Accounting for Investments, Volume 2

A Practitioner's Handbook

R. Venkata Subramani

• Publisher: Wiley
• Year: 2011
• ISBN:
  9780470829059
• Edition: 1
• Topic: Business
• Subtopic: Financial Accounting
• Index: Business

A comprehensive guide to new and existing accounting practices for fixed income securities and interest rate derivatives

The financial crisis forced accounting standard setters and market regulators around the globe to come up with new proposals for modifying existing practices for investment accounting. Accounting for Investments, Volume 2: Fixed Income and Interest Rate Derivatives covers these revised standards, as well as those not yet implemented, in detail.

Beginning with an overview of the financial products affected by these changes—defining each product, the way it is structured, its advantages and disadvantages, and the different events in the trade life cycle—the book then examines the information that anyone, person or institution, holding fixed income security and interest rate investments must record.

• Offers a comprehensive overview of financial products including fixed income and interest rate derivatives like interest rate swaps, caps, floors, collars, cross currency swaps, and more
• Follows the trade life cycle of each product
• Explains how new and anticipated changes in investment accounting affect the investment world

Accurately recording and reporting investments across financial products requires extensive knowledge both of new and existing practices, and Accounting for Investments, Volume 2, Fixed Income Securities and Interest Rate Derivatives covers this important topic in-depth, making it an invaluable resource for professional and novice accountants alike.

CHAPTER 1

Fixed Income Securities—Theory

LEARNING OBJECTIVES

After studying this chapter you will be able to get a grasp of the following:

• Fixed income securities in general
• Basics of the bond market
• Types of issues and special characteristics
• Bond coupons
• Bond maturity
• Bond pricing
• Yield measures—current yield, yield to maturity, and yield to call
• Duration
• Corporate bonds
• Municipal bonds
• Risks of investment in bonds
• Definition of financial instruments
• An overview of the categories of financial instruments
• Recent amendments to accounting standards relating to financial instruments

FIXED INCOME SECURITIES IN GENERAL

Fixed income refers to any type of investment that yields a regular (or fixed) return. A bond is a debt security. When an investor purchases a bond, the investor is actually lending money to the issuer of the bond. The issuer could be a government, municipality, corporation, federal agency or other entity. In return for the money lent, the issuer provides the investor with a certificate in which it promises to pay a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due. This certificate is known as the “bond.”

Among the types of bonds available for investment are: U.S. government securities; municipal bonds; corporate bonds; mortgage- and asset-backed securities; federal agency securities; and foreign government bonds.

BASICS OF THE BOND MARKET

Types of issues and special characteristics

Various governments issue government bonds in their own currency and sovereign bonds in foreign currencies. Local governments issue municipal bonds to finance their projects. Corporate entities also issue bonds or borrow money from a bank or from the public.

The term “fixed income security” is also applied to an investment in a bond that generates a fixed income on such investment. Fixed income securities can be distinguished from variable return securities such as stocks where there is no assurance about any fixed income from such investments. For any corporate entity to grow as a business, it must often raise money to finance the project, fund an acquisition, buy equipment or land or invest in new product development. Investors will invest in a corporate entity only if they have the confidence that they will be given something in return commensurate with the risk profile of the company.

Bond coupon

The coupon or coupon rate of a bond is the amount of interest paid per year expressed as a percentage of the face value of the bond. It is the stated interest rate that a bond issuer will pay to a bond holder.

For example, if an investor holds $100,000 nominal of a 5 percent bond then the investor will receive $5,000 in interest each year, or the same amount in two installments of $2,500 each if interest is payable on a half-yearly basis.

The word “coupon” indicates that bonds were historically issued as bearer certificates, and that the possession of the certificate was conclusive proof of ownership. Also, there used to be printed on the certificate several coupons, one for each scheduled interest payment covering a number of years. At the due date the holder (investor) would physically detach the coupon and present it for payment of the interest.

Bond maturity

The bond’s maturity date refers to a future date on which the issuer pays the principal to the investor. Bond maturities usually range from one year up to 30 years or even more. But this maturity date must be seen as the last future date (except if the borrower is in default) on which the investor will receive the principal amount from the issuer. Depending on redemption features, the real reimbursement date can be very different (much shorter). These redemption features usually give the right to the investors and/or the issuer to advance the maturity date of the bond.

Call feature: This is a provision that allows the issuer to repay the bond before the maturity date. The issuer will “call” his bond if the interest rate index is lower than when the bond was originally issued. From the investor’s perspective, it means that the bond gets prepaid if the bond earns too much interest compared to the prevailing market rates.

Put feature: This is a provision that gives investors the right to put the bond back to the issuer to redeem the bond before the maturity date. An investor would exercise this option when the current market rates are higher so that the investor can reinvest his money at this higher rate.

Bond pricing

The price of a bond will be determined by the market, taking into account among other things:

• The amount and date of the redemption payment at maturity;
• The amounts and dates of the coupons;
• The ability of the issuer to pay interest and repay the principal at maturity;
• The yield offered by other similar bonds in the market.

Yield measures

Current yield

To obtain the current yield, the annual coupon interest is divided by the market price. The current yield calculation takes into account only the coupon interest and no other source of return that will affect an investor’s yield. The capital gain that the investor will realize when a bond is purchased at a discount, or the capital loss that the investor will realize if a bond purchased at a premium is held to maturity are not taken into consideration. The time value of money is also ignored. Hence it is considered as an incomplete and simplistic measure of yield.

Yield to maturity

The yield on any investment is the interest rate that will make the present value of the cash flows from the investment equal to the price of the investment. As a starting point an approximate value is calculated as being the average income per period divided by the average amount invested. To find a more accurate value, an iterative procedure is used. The objective is to find the interest rate that will make the present value of the cash flows equal to the price.

The yield to maturity calculation considers the current coupon income as well as the capital gain or loss the investor will realize by holding the bond until maturity. Also it takes into account the timing of the cash flows.

Yield to call

For bonds that may be called prior to the stated maturity date another yield measure commonly quoted is known as the “yield to call.” To compute the yield to call, the cash flows that occur if the issue is called on its first call date are used.

Duration

The duration of a bond is a measure of the sensitivity of the bond’s price to interest rate movements. It broadly corresponds to the length of time before the bond is due to be repaid. This duration is equal to the ratio of the percentage reduction in the bond’s price to the percentage increase in the redemption yield of the bond. This equation is valid for small changes in those quantities only. Duration is symbolized by λ, or lambda, the Greek letter used for derivative pricing. In contrast, the absolute change in a bond’s price with respect to interest rate (Δ or delta) is referred to as the dollar duration.

Corporate bonds

A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date.

Corporate bonds are often listed in major stock exchanges and they are traded in the secondary market. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based, over-the-counter markets. The bond price depends on the prevailing market interest rates during the time of trading. The bond price will go up if the mentioned coupon rate is higher than the market interest rate. During that time the bonds are quoted at a premium. On the other hand, if the mentioned coupon rate is less than the market interest rate, the price of the bonds will come down and they are quoted at a discount. The coupon rate received by the bond holder is usually taxable. Corporate bonds will have a higher risk of default when compared to government bonds.

Municipal bonds

Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities, which use the money to build schools, highways, hospitals, sewer systems, and many other projects for the public good.

Not all municipal bonds offer income exempt from both federal and state taxes. There is an entirely separate market of municipal issues that are taxable at the federal level but which still offer a tax exemption on interest paid to residents of the state of issuance.

Most of this municipal bond information refers to munis, which are free of federal taxes. See the section on Taxable Municipal Bonds for more about taxable municipal issues.

Zero coupon bonds

Zero coupon bonds are bonds that do not pay interest during the life of the bond. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it “matures” or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest.

Risks of investment in bonds

Interest rate risk: When interest rates rise, bond prices fall; conversely, when interest rates decline, bond prices rise. The longer the time to a bond’s maturity, the greater its interest rate risks.

Duration risk: The modified duration of a bond is a measure of its sensitivity to interest rate movements, based on the average time to maturity of its interest and principal cash flows. Duration enables investors to more easily compare bonds with different maturities and coupon rates by creating a simple rule: with every percentage change in interest rates, the bond’s value will decline by its modified duration, stated as a percentage. For example, an investment with a modified duration of five years will rise 5 percent in value for every 1 percent decline in interest rates and fall 5 percent in value for every 1 percent increase in interest rates.

Reinvestment risk: When interest rates are declining, investors have to reinvest their interest income and any return of principal, whether scheduled or unscheduled, at lower prevailing rates.

Inflation risk: Inflation causes tomorrow’s dollar to be worth less than today’s; in other words, it reduces the purchasing power of a bond investor’s future interest payments and principal, collectively known as “cash flows.” Inflation also leads to higher interest rates, which in turn leads to lower bond prices. Inflation-ind...