[Audio] Starting with bonds. A bond is a type of financial instrument issued by market makers. When you buy a bond, you're essentially lending money to the issuer. In return for lending that money, the issuer agrees to pay you back the principal amount, typically with interest, over a specified period. Bonds are listed on the financial markets and traded using standard contracts. These contracts outline the terms of the bond, such as the interest rate, maturity date, and payment schedule, ensuring that both the bondholder and issuer are clear on the agreement..
[Audio] Buying a bond involves multiple cash inflows and outflows across the bond's life. To observe these flows we'll represent them on a time axis, where every upward flow is an inflow, and every downward flow is an outflow. Typically, when you buy a bond, you pay the bond price upfront. In return, the bondholder receives periodic interest payments, also known as coupons, throughout the life of the bond. At the end of the bond's term, the bondholder receives a final payment, which includes both the face value and the last interest payment. This final payment, marking the closure of the loan, is made on the bond's maturity date. For investors looking to evaluate whether a particular bond is a good investment, Yield to Maturity (YTM) is a critical metric to consider. YTM represents the rate of return at which the present value of all future cash flows from the bond, coupon payments and the face value, are equal to the current bond price, adjusted for time. This sums up the behavior of a normal bond..
[Audio] Many corporate actions may affect bond instruments, some of them relies on the bond's definition itself. We'll cover 6 of the most common CAs on bonds. The coupon payment, a mandatory CA, that is the interest payment received by the bondholder. Its name originates from the early versions of the bond where the bond holder would a have a physical paper with multiple coupons attached to it and would redeem each coupon at its payment date. The final redemption is a mandatory CA and corresponds to the face value the bondholder receives at maturity of the bond. Partial redemption, is also a mandatory corporate action, where the issuer pays a part of the face value he owes to the bondholder before maturity date. Early redemption is when the issuer pays the complete face value before maturity date. It is a mandatory corporate action. Installment is when the issuer divides the face value into multiple equal payments. This CA is mandatory. Pay in kind is when the issuer has the choice to pay the coupon payments in different ways for example in EUR or USD. We'll continue by analyzing each of these CAs and visualize their effects on the flows..
[Audio] Coupon payment and Final redemption are applicable on a typical normal bond. First a cash outflow represents paying the bond's price Then every interest period, let's say yearly to make things easier, the bondholder receives a coupon payment expressed as a percentage of the face value. At maturity date, the bondholder receives the face value and the last coupon payment..
[Audio] The flow involving a partial redemption is similar to the one of a typical bond but with a difference. First, we buy the bond, represented by an outflow. Then, the bondholder also receives coupon payments expressed as a percentage of the total face value. At a given date before maturity date, the issuer pays a part of the face value. The amount paid is adjusted with time and deducted from the final face value. At maturity, the issuer pays the remaining part of the face value. Not all bonds allows for partial redemption, such characteristics are specified in the listed contracts. Bonds allowing for partial redemption are usually sold at lower rates because the investor is risking missing on investments associated with less face value accumulating at a specified rate..
[Audio] In the case of early redemption, the issuer closes the bond before the maturity date. The flows include buying the bond and receiving coupon payment up to a given date before the maturity date. At this date, the issuer pays the whole face value, adjusted with time. After this date, the bond is closed, and the bondholder stops receiving any payment. Bonds allowing for early redemption are sold for a discount because the investor risk losing his investment earlier..
[Audio] Installment is like the loan we take as individuals from the bank where we pay a fixed amount periodically until maturity. It's like we are the issuers, and the bank is the bondholders lending us money. It includes the same flows as a standard bond for the coupon payments and buying the bond But instead of receiving a face value at the end, the face value is divided into equal payments received with each coupon payment. At maturity, the whole amount would have been reimbursed, and the bond is closed.
[Audio] Pay in kind corporate action is mandatory and it is linked to the bond's definition. For PIK bonds the issuer has the freedom to pay the coupon in different forms. A common PIK bonds in the market is when the issuer pays the coupon by giving the bond holder additional bonds. To better understand what it means let's look at the cashflows and capital flows of a normal bond and that of a PIK bond. For a normal bond, as seen previously, the cashflow includes paying the bond's price and receiving coupon payment in addition to face value at maturity. The capital flow in a normal bond, neglecting market value fluctuations, includes two flows: One inflow at the bond's acquisition and one outflow at the bond's maturity when the bond is closed. For a PIK it's the opposite. The cashflow includes two flows, one outflow when buying the bond and one inflow corresponding to the face value at maturity. The capital flow includes one inflow at the bond's acquisition and coupon payment in the form of additional capital, meaning the coupon payment are added to the face value and adjusted with time. The coupon payment being expressed as a percentage of the face value can be tricky considering the face value depends on the coupon payment. Before the roll date the coupons are expressed as a percentage of the initial face value. For example, if the initial face value is one million and the coupon payment is 5%, after the first coupon payment is fifty thousands and the face value becomes one million fifty thousands. The second coupon is also fifty thousands, and the face value becomes one million one hundred thousands. If the third coupon is on the roll date, the coupon is now calculated as a percentage of the new face value. So, the third coupon is 5% of one million one hundred thousands equals to fifty-five thousands instead of fifty thousands. All next coupon are calculated as percentages of the new face value accelerating considerably the increase in face value. And at maturity the last coupon is added, and the final face value is calculated..