2.2 Debt types and features Flashcards
What options do companies vs governments have for raising capital?
Companies: debt and equity
Governments: Debt only
Can governments use bank loans to raise capital?
No - only companies have this option
What are the two types of debt securities and their respective maturities?
Bills: <1 year
Bonds: >1 year
What is the difference between capital markets and money markets?
Capital markets: Long-term issuance, generally >1year; (bonds)
Money markets: Short-term issuance, generally <1year; (bills)
What are the 4 main features of a bond?
- Coupon - represents interest (expressed as annual percentage per £100 of nominal value)
- Nominal value - capital payment holder receives at redemption (not the price of the bond!)
- Name - name given at issue (common for governments to refer to their bonds as treasury stock/bonds)
- Redemption - the year and date when the gilt is repaid (maturity date)
How often can coupons be paid?
On an annual or semi-annual basis
- UK Government pays coupon on semi-annual basis
What are other names for the nominal value of a bond?
Par/redemption/capital
value
Why is the coupon of a bond often called the gross coupn?
Coupons are taxable (subject to income tax for individuals); but tax
is not normally deducted from the coupon payment -0 therefore it is referred to as being a gross coupon.
Who is responsible for debt and cash management for the UK government?
The Debt Management Office (DMO)
- they repay capital to investor at redemption of a bond
What is the yield on UK Gilts considered?
UK Gilts are effectively credit risk free and are therefore used for benchmarking - their yield is considered the risk-free rate for sterling denominated bonds
What are the two main types of UK government bond?
- Conventional
- Index linked
What are the features of a conventional government bond?
- fixed coupons
- fixed maturity
What is a disadvantage of conventional gov. bonds?
If invested for a long period of time cashflows (coupon and nominal value) can be very easily eroded by inflation
What are the features of an index-linked government bond?
- coupon and nominal value linked to inflation index
- therefore inflation protected
- NOTE: no deflation protection
- stated cashflows (coupon and nominal value) will be returned in the case of zero-inflation since investing in the bond
Do index-linked bonds have higher or lower yield than conventional?
- Lower yields as they provide additional safety so are lower risk (and therefore lower potential return)
What is the RPI?
Retail Prices Index - An average change in the prices of household
goods and services
What is the CPI?
Consumer Prices Index: Based on an EU-wide formula to allow
international comparison. Used by the MPC (monetary policy committee)
What is the PPI?
Producer Prices Index: Looks at goods and services further up the
production chain, at the wholesale level
What does STRIPS stand for?
Separate Trading of Registered Interest and Principal of Securities
What is a zero-coupon bond?
A bond issued at a discount to the nominal value - later redeemed at nominal value (pays no coupon)
What is a key benefit of zero coupon bonds?
It removes reinvestment risk as investors can precisely match their liabilities
Which firms dominate the zero-coupon market?
Large institution investors, insurance companies, pension funds - who have liabilities to meet
aka. Liability driven investors
Do UK and US governments issue zero-coupon bonds?
UK and US governments have historically never issued zero-coupon bonds in the capital market
How do the UK and US provide investors with zero-coupon bonds in another way?
Through the STRIPS market developed in US and UK treasury market
Designate certain UK Gilts to be strippable by the DMO - take all the cash flows of a gilt and turn it into a mini-zero coupon bond (STRIPS)
Which 3 parties in the UK are permitted to strip Gilts and create the zero-coupons?
GEMMs - Gilt-Edged Market Makers
HMT
BoE
How many STRIPS can a 5 year strippable Gilt be stripped into?
11 - it is the number of years x2 (to get the coupon cash flows) + 1 (to get the capital payment cash flow)
What is reinvestment risk and how can it be avoided?
- Where the investor may not receive a required rate
of return when reinvesting coupon payments - Often avoided through
cash-flow matching, or dedication
What is dedication?
Where the investor matches the maturity of cash-flows to the
liabilities
- Simplest way to do this is use a zero-coupon bond
What are the features of French government bonds?
Legal form - bearer
Life when issued -
OATs: 2-50 years
Coupons - annual
Settlement time - T+2
What are the features of German government bonds?
Legal form - bearer
Life when issued -
Schatz: Up to 2 years
Bobl: 5 years
Bund: >10 years
Coupons - annual
Settlement time - T+2
What are the features of UK government bonds?
Legal form - registered
Life when issued -
Short: < 7 years
Medium: 7-15 years
Long: >15 years
Coupons - semi-annual
Settlement time - T+1
What are the features of US government bonds?
Legal form - registered
Life when issued -
T-notes: 2-10 years
T-bonds: >10 years
Coupons - semi-annual
Settlement time - T+1
What are the features of Japanese government bonds?
Legal form - registered or bearer
Life when issued -
Maturities tend to be anywhere between 2-40 years
Long: 10 years (most common)
Superlong: 20 years
Coupons - semi-annual
Settlement time - T+1
Where has a significant increase in issuance of government bonds been observed and what is a downfall?
In emerging/frontier markets:
- increased volatility and uncertainty
List the emerging markets
Brazil, Russia, India, China, South Africa, Indonesia, Mexico, Turkey and Malaysia
List the frontier markets
Bangladesh, Bahrain, Mauritius and Sri Lanka
What are the two main types of corporate bonds?
- secured debt securities
- unsecured debt securities
What are the 2 types of secured corporate bonds?
- Fixed charge over assets
- Floating charge over assets
What are fixed charge over assets secured bonds?
a fixed charge is security over a certain
specific (named) company asset, e.g. a building or land, and is the most common form of security for debentures
A mortgage charge is a type of fixed charge
What are floating charge over assets secured bonds?
security over a class (pool)
of assets, e.g. plant and machinery, fixtures and fittings, trade debtors, inventory, receivables
What is another term for unsecured debt?
Loan stock
What is an unsecured debt transaction called in the UK?
A debenture
What does debenture refer to in the US?
Generally refers to a loan agreement with no security at all
What terms does the US use for secured issues and secured debt?
Secured issue: asset-backed security
Secured debt: asset backed security (ABS)
List corporate bonds in order of least to most risky
- fixed charge over assets secured bond
- floating charge over assets secured bond
- unsecured bond
What is the difference between ABS and covered bonds?
The difference comes from who owns the pool of assets:
- if owned by the originator (eg. the bank that lent out money for mortgage in first place): covered bond
- if owned by a SPV (sold on by bank to SPV whose purpose is to securitise the bond)
What does it mean to securitise something?
Turn it into a security (take smt difficult to trade and turn it into smt easy to trade)
What is a trust deed?
Empowers trustee alone to act on behalf of debenture holders (for ABS) - ensures organised action and parity of treatment through a single entity
What is the role of the trustee?
Protect interests of debenture holders
What is a note trustee?
- Appointed to represent the interests of holders of issues of securities
- also provides guidance to the issuer
What is a security trustee?
- takes legal control of assets; assets re-registered in trustee’s name
- Where bonds are secured (debentures) the security is protected by the
trustee for the benefit secured parties - The governing documents dictate
the order of priority of payments among the entitled parties
What is a share trustee?
- Holds the shares in an issuing Special Purpose Vehicle (SPV) in order to ensure off-balance-sheet treatment for the originator of
the transaction - Share trustee becomes legal owner of SPV
- Sometimes these SPVs are domiciled in offshore
jurisdictions
What is a successor trustee?
This role played by a trustee is provided for banks which need to resign because of conflicts of interest (especially in connection with defaulted or
bankrupt issues) or when work requirements exceed the bank’s capacity
What is the typical life of unsecured corporate bonds?
7-30 years
What are the 5 types of unsecured debt with different features to conventional bonds?
- convertible bonds
- exchangeable bonds
- guaranteed bonds
- Floating rate notes (FRNs)
- Payment in kind notes (PIK)
What is a convertible bond?
Choice to convert into stock of the issuer (at discretion of investor)
What is an exchangeable bond?
Converts into stock of another (usually subsidiary of issuer)
What is a guaranteed bond?
Credit enhancement based on credit rating of a third party (a guarantor)
So investors know that there is a bigger/better company than the issuer that is guaranteeing the debt
- this is a safer bond (less risk) and therefore reduces financing cost for issuer (can issue more cheaply)
What are floating rate notes?
- variable coupon
- coupon floats in line with market interest rates
- trades near par (price = nominal value usually) so you dont have the inverse relationship between interests rates and bond prices
- capital protection as it trades near par (less risk of loss of capital)
What are PIKs?
- generally subordinated debt
- zero coupon bonds that are issued at substantial discount to face value
What is a Eurobond?
- international bonds issued in more than 1 country
- bearer documents
- issued in eurocurrency
What is eurocurrency?
- any currency other than the currency of the market in which the eurobond is issued
Where are eurobonds typically dealt?
Usually OTC but some are exchange traded
Who regulates Eurobonds and what is settlement period?
International Capital Markets Association (ICMA)
- trades reported and matched through TRAX
- settlement is T+2(if settled through euroclear/clearstream)
What is the day count convention for accrued interest on eurobonds?
30/360
Is the coupon taxed for a eurobond and how often are they issued ?
No - its a gross annual coupon
What does it mean to immobilise a bearer document?
Put in a depositary (eg. Euroclear/clearstream
What is the order of payout in the case of liquidation?
- Liquidator
- Fixed charge holders (Fixed charge debentures)
- Preferential creditors (eg. employees)
- Floating charge holders
- Unsecured creditors (eg. trade creditors and the government, unsecured bonds)
- Subordinated loan stock (eg. PIK)
^the above are creditors - preference shareholders (nominal value only except participating shares)
- ordinary shareholders
^the above are owners
What is the order in which bondholders get paid in event of liquidation?
- Fixed charge holders
- Floating charge holders
- Unsecured creditors
- Subordinated loan stock
5.. Mezzanine debt
What sits on the line between subordinate loan stock and pref. shareholders?
Mezzanine debt - lowest form of debt
What is a straight or plain vanilla eurobond?
fixed coupon eurobonds or bullet bonds that normally pay the coupons once a year
What is a ZCB (eurobond variant)?
Zero coupon bond - no coupon
Issued at a discount and
redeemed at par value
What is a floating rate eurobond?
Eurobonds where the coupon rate
varies
The rate is adjusted in line with published market interest rates
The published interest rates that are normally used are a reference rate e.g. SONIA
What is a Stepped bond?
A variant of eurobond where the coupon increases over the life of the bond
What is speculative grade/bonds in default for Standard and Poor’s and Fitch?
- Starts at BB +
(each grade (exceot AAA) divided into two, plus and minus) - D
What is speculative grade/bonds in default for Moody’s?
- Starts at Ba 1 (each grade (Except Aaa) subdivided into three - 1, 2, 3)
- C
What happens when credit worthiness changes?
Credit rating goes down: Price goes down, yield goes up
Credit rating goes up: Price goes up, yield goes down
NOTE: Coupon is never affected (only the yield/return)
What kind of relationship do prices and yields have?
Inverse
What are the pros and cons of debt for companies?
Pros:
- another way to raise capital
- no sacrifice of control
- known obligations (fixed coupon, nom value, redemption date etc)
- paid from pre-tax profit (interest charge comes out before tax on IS)
- cheaper to finance
Cons:
- obligation to pay regardless of performance
- redemptions (have to pay back)
- default can lead to significant repercussions
What are the pros and cons of debt for investors?
Pros:
- known payments
- priority in payment
- some debt is default risk-free
Cons:
- historically lower return
- not all debt is default risk free
What are the credit rating agencies for Japan and Africa?
- Japan Credit Rating Agency
- Global Credit Rating (for Africa)
