Bonds: Calculating Yield

When talking about bonds (especially when buying them) you have to take into consideration the yield of the bond. Simply put, a bond’s yield shows the relationship of the investment and the income. For the sake of comparability yield is always shown as an annualized (yearly) percentage.

Current Yield

Although we may know the coupon rate of a bond that only shows the real yield of the bond if the bond was bought at par value and will be held till maturity. Current yield compares the yearly interest income with the current market price. If the bond was bought with a discount the current yield will be higher than the coupon rate, if it was bought with a premium it will be lower. Current yield is calculated with the following formula:

CY=

Holding-period Yield

This yield is used when the investor knows when he will sell his bonds. In this case we use an estimated selling price instead of the face value.

Yield to Maturity

Yield to maturity is the rate at which if we discount the incomes (cash-flows) of the bond, we get the par value exactly. This yield is used most because it takes into consideration all future incomes and also their change over time.

Simplified Yield to Maturity - SYTM

Yield can be calculated many ways. There are bond-tables from which you can calculate yield fairly easily. Some more serious calculators are also capable of doing the calculations. Without these we have two choices. We can either use a method called the trial and error method, or we can use simplified yield calculated method, aptly named SYTM or simplified yield to maturity. Both these choices are approximations, although I consider the trial and error method to be inferior because doing it in reality would be much longer and most probably less exact. The formula for calculating it is:

Yield of Zero Coupon Bonds

Because there is no interest payment here, only one cash-flow, the repayment of the face value, there is no need to use approximations because we know all the information we need. We know already that:

Rearranged:   

Please note that we can also use PVIF tables to solve these problems because:

By substituting this we get:

Yield of Perpetual Bonds

Calculating yield here is very simple, I will only mention it because no further explanation is needed.

Bond pricing

FI (fixed income) securities are traded in market like stocks, so they too have price.
The price of the bond is determined by the :

1. The current rates prevalent in the market
2. Future interest rate expectations
3. Credit quality of the issuer

Like any other asset, the price of the FI security is a present value of the future cash flows.
Bonds and interest rates inverse relation
Bonds price in secondary markets 
Calculating bond price

Calculating the bond price

Fundamentally, however, the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: all we are doing is discounting the known future cash flows. Remember, to calculate present value--which is based on the assumption that each payment is re-invested at some interest rate once it is received--we have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield. (If the concepts of present and future value are new to you or you are unfamiliar with their calculations, refer to our article “Understanding the Time Value of Money” for a quick brush-up.)



Here is the formula for calculating a bond's price, which uses the basic present value (PV) formula:

C = coupon payment
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value
The succession of coupon payments to be received in the future is referred to as an ordinary annuity, which is a series of fixed payments at set intervals over a fixed period of time. (Coupons on a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired (the calculation assumes this time is the present).
You may have guessed that the bond pricing formula shown above may be tedious to calculate since it requires us to add the present value of each future coupon payment. But since these payments are paid at an ordinary annuity, we can use the shorter PV-of-ordinary-annuity formula that is mathematically equivalent to the summation of all the PVs of future cash flows. This PV-of-ordinary-annuity formula replaces the need to add all the present values of the future coupon. The following diagram illustrates how present value is calculated for an ordinary annuity:

Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods 1, 2, and 3. Notice how the present value decreases for those coupon payments that are further into the future (if you don't know why, see “Understanding the Time Value of Money”): the present value of the second coupon payment is worth less than the first coupon, and the third coupon is worth the least amount today. The further into the future a payment is to be received, the less it is worth today—this is the fundamental concept for which the PV-of-ordinary-annuity formula accounts. It calculates the sum of the present values of all future cash flows, but, unlike the bond-pricing formula we saw earlier, it doesn't require us to add the value of each coupon payment. (For more on calculating the time value of annuities, see our article "Anything but Ordinary: Calculating the Present and Future Value of Annuities.")
By incorporating the annuity model into the bond pricing formula, which requires us to include also the present value of the par value received at maturity, we arrive at the following formula:

Let's now go through a basic example to find the price of a plain vanilla bond.
Example 1 Calculate the price of a bond with a par value of $1000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. In our example we'll assume that coupon payments are made semi-annually to bond holders, and that the next coupon payment is expected in six months. Here are the steps we have to take to calculate the price:

1. Determine the number of coupon payments: Since two coupon payments will be made each year for ten years, we will have a total of 20 coupon payments.
2. Determine the value of each coupon payment: Since the coupon payments are semi-annual, divide the coupon rate in half. The coupon rate is the percentage off the bond's par value. As a result, each semi-annual coupon payment will be $50 ($1000 X 0.05).
3. Determine the semi-annual yield: Like the coupon rate, the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. (If we left the required yield at 12%, our bond price would be very low and inaccurate.) Therefore, the required semi-annual yield is 6% (0.12/2).
4. Plug the amounts into the formula:

Not too hard was it? From the above calculation, we have determined that the bond is selling at a discount: the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. The bond must sell at a discount to attract investors, who could find higher interest elsewhere in the prevailing rates. In other words, because investors can make a larger return in the market, they need an extra incentive to invest in the bonds.
Accounting for Different Payment Frequencies
In the example above coupons were paid semi-annually, so we divided the interest rate and coupon payments in half to represent the two payments per year. You may be now wondering whether there is a formula that does not require steps two and three outlined above (which are required if the coupon payments occur more than once a year). A simple modification of the above formula will allow you to adjust interest rates and coupon payments to calculate a bond price for any payment frequency:

Notice that the only modification to the original formula is the addition of “F,” which represents the frequency of coupon payments, or the number of times a year the coupon is paid. Therefore, for bonds paying annual coupons, F would have a value of 1. Should a bond pay quarterly payments, F would equal 4, and, if the bond paid semi-annual coupons, F would equal 2.
Pricing Zero-Coupon Bonds
So what happens when there are no coupon payments? For the aptly-named zero-coupon bond, there is no coupon payment until maturity. Because of this, the present value of annuity formula is unnecessary. You simply calculate the present value of the par value at maturity. Here's a simple example:
Example 2(a) Let's look at how to calculate the price of a zero-coupon bond that is maturing in five years, has a par value of $1000, and a required yield of 6%.

1. Determine the number of periods: Unless otherwise indicated, the required yield of most zero-coupon bonds is based on a “semi-annual coupon payment.” Here's why: the interest on a zero-coupon bond is equal to the difference between purchase price and maturity value, but we need a way to compare a zero-coupon bond to a coupon bond, so the 6% required yield must be adjusted to the equivalent of its semi-annual coupon rate. Therefore, the number of periods for zero-coupon bonds will be doubled, so the zero coupon bond maturing in five years would have ten periods (5 x 2).
2. Determine the yield: The required yield of 6% must also be divided by two since the number of periods used in the calculation has doubled. The yield for this bond is 3% (6% / 2).
3. Plug the amounts into the formula:

You should note that zero-coupon bonds are always priced at a discount: if zero-coupon bonds were sold at par, investors would have no way of making money from them and therefore no incentive to buy them.
Pricing Bonds between Payment Periods
Up to this point we have assumed that we are purchasing bonds whose next coupon payment occurs one payment period away, according to the regular payment-frequency pattern. So far, if we were to price a bond that pays semi-annual coupons and we purchased the bond today, our calculations would assume that we would receive the next coupon payment in exactly six months. Of course, since you won't always be buying a bond on its coupon payment date, it's important you know how to calculate price if, say, a semi-annual bond is paying its next coupon in three months, one month, or 21 days.

Determining Day Count
To price a bond between payment periods, we must use the appropriate day-count convention. Day count is a way of measuring the appropriate interest rate for a specific period of time. There is actual/actual day count, which is used mainly for Treasury securities. This method counts the exact number of days until the next payment. For example, if you purchased a semi-annual Treasury bond on March 1, 2003, and its next coupon payment is in four months (July 1st, 2003), the next coupon payment would be in 122 days:
Time Period = Days Counted
March 1-31 = 31 days
April 1-30 = 30 days
May 1-31 = 31 days
June 1-30 = 30 days
July 1 = 0 days
Total Days = 122 days
To determine the day count, we must also know the number of days in the six-month period of the regular payment cycle. In these six months there are exactly 182 days, so the day count of the Treasury bond would be 122/182, which means that out of the 182 days in the six-month period, the bond still has 122 days before the next coupon payment. In other words, 60 days of the payment period (182 - 122) have already passed. If the bondholder sold the bond today, he or she must be compensated for the interest accrued on the bond over these 60 days.
(Note that if it is a leap year, the total number of days in a year is 366 rather than 365.)
For municipal and corporate bonds, you would use the 30/360 day count convention, which is much simpler as there is no need to remember the actual number of days in each year and month. This count convention assumes that a year consists of 360 days and each month consists of 30 days. As an example, assume the above Treasury bond was actually a semi-annual corporate bond. In this case, the next coupon payment would be in 120 days.
Time Period = Days Counted
March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
July 1 = 0 days
Total Days = 120 days
As a result, the day count convention would be 120/180, which means that 66.7% of the coupon period remains. Notice that we end up with almost the same answer as the actual/actual day count convention above: both day-count conventions tell us that 60 days have passed into the payment period.
Determining Interest Accrued 
Accrued interest is the fraction of the coupon payment the bond seller earns for holding the bond for a period of time between bond payments. The bond price's inclusion of any interest accrued since the last payment period determines whether the bond's price is “dirty” or “clean.” Dirty bond prices include any accrued interest that has accumulated since the last coupon payment while clean bond prices do not. In newspapers, bond prices quoted are often their clean prices.
Since, however, many bonds traded in the secondary market are often traded in between coupon payment dates, the bond seller must be compensated for the portion of the coupon payment he or she earns for holding the bond since the last payment. The amount of the coupon payment that the buyer should receive is the coupon payment minus accrued interest.
Let's go through a simple example:
On March 1, 2003, Francesca is selling a corporate bond with a face value of $1000 and a 7% coupon paid semi-annually. The next coupon payment after March 1, 2003, is expected on June 30, 2003. What is the interest accrued on the bond?
1. Determine the semi-annual coupon payment: Since the coupon payments are semi-annual, divide the coupon rate in half, which gives a rate of 3.5% (7% / 2). Each semi-annual coupon payment will then be $35 ($1000 X 0.035).
2. Determine the number of days remaining in the coupon period: Since it is a corporate bond, we will use the 30/360 day-count convention.
Time Period = Days Counted
March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
Total Days = 120 days
There are 120 days remaining before the next coupon payment, but, since the coupons are paid semi-annually (two times a year), the regular payment period if the bond is 180 days, which, according to the 30/360 day count, is equal to six months. The seller, therefore, has accumulated 60 days worth of interest (180-120).
3. Calculate the accrued interest: Accrued interest is the fraction of the coupon payment that the original holder (in this case Francesca) has earned. It is calculated by the following formula:

In this example, the interest accrued by Francesca is $11.67. If the buyer only paid her the clean price, she would not receive the $11.67 to which she is entitled for holding the bond for those 60 days of the 180-day coupon period.

Now you know how to calculate the price of a bond, regardless of when its next coupon will be paid. Since bond price quotes are typically their clean prices but buyers of bonds pay the dirty, or full price, both buyers and sellers should understand for what amount a bond should be sold or purchased. In addition, the tools you learned in this section will better enable you to learn the relationship between coupon rate, required yield, and price, and the reasons why bond prices change in the market.

Bonds price in secondary markets

An issued fixed income pays fixed rate of interest in form of coupon until it matures. But if it is sold in the secondary markets before maturity , its value is affected by the current market rates.
So there are 2 cases :

• When the coupon rate is less than current interest rate:
  In this case security will be sold at discount
• When the coupon rate is more that current interest rate
  In this case security will be sold at premium(i.e  at profit)

Bonds can be priced at a premium, discount, or at par. If the bond's price is higher than its par value, it would sell at a premium because its interest rate is higher than current prevailing rates. If the bond's price is lower than its par value, the bond would sell at a discount because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond, given the bond's coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. So, usually the required yield on a bond is equal to or greater than the current prevailing interest rates.

Bonds and interest rates are inversely proportional

Lets understand a relation between bonds and interest rates. Suppose a investor has 2 choices to invest : 

1. A Govt backed bond

2. Govt zero

So in both case, risk factor is same, as issuer is same i.e. government and assume that returns are the same. Let the first bond pays 5% return and govt. bond's face value is Rs. 100.

So calculate the discounted value of zero.

So solution as both bond return the same, assume that P be the discounted value. 

So 100 = P+5% of P

P=100/105*100=95.23

Now suppose that return increases to 10% , the P = 100/110*100 =90.9

If suppose return decreases to 2% , P = (100/102)*100 = 98.40 .

So clearly we can infer:

Price is inversely proportional to interest rates

STAGES IN ISSUANCE OF NON-GOVT BONDS

These are the steps in issuance of non-govt bonds:

• Origination
• Syndication
• Distribution

Origination
Origination is the first stage in the process for distributing non-government bonds on the primary market. Origination occurs when a borrower authorizes an investment bank to manage new bond issues on its behalf.
The bank purchases the bonds from the borrower and distributes them to investors – a process known as underwriting. In this way, the issuer avoids the risk of being left with unsold bonds.


Selecting a Lead Manager
Lead manager - A bank that has been chosen to manage new bond issues on behalf of a borrower is known as lead manager

The borrower has two options when selecting a lead manager.
1. Build on an existing investment banking relationship
The borrower can decide to choose an investment bank with which they have an established relationship. In this case, the borrower negotiates the terms and conditions of the issue with the bank.
Depending on the size of the issue, the investment bank may invite other banks to share the risk and help sell the issue.

2. Request tenders from different investment banks
The borrower can request tenders from a group of investment banks. The borrower can provide the banks with details such as the size and currency of the transaction and the banks submit their tenders based on this information.
Alternatively, if investment banks are aware that an issuer is considering origination, they may approach the issuer with proposals even before the issuer makes a request.

Syndication
The lead manager rarely has the resources to underwrite the entire bond issue. For this reason, the lead manager may decide to form a syndicate to share the risk with other investment banks or security houses. This process is called syndication.
On the day the issuer announces the bond issue the lead manager invites other banks and security houses to join the syndicate.
Between them, the syndicate members purchase the entire bond issue and resell it to investors. In some cases, they only purchase the issue on a 'best efforts' basis. This means that they agree to sell as much of the issue as they can and return the rest to the issuer.

Besides underwriting the bond issue, the syndicate is also responsible for bond pricing and bond listing.

• Bond Pricing
• Bond Listing

Bond Pricing




Syndication: Bond Pricing
Bonds are not always priced at the total principal amount. Some bonds can be priced at less than the principal amount and others can be priced at more.




Syndication: Bond Pricing
When deciding on the issue price, the syndicate considers the coupon and the yield.
Determining Coupon
In general, the lead manager aims to price bonds as close as possible to par. To achieve this, the lead manager observes yields and maturities of similar bonds on the market and then assigns a coupon rate to the issue based on the market trends.
Coupons are generally fixed in even multiples of 1/8 of a percent. Yields, however, vary depending on interest rates. In general, if the market yield is greater than the coupon, the bond trades below par. If the yield is smaller than the coupon, the bond trades above par.
Lead managers normally choose a coupon so that the new issue price will be as close as possible to, but lower than, 100%.



Syndication: Bond Pricing
Determining Yields
Issuing bonds above or below par influences the yield of a new issue. The yield is the return you earn on a bond and is expressed as a percentage of the amount you paid for the bond. If a bond is issued below par, the investor's yield is increased. If it is issued above par, the yield is reduced.


The determination of yield on a new issue is relative to some benchmark, often a government bond with the same maturity and currency as the new issue.
New non-government bond issues are priced to give a greater yield than government bonds because non-government bonds are more risky.

In order to determine the yield on the new issue, investment bankers consider:
the spread on similar bonds from the issuer on the secondary market
bonds from comparable issuers (if the issuer has no similar bonds)
the pricing of the issue on the gray market
how frequently the borrower has issued bonds on the market



Syndication: Bond Listing

It is not necessary to list bonds on the stock exchange. In fact, most bonds are rarely traded on stock exchanges because it is more costly and less flexible than the over-the-counter market. Eurobonds however, are normally listed on one or more stock exchanges, the most common being London and Luxembourg.
In order to list bond issues on a stock exchange, syndicates must submit an application.
Reasons for Listing
Bond issues are listed for the following reasons:
To make securities available to the widest possible range of investors
To assist in the initial placement of an issue and its subsequent marketability
To provide good value to the borrower
To advertise: it reminds people who read the financial newspapers of the borrower's existence

Fixed income : Government securities

• T-bills - Short term zero coupon securites with maturity of 1 year or less (issued with 3-, 6- or 12-month maturities)
• T-notes - Issued with 2-10 years maturity with coupons issued at 6 months
• T-bonds - Maturity of 30 years with coupons at 6 months
• Treasury Inflation protection securities(TIPS) - Inflation indexed bonds with maturity of 5-20 years.

Why govt issues bonds?

The government issues bonds for couple of reasons:
1. To raise money for large and long project
2. To finance budgetary deficit
3. To control money supply in the economy

Bonds vs Debentures

Strictly speaking the word "bond" is reserved for the issue by the government while the issue by the private firm is called "debentures". These both are types of fixed income. Though bond is used liberally in the industry.

Bond Issuers

There are four main categories of bond issuers:

• Sovereign governments issue bonds principally to cover a shortfall between taxation revenue and expenditure.
• Government agencies, municipals, and local government authorities issue bonds to fund their services and operations.
• Various supranational authorities, such as the International Bank for Reconstruction and Development (IBRD, the original institution of the World Bank Group) and the International Finance Corporation (IFC, a member of the World Bank Group), engage in major bond issuance to fund lending to developing countries.
• Corporations of all types and sizes use bonds as an important source of funding for their operations and activities.

What is Fixed income?

Definition: Fixed income is when a person gets a return or interest for the security or principal he has given to the borrower. When the period of loan gets over, the person gets the principal back.
Security means promising that I will return principal + interest after some amount of time. But promise can be easily broken due to market risks etc.

What is fixed about fixed income markets? OR why they are called fixed income markets ?

Fixed income markets offer "fixed return" at periodic intervals. But now this "fixed" word is kind of "legacy". Because think of what is fixed about fixed income??
Period of return - Periods of fixed income are not fixed, they vary from 6 months to even 99 years.
Principal return - There are lots of risk prevailing in the industry. So what if company which borrowed money turns bankrupt. Now even the principal is not secured.
Note: That Fixed deposits are secured by Govt. of India per person.

Terminologies related to Fixed Income

• Issuer 
• Maturity date
• Principal value
• Coupon dates
• Coupon
• Indentures

Defining the whole terminology

Classification on the basis of Principal Repayment

• Amortising Bonds Amortising Bonds are those types of bonds in which the borrower (issuer) repays the principal along with the coupon over the life of the bond. The amortising schedule (repayment of principal) is prepared in such a manner that whole of the principle is repaid by the maturity date of the bond and the last payment is done on the maturity date. For example - auto loans, home loans, consumer loans, etc.

• Bonds with Sinking Fund Provisions Bonds with Sinking Fund Provisions have a provision as per which the issuer is required to retire some amount of outstanding bonds every year. The issuer has following options for doing so:
  
  
  
  
  
  • By buying from the market
  • By creating a separate fund which calls the bonds on behalf of the issuer
  
  Since the outstanding bonds in the market are continuously retired by the issuer every year by creating a separate fund (more commonly used option), these types of bonds are named as bonds with sinking fund provisions. These bonds also allow the borrowers to repay the principal over the bond’s life.
  
  

Classification on the Basis of Variability of Maturity

• Callable Bonds The issuer of a callable bond has the right (but not the obligation) to change the tenor of a bond (call option). The issuer may redeem a bond fully or partly before the actual maturity date. These options are present in the bond from the time of original bond issue and are known as embedded options.
  
  A call option is either a European option or an American option. Under an European option, the issuer can exercise the call option on a bond only on the specified date, whereas under an American option, option can be exercised anytime before the specified date.
  
  This embedded option helps issuer to reduce the costs when interest rates are falling, and when the interest rates are rising it is helpful for the holders.

• Puttable Bonds - The holder of a puttable bond has the right (but not an obligation) to seek redemption (sell) from the issuer at any time before the maturity date. The holder may exercise put option in part or in full. In riding interest rate scenario, the bond holder may sell a bond with low coupon rate and switch over to a bond that offers higher coupon rate. Consequently, the issuer will have to resell these bonds at lower prices to investors. Therefore, an increase in the interest rates poses additional risk to the issuer of bonds with put option (which are redeemed at par) as he will have to lower the re-issue price of the bond to attract investors.

• Convertible Bonds - The holder of a convertible bond has the option to convert the bond into equity (in the same value as of the bond) of the issuing firm (borrowing firm) on pre-specified terms. This results in an automatic redemption of the bond before the maturity date. The conversion ratio (number of equity of shares in lieu of a convertible bond) and the conversion price (determined at the time of conversion) are pre-specified at the time of bonds issue. Convertible bonds may be fully or partly convertible. For the part of the convertible bond which is redeemed, the investor receives equity shares and the non-converted part remains as a bond.

Classification on the basis of Variability of Coupon

• Zero Coupon Bonds - Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders and hence, there are no cash inflows in zero coupon bonds. The difference between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders. The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the maturity period lesser would be the issue price and vice-versa. These types of bonds are also known as Deep Discount Bonds.

• Treasury Strips - Treasury strips are more popular in the United States and not yet available in India. Also known as Separate Trading of Registered Interest and Principal Securities, government dealer firms in the United States buy coupon paying treasury bonds and use these cash flows to further create zero coupon bonds. Dealer firms then sell these zero coupon bonds, each one having a different maturity period, in the secondary market.

• Floating Rate Notes(FRNs) - In some bonds, fixed coupon rate to be provided to the holders is not specified. Instead, the coupon rate keeps fluctuating from time to time, with reference to a benchmark rate. Such types of bonds are referred to as Floating Rate Bonds.
  
  For better understanding let us consider an example of one such bond from IDBI in 1997. The maturity period of this floating rate bond from IDBI was 5 years. The coupon for this bond used to be reset half-yearly on a 50 basis point mark-up, with reference to the 10 year yield on Central Government securities (as the benchmark). This means that if the benchmark rate was set at “X” %, then coupon for IDBI’s floating rate bond was set at “(X + 0.50)” %.
  
  Coupon rate in some of these bonds also have floors and caps. For example, this feature was present in the same case of IDBI’s floating rate bond wherein there was a floor of 13.50% (which ensured that bond holders received a minimum of 13.50% irrespective of the benchmark rate). On the other hand, a cap (or a ceiling) feature signifies the maximum coupon that the bonds issuer will pay (irrespective of the benchmark rate). These bonds are also known as Range Notes.
  
  More frequently used in the housing loan markets where coupon rates are reset at longer time intervals (after one year or more), these are well known as Variable Rate Bonds and Adjustable Rate Bonds. Coupon rates of some bonds may even move in an opposite direction to benchmark rates. These bonds are known as Inverse Floaters and are common in developed markets.
• Stepped Coupon Bonds
   Stepped-coupon bonds are a variation of straight fixed rate bonds that have been issued by some borrowers. These are securities whose coupon rate increases during the life of the bond.
  
  For example, a 5-year ‘step-up’ bond might be issued with a coupon of 5% for the first year, 5.5% for the second year, 6% for the third year, and so on. After an initial non-callable period, step-up bonds are callable at each step-up date and are therefore attractive to issuers with a strongly held view that interest rates will fall – a replacement bond can then be issued at a lower rate.
  
  Bonds with stepped-coupon features were quite popular with some telecommunications issuers in early 2000. Due to the uncertain credit outlook for these issuers, these bonds offered investors an incentive in the form of a coupon step-up if the issuer’s credit rating fell. The stepped-coupon feature of these issues essentially represented a form of bond covenant.
  
  A bond whose coupon increases in response to the weakening of the issuer’s credit rating is sometimes referred to as a ‘structured credit’ bond. The downside for investors in these issues is that the coupon often also ‘steps-down’ in the event of a ratings upgrade.
  

Types of Bonds

Classification on the basis of issuers
Classification on the basis of Variability of Coupon
Classification on the Basis of Variability of Maturity 
Classification on the basis of Principal Repayment

Other type of BondsHigh Yield (Junk) Bonds

High yield bonds are securities rated below investment grade, that is, rated below Baa3 (Moody’s) or BBB- (Standard & Poor's). This form of debt carries a higher risk of default compared with other forms of debt, but compensates investors by paying a higher yield.

The high yield market was relatively small up until the 1970s. During that decade, companies that were once investment grade companies (‘fallen angels’) were looking to raise funds. To achieve this, they had to offer high coupon rates on their bond issues. Even then, some fund managers and other investors were reluctant to enter the high yield market. But the fallen angels were not the only ones finding it difficult to get funding – so too were the start-ups. These companies also had to offer high coupons in order to attract investors.

Today, high-yield bonds are more commonly used to provide working capital for growing companies. Most high yield bonds are issued with original maturities of 10 years or less. They are typically callable, but investors usually have call protection for the first four or five years.

Covered Bonds
Covered bonds are bonds collateralized by commercial and/or residential mortgages and/or public sector assets. They represent the senior debt instrument of the issuer, with the bondholder having full recourse to a pool of assets ring-fenced from the issuer's other assets. Covered bonds are similar in some ways to asset-backed securities; however, the pool of assets is not placed in a special purpose vehicle (SPV) but instead remains on the balance sheet of the issuer. Segregation of the pool assets has to be undisputed, otherwise a high rating for the pool may not be achieved. The credit strength of the issuer is the main driver.

Covered bonds typically range from one to ten years, with the euro being the preferred currency choice for issuers.

The largest and best-known market for covered bonds is the German Pfandbriefe market. The issuing of Pfandbriefe dates back to the 18th century. Today, Pfandbriefe are issued in two forms, Öffentliche Pfandbriefe (collateralized by public sector assets) and Hypothekenpfandbriefe (collateralized by commercial and/or residential mortgages). The market remained largely unknown outside Germany until the emergence in 1995 of Jumbo Pfandbriefe, which have a minimum issue size of EUR 1 billion and the market-making commitment of at least three investment banks. International institutional investors are attracted to this market not only because of the pure size of the issues, but also because of the extremely high liquidity.

Although the German market remains the biggest market for covered bonds today, other countries are beginning to establish markets for these securites. For example, covered bond markets have grown significantly in Spain (Cédulas Hipotecarias), France (Obligations Foncières), Ireland, and the UK.

From an investor’s point of view, there are a number of attractions in relation to covered bonds, including:

’double protection’ (a claim against the issuer and a preferential claim over the cover pool in case of issuer insolvency)
yield pick-up compared to government, supranational, and agency securities
high liquidity due to large issue sizes and market maker commitments, particularly for ’jumbo’ issues
a form of diversification from other bonds in an investor’s portfolio
The investor base for covered bonds includes: fund/asset managers, savings and cooperative banks, central banks, and insurance companies.

Terminology related to bonds or fixed income

Bonds refer to debt instruments bearing interest on maturity.
In simple terms, organizations may borrow funds by issuing debt securities named bonds, having a fixed maturity period (more than one year) and pay a specified rate of interest (coupon rate) on the principal amount to the holders.
Bonds have a maturity period of more than one year which differentiates it from other debt securities like commercial papers, treasury bills and other money market instruments.

More technically, bonds are negotiable certificates that represent the indebtedness of the issuer to the holder. The negotiable element refers to the fact that the ownership of a bond can be transferred from one party to another in the secondary market.
Terminology

Used in Bond Market	Meaning in General Terms
Bonds	Loans (in the form of a security)
Issuer of Bonds	Borrower
Bond Holder	Lender
Principal Amount	Amount at which issuer pays interest and which is repaid on the maturity date
Issue Price	Price at which bonds are offered to investors
Maturity Date	Length of time (More than one year)
Coupon	Rate of interest paid by the issuer on the par/face value of the bond
Coupon Date	The date on which interest is paid to investorstd-txt
Credit quality	Every one wishes to be confident that their money will be repaid.
Maturity	Maturity of bond can vary from one year to 1000 years, although most maturity period vary from 5 to 10 years.
Yield	It is the rate of return received from investing in bond and depends on the price paid for the bond and the coupon(interest) payment.

Notes :
COUPON - Generally companies provide fixed rate of interest but FRNs are exception where rate of interest fluctuates. Another exception, zero-coupon bonds, do not pay any interest throughout their life. Instead, they provide a return to investors by being sold at a discount to the redemption (par) value. At maturity, the holder receives the full redemption amount. We will see them again below.

PRICE - The price of a bond is dependent upon a number of factors, including

• market interest rates, 
• credit quality, 
• maturity, and 
• supply and demand. 

Newly-issued bonds generally sell at (or near) their par value, but it is important to note that the par value is not necessarily the price of the bond in the secondary market. Bond prices fluctuate throughout their life in response to a number of factors. Those trading above their par value are said to trade at a premium, while those priced below their par value are said to trade at a discount.


Depending on the market, bond prices can be quoted ‘clean’ or ‘dirty’.

The clean or flat price of a bond is its price excluding accrued interest (the amount of interest due since the last coupon payment date). The seller, however, expects to receive the accrued interest on the bond, that is, the coupon amount that the seller has ‘earned’ by holding the bond since the last coupon payment date. The buyer must pay this accrued interest to the seller. Therefore, the dirty or full price (which includes the accrued interest) is the price paid by the buyer to the seller of a bond.

YIELD - The simplest measure of yield is current yield.

 Current yield = Annual coupon / price
When bond is purchased at par, current yield = interest but when market value changes, so does the yield.
Yield is inversely proportional to price.
Better parameter for yield calculation is yield to maturity (YTM), which takes into account :

• The coupon payment on the bond on the way to maturity
• The time value of money
• Any capital gain or loss that will be realized by holding the bond until maturity