"X"...in a box: bonds

Dealing in bonds is a rich universe of calculations and ratings. Within such an environment, a large terminology set is expected. One can go in-depth and attempt to remember the vocabulary. IME, an easier start on useful bond terminology is to know the six elements we use for pricing a bond. Once pricing, the difficult kernel, is understood, the peripheral terms became clearer to me. The main pricing terms are shown in the graphic below, only lacking the "market price". The market price is another name for a type of benchmark, a concept slightly more complex than can be explained in the graphic anyway.

"Coupon rate" is also sometimes called the "contract rate". It's the annual interest rate the issuer pays on the bond. Accordingly, a "zero-coupon" bond pays no interest.

primary or secondary

With these elements, how does one determine how to purchase a bond? Unlike the equity market, we can calculate what to offer for a bond on any given day. This bond price will be moving if we're looking at the secondary market.

primary market: revenues from the bonds go directly to the issuing organization as capital. Typically, these are sold at par.
secondary market: the issuing organization receives no proceeds -- these are sales between customers. Prices fluctuate by the second, same as equities. The categories are discount, par, and premium.

discount, par, premium

The results of our price calculation will result in the bond's current price having a designation: discount, par, or premium, depending on how the price corresponds to the face value of the bond.

Bonds are considered interesting because "the price goes down when the yield goes up". This indirect relationship is what determines the bond's description that second. As we know from JHS math, when a fraction's denominator increases, the overall value of the fraction decreases. Yield is in the denominator, and the price is the overall quotient.

discount bond

Zero coupon bonds are alwasy discount bonds. One of the more straightforward descriptions of a discount bond (its YTM) comes from this Reddit post.

So this makes sense insofar as the yield (interest rate) is in the denominator. The larger the denominator, the smaller the quotient. The quotient is the selling price. So then the price will go down as the interest rate increases. This is not even mildly interesting mathematically. However it's pivotal in terms of trading spreads and so forth.

Pricing Bond w/YTM: Mithril 13 (11:04) MithrilMoney, 2013. The relationship of various features of bonds that lead to the interest rate up, price down, when pricing for Yield to Maturity.
More about YTM: Mithril 14 (14:29) MithrilMoney, 2013. Excel manipulations to iterate (basically Newton's method) to reverse engineer what the price of the initial offering should be to get to a target yield. The inverse pricing relationship: yield up, price down.

More interesting is why money is discounted the day it is sold. Why is the selling price less than the value of a bond? I have no idea.

Here's what I mean. A corporation (Ace) selling a 10 year $100 bond with a 2% interest rate not only pays less interest over 10 years ($20), but also receives $82.03 today. Whereas a corporation (Bass) that has to pay bond purchasers a 6% rate only receives $55.84 today and has to pay $60 over 10 years. Ace and Bass both selling $100 bonds, so you'd think they each receive $100 each today, but they receive different amounts for the bond, because the interest rates is factored into the price. Why? I don't know. In neither case is it simply a $100 IOU.

worse

Here's another way it's interesting. Say we both buy $100 10 year bonds. I paid $55.84 for the 6% Bass and you paid $82.03 for your 2% Ace. But to make this easier, lets round to $56 and $82.

Ok, you and I each start with $100. This means I have $44 left in my hand, after paying $56 for the 10 year Bass. You have $18 left in your hand, after buying the 10 year Ace. You're going to get $2 per year for 10 years or $20, plus your principle of $100, so 18+20+100 or $138 total $$ at the end of 10 years. I start with $44 in hand, receive $60 interest, plus $100 = $204. I made $66 more dollars than you.

The company is also a weird scenario. In your case, it received $82 and had to pay back $120, so that money cost them $38 (120-82) for 10 years' use of $82. In my case, it received $56 and had to pay back $160, so that money cost them $104 (160-56) for 10 years' use of $56.

This means Bass paid about 20% on a 6% IOU, and Ace paid about 5% on a supposed 2% IOU. Wow.

You'd think it worked much more directly where we each loaned them $100 for 10 years and in my case I made $60, and your case you made $20 and that's all it cost the company. So a bond is not exactly like a loan. They lose 5% on you and 20% on me.

explanation

There are three types of bond in the initial market, not secondary market: bonds issued at par, discount or premium. The scenario above, the most common one, where "yields go up when price goes down" is for, I believe, discounted bonds.

secondary market

Bonds explained: primary market (6:41) Killik & Co, 2013. Mileage,
Bonds explained: secondary market (10:28) Killik & Co, 2013. Straightforward description but without much math. It's noted at 4:26 that calculating a bond's Yield to Maturity (Gross redemption yield).

trading

Traders need to look at curves and know *which* curve. First is just the basics of understanding a yield curve. Second, understand yield spreads. Also we can trade options or futures in bonds, so their are derivatives.

yield curve

The plot is of bonds of equal credit quality and different maturity dates. A curve can therefore be drawn macro, or down to the curve for a particular company.

Yield curve (5:10) IronHawkResearch, 2021. Rudimentary but useful.
Streamlit and his coding (56:10) Part Time Larry, 2021. Using Streamlit to avoid a webserver when visualizing with Python.
Google Sheets version of Stock Dash (1:06:24) Think Stocks, 2021. Goes through all elements including coding of various formulas.
Accounting on discounts and premiums (7:15) Prof. Elbarrad, 2019. Straight line accrual accounting on the premium.

yield spread

We may wish to trade the yield spread. For this we'd want to understand the yield curve.

Yield Curve (8:58) The Plain Bagel, 2018. Bases a description in the secondary market.
Bond Trading 101 (7:31) Will Armstrong, 2018. Very simple description and a simple view of a website's purchase interface and how to use. Bonds often issued when organizations need more than a loan amount.

trading dashboard

Equities Dashboard Excel (27:05) MyOnlineTrainingHub, 2021. Although this is done in Excel365, it can nearly be duplicated in Google Sheets. This lady Minta has many vids on spreadsheet dashboards
Streamlit and his coding (56:10) Part Time Larry, 2021. Using Streamlit to avoid a webserver when visualizing with Python.
Google Sheets version of Stock Dash (1:06:24) Think Stocks, 2021. Goes through all elements including coding of various formulas.
Accounting on discounts and premiums (7:15) Prof. Elbarrad, 2019. Straight line accrual accounting on the premium.

api scrape

Just as with equities, we may wish to use an API to scrape information from websites to make various bond transactions.

ratings

As you'll find if you open, or buy, a business. The business will eventually acquire a credit rating, for better or worse. It also will acquire a DUNS number and a Dun and Bradstreet rating used to rate your bonds.

yield curve/benchmark

The yield curve is also one of the benchmarks. Taken by itself, it's considered an economic indicator. But it also is an input into yield to maturity calculations. We need to consider the bond rating and some benchmark when, eg discounting zero coupon bonds, or when making the calculation for daily pricing.

"X"...in a box

Thursday, March 11, 2021

bonds