Plain vanilla bonds

The definition of bonds given earlier in this chapter referred to conventional or plain vanilla bonds. There are many variations on vanilla bonds and we can introduce a few of them here. 

The presence of embedded options in a bond makes valuation more complex compared to plain vanilla bonds. 

This chapter describes the German mortgage-bonds or Pfandbriefe market, its institutions, and working practice. We also consider other aspects of the European covered bond market. The instruments themselves are essentially plain vanilla bonds, and while they can be analysed in similar ways to US agency bonds and mortgage-backed bonds, there are also key differences between them, which we highlight in this chapter. Mortgage-backed securities are described in Chapter 11. 

Documentaaon Involved In a Plain Vanilla Bond Issnance... 

The paragraphs below describe the documentation usually involved in a plain vanilla bond issuance. This should not be taken as an exhaustive list, additional documents may be needed depending on the structure of the bond. 

After the mandate letter is signed, the process of preparing all the relevant documentation starts. The length of time needed from the mandate to the issuance depends on the specific circumstances of the transaction, market conditions and the experience of the issuer, it can take from three days in the case of a plain vanilla bond issued under an MTN programme to six or even more months for a structured transaction. 

There are a large variety of bonds. The most common type is the plain vanilla, otherwise known as the straight, conventional, or bullet bond. A plain vanilla bond pays a regular— annual or semiannual—fixed interest payment over a fixed term. All other types of bonds are variations on this theme. 

Duration is a measure of price sensitivity to interest rates—that is, how much a bond s price changes in response to a change in interest rates. In mathematics, change like this is often expressed in terms of differential equations. The price-yield formula for a plain vanilla bond, introduced in chapter 1, is repeated as (2.1) below. It assumes complete years to maturity, annual coupon payments, and no accrued interest at the calculation date. 

Up to this point the discussion has involved plain vanilla bonds. But duration applies to all bonds, even those that have no conventional maturity date, the so-called perpetual, or irredeemable, bonds (also known as annuity bonds), which pay out interest for an indefinite period. Since these make no redemption payment, the second term on the right side of the duration equation disappears, and since coupon payments can stretch on indefinitely, n approaches infinity. The result is equation (2.12), for Macaulay duration. 

Bond traders wishing to hedge the interest rate risk of their bond positions have several tools to choose from, including other bonds, bond futures, and bond options, as well as swaps. Swaps, however, are particularly efficient hedging instruments, because they display positive convexity. As explained in chapter 2, this means that they increase in value when interest rates fall more than they lose when rates rise by a similar amount—just as plain vanilla bonds do. 

As explained in chapter 1, the curve representing a plain vanilla bond s price-yield relationship is essentially convex. The price-yield curve for a bond with an embedded option changes shape as the bond s price approaches par, at which point the bond is said to exhibit negative convexity. This means that its price will rise by a smaller amount for a decline in yield than it will fall for a rise in yield of the same magnitude. FIGURE 11.13 summarizes the price-yield relationships for both negatively and positively convex bonds. 

Cash flow yield calculated in this way is essentially a redemption yield calculated assuming a prepayment rate to project the cash flows. As such, it has the same drawbacks as the redemption yield for a plain vanilla bond it assumes that all the cash flows will be reinvested at the same interest rate and that the bond will be held to maturity. In fact, the potential inaccuracy is even greater for a mortgage-backed bond because the frequency of interest payments is higher, which makes the reinvestment risk greater. The final yield of a mortgage-backed bond depends on the performance of the mortgages in the pool—specifically, their prepayment pattern. 

As noted in chapter 3, it is possible to calculate a bond s price given its yield and vice versa. As with a plain vanilla bond, a mortgage-backed bond s price is the sum of the present values of its projected cash flows. The discount rate used to derive the present values is the bond-equivalent yield converted to a monthly basis. 

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