Fixed Income Securities: Features and Types

Question 1

What are fixed income securities, explain using terminology of principal, maturity date, bonds, and debentures:

Answer 1

• Governments, corporations, and many other entities borrow funds to finance and expand their operations. In addition to bank lending and private loans, these entities also have the option of issuing fixed-income securities in the financial markets. From the investor’s perspective, purchasing a fixed-income security essentially represents the decision to lend money to the issuer. Investors become creditors of the issuing organization. They do not gain ownership rights, as they would with an equity investment.
• To put it in perspective, the dollar amount traded on Canada’s bond markets consistently averages about 10 times that of total equity trading in any given year.
• Fixed-income securities represent debt of the entity that issues them. As such, you will often hear the term debt securities to describe them. The terms of a fixed-income security include a promise by the issuer to repay the maturity value, or principal, on the maturity date, and to pay interest either at stated intervals over the life of the security or at maturity.
• Fixed-income securities trading in today’s markets come in many varieties, including bonds, debentures, money market instruments, mortgages, and even preferred shares

Question 2

What is the rationale for issuing fixed-income securities from the company and government’s PoV:

Answer 2

• Corporations and governments regularly raise money to finance their operations by issuing fixed-income securities. Governments fund their programs and other obligations largely through tax revenue. However, when a government spends more on those obligations than it receives in tax revenue, it must make up the difference by borrowing money. Most governments borrow by issuing fixed-income securities.
• Although companies issue fixed-income securities for various purposes, two particular reasons are commonly cited: * To finance operations or growth * To take advantage of financial leverage

Question 3

Specifically go into what a bond is vs a debenture:

Answer 3

• A bond is a long-term, fixed-obligation debt security that is secured by physical assets—such as a building or a railway car—owned by the issuing company.
• The details of a bond issue are outlined in a legal document called the trust deed and written into a bond contract. If the issuer can no longer meet the fixed obligations, the bond goes into default. When that happens, the provisions of the trust deed allow the bondholders to seize specified physical assets and sell them to recover their investment.
• A debenture is a type of bond that is secured by something other than a specified physical asset, typically by a general claim on residual assets. Therefore, the debenture is backed by the general creditworthiness of the issuer. For this reason, debentures are also referred to as unsecured bonds.

Question 4

Define the following bond terminology: par value, coupon rate, maturity date, bond price, and yield to maturity:

Answer 4

• Par value The par value of a bond (also called face value) is the principal amount the bond issuer contracts to pay at maturity to the bondholder. A bond is issued and matures at its par value.
• Coupon rate The coupon rate, or simply the coupon, is the interest or rate paid by the bond issuer relative to the bond’s par or face value over the term of the bond. The coupon represents the regular interest the bond issuer is obliged to pay to the bondholders. Most bonds are coupon bonds, paying fixed coupon rates. Most bonds make semi-annual coupon payments; some bonds pay coupons on an annual basis.
• Maturity date The maturity date is the date at which a bond matures, when the principal amount of the loan is paid back to the investor holding the bond. Upon maturity, the final interest payment is also made.
• Bond price The bond price is the present discounted value of all the future payments that the bond issuer is obligated to pay the investor. Specifically, the bond price is the sum of the present value of all future interest payments plus the present value of the future repayment of the loan upon maturity. Think of it like this: If you lend someone money, they promise to pay you back later with interest. The bond price is how much that promise is worth today. The price of a bond can go up or down depending on market interest rates. If interest rates go up, new bonds pay more, so older bonds with lower rates become less valuable. If interest rates go down, older bonds with higher rates become more valuable
  o Example: A bond has a face value (par value) of $1,000 (the amount you’ll get back at maturity). Pays a 5% annual interest rate (called a coupon rate), so you get $50 per year in interest. Matures in 5 years (meaning you’ll get your $1,000 back in 5 years). Now, suppose market interest rates rise to 7%. New bonds are paying $70 per year instead of $50. That makes your bond less attractive, so if you want to sell it, buyers won’t pay the full $1,000—maybe they’ll only pay $900. On the other hand, if market interest rates drop to 3%, new bonds only pay $30 per year. Your $50 per year bond now looks better, so buyers might be willing to pay more than $1,000, maybe $1,100. This is why bond prices go up when interest rates go down and go down when interest rates go up!
• Yield to maturity The yield to maturity is the annual return on a bond that is held to maturity. You will learn more about this concept in the chapter on bond pricing and trading

Question 5

What are the different terms for maturity for a bond?

Answer 5

• Short-term bonds have more than one year but less than five years remaining in their term.
• Medium-term bonds have terms of five to 10 years.
• Long-term bonds have terms greater than 10 years.
• Certain bonds that have a term to maturity of up to one year trade as money market securities. Money market securities are a special type of short-term, fixed-income security, generally with a term of one year or less.

Question 6

What are convertible bonds and how do they work?

Answer 6

• Convertible bonds and convertible debentures (often called convertibles) combine certain advantages of a bond with the option of exchanging the bond for common shares. In effect, a convertible security allows an investor to lock in a specific price (called the conversion price) for the common shares of the company. The right to exchange a bond for common shares on specifically determined terms is called the conversion privilege. Convertible bonds are like regular bonds; they have a fixed interest rate and a definite date on which the principal must be repaid. However, they offer the possibility of capital appreciation through the right to convert the bonds into common shares at the holder’s option, at stated prices over stated periods. Convertible bonds therefore offer the investor the potential to share in the company’s growth.
• The conversion price of most convertible bonds goes up gradually over time to encourage early conversion. Convertible bonds may normally be converted into stock at any time before the conversion privilege expires.

Question 7

What are forced conversions, in what two scenarios would a company seek to issue them, and what’s the trade-off for the investor in converting early or waiting?

Answer 7

• Forced conversion is an innovation built into certain convertible debt issues to give the issuing company more control in calling in the debt for redemption. The conversion forces bondholders to convert the company’s bonds into a predetermined number of common shares. The issuing company will typically be interested in forcing a conversion when market interest rates fall below the bond’s coupon rate, or if the price of the underlying common shares begins to trade above the conversion price. This redemption provision usually states that, once the market price of the common stock involved in the conversion rises above a specified level and trades at or above this level for a specific number of consecutive trading days, the company can call the bonds for redemption at a stipulated price. The price at which the company calls the bonds back is much lower than the level at which the convertible debt would otherwise be trading because of the rise in the price of the common stock.
• A forced conversion is an advantage to the issuing company, rather than to the debt holder, for several reasons:
  o It relieves the issuer of the obligation to make interest payments on debt once investors convert their debt into equities.
  o It can free up room for new debt financing if needed.

That’s the trade-off investors have to think about.
* If you convert early, you lock in more shares (44.033 at $22.71 each), but you risk missing out on a higher stock price later.
* If you wait, the company might force conversion, and while you get fewer shares, they are worth more because the stock price is higher.

Question 8

Government of Canada – bonds, treasury bills, real return bonds, guaranteed bonds, and provincial securities

Answer 8

• The Government of Canada issues marketable bonds in its own name. It also allows Crown corporations to issue debt that has a direct call on the Government of Canada. Government of Canada bonds have a specific maturity date and a specified coupon or interest rate. They are also transferable, which means that they can be traded in the market.
• Treasury bills (T-bills) are short-term government obligations offered in denominations from as low as $1,000. These securities appeal to a broad range of investors, including large institutional investors such as banks, insurance companies, and trust and loan companies, as well as to retail investors. T-bills do not pay interest; instead, they are sold at a discount (below par) and mature at 100. The difference between the issue price and par at maturity represents the return on the investment. Under the Income Tax Act, this return is taxable as income, not as a capital gain. Every two weeks, regular T-bills are sold at auction by the Ministry of Finance through the Bank of Canada. These bills have original terms to maturity of approximately three months, six months, and one year.
• Like conventional bonds, real return bonds pay interest throughout the life of the bond and repay the original principal amount upon maturity. Unlike conventional bonds, however, the coupon payments and principal repayment are adjusted for inflation to provide a fixed real coupon rate.
• Many provinces also guarantee the bond issues of provincially appointed authorities and commissions. Most provinces (and some of their enterprises) also issue T-bills. Investment dealers and banks purchase them, both at tender and by negotiation, usually for resale.
• Some provinces may issue different types of savings bonds. Check with the securities regulator in your province for more information

Question 9

What are domestic, foreign, and Eurobonds?

Answer 9

• Domestic bonds are issued in the currency and country of the issuer. Therefore, bonds issued by a Canadian corporation or by the Canadian government, in Canadian dollars, in the Canadian market are domestic bonds. These bonds are the most common type.
• Foreign bonds are issued outside of the issuer’s country and denominated in the currency of the country in which they are issued. Foreign bonds give the issuers access to sources of capital in other countries.
  o When a Canadian company issues bonds in U.S. dollars in the United States, these bonds are considered foreign bonds in the U.S. market. They are also called Yankee bonds. When a British company issues yen-denominated bonds in Japan, the bonds are called Samurais and are considered foreign bonds in the Japanese market. When a foreign company issues Canadian dollar-denominated bonds in Canada, the bonds are called Maple bonds and are considered foreign bonds in the Canadian market.
• Some bonds offer the investor a choice of interest payments in either of two currencies; other bonds pay interest in one currency and the principal in another. These so-called foreign pay bonds offer investors increased opportunity for portfolio diversification while providing the issuer with cost-effective access to capital in other countries.
• Eurobonds are international bonds issued in a currency other than the currency of the country where the bond is issued.

Question 10

What are commercial paper type bonds?

Answer 10

• Commercial paper is either an unsecured promissory note issued by a corporation or an asset-backed security backed by a pool of underlying financial assets. Issue terms range from less than three months to one year. Like T-bills, commercial paper is sold at a discount and matures at face value. Commercial paper is issued by large firms with an established financial history. Rating agencies rank commercial paper according to the issuer’s ability to meet short-term debt obligations. These securities may be bought and sold in a secondary market before maturity at prevailing market rates. They generally offer a higher yield than Government of Canada T-bills.

Question 11

What are Guaranteed investment Certificates? What is an escalating rate, laddered, and instalment, index-linked, and interest-rate linked GICs?

Answer 11

• Guaranteed investment certificates (GIC) offer fixed rates of interest for a specific term. Both principal and interest payments are guaranteed. They can be redeemable or non-redeemable. Non-redeemable GICs cannot be cashed before maturity, except in the event of the depositor’s death or extreme financial hardship. Interest rates on redeemable GICs are lower than non-redeemable GICs of the same term, given that they can be cashed before maturity. Many GICs offer compound interest.
• Escalating-rate GIC The interest rate for these GICs increases over the GIC’s term
• Laddered GIC* The investment for these GICs is evenly divided into multiple-term lengths. As each portion matures, it can be reinvested or redeemed. This diversification of terms reduces interest rate risk.
• Instalment GIC An initial lump-sum contribution is made for these GICs, with further minimum contributions made weekly, bi-weekly, or monthly.
• Index-linked GIC These GICs provide the investor with a return that is linked to the direction of a market index, with the hope that a higher market return will generate a higher GIC return than would typically be expected from a standard GIC. The GIC guarantees a return of the initial investment at expiry while providing some exposure to equity markets. They may be indexed to domestic or global indexes or a combination of benchmarks.
• Interest-rate linked GIC These GICs offer interest rates linked to the change in other rates such as the prime rate, the bank’s non-redeemable GIC interest rate, or money market rates.

Question 12

What are fixed-income mutual funds and exchange traded funds?

Answer 12

• The demand for fixed-income mutual funds and exchange-traded funds that specialize in bonds has grown significantly over the past decade. Increased demand is largely due to equity market uncertainty and a low-interestrate environment. These managed products provide investors with easy access to a diversified portfolio of debt securities for both domestic and global markets that would be difficult for individual investors to replicate. They also include other attractive features, such as professional investment management, liquidity, and low investment costs. Fixed-income mutual funds and exchange-traded funds are particularly attractive for investors who have a limited amount of money to invest or who find investing in individual bonds too complex.

Question 13

How does the rating of companies impact the bond price?

Answer 13

• Some media sources publish a single price for the bond, which may be the bid price, the midpoint between the final bid and ask quote for the day, or an estimate based on current interest rate levels. Convertible issues are usually grouped together in a separate listing. In Canada, DBRS, Moody’s Canada Inc. (Moody’s), and the Standard & Poor’s Bond Rating Service (S&P) provide independent rating services for many fixed-income securities. These ratings can help investors assess the quality of their debt holdings and confirm or challenge conclusions based on their own research and experience. Table 6.5 provides an overview of the Moody’s global long-term rating scale. The definitions indicate the general attributes of debt bearing any of these ratings. They do not constitute a comprehensive description of all the characteristics of each category. Similar services in the United States have provided ratings on a ranked scale for many years. Investors closely watch these ratings. Any change in rating, particularly a downgrading, can have a direct impact on the price of the securities involved. From a company’s point of view, a high rating provides benefits such as the ability to set lower coupon rates on issues of new securities. Ratings classify securities from investment grade through to speculative and can be used to compare one company’s ability to meet its debt obligations with those of other companies.