Fixed Income Flashcards
Fixed income security
Global Fixed Income Markets
A fixed-income security is a debt instrument issued by a government, corporation or other entity to finance and expand their operations. Fixed-income securities provide investors a return in the form of fixed periodic payments and eventual return of principal at maturity.
Global fixed-income markets represent the largest subset of financial markets in terms of number of issuances and market capitalization, they bring borrowers and lenders together to allocate capital globally to its most efficient uses. Fixed-income markets include not only publicly traded securities, such as commercial paper, notes, and bonds, but also non-publicly traded loans. Although they usually attract less attention than equity markets, fixed-income markets are more than three times the size of global equity markets. The Institute of International Finance reports that the size of the global debt market surpassed USD 253 trillion in the third quarter of 2019, representing a 322% global debt-to-GDP ratio
Bond
A bond is a contractual agreement between the issuer and the bondholders
Bond Issuers
Three bond market sectors: the government and government-related sector (i.e., the first four types of issuers just listed), the corporate sector (the fifth type listed), and the structured finance sector (the last type listed)
Bond issuers are classified into categories based on the similarities of these issuers and their characteristics. Major types of issuers include the following:
Supranational organizations, such as the World Bank or the European Investment Bank;
Sovereign (national) governments, such as the United States or Japan. As sovereign bonds are backed by the full faith and credit of each respective government, they usually represent the lowest risk and most secure bonds in each market;
Non-sovereign (local) governments, such as the State of Minnesota in the United States, the Catalonia region in Spain, or the City of Edmonton in Alberta, Canada;
Quasi-government entities (i.e., agencies that are owned or sponsored by governments), such as postal services in many countries—for example, Correios in Brazil, La Poste in France, or Pos in Indonesia;
Companies (i.e., corporate issuers). A distinction is often made between financial issuers (e.g., banks and insurance companies) and non-financial issuers; and
Special legal entities (i.e., special purpose entities) that use specific assets, such as auto loans and credit card debt obligations, to guarantee (or secure) a bond issue known as an asset-backed security that is then sold to investors
Asset Backed Securities
Asset-backed securities (ABS) are created from a process called securitization, which involves moving assets from the owner of the assets into a special legal entity. This special legal entity then uses the securitized assets as guarantees to back (secure) a bond issue, leading to the creation of ABS. Assets that are typically used to create ABS include residential and commercial mortgage loans (mortgages), automobile (auto) loans, student loans, bank loans, and credit card debt. Many elements discussed in this reading apply to both traditional bonds and ABS. Considerations specific to ABS are discussed in a separate reading on asset-backed securities.
maturity
tenor
The maturity date of a bond refers to the date when the issuer is obligated to redeem the bond by paying the outstanding principal amount
The tenor is the time remaining until the bond’s maturity date. Tenor is an important consideration in analyzing a bond’s risk and return, as it indicates the period over which the bondholder can expect to receive interest payments and the length of time until the principal is repaid in full.
money market securities
Fixed-income securities with maturities at issuance of one year or less.
issuers of money market securities include governments and companies. Commercial paper and certificates of deposit are examples of money market securities.
capital market securities
Fixed-income securities with original maturities that are longer than one year are called capital market securities
perpetual bond
bond with no stated maturity date
eg: consols issued by the sovereign government in the United Kingdom, have no stated maturity date.
Par value
The principal amount, principal value, or simply principal of a bond is the amount that the issuer agrees to repay the bondholders on the maturity date. This amount is also referred to as the par value, or simply par, face value, nominal value, redemption value, or maturity value. Bonds can have any par value.
When the bond is priced at 100% of par, the bond is said to be trading at par. If the bond’s price is below 100% of par, the bond is trading at a discount. Alternatively, if the bond’s price is above 100% of par, the bond is trading at a premium.
Coupon Rate and Frequency
The coupon rate or nominal rate of a bond is the interest rate that the issuer agrees to pay each year until the maturity date. The annual amount of interest payments made is called the coupon. A bond’s coupon is determined by multiplying its coupon rate by its par value.
coupon payments
Coupon payments may be made annually, semi-annually, quarterly or monthly
Mortgage Backed Securities
Debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property.
plain vanilla bond or conventional bond
Bond that makes periodic, fixed coupon payments during the bond’s life and a lump-sum payment of principal at maturity. Also called conventional bond.
floating-rate notes (FRNs) or floaters
A note on which interest payments are not fixed but instead vary from period to period depending on the current level of a reference interest rate.
The coupon rate of an FRN includes two components: a market reference rate (MRR) plus a spread.
Spread and basis points
The spread, also called margin, is typically constant and is expressed in basis points (bps). A basis point is equal to 0.01% (i.e., 100 basis points equals 1%). The spread is set when the bond is issued based on the issuer’s creditworthiness at issuance: The higher the issuer’s credit quality, the lower the spread
zero-coupon bonds. Zero-coupon, or pure discount bonds
A bond that does not pay interest during its life. It is issued at a discount to par value and redeemed at par. Also called pure discount bond.
Currency Denomination
Bonds can be issued in any currency, although a large number of bond issues are made in either euros or US dollars. The currency of issue may affect a bond’s attractiveness. Borrowers in emerging markets often elect to issue bonds in euros or US dollars because doing so makes the bonds more attractive to international investors than bonds in a domestic currency that may be illiquid or not freely traded. Issuers may also choose to borrow in a foreign currency if they expect cash flows in that currency to offset interest payments and principal repayments. If a bond is aimed solely at a country’s domestic investors, it is more likely that the borrower will issue in the local currency
Dual-currency bonds
Bonds that make coupon payments in one currency and pay the par value at maturity in another currency.
currency options bonds
Bonds that give bondholders the right to choose the currency in which they want to receive interest payments and principal repayments.
Yield Measures
current yield or running yield
yield-to-maturity, yield-to-redemption or redemption yield
Several yield measures are commonly used by market participants
Running yield is the annual income on an investment divided by its current market value
The sum of the coupon payments received over the year divided by the flat price; also called the income or interest yield or running yield.
Annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity. It is the discount rate that equates the present value of the bond’s expected cash flows until maturity with the bond’s price. Also called yield-to-redemption or redemption yield.
Bond Indenture
The governing legal credit agreement, typically incorporated by reference in the prospectus. also called a trust deed
The trust deed is the legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders. This legal contract is often referred to as the bond indenture,
Collateral
Assets or financial guarantees underlying a debt obligation that are above and beyond the issuer’s promise to pay.
Credit enhancement
Provisions that may be used to reduce the credit risk of a bond issue.
Covenants
The terms and conditions of lending agreements that the issuer must comply with; they specify the actions that an issuer is obligated to perform (affirmative covenant) or prohibited from performing (negative covenant)
fiduciary
Because it would be impractical for the issuer to enter into a direct agreement with each bondholder, the indenture is usually held by a trustee. The trustee is typically a financial institution acting as a fiduciary
An entity designated to represent the rights and responsibilities of a beneficiary whose assets they are managing, such as a bond trustee acting on behalf of fixed-income investors.
The indenture identifies basic bond features
the legal identity of the bond issuer and its legal form;
the source of repayment proceeds;
the asset or collateral backing (if any);
the credit enhancements (if any); and
the covenants (if any)
three major sources for repayment of non-sovereign government debt issues, and bonds are
The first source is the general taxing authority of the issuer.
The second source is from the cash flows of the project the bond issue is financing.
The third source is from special taxes or fees established specifically for the purpose of funding interest payments and principal repayments.
Asset or Collateral Backing
Collateral backing is a way to alleviate credit risk. Investors should review where they rank compared with other creditors in the event of default and analyze the quality of the collateral backing the bond issue.
Secured Bonds
Unsecured Bonds
Bonds secured by assets or financial guarantees pledged to ensure debt repayment in case of default.
unsecured bonds 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 its yield.
Seniority Ranking
the systematic way in which lenders are repaid in case of bankruptcy or liquidation
The ranking refers to the priority of payment in the event of a default. The most senior or highest-ranking debt have the first claim on the cash flows and assets of the issuer, with the remaining going towards the next highest-ranking debt
Debentures
Type of bond that can be secured or unsecured.
Collateral Trust Bonds
Bonds 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
Equipment trust certificates
Bonds secured by specific types of equipment or physical assets.
Covered Bonds
Debt obligation secured by a segregated pool of assets called the cover pool. The issuer must maintain the value of the cover pool. In the event of default, bondholders have recourse against both the issuer and the cover pool.
Covered bonds are debt securities issued by a bank or mortgage institution and collateralized against a pool of assets that, in case of failure of the issuer, can cover claims at any point of time. They are subject to specific legislation to protect bond holders.
types of credit enhancement
Internal credit enhancement relies on structural features regarding the bond issue.
External credit enhancement refers to financial guarantees received from a third party, often called a financial guarantor.
Internal Credit Enhancement
The most common forms of internal credit enhancement are subordination, overcollateralization, and reserve accounts
Subordination, also known as credit tranching
Form of internal credit enhancement that relies on creating more than one bond tranche and ordering the claim priorities for ownership or interest in an asset between the tranches. The ordering of the claim priorities is called a senior/subordinated structure, where the tranches of highest seniority are called senior followed by subordinated or junior tranches. Also called credit tranching.
overcollateralization
Form of internal credit enhancement that refers to the process of posting more collateral than needed to obtain or secure financing.
reserve accounts
Form of internal credit enhancement that relies on creating accounts and depositing in these accounts cash that can be used to absorb losses. Also called reserve funds.
An excess spread account is an allocation of any asset cash flows remaining after paying interest to bondholders. The excess spread (or excess interest cash flow) can be retained and deposited into a reserve account as a first line of protection against losses. In a process called “turboing,” the excess spread can be used to retire the principal, with the most senior tranche having the first claim on these funds.
External Credit Enhancement
The most common forms of external credit enhancement are bank guarantees and surety bonds, letters of credit, and cash collateral accounts.
bank guarantees and surety bonds
Form of external credit enhancement whereby a rated and regulated insurance company guarantees to reimburse bondholders for any losses incurred up to a maximum amount if the issuer defaults.
Bank guarantees and surety bonds are very similar in nature because they both reimburse bondholders for any losses incurred if the issuer defaults. However, there is usually a maximum amount that is guaranteed, called the penal sum.
The major difference between a bank guarantee and a surety bond is that the former is issued by a bank, whereas the latter is issued by a rated and regulated insurance company.
Insurance companies that specialize in providing financial guarantees are typically called monoline insurance companies or monoline insurers. Monoline insurers played an important role in securitization until the 2007–2009 global financial crisis, but they are now a less common form of credit enhancement due to the credit downgrades of these insurers during the crisis.
letters of credit
Form of external credit enhancement whereby a financial institution provides the issuer with a credit line to reimburse any cash flow shortfalls from the assets backing the issue.
cash collateral accounts
Form of external credit enhancement whereby the issuer immediately borrows the credit-enhancement amount and then invests that amount, usually in highly rated short-term commercial paper.
. Because a cash collateral account is an actual deposit rather than a pledge of cash, a cash collateral account provider downgrade will not necessarily result in a downgrade of the bond issue backed by that provider.
Covenants(promises)
Bond covenants are legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue. An indenture will frequently include affirmative (or positive) and negative covenants. Affirmative covenants enumerate what issuers are required to do, whereas negative covenants specify what issuers are prohibited from doing
Pari Passu clause
Covenant or contract clause that ensures a debt obligation is treated the same as the borrower’s other senior debt instruments and is not subordinated to similar obligations.
cross default clause
Covenant or contract clause that specifies a borrower is considered in default if they default on another debt obligation.
+ covenants
- covenants
Affirmative covenants are typically administrative in nature
negative covenants are frequently costly and materially constrain the issuer’s potential business decisions. They protect bondholders from the dilution of their claims, asset withdrawals or substitutions, and suboptimal investments by the issuer
global bond market
national bond market
domestic bonds
foreign bonds
bearer bonds
registered bonds
The global bond markets consist of national bond markets and the Eurobond market
A national bond market includes all the bonds that are issued and traded in a specific country and are denominated in the currency of that country.
Bonds issued by entities that are incorporated in that country are called domestic bonds
bonds issued by entities that are incorporated in another country are called foreign bonds
Bonds for which ownership is not recorded; only the clearing system knows who the bond owner is.
Bonds for which ownership is recorded by either name or serial number
Tax Considerations bonds
Bond interest is usually taxed at the ordinary income tax rate, which is typically the same tax rate that an individual would pay on wage or salary income. Tax-exempt securities are the exception to this rule.
The tax status of bond income may also depend on where the bond is issued and traded.
capital gain/loss from bond
a bond investment will generate a capital gain or loss if sold prior to maturity at a price different from the purchase price. This change will generate a capital gain if the bond price has increased or a capital loss if the bond price has decreased. Capital gains or losses usually face different tax treatment from taxable income, which often varies for long-term and short-term capital gains
bond issued at discount
For bonds issued at a discount, the tax status of the original issue discount is an additional tax consideration. The original issue discount is the difference between the par value and the original issue price.
Bullet bond
Bond in which the principal repayment is made entirely at maturity.
Amortizing Bonds
Bond with a payment schedule that calls for periodic payments of interest and repayments of principal.
fully amortized bond
A fully amortized bond is characterized by a fixed periodic payment schedule that reduces the bond’s outstanding principal amount to zero by the maturity date
partially amortized bond
A partially amortized bond also makes fixed periodic payments until maturity, but only a portion of the principal is repaid by the maturity date.
Balloon Payments
Large payment required at maturity to retire a bond’s outstanding principal amount.
Sinking Fund Arrangement
Provision that reduces the credit risk of a bond issue by requiring the issuer to retire a portion of the bond’s principal outstanding each year.
A sinking fund is an account containing money set aside to pay off a debt or bond. Sinking funds may help pay off the debt at maturity or assist in buying back bonds on the open market. Callable bonds with sinking funds may be called back early removing future interest payments from the investor.
step-up coupon bonds
Bond for which the coupon, fixed or floating, increases by specified margins at specified dates
Bonds with step-up coupons offer bondholders some protection against rising interest rates, and they may be an important feature for callable bonds. When interest rates increase, there is a higher likelihood that the issuer will not call the bonds, particularly if the bonds have a fixed rate of interest.
Credit-Linked Coupon Bond
Bond for which the coupon changes when the bond’s credit rating changes
Payment-in-Kind Coupon Bonds
A payment-in-kind (PIK) coupon bond 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 issuers who are concerned that the issuer may face potential cash flow problems in the future.
Deferred coupon bond
Bond that 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. Also called split coupon bond.
One of the main advantages of investing in a deferred coupon bond is that these bonds are typically priced at significant discounts to par. Investors may also find the deferred coupon structure to be very helpful in managing taxes. If taxes due on the interest income can be delayed, investors may be able to minimize taxes. This tax advantage, however, depends on the jurisdiction concerned and how its tax rules apply to deferred coupon payments.
A zero-coupon bond can be thought of as an extreme form of deferred coupon bond. These securities pay no interest to the investor and thus are issued at a deep discount to par value. At maturity, the bondholder receives the par value of the bond as payment. Effectively, a zero-coupon bond defers all interest payments until maturity.
Index-linked bond
Bond for which coupon payments and/or principal repayment are linked to a specified index.
Inflation linked bonds
Type of index-linked bond that offers investors protection against inflation by linking the bond’s coupon payments and/or the principal repayment to an index of consumer prices. Also called linkers.
Zero-coupon-indexed bond
Interest-indexed bonds
capital indexed bonds
Indexed-annuity bonds
pay no coupon, so the inflation adjustment is made via the principal repayment only
pay a fixed nominal principal amount at maturity but an index-linked coupon during the bond’s life
pay a fixed coupon rate, but it is applied to a principal amount that increases in line with increases in the index during the bond’s life.
are fully amortized bonds, in contrast to interest-indexed and capital-indexed bonds that are non-amortizing coupon bonds. The annuity payment, which includes both payment of interest and repayment of the principal,
Contingency Provisions
Clause in a legal document that allows for some action if a specific event or circumstance occurs.
embedded options
Contingency provisions that provide the issuer or the bondholders the right, but not the obligation, to take action. These options are not part of the security and cannot be traded separately
types of bonds with embedded options
callable bond
putable bonds
convertible bonds.
Callable bonds
A bond containing an embedded call option that gives the issuer the right to buy the bond back from the investor at specified prices on pre-determined dates.
The primary reason why issuers choose to issue callable bonds rather than non-callable bonds is to protect themselves against a decline in interest rates.
Callable bonds present investors with a higher level of reinvestment risk than non-callable bonds
the issuer can benefit from a decline in interest rates by being able to refinance its debt at a lower interest rate.
callable bonds have to offer a higher yield and sell at a lower price than otherwise similar non-callable bonds. The higher yield and lower price compensate the bondholders for the value of the call option to the issuer.
Available exercise styles on callable bonds
American-style call, sometimes referred to as continuously callable, for which the issuer has the right to call a bond at any time starting on the first call date.
European-style call, for which the issuer has the right to call a bond only once on the call date.
Bermuda-style call, for which the issuer has the right to call bonds on specified dates following the call protection period. These dates frequently correspond to coupon payment dates.
Putable Bonds
Bonds that give the bondholder the right to sell the bond back to the issuer at a predetermined 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 issuance and bond prices fall, the bondholders can put the bond back to the issuer and reinvest the proceeds in bonds that offer higher yields, in line with higher market interest rates.
the yield on a bond with a put provision will be lower than the yield on an otherwise similar non-putable bond. The lower yield compensates the issuer for the value of the put option to the investor.
Available exercise styles on putable bonds
Putable bonds that incorporate a single sellback opportunity include a European-style put and are often referred to as one-time put bonds.
Putable bonds that allow multiple sellback opportunities include a Bermuda-style put and are known as multiple put bonds. Multiple put bonds offer more flexibility for investors, so they are generally more expensive than one-time put bonds
Convertible Bond
Bond that gives the bondholder the right to exchange the bond for a specified number of common shares in the issuing company.
Because the conversion provision is valuable to bondholders, the price of a convertible bond is higher than the price of an otherwise similar bond without the conversion provision. Similarly, the yield on a convertible bond is lower than the yield on an otherwise similar non-convertible bond. However, most convertible bonds offer investors a yield advantage; the coupon rate on the convertible bond is typically higher than the dividend yield on the underlying common share.
From the issuer’s perspective, convertible bonds offer two main advantages. The first is reduced interest expense. Issuers are usually able to offer below-market coupon rates due to the conversion feature’s value. The second advantage is the elimination of debt if the conversion option is exercised, but this is dilutive to existing shareholders.
Conversion price
Conversion Ratio
Conversion value
Conversion premium
Conversion parity
For a convertible bond, the price per share at which the bond can be converted into shares.
For a convertible bond, the number 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 a convertible bond, the current share price multiplied by the conversion ratio.
The difference between the convertible bond’s price and its conversion value.
Conversion parity occurs if the conversion value is equal to the convertible bond’s price
Warrant
A warrant is an “attached” rather than embedded option entitling 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.” Warrants are actively traded in some financial markets, such as the Deutsche Börse and the Hong Kong Stock Exchange.
Contingent convertible bonds
Bonds that automatically convert into equity if a specific event or circumstance occurs, such as the issuer’s equity capital falling below the minimum requirement set by the regulators. Also called CoCos.
(reading 2 )Classification Of Fixed Income Markets
Common criteria used to classify fixed-income markets include the : type of issuer the bonds’ credit quality maturity currency denomination type of coupon where the bonds are issued and traded
Classification by the type of issuer
four bond market sectors: households, non-financial corporates, government, financial institutions
Classification by Credit Quality
Investors who hold bonds are exposed to credit risk, which is the risk of loss resulting from the issuer failing to make full and timely payments of interest and/or principal. Bond markets can be classified based on the issuer’s creditworthiness as judged by credit rating agencies.
In contrast, ratings below these levels(BBB) are referred to as non-investment grade, high yield, speculative, or “junk.” An important point to understand is that credit ratings assess the issuer’s creditworthiness at a certain point in time; they are not a recommendation to buy or sell the issuer’s securities. Credit ratings are not static, however; they will change if a credit rating agency perceives that the probability of default for an issuer has changed.
Globally, investment-grade bond markets tend to be more liquid than high-yield bond markets.
Classification by Maturity
Fixed-income securities can also be classified by the original maturity of the bonds when they are issued. Securities may be issued with maturities at issuance (original maturity) ranging from overnight to 30, 40, 50, and up to 100 years
Classification by Currency Denomination
The currency denomination of the bond’s cash flows influences the yield that must be offered to investors to compensate for the potential impact of currency movements on bond investment returns
Classification by Type of Coupon
Another way of classifying fixed-income markets is by type of coupon. Some bonds pay a fixed rate of interest; others, called floating-rate bonds, floating-rate notes (FRNs), or floaters, pay a rate of interest that adjusts to market interest rates at regular, short-term intervals (e.g., quarterly).
Reference Rates
The coupon rate of a floating-rate bond is typically expressed as a reference rate plus a constant spread or margin. It is primarily a function of the issuer’s credit risk at issuance: The lower the issuer’s credit quality (the higher its credit risk), the higher the spread. The reference rate, however, resets periodically. Therefore, the coupon rate adjusts to the level of market interest rates each time the reference rate is reset.
Classification by Geography
A distinction is very often made among the domestic bond, foreign bond, and Eurobond markets.
Bonds issued in a specific country, denominated in the currency of that country, and sold in that country are classified as domestic bonds if they are issued by an issuer domiciled in that country and foreign bonds if they are issued by an issuer domiciled in another country. Domestic and foreign bonds are subject to the legal, regulatory, and tax requirements that apply in that particular country.
In contrast, a Eurobond is issued internationally, outside the jurisdiction of the country in whose currency the bond is denominated. The Eurobond market has traditionally been characterized by fewer reporting, regulatory, and tax constraints than domestic and foreign bond markets. This less constrained environment explains why approximately 80% of entities that issue bonds outside their country of origin choose to do so in the Eurobond market rather than in a foreign bond market. In addition, Eurobonds are attractive for issuers because it enables them to reach out to more investors globally. Access to a wider pool of investors often allows issuers to raise more capital, usually at a lower cost. Along these lines, Eurobond markets are attractive for investors because they offer investors the ability to take on sovereign credit risk without being exposed to risks that are germane to the individual jurisdiction of the issuer countries, such as potential changes to capital control rules, which would restrict the return of capital, and other country risks.
Other Classifications of Fixed-Income Markets
Specific market sectors that are of interest to some investors are inflation-linked bonds and, in some jurisdictions, tax-exempt bonds.
Inflation-linked bonds or linkers are typically issued by governments, government-related entities, and corporate issuers that have an investment-grade rating. They offer investors protection against inflation by linking the coupon payment and/or the principal repayment to an index of consumer prices
Tax-exempt bonds can be issued only in those jurisdictions that recognize such tax exemption In particular, local governments can issue municipal bonds (or munis) that are tax exempt (they can also issue taxable municipal bonds, although tax-exempt munis are more frequently issued than taxable munis). Tax-exempt bonds also exist in other jurisdictions
Fixed income index
A fixed-income index is a multi-purpose tool used by investors and investment managers to describe a given bond market or sector, as well as to track and quantify the performance of investments and investment managers. Most fixed-income indexes are constructed as portfolios of securities that reflect a particular bond market or sector. The index construction—that is, the security selection and the index weighting—varies among indexes. Index weighting may be based on price, value (market capitalization), or total return.
Many other fixed-income indexes are available to investors and investment managers to measure and report performance.
It is important to note that constructing a fixed-income index is more challenging than constructing an equity index, because fixed-income markets feature far more securities of different types and more frequent changes in the index as new bonds are issued while others reach maturity
Investors in Fixed-Income Securities
it is important to consider the demand side because demand for a particular type of bond or issuer may affect supply. After all, market prices are the result of the interaction between demand and supply; neither one can be considered in isolation.
There are different types of investors in fixed-income securities. Major categories of bond investors include central banks,
institutional investors,
retail investors.
The first two typically invest directly in fixed-income securities. In contrast, retail investors often invest indirectly, traditionally through fixed-income mutual funds and, during the last two decades, through exchange-traded funds (ETFs), described later.
CENTRAL BANKS-Central banks use open market operations to implement monetary policy. By purchasing (selling) domestic bonds, central banks increase (decrease) the monetary base in the economy. Central banks may also purchase and sell bonds denominated in foreign currencies as part of their efforts to manage the relative value of the domestic currency and their country’s foreign reserves.
INSTITUTIONAL INVESTORS-Institutional investors, including pension funds, hedge funds, charitable foundations and endowments, insurance companies, and banks, represent the largest groups of investors in fixed-income securities. Another major group of investors is sovereign wealth funds, which are state-owned investment funds that tend to have very long investment horizons and aim to preserve or create wealth for future generations.
RETAIL INVESTORS-Finally, retail investors often invest heavily in fixed-income securities because of the attractiveness of relatively stable prices and steady income production.
open market operations
The purchase or sale of bonds by the national central bank to implement monetary policy. The bonds traded are usually sovereign bonds issued by the national government.
Primary Bond Market
A market in which issuers first sell bonds to investors to raise capital.
Different bond issuing mechanisms are used depending on the type of issuer and the type of bond issued.
A bond issue can be sold via a public offering (or public offer), in which any member of the public may buy the bonds, or via
a private placement, in which only a selected investor, or group of investors, may buy the bonds.
Public Offerings
The most common bond issuing mechanisms are underwritten offerings,
best-efforts offerings,
auctions.
Underwritten Offerings/ firm commitment offering
A type of securities issue mechanism in which the investment bank guarantees the sale of the securities at an offering price that is negotiated with the issuer. Also known as firm commitment offering.
Underwritten offerings are typical bond-issuing mechanisms for corporate bonds, some local government bonds (such as municipal bonds in the United States), and some asset-backed securities (such as mortgage-backed securities). The underwriting process typically includes six phases.
6 phases of underwritten offerings
- The determination of the funding needs- Often with the help of an adviser or advisers, the issuer must determine how much money must be raised, the type of bond offering, and whether the bond issue should be underwritten.
- The selection of the underwriter- The underwriter of a bond issue takes the risk of buying the newly issued bonds from the issuer, and it then resells them to investors or to dealers that then sell them to investors. The difference between the purchase price of the new bond issue and the reselling price to investors is the underwriter’s revenue
(syndicated offering). A lead underwriter invites other investment banks to join the syndicate and coordinates the effort. The syndicate is collectively responsible for determining the pricing of the bond issue and for placing (selling) the bonds with investors. - The structuring and announcement of the bond
offering- the issuer and the lead underwriter discuss the terms of the bond issue, such as the bond’s notional principal (total amount), the coupon rate, and the expected offering price. The issuer must also choose a trustee, which is typically a trust company or the trust department of a bank, to oversee the master bond agreement
The bond offering is formally launched the day the transaction is announced, usually in the form of a press release. The announcement specifies the new bond issue’s terms and conditions, including the bond’s features, such as the maturity date, the currency denomination, and the expected coupon range, as well as the expected offering price - Pricing- The pricing day is the last day when investors can commit to buy the bond issue, and it is also the day when the final terms of the bond issue are agreed on. The following day, called the “offering day,” the underwriting agreement that includes the bond issue’s final terms is signed
- Issuance- The underwriter or the syndicate purchases the entire bond issue from the issuer, delivers the proceeds, and starts reselling the bonds through its sales network
- Closing.- The underwriting process comes to an end about 14 days later, on the closing day, when the bonds are delivered to investors
Shelf Registration
A type of public offering that allows the issuer to file a single, all-encompassing offering circular that covers a series of bond issues.
A shelf registration allows certain authorized issuers to offer additional bonds to the general public without having to prepare a new and separate offering circular for each bond issue
Because shelf issuances are subject to a lower level of scrutiny compared with standard public offerings, they are an option only for well-established issuers that have convinced the regulatory authorities of their financial strength. Additionally, certain jurisdictions may allow shelf registrations to be purchased only by “qualified” institutional investors—that is, institutional investors that meet a set of criteria set forth by the regulators.
Auctions
Primary Dealers
An auction is a method that involves bidding. It is helpful in providing price discovery (i.e., it facilitates supply and demand in determining prices) and in allocating securities. In many countries, most sovereign bonds are sold to the public via a public auction
The public auction process used in the United States is a single-price auction through which all the winning bidders pay the same price and receive the same coupon rate for the bonds
a multiple-price auction process, which generates multiple prices and yields for the same bond issue.
The US sovereign bond market is one of the largest and most liquid bond markets globally, so we will illustrate the US single-price auction process. This process includes three phases:
announcement, bidding, and issuance.
First, the US Treasury announces the auction and provides information about the bond issue, such as the amount of securities being offered, the auction date, the issue date, the maturity date, bidding close times, and other pertinent information.
After the auction announcement is made, dealers, institutional investors, and individual investors may enter competitive or non-competitive bids
With competitive bids, a bidder specifies the rate (yield) that is considered acceptable; if the rate determined at auction is lower than the rate specified in the competitive bid, the investor will not be offered any securities. In contrast, with non-competitive bids, a bidder agrees to accept the rate determined at auction; non-competitive bidders always receive their securities.
On the issue day, the US Treasury delivers the securities to the winning bidders and collects the proceeds from investors. After the auction process is complete, the securities are traded in secondary markets like other securities.
Financial institution that is authorized to deal in new issues of sovereign bonds and that serves primarily as a trading counterparty of the office responsible for issuing sovereign bonds
Private Placements
A private placement is typically a non-underwritten, unregistered offering of bonds that are sold only to an investor or a small group of investors. Typical investors in privately placed bonds are large institutional investors. A private placement can be accomplished directly between the issuer and the investor(s) or through an investment bank. Because privately placed bonds are unregistered and may be restricted securities that can be purchased by only some types of investors, there is usually no active secondary market to trade them.
Even if trading is possible, privately placed bonds typically exhibit lower liquidity than publicly issued bonds. Insurance companies and pension funds are major buyers of privately placed bonds because they do not need every security in their portfolios to be liquid and they often value the additional yield offered by these bonds.
Syndicated loan
A loan from a group of lenders to a single borrower.
Secondary Bond Market
Secondary markets, also called the “aftermarket,” are where existing securities are traded among investors. Securities can be traded directly from investor to investor, through a broker or dealer, or directly from issuer to investor by way of bond tender offer. The major participants in secondary bond markets globally are large institutional investors and central banks. The direct presence of retail investors in secondary bonds markets is limited, unlike in secondary equity markets. Retail investors do participate in secondary bond markets, albeit indirectly, through mutual and exchange-traded funds (ETFs) offered by fund management companies.
There are three main ways for secondary markets to be structured: as an organized exchange, as an over-the-counter market, or as a bond tender offer
Organized Exchange
OTC markets
Bond tender
A securities marketplace where buyers and seller can meet to arrange their trades. Although buy or sell orders may come from anywhere, the transaction must take place at the exchange according to the rules imposed by the exchange
A decentralized market where buy and sell orders initiated from various locations are matched through a communications network.
A bond tender offer involves an issuer making an offer to existing bondholders of the company to repurchase a specified number of bonds at a particular price and a specified time
Liquidity
A key indicator and measurement of liquidity is the bid–offer spread or bid–ask spread, which reflects the prices at which dealers will buy from a customer (bid) and sell to a customer (offer or ask)
bid offer spread - The difference between the prices at which dealers will buy from a customer (bid) and sell to a customer (offer or ask). It is often used as an indicator of liquidity.
The key to understanding how secondary bond markets are structured and function is to understand liquidity. Liquidity refers to the ability to trade (buy or sell) securities quickly and easily at prices close to their fair market value. Liquidity involves much more than “how quickly one can turn a bond into cash.” This statement implicitly assumes a long position, but some market participants need to buy quickly when covering a short position. The other aspect of liquidity that is often ignored is that speed of trading alone does not constitute a liquid market. One can always buy something quickly by offering a very high price or sell something quickly by accepting a very low price. In a liquid market, trading takes place quickly at prices close to the security’s fair market value.
Settlement
The process that occurs after a trade is completed, the securities are passed to the buyer, and payment is received by the seller.
Sovereign Bonds
A bond issued by a national government. Also called “Sovereign.”
Sovereign bonds denominated in local currency have different names in different countries
on the run securities
benchmark issue
The most recently issued and most actively traded sovereign securities.
The latest sovereign bond issue for a given maturity. It serves as a benchmark against which to compare bonds that have the same features but that are issued by another type of issuer.
Credit Quality of Sovereign Bonds
Sovereign bonds are usually unsecured obligations of the sovereign issuer—that is, they are backed not by collateral but by the taxing authority of the national government. When a national government runs a budget surplus, excess tax revenues over expenditures are the primary source of funds for making interest payments and repaying the principal. In contrast, when a country runs a budget deficit, the source of the funds used for the payment of interest and repayment of principal comes either from tax revenues and/or by “rolling over” (refinancing) existing debt into new debt.
Highly rated sovereign bonds denominated in local currency are virtually free of credit risk. Credit rating agencies assign ratings to sovereign bonds, and these ratings are called sovereign ratings.
Credit rating agencies distinguish between bonds issued in the sovereign’s local currency and bonds issued in a foreign currency. In theory, a government can make interest payments and repay the principal by generating cash flows from its unlimited power (in the short run at least) to tax its citizens. A national government also has the ability to print its own currency, whereas it is restricted in being able to pay in a foreign currency only what it earns in exports or can exchange in financial markets. Thus, it is common to observe a higher credit rating for sovereign bonds issued in local currency than for those issued in a foreign currency
If the local currency is liquid and freely traded, the sovereign issuer may also attract international investors who may want to hold that sovereign issuer’s bonds and have exposure to that country’s local currency.
Types of Sovereign Bonds
Fixed-Rate Bonds
Floating-Rate Bonds
Inflation-Linked Bonds
Fixed Rate Bonds &types
Fixed-rate bonds (i.e., bonds that pay a fixed rate of interest) are by far the most common type of sovereign bond
two types of fixed-rate bonds:
zero-coupon bonds (or pure discount bonds) - A zero-coupon bond does not pay interest. Instead, it is issued at a discount to par value and redeemed at par at maturity
coupon bonds - Coupon bonds are issued with a stated rate of interest and make interest payments periodically, such as semi-annually or annually. They have a terminal cash flow equal to the final interest payment plus the par value.
Floating Rate Bonds
The price of a bond changes in the opposite direction from the change in interest rates
investors who hold fixed-rate bonds are exposed to interest rate risk: As interest rates increase, bond prices decrease, which lowers the value of their portfolio. In response to public demand for less interest rate risk, some national governments around the world issue bonds with a floating rate of interest that resets periodically based on changes in the level of a reference rate such as Libor.
Inflation-Linked Bonds
Fixed-income investors are exposed to inflation risk. The cash flows of fixed-rate bonds are fixed by contract. If a particular country experiences an inflationary episode, the purchasing power of the fixed cash flows erodes over time.
The inflation adjustment can be made via the coupon payments, the principal repayment, or both.
Non- sovereign bonds
Levels of government below the national level, such as provinces, regions, states, and cities, issue bonds called non-sovereign government bonds or non-sovereign bonds. These bonds are typically issued to finance public projects, such as schools, motorways, hospitals, bridges, and airports. The sources for paying interest and repaying the principal include the taxing authority of the local government, the cash flows of the project the bond issue is financing, or special taxes and fees established specifically for making interest payments and principal repayments. Non-sovereign bonds are typically not guaranteed by the national government.
Credit ratings for non-sovereign bonds vary widely because of the differences in credit and collateral quality. Because default rates of non-sovereign bonds are historically low, they very often receive high credit ratings. However, non-sovereign bonds usually trade at a higher yield and lower price than sovereign bonds with similar characteristics. The additional yield depends on the credit quality, the liquidity of the bond issue, and the implicit or explicit level of guarantee or funding commitment from the national government. The additional yield is the lowest for non-sovereign bonds that have high credit quality, are liquid, and are guaranteed by the national government.
Quasi government bonds
National governments establish organizations that perform various functions for them. These organizations often have both public and private sector characteristics, but they are not actual governmental entities. They are referred to as quasi-government entities, although they take different names in different countries. These quasi-government entities often issue bonds to fund specific financing needs. These bonds are known as quasi-government bonds or agency bonds.
Most quasi-government bonds, however, do not offer an explicit guarantee by the national government, although investors often perceive an implicit guarantee.
Because a quasi-government entity typically does not have direct taxing authority, bonds are repaid from the cash flows generated by the entity or from the project the bond issue is financing. Quasi-government bonds may be backed by collateral, but this is not always the case. Quasi-government bonds are usually rated very high by the credit rating agencies because historical default rates are extremely low. Bonds that are guaranteed by the national government receive the highest ratings and trade at a lower yield and higher price than otherwise similar bonds that are not backed by the sovereign government’s guarantee.
Supranatural Bonds
A form of often highly rated bonds is issued by supranational agencies, also referred to as multilateral agencies.
Bonds issued by supranational agencies are called supranational bonds.
Supranational bonds are typically plain-vanilla bonds, although floating-rate bonds and callable bonds are sometimes issued.
Bank Loans
A bilateral loan×
A loan from a single lender to a single borrower.
is a loan from a single lender to a single borrower. Companies routinely use bilateral loans from their banks, and these bank loans are governed by the bank loan documents. Bank loans are the primary source of debt financing for small and medium-size companies as well as for large companies in countries where bond markets are either underdeveloped or where most bond issuances are from government, government-related entities, and financial institutions. Access to bank loans depends not only on the characteristics and financial health of the company but also on market conditions and bank capital availability.
Syndicated Loans
A syndicated loan is a loan from a group of lenders, called the “syndicate,” to a single borrower. A syndicated loan is a hybrid between relational lending and publicly traded debt. Syndicated loans are primarily originated by banks, and the loans are extended to companies but also to governments and government-related entities. The coordinator, or lead bank, originates the loan, forms the syndicate, and processes the payments. In addition to banks, a variety of lenders participate in the syndicate, such as pension funds, insurance companies, and hedge funds. Syndicated loans are a way for these institutional investors to participate in corporate lending while diversifying the credit risk among a group of lenders.
Most bilateral and syndicated loans are floating-rate loans, and the interest rate is based on a reference rate plus a spread. The reference rate may be MRR, formerly Libor, a sovereign rate (e.g., the T-bill rate), or the prime lending rate, also called the “prime rate.” The prime rate reflects the rate at which banks lend to their most creditworthy customers, which tends to vary based on the overnight rate at which banks lend to each other plus a spread. Bank loans can be customized to the borrower’s needs. They can have different maturities, as well as different interest payment and principal repayment structures. The frequency of interest payments varies among bank loans. Some loans are bullet loans, in which the entire payment of principal occurs at maturity, and others are amortizing loans, in which the principal is repaid over time.
For highly rated companies, both bilateral and syndicated loans can be more expensive than bonds issued in financial markets. Thus, companies often turn to money and capital markets to raise funds, which allows them to diversify their sources of financing.
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Commercial Paper
Commercial paper is a short-term, unsecured promissory note issued in the public market or via a private placement that represents a debt obligation of the issue
Characteristics of Commercial Paper
Commercial paper is a valuable source of flexible, readily available, and relatively low-cost short-term financing. It is a source of funding for working capital and seasonal demands for cash. It is also a source of bridge financing—that is, interim financing that provides funds until permanent financing can be arranged.
The market conditions for issuing long-term bonds may currently be volatile, which would translate into a higher cost of borrowing. Rather than issuing long-term bonds immediately, the company may opt to raise funds with commercial paper and wait for a more favorable environment in which to sell long-term bonds.
The maturity of commercial paper can range from overnight to one year, but a typical issue matures in less than three months
Credit Quality of Commercial Paper
Traditionally, only the largest, most stable companies issued commercial paper. Although only the strongest, highest-rated companies issue low-cost commercial paper, issuers from across the risk spectrum can issue commercial paper with higher yields than higher-rated companies. Thus, investors in commercial paper are exposed to various levels of credit risk depending on the issuer’s creditworthiness. Many investors perform their own credit analysis, but most investors also assess a commercial paper’s credit quality by using the ratings provided by credit rating agencies
