Part 12. Fixed Income Securities: Defining Elements

Question 1

Fixed Income Securities

Answer 1

1. Most common type is a bond = this promises to make a series of interest payments in fixed amount =, and repay principle amount in maturity.
   - market IR (bond yield) increase, value of bond decreases as PV of bond promised cash flows decrease when higher discount rate is used.
2. Bond are rated based on their relative probability of default (failure to make promised payments).
   - investors prefer bonds with lower probability of default, bonds with lower credit quality must offer investors higher yields to compensate greater probability of default
   - all other things equal, a decrease in bond rating (rise in probability of default) will decrease price of bond, increasing yield.

Question 2

Features of FI security include:

Answer 2

1. The issuer of bond
2. The maturity date of the bond
3. The par value (principle value to be repaid).
4. Coupon rate and frequency
5. Currency in which payments will be made

Question 3

Issuers of bonds

Answer 3

• Corporations
• Sovereign national government (e.g. US Treasury)
• Non-sovereign governments (e.g. State of California)
• Quasi-government entities - not direct obligation of countries gov/CB (e.g. Fannie Mae)
• Supranational entities - global organisations (e.g. World Bank, European Investment Bank, IMF)

Question 4

Bond maturity

Answer 4

• The maturity date is the date which the principal is to be repaid.
• term to maturity/tenor = the time remaining until maturity
• perpetual bonds = bonds with no maturity date, making periodic interest payments, but do not promise to repay principle amount.
• money market securities = bonds with original maturities of one year or less.
• capital market securities = bonds with original maturities of more than one year.

Question 5

Par value

Answer 5

The principle amount that will be repaid at maturity, referred to as face value, maturity value, redemption value or principle value of bond.

e.g. bond with par value of $1000 quoted at 98 is selling for $980.

premium to par = a bond selling for more than its par value
discount to par = a bond selling for less than its par value
trading at par = a bond selling for exactly its par value

Question 6

Coupon payments

Answer 6

• coupon rate = the annual percentage of its par value that will be paid to bondholders, with coupon interest payments being annual, semi-annual, quarterly or monthly.
  e. g. $1,000 par value semi annual-pay bond with 5% coupon would pay 2.5% of $1,000 or $25 every 6 months.

plain vanilla/conventional bond = a bond with fixed coupon.

zero coupon/pure discount bonds = bonds pay no interest prior to maturity.
pure discount = refers to bonds sold at discount to their par value, and interest is all paid at maturity when bondholders receive the par value.

e.g. 10 year, $1,000 zero-coupon bond yielding 7% would sell about $500 initially, and pay $1,000 maturity.

Question 7

Currencies

Answer 7

• sometimes borrowers from countries with volatile currencies issue bonds denominated in euros or US dollars to make the more attractive to a wide range of investors.
• dual currency bond = makes coupon interest payments in one currency and principal repayment at maturity in another currency.
• currency option bond = gives bondholders a choice of which 2 currencies they would like to receive their payments in.

Question 8

Bond indenture (trust deed)

Answer 8

• the legal contract between bond issuer (borrower) and bondholders (lenders).
• indenture defines obligations of and restrictions on borrower and forms basis for all future transactions between bond holder and issuer.
• covenants = the provisions in the bond indenture.

Question 9

Negative covenants

Answer 9

• prohibitions on the borrower
• this includes restrictions on asset sales, negative pledge of collateral (co. cant claim same assets back several debt issues simultaneously), restrictions on additional borrowings (co. can’t borrow additional money unless certain financial conditions are met).
• serve to protect interest of bondholders and prevent issuing firm from taking actions that would increase the risk of default.
• covenants must not be so restrictive that they prevent firm from taking advantage of opportunities arise or responding appropriately to changing business circumstances.

Question 10

Affirmative covenants

Answer 10

• they do not typically restrict operating decisions of the issuer.
• they make timely interest and principal payments to bondholders, to insure and maintain assets and to comply with applicable laws and regulations.

Question 11

Types of bonds

Answer 11

domestic bonds - bonds issued by a firm domiciled in country, and also traded in country’s currency.

foreign bonds - bonds issued by a firm incorporated in foreign currency trade on national bond market of another country in that country’s currency.

panda bonds - bonds issued by foreign firms trade in China and denominated in yuan.

yankee bonds - bonds issued by foreign firms outside US that trade in US and denominated in US dollars.

Question 12

Eurobonds

Answer 12

These are issued outside jurisdiction of any one country and denominated in currency different from currency of the countries in which they are sold.

• subject to less regulation than domestic bonds in most jurisdictions, introduced initially to avoid US regulation.
  e. g. bond issued by Chinese firm that is denominated in yen, and traded in markets outside of Japan.

global bonds = Eurobonds that trade in national bond market of country other than country that issues the currency bond is denominated in and in the Eurobond market.

e.g. Euro dollar bonds are denominated in US dollars.

• ownership of bearer bonds = possessing the bonds, more attractive to those seeking to avoid taxes.
• ownership of registered bonds = bond is recorded

Question 13

Other issues arising in trust deed:

Answer 13

• legal info about entity issuing bond
• any assets pledged to support repayment of bond
• any add. features that increase probability of repayment (credit enhancements)
• covenants describing any actions firm must take and any actions firm is prohibited from taking.

Question 14

Issuing entities

Answer 14

• bondholders must pay attention to specific entity issuing the bonds as the credit quality can differ among related entities.

special purpose entities/vehicles (SPE/Vs) = entity created solely for purpose of owning specific assets and issuing bonds to provide funds to purchase asset, where bonds issued by these entities are securitised bonds.

e.g. firm sell loans made to client to an SPE issues bonds to purchase loans, where interest and principal payments on loans are used to make interest and principal payments on bonds.

bankruptcy remote vehicles = SPE can issue bonds at lower IR than bonds issued by originating corporation, as assets supporting bonds are owned by SPE and used to make payments to holders of securitised bonds even if company itself runs into financial trouble.

Question 15

Sources of repayment

Answer 15

• Corporations = from cash generated by firms operations.
• Non-sovereign governments (e.g. State of California) = repaid by general tax, revenues of specific project (i.e. airport) or special taxes or fees dedicated to bond repayment (i.e. water/sewer district)
• securitised bonds = repaid from cash flows of financial assets owned by SPE.

Question 16

Collateral

Answer 16

• unsecured bond = claim to overall assets and cash flows of issuer.
• secured bond = backed by claim to specific assets of corporation, reducing their risk of default and yield investors required on bonds.
• 2 different issued have different priority in event of bankruptcy or liquidation of issuing entity, where claim of senior unsecured debt is below that of secured but ahead of subordinated/junior debt.
• collateral = assets pledged to support a bond issue (or any loan).
• equipment trust certificates = debt securities backed by equipment such as railroad car and oil drilling rigs.
• collateral trust bonds = backed by financial assets, such as stocks and other bonds.
• debentures = unsecured debt in US and elsewhere in GB and some other countries the term refers to bonds collateralised by specific assets.
• Mortgaged backed security (MBS) = most common type of securitised bond, where underlying assets are a pool of mortgages, and interest and principal payments from mortgages are used to pay interest and principal on MBS.
• covered bonds = similar to asset backed securities, but underlying assets (cover pool) although segregated, remain on BS of issuing corporation (i.e. no SPE created).
• protected by special legislation in cover pool in event of insolvency, covered bond provides resource to issuing firm must replace/augment non-performing assets in cover pool, so provides for the payment of covered bonds, promised interest and principal payments.

Question 17

Credit enhancement

Answer 17

• this can be either internal (built into structure of bond issue) or external (provided by 3rd party).

methods of internal credit enhancement:

1. overcollateralisation
   - collateral pledged has value greater than the par value of debt issued, but limitation is additional collateral is also the underlying assets, so when asset defaults are high, the value of excess collateral declines.
2. cash reserve fund
   - cash set aside to makeup for credit losses on underlying assets
3. excess spread account
   - the yield promised on bonds issued less than promised yield on assets supporting ABS, giving some protection if yield on financial assets is less than anticipated.
   - if assets perform as anticipated, the excess cash flow from collateral can be used to retire (pay off principal on) some of the outstanding bonds.
4. tranches
   - divide bond issue with different seniority of claims.
   - any losses due to poor performance of assets supporting securitised bond are first absorbed by bonds with lowest seniority, then next lowest priority of claims.

• senior tranches can receive very high credit ratings as probability is very low that losses will be so large they cannot be absorbed by subordinated tranches.
• subordinate tranches must have higher yield to compensate investors for add. default risk = water fall structure

Question 18

External credit enhancement

Answer 18

• surety bonds = issued by insurance companies and a promise to make up any shortfall in cash available to service debt.
• bank guarantees = serve the same function.
• letter of credit = a promise to lend money to issuing entity if it does not have enough cash to make promised payments on covered debt.

ALL 3:

• increase credit quality of debt issues
• decrease yield of debt issues
• deterioration of credit quality of guarantor will also reduce credit quality of covered issue.

Question 19

Taxation of bond income

Answer 19

• when bondholders sells coupon bond to maturity, there will be a gain or loss relative to its purchase price.
• gains or losses are considered capital gains income - taxed at a lower rate to ordinary income, or even lower if its LT capital gains.

original issue discount bonds (OID) = pure discount bonds and other bonds sold at significant discounts to par when issued, as gains over bonds tenor as price moves to par value, the interest income bonds generate a tax liability even when no cash interest payment has been made.

• tax allows tax basis of OID bonds increased each year by amount of interest income recognised, so no add. capital gains tax liability at maturity.
• some jurisdictions allow part of premium to be used to reduce taxable portion of coupon interest payments.

Question 20

Sinking fund provisions

Answer 20

This provides for repayment of principal through a series of payments over the life of the issue.

e. g. 20 year issue with face amount of $300m may require that issuer retire $20m of the principal every year beginning in 6th year.
- price is typically par, but if market price is less than sinking fund redemption price issuer can satisfy provision by buying bonds in open market with par value = amount of bonds must be redeemed.

Question 21

Pros and cons of sinking fund provisions

Answer 21

Pros:

• less credit risk as periodic redemptions reduce total amount of principal to be repaid at maturity.

Cons:

• in case where IR fall since bond issuance, bonds are trading at price above sink fund redemption price; causing bond trustee select outstanding bonds for redemption randomly.
• this means bonds have more reinvestment risk as holders who have bonds redeemed can only reinvest in funds at lower yields will suffer at a loss.

Question 22

Floating rate notes

Answer 22

• bonds pay periodic interest depends on current market rate of interest, with market rate of interest referred to as reference rate.
• promise to pay reference rate plus some interest margin, expressed in basis points, 100th of 1% (i.e. 120 bp = 1.2%).
  e. g. LIBOR plus margin of 0.75% annually, if 1yr LIBOR is 2.3% at beginning of year, bond will pay 2.3% + 0.75% = 3.05% of par value at end of year.
• most floaters pay on quarterly (90 day) reference rate.
• cap = benefits issuer by placing limit on how high the coupon rate can rise.
• floor = benefits bondholders placing minimum on coupon rate (regardless of how low RR falls)
• inverse floater = coupon rate increases when RR decreases and vice versa.

Question 23

Step up coupon bonds

Answer 23

• structured so coupon rate increases over time according to predetermined schedule.
• call feature = allows firms to redeem the bond issue at set price at each step up date, so if new higher coupon rate > market yield at call price, firm will call bonds and retire them.
• yield could increase as issuer credit rating has fallen, so higher step up coupon rate compensates investors for greater credit risk.
• considered as protection against increase in market IR to extent offset by rise in bond coupon rates.

Question 24

Credit linked coupon bond

Answer 24

• carries provision that coupon rate will go up by certain amount if credit rating of issuer falls and go down if credit rating of issuer improves.
• offers some protection against credit downgrade, higher required CP may increase probability of default.

Question 25

Payment-in-kind bond

Answer 25

• This allows issuer to make coupon payments by increasing principal amount of outstanding bonds, so paying bond interest with more bonds.
• firms issue as they anticipate firm cash flows may be less than required to service debt, due to high levels of debt financing.
• bonds have higher yields as lower perceived credit quality from cash flow shortfalls due to high leverage of issuing firm.

Question 26

Deferred/split coupon bond

Answer 26

• issued by firms that anticipate cash flows will increase in future to allow them to make coupon interest payments.
• appropriate financing for firm financing large project that will not be completed, and generating revenue for some period of time after bond issuance.
• may offer some tax advantages.
• zero coupon bond can be considered to be a deferred bond.

Question 27

Index linked bond

Answer 27

• coupon payments and/or principal value based on commodity index, equity index and other published index number.
  e. g. inflation linked bonds - most common type, with payments based on change in inflation index such as CPI in US.

principal protected bonds = index bonds will not pay less than original par value at maturity even when index has decreased.

Question 28

Different structures of inflation linked bonds

Answer 28

Index-annuity bonds = full amortizing bonds with periodic payments directly adjusted for inflation or deflation.

Index zero-coupon bonds = payment at maturity adjusted for inflation.

Interest-indexed bonds = coupon rate adjusted for inflation while principal value remains unchanged.

Capital-indexed bonds = most common, US Treasury Inflation Protected Securities (TIPS), coupon rate remains constant, and principal value of bonds is increased by rate of inflation (decreased by deflation).

Question 29

Contingency provision

Answer 29

A contract describes an action that may be taken if an event actually occurs, where in bind indentures its referred to as embedded options.

Straight/option free = bonds with no contingency provisions.

Question 30

Call option

Answer 30

This gives issuer the right to redeem all or part of bond issue at specific price (call price) if they choose to.

e.g. consider 6% 20yr bond issued at par on June 1, 2012, indenture includes call schedule:

• bonds redeemed by issuer at 102% (call price, with call premium at 2%) of par after June 1, 2017 (first call date)
• bonds redeemed by issuer at 101% of par after June 1, 2020 (call price declines)
• bonds redeemed by issuer at 100% of par after June 1, 2022 (first par call date - callable)
• for 5 year period, from issue date there is a lockout period, where call is protected.
• call price puts upper limit on value of bond in market
• a value to issuer as gives them the right redeem bond and issue new bond if market yield on bond decline, from IR decrease or credit quality increase (higher default risk).

Question 31

3 styles of exercise

Answer 31

1. American - bonds can be called anytime after first call date.
2. European - bonds can only be called on call date specified.
3. Bermuda - bonds can be called on specified dates after first call date, often on coupon payment dates.

Question 32

3 styles of exercise

Answer 32

1. American - bonds can be called anytime after first call date.
2. European - bonds can only be called on call date specified.
3. Bermuda - bonds can be called on specified dates after first call date, often on coupon payment dates.

Question 33

Make-whole call provisions

Answer 33

• to avoid high IR required on callable bonds but still preserve that option to redeem bonds early when corporate/operating events require it.
• call price is not fixed, but includes lump-sum payment based on PV of future coupons the bondholder will not receive if bond is called early.
• the calculated call price is unlikely lower than MV of bond, so issuer is unlikely to call bond except when corporate circumstances such as acquisition or restructuring require it.
• does not put upper limit on bond values when IR fall.
• it penalises issuer for calling bond, with net effect that bond can be called if necessary, but also issued at lower yield than bond with traditional call provision.

Question 34

Put option

Answer 34

This gives bondholder the right to sell the bond back to issuing company at prespecified price, typically par.

• exercise this when fair value of bond < put price, as IR have risen or credit quality of issuer has fallen.
• is of value to bondholder as choice of whether to exercise option is the holder; so will sell at higher price (offer lower yield) compared to identical option free bond.

Question 34

Put option

Answer 34

This gives bondholder the right to sell the bond back to issuing company at prespecified price, typically par.

• exercise this when fair value of bond < put price, as IR have risen or credit quality of issuer has fallen.
• is of value to bondholder as choice of whether to exercise option is the holder; so will sell at higher price (offer lower yield) compared to identical option free bond.

Question 34

Put option

Answer 34

This gives bondholder the right to sell the bond back to issuing company at prespecified price, typically par.

• exercise this when fair value of bond < put price, as IR have risen or credit quality of issuer has fallen.
• is of value to bondholder as choice of whether to exercise option is the holder; so will sell at higher price (offer lower yield) compared to identical option free bond.

Question 35

Convertible bonds

Answer 35

This is issued with maturities of 5-10 years, give bondholders the option to exchange the bond for specific number of shares of issuing corporation common stock.

• allows for bondholders to profit from increase value in shares.
• regardless of price of shares, bond will be at least equal to its bond value without conversion option.
• value of conversion option means bonds can be issued with lower yields.

hybrid security = part debt and part equity; as owner of bond has downside protection of bond but reduced yield and upside opportunity of equity shares.

Question 36

Advantages of issuing bonds

Answer 36

• low yield (interest cost)
• debt financing is converted to equity financing

terms:

conversion price = price per share at which bond (par value) may be converted to common stock.

conversion ratio = equal to par value of bond divided by conversion prices, if bond with $1,000 par value has conversion price of $40, the conversion ratio is 1,000/40 = 25 shares per bond.

conversion value = MV of shares would be received upon conversion, bond with ratio of 25 shares when current market price of common share is $50 would have conversion value of 25 x 50 = $1,250.

• call price less than conversion value of shares by exercising call provision, the issuers can force bondholders to exercise conversion option when CV is significantly above par value.

Question 37

Warrants

Answer 37

They give holders the right to buy the firms bonds when issued.

e. g. warrant for share worth $40 provide profits if common shares increase in value above $40 prior to expiration of warrants.
- sweetener for making debt more attractive to investors as adds potential upside profits if common shares increase in value.

Question 38

Contingent convertible bonds

Answer 38

• Bonds that convert from debt to common equity automatically if specific event occurs, where banks must maintain a specific level of equity financing.
• if banks equity falls below required level, they must raise more equity financing to comply with regulations.
• often structured that if bank equity capital falls below given level, automatically converted to common stock.
• the effect is decreasing banks debt liabilities, and increasing equity capital at same time, helping banks meet minimum equity requirement.