Fixed Income: Features, Issuance & Trading Flashcards
Loans
Private (nontradable) agreements between a borrower and lender.
Bonds (Fixed-Income Securities)
Standardized, tradable securities representing a debt investment.
Investors in bonds are lending capital (referred to as principal, par, or face value) to the issuer of the bond. The issuer of the bond promises to repay this principal amount plus interest, typically in the form of a regular periodic coupon that is stated as a percentage of par. The capital raised is usually used to finance the long- term investments of the bond issuer.
Issuers of a Bond
Sovereign national governments, corporations, local governments, supernational entities, quasi government entities, special purpose entities
Maturity, Tenor, money market & capital market securities, perpetual bonds
-The maturity date of a bond is the date on which the final cash low is to be paid.
-Once a bond has been issued, the time remaining until maturity is referred to as the tenor of a bond.
-Bonds with original maturities of one year or less are referred to as money market securities.
-Bonds with original maturities of more than one year are referred to as capital market securities.
-Bonds that have no stated maturity date are called perpetual bonds.
Principal or Par Value or Face Value
The par value of a bond is the principal amount that will be repaid. Repayment of principal typically occurs at maturity, but debt instruments may specify that principal is paid back gradually over the life of the instrument, such as with a mortgage loan.
Coupon Rate & Frequency
-The coupon rate on a bond is the annual percentage of its par value that will be paid to bondholders, default frequency is semi-annual, although may vary.
-Coupon rates can based on variable market rate called Floating Rate Notes (based on MRR)
-Zero Coupon Bonds or Pure Discount Bonds refer to bonds that are sold at a discount to their par value, and the interest is all paid at maturity when bondholders receive the par value.
Seniority
In the event of bankruptcy or liquidation of an issuer, debt investors’ claims on the issuer’s assets rank above those of equity investors, making debt senior to equity in the capital structure of the issuer. However, not all debt claims rank equally. Senior debt ranks higher than junior debt (also called subordinated debt), making senior debt a less risky investment from a credit risk perspective.
Contingency Provision
A bond may have an embedded option, such as a call option, put option, or the right to convert the debt into equity.
Yield
Given a bond’s price and its expected cash lows, we can calculate the expected return from investing in the bond, referred to as the bond’s yield. For a fixed-coupon bond, when prices fall, the bond offers a higher yield, and when prices rise, the bond offers a lower yield. As such, prices and yields are inversely related.
Yield Curve
Graphical Plot of yield versus maturity
Upward Sloping: High Yield for High Maturity (Normal Yield Curve)
Downward Sloping: Low Yield for High Maturity - lnverted Yield Curve - less common
Bond Indenture
The legal contract between the bond issuer (borrower) and bondholders (lenders).
The indenture de fines obligations of, and restrictions on, the borrower, including the sources of repayment, and it forms the basis for all future interactions between the bondholder and the issuer.
Sources of Repayment
-Sovereign Bonds: Repaid from taxes collected on economic activity
-Local Gov Bonds: Local Taxes/Revenue
-Secured Corporate Bond: Operating Cash Flow + Investment Cash Flows + Added security of legal claim (lein/pledge) on specific assets (collateral) in the event of issuer default.
- Unsecured Corporate Bond: repaid only from the operating and investment cash f low of the issuing company.
- ABSs: Cash flows from underlying asset
Bond Covenants
- Affirmative Covenants: requirements issuer must fulfill.
Cross-default: default on any other debt –> default on the bond
Pari-Passu: Bond ranks equal to other senior debt issues - Negative Covenants: restrictions on the issuer.
Negative Pledge Clause: Bond issue ranks more senior than existing debt
Incurrence Test: Breach of pre-defined financial ratios
Bullet Structure
Principal (par value) is paid back in a single payment at maturity. Periodic payments across the life of the bond (referred to as the bond’s coupons) are purely interest payments.
Amortizing Loan
A loan structure in which the periodic payments include both interest and some repayment of principal (the amount borrowed) is called an amortizing loan.
A bond can be fully amortizing or partially amortizing (or have a bullet structure).
Fully Amortizing Bond
If a bond (loan) is fully amortizing, this means the principal is fully paid off when the last periodic payment is made.
Partially Amortizing Bond
A bond can also be structured to be partially amortizing so that there is a repayment of some principal at maturity (referred to as a balloon payment). Unlike a bullet structure, the final payment includes just the remaining unamortized principal amount rather than the full principal amount.
Sinking Fund Provisions
Provide for the repayment of principal through a series of payments over the life of a bond issue.
For example, a 20-year issue with a face amount of $300 million may require that the bond trustee redeems $20 million of the principal from investors selected at random every year beginning in the sixth year.
+ve: Less Credit Risk as reduces total amount owed over the years
-ve: Reinvestments risk for the same reason.
Waterfall Structure
Used to establish principal repayments to holders of ABSs and MBSs.
These structured products can be split into tranches of varying seniority. A common waterfall structure is for junior tranches not to receive any principal payment from the collateral pool until all senior tranches have been fully repaid. Interest payments would still be made to all tranches.
FRNs/Floaters
Some bonds pay periodic interest that depends on the prevailing market rate of interest at the time future coupon payments are made. These bonds are called floating-rate notes (FRNs) or lfoaters. The variable market rate of interest is called the market reference rate (MRR), and an FRN promises to pay the MRR plus some f ixed margin (called a credit spread).
Step-Up Coupon Bonds
Structured so that the coupon rate increases over time according to a predetermined schedule, providing protection to investors against interest rates rising over the life of the bond.
Coupon changes could also be linked to future potential events., eg: Debt/EBITDA rising above 3% will call for an extra credit spread of 50 basis points.
Leveraged Loans
Loans to borrowers of lower credit quality or borrowers who already have a high amount of debt
Credit-Linked Notes
The coupon rate increases if the credit rating of the issuer deteriorates (or decreases if the credit rating improves).
Payment in Kind (PIK) Bonds
Allows the issuer to make the coupon payments by increasing the principal amount of the outstanding bonds, essentially paying bond interest with more bonds.
When firms anticipate that firm cash flows may be less than required to service the debt, often because of high levels of debt financing (leverage).
These bonds typically have higher yields because of the lower perceived credit quality implied by expected cash flow shortfalls, or simply because of the high leverage of the issuing firm.
Green Bonds
Whereby the coupon paid increases if certain environmental goals (for example CO2 emissions reduction) are not met by
the issuer over a speci fied time frame.
Index-Linked Bond
Coupon payments or a principal value that is based on a specif ied published index.
Inflation-Linked Bonds (Linkers)
Most common type of index-linked bonds, which increase their cash lows in line with a speci fied inf lation index, such as the Consumer Price Index (CPI) in the United States, to protect the real value of the cash lows promised to investors.
Structure of Inflation-indexed bonds
- Interest-indexed bonds. The coupon rate is adjusted for inf lation, while the principal value remains unchanged. This means the principal value of the debt is not in flation-protected.
- Capital Indexed Bond: The coupon rate remains constant, but the principal value is increased by the rate of in flation, or decreased by def lation.
(*Coupon value increased if inflation increased as principal value increases - only RATE is constant)
In the case of def lation, TIPS investors receive the maximum of inf lation-adjusted principal or the unindexed par amount at maturity.
Zero Coupon Bond
Simplest form of fixed-income instrument, offering only a single payment of par at maturity. These bonds are popular with investors that wish to minimize reinvestment risk. With no periodic coupon, zero-coupon bonds must trade below par to offer investors a positive return.
Contingency Provision
Describes an action that may be taken if an event (the contingency) actually occurs. Contingency provisions in bond indentures are referred to as embedded options.
Bonds that do not have contingency provisions are referred to as straight bonds or option-free bonds.
Deferred Coupon Bond
Regular coupon payments do not begin until a specif ied time after issuance. These bonds may be appropriate financing for issuers with a low credit rating or with a large project that will not be completed and generating revenue for some period after bond issuance. Zero-coupon bonds can be considered the most extreme type of deferred coupon bond—and, like zero-coupon bonds, deferred coupon bonds often trade below par to provide investors with the yields they demand.
Callable Bonds
A callable bond gives the issuer the right, but not the obligation, to redeem (through buying bonds back from investors before maturity) all or part of a bond issue at a predetermined fixed price (known as a call price).
Call Protection
The period until which bond is not callable.
Call Period
Where bonds can be called by the issuer
Call Risk
The issuer holding the call option creates call risk for the bondholder. Call risk relates to the fact that bondholders face an uncertain redemption date. For a bond that is in its call period, the call price will put an upper limit on the value of the bond in the market.
Value of Callable Bond
Due to call risk, bondholders will demand a higher yield and will pay a lower price for a callable bond than they would for an otherwise equivalent straight bond. The difference in price between a callable bond and an otherwise identical noncallable bond is equal to the value of the call option to the issuer.
VCB < VNCB
VCB = VNCB - Co
Putable Bond
Gives the bondholder the right to sell the bond back to the issuing company at a prespeci ied price, typically par. Bondholders are likely to exercise such a put option when the price of the bond is less than the put price because interest rates have risen or the credit quality of the issuer has fallen.
Value of Putable Bond
The embedded option for a putable bond has value to the bondholder because the choice of whether to exercise the option is the bondholder’s. For this reason, a putable bond will sell at a higher price (offer a lower yield) than an otherwise equivalent straight bond. The difference in price between an otherwise identical straight bond and a putable bond is equal to the value of the put option to the bondholder.
VPB > VNPB
VPB = VNPB + Po
(Reinvestment risk for issuer and hence will issue at higher price)
Convertible Bond
Gives bondholders the option to exchange the bond for a speci fic number of shares of the issuing corporation’s common stock. This gives bondholders the opportunity to prof it from increases in the value of the common shares.
VCB > VNCB
Conversion Price
This is the par amount per share at which the bond may be converted to common stock.
Conversion Ratio
This is equal to the par value of the bond divided by the conversion price. If a bond with a $1,000 par value has a conversion price of $40, its conversion ratio is 1,000 / 40 = 25 shares per bond.
Conversion Value
This is the market value of the shares that would be received upon conversion. A bond with a conversion ratio of 25 shares when the current market price of a common share is $50 would have a conversion value of 25 × $50 = $1,250.
Warrants
An alternative way to give bondholders an opportunity for additional returns when the firm’s common shares increase in value is to attach warrants to straight bonds when they are issued. Warrants give their holders the right to buy the f irm’s common shares at a fixed price over a given period.
Warrants can be detached from the bond issue and traded on securities exchanges.
Contingent Convertible Bonds (CoCos)
Bonds that convert from debt to common equity automatically if a speci fic event occurs.
Eg: Banks must maintain speci fic levels of equity financing. CoCos are often structured so that if the bank’s equity capital falls below a given level, they are automatically converted to common stock. This has the effect of decreasing the bank’s debt liabilities and increasing its equity capital at the same time, which helps the bank to meet its minimum equity requirement.
Domestic Bonds
Bonds of issuers domiciled in the same country as the market in which the bonds are issued and traded are referred to as domestic bonds
Foreign Bonds
Bonds of issuers from countries other than the market in which the bond trades are referred to as foreign bonds.
(UK Company raised $$ in US Market)
Eurobonds
Issued outside the jurisdiction of any one country and can be issued in any currency, have less regulations. Ex: Bond issued by a Chinese firm denominated in yen traded outside Japan (Euroyen).
Global Bonds
Eurobonds that trade in at least one domestic bond market and in the Eurobond market are referred to as global bonds.
International Bonds
Foreign bonds, global bonds, and Eurobonds that involve more than one country are often collectively referred to as international bonds to distinguish them from domestic bonds, which involve only a single country.
Sukuk Bonds
Sharia-compliant bonds with speci fic restrictions on the payment of interest and use of the proceeds of the bond issue to comply with Islamic law. The periodic payments on these bonds are considered to be cash flows from rent on underlying assets.
Original Issue Discount (OID) Bonds
Zero-coupon bonds and other bonds sold at signif icant discounts to par when issued are termed original issue discount (OID) bonds.
Because the gains over an OID bond’s tenor as its price moves toward par value are really interest income, these bonds can generate a tax liability even when no cash interest payment has been made.
In many tax jurisdictions, a portion of the discount from par at issuance is treated as taxable interest income each year.
Bond Taxation
- Interest usually taxed as ordinary income (wages, salaries)
- If sold before maturity, may be sold at profit or loss - this will be treated as capital gains income (maybe Long/Short Term)
- Sovereign Bonds - Interest Income maybe tax free
- In many tax jurisdictions, a portion of the discount from par at issuance is treated as taxable interest income each year.
- Some tax jurisdictions provide a symmetric treatment for bonds issued at a premium to par, allowing part of the premium to be used to reduce the taxable portion of coupon interest payments.
