42. Fixed-income securities: defining elements

Question 1

Fixed-income securities

Answer 1

are the dominant means of raising capital. It is a way for corporations to borrow without relinquishing ownership. Investors use them to diversify equity risk and fund known payment streams.

Question 2

Issuer

Answer 2

Entities that raise capital by issuing debt include companies, national (sovereign) governments, sub-national (non-sovereign) governments, quasi-government agencies, and supranational organizations (e.g., World Bank). Special purpose entities that are created to securitize assets (e.g., mortgage-backed securities) are typically treated as another type of issuer.

Question 3

Maturity

Answer 3

The maturity date is the due date of the principal. The tenor is the time remaining until maturity. A 10-year bond issued 2 years ago has an 8-year tenor. Maturities range from overnight to 30+ years.

Money market securities have maturities of less than one year, while longer-dated debt trades in the capital market. Perpetual bonds have no stated maturity.

Question 4

Par Value

Answer 4

amount that must be repaid at maturity. Often the price of a bond is quoted as a percentage of the par value. Bonds selling below the par value are at a discount and bonds selling above the par value are at a premium.

Question 5

Coupon Rate and Frequency

Answer 5

The issuer agrees to pay the coupon rate (nominal rate) each year. For example, a 5% coupon bond with a $1,000 par value pays $50 in coupons annually. If the frequency is annual, bondholders will receive a single $50 payment at the end of each year. If the frequency is semi-annual, the same bond would pay $25 coupons every six months until maturity. Mortgage-backed securities typically pay monthly coupons.

Question 6

floating-rate notes

Answer 6

have coupon rates that change based on the performance of a reference rate (e.g., Libor).

Question 7

Conventional bonds

Answer 7

pay a fixed interest rate

Question 8

zero-coupon bond

Answer 8

is called a pure discount bond because no coupons are paid. Instead, investors purchase these securities at a discount and receive their par value at maturity.

Question 9

Dual-currency issues

Answer 9

make coupon payments in one currency and principal payments in another. Currency option bonds give bondholders the right to choose which of two currency denominations they prefer for coupons and principal repayments.

Question 10

The trust deed (or bond indenture)

Answer 10

describes the obligations of the bond issuer and the rights of the bondholders. It specifies the principal value, coupon rate, maturity date, covenants, contingency provisions, collateral, and credit enhancements.

Question 11

trustee

Answer 11

helds the indenture, is an institution. The trustee is appointed by the issuer but acts in a fiduciary capacity for bondholders. The trustee duties are mainly administrative (e.g., maintaining records) unless a default occurs.

Question 12

Secured bonds

Answer 12

are backed by collateral that lenders can claim if the issuer defaults on its obligations. Collateral may be specifically identified assets. For example, collateral trust bonds are secured by financial assets, and equipment trust certificates are secured by physical assets. Alternatively, collateral can be broadly defined as “general plant and equipment.”

Question 13

debentures

Answer 13

typically refers to secured bonds in the UK and its former colonies and unsecured bonds in the rest of the world.

Question 14

Credit Enhancements

Answer 14

Internal and external credit enhancements can be used to reduce credit risk. Internal credit enhancements include subordination (through waterfall structure), over-collateralization, and excess spread. External credit enhancements include surety bonds, bank guarantees, and letters of credit or guarantees from financial institutions.

Question 15

Bond covenants

Answer 15

are rules agreed to at the time of issue. They include both affirmative (positive) and negative covenants. Affirmative covenants are usually administrative in nature. Negative covenants typically restrict the issuer in areas such as additional debt issuance, changing claims on assets, shareholder distributions, asset disposals, risky investments, and mergers and acquisitions.

Question 16

Eurobonds

Answer 16

are traded on the Eurobond market and are typically less regulated because they are beyond the jurisdiction of any single country. Eurobonds are named after the currency in which they are denominated. For example, Euroyen bonds are denominated in Japanese yen. Eurobonds are usually unsecured bonds underwritten by a consortium of financial institutions known as a syndicate.

Question 17

Global bonds

Answer 17

are simultaneously issued in the Eurobond market and at least one domestic market.

Question 18

Bullet bonds

Answer 18

(the most common type) repay the entire principal at maturity. Periodic coupon payments for interest are made prior to maturity

Question 19

fully amortized bond

Answer 19

provides equal annuity-like payments that are split between interest and principal. Over time, the interest portion decreases and the principal portion increases

Question 20

partially amortized bond

Answer 20

amortizes some principal in each of its periodic payments and makes a final balloon payment that includes any principal that has not already been amortized.

Question 21

Sinking funds

Answer 21

can also be used to periodically retire the bond principal. The schedule usually specifies a percentage of a bond issue that must be retired each year. The trustee could choose which bonds to redeem randomly.

Question 22

Call provisions

Answer 22

can also be used that allow the issuer to retire some percentage of the bonds early. The actual bonds within the issue to be repurchased are selected at random.

Question 23

Coupons

Answer 23

are the interest payments made to the bondholders. Most sovereign and corporate bonds pay coupons semi-annually (twice a year). Eurobonds typically pay coupons annually. While most bonds pay fixed-rate coupons, there are many variations.

Question 24

floating-rate notes

Answer 24

Bonds with coupon rates linked to an external index

Question 25

Some FRNs, called variable-rate notes

Answer 25

have variable spreads. FRNs have virtually no interest rate risk because the coupon payments will increase when rates rise. Many FRNs have caps and floors to limit interest rate payments. Inverse floaters have coupon rates that move inversely with the reference rate.

Question 26

Step-Up Coupon Bonds

Answer 26

pay coupons that increase periodically based on a set schedule. They offer investors protection against rising interest rates and give issuers an incentive to repurchase (call) bonds if interest rates remain stable or fall.

Question 27

credit-linked coupon bonds

Answer 27

Bonds that have coupon rates tied to credit ratings

Question 28

Payment-in-Kind (PIK) Coupon Bonds

Answer 28

allow the issuer to pay coupons with more bonds rather than cash. Lenders expect higher yields on the bonds because borrowers increase their credit risk by issuing more bonds as in-kind coupon payments.

Question 29

Deferred coupon bonds, also called split coupon bonds

Answer 29

pay no coupons in the early years and then higher coupons in later years. This structure allows issuers to defer cash payments while investors can potentially defer their tax liability. Zero-coupon bonds are an extreme example of the deferred coupon structure.

Question 30

Index-Linked Bonds

Answer 30

Indexed-linked bonds have the coupons tied to a specific index. While any index can be used, inflation-type indexes are common. Governments are the major issuers of inflation-linked bonds. The effect of inflation may be reflected in changes to the coupons or principal.

Question 31

contingency provisions

Answer 31

specify actions that may be taken under certain conditions. Provisions that may be embedded in bonds include call options, put options, and conversion options. Stated in the bond’s indenture.

Question 32

Convertible Bonds

Answer 32

grant lenders the right to convert their bonds into a specified number of the issuer’s common shares. Bondholders will exercise this option when the issuer’s stock does well.
Conversion parity exists if the conversion premium is zero. If the convertible bond price is greater than the conversion value, there is a positive conversion premium and the conversion condition is described as below parity. If the convertible bond price is less than the conversion value, the conversion premium is negative and the conversion condition is above parity.

Question 33

Warrants

Answer 33

e like a conversion option in the sense that they allow the holder to purchase common shares at a specific price. However, they are often offered as “sweeteners” to reduce borrowing costs rather than being structured as embedded options. Warrants may be traded separately on public equity exchanges.

Question 34

Contingent convertible bonds (CoCos)

Answer 34

are issued by financial institutions. The bonds automatically convert to equity if a certain trigger is reached (e.g., the issuer’s capitalization ratio falls below the regulatory minimum level). Lenders have no control over the timing of exercise and they are exposed to downside risk, so yields are relatively high compared to otherwise equivalent bonds.