Fixed Income Flashcards
bond indenture / trust deed
The legal contract between the bond issuer (borrower) and bondholders (lenders)
Negative covenants
restrictions on asset sales (the company can’t sell assets that have been pledged as collateral), negative pledge of collateral (the company can’t claim that the same assets back several debt issues simultaneously), and restrictions on additional borrowings (the company can’t borrow additional money unless certain financial conditions are met).
Negative covenants serve to protect the interests of bondholders and prevent the issuing firm from taking actions that would increase the risk of default. At the same time, the covenants must not be so restrictive that they prevent the firm from taking advantage of opportunities that arise or responding appropriately to changing business circumstances.
Affirmative covenants
do not typically restrict the operating decisions of the issuer. Common affirmative covenants are to make timely interest and principal payments to bondholders, to insure and maintain assets, and to comply with applicable laws and regulations.
Two examples of affirmative covenants are cross-default and pari passu provisions. A cross-default clause states that if the issuer defaults on any other debt obligation, they will also be considered in default on this bond. A pari passu clause states that this bond will have the same priority of claims as the issuer’s other senior debt issues.
foreign bonds
firm trades bonds in another county
Eurobonds/global bonds
bonds traded across the globe in a separate currency
Bearer bond
better for tax than registered bond
Collateral trust bonds
securities held by trustee
Equipment trust certificate
physical assets owned by trust, leased to firm
Secured bonds have seniority over unsecured bonds
Securitised bonds:
- Issued by a SPE/SPV
- Firm sells assets to SPV
- Assets cash flow make payments to bondholders
- Assets separate from firm, safe form firm problems
- Created to reduce borrowing costs
Covered Bonds:
- Primarily issued by financial firms
- Firm must augment assets whenever they are insufficient to support the covered bonds
- Bond holders effectively have resource to firm as well as the segregated financial assets
Credit enhancement (external):
- Bank guarantee
- Surety bond
- Letter of credit
- Cash collateral account
Credit enhancement (internal):
- Overcollateralization – collateral value is greater than amount borrowed
- Excess spread – underlying asset return greater than bond cost
- Tranches – waterfall to insulate risks
Tax considerations:
- Interest typically taxed as ordinary income
- Interest on municipal bonds (U.S.) exempt from taxes
- Some domestic bonds pay interest net of tax
- For bonds sold prior to maturity, may be capital gains or losses if yield has changed
- Long-term capital gains (and capital gains in general) often taxed at a lower rate
Zero coupon bond = weird stuff because no tax flow but still get taxed
balloon payment
final payment includes a lump sum in addition to the final period’s interest
Sinking fund provisions
must retire a certain amount of principal from a set time
Step-up coupon
increases on a schedule + call feature
Credit linked coupon
coupon rate increases if credit rating decreases, decreases if credit rating increases
Payment-in-kind
Issuer may make coupon payments by increasing principal amount
Deferred (split) coupon
Coupon payments do not begin until a period after issuance
Index link bonds
inflation, equity linked, commodity linked bonds (changes face value which flows through to coupon payments)
Inflation linked bonds (linkers
interest indexed = coupon rate adjusted, capital-indexed = par value adjusted
Indexed annuity bonds
fully amortised, payments adjusted
Principal-protected
pay original face value if index decreases over life of bond
Contingency provisions
are actions the issuer or bondholders may take
Callable bonds
issuer may redeem bonds before maturity on scheduled call dates at specific prices
Make-whole clause
includes PV of future coupons
Putable bonds
bondholder may sell bond back to issuer typically for par value
Contingent convertibles or Cocos
convert to common stock automatically if specified event occurs (bank with minimum equity percentage this automatically increases equity
Global bond markets can be classified by several bond characteristics
- Type of issuer
- Credit quality
- Original maturities
- Coupon structures – (market reference rate + margin = floating vs fixed)
- Currency denomination
- Geography (developed markets or emerging markets)
- Indexing
- Tax status
Describe the use of interbank offered rates as reference rates in floating-rate debt
Move away from using London Interbank Offered Rate (LIBOR) because it has been manipulated previously. Banks no longer required to report using LIBOR. In USA they are now using secured overnight financing rate (SOFR)
grey market
when issued basis (before they go public)
US treasury securities
single price auctions with primary dealers
Shelf registration
bonds issued overtime as required
Corporate bonds settle on
T+2 or T +3
Government bonds settle on
T+1
Liquid markets indicator
10 to 12 basis point spread
on-the-run bonds and also as benchmark bonds
Trading is most active and prices most informative for the most recently issued government securities of a particular maturity.
Bond tenure
Short term < 5 years, 5 -12 years = medium term, 12+ years = long term
Yield enhancement instruments
credit-linked note (CLN)
Capital protected instruments
A capital protected instrument offers a guarantee of a minimum value at maturity as well as some potential upside gain
Participation instruments
A participation instrument has payments that are based on the value of an underlying instrument, often a reference interest rate or equity index
Leveraged instruments
An inverse floater is an example of a leveraged instrument
Describe short-term funding alternatives available to banks
- certificates of deposit (CDs)
- central bank funds market
- interbank funds
Repo agreements
an arrangement by which one party sells a security to a counterparty with a commitment to buy it back at a later date at a specified (higher) price. The repurchase price is greater than the selling price and accounts for the interest charged by the buyer, who is, in effect, lending funds to the seller with the security as collateral. The interest rate implied by the two prices is called the repo rate
Repo rate calc
(repo price/original purchase price) – 1
Repo margin or haircut
(market value/ originating repo price)-1
Repo agreement dynamics
The repo rate is:
* Higher, the longer the repo term.
* Lower, the higher the credit quality of the collateral security.
* Lower when the collateral security is delivered to the lender.
* Higher when the interest rates for alternative sources of funds are higher.
The repo margin is influenced by similar factors. The repo margin is:
* Higher, the longer the repo term.
* Lower, the higher the credit quality of the collateral security.
* Lower, the higher the credit quality of the borrower.
* Lower when the collateral security is in high demand or low supply.
