Bond Fundamentals and Pricing

Par, coupon and the shape of the promise

Par value — also called face value or principal — is conventionally $1,000 for a corporate or municipal bond. Unlike common stock's par, this number does real work: it is the amount repaid at maturity and the base on which the coupon is computed.

The coupon, or nominal yield, is the annual interest rate stated on the bond as a percentage of par. A 6 percent bond pays $60 a year, in two semiannual payments of $30. Semiannual payment is the default convention for corporate and municipal bonds and for Treasury notes and bonds; deviations are always stated. The coupon never changes for a fixed-rate bond, however far the price moves.

Maturity is the date principal is repaid. Bonds mature in three patterns. A term bond has one maturity date for the whole issue. A serial bond matures in instalments across a range of dates, which is the standard structure for municipal issues. A balloon or series structure combines the two. Recognising serial as the municipal default matters for Module 4.

Form of ownership has consolidated to book entry: the ownership record is electronic and no certificate exists. Older forms the exam still names are fully registered (name on the issuer's books, principal and interest sent automatically), registered as to principal only, and bearer or coupon bonds, where whoever held the paper clipped the coupon. Bearer bonds have not been issued in the United States since the early 1980s.

Quotation conventions

Three conventions, and the exam mixes them deliberately.

Corporate and municipal bonds are quoted as a percentage of par. A quote of 98 means 98 percent of $1,000, or $980. A quote of 101.5 means $1,015. Traditionally corporate quotes moved in eighths of a point, so a quote of 98 1/8 meant $981.25; decimals are now standard. One point on a $1,000 bond is $10, and one basis point — a hundredth of a percentage point of yield — is a useful unit to internalise now, because municipal analysis in Module 4 uses it constantly.

Government notes and bonds are quoted in thirty-seconds of a point. A quote of 98:16, sometimes written 98-16, means 98 and 16/32 percent of par, which is 98.5 percent, or $985. The plus sign means a further sixty-fourth: 98:16+ is 98 and 33/64. A candidate who reads 98:16 as $98.16 has lost the question before starting.

Treasury bills are quoted on a discount basis rather than as a price — the quote is the annualized discount from par, so a lower quoted number means a more expensive bill. Bills pay no coupon; the return is the difference between the discounted purchase price and par at maturity.

Municipal bonds are frequently quoted on a yield basis rather than a price basis. A quote of '5.20 basis' states the yield to maturity and leaves the dollar price to be computed. Dollar bonds — usually large term issues — are quoted as a price instead.

Accrued interest

Interest accrues to the seller up to but not including the settlement date. The buyer pays the seller the accrued interest on top of the price and is then made whole by receiving the full coupon at the next payment date. The price without accrued interest is the clean price; with it, the dirty price or invoice amount.

Two day-count conventions, and which one applies is determined by the security type, not by the question's phrasing.

Corporate and municipal bonds use 30/360: every month is treated as thirty days and every year as three hundred sixty. Count from the last coupon date up to but excluding settlement. Worked example: a 6 percent corporate bond pays 1 January and 1 July, and settles on 20 September. From 1 July to 20 September under 30/360 is 30 plus 30 plus 19, which is 79 days. Annual interest is $60, so daily interest is $60 divided by 360, or one-sixth of a dollar. Accrued interest is 79 times that, which is $13.17.

Government notes and bonds use actual/actual: count the real days elapsed over the real days in the coupon period.

Some instruments trade flat, meaning without accrued interest. The three cases are zero-coupon bonds, which have no coupon to accrue; income or adjustment bonds, which pay interest only if the issuer earns it; and bonds in default. A question describing a bond trading flat is telling you which of those three it is.

The indenture and the trustee

The indenture is the contract between issuer and bondholders. It sets the coupon, the maturity, the call provisions, any sinking fund, the collateral if any, and the protective covenants — promises about what the issuer will and will not do, such as maintaining a minimum interest coverage ratio or limiting additional debt.

The Trust Indenture Act of 1939 requires that a public corporate debt offering above a threshold amount be issued under an indenture qualified with the SEC and administered by an independent trustee whose job is to act for the bondholders and enforce the covenants. Municipal securities and US government securities are exempt from the Act, which is why municipal revenue bonds have a trust indenture by market practice rather than by federal requirement — and why the presence and quality of covenants is something a municipal analyst must check rather than assume.

Ratings agencies — Moody's, Standard and Poor's, Fitch — assess credit risk and publish letter ratings. The investment-grade boundary is Baa3 at Moody's and BBB- at S&P and Fitch; anything below is high yield, colloquially junk. A rating is an opinion about default probability, not about market risk: a AAA thirty-year bond can lose a great deal of value when rates rise without its rating changing at all. That distinction is a favourite exam trap.

Price and yield move in opposite directions

The single most important fact about a fixed-rate bond is that its price and its yield move inversely. The coupon is fixed in dollars; if the market demands a higher return, the only way to deliver it is for the price to fall.

A bond trading above par is at a premium, and its yield is below its coupon. A bond below par is at a discount, and its yield is above its coupon. At par, yield equals coupon.

Two characteristics amplify the price response to a rate change. Longer maturity increases sensitivity, because more distant cash flows are discounted more heavily by a change in rate. Lower coupon increases sensitivity, because more of the total return sits in the final principal payment rather than in near-term interest. Combine them and you get the most volatile ordinary bond there is: a long-dated zero-coupon bond. That combination is the answer to a whole family of exam questions about which holding will move most, and it is the reason zero-coupon Treasury STRIPS are used to speculate on falling rates.

The formal measure of this sensitivity is duration, which the outline expects you to understand qualitatively: higher duration means greater price change for a given change in yield, and duration rises with maturity and falls with coupon.