6.1 fixed-income features, cash flows, issuance, and trading Flashcards
Bind Issuers can be classified into two broad categories:
- The government and government-related sector:
–> Supranational organizations
–> Sovereign (national) governments
–> Non-sovereign (local) governments
–> Quasi-government entities
- The private sector:
–> Corporations
–>Special purpose entities that issue asset-backed securities
A debt security’s tenor
the time remaining to maturity
money market securities
Fixed-income instruments with maturities of less than one year
capital market securities
Fixed-income instruments with maturities of more than one year
perpetual bonds
no stated maturity, which makes them similar to equity in the sense that they are a permanent source of capital.
However, perpetual bonds differ from equity because they have contractual cash flows, greater seniority, and no voting rights.
Floating-rate notes (FRNs)
coupon rates that change based on the performance of a market reference rate (MRR) with a spread that reflects the issuer’s creditworthiness.
For example, a floating-rate note with a stated coupon rate of MRR + 1% will pay a 5% coupon if the MRR is at 4%. If the MRR falls to 2%, the bond’s next coupon payment will be for 3% of par value.
these instruments are attractive to investors who expect interest rates to rise, although they are exposed to the risk that rates will fall.
A zero-coupon bond
also known as a pure discount bond does not provide any coupon payments during its lifetime.
Instead, investors purchase these securities at a discount and receive their par value at maturity. The difference between the bond’s par value and the discounted purchase price can be thought of as a cumulative interest payment.
embedded call option contingency
allow the issuer to buy back its debt from lenders at a pre-determined price
embedded call option contingency
grants lenders the right to force issuers to repurchase their debt
current yield
the bond’s annual coupon divided by its current price
yield to maturity (YTM)
the internal rate of return that makes the present value of a bond’s future cash flows equal to its current price
An investor who purchases a bond today at its current price will earn the YTM as an annualized rate of return if the following conditions are met:
The issuer makes all interest and principal payments as scheduled
All payments received before maturity are reinvested to earn the YTM
The investor holds the bond to maturity
The trust deed (or bond indenture)
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.
The indenture is held by a trustee, which is typically a financial institution. The trustee is appointed by the issuer but acts in a fiduciary capacity for bondholders. The trustee’s duties are mainly administrative (e.g., maintaining records) unless a default occurs.
unsecured bonds
backed only by the issuer’s operating cash flows
A pari passu (or “equal footing”) clause
ensures that all creditors within the same seniority class are treated equally.
common affirmative covenant
a cross-default clause
deems a borrower to be in default on all of its debt obligations if it defaults on any of its issues.
common affirmative covenant
negative pledge clause
A commitment to refrain from issuing new debt with a higher seniority
incurrence test
A prohibition on breaching specific levels of certain leverage or solvency ratios
bullet bonds
coupon payments paid at regular intervals and the full face value repaid at maturity
Fixed-income securities are most commonly structured as bullet bonds
These instruments are attractive to investors because both the timing and amount of cash flows are known in advance
Amortizing Debt
A debt instrument is described as amortizing if part or all of its principal is repaid before maturity
A fully amortized loan
provides equal annuity-like payments that are split between interest and principal.
Over time, the interest portion decreases and the principal portion increases.
Credit risk decreases as the borrower’s liability is reduced with each payment.
A partially amortized bond
amortizes some principal in each of its periodic payments
A balloon payment is made at maturity for any portion of the face value that has was not amortized over the term of the loan, but this is less than the bullet payment that is due when a conventional bond matures.
a sinking funds arrangement
periodic payments do not include any principal but the borrower agrees to deposit funds into an escrow account according to a schedule
These funds can then be used to return a portion of the bond’s principal prior to maturity
For example, an issuer may direct the escrow account’s trustee to retire a percentage of outstanding principle by choosing bondholders at random and repurchasing their bonds. From the perspective of investors, a sinking fund reduces exposure to credit risk in the same way as amortization, but it creates potential exposure to reinvestment risk if they are required to redeem their bonds early.
A waterfall structure
creates multiple classes of investors with different priority claims.
This type of tranching is commonly used for mortgage-backed securities.
Incoming payments are a combination of interest and principal, but they are directed to the tranche with the highest priority claim to ensure that these investors are paid a set coupon rate and have their principal returned on schedule.
Investors in the lower priority class have greater exposure to the risk that payments from the underlying mortgages will not be received.
step-up bonds
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.
This structure is often used for leveraged loans to issuers with relatively low credit quality.
Sustainability-linked bonds
recent innovation that pays a stepped up coupon rate if the issuer fails to meet the environmental performance targets listed in the indenture
Credit-linked notes
coupon rates that are tied to the issuer’s credit ratings
The coupon rate will increase if the issuer gets downgraded and decrease if the issuer gets upgraded.
Payment-in-kind (PIK) bonds
allow the issuer to pay coupons with more bonds rather than cash.
This is an attractive funding option for companies that are uncertain about their future cash flows.
Of course, lenders expect higher yields on these bonds because issuing more bonds as in-kind coupon payments increases the borrower’s credit risk.
Indexed-linked bonds
pay coupons based on a rate that is 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.
Interest-indexed bonds are structurally equivalent to FRNs because they make a fixed principal repayment but their coupons are adjusted based on a reference rate of inflation.
Capital-indexed bonds pay a fixed coupon rate that is applied to a principal amount that is adjusted for inflation.
Deferred coupon bonds, also called split coupon bonds
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.
Conceptually, zero-coupon bonds are an extreme example of the deferred coupon structure, which explains why these securities are typically priced at a discount to their par value.
a call protection period
Callable bonds often specify a call protection period
the issuer is not permitted to exercise its call option
A Bermuda-style put option
gives investors multiple opportunities to sell their bonds back
European-style put option
provides investors just one opportunitiy to sell their bonds back
Key features of convertible bonds include:
Conversion price: The share price at which convertible bonds can be converted.
Conversion ratio: The number of common shares that will be received for each convertible bond.
Conversion value: The convertible bond’s value if converted immediately.
Conversion premium: This is the difference between the convertible bond’s price and its conversion.
Conversion parity exists if
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.
Warrants
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
Contingent convertible bonds (CoCos)
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.
Eurobonds
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.
most Eurobonds have been bearer bonds,
bearer bonds
only the clearing system knows who owns the bonds.
Global bonds
imultaneously issued in the Eurobond market and at least one domestic market.
While there is no universal definition, fixed-income securities can be categorized as follows along the maturity spectrum:
Short-term: Less than one year
Intermediate-Term: 1 to 10 years
Long-term: Greater than 10 years
A simple classification scheme along the credit quality spectrum includes the following categories:
Default risk free: Developed market sovereign issuers, typically rated AAA
Investment grade: Corporate issuers rated BBB- or higher
High Yield: Corporate issuers rated BB+ or lower
fallen angels
the term used to describe issues that were originally given an investment grade rating but have subsequently been downgraded below BBB-.
However, there are several important differences between these two types of indexes (equity and bonds) that make it more challenging to replicate the performance of bond indexes.
While corporate issuers may have one or two classes of common stock, they can have dozens of different types of fixed-income securities outstanding. As a result, some bond indexes have over 10,000 components.
Unlike equity securities, bonds have a finite life. Bond indexes need to be rebalanced and reconstituted relatively frequently (e.g., monthly) to replace components that are nearing maturity.
Similar to equity indexes that are weighted based on market capitalization, bond indexes are typically weighted according to the market value of debt outstanding. Bond indexes must adapt as different types of issuers or issues become a larger or smaller share of the market. Additionally, bond market indexes tend to give significant weight to government securities, which are often the largest and most actively traded bonds.
Replacement of maturing bonds is much more common than a reopening
true or false
true
reopening of bonds
increases the size of an issuer’s existing bond trading at a price that is significantly different than its par value
shelf registrations
allow frequent issuers to offer a range of bonds through a single, all-compassing offering circular that is updated regularly over time
Because disclosure requirements are lower, only well-established issuers have access to shelf registration.
Some jurisdictions limit sales of shelf offerings to qualified institutional investors.
Underwritten offerings also called firm commitment offerings)
are underwritten by an investment bank, which agrees to purchase any bonds that cannot be sold to investors
best-efforts offering
the investment bank’s involvement is limited to acting as a broker.
Sovereign debt is typically issued in the primary market via?
auctions.
The bid-offer spread (bid-ask spread)
v]represents the difference between the prices at which a dealer will buy and sell a bond
A low bid-ask spread indicates a liquid market
Distress debt issues
companies that are near or already in bankruptcy generally trade at prices that reflect the expected recovery rate
Opportunistic investors may be willing to buy distressed debt at a significant discount to par value from institutional investors with constraints against holding high-yield securities.
Distressed debt securities will continue to be traded in OTC secondary bond markets even after the issuer’s common shares have been removed from exchanges for failing to meet the listing requirements.
