Debt: types and features

Question 1

Define nominal value and redemption

Answer 1

The capital payment the holder receives at redemption.

The year when the gilt is repaid.

Question 2

Explain coupons.

Answer 2

Typically semi-annually. Quote coupon of a gilt represents the annual amount of interest paid per £100 nominal value. Coupons are taxable (subject to income tax for individuals). However, tax is not normally deducted from the coupon payment. It is therefore referred to as being a gross coupon.

Question 3

Redemption:

Answer 3

the redemption date is the specified date on which the capital is repaid by the DMO. Normally, redemption is at par, i.e. £100 for each £100 nominal value held. All remaining stock must be repaid on the redemption date.

Question 4

Benchmarking

Answer 4

the yield available on UK gilts is considered the risk-free rate for sterling denominated bonds – UK gilts are effectively credit risk-free.

Question 5

Describe the situation with respect to index-linked government bonds.

Answer 5

Index-linked: Coupon and redemption linked to an inflation index

• Inflation protected
• Return during zero inflation

Question 6

Explain the usefulness of STRIPS

Answer 6

Liability driven investors, such as pension funds, often use bonds to meet their liabilities. However, this can lead to reinvestment risk. Reinvestment risk is where the investor may not receive a required rate of return when reinvesting coupon payments. This is often avoided through cash-flow matching, or dedication.
Dedication is where the investor matches the maturity of cash-flows to the liabilities. The simplest way to do this is use a zero-coupon bond. As STRIPS function like zero-coupon bonds, they provide a useful tool in this strategy.

Question 7

STRIPS permitted parties:

Answer 7

• GEMMS
• HM Treasury
• Bank of England

Question 8

Explain debentures.

Answer 8

Debentures
In the UK, a secured debt transaction is called a debenture, whereas in the US the term debenture generally refers to a loan agreement with no security at all. In the US, the term asset-backed security is more commonly used for secured issues. In the US secured debt is commonly known as an asset backed security (ABS)

Question 9

Define fixed charge over assets vs floating charge over assets.

Answer 9

Fixed Charge Over Assets – a fixed charge is security over a certain specific 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.
Floating Charge Over Assets – a floating charge is security over a class of assets, e.g. plant and machinery, fixtures and fittings, trade debtors.

Question 10

Asset-backed securities / covered bonds

Answer 10

• Bonds secured by a pool of assets, e.g. property, loans
• Who owns the pool determines the type of bond
- Pool owned by the originator
• Covered bond
- Pool owned by a special purpose vehicle (SPV)
• Asset backed security
• Underlying assets securitised

Question 11

Secured debt (debentures)/asset-backed securities

Answer 11

Trust deed
• Empowers the trustee alone to act on behalf of debenture holders
- Ensures organised action and parity of treatment through a single entity

Question 12

Types of Trustee

Answer 12

Note trustee
The note trustee is appointed to represent the interests of holders of issues of securities, while providing guidance to the issuer.
Security trustee
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.
Share trustee
The 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. Sometimes these SPVs are domiciled in offshore jurisdictions.
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.

Question 13

Unsecured debt

Answer 13

• Convertible bonds
- Converts into stock of the issuer
• Exchangeable bonds
- Converts into stock of another, usually subsidiary of the issuer
• Guaranteed bonds
- Credit enhancement based on the credit rating of a third party
• Floating rate notes (FRNs)
- Coupon floats in line with market interest rates
- Trade near par
- Capital protection
• Payment in kind notes (PIK)
- Generally subordinated debt
- Zero coupon bonds that are issued at a substantial discount to their face value
Unsecured corporate debt has a typical life of 7-30 years.

Question 14

Types of eurobonds

Answer 14

• Definition

• International bonds
• Bearer documents
• Issued in a eurocurrency
• Any currency other than the currency of the market on which it is issued

Question 15

Eurobonds dealing and settlement

Answer 15

Dealing and settlement
• Typically OTC but some exchange-traded
• Regulated by International Capital Markets Association (ICMA)
- Trades reported and matched through TRAX
- Settlement: T+2 (if settled through Euroclear/Clearstream)
• Gross annual coupon
• Day-count convention for accrued interest
- 30/360

Question 16

Immobilisation of Eurobonds

Answer 16

Immobilisation
• As bearer documents, eurobonds are often held in depositaries (immobilised)
- Euroclear/Clearstream

Question 17

Listing Eurobonds

Answer 17

a London listing of a eurobond consists of admission to listing by the United Kingdom Listing Authority (UKLA) – a division of the Financial Conduct Authority (FCA), and admission to trading on a recognised investment exchange such as the London Stock Exchange.

Question 18

Eurobond variants

Answer 18

Straight or plain vanilla – fixed coupon eurobonds or bullet bonds normally pay the coupons once a year.
Zero Coupon Bonds (ZCBs) – no coupon. Issued at a discount and redeemed at par value.
Floating rate eurobonds (FRN/VRN) – bonds 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 LIBOR and Euribor.
Stepped bonds – Coupon increases over the life of the bond.

Question 19

Impact of security

Answer 19

Creditors
1. Liquidator
2. Fixed charge holders
3. Preferential creditors (e.g. employees)
4. Floating charge holders
5. Unsecured creditors (e.g. trade creditors and the
Government)
6. Subordinated loan stock
Owners
7. Preference shareholders (nominal value only except
participating shares)
8. Ordinary shareholders

Question 20

What is the impact of a security?

Answer 20

The impact of security is significant when a company becomes insolvent or is wound up.
All classes of debt rank more highly than equity (i.e. debt is paid back before equity). However, not all types of debt are equal – some are senior (take priority), whilst others are subordinate.

Question 21

Mezzanine debt

Answer 21

Mezzanine level of debt will rank below other forms of debt but above the equity in a liquidation, e.g. payment in kind note.

Question 22

Where do government bonds and convertible bonds rank alongside?

Answer 22

Unsecured bonds.