(R42) Fixed Income Securities: Defining Elements

Question 1

Basic Features of a Fixed Income Security

Answer 1

Issuers, maturity, Par value, coupon rate/frequency, currency,

Question 2

Main issuers of fixed income securities

Answer 2

• Supranational organizations
• government (sovereign and non-sovereign)
• corporate

Sovereign is federal level and non-sovereign is at state level

Question 3

Maturity vs. Term to maturity

Answer 3

Maturity - date when principal is due (maturity date)

Term to maturity (tenor) - time remaining to maturity

Question 4

Money market vs capital market securities

Answer 4

original maturity <1 year vs. original maturity >1 year

Question 5

Describe relationship between bond price and YTM

Answer 5

Bond price and the yield to maturity are inversely related.

Question 6

Discount vs. Premium Bond

Answer 6

Discount is a bond that is selling for less than its par value; premium is selling for more than par

Question 7

Coupon rate

Answer 7

Annual percentage of par value that will be paid to bondholders (zero coupon is a discount bond with no coupon). Coupon rate x par value

Question 8

What are credit enhancements? What is the difference between internal and external credit enhancements?

Answer 8

These reduce the credit risk of a bond; Internal includes subordination/credit trenching, overcollateralization, excess spread; External includes surety bonds and letter of credit

Question 9

What is a covenant?

Answer 9

Covenants are provisions of a bond indenture that protect the bondholders’ interests. These are legally enforceable rules

Question 10

Affirmative covenants

Answer 10

Affirmative covenants are administrative actions the issuer must perform, such as making the interest and principal payments on time; comply with all laws and regulations, pay taxes

Question 11

Negative covenants

Answer 11

Negative covenants are restrictions on a bond issuer’s operating decisions. What an issuer will not do.

Example: prohibiting the issuer from issuing additional debt or selling the assets pledged as collateral; restrictions on debt such as max debt ratios and/or minimum interest coverage ratios; restrictions on prior claims; restrictions on asset disposal; restrictions on investments

The purpose is to protect bondholders

Question 12

Dual Currency Bond

Answer 12

Coupon in one currency and payment in another

Question 13

Define bond indenture and the three main items to be included

Answer 13

A bond indenture is a legally binding contract between bond issuer and bondholder. Bond indenture must include: Form of bond, Obligations of issuer, and rights of bondholders

Question 14

Secured vs. Unsecured bonds

Answer 14

Secured: backed by a claim to specific assets of a corporation, which reduces the risk of default, and consequently, the yield that investors require on the bonds. Unsecured: represent a claim to the overall assets and cash flows to the issuer. Secured bonds are paid first

Question 15

Zero coupon bond

Answer 15

No coupon or interest payments and sold at a discount

Question 16

Coupon rate and YTM relationship for premium and discount bonds

Answer 16

Premium bond: coupon rate > YTM

Discount bond: coupon rate < YTM

Question 17

Define a bond with a bullet structure

Answer 17

Pays coupon interest periodically and the principal all at maturity (this is the most common type of cash flow structure). Aka plain vanilla

Question 18

Define a bond with a fully amortizing structure

Answer 18

Equal periodic payments of interest and principal where the principal is reduced to zero by maturity (i.e. paying car loan or personal loan)

Question 19

Define a bond with a partially amortizing structure

Answer 19

Mix of bullet structure and fully amortizing that calls for period payments of interest and principal but a balloon payment is needed at maturity to reduce principal to zero

Question 20

Define a bond with a sinking fund arrangement

Answer 20

Some % of bond is put aside each year to make payments.

Question 21

Fixed rate bond vs. floating rate bond

Answer 21

Floating-rate notes have coupon rates that adjust based on a reference rate such as Libor. There is very little volatility since coupons are reset at market rates on each coupon date. There is higher coupon volatility. With this you get uncertain cash flows. May have a cap and floor rate

Fixed coupon (conventional bond): you will get certain cash flows and more price volatility

Question 22

Callable Bonds

Answer 22

Issuer has the right to redeem (call) all or part of the bond before maturity. Benefits the issuer because the issuer can call the bond back if there is a decline in interest rate (Higher coupon or lower price)

Question 23

Domestic vs. Foreign vs. Eurobond

Answer 23

Domestic: Issuer, country, and currency all match
Foreign: country and currency match, issuer does not
Eurobond: issued outside jurisdiction of any country

Question 24

Putable Bonds

Answer 24

Allows the bondholder to sell bonds back to the issuer at a specified put price. Benefits bondholder because it protects the holder against a rise in rates. (Lower yield or higher prices

Question 25

Conversion Bonds

Answer 25

Conversion options allow the bondholder to exchange bonds for a specified number of shares of the issuer’s common stock; Lower yield or higher price; Issuer pays lower interest, plus may avoid principal repayment

Question 26

Step-up coupon bonds

Answer 26

Coupon increases over time

Question 27

Credit-linked coupon bonds

Answer 27

Coupon increases/decreases when bond’s credit rating decreases/increases.

Question 28

Payment-in-kind bonds

Answer 28

Interest paid with more amounts of the bond (or with common shares)

Question 29

Deferred coupon bonds

Answer 29

No coupon payments for the first few years

Question 30

Index-linked bonds

Answer 30

Coupons are linked to some index