixed, regular income that could either substitute or add to their earnings.

An example of a fixed income security is a government bond with a 5% interest rate and a ten-year maturity period. Investing $1,000 in this bond would yield $50 annually and $1,000 in the tenth year.

The most common types of fixed income bonds are the ones that are issued by the government. They generally include government notes and bills that have a maturity period of one to ten years. However, fixed income bonds yield a lower return than variable income securities.

How do Fixed Income Bonds Work?

Fixed income bonds are based on the simple principle of lending money to a borrower and receiving interest payments at regular intervals. The lender receives the principal amount after the loan matures.

The interest rates are generally fixed at the time of bond issuance. Irrespective of the movement of interest rates in the market, a bondholder is assured of the rate on his/her bonds. However, bondholders would be impacted by changes in the market interest rates if they decide to sell their bonds earlier than the maturity date.

Benefits of Fixed Income Bonds

The benefits of fixed income bonds include:

They provide a predictable income stream.

Investments are safe.

Irrespective of market trends and interest rate fluctuations, an investor is aware of the final payment of the fixed-income bond.

Risks Related to Fixed Income Bonds

While buying a fixed income bond, an investor must consider the following risk elements:

Credit risk: Evaluate the credit worthiness of the issuer to minimize the risk of payment defaults. Federal bonds backed by the US government and government agencies are considered to be the safest.

Interest rate fluctuations: Interest rate fluctuations alter bond prices. However, this risk is valid for bonds that are sold prior to the maturity date. An increase in interest rates is unfavorable for bond prices and the reverse also holds true. This inverse relationship is an outcome of the issuance of new bonds with a higher interest rate, which affects the attractiveness of existing bonds having a lower interest rate. The longer the maturity period of the bonds, the greater will be the impact of the changes on the rate of return.

Inflation risk: Annual inflation dilutes the actual value of returns. To avoid this, an investor can consider buying US Treasury Inflation-Protected Securities (TIPS). TIPS adjusts the final return against the consumer price index (CPI).

Posted in Business in Switzerland Tagged as bond issuance, bondholder, Bonds, borrower, buy bonds, Cofinax SA, CPI, credit risk, federal bonds, fixed income bonds, income, income securities, income stream, interest payments, Interest rate, investments, investors, issuance of new bonds, lender, market, maturity, returns, safety, security, sell bonds, TIPS

Raising Capital by Issuing Bonds

Posted November 16th, 2010 by admin. 0 Comments

Bonds are a popular way to raise capital for companies and government bodies (federal government, cantons, communities). The borrower of a bond issue is also known as the issuer . Bonds are a popular investment vehicle for investors. Investors buy bonds with the aim of getting back their capital, plus interest. The return on a bond investment can increase or decrease depending on the buying and selling price.

Bonds are debt securities. Investors who buy bonds do not own a stake in the equity capital (such as shares conferring equity rights) but loan the issuer debt capital for a certain period of time. Bonds involve less risk than shares, although this does depend on the credit rating of the borrower. The yield is also limited, however.

Bonds may feature a fixed or floating interest rate (coupon) and have a predetermined duration and form of redemption(repayment). Special types of bonds such as warrant bonds and convertible bonds are part of the product universe listed or admitted to trading on the SIX Swiss Exchange.

In principle, bonds are sold on the basis of nominal values. The denomination varies depending on the issuer and issues usually have denominations of CHF 1’000, CHF 5’000, CHF 10’000 or CHF 100’000. Bonds can either be placed privately or listed/admitted to trading on a stock exchange (primary or secondary listing). If a bond is listed on the stock exchange, the issuer is obliged to produce an issuing prospectus. The issuing prospectus is the legal basis and contains all the key conditions connected with the debt security.

rimary market	Bonds can be bought at the time of the issue and held until maturity. When bonds are bought at the time of issue, the technical term for this is primary market.
Secondary market	Bonds can also be bought and sold after the issue and before maturity. This is referred to as secondary trade and takes place on the stock exchange. The market price of bonds is determined by supply and demand.

In the case of a public offering (issue) with a stock exchange listing, two phases are distinguished:

Apart from its nominal value, another important feature of a bond is its current market price, which is the price at which it can be purchased on the stock exchange. The market price is expressed as percentage (e.g. 100.24 %).

As interest-bearing securities, bonds have two main features: interest payments and debt capital base.

Interest payment in return for lending capital

In return for lending money, the investor is paid interest on an annual basis. In the case of zero bonds (which do not pay any interest), the investor is usually compensated in the form of a lower issue price

The interest rate depends on the duration, the capital market conditions at the time of issue and the credit rating of the company in question. The creditworthiness refers to the issuer’s solvency, which may vary. The interest rate may be fixed throughout the duration or adjusted on the interest dates.

Normally, the borrower pays the full nominal amount of the bond back to the lender at the end of the duration. This is called “repayment”. If the bond is sold on the stock market before the end of the duration, repayment goes to the owner who holds the bond at the end of the duration. The method for calculating bond prices is described under bond valuation.

Bonds represent borrowed capital

Bonds are borrowed capital and not equity capital of the type provided in the case of shares. The difference is that that:

the bond accrues interest independently of the company’s profit performance;
it is repayable by the issuer, because the capital provided is similar to a loan;
if the company is liquidated, bond holders are first in line to claim back their money from the estate in bankruptcy and are therefore in a better position than shareholders.

Unlike shares, bonds do not confer any membership rights on the investor (participation in general meetings, voting rights).

SIX Swiss Exchange

Posted in Business in Switzerland Tagged as annual basis, bond investment, bond issuer, bondholders, Bonds, borrowed capital, borrower, buy bonds, calculating bond prices, capital, capital market conditions, Cofinax SA, Convertible bonds, coupon, creditworthiness, debt capital, debt capital base, debt securities, duration, equity capital, fixed interest rate, floating interest rate, interest payments, interest-bearing securities, investment, investors, issuer, issues, issuing prospectus, lender, lending capital, loan, market price, maturity, nominal values, primary listing, primary market, raise capital, repayment, secondary listing, shareholders, shares, stock exchange listing, trading, trading on a stock exchange, warrant bonds, zero bonds

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