CFA 51: Fixed-Income Securities: Defining Elements

Question 1

securitized bonds

Overview of a Fixed-Income Security

Answer 1

Bonds created from a process called securitization, which involves moving assets into a special legal entity. This special legal entity then uses the assets as guarantees to back (secure) a bond issue, leading to the creation of securitized bonds.

Question 2

tenor (term to maturity)

Overview of a Fixed-Income Security

Answer 2

The time remaining until the bond’s maturity date. It indicates the period over which the bondholder can expect to receive the coupon payments and the length of time until the principal is repaid in full.

Question 3

money market securities

Overview of a Fixed-Income Security

Answer 3

Fixed-income securities with maturities at issuance (original maturity) of one year or less. Example: commerical paper and certificates of deposit.

Question 4

capital market securities

Overview of a Fixed-Income Security

Answer 4

Fixed-income securities with original maturities that are longer than one year.

Question 5

perpetual bonds

Overview of a Fixed-Income Security

Answer 5

Bonds with no state maturity date. Very rare.

Question 6

principal amount (principal value, or principal)
Overview of a Fixed-Income Security

Answer 6

The amount that the issuer agrees to repay the bondholders on the maturity date. Also referred to as the par value, or simply par, face value, nominal value, redemption value, or maturity value. Bond’s can have any par value. In practice, bonds are quoted as a percentage of their par value.

Question 7

plain vanilla bond (conventional bond)

Overview of a Fixed-Income Security

Answer 7

A bond that pays a fixed rate of interest. In this case, the coupon payment does not change during the bond’s life. Also called a “bullet bond” because the entire principal payment is made at maturity.

Question 8

floating-rate notes (FRNs, or floaters)

Overview of a Fixed-Income Security

Answer 8

The coupon rate of a FRN includes two components: a reference rate plus a spread. The spread, also called margin, is typically constant and expressed in basis points

Question 9

zero-coupon bonds

Overview of a Fixed-Income Security

Answer 9

Bonds that do not pay interest. Instead, they are issued at a discount to par value and redeemed at par. Sometimes they are referred to as pure discount bonds. The interest earned on a zero-coupon bond is implied and equal to the difference between the par value and the purchase price. For example, if the par value is $1000, and the purchase price is is $950, the implied interest is $50.

Question 10

dual-currency bonds

Overview of a Fixed-Income Security

Answer 10

Make coupon payments in one currency and pay the par value at maturity in another currency.

Question 11

currency option bonds

Overview of a Fixed-Income Security

Answer 11

Can be viewed as a combination of a single-currency bond plus a foreign currency option. They give bondholders the right to choose the currency in which they want to receive interest payments and principal repayments. Bondholders can select one of two currencies for each payment.

Question 12

current yield (running yield)
Overview of a Fixed-Income Security

Answer 12

Equal to the bond’s annual coupon divided by the bond’s price, expressed as a percentage. The current yield is a measure of income that is analogous to the dividend yield for a common share.

Question 13

yield to maturity

Overview of a Fixed-Income Security

Answer 13

The internal rate of return on a bond’s expected cash flows - that is, the discount rate that equates the present value of the bond’s expected cash flows until maturity with the bond’s price. The yield to maturity can be considered an estimate of the bond’s expected return; it reflects the annual return that an investor will earn on a bond if the investor purchases the bond today and holds it unitl maturity. There is an inverse relationship between the bond’s price and its yield to maturity, all else being equal.
The higher the bond’s yield to maturity, the lower the price. Alternatively, the higher the bond’s price, the lower its yield to maturity. Thus, investors anticipating a lower interest rate environment (in which investors demand a lower yield-to-maturity on the bond) hope to earn a positive return from price appreciation.

Question 14

bond

Legal, Regulatory, and Tax Considerations

Answer 14

A contractual agreement between the issuer and the bondholders.

Question 15

trust deed (indenture)
Legal, Regulatory, and Tax Considerations

Answer 15

The legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders. Market participants frequently call this legal contract the bond indenture, particularly in the US and Canada. The indenture is written in the name of the issuer and references the features of the bond issue, such as the principal value for each bond, the interest rate or coupon rate to be paid, the the dates when the interest payments will be made, the maturity date when the bonds will be repaid, and whether the bond issue comes with an contingency provisions. The indenture also includes information regarding the funding sources for the interest payment and principal repayments, and it specifies any collaterals, credit enhancements, or convenants.

Question 16

collaterals

Legal, Regulatory, and Tax Considerations

Answer 16

Assets or financial guarantees underlying the debt obligation above and beyond the issuer’s promise to pay.

Question 17

credit enhancements

Legal, Regulatory, and Tax Considerations

Answer 17

Provisions that may be used to reduce the credit risk of the bond issue.

Question 18

covenants

Legal, Regulatory, and Tax Considerations

Answer 18

Clauses that specify the rights of the bondholders and any actions that the issuer is obligated to perform or prohibited from performing.

Question 19

secured bonds

Legal, Regulatory, and Tax Considerations

Answer 19

Backed by assets or financial guarantees pledged to ensure debt repayment in the case of default. In contrast unsecured bond have no collateral; bondholders have only a general claim on the issuer’s assets and cash flows. Thus, unsecured bonds are paid after secured bonds in the event of default. By lowering credit risk, collateral backing increases the bond issue’s credit quality and decreases it’s yield.

Question 20

debentures

Legal, Regulatory, and Tax Considerations

Answer 20

A type of bond that can be secured or unsecured. In many jurisdictions, debentures are unsecured bonds, with no collateral backing assigned to the bondholders. In the UK and India, and other commmonwealth countries, they are usually backed by an asset or pool of assets assigned as collateral support for the bond obligations and segregated from the claims of other creditors.

Question 21

collateral trust bonds

Legal, Regulatory, and Tax Considerations

Answer 21

Secured by securities such as common shares, other bonds, or other financial assets. These securities are pledged by the issuer and typically held by the trustee.

Question 22

equipment trust certificates

Legal, Regulatory, and Tax Considerations

Answer 22

Bonds secured by specific types of equipment or physical assets, such as aircraft, railroad cars, shipping containers, or oil rigs. They are most commonly issued to take advantage of the tax benefits of leasing. For example suppose an airline finances the purchase of new aircraft
with equipment trust certificates. The legal title to the aircraft is held by the trustee, which issues equipment trust certificates to investors in the amount of the purchase price. The trustee leases the aircraft to the airline and collects lease payments from the airline to pay the interest on the certificates. When the certificates mature, the trustee sells the aircraft to the airline, uses the proceeds to retire the principal, and cancels the lease.

Question 23

mortgage-backed-securities (MBS)

Legal, Regulatory, and Tax Considerations

Answer 23

Debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity.

Question 24

covered bond

Legal, Regulatory, and Tax Considerations

Answer 24

Debt obligation backed by a segregated pool of assets called a “cover pool”. Covered bonds are similar to securitiezed bonds but offer bondholders additional protection if the financial institution defaults. In the case of default, the bondholders have recourse agains the financial institution that holds holds the pool AND the cover pool. The cover pool is like an SPV but stays on the institution’s balance sheet rather than being a “bankruptcy-remote” vehicle.

Question 25

surety bond ( and bank guarantee)
Legal, Regulatory, and Tax Considerations

Answer 25

A form of an external credit enhancement. Surety bonds and bank guarantees are very similar in nature because they both remiburse investors for any losses incurred if the issuer defaults. However, there is usually a maximum amount hat is guaranteed, called the penal sum. The major difference between a surety bond and a bank guarantee is that the former is issued by a rated and regulated insurance company, whereas the latter is issued by a bank.

Question 26

credit enhancement

Legal, Regulatory, and Tax Considerations

Answer 26

refers to a variety of provisions that can be used to reduce the credit risk of a bond issue and is very often used in scuritiezed bonds. Credit enhancement provides additional collateral, insurance, and/or a third-party guarantee that the issuer will meet its obligations. Thus, it reduces credit risk, which increases the issue’s credit quality and decreases the bond’s yield. There are two primary types of credit enhancement: internal and external. Internal credit enancement relies on structural features regarding the priority of payment or the value of the collateral. External credit enhancement refers to guarantees received from a third party, often called a guarantor.

Question 27

letter of credit

Legal, Regulatory, and Tax Considerations

Answer 27

A form of external credit enhancement. The financial institution provides the issuer with a credit line to remiburse any cash flow shortfalls from the assets backing the issue.

Question 28

bond covenants

Legal, Regulatory, and Tax Considerations

Answer 28

Legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue. The indenture will frequently include affirmative (or positive) and negative convenants. Affirmative covenants enumerate what issuers are required to do, whereas negative covenants enumerate what issuers are prohibited from doing.

Question 29

affirmative covenants

Legal, Regulatory, and Tax Considerations

Answer 29

Typically administrative in nature. For example, affirmative covenants frequently include what the issuer will do with the proceeds from the bond issue and the promise of making the contractual payments.

Question 30

negative covenants

Legal, Regulatory, and Tax Considerations

Answer 30

Their purpose is to protect bondholders from such problems as the dilution of their claims, asset withdrawals or substitutions, and suboptimal investments by the issuer. They are frequently costly and do materially constrain the issuer’s potential business decisions.

Question 31

Eurobonds

Legal, Regulatory, and Tax Considerations

Answer 31

Bonds issued and traded on the Eurobond market. They are named after the currency in which they are denominated, such as Eurodollar, Euroyen. Eurobonds are typically less regulated than domestic and foreign bonds because they are issued outside the jurisdiction of any single country. They are usually unsecured bonds that can be denominated in any currency, including the issuer’s domestic currency. Eurobonds are bearer bonds, meaning that the trustee does not keep track of who owns the bonds.

Question 32

bearer bonds

Legal, Regulatory, and Tax Considerations

Answer 32

The trustee does not keep records of who owns the bonds.

Question 33

registered bonds

Legal, Regulatory, and Tax Considerations

Answer 33

Ownership is recorded by name or serial number.

Question 34

amortizing bond

Structure of a Bond’s Cash Flows

Answer 34

A bond with a payment schedule that calls for periodic payments of interest and repayments of principal. A bond that is fully amortized is charaterized by a fixed periodic payment schedule tthat reduces the bond’s outstanding principal amount to 0 by the maturity date. A partially amortized bond also makes fixed periodic payments until maturity, but only a portion of the principal is repaid by maturity date. Thus, a balloon payment is required at maturity to retire the bond’s outstanding pricinpal amount.

Question 35

balloon payment

Structure of a Bond’s Cash Flows

Answer 35

The payment required at maturity to retire a bond’s outstanding principal amount.

Question 36

sinking fund arrangement

Structure of a Bond’s Cash Flows

Answer 36

Refers to an issuer’s plans to set aside funds over time to retire the bond. A sinking fund arrangement specifies the portion of the bond’s principal outstanding that must be repaid each year throughout the bond’s life or after a specified date. Typically, the issuer will forward repayment proceeds to the bond’s trustee. The trustee will then either redeem bonds to this value or selct by lottery the serial numbers of bonds to be paid off. This repayment occurs whether or not an acutal segregated cash reserve has been created (as it used to be in olden times). Another version is where the total amount of principal retired increases each year. Another verison, also, is where there is a call provision, where the issuer has the option to repurchase the bonds before maturity. The benefit of a sinking fund arrangement is that it ensures that a formal plan is in place for retiring the debt. For investors, it reduces credit risk of the bond. However, that gives investors reinvestment risk.

Question 37

variable-rate note

Structure of a Bond’s Cash Flows

Answer 37

When the spread of an FRN is not fixed.

Question 38

step-up coupon bond

Structure of a Bond’s Cash Flows

Answer 38

A bond which may either be fixed or floating, where the coupon increases by specified margins at specified dates. It gives bondholders some protection against rising interest rates.

Question 39

credit-linked coupon bond

Structure of a Bond’s Cash Flows

Answer 39

A bond with a coupon that changes when the bond’s credit rating changes. They are attractive to investors who are concerned about the future creditworthiness of the issuer. May also provide some protection against a poor economy when credit ratings typicall decline.

Question 40

payment-in-kind (PIK) coupon bond

Structure of a Bond’s Cash Flows

Answer 40

Typically allows the issuer to pay interest in the form of additional amounts of the bond issue rather than as a cash payment. Such bonds are favored by investors who are concerned that the issuer may face potential cash flow problems in the future. Investors usually demand a higher yield. With a PIK toggle note, the borrower has an option, for each interest period, to pay interest in cash, to make the interest in kind, or some combination of the two.

Question 41

deferred coupon bond (split coupon bond)

Structure of a Bond’s Cash Flows

Answer 41

Pays no coupons for its first few years but then pays a higher coupon than it otherwise normally would for the remainder of its life. Issuers of deferred coupon bonds are usually seeking ways to conserve cash in the years immediately following the bodn issue, which may indicate poorer credit quality. Also common for in project financing when the assets being deveolped do not generate any income during the development phase. One of the main advantages is that these bonds are typicall priced at significant discounts to par. Also, there may be tax benefits to investors.

Question 42

index-linked bond

Structure of a Bond’s Cash Flows

Answer 42

Coupon payments and/or principal repayment linked to a specified index.

Question 43

inflation-linked bonds

Structure of a Bond’s Cash Flows

Answer 43

An example of index-linked bonds that offer investors protection against inflation by linking a bond’s coupon payments and/or the principal repayments to an index of consumer prices such as the CPI.

Question 44

capital-indexed bonds

Structure of a Bond’s Cash Flows

Answer 44

Pay a fixed coupon rate but it is applied to principal amount that increases in line with increases in the index during the bond’s life. Thus, both the interest payments and the principal repayment are adjusted for inflation.

Question 45

equity-linked note (ELN)

Structure of a Bond’s Cash Flows

Answer 45

A fixed-income security that differs from a conventional bond in that the final payment is based on the return of an equity index. They can be thought of as a zero-coupon bond with a return profile linked to the value of the equity index. Usually, the investor can expect to receive at least 100% of the principal.

Question 46

contingency provision

Bonds with Contingency Provisions

Answer 46

A contingency refers to some future event or cicumstance that is possible but not certain. A contingency provision is a clause in a legal document that allows for some action if the event or circumstance does occur.

Question 47

embedded option

Bonds with Contingency Provisions

Answer 47

Refers to various contingency provisions found in the indenture. These contingency provisions provide the issuer or the bondholders the right, but not the obligation, to take some action. The rights are called options. These options are not indenendent of the bond and cannot be traded separately.

Question 48

callable bond

Bonds with Contingency Provisions

Answer 48

Gives the issuer the right to redeem all or part of the bond before the specified maturity date. The primary reason why issuers choose to issue callable bonds rather than non-callable bonds is to protect themselves agains a decline in interest rates. This decline can come either from market interest rates falling or from the issuer’s credit quality improving. If market interest rates fall or credit quality improves, the issuer of a callable bond has the right to replace an old, expensive bond issue with a new, cheaper bond issue. Callable options present the investor with a higher level of reinvestment risk than non-callable bonds, and for that reason, have to offer a higher yield and sell at a lower price than otherwise similar non-callable bonds.

Question 49

Bermuda-style call

Bonds with Contingency Provisions

Answer 49

The issuer has the right to call bonds on specified dates following the call protection period. These dates frequently correspond to coupon payment dates.

Question 50

American call

Bonds with Contingency Provisions

Answer 50

Issuer has the right to call a bond at any time starting on the first call date.

Question 51

European call

Bonds with Contingency Provisions

Answer 51

Issuer has the right to call a bond only once on the call date.

Question 52

putable bonds

Bonds with Contingency Provisions

Answer 52

A provision that gives the bondholders the right to sell the bond back to the issuer at a pre-determined price on specified dates. Putable bonds are beneficial for the bondholder by guaranteeing a pre-specified selling price at the redemption dates. If interest rates rise after the issue date, thsu depressing the bond’s price, the bondholders can put the bond back to the issuer and get cash. This cash can be reinvested in bonds that ofer higher yields, in line with the higher market interest rates. Because a put provision has value to the bondholders, the price of a putable bond will be higher than the price of an otherwise similar bond issued without the put provision. Similarly, the yield on a bond with a put provisision will be lower than a yield on an otherwise similar non-putable bond. The lower yield compensates the issuer for the value of the put option to the investor. The indenture lists the redemption dates and the prices applicable to the sale of the bond back to the issuer. The selling price is usually the par value of the bond. Depending on the terms set out in the indenture, putable bonds may allow buyers to force a sellback only once or multiple times during the bond’s life. Putable bonds that incorporate a single sellback opportunity are referred to as ONE-TIME put bonds, whereas those that lalow these sellback opportunites more frequently are knowna s MULTIPLE put bonds.

Question 53

convertible bond

Bonds with Contingency Provisions

Answer 53

A hybrid security with both debt and equity features. It gives the bondholder the right to exchange the bond for a specified number of common shares in the issuing company. The advantage to the investor is obvious. There are two main advantages to the issuer: The first is reduced interest expense. Issuers are usually able to offer below-market coupon rates because of investors’ attraction to the conversion feature. The second advantage is the elimination of debt if the conversion option is exercised. But the conversion option is dilutive to existing shareholders.

Question 54

conversion price

Bonds with Contingency Provisions

Answer 54

The price per share at which the convertible bond can be converted into shares.

Question 55

conversion ratio

Bonds with Contingency Provisions

Answer 55

The nubmer of common shares that each bond can be converted into. The indenture sometimes does not stipulate the conversion ratio, but only mentions the conversion price. The conversion ratio is equal to the par value divided by the conversion price. For example, if the par value is $1,000 and the conversion price is $20, the conversion ratio is 1000/20=50/1, or 50 common shares per bond.

Question 56

conversion value (parity value)
Bonds with Contingency Provisions

Answer 56

The current share price multiplied by the conversion ratio For example, if the current share price is $33 and the conversion ratio is 30:1, the conversion value is $33 x 30 = $990.

Question 57

conversion premium

Bonds with Contingency Provisions

Answer 57

Difference between the convertible bond’s price and its conversion value.

Question 58

warrant

Bonds with Contingency Provisions

Answer 58

Not an embedded option but rather an “attached” option. A warrent entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date. Warrants are considered yield enhancements; they are frequently attached to bond issues as a “sweetener”.

Question 59

contingent convertible bonds (CoCos)

Bonds with Contingency Provisions

Answer 59

Bonds with contingent write-down provisions. Two main features distinguish bonds with contingent write-down provisions from the traditional convertible bonds just described. a traditional convertible bond is convertible at the option of the bondholder, and conversion occurs on the upside - that is, if the issuer’s share price increases. In contrast, bonds with contingent write-down provisions are convertible on the downside. In the case of CoCos, conversion is automatic if specified event occurs - for example, if the bank’s core Tier 1 capital ratio ( a measure of the bank’s proportion of core equity capital available to absorb losses) falls below the minimum requirement set by the regulators. Thus, in the event that he bank experiences losses that reduce its equity capital below the minimum requirement, CoCos are a way to reduce the bank’s likelihood of default and, therefore, systemic risk. When the bank’s core Tier 1 capital falls below the minimum requirement, the CoCos immediately convert into equity, automatically recapitalizing the bank, lightening the debt burden, and reducing the risk of default. Because the conversion isn not at the option of the bondholders but automatic, COCOs force bondholders to take losses. For this reason, CoCos must offer a higher yield than otherwise similar bonds.