How to trade effectively in Bonds ?

What is Bond ?

* Meaning :  Type of debt or long-term promissory note, issued by a borrower, promising to its holder a predetermined and fixed amount of interest per year and repayment of principal at maturity.
*  Issuers or Borrowers :  Corporations, US Government, State and Local Municipalities. Bond ladder strategy : building a bond ladder means buying bonds scheduled to come due at several different dates in the future, rather than all in the same year.
◆  This process is known as laddering because each group on bonds represents a rung on the investments maturity ladder.

Advantages :

• Beneficial in both situation when interest rate rise or fall.


• Effective tool for someone who needs large mounts of money available on certain future dates, for example, to pay for a child education.

Disadvantages

• If interest rates plunge, invester would be better off owning only long term bonds.


• Ladders also not make sense for investors with small amounts of money.

BOND IMMUNIZATION

◆  Bond immunization is an Investment strategy used to minimize the interest rate of bond investments by adjusting the portfolio duration to match the investors investment time horizon.

Here's how they work...

1.Lender (you)

When you purchase a bond, you are loaning money to a corporation or government body known as the issuer.

2.Issuer (borrower)

The issuer uses the money from the loan to finance new projects or support ongoing operations.  There are a wide range of issuers, including :

   ●  U.S., state, and local governments and their agencies
   ●  Private institutions like hospitals or colleges
   ●  Foreign governments---of emerging or developed nations
   ●  Corporations ---start-ups to Fortune 500

 3.Interest payments

In return for your loan, the issuer promises to pay you an interest payment (often twice a year) for a defined period of time, which ends on the Bond's maturity date.  The amount of the interest payment is generally set by the issuer and determined by :

         ●  The issuer's financial strength and ability to make interest and principal payments
         ●  Length of time to the bond's maturity
         ●  Prevailing interest rates
 
4.Return of principal

At the end of the defined period of time, the bond matures and the issuer repays you the amount you loaned ( the principal ), assuming no default.  Generally, the maturity date can be from 1 to 30 years in the future, depending on the issuer's needs.

◆  In general, the longer the term to maturity, the greater the sensitivity to interest rate changes.
◆  Example: Suppose the zero coupon yield curve is flat at 12%.  Bond A pays $1762.34 in five years.  Bond B pays $3105.85 in ten years, and both are currently priced at $1000.


Bond Type                                        Description

Corporate              Corporations issue bonds to expand, cover expense,
                               and finance other activities.


                                Corporate bonds are fully taxable and usually pay a
                                higher rate of interest than government bonds.

(Government)        Treasury bonds are debt instruments of the U.S.
    Treasury             government, used to pay for government activities
                                and to pay off government debt.

                          
                               Considered to be long term investments, Treasury
                               bonds have maturities of 10 years or longer. Treasury
                               bonds carry the lowest degree of risk and are the
                               benchmark against which all other types of bonds are
                               measured.  Although their market value fluctuates,
                               they are considered to be the safest of bonds due to
                               the fact that they are secured by the full faith and
                               credit of the U.S. government.

Agency (GSE).      U.S. Government agencies ( also called Government -
                              Sponsored Enterprises, or GSE) issue bonds to
                              support projects relevant to public policy, such as
                              farming and small business, as well as to offer
                              assistance to students and homebuyers.

                              Examples of these agencies include Fannie Mae,
                              Freddie Mac and the Small Business Association.
                              Unlike Treasuries, these bonds do not carry the "full
                              faith and credit" guarantee of government issued
                              Treasury bonds.

Municipal.             A municipal bond, or "muni bond," is a debt obligation
                              issued by a state, city or local government to finance
                              governmental needs or special projects.

                              The majority of municipal bonds are exempt from
                              federal, state and local taxes.
 

Bonds

  ◆Definition:  A bond is a security with pre-specified cash flows to be paid on pre-specified dates.

  ◆ Terms

      ●     face value or maturity value
      ●     coupon rate / coupon payment
      ●     maturity
      ●     yield-to-maturity

           ∆ ......... is the interest rate that makes the PV of the promised future cash flows equal to the current price.

          ∆  Important note: the yield-to-maturity is always quoted as an APR.

Decisions Bond Investors Must Make

●  Decide on risk level.
     -- Investment grade bonds: top 4 grades (BBB, A , AA , AAA)
     -- Junk bonds ( a.k.a., high yield bonds ) : lower rated and higher risk
●  Decide on maturity.
     -- Match to financial goals
●  Determine the after-tax return.
     -- Taxable versus tax-exempt

Example on Immunization

■  Ex. Abhisekh has 50,000 to make one time investment.  His son has entered the Higher Secondary school and he needs his money back after two years for his son's educational expenses.  As Abhisekh's outflow is one time outflow, duration is simply 2 years. Now he has choice of 2 types of bonds.

1)  BOND A has a coupon rate 7% and maturity period of 4 years with current yield of 10%.  current price is 904.90 Rs.
2)  BOND B has a coupon rate 6% and maturity period of 1 years with current yield of 10%. current price is 963.64 Rs. 

Immunization

●  Immunization is a hybrid strategy
●  Used to protect a bond portfolio against interest rate risk
        ◆  Price risk and reinvestment risk cancel
●  Price risk results from relationship between bond prices and rates
●  Reinvestment risk results from uncertainty about the reinvestment rate for future coupon income

 Bond Immunization

■  Strategy to derive a specified rate of return regardless of what happens to market interest rates over holding period
■  Seeks to offset the opposite changes in bond valuation caused by price effect and reinvestment effect
     ◆  Price effect: change in bond value caused by interest rate changes
     ◆  Reinvestment effect: as coupon payments are received, they are reinvested at higher or lower rates than original coupon rate
■  Bond immunization occurs when the average duration of the bond portfolio just equals the investment time horizon.