Topic 1: Defining Elements of Fixed-income Securities

Topic 1: Defining Elements of Fixed-income Securities.

Student learning objectives. After completing this chapter, you will be able to do the following: Describe basic features of a fixed-income security; Describe content of a bond indenture; Compare affirmative and negative covenants and identify examples of each; Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities; Describe how cash flows of fixed-income securities are structured; describe contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities and identify whether such provisions benefit the borrower or the lender..

Overview of a fixed-income security. A fixed-income security is a financial obligation of an entity (the issuer) that promises to pay a specified sum of money at specified future dates. A fixed-income security is an instrument that allows governments, companies, and other types of issuers to borrow money from investors. Any borrowing of money is debt. The terms “fixed-income securities,” “debt securities,” and “bonds” are often used interchangeably..

Overview of a fixed-income security. There are three important elements when investing in fixed-income securities: All bonds, whether they are traditional or securitized bonds, are characterized by the same basic features..

Basic Features of a Bond. Issuer: Major types of issuers include the following: Supranational organizations, such as the World Bank or the European Investment Bank; Sovereign (national) governments, such as the United States or Japan; Non-sovereign (local) governments, such as the state of Minnesota in the United States, the region of Catalonia in Spain, etc. Quasi-government entities (i.e., agencies that are owned or sponsored by governments), such as postal services in many countries—for example, Correios in Brazil, La Poste in France, or Pos in Indonesia; Companies (i.e., corporate issuers). Market participants often distinguish between financial issuers (e.g., banks and insurance companies) and non-financial issuers. Special legal entities that securitize assets to create ABS that are then sold to investors..

Basic Features of a Bond. Bondholders are exposed to credit risk—that is, the risk of loss resulting from the issuer failing to make full and timely payments of interest and/or repayments of principal. Credit risk is inherent to all debt investments. One major distinction is between investment-grade and non-investment-grade (also called high-yield or speculative) bonds. The promised payments of investment-grade bonds are perceived as less risky than those of non-investment-grade bonds because of profitability and liquidity considerations. Some regulated financial intermediaries, such as banks and life insurance companies, may face explicit or implicit limitations of holdings of non-investment-grade bonds. The investment policy statements of some investors may also include constraints or limits on such holdings..

Basic Features of a Bond. Maturity: The maturity date of a bond refers to the date when the issuer is obligated to redeem the bond by paying the outstanding principal amount. Maturities typically range from overnight to 30 years or longer. The tenor , also known as the term to maturity, is the time remaining until the bond’s maturity date. Fixed-income securities with maturities at issuance of one year or less are known as money market securities . Issuers of money market securities include governments and companies. Fixed-income securities with original maturities that are longer than one year are called capital market securities ..

Basic Features of a Bond. Par Value: The principal amount , principal value , or simply principal of a bond is the amount that the issuer agrees to repay the bondholders on the maturity date. This amount is also referred to as the par value, or simply par, face value, nominal value, redemption value, or maturity value. In practice, bond prices are quoted as a percentage of their par value. For example, assume that a bond’s par value is $1,000. A quote of 95 means that the bond price is $950 (95% × $1,000). When the bond is priced at 100% of par, the bond is said to be trading at par. If the bond’s price is below 100% of par, such as in the previous example, the bond is trading at a discount. Alternatively, if the bond’s price is above 100% of par, the bond is trading at a premium..

Basic Features of a Bond. Coupon Rate and Frequency The coupon rate or nominal rate of a bond is the interest rate that the issuer agrees to pay each year until the maturity date. The annual amount of interest payments made is called the coupon. A bond’s coupon is determined by multiplying its coupon rate by its par value. For example, a bond with a coupon rate of 6% and a par value of $1,000 will pay annual interest of $60 (6% × $1,000). Coupon payments may be made annually, such as those for German government bonds or Bunds. Many bonds, such as government and corporate bonds issued in the United States or government gilts issued in the United Kingdom, pay interest semi-annually. Some bonds make quarterly or monthly interest payments..

Basic Features of a Bond. Many mortgage-backed securities pay interest monthly to match the cash flows of the mortgages backing these bonds. An example: If a bond has a coupon rate of 6% and a par value of $1,000, the periodic interest payments will be $60 if coupon payments are made annually, $30 if they are made semi-annually, $15 if they are made quarterly, and $5 if they are made monthly. A plain vanilla bond or conventional bond pays a fixed rate of interest. In this case, the coupon payment does not change during the bond’s life..

Basic Features of a Bond. Floating-rate notes (FRNs) or floaters: The coupon rate of an FRN includes two components: a reference rate plus a spread. The spread, also called margin, is typically constant and expressed in basis points (bps). A basis point is equal to 0.01%; put another way, there are 100 basis points in 1%. The spread is set when the bond is issued based on the issuer’s creditworthiness at issuance: The higher the issuer’s credit quality, the lower the spread. The reference rate, however, resets periodically. Thus, as the reference rate changes, the coupon rate and coupon payment change accordingly..

Basic Features of a Bond. A widely used reference rate is the London interbank offered rate (Libor). Libor is a collective name for a set of rates covering different currencies for different maturities ranging from overnight to one year. Other reference rates include the Euro interbank offered rate (Euribor), the Hong Kong interbank offered rate (Hibor), or the Singapore interbank offered rate (Sibor) for issues denominated in euros, Hong Kong dollars, and Singapore dollars, respectively..

Basic Features of a Bond. For example, assume that the coupon rate of an FRN that makes semi-annual interest payments in June and December is expressed as the six-month Libor + 150 bps. Suppose that in December 20X0, the six-month Libor is 3.25%. The interest rate that will apply to the payment due in June 20X1 will be 4.75% (3.25% + 1.50%). Now suppose that in June 20X1, the six-month Libor has decreased to 3.15%. The interest rate that will apply to the payment due in December 20X1 will decrease to 4.65% (3.15% + 1.50%).

Basic Features of a Bond. Zero-coupon bonds . Such bonds do not pay interest, hence their name. Instead, they are issued at a discount to par value and redeemed at par; they are sometimes referred to as pure discount bonds . The interest earned on a zero-coupon bond is implied and equal to the difference between the par value and the purchase price. For example, if the par value is $1,000 and the purchase price is $950, the implied interest is $50..

Basic Features of a Bond. Currency Denomination: Bonds can be issued in any currency, although a large number of bond issues are made in either euros or US dollars. The currency of issue may affect a bond’s attractiveness. If the currency is not liquid or freely traded, or if the currency is very volatile relative to major currencies, investments in that currency will not appeal to many investors. Issuers may also choose to issue in a foreign currency if they are expecting cash flows in the foreign currency because the interest payments and principal repayments can act as a natural hedge, reducing currency risk. If a bond is aimed solely at a country’s domestic investors, it is more likely that the borrower will issue in the local currency..

Basic Features of a Bond. Dual-currency bonds make coupon payments in one currency and pay the par value at maturity in another currency. For example, assume that a Japanese company needs to finance a long-term project in the United States that will take several years to become profitable. The Japanese company could issue a yen/US dollar dual-currency bond. The coupon payments in yens can be made from the cash flows generated in Japan, and the principal can be repaid in US dollars using the cash flows generated in the United States once the project becomes profitable. Currency option bonds can be viewed as a combination of a single-currency bond plus a foreign currency option. They give bondholders the right to choose the currency in which they want to receive interest payments and principal repayments..

Basic Features of a Bond. [image] EXHIBIT 1 V20 Cash Flows for a Plain Vanilla Bond V20 V20 V20 V20 V20 V20 VIOJ20 V20 Annual Time.