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Bond Market PDF generatPDF generated at: Wed, 20 Feb 2013 07:09:32 UTCp://code.pediapress.com/ for more information. Contents Articles Bond market 1 Bond valuation 4 Corporate bond 9 Fixed income 11 Government bond 14 High-yield debt 15 Municipal bond 19 References Article Sources and Contributors 26 Image Sources, Licenses and Contributors 27 Article Licenses License 28 Bond market 1 Bond market The bond market (also known as the credit, or fixed income market) is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the Secondary market, usually in the form of bonds. The primary goal of the bond market is to provide a mechanism for long term funding of public and private expenditures. Traditionally, the bond market was largely dominated by the United States, but  today the US is about 44% of the market. As of 2009, the size of the worldwide bond market (total debt outstanding) is an estimated $82.2 trillion,of which the size of the outstanding U.S. bond market debt was $31.2 trillion according to Bank for International Settlements (BIS), or alternatively $35.2 trillion as of Q2 2011 according  to Securities Industry and Financial Markets Association (SIFMA).  Nearly all of the $822 billion average daily trading volume in the U.S. bond market takes place between broker-dealers and large institutions in a decentralized, over-the-counter (OTC) market. However, a small number of bonds, primarily corporate, are listed on exchanges. References to the "bond market" usually refer to the government bond market, because of its size, liquidity, relative lack of credit risk and, therefore, sensitivity to interest rates. Because of the inverse relationship between bond valuation and interest rates, the bond market is often used to indicate changes in interest rates or the shape of the yield curve. The yield curve is the measure of "cost of funding". Types of bond markets The Securities Industry and Financial Markets Association (SIFMA) classifies the broader bond market into five specific bond markets. • Corporate • Government & agency • Municipal • Mortgage backed, asset backed, and collateralized debt obligation • Funding Bond market participants Bond market participants are similar to participants in most financial markets and are essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both. Participants include: • Institutional investors • Governments • Traders • Individuals Because of the specificity of individual bond issues, and the lack of liquidity in many smaller issues, the majority of outstanding bonds are held by institutions like pension funds, banks and mutual funds. In the United States, approximately 10% of the market is currently held by private individuals. Bond market 2 Bond market size Amounts outstanding on the global bond market increased by 2% in the twelve months to March 2012 to nearly $100 trillion. Domestic bonds accounted for 70% of the total and international bonds for the remainder. The US was the largest market with 33% of the total followed by Japan (14%). As a proportion of global GDP, the bond market increased to over 140% in 2011 from 119% in 2008 and 80% a decade earlier. The considerable growth means that in March 2012 it was much larger than the global equity market which had a market capitalisation of around $53 trillion. Growth of the market since the start of the economic slowdown was largely a result of an increase in issuance by governments. The outstanding value of international bonds increased by 2% in 2011 to $30 trillion. The $1.2 trillion issued during the year was down by around a fifth on the previous year's total. The first half of 2012 was off to a strong start with issuance of over $800bn. The US was the leading centre in terms of value outstanding with 24% of the total followed by the UK 13%.  U.S. bond market size  According to the Securities Industry and Financial Markets Association (SIFMA), as of Q2 2011, the U. S. bond market size is (in trillions of dollars) Category Amount Percentage Government 9.2 28 Municipal 2.9 9 Agency 2.4 7 Corporate 7.7 24 Mortgage related 8.3 26 Asset Backed 1.9 6 Total 32.3 100 Note that the total Federal Government debts recognized by SIFMA are significantly less than the total bills, notes  and bonds issued by the U. S. Treasury Department, of some 14.4 trillion dollars at the time. This figure is likely to have excluded the inter-governmental debts such as those held by the Federal Reserve and the Social Security Trust. Bond market volatility For market participants who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a pre-determined schedule. But participants who buy and sell bonds before maturity are exposed to many risks, most importantly changes in interest rates. When interest rates increase, the value of existing bonds falls, since new issues pay a higher yield. Likewise, when interest rates decrease, the value of existing bonds rises, since new issues pay a lower yield. This is the fundamental concept of bond market volatility: changes in bond prices are inverse to changes in interest rates. Fluctuating interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes. Economists' views of economic indicators versus actual released data contribute to market volatility. A tight consensus is generally reflected in bond prices and there is little price movement in the market after the release of "in-line" data. If the economic release differs from the consensus view the market usually undergoes rapid price movement as participants interpret the data. Uncertainty (as measured by a wide consensus) generally brings more volatility before and after an economic release. Economic releases vary in importance and impact depending on Bond market 3 where the economy is in the business cycle. Bond market influence Bond markets determine the price in terms of yield that a borrower must pay in order to receive funding. In one notable instance, when President Clinton attempted to increase the US budget deficit in the 1990s, it led to such a sell-off (decreasing prices; increasing yields) that he was forced to abandon the strategy and instead balance the budget. 7] I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would “ like to come back as the bond market. You can intimidate everybody. ” — James Carville, political advisor to President Clinton, Bloomberg Bond investments Investment companies allow individual investors the ability to participate in the bond markets through bond funds, closed-end funds and unit-investment trusts. In 2006 total bond fund net inflows increased 97% from $30.8 billion in 2005 to $60.8 billion in 2006.Exchange-traded funds (ETFs) are another alternative to trading or investing directly in a bond issue. These securities allow individual investors the ability to overcome large initial and incremental trading sizes. Bond indices A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The most common American benchmarks are the Barclays Capital Aggregate Bond Index, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolios. References  http://www.investinginbondseurope.org/Pages/LearnAboutBonds.aspx?folder_id=464  Outstanding World Bond Market Debt (http://www.aametrics.com/pdfs/world_stock_and_bond_markets_nov2009.pdf) from the Bank for International Settlements via Asset Allocation Advisor. Original BIS data as of March 31, 2009; Asset Allocation Advisor compilation as of November 15, 2009. Accessed January 7, 2010.  Avg Daily Trading Volume (http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USBondMarketTradingVolume.pdf) SIFMA 2009 Jan-Nov Average Daily Trading Volume. Accessed January 6, 2010.  (http://www.thecityuk.com/assets/Uploads/Bond-Markets-2012-F1.pdf) Bond Markets 2012 report  (http://www.sifma.org/research/statistics.aspx) SIFMA Statistics  (http://www.fms.treas.gov/bulletin/index.html) Treasury Bulletin  M&G Investments - Bond Vigilantes - Are the bond vigilantes vigilant enough? (http://www.bondvigilantes.co.uk/blog/2009/02/20/ 1235143740000.html), 20 February 2009  Bloomberg - Bond Vigilantes Push U.S. Treasuries Into Bear Market (http://www.bloomberg.com/apps/news?pid=20601103& sid=adGdbnMsKTQg&refer=news), 10 February 2009  Bond fund flows (http://www.bondmarkets.com/story.asp?id=2793) SIFMA. Accessed April 30, 2007. Bond valuation 4 Bond valuation Bond valuation is the determination of the fair price of a bond. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. In practice, this discount rate is often determined by reference to similar instruments, provided that such instruments exist. Various related yield-measures are calculated for the given price. If the bond includes embedded options, the valuation is more difficult and combines option pricing with discounting. Depending on the type of option, the option price as calculated is either added to or subtracted from the price of the "straight" portion. See further under Bond option. This total is then the value of the bond. Bond valuation As above, the fair price of a "straight bond" (a bond with no embedded options; see Bond (finance)# Features) is usually determined by discounting its expected cash flows at the appropriate discount rate. The formula commonly applied is discussed initially. Although this present value relationship reflects the theoretical approach to determining the value of a bond, in practice its price is (usually) determined with reference to other, more liquid instruments. The two main approaches, Relative pricing and Arbitrage-free pricing, are discussed next. Finally, where it is important to recognise that future interest rates are uncertain and that the discount rate is not adequately represented by a single fixed number - for example when an option is written on the bond in question - stochastic calculus may be employed. Where the market price of bond is less than its face value (par value), the bond is selling at a discount. Conversely, if the market price of bond is greater than its face value, the bond is selling at a premium.For this and other relationships relating price and yield, see below. Present value approach Below is the formula for calculating a bond's price, which uses the basic present value (PV) formula for a given discount rate:3](This formula assumes that a coupon payment has just been made; see below for adjustments on other dates.) where: F = face value i = contractual interest rate F C = F * iF= coupon payment (periodic interest payment) N = number of payments i = market interest rate, or required yield, or observed / appropriate yield to maturity (see below) M = value at maturity, usually equals face value P = market price of bond. Bond valuation 5 Relative price approach Under this approach - an extension of the above - the bond will be priced relative to a benchmark, usually a government security; see Relative valuation. Here, the yield to maturity on the bond is determined based on the bond's Credit rating relative to a government security with similar maturity or duration; see Credit spread (bond). The better the quality of the bond, the smaller the spread between its required return and the YTM of the benchmark. This required return is then used to discount the bond cash flows, replacing in the formula above, to obtain the price. Arbitrage-free pricing approach See: Rational pricing: Fixed income securities. As distinct from the two related approaches above, a bond may be thought of as a "package of cash flows" - coupon or face - with each cash flow viewed as a zero-coupon instrument maturing on the date it will be received. Thus, rather than using a single discount rate, one should use multiple discount rates, discounting each cash flow at its own rate.1]Here, each cash flow is separately discounted at the same rate as a zero-coupon bond corresponding to the coupon date, and of equivalent credit worthiness (if possible, from the same issuer as the bond being valued, or if not, with the appropriate credit spread). Under this approach, the bond price should reflect its "arbitrage-free" price, as any deviation from this price will be exploited and the bond will then quickly reprice to its correct level. Here, we apply the rational pricing logic relating to "Assets with identical cash flows". In detail: (1) the bond's coupon dates and coupon amounts are known with certainty. Therefore (2) some multiple (or fraction) of zero-coupon bonds, each corresponding to the bond's coupon dates, can be specified so as to produce identical cash flows to the bond. Thus (3) the bond price today must be equal to the sum of each of its cash flows discounted at the discount rate implied by the value of the corresponding ZCB. Were this not the case, (4) the abitrageur could finance his purchase of whichever of the bond or the sum of the various ZCBs was cheaper, by short selling the other, and meeting his cash flow commitments using the coupons or maturing zeroes as appropriate. Then (5) his "risk free", arbitrage profit would be the difference between the two values. Stochastic calculus approach When modelling a bond option, or other interest rate derivative (IRD), it is important to recognize that future interest rates are uncertain, and therefore, the discount rate(s) referred to above, under all three cases - i.e. whether for all coupons or for each individual coupon - is not adequately represented by a fixed (deterministic) number. In such cases, stochastic calculus is employed. The following is a partial differential equation (PDE) in stochastic calculus which is satisfied by any zero-coupon bond.  The solution to the PDE - given in - is: where is the expectation with respect to risk-neutral probabilities, and is a random variable representing the discount rate; see also Martingale pricing. To actually determine the bond price, the analyst must choose the specific short rate model to be employed. The approaches commonly used are: • the CIR model • the Black-Derman-Toy model • the Hull-White model Bond valuation 6 • the HJM framework • the Chen model. Note that depending on the model selected, a closed-form solution may not be available, and a lattice- or simulation-based implementation of the model in question is then employed. See also Jamshidian's trick. Clean and dirty price When the bond is not valued precisely on a coupon date, the calculated price, using the methods above, will incorporate accrued interest: i.e. any interest due to the owner of the bond since the previous coupon date; see day count convention. The price of a bond which includes this accrued interest is known as the "dirty price" (or "full price" or "all in price" or "Cash price"). The "clean price" is the price excluding any interest that has accrued. Clean prices are generally more stable over time than dirty prices. This is because the dirty price will drop suddenly when the bond goes "ex interest" and the purchaser is no longer entitled to receive the next coupon payment. In many markets, it is market practice to quote bonds on a clean-price basis. When a purchase is settled, the accrued interest is added to the quoted clean price to arrive at the actual amount to be paid. Yield and price relationships Once the price or value has been calculated, various yields relating the price of the bond to its coupons can then be determined. Yield to Maturity The yield to maturity is the discount rate which returns the market price of the bond; it is identical (required return) in the above equation. YTM is thus the internal rate of return of an investment in the bond made at the observed price. Since YTM can be used to price a bond, bond prices are often quoted in terms of YTM. To achieve a return equal to YTM, i.e. where it is the required return on the bond, the bond owner must: • buy the bond at price P , 0 • hold the bond until maturity, and • redeem the bond at par. Coupon yield The coupon yield is simply the coupon payment (C) as a percentage of the face value (F). Coupon yield = C / F Coupon yield is also called nominal yield. Current yield The current yield is simply the coupon payment (C) as a percentage of the (current) bond price (P). Current yield = Bond valuation 7 Relationship The concept of current yield is closely related to other bond concepts, including yield to maturity, and coupon yield. The relationship between yield to maturity and the coupon rate is as follows: • When a bond sells at a discount, YTM > current yield > coupon yield. • When a bond sells at a premium, coupon yield > current yield > YTM. • When a bond sells at par, YTM = current yield = coupon yield Price sensitivity The sensitivity of a bond's market price to interest rate (i.e. yield) movements is measured by its duration, and, additionally, by its convexity. Duration is a linear measure of how the price of a bond changes in response to interest rate changes. It is approximately equal to the percentage change in price for a given change in yield, and may be thought of as the elasticity of the bond's price with respect to discount rates. For example, for small interest rate changes, the duration is the approximate percentage by which the value of the bond will fall for a 1% per annum increase in market interest rate. So the market price of a 17-year bond with a duration of 7 would fall about 7% if the market interest rate (or more precisely the corresponding force of interest) increased by 1% per annum. Convexity is a measure of the "curvature" of price changes. It is needed because the price is not a linear function of the discount rate, but rather a convex function of the discount rate. Specifically, duration can be formulated as the first derivative of the price with respect to the interest rate, and convexity as the second derivative (see: Bond duration closed-form formula; Bond convexity closed-form formula). Continuing the above example, for a more accurate estimate of sensitivity, the convexity score would be multiplied by the square of the change in interest rate, and the result added to the value derived by the above linear formula. Accounting treatment In accounting for liabilities, any bond discount or premium must be amortized over the life of bond. A number of methods may be used for this depending on applicable accounting rules. One possibility is that amortization amount in each period is calculated from the following formula: = amortization amount in period number "n+1" Bond Discount or Bond Premium = = Bond Discount or Bond Premium = References and external links References ] Fabozzi, 1998  http://www.investopedia.com/terms/a/amortizable-bond-premium.asp  http://www.investopedia.com/university/advancedbond/advancedbond2.asp  John C. Cox, Jonathan E. Ingersoll and Stephen A. Ross (1985). A Theory of the Term Structure of Interest Rates (http://www.javaquant. net/papers/CIR1985.pdf), Econometrica 53:2 Bibliography • Guillermo L. Dumrauf (2012). Bonds, a Step by Step Analysis with Excel, Chapter 1: Pricing and Return (http:// www.amazon.com/Bonds-Analysis-Excel-Chapter-ebook/dp/B008D4PRIU). Kindle Edition. Bond valuation 8 • Frank Fabozzi (1998). Valuation of fixed income securities and derivatives (3rd ed.). John Wiley. ISBN 978-1-883249-25-0. • Frank J. Fabozzi (2005). Fixed Income Mathematics: Analytical & Statistical Techniques (4th ed.). John Wiley. ISBN 978-0071460736. • R. Stafford Johnson (2010). Bond Evaluation, Selection, and Management (2nd ed.). John Wiley. ISBN 0470478357. • Donald J. Smith (2011). Bond Math: The Theory Behind the Formulas. John Wiley. ISBN 1576603067. • Bruce Tuckman (2011). Fixed Income Securities: Tools for Today's Markets (3rd ed.). John Wiley. ISBN 0470891696. • Pietro Veronesi (2010). Fixed Income Securities: Valuation, Risk, and Risk Management. John Wiley. ISBN 978-0470109106. Discussion • Bond Valuation (http://www.duke.edu/~charvey/Classes/ba350/bondval/bondval.htm), Prof. Campbell R. Harvey, Duke University • A Primer on the Time Value of Money (http://pages.stern.nyu.edu/~adamodar/New_Home_Page/PVPrimer/ pvprimer.htm), Prof. Aswath Damodaran, Stern School of Business • Basic Bond Valuation (http://www.wfu.edu/~palmitar/Law&Valuation/chapter 4/4-2-2.htm) Prof. Alan R. Palmiter, Wake Forest University • Bond Price Volatility (http://www.iassa.co.za/images/file/IASJournals/no501999Lwabona.pdf) Investment Analysts Society of South Africa • Duration and convexity (http://www.iassa.co.za/images/file/IASJournals/No512000Lwabona.pdf) Investment Analysts Society of South Africa Calculators • General-Purpose Bond Calculator (http://www.investinginbonds.com/calcs/tipscalculator/TipsCalcForm. aspx), Securities Industry and Financial Markets Association • Bond Price (http://www.wfu.edu/~palmitar/Law&Valuation/chapter 4/Attachments/Worksheet-BondPrices. xls) Excel spreadsheet, Prof. Alan R. Palmiter, Wake Forest University • Bond Pricing and Duration (http://www.mngt.waikato.ac.nz/kurt/frontpage/ModelsAcademic/ExcelModels/ Bond Price with Excel Functions.xls) Excel spreadsheet, Prof. Kurt Hess, Waikato Management School, University of Waikato Corporate bond 9 Corporate bond A corporate bond is a bond issue by a corporation. It is a bond that a corporation issues to raise money effectively  in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. (The term "commercial paper" is sometimes used for instruments with a shorter maturity.) Sometimes, the term "corporate bonds" is used to include all bonds except those issued by governments in their own currencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of local authorities and supranational organizations do not fit in either category. Corporate bonds are often listed on major exchanges (bonds there are called "listed" bonds) and ECNs, and the coupon (i.e. interest payment) is usually taxable. Sometimes this coupon can be zero with a high redemption value. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based, over-the-counter markets. Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into equity. Corporate Credit spreads may alternatively be earned in exchange for default risk through the mechanism of Credit Default Swaps which give an unfunded synthetic exposure to similar risks on the same 'Reference Entities'. However, owing to quite volatile CDS 'basis' the spreads on CDS and the credit spreads on corporate bonds can be significantly different. Types Corporate debt fall into several broad categories: • secured debt vs unsecured debt • senior debt vs subordinated debt Generally, the higher one's position in the company's capital structure, the stronger one's claims to the company's assets in the event of a default. Risk analysis Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends on the particular corporation issuing the bond, the current market conditions and governments to which the bond issuer is being compared and the rating of the company. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds. The difference in yield reflects the higher probability of default, the expected loss in the event of default, and may also reflect liquidity and risk premia. Other risks in Corporate Bonds -Default Risk has been discussed above but there are also other risks for which corporate bondholders expect to be compensated by credit spread. This is, for example why the Option Adjusted Spread on a Ginnie Mae MBS will usually be higher than zero to the Treasury curve. -Credit Spread Risk. The risk that the credit spread of a bond (extra yield to compensate investors for taking default risk), which is inherent in the fixed coupon, becomes insufficient compensation for default risk that has later deteriorated. As the coupon is fixed the only way the credit spread can readjust to new circumstances is by the market price of the bond falling and the yield rising to such a level that an appropriate credit spread is offered. Corporate bond 10 -Interest Rate Risk. The level of Yields generally in a bond market, as expressed by Government Bond Yields, may change and thus bring about changes in the market value of Fixed-Coupon bonds so that their Yield to Maturity adjusts to newly appropriate levels. -Liquidity Risk. There may not be a continuous secondary market for a bond, thus leaving an investor with difficulty in selling at, or even near to, a fair price. This particular risk could become more severe in developing markets, where a large amount of junk bonds belong, such as China, Vietnam, Indonesia, etc.  -Supply Risk. Heavy issuance of new bonds similar to the one held may depress their prices. -Inflation Risk. Inflation reduces the real value of future fixed cash flows. An anticipation of inflation, or higher inflation, may depress prices immediately. -Tax Change Risk. Unanticipated changes in taxation may adversely impact the value of a bond to investors and consequently its immediate market value. Corporate bond indices Corporate bond indices include the Barclays Corporate Bond Index, the Citigroup US Broad Investment Grade Credit Index, and the Dow Jones Corporate Bond Index. Corporate bond market transparency Speaking in 2005, SEC Chief Economist Chester S. Spatt offered the following opinion on the transparency of corporate bond markets: Frankly, I find it surprising that there has been so little attention to pre-trade transparency in the design of the U.S. bond markets. While some might argue that this is a consequence of the degree of fragmentation in the bond market, I would point to options markets and European bond markets-which are similarly fragmented, but much more transparent on a pre-trade basis. A combination of mathematical and regulatory initiatives are aimed at addressing pre-trade transparency in the U.S. corporate bond markets. References  Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action (http://www.pearsonschool.com/index. cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4). Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 281. ISBN 0-13-063085-3. .  Michael Simkovic and Benjamin Kaminetzky, Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution (http://ssrn.com/abstract=1632084) (August 29, 2010). Columbia Business Law Review, Vol. 2011, No. 1, p. 118, 2011  Vuong, Quan Hoang; Tran, Tri Dung (2010). "Vietnam's Corporate Bond Market, 1990-2010: Some Reflections" (http://www.vietnamica. net/op/wp-content/uploads/2010/11/VuongTran.JEPR_.Vol6_.No1_.2011.pdf). The Journal of Economic Policy and Research (Institute of Public Enterprises) 6 (1): 1–47. .  Spatt, Chester. "Broad Themes in Market Microstructure" (http://www.sec.gov/news/speech/spch050605css.htm). . Fixed income 11 Fixed income Fixed income refers to any type of investment under which the borrower/issuer is obliged to make payments of a fixed amount on a fixed schedule: for example, if the borrower has to pay interest at a fixed rate once a year, and to repay the principal amount on maturity. Fixed-income securities can be contrasted with equity securities, often referred to as stocks and shares, that create no obligation to pay dividends or any other form of income. In order for a company to grow its business, it often must raise money: to finance an acquisition, buy equipment or land or invest in new product development. The terms on which investors will finance the company will depend on the risk profile of the company. The company can give up equity by issuing stock, or can promise to pay regular interest and repay the principal on the loan (bond, bank loan, or preferred stock). The term "fixed" in "fixed income" refers to both the schedule of obligatory payments and the amount. "Fixed income securities" can be distinguished from inflation-indexed bonds, variable-interest rate notes, and the like. If an issuer misses a payment on a fixed income security, the issuer is in default, and depending on the relevant law and the structure of the security, the payees may be able to force the issuer into bankruptcy. In contrast, if a company misses a quarterly dividend to stock (non-fixed-income) shareholders, there is no violation of any payment covenant, and no default. The term fixed income is also applied to a person's income that does not vary materially over time. This can include income derived from fixed-income investments such as bonds and preferred stocks or pensions that guarantee a fixed income. When pensioners or retirees are dependent on their pension as their dominant source of income, the term "fixed income" can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large or discretionary expenditures. Types of borrowers Governments issue government bonds in their own currency and sovereign bonds in foreign currencies. Local governments issue municipal bonds to finance themselves. Debt issued by government-backed agencies is called an agency bond. Companies can issue a corporate bond or obtain money from a bank through a corporate loan. Preferred stocks share some of the characteristics of fixed interest bonds. Securitized bank lending (e.g. credit card debt, car loans or mortgages) can be structured into other types of fixed income products such as ABS – asset-backed securities which can be traded on exchanges just like corporate and government bonds. Terminology Some of the terminology used in connection with these investments is: • The issuer is the entity (company or government) who borrows the money by issuing the bond, and is due to pay interest and repay capital in due course. • The principal of a bond – also known as maturity value, face value, par value – is the amount that the issuer  borrows which must be repaid to the lender. • The coupon (of a bond) is the annual interest that the issuer must pay, expressed as a percentage of the principal. • The maturity is the end of the bond, the date that the issuer must return the principal. • The issue is another term for the bond itself. • The indenture, in some cases, is the contract that states all of the terms of the bond. Fixed income 12 Investors Investors in fixed-income securities are typically looking for a constant and secure return on their investment. For example, a retired person might like to receive a regular dependable payment to live on, but not consume principal. This person can buy a bond with their money, and use the coupon payment (the interest) as that regular dependable payment. When the bond matures or is refinanced, the person will have their money returned to them. Pricing factors The main number which is used to assess the value of the bond is the gross redemption yield. This is defined such that if all future interest and principal repayments are discounted back to the present, at an interest rate equal to the gross redemption yield (gross means pre-tax), then the discounted value is equal to the current market price of the bond (or the initial issue price if the bond is just being launched). Fixed income investments such as bonds and loans are generally priced as a credit spread above a low-risk reference rate, such as LIBOR or U.S. or German  Government Bonds of the same duration. For example, if a 30 year mortgage denominated in US dollars has a gross redemption yield of 5% per annum and 30 year US Treasury Bonds have a gross redemption yield of 3% per annum (referred to as the risk free yield), the credit spread is 2% per annum (sometimes quoted as 200 basis points). The credit spread reflects the risk of default.Risk free interest rates are determined by market forces and vary over time, based on a variety of factors, such as current short-term interest rates, e.g. base rates set by central banks such as the US Federal Reserve, the Bank of England in the UK, and the Euro Zone ECB. If the coupon on the bond is lower than the yield, then its price will be below the par value, and vice versa. In buying a bond, one is buying a set of cash flows, which are discounted according to the buyer's perception of how interest and exchange rates will move over its life. Supply and demand affect prices, especially in the case of market participants who are constrained in the investments they make. Insurance companies and pension funds usually have long term liabilities that they wish to hedge, which requires low risk, predictable cash flows, such as long dated government bonds. Inflation-linked bonds There are also inflation-indexed bonds, fixed-income securities linked to a specific price index. The most common examples are US Treasury Inflation Protected Securities (TIPS) and UK Index Linked Gilts. The interest and principal repayments under this type of bond are adjusted in line with a Consumer Price Index (in the US this is the CPI-U for urban consumers). This means that these bonds are guaranteed to outperform the inflation rate (unless (a) the market price has increased so that the "real" yield is negative, which is the case in 2012 for many such UK bonds, or (b) the government or other issuer defaults on the bond). This allows investors of all types to preserve the purchasing power of their money even at times of high inflation. For example, assuming 3.88% inflation over the course of 1 year (just about the 56 year average inflation rate, through most of 2006), and a real yield of 2.61% (the fixed US Treasury real yield on October 19, 2006, for a 5 yr TIPS), the adjusted principal of the fixed income would rise from 100 to 103.88 and then the real yield would be applied to the adjusted principal, meaning 103.88 x 1.0261, which equals 106.5913; giving a total return of 6.5913%. TIPS moderately outperform conventional US Treasuries, which yielded just 5.05% for a 1 yr bill on October 19, 2006. Fixed income 13 Derivatives Fixed income derivatives include interest rate derivatives and credit derivatives. Often inflation derivatives are also included into this definition. There is a wide range of fixed income derivative products: options, swaps, futures contracts as well as forward contracts. The most widely traded kinds are:  • Credit default swaps • Interest rate swaps • Inflation swaps • Bond futures on 2/10/30-year government bonds • Interest rate futures on 90-day interbank interest rates • Forward rate agreements Risks Fixed income securities have risks that may include but are not limited to the following, many of which are synonymous, mutually exclusive, or related: • inflation risk – that the buying power of the principal and interest payments will decline during the term of the security • interest rate risk – that overall interest rates will change from the levels available when the security is sold, causing an opportunity cost • currency risk – that exchange rates with other currencies will change during the security's term, causing loss of buying power in other countries • default risk – that the issuer will be unable to pay the scheduled interest payments or principal repayment due to financial hardship or otherwise • reinvestment risk – that the purchaser will be unable to purchase another security of similar return upon the expiration of the current security • liquidity risk – that the buyer will require the principal funds for another purpose on short notice, prior to the expiration of the security, and be unable to exchange the security for cash in the required time period without loss of fair value • duration risk • convexity risk • credit quality risk • political risk – that governmental actions will cause the owner to lose the benefits of the security • tax adjustment risk • market risk – the risk of market-wide changes affecting the value of the security • event risk – the risk that externalities will cause the owner to lose the benefits of the security Fixed income 14 References  http://apps.finra.org/investor_information/smart/bonds/bondglossary.asp  Michael Simkovic, Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution (http://ssrn.com/ abstract=1632084) Columbia Business Law Review, Vol. 2011, No. 1, p. 118, 2011  Michael Simkovic, "Secret Liens and the Financial Crisis of 2008" (http://ssrn.com/abstract=1323190), American Bankruptcy Law Journal 2009 External links • UK Debt Management Office (http://www.dmo.gov.uk/) Government bond A government bond is a bond issued by a national government, generally promising to pay a certain amount (the face value) on a certain date, as well as periodic interest payments. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country. Government bonds are usually denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bondalthough the term "sovereign bond" may also refer to bonds issued in a country's own currency. History The first ever government bond was issued by the Bank of England in 1693 to raise money to fund a war against France. It was in the form of a tontine. Later, governments in Europe started issuing perpetual bonds (bonds with no maturity date) to fund wars and other government spending. The use of perpetual bonds ceased in the 20th century, and currently governments issue bonds of limited duration. Risk Credit risk Government bonds are usually referred to as risk-free bonds, because the government can raise taxes or create additional currency in order to redeem the bond at maturity. Some counter examples do exist where a government has defaulted on its domestic currency debt, such as Russia in 1998 (the "ruble crisis"), though this is very rare (see national bankruptcy). Currency and inflation risk As an example, in the US, Treasury securities are denominated in US dollars. In this instance, the term "risk-free" means free of credit risk. However, other risks still exist, such as currency risk for foreign investors (for example non-US investors of US Treasury securities would have received lower returns in 2004 because the value of the US dollar declined against most other currencies). Secondly, there is inflation risk, in that the principal repaid at maturity will have less purchasing power than anticipated if the inflation rate is higher than expected. Many governments issue inflation-indexed bonds, which protect investors against inflation risk by increasing the interest rate given to the investor as the inflation rate of the economy increases. Government bond 15 Terminology United Kingdom In the UK, government bonds were called "government stock" or "treasury stock" and the older issues are still called   "treasury stock". Newer issues are called "gilts". The name "bond" was reserved for fixed-value investments, which were not tradeable on the stock market. Inflation-indexed bonds are called Index-linked gilts in the UK.] References  "Sovereign Bond Definition" (http://www.investopedia.com/terms/s/sovereignbond.asp). investopedia.com. 2011 [last update]. . Retrieved 15 December 2011.  http://www.dmo.gov.uk/reportView.aspx?rptCode=D3B.2&rptName=72460326&reportpage=Gilts/Daily_Prices  "Gilt Market: About gilts" (http://www.dmo.gov.uk/index.aspx?page=Gilts/About_Gilts). UK Debt Management Office. . Retrieved 2011-06-13.  "Gilt Market: Index-linked gilts" (http://www.dmo.gov.uk/index.aspx?page=gilts/indexlinked). UK Debt Management Office. . Retrieved 2011-06-13. High-yield debt In finance, a high-yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a bond that is rated below investment grade. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors. Flows and levels Global high yield bond (debt) issuance is disproportionately centered in the United States, although issuers in Europe, Asia and South Africa have turned to high-yield debt in connection with refinancings and acquisitions. In  2006, European companies issued over €31 billion of high-yield bonds. 2010 was a record year for European Junk Bond issuance, with as much as €50bn expected. In the US, high yield bond issuance has surged since the financial market meltdown of 2008-09, culminating in a record $346 billion in offerings during 2012, easily besting the then-record $287 billion seen in 2010.3] The 2013 US high yield debt market took off where 2012 ended, pricing more than $31 billion in deals during the  first month of the year, making it the busiest January on record. The eye-popping volume (and accompanying record-low yields) comes amid sustained institutional investor appetite and a quest for higher yielding paper. Risk The holder of any debt is subject to interest rate risk and credit risk, inflationary risk, currency risk, duration risk, convexity risk, repayment of principal risk, streaming income risk, liquidity risk, default risk, maturity risk, reinvestment risk, market risk, political risk, and taxation adjustment risk. Interest rate risk refers to the risk of the market value of a bond changing in value due to changes in the structure or level of interest rates or credit spreads or risk premiums. The credit risk of a high-yield bond refers to the probability and probable loss upon a credit event (i.e., the obligor defaults on scheduled payments or files for bankruptcy, or the bond is restructured), or a credit quality change is issued by a rating agency including Fitch, Moody's, or Standard & Poors. A credit rating agency attempts to describe the risk with a credit rating such as AAA. In North America, the five major agencies are Standard and Poor's, Moody's, Fitch Ratings, Dominion Bond Rating Service and A.M. Best. Bonds in other countries may be rated by US rating agencies or by local credit rating agencies. Rating scales vary; the most popular scale uses (in order of increasing risk) ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, with the High-yield debt 16 additional rating D for debt already in arrears. Government bonds and bonds issued by government sponsored enterprises (GSEs) are often considered to be in a zero-risk category above AAA; and categories like AA and A may sometimes be split into finer subdivisions like "AA−" or "AA+". Bonds rated BBB− and higher are called investment grade bonds. Bonds rated lower than investment grade on their date of issue are called speculative grade bonds, or colloquially as "junk" bonds. The lower-rated debt typically offers a higher yield, making speculative bonds attractive investment vehicles for certain types of financial portfolios and strategies. Many pension funds and other investors (banks, insurance companies), however, are prohibited in their by-laws from investing in bonds which have ratings below a particular level. As a result, the lower-rated securities have a different investor base than investment-grade bonds. The value of speculative bonds is affected to a higher degree than investment grade bonds by the possibility of default. For example, in a recession interest rates may drop, and the drop in interest rates tends to increase the value of investment grade bonds; however, a recession tends to increase the possibility of default in speculative-grade bonds. Usage Corporate debt The original speculative grade bonds were bonds that once had been investment grade at time of issue, but where the credit rating of the issuer had slipped and the possibility of default increased significantly. These bonds are called "fallen angels". The investment banker Michael Milken realized that fallen angels had regularly been valued less than what they were worth. His time with speculative grade bonds started with his investment in these. Only later did he and other investment bankers at Drexel Burnham Lambert, followed by those of competing firms, begin organizing the issue of bonds that were speculative grade from the start. Speculative grade bonds thus became ubiquitous in the 1980s as a financing mechanism in mergers and acquisitions. In a leveraged buyout (LBO) an acquirer would issue speculative grade bonds to help pay for an acquisition and then use the target's cash flow to help pay the debt over time. In 2005, over 80% of the principal amount of high-yield debt issued by U.S. companies went toward corporate purposes rather than acquisitions or buyouts. In emerging markets, such as China and Vietnam, bonds have become increasingly important as term financing options, since access to traditional bank credits has always been proved to be limited, especially if borrowers are non-state corporates. The corporate bond market has been developing in line with the general trend of capital market, and equity market in particular.6] High-yield debt 17 Debt repackaging and subprime crisis High-yield bonds can also be repackaged into collateralized debt obligations (CDO), thereby raising the credit rating of the senior tranches above the rating of the original debt. The senior tranches of high-yield CDOs can thus meet the minimum credit rating requirements of pension funds and other institutional investors despite the significant risk in the original high-yield debt. When such CDOs are backed by assets of dubious value, such as subprime mortgage loans, and lose market liquidity, the bonds and their derivatives become what is referred to as "toxic debt". Holding such "toxic" assets has led to the demise of several investment banks such as Lehman Brothers and other financial institutions during the subprime mortgage crisis of 2007-09 and led the US Treasury to seek congressional appropriations to buy those assets in September 2008 to prevent a systemic crisis of the banks. Such assets represent a serious problem for purchasers because of their complexity. Having been repackaged maybe several times, it is difficult and time-consuming for auditors and accountants to determine their true value. As the recession of 2008-9 bites, their value is decreasing further as more debtors default, so they represent a rapidly depreciating asset. Even those assets that might have gone up in value in the long-term are now depreciating rapidly, quickly becoming  The New York City headquarters of Barclays "toxic" for the banks that hold them. Toxic assets, by increasing the (formerly Lehman Brothers, as shown in the variance of banks' assets, can turn otherwise healthy institutions into picture). In background, the AXA Center, zombies. Potentially insolvent banks have made too few good loans headquarters of AXA, first worldwide insurance creating a debt overhang problem.  Alternatively, potentially company. insolvent banks with toxic assets will seek out very risky speculative  loans to shift risk onto their depositors and other creditors. On March 23, 2009, U.S. Treasury Secretary Timothy Geithner announced a Public-Private Investment Partnership (PPIP) to buy toxic assets from banks' balance sheets. The major stock market indexes in the United States rallied on  the day of the announcement rising by over six percent with the shares of bank stocks leading the way. PPIP has two primary programs. The Legacy Loans Program will attempt to buy residential loans from banks' balance sheets. The Federal Deposit Insurance Corporation will provide non-recourse loan guarantees for up to 85 percent of the purchase price of legacy loans. Private sector asset managers and the U.S. Treasury will provide the remaining assets. The second program is called the legacy securities program which will buy mortgage backed securities (RMBS) that were originally rated AAA and commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) which are rated AAA. The funds will come in many instances in equal parts from the U.S. Treasury's Troubled Asset Relief Program monies, private investors, and from loans from the Federal Reserve's Term Asset Lending Facility (TALF). The initial size of the Public Private Investment Partnership is projected to be  $500 billion. Nobel Prize winning Economist and former Enron advisor Paul Krugman has been very critical of this program arguing the non-recourse loans lead to a hidden subsidy that will be split by asset managers, banks' shareholders and creditors. Banking analyst Meredith Whitney argues that banks will not sell bad assets at fair  market values because they are reluctant to take asset write downs. Removing toxic assets would also reduce the volatility of banks' stock prices. Because stock is akin to a call option on a firm's assets, this lost volatility will hurt  the stock price of distressed banks. Therefore, such banks will only sell toxic assets at above market prices. High-yield debt 18 High-yield bond indices High-yield bond indices exist for dedicated investors in the market. Indices for the broad high-yield market include the CSFB High Yield II Index (CSHY), Citigroup US High-Yield Market Index, the Merrill Lynch High Yield Master II (H0A0), the Barclays High Yield Index, and the Bear Stearns High Yield Index (BSIX). Some investors, preferring to dedicate themselves to higher-rated and less-risky investments, use an index that only includes BB-rated and B-rated securities, such as the Merrill Lynch Global High Yield BB-B Rated Index (HW40). Other investors focus on the lowest quality debt rated CCC or distressed securities, commonly defined as those yielding 1500 basis points over equivalent government bonds. EU Member-State Debt Crisis On 27 April 2010, the Greek debt rating was decreased to "junk" status by Standard & Poor's amidst fears of default by the Greek Government. They also cut Portugal's credit ratings by two notches to A, over concerns about its  state debt and public finances on 28 April. On 5 July 2011, Portugal's rating was decreased to "junk" status by Moody's (by four notches from Baa1 to Ba2) saying there was a growing risk the country would need a second bail-out before it was ready to borrow money from financial markets again, and private lenders might have to  contribute. On 13 July 2012, Moody's cut Italy's credit rating two notches, to Baa2 (leaving it just above junk). Moody's warned the country it could be cut further. With the ongoing deleveraging process within the European banking system, many European CFOs are still issueing high-yield bonds. As a result, by the end of September 2012, the total amount of annual primary bond issuances stood at EUR 50 billion. It is assumed that high-yield bonds are still attractive for companies with a stable funding base, although the ratings have declined continuously for most of those bonds.  References  Edwards, Bryant; et al. (2006). High Yield In France (http://www.lw.com/upload/pubContent/_pdf/pub1715_1.pdf). Latham & Watkins. .  http://www.ft.com/cms/s/0/439e8134-fe11-11de-9340-00144feab49a.html  "How big is the high yield bond market?" (http://www.highyieldbond.com/primer/#!high-yield-bond-volume). High Yield Bond Primer. Leveraged Commentary & Data. .  "High yield bond mart sees record January issuance, though tone is softening" (http://www.highyieldbond.com/ high-yield-bond-mart-sees-record-january-issuance-though-tone-is-softening/). HighYieldBond.com. .  "In low-rate environment, more "high yield" bond issuers forge into 4% territory" (http://www.forbes.com/sites/spleverage/2013/01/25/ in-low-rate-environment-more-high-yield-issuers-forge-into-4-territory/). Forbes. .  "Vietnam's corporate bond market, 1990-2010: Some reflections" (http://www.vietnamica.net/op/wp-content/uploads/2010/11/ VuongTran.JEPR_.Vol6_.No1_.2011.pdf). The Journal of Economic Policy and Research, 6(1): 1-47. March 15, 2011. . Retrieved November 27, 2010.  "Marketplace Whiteboard: Toxic assets" (http://marketplace.publicradio.org/videos/whiteboard/toxic_assets.shtml). Marketplace. . Retrieved 2009-03-20.  "Debt Overhang and Bank Bailouts" (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1336288). SSRN.com. February 2, 2009. . Retrieved February 2, 2009.  "Common (Stock) Sense about Risk-Shifting and Bank Bailouts" (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1321666). SSRN.com. December 29, 2009. . Retrieved January 21, 2009.  Andrews, Edmund L.; Dash, Eric (March 24, 2009). "U.S. Expands Plan to Buy Banks’ Troubled Assets" (http://www.nytimes.com/ 2009/03/24/business/economy/24bailout.html). New York Times. . Retrieved February 12, 2009.  "FACT SHEET PUBLIC-PRIVATE INVESTMENT PROGRAM" (http://www.treas.gov/press/releases/reports/ppip_fact_sheet.pdf). U.S. Treasury. March 23, 2009. . Retrieved March 26, 2009.  Paul Krugman (March 23, 2009). "Geithner plan arithmetic" (http://krugman.blogs.nytimes.com/2009/03/23/geithner-plan-arithmetic/ ). New York Times. . Retrieved March 27, 2009.  "Meredith Whitney: A Bad Bank Won't Save Banks" (http://www.businessinsider.com/2009/1/ meredith-whitney-a-bad-bank-wont-save-us). businessinsider.com. January 29, 2009. . Retrieved March 27, 2009. High-yield debt 19  "The Put Problem with Buying Toxic Assets" (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1343625). SSRN.com. February 14, 2009. . Retrieved February 15, 2009.  Greek Debt Rating cut to Junk Status (http://www.nytimes.com/2010/04/28/business/global/28drachma.html), The New York Times, April 27, 2010  "Fears grow over Greece shockwaves" (http://news.bbc.co.uk/1/hi/business/8648029.stm). BBC News. April 28, 2010. . Retrieved May 4, 2010.  "Portugal's debt is downgraded to junk status by Moody's" (http://www.bbc.co.uk/news/business-14038529). BBC News. July 5, 2011. . Retrieved July 5, 2011.  Fitch: High-Yields to Remain Good Alternative in Europe (http://www.cfo-insight.com/financing-liquidity/loans-and-bonds/ fitch-high-yields-to-remain-good-alternative-in-europe/) CFO Insight Magazine. Fitch 50 Europe report. Dec 12, 2012; Retrieved 12-12-2012 External links • Junk Bonds: Everything You Need to Know (http://www.investopedia.com/articles/02/052202.asp) Municipal bond A municipal bond is a bond issued by a local government, or their agencies. Potential issuers of municipal bonds include cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) below the state level. Municipal bonds may be general obligations of the issuer or secured by specified revenues. In the United States, interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued fo
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