Chapter 4 · Bonds

A bond is a loan from the investor to the issuer. The investor lends principal; the issuer pays periodic interest (the coupon) and repays the principal at maturity. Bondholders are CREDITORS of the issuer — NOT owners.

In a winding-up, bondholders rank ABOVE all shareholders. This is why bond yields are generally lower than equity return expectations for the same issuer — you're being paid less because your risk is lower.

Par (face) value: the amount the issuer repays at maturity, and the basis for coupon calculations. Common par values: $1,000 (US corporate), $100 (UK gilts / many corporates), €1,000 (eurobonds).

Coupon: fixed periodic interest, expressed as % of par. A 5% coupon on $1,000 par = $50 per year, typically paid semi-annually as two $25 instalments.

Maturity: the date the principal is repaid. Terms range from a few months to 100 years (Austria issued a 100-year sovereign bond in 2017).

UK gilts are classified by remaining life:

• Shorts: up to 7 years to maturity
• Medium-dated: 7–15 years
• Longs: over 15 years
• Undated / irredeemable: no fixed redemption date (rare)

Worked: $10,000 nominal bond paying a 4% coupon → $10,000 × 4% = $400/year, typically paid as two $200 semi-annual instalments.

When market interest rates RISE, existing fixed-coupon bonds become less attractive vs new higher-yielding issues → their price FALLS until yield matches the new market level.

When rates FALL, existing higher-coupon bonds become MORE attractive → their price RISES.

Premium: price > par (e.g. $105 on a $100 par bond). Usually because coupon > current market yields.

Discount: price < par. Coupon < current market yields.

At par: price = par. Coupon ≈ market yield.

Bond prices are typically quoted as a percentage of par. A quote of "98.50" means 98.50% of par → a $1,000 par bond has a cash price of $985.

US Treasury bond quotes traditionally use 32nds: "98-16" = 98 + 16/32 = 98.50.

• Credit / default risk: issuer fails to pay coupon or principal
• Interest rate risk: bond prices fall when market rates rise (mark-to-market risk for anyone selling before maturity)
• Inflation risk: rising inflation erodes the real purchasing power of fixed coupon/principal payments
• Liquidity risk: cannot sell quickly without price concession
• Currency risk: FX exposure for foreign-currency bonds

Note: index-linked bonds (UK linkers, US TIPS) protect against inflation by adjusting coupons and principal to CPI/RPI.

When a bond is traded between coupon dates, the buyer pays the seller the DIRTY price = CLEAN (quoted) price + accrued interest since the last coupon. This compensates the seller for the interest earned during the period they held the bond.

Most developed-market bond outright trades settle on T+1 (US Treasuries T+1, UK gilts T+1, many EUR govies T+2). Bond markets have historically been faster than equity markets on settlement.

Standard & Poor's (S&P), Moody's, and Fitch. They dominate the global rating market. DBRS Morningstar is a distant fourth.

High-yield bonds = non-investment grade. Higher default risk → higher yields demanded. Market grew massively from the 1980s onward (Michael Milken era).

A fallen angel is a bond that has been downgraded from investment grade to junk — often triggers forced selling from rating-constrained holders (pension funds, insurers).

Downgrade = perceived higher credit risk → investors demand higher yield → bond price FALLS.

The 10-year T-Note is the most-watched US bond — its yield is a benchmark for mortgage rates and global asset pricing.

UK government bonds are called gilts (from "gilt-edged" certificates). Issued by the Debt Management Office (DMO) — an executive agency of HM Treasury with operational independence since 1998.

Bunds (Bundesanleihen): 10–30 year German government bonds. European benchmark — bund yields anchor euro-area fixed income. Shorter German maturities: Bobl (5yr), Schatz (2yr), Bubill (≤ 12m).

JGBs (Japanese Government Bonds): issued in maturities up to 40 years. Japan has one of the world's largest sovereign debt stocks (very high debt-to-GDP), and yields sat near or below zero for much of the last two decades.

US TIPS: principal adjusts with CPI. Fixed % coupon on the ADJUSTED principal → coupon $ rises with inflation.
UK index-linked gilts: same idea, historically indexed to RPI, newer issues use CPIH.
EU equivalents: French OATi, German Bund-i.

Most major governments issue via auctions, typically through a network of designated primary dealers. UK DMO conducts ~weekly gilt auctions; US Treasury runs regular Bill/Note/Bond auctions. Syndication is used for some large new bond launches.

Secured bond: backed by specific assets of the issuer that bondholders can claim on default (buildings, equipment, receivables).

Unsecured bond: backed only by issuer's general creditworthiness. In US/international usage this is called a debenture. (Historical UK usage of "debenture" was different — it meant SECURED — but IISI follows the international convention.)

Subordinated bond: ranks BELOW senior debt of the same issuer in priority of repayment — typically pays a higher coupon to compensate. Common in bank capital (Tier 2 = subordinated; AT1 = even more deeply subordinated + perpetual).

Callable bond: the ISSUER may redeem the bond early at a pre-set price. Typically called when rates have fallen (refinance cheaper). Investor gets a higher coupon in compensation but loses the bond when it's most valuable.

Putable bond: the BONDHOLDER may sell the bond back to the issuer at par before maturity. Useful if rates rise. Holder pays for this via a lower coupon.

Corporate debt continuously offered to investors through a dealer, under a single shelf-registered programme. Highly flexible: size, maturity, coupon can all vary per drawdown. "Medium-term" is somewhat historical — MTN programmes today issue anything from 9 months to 30+ years.

Coupon RESETS periodically (every 3 or 6 months) to a reference rate + fixed credit spread. Reference rates today: SONIA (£), SOFR ($), €STR (€), TONA (¥). Older FRNs referenced LIBOR (mostly discontinued 2023).

Holder is largely INSULATED from interest-rate risk (the coupon moves with rates) but bears the credit spread risk.

Bond + embedded equity option. Holder may convert into a pre-set number of shares at a future date. Lower coupon than an equivalent straight bond (they're paying for the option). Attractive when the issuer is a growth company — the convertible captures share-price upside.

No coupons. Sold at a deep discount to par; redeems at par at maturity. Return = par − issue price.

Common examples: US T-Bills (technically all ≤1yr Treasuries are ZCBs), STRIPS (stripped Treasuries). Highest interest-rate sensitivity for a given maturity because all cashflow is at the end.

No fixed maturity. Coupons paid indefinitely (or until called, if callable). Common in bank AT1 capital. Historic UK undated gilts ("consols") were examples of pure perpetuals.

The legal contract between issuer and bondholders. Specifies: coupon, maturity, payment dates, security (if any), covenants (restrictions on the issuer), events of default, trustee. A trustee enforces the indenture on behalf of holders.

1. Secured creditors (including secured bondholders)
2. Unsecured creditors (unsecured bonds / debentures, trade creditors)
3. Preference shareholders
4. Ordinary shareholders

Tax and wages may rank ahead in some jurisdictions.

A bond whose payments come from a pool of underlying financial assets (mortgages, auto loans, credit-card receivables). The pool is sold to a special-purpose vehicle (SPV), which issues bonds against the pool's cashflow.

ABS whose underlying pool is mortgages. US market dominated by agency MBS (Ginnie Mae, Fannie Mae, Freddie Mac). Non-agency / "private-label" MBS played a central role in the 2008 crisis.

Key distinction:

• ABS: assets sold to SPV. Investors have recourse ONLY to the SPV's pool.
• Covered bond: assets stay on issuer's balance sheet. Investors have DUAL RECOURSE — to both the issuer AND the ring-fenced "cover pool" of assets.

Covered bonds have been used widely in Europe (especially Germany's Pfandbriefe) even pre-2008.

Issued by a domestic issuer, in the home market, in the home currency, under home regulation. E.g. Microsoft issuing USD bonds in the US to US investors.

Issued by a FOREIGN issuer, in the LOCAL market, in the LOCAL currency, under LOCAL regulation. Nicknames:

• Yankee: foreign issuer, US market, USD
• Samurai: foreign issuer, Japan, JPY
• Bulldog: foreign issuer, UK, GBP
• Matador: foreign issuer, Spain, EUR
• Kangaroo: foreign issuer, Australia, AUD

A eurobond is issued in a currency OTHER than the currency of the country of issue. Classic example: a USD bond issued in London.

The "euro-" prefix is NOTHING to do with the euro currency. A USD bond issued in London is a "eurodollar bond". A JPY bond issued in Frankfurt is a "euroyen bond".

Eurobonds are typically settled and held in custody via Euroclear (Brussels-based) and Clearstream (Luxembourg-based) — the two major international central securities depositories.

Eurobonds are traditionally in bearer form — ownership = physical possession of the certificate (or being recorded in a custodian's book at Euroclear/Clearstream). Historically attractive for anonymity / tax planning.

Most domestic markets today use registered form, with ownership recorded in a central register. Modern eurobonds are typically "immobilised" — held in custody at the depositaries rather than physically.

Most bonds trade OVER-THE-COUNTER (OTC): dealer-intermediated, often via electronic platforms or voice trading. Why? Each issuer typically has many distinct bond lines (different coupons, maturities), each lightly traded — a centralised exchange wouldn't pool liquidity well.

Flat yield = (Annual coupon ÷ Current price) × 100

Simple measure of income return at current price. Does NOT account for capital gain/loss to maturity.

Bond at a premium (price > par) → flat yield < coupon.
Bond at a discount (price < par) → flat yield > coupon.
Bond at par → flat yield = coupon.

The discount rate that equates the present value of ALL future cashflows (coupons + redemption) to the current price. Accounts for capital gain (if bought at discount) or loss (if bought at premium) — a better single-number measure of total return than flat yield.

For a bond at a PREMIUM: Coupon > Flat yield > YTM (capital loss to maturity drags YTM below flat yield).

For a bond at a DISCOUNT: YTM > Flat yield > Coupon (capital gain adds to YTM).

A plot of yields (y-axis) against remaining maturities (x-axis), for a single issuer (typically government).

• Normal: upward-sloping. Longer maturities yield more (term premium). Most common shape.
• Inverted: short-term yields exceed long-term. Signals markets expect future short rates to FALL — historically associated with elevated recession risk. Preceded most US recessions by ~12–18 months.
• Flat: yields similar across maturities. Suggests uncertainty or transition between growth phases.

Credit spread = Corporate yield − same-maturity government yield.

Compensation for credit risk + liquidity risk + (sometimes) tax. Widens in stressed markets (2008, 2020, 2022), narrows in benign "risk-on" markets.