2015 Study Session # 15, Reading # 51

FIXED-INCOME SECURITIES: DEFINING ELEMENTS

FI = Fixed Income
CFs = Cash Flows

1. INTRODUCTION
FI security an instrument that allow governments, companies &
other types of issuers to borrow money from investors.
Adding FI securities to portfolio adds diversification benefits.

2. OVERVIEW OF A FIXED-INCOME SECURITY

Three important elements of bond investing:
The bonds features
Legal, regulatory & tax consideration.
Contingency provisions.

2.1 Basic Features of a Bond

2.1.1 Issuer

2.1.2 Maturity

Major types of bond issuer include:

Supranational organizations e.g. World Bank.
Sovereign governments e.g. UK, USA.
Non-sovereign governments.
Quasi-govt. entities.
Corporate issuers.
Credit risk risk of loss resulting from the issuer
failing to make full & timely payment of
interest/principal.

Maturity date date when the issuer is

obligated to redeem the bond by paying
the outstanding principal.
Tenor time remaining until maturity
date.
Money market securities maturities at
issuance of one year or less.
Capital market securities FI securities
with maturity > 1 year.

2.1.3 Par Value

2.1.4 Coupon Rate and Frequency

Principal or par value amount that the issuer

agrees to repay the bondholder on maturity date

Coupon/nominal rate interest rate that

the issuer agrees to pay every year until
maturity.
Plain vanilla bond fixed rate bond.
Floaters bonds with floating rate
coupon.
Zero coupon bonds issued at discount
to par & redeemed at par.

2.1.5 Currency Denomination

Dual currency bonds pay interest in one
currency & principal in another currency.
Currency option bonds single currency
bond+ foreign currency option.

2.2 Yield Measures

Yield to maturity (YTM) internal rate of return on a

bonds expected cash flows.
Lower IR scenario anticipation, lower YTM demand.

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2015 Study Session # 15, Reading # 51

3. LEGAL, REGULATORY, AND TAX CONSIDERATIONS

3.1 Bond Indenture

Trust deed (indenture) legal contract that describe:
Bond form
Issuers obligations.
Bondholders rights.
Collateral assets or financial guarantees above &
beyond the issuers promise to pay.
Credit enhancements provisions to reduce the
credit risk of the bond issue.
Covenants clauses that define bond-holders rights
and an issuers actions.

3.1.1 Legal Identity of the Bond Issuer and its Legal Form
Bond issuer is legally obliged to make contractual
payments.

3.1.2 Source of Repayment Proceeds

Supranational organization either the
repayment of previous loans or the paid-in-capital
from its members.
Sovereign bonds tax revenue & print money is
the major source of repayment.
Non-sovereign govt. debt:
Tax
Cash flow of project (financed with bond
issue).
Special tax or fees.
Corporate bonds issuers ability to generate
CFs from operations.
Securitization CFs generated by one or more
underlying financial assets.

3.2 Legal and Regulatory

FI securities are subject to legal & regulatory
requirements.
National bond market bonds that are issued &
traded in a specific county.
Euro bonds bond issued & traded on euro bond
market.
Bearer bonds trustee doesnt keep records
of bonds ownership.
Registered bonds ownership is recorded by
either name or serial number.

3.1.3 Asset or Collateral Backing

3.1.3.1 Seniority Ranking
Secured bonds backed by assets or financial
guarantees pledged to ensure debt repayment in
case of default.
Unsecured bonds no collateral bond.
Debentures types of bond that can be
unsecured.

3.1.3.2 Types of Collateral Backing

Collateral trust bonds secured by securities
such as shares other bonds or financial assets.
Equipment trust certificates bonds secured by
specific types of equipment or physical assets.
Mortgage-backed securities debt obligations
that represent claims to the CFs from pools of
mortgage loans.
Covered bonds debt backed by a segregated
pool of assets called cover pool

3.1.4 Credit Enhancement

Credit enhancement variety of provisions that
can be used to the credit risk of a bond issue.
3.1.4.1 Internal credit enhancement
subordination ordering of claim priorities for
ownership or interest in an asset.
Junior tranche function as credit protection
for senior tranche.
Excess spread difference b/w CF received
from the assets used to secured issue & the
interest paid to investors.
3.1.4.2 External credit enhancement.
Surety bond issued by a rated & regulated
insurance company.
Letter of credit provided by a financial
institution.
Less common form.

3.1.5 Covenants
Bond covenants legally enforceable rules that
borrowers & lenders agree on at the time of a
new bond issue.
Affirmative covenants what issuers required to
do (admin nature).
Negative covenants what issuers are
prohibited from doing (costly & do materially
constrain the issuers potential business decision).
Examples restrictions on debt, negative
pledges. Restriction on prior claims
restrictions on investments etc.

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2015 Study Session # 15, Reading # 51

3.3 Tax Considerations

Income portions of a bond investment taxed at
ordinary income tax rate.
Capital gain/loss if the price is likely to have changed
compared with the purchase price.
Different tax rate for long term & short term capital
gains in different countries.

4. STRUCTURE OF A BOND'S CASH FLOWS

4.1 Principal Repayment Structures

4.1.1 Bullet, Fully Amortized, and Partially Amortized Bonds

Bullet bond entire principal payment occurs at maturity.
Amortizing bond periodic payments of interest &
repayment of principal.
Partially amortized bond fixed periodic payments until
maturity & a portion of the principal at maturity date.
Balloon payment payment to retire the bonds
outstanding principal at maturity.

4.1.2 Sinking Fund Arrangements

Sinking fund an issuers plan to set aside funds
over time to retire the bond.
Benefit:
Formal plan to retire the debt.
Disadvantage:
Reinvestment risk
Issuer may have option to repurchase bonds
at below market prices.

4.2 Coupon Payment Structures

Coupon interest payment that the bond issuer
makes to the bondholder.
Usually coupon is paid semi-annually for sovereign &
corporate bonds.

4.2.1 Floating-Rate Notes

4.2.2 Step-Up Coupon Bonds

Coupon rate is linked to an external reference

rate e.g. LIBOR.
Quarterly coupons.
Typical coupon rate = 3M LIBOR+---BPS (spread).
Variable rate note spread is not fixed.
Little interest rate risk.
Additional features may include a floor or cap.
Inverse floater inverse relationship to the
reference rate.

Fixed or floating coupon which by specified

margins at specified dates.
Provides some protection against rising interest
rates.

4.2.3 Credit-Linked Coupon Bonds

4.2.4 Payment-in-Kind Coupon Bonds

Coupon rate change when bonds credit rating

change.
Attractive to investors who are concerned about
the future credit worthiness of the issuer.

Coupon is paid in the form of additional amounts

of the bonds issue rather than as a cash payment.
Favored when issuers future cash flows will be
questionable.

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2015 Study Session # 15, Reading # 51

4.2 Coupon Payment Structures

4.2.5 Deferred Coupon Bonds

4.2.6 Index-Linked Bonds

These bonds:
Paid no coupon for first few years & pays
higher than normal coupon for the remainder
of its life.
Common in project financing.
Priced at significant discount to par.

Coupon &/or principal repayments are linked to a

specific index.
Example inflation linked bonds.
Real interest rate = nominal interest rate
inflation.
Equity-linked note final payment is based on
the return of an equity index.

5. BONDS WITH CONTINGENCY PROVISIONS

Contingency provision clause in legal document that allows for some
action if the event does occur.
Embedded option various contingency provisions found in the indenture.

5.1 Callable Bonds

Callable bond gives the issuer the right to redeem all or part of the bond before maturity date.
Provide protection to issuer in declining interest rate environment.
The yield & price compensate the bondholders for the value of the call option to the issuer.
Bermuda-style call issuer has the right to call bonds on specified dates following the call protection period.

5.2 Putable Bonds

Put provisions provide right to the bondholder to sell the bond back to the issuer at a predetermined price on specified dates.
Pre-specified selling price of put able bond provide benefit to bond holder.
Lower yield on these bonds compensate the issuer for the value of the put option to the
investor.

5.3 Convertible Bonds

Convertible bond hybrid security with both debt & equity features (bond holder has a right to
exchange the bond for specified number of shares in issuing company).
Convertible bond may further include call provision.
Advantages for investor:
Investor can participate in equity upside.
Investor receives downside protection.
Price of convertible bond cant fall below the price of the straight bond.
Price of a convertible bond is than the price of the bond without this provision.
Conversion price price per share at which the convertible bond can be converted into shares.
Conversion ratio number of common shares that each bond can be converted into.
Conversion value current share price conversion ratio.

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