Fixed Income: Reference manual for its business usage, valuation and accounting by Mr. Nidhish singh (ACCA)

Fixed Income: Reference manual for its business usage, valuation and accounting by Mr. Nidhish singh (ACCA)

 Learning Objectives

  • Identify the features of fixed income securities
  • Who are bond issuers
  • Identify coupon types
  • Coupon calculations
  • Understand what a discount paper is
  • Debt vs equity
  • Understand the principle of risk vs return
  • Explain bond trading and valuation

 Content

Debt instruments (bonds) are securities issued by institutions as a means of raising money. They are an alternative to bank loans.  An investor loans out money to a borrower (company or government) for a defined period of time at a specified interest rate, known as the coupon rate. The riskier the bond, the higher the rate of interest that must be offered on the bond. 

 

The bond-holder is a creditor of the bond issuer and has no control over the decision making within that organization.  Bond is a type of fixed income financial instrument as the exact amount of cash is know which is lent or borrowed.

 

One of the prime reason an investor would purchase a bond is to earn the coupon interest over the duration of the bond. The principal is viewed to be quite secure. Except for cases of default, the bond issuer will repay the principal on the maturity date of the bond.

 

 Bond Issuers

The two main issuers of bonds are;

 Corporations

Companies issue bonds to raise funds to expand into new markets, upgrade equipment, fund research and development or for whatever reason the Board of Directors decide is prudent. Corporate bonds usually offer slightly higher interest rates than government bonds because of their perceived higher risk.

 

 Governments

Governments need money for everything from infrastructure improvements to social programs. Whenever their tax receipts are not sufficient to cover their expenses, governments issue bonds to make up the difference. 

 

 Coupon Types

The interest rate stated on a bond is known as the bond coupon rate.  The investor receives interest payments (coupons) throughout the life of the bond. A bond can pay a fixed rate or a floating rate of interest.

 

 Fixed rate

A fixed rate means that the interest rate remains the same for the entire life of the bond.  On each coupon payment date, usually every six months, a coupon interest payment is paid by the bond issuer to the investor based on the quantity (nominal value or face) of the bond

 

 

 

Each day, a bond accrues a portion of its next coupon. This is accrued interest.  Whenever a bond is bought or sold, the accrued interest is also bought or sold – when the bond price includes the accrued interest, that is called a dirty price. The bond excluding accrued interest is called a clean price.

 

 Floating rate 

A floating rate (also referred to as a variable rate) is an interest rate that moves up and down over the maturity period of the bond.  With this type of coupon, the rate is re-set at each coupon payment date. The rate is set with reference to either the Fed Rate or the LIBOR (London Inter-Bank Offer Rate) plus a spread e.g. LIBOR + 250 bps. When LIBOR is 2%, then this coupon will be 4 ½ %. On each coupon payment date, a coupon interest payment is paid by the bond issuer to the investor based on the quantity (nominal value or face) of the bond at the prevailing rate of interest

Text Box: Qty X int %
coupon frequency 
 

 

 

 

Each day, a bond accrues a portion of its next coupon. This is accrued interest.  Whenever the bond is bought or sold, the accrued interest is also bought or sold.

 

​​​​​​​ Calculating Interest

How the coupon is spread over its coupon period is determined by a day-count method. There are 3 main methods:

 

  1. 30/360
  2. Actual/actual
  3. Actual/365

A $1,000,000 4% US Treasury 2/15/14 will pay a coupon of $40,000 (A) each year, payable each year on Feb 15 and Aug 15 (B = 2) and uses a ACT/ACT day count method.

 

At each coupon date the coupon interest amount = 1,000,000 x 0.04 / 2 = $20,000.00

 

The amount of accrued interest on any day can also be calculated. Counting begins from the last coupon payment date

 

For example. to calculate the interest to May 7th, the last coupon payment date would be the 15th Feb. Using ACT/ACT as the day count method the days accrued are 13 days in Feb, 31 days in Mar, 30 days Apr, and 7 days May totaling 81 days (D). The coupon of $20,000 is receivable on Aug 15 and there are 181 days (C) in the coupon period (13+31+30+31+30+31+15).

 

The accrued interest as at May 7th = 20,000 x 81/181 = $8,950.28

​​​​​​​ Discount Paper

These are short term debt instruments which are issued and traded at a discount and mature at par.  This means that rather than paying interest coupons like bonds the appreciation of the discount paper value provides the return to the holder. The most common type of discount paper are the United States Treasury Bills. 

 

With discount paper the issuer will never pay a coupon. The implied interest component is included in the price.

 

Example:

 

We purchased a discount paper in April that matures three months later. The quantity (or “face” amount) is 1,000,000 and the cost is $988,852.50.

 

Upon maturity, we will receive $1,000,000.00 from the issuer. The $11,147.50 gain is reclassified as interest income for tax purposes.

​​​​​​​ Difference between Debt and Equity

 

While bond is a borrowing and debt, stocks are equity. This is a key differentiator between bond and equity. Purchase of stock/equity, makes one the partial owner of the entity which also provides voting rights. Equity also provides the right to share the profit of the entity. On the contrary, purchase of debt (bonds), makes the a creditor to the entity.  

 

Benefit of being a creditor, as a bond-holder is that one gets a higher or preferential claim on assets vis-à-vis shareholders. This means, in case of a bankruptcy, bondholder will get their payment before the shareholder. The downside is that the bondholder will not impart in the profit of the company, as they will only get a predecided amount of capital and fixed/floating interest. Since, bondholder has a first right on the asset of the company, they have less risk and reward both. ​​​​​​​

 Risk vs Return

Bond Yield is the return bondholders receive on a bond. Typically, yield is calculated using the following formula:

 

Yield is an effective rate of interest paid to bondholders on a bond. When a bond is sold at par, yield equals to the coupon and interest rate. When the price changes in response to the interest rates, so does  the yield.

 

Example:

 

If a bond is sold at a stated interest rate of 10% at par $100, the yield is 10% ($10 / $100).

 

If the price goes down to $93, then the yield goes up. This happens because you are getting the same guaranteed coupon of $10 on an asset that has depreciated in value to $93 ($10 / $93 = 10.75%).

 

However if the bond price appreciates to $104 the yield shrinks to 9.615% ($10 / $104).

 

Yield is usually the Yield to Maturity – YTM percent. YTM reflects the true return of the bond, as it provides the total return of the bond if the bond is held until maturity. It equals all the returns received in future and discounted to present value and assumed that every single dollar or INR received in relation to the bond held is reinvested at the same rate.

 

The interest rates in the economy influences the price of a bond. When interest rates rise, the price of bonds in the market falls.  This increaese the yield of the older bonds and brings them into line with newer bonds issued with higher coupon rates.

 

If interest rates decreases, the price of bonds in the market increases, as the interest rate and price of the bonds are inversely related. This decreases the yield of the older bonds and brings them into line with newer bonds issued with lower coupons.

 

​​​​​​​ Accounting & Valuation

Bond’s price changes on every trading day, like any other publicly traded security.  Since a bond is traded in the open market, it does not have to be held to maturity.  At any time a bond can be bought or sold in the open market. For accounting purposes, bonds have to be treated ‘clean’. This means stripping out the accrued interest from the cost (principal amount) of the bond. In line with best practice, most accounting systems now do this.  If interest is included in the price of the bond this is referred to as a ‘dirty price’ (ie interest = 1,500 bond value = 1,000,000 x 101.25 = 1,012,500 when priced dirty the price would be priced at 101.4 (1,012,500 + 1,500 / 1,000,000 x 100)).  It is important that when pricing bonds that we use the clean price.

 

The seller is entitled to the accrued interest amount up to the settlement date of the trade. This accrued interest is added to the agreed upon price to arrive at the net cash flow. However it’s very important to categorize the price and the interest separately. The price is part of the principal amount which is used to calculate your capital gain or loss. The interest is classified as ordinary income. This is a very important distinction. 

 

​​​​​​​ Calculating cost:  

 

 

Ticket Type

Buy

Quantity

1,000,000

Instrument

US Treasury 4% 2/15/14

Trade Date

4-May-07

Settlement Date

7-May-07

Execution Broker

Bear Stearns

Settlement Broker

Morgan Stanley

Price

USD 96-18

 

 

Cost (principal) = 1,000,000 x 96.5625 /100

   = 965,625.00

 

The amount of interest and coupon accrued up to the date of next settlement, is added to the principal to calculate the total net cash flow that appears on the broker statement.

 

 

Net Cash Flow = 965,625.00 + 8,950.28

   = 974,575.28

 

GL Entries

 

Trade date

Dr        Bond Long Cost                   965,625.00 (Asset)

Dr        Acq Bond Int                             8,950.28 (Asset)

Cr        A/P Prime Broker                                         974,575.28 (Liability)

 

Settlement date

Dr        A/P Prime Broker                 974,575.28 (Liability)

Cr        Prime Broker Cash                                      974,575.28 (Asset)

 Calculating unrealized: 

 

On each NAV date (May 2007), all securities must be priced. For bonds, the price is quoted per Par value (face value):  For example a price of $95.078125 is per $100 of the bond

 

Text Box: The market value of the bond principal = quantity x price / par

 

 

 

A quantity (or face) of $1,000,000 at a price of $95.078125 gives a valuation of:

 

                              $1,000,000 x 95.078125 / 100 = $950,781.25

 

Once again, for accounting purposes, bonds have to be treated ‘clean’. This means stripping out the accrued interest from the market value of the bond. Therefore, at valuation date, we must also do a separate interest accrual using the method shown earlier in this manual. For your convenience we have repeated the calculation below. 

 

Text Box: Calculation:
A.	Quantity x coupon rate
B.	Coupon frequency (e.g. semi-annually = 2)
C.	Number of days elapsed since last payment date

Accrued interest = A/B x D/C

 

 

 

 

Unrealized    = Mkt Value – Base Cost (Base Principal)

                        = $950,781.25 - 965,625.00

                        = (14,843.75) Unrealized loss

 

Interest Accrual (see above)

                        = 1,000,000 x 4%/2 x 105/181

                        = 11,602.21

 

This figure represent the amount the bond has accrued since the last payment date.  Out of the 11,602.21, we account 2,651.93 has bond income for the month of May.

 

GL Entries

 

Dr        Unrealized Bond Long                   14,843.75 (Revenue)

Dr        Bond Accrual                                                  2,651.93 (Asset)

Cr        Unrealized Bond Long                                           14,843.75 (Asset)

Cr        Bond Interest Income                                                2,651.93 (Revenue)

 

​​​​​​​ Calculating realized: 

 

Ticket Type

Sell

Quantity

500,000

Instrument

US Treasury 4% 2/15/14

Trade Date

18-Jun-07

Settlement Date

19-Jun-07

Execution Broker

Bear Stearns

Settlement Broker

Morgan Stanley

Price

USD 96-28

Proceeds       = Quantity Sold x Price Sold /Par

                        = 500,000 x 96.875/100

                        = 484,375

 

Accrued Interest

                        = 500,000 x 4%/2 x 124/181

                        = 6,850.83

 

New Cash Flow = Proceeds + Accrued Interest

                        = 484,375 + 6,850.83

                        = 491,225.83

 

Realized        = Proceeds – Base Cost

                        = 484,375 – 482,812.50

                        = 1,562.50 Realized Gain

 

GL Entries

 

Trade Date

 

Dr        A/R Prime Broker                                                               484,375 (asset)

Dr        Unrealized Bond Long                                                         7,421.88 (asset)

Cr        Bond Long Cost                                                                   482,812.50 (asset)

Cr        Realized Bond Long                                                                1,562.50 (revenue)

Cr        Unrealized Bond Long                                                            7,421.88 (revenue)

 

Settle Date

 

Dr        Cash                                                                     491,225.83 (asset)

Cr        A/R Prime Broker                                                     484,375 (asset)

Cr        Acq Bond Interest                                                        4,475.14 (asset)

Cr        Accrued Bond Interest                                                1,325.97 (asset)

Cr        Bond Income                                                                1,049.72 (revenue)

 

 

BY: Admin Tax4wealth

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