(42) Fixed-Income Securities: Defining Elements

Question 1

LOS 51. a: Describe basic features of a fixed-income security.

Answer 1

Basic features of a fixed income security include the issuer, maturity date, par value, coupon rate, coupon frequency, and currency denomination.

Question 2

LOS 51. a: Describe basic features of a fixed-income security. Who are the issuers?

Answer 2

Issuers include corporations, special purpose entities, governments, quasi-government entities, and supranational entities.

Question 3

LOS 51. a: Describe basic features of a fixed-income security. What is the maturity date, tenor, and range? Define money market securities & capital market securities

Answer 3

Maturity date: this is when the principal is due (bonds end date)

Tenor: remaining time to maturity date

Range: overnight to 30 years or longer

Bonds with original maturities of one year or less are money market securities. Bonds with original maturities of more than one year are capital market securities.

Question 4

LOS 51. a: Describe basic features of a fixed-income security. Define par value, premium, and discount.

Answer 4

Par value is the principal amount that will be repaid to bondholders at maturity. Bonds are trading at a premium if their market price is greater than par value or trading at a discount if their price is less than par value.

Question 5

LOS 51. a: Describe basic features of a fixed-income security. Define coupons and their payment frequency.

Answer 5

Coupon rate is the percentage of par value that is paid annually as interest. Coupon frequency may be annual, semiannual, quarterly, or monthly. (coupon rate x par value)

Question 6

LOS 51. a: Describe basic features of a fixed-income security. Define zero-coupon bonds

Answer 6

Zero coupon bonds have the following traits:

• No coupon/interest payments - sold at a discount
• All income = interest
• Most money market securities are zero coupon bonds

Also called pure discount bonds. This type of bond earns the most interest on an imlied basis

Question 7

LOS 51. a: Describe basic features of a fixed-income security. How do different currencies play a role in bonds being issued?

Answer 7

Bonds may be issued in a single currency, dual currencies (one currency for interest and another for principal), or with a bondholder’s choice of currency (currency option bonds).

Question 8

LOS 51. a: Describe basic features of a fixed-income security. Explain the different types of yield measures and the relationship between price and YTM.

Answer 8

Current or running yield = annual coupon/price

Yield to maturity: this is the IRR of the bond’s expected cash flows; an estimate of the bond’s expected return

There is an inverse relationship between price and YTM (higher price, lower YTM)

Premium bond coupon rate > YTM

Discount bond coupon rate < YTM

Question 9

LOS 51. b: Describe content of a bond indenture. Define.

Answer 9

Bond indentures or trust deed is a contract between a bond issuer and the bondholders, which describes the following: the form of the bond, obligations of the bond issuer, and the righs of the bondholder

Question 10

LOS 51. b: Describe content of a bond indenture. What does an indenture specify?

Answer 10

An indenture specifies:

• the entity issuing the bond and its legal form
• the source of funds for repayment
• assets pledged as collateral
• credit enhancements, and;
• any covenants with which the issuer must comply.

Question 11

LOS 51. c: Compare affirmative and negative covenants and identify examples of each. Define covenant.

Answer 11

Covenants are provisions of a bond indenture that protect the bondholders’ interests. These are legally enforceable rules

Question 12

LOS 51. c: Compare affirmative and negative covenants and identify examples of each. What are negative covenants?

Answer 12

Negative covenants are restrictions on a bond issuer’s operating decisions. What an issuer will not do.

Example: prohibiting the issuer from issuing additional debt or selling the assets pledged as collateral; restrictions on debt such as max debt ratios and/or minimum interest coverage ratios; restrictions on prior claims; restrictions on asset disposal; restrictions on investments

The purpose is to protect bondholders

Question 13

LOS 51. c: Compare affirmative and negative covenants and identify examples of each. What are affirmative covenants?

Answer 13

Affirmative covenants are administrative actions the issuer must perform, such as making the interest and principal payments on time; comply with all laws and regulations, pay taxes

Question 14

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. List the legal and regulatory matters that affect fixed income securities:

Answer 14

Legal and regulatory matters that affect fixed income securities include:

• the places where they are issued and traded
• the issuing entities
• sources of repayment, and;
• collateral and credit enhancements.

Question 15

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. Define domestic bonds

Answer 15

Domestic bonds trade in the issuer’s home country and currency.

Question 16

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. Define foreign bonds

Answer 16

Foreign bonds are form foreign issuers but denominated in the currency of the country where they trade.

Question 17

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. Define Eurobonds

Answer 17

Eurobonds are issued outside the jurisdiction of any single country and denominated in a currency other than that of the countries in which they trade.

Question 18

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. What are possible issuing entities of fixed-income securities?

Answer 18

Issuing entities may be:

• a government or agency;
• a corporation, holding company, or subsidiary;
• or a special purpose entity.

Question 19

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. What are the source of repayment for sovereign bonds?

Answer 19

The source of repayment for sovereign bonds is the country’s taxing authority.

Question 20

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. What are the source of repayment for non-sovereign government bonds?

Answer 20

For non-sovereign government bonds, the sources may be taxing authority or revenues from a project

Question 21

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. What are the source of repayment for corporate bonds?

Answer 21

Corporate bonds are repaid with funds form the firm’s operations.

Question 22

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. What are the source of repayment for securitized bonds?

Answer 22

Securitized bonds are repaid with cash flows from a pool of financial assets.

Question 23

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. When are bonds secured vs. unsecured?

Answer 23

Bonds are secured if they are backed by specific collateral or unsecured if they represent an overall claim against the issuer’s cash flows and assets.

Question 24

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. What are some internal credit enhancements?

Answer 24

Credit enhancements may be internal, examples include:

• overcollateralization
• excess spread
• tranches with different priority of claims

Question 25

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. What are some external credit enhancements?

Answer 25

Credit enhancements may be external, examples include:

• surety bonds
• bank guarantees
• letters of credit

Question 26

LOS 51. d: Describe how legal, regulatory, and tax considerations affect the issuance of trading of fixed-income securities. How are fixed-income securities normally taxed?

Answer 26

Interest income is typically taxed at the same rate as ordinary income, while gains or losses from selling a bond are taxed at the capital gains tax rate.

The discount on a discount bond is amortized over the life of the bond and treated as implied interest (opposite effect for premium bonds). In the United States, interest income from municipal bonds is usually tax-exempt at the national level and in the issuer’s state.

Question 27

LOS 51. e: Describe how cash flows of fixed-income securities are structured. Define a bond with a bullet structure

Answer 27

A bond with a bullet structure pays coupon interest periodically and repays the entire principal value at maturity.

Most common type of cash flow; Almost all government and corporate bonds use this structure

Question 28

LOS 51. e: Describe how cash flows of fixed-income securities are structured. Define a bond with a fully amortizing structure

Answer 28

An amortized bond has a payment shcedule that calls for periodic payments of interest and repayments of principal. Fully amortized is characterized by a fixed periodic payment schedule that reduces the bond’s outstanding principal amount to zero by the maturity date.

Question 29

LOS 51. e: Describe how cash flows of fixed-income securities are structured. Define a bond with a partially amortizing structure

Answer 29

An amortized bond has a payment shcedule that calls for periodic payments of interest and repayments of principal.

A partially amortized bond also makes fixed periodic payments until maturity, but only a portion of the principal is repaid by the maturity date. Thus a balloon payment is required at maturity to retire the bond’s outstanding principal amount.

Question 30

LOS 51. e: Describe how cash flows of fixed-income securities are structured. Define a bond with a partially amortizing structure

Answer 30

A partially amortizing structure has a balloon payment at maturity, which repays the remaining principal as a lump sum.

Question 31

LOS 51. e: Describe how cash flows of fixed-income securities are structured. Define a bond with a sinking fund arrangement

Answer 31

Another approach to periodically retire the bond’s principal outstanding. The term sinking fund refers to an issuer’s plans to set aside funds over time to retire the bond.

This lower’s default/credit risk but raises re-investment risk or call risk

Question 32

LOS 51. e: Describe how cash flows of fixed-income securities are structured. Define a note with a floating-rate and a note with a fixed coupon

Answer 32

Floating-rate notes have coupon rates that adjust based on a reference rate such as Libor. There is very little volatility since coupons are reset at market rates on each coupone date. There is higher coupon volatility. With this you get uncertain cash flows. May have a cap and floor rate

Fixed coupon (conventional bond): you will get certain cash flows and more price volatility

Question 33

LOS 51. e: Describe how cash flows of fixed-income securities are structured. What are some other coupon structures?

Answer 33

Other coupon structures include:

• step-up coupon notes - Coupon increases by specified margins at specified dates
• credit-linked coupon bonds - coupon increases/decreases when bond’s credit rating decreases/increases
• payment-in-kind bonds - interest paid with more amounts of the bond (or with common shares)
• deferred coupon bonds - no coupon payments for the first few years followed by higher coupon than otherwise
• index-linked bonds - coupons are linked to some index

Question 34

LOS 51. f: 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. Define contingency and embedded options. What type of options benefit which party?

Answer 34

Contingency is some future event or circumstance that is possible but not certain. Contingency provision gives issuer or bondholder a right (embedded option) to some action

Embedded options benefit the party who has the right to exercise them. Call options benefit the issuer, while put options and conversion options benefit the bondholder.

Question 35

LOS 51. f: 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. Define callable bonds.

Answer 35

Issuer has the right to redeem all or part of the bond before maturity. Call options give value to the issuers. Issuer is protected from a decline in interest rates

There is either a higher coupon or lower price.

Calls can be:

• American: continuously callable
• European: only on call date (1 date)
• Bermuda: only on call dates after the lockout period, usually on coupon dates

When you make the whole call - it results in a call price greater than current market price

Question 36

LOS 51. f: 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. Define put options.

Answer 36

Put options allow the bondholder to sell bonds back to the issuer at a specified put price. (Value on bondholder). Protects the bondholder against a rise in rates

Lower yield or higher prices

Question 37

LOS 51. f: 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. Define conversion options.

Answer 37

Conversion options allow the bondholder to exchange bonds for a specified number of shares of the issuer’s common stock.

If share price decreases, get bond principal (downside protection)

If share price goes up, get share price (upside particpation)

Lower yield or higher price

Issuer pays lower interest, plus may avoid principal repayment

Question 38

Asset or collateral backing ranking:

Answer 38

1. Secured bond - backed by assets (less risky)
2. Unsecured bond - backed by a general pledge (aka no collateral) very risky

Secured bonds are paid before unsecured bonds

Debentures are a type of bond that can be secured or unsecured

Question 39

Types of collateral:

Answer 39

• Collateral Trust Bond: backed by other financial assets (held by a trustee)
• Equipment trust certificate: backed by a specific equipment; typically used to engineer a lease
• Mortgage backed securities: backed by a pool of mortgages
• Covered bonds: backed by a segregated by pool of assets that are not transferred to a SPE

Question 40

What is credit enhancement and different types?

Answer 40

Credit enhancements reduce the credit risk of a bond

Types:

• Internal
  
  • Subordination or credit tranching
  • Overcollateralization: posting more collateral than is needed
  • Reserve accounts or reserve funds
• External
  
  • Bank guarantee and surety (insurance company) bonds
  • Letter of credit: a credit line to reimburse any cash flow shortfalls from the assets backing the issue
  • Cash collateral account - does not rely on 3rd party credit worthiness

Question 41

Categories/types of bonds and describe each:

Answer 41

• Domestic bonds: issued in issuer’s home country in the currency of that country (Canadian company issues in Canada in Canadian dollars)
• Foreign Bonds: issuing entity not of the target country (US company issues in canada in Canadian dollar)
• Domestic and foreign bonds are regulated by the market the bonds are issued in
• Euro bonds: created to bypass legal/regulatory/tax constraints immposed on issuers
  
  • less regulated since they are issued outside the jurisdiction of any single country
  • usually unsecured
  • can be issued in any currency
• Global bonds: bonds issued simultaneously in the Eurobond market and in at least one domestic market

Question 42

What are the different types of index-linked bonds? Describe each

Answer 42

1. Zero-coupon indexed bond - principal only increases for inflation (no coupon)
2. Interest-indexed bonds - fixed nominal principal plus index-linked coupon (principal does not change)
3. Capital-indexed bonds - fixed coupon plus index-linked principal (principal increases by inflation)
4. Index-annuity bonds - fully amortizing; interest plus principal payments