# Fixed Income 01: Vanilla Bonds

Fixed income Analysis and Future and other derivatives are the two great sources for understanding the Fixed income.

Financial Instruments:

There are three classes of Financial Instruments:

- Financing Instruments: the transfer happens from the saver to spender, and it can be either in the form of a Debt instrument or an equity instrument. (Bond, convertible bonds…)
- Managing Risks: Using the instruments for hedging or preventing investors from some sources of risk. (Hedge…)
- Investment/ Speculation: investors are healthy individuals or institutions whose primary purpose is to have a healthy investment, however, in speculation, the level of risk is higher and the investment horizon is short. (Credit Defaults,…)

In a general analysis, we can combine the category 2 and 3 into one category. so we can have two main categories on one, in both these categories, there is betting on something that may happen or may not happen.

Lets start with the Fixed income cases, which are bonds:

and the simplest ones are Vanilla bonds, lets start with a sample bond issued by a Polish state bank, on behalf of National Road development project financing.

The bond has the following part in its letter of issue:

- Issuer information
- the purpose and the legal back ground
- How it is allocated in the primary market
- How the math is done

You can find the template of the calculation Download here:

**General terms and definitions:**

- Face Value: A bond with the Face value (Par Value or Nominal Value) of 1000 PLN, means that at the time it was issued, in the auction made in 2014, the starting value for auction was 1000 PLN at the primary value.
- The interest rate or Coupon: It is the fixed value paid in a year. there are two types of bonds.

2.1. Plain Value (Plain vanilla bond)

2.2. Floating Bond: Based on a reference rate, like the interest of central bank bonds, or … the interest rate changes at a specific time.

2.3. No Coupon Value: there is no coupon or interest paid for this case. these are mainly issued currently by European governments, after Covid.

3. Copun Date: there is the timetable for payment of the interests. in the bond of our example on page 4 we can find the calendar of payment. Usually, for convenience, the interest period are all on the same day of the month.

4. Maturity/redemption/ Repurchase Date: It is the day that the borrower pays back the amount of face value of the bond.

Look: gpwcatalyst.pl/instruments

5. Clean Price and dirty price: there are two ways to price a bond. the clean price is the price without the Accrued interest, and the dirty price is the one with the accrued interest. Check the following file for the accrued interest calculation. Depending on the standards of any exchange market the calculations differ. usually for convenience the bonds are quoted with the value of 100 units of Face value.

6. Issuance Date:

7. Yield to Maturity (Gross redemption Yield): this is the annual pre-tax effective rate of return. it shows how much the investor earns from the bond? to calculate this, we have to use the internal rate of return. in excel we use XIRR. The YTM is a compound rate, so it assumes that the price is compounded.

The Problem with the YTM calculation is that it has a Compound meaning in it. While the realistic calculation is based on the Modified Internal Rate of return, to be sure if it is working or not.

Read My Article About Junk Bondas and Tricks behind it

**8. Deed of Guarantee: **the bonds should have a Guarantee by a Guarantor. for this case, the Polish …

**9. Days calculated:**

ACT Day Counting Convention, is introduced by the International Capital Market Association, which is based on the calendar. in the accounting convention mainly used in bonds, the calculation is 30/360. it means that each month is 30 days.

*Example: Calculation of Calendar Periods*

*how many days is between 25.10.2020 and 17.02.2021?*

ACT calculates it in 115 days, while the 30/360 calculates it as 17+3*30+ which is 112 days. again this should be checked inside the bond letter.

**Taxes on the Bond income:**

on the bond, the Taxes are imposed only on the interests and not on the face value of the bond received.

**The Risks of Bonds:**

there are in general two types of Risks,

- Systematic Rist: Like inflation,
- Specific Rate: like Credit Risks

2.1. Credit Risk ( Risk of nonpayment): To calculate this we have to find the credit rating. we use the credit rate of the bond Guarantor, from international organization.

2.2. Interest rate risk:

if one holds the bond to maturity, there is no interest rate risk. But in case, you are going to sell the bond before maturity, then the ultimate rate of return will be on the selling price.

**Types of interest rate risk:**

2.2.1. Price risk: this means that if before we sell the bond the Yield to Maturity rises, then the price of the bond lowers. This case happens when the Benchmark interest rate increases, or bond-related risk increases.

2.2.2. Reinvestment Risk: In the YTM calculation, we assumed the rate is compound, which means that we assumed the earned interest is calculated based on the Reinvestment rate= Bond YTM rate.

Risk Scenarios:

SN1: Bond Price decreases and at the same money the reinvestment rates increases.

SN2: Bond Price risk and increase in Reinvestment risk

**How to Manage the Risks of the Bonds?**