CHAPTER 1 The Bond Instrument

Bonds are debt-capital market instruments that represent a cash flow payable during a specified time period heading into the future. This cash flow represents the interest payable on the loan and the loan redemption. So, essentially, a bond is a loan, albeit one that is tradable in a secondary market. This differentiates bond-market securities from commercial bank loans.

In the analysis that follows, bonds are assumed to be default-free, which means that there is no possibility that the interest payments and principal repayment will not be made. Such an assumption is reasonable when one is referring to government bonds such as U.S. Treasuries, UK gilts, Japanese JGBs, and so on. However, it is unreasonable when applied to bonds issued by corporates or lower-rated sovereign borrowers. Nevertheless, it is still relevant to understand the valuation and analysis of bonds that are default-free, as the pricing of bonds that carry default risk is based on the price of risk-free securities. Essentially, the price investors charge borrowers that are not of risk-free credit standing is the price of government securities plus some credit risk premium.

BOND-MARKET BASICS

All bonds are described in terms of their issuer, maturity date, and coupon. For a default-free conventional, or plain-vanilla, bond, this will be the essential information required. Nonvanilla bonds are defined by further characteristics such as their interest basis, flexibilities in their ...

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