Reading 42: Fixed-Income Securities: Defining Elements

Question 1

Describe the terms that are relevant to the conversion provision.

Answer 1

The conversion price is the price per share at which the convertible bond can be converted into shares.

The conversion ratio refers to the number of common shares that each bond can be converted into.

The conversion value is calculated as the current share price multiplied by the conversion ratio.

The conversion premium equals the difference between the convertible bond’s price and the conversion value.

Conversion parity occurs if the conversion value equals the convertible bond’s price.

Question 2

List what is included in the bond indenture.

Answer 2

The name of the issuer
The principal value of the bond
The coupon rate
Dates when the interest payments will be made
The maturity date
Funding sources for the interest payments and principal repayments
Collaterals
Covenants
Credit enhancements

Question 3

How is the yield-to-maturity (YTM) calculated?

Answer 3

As the discount rate that equates the present value of a bond’s expected future cash flows until maturity to its current price.

Question 4

Identify the exercise styles available for callable bonds.

Answer 4

American calls (also known as continuously callable) can be called by the issuer at any time starting on the first call date.

European calls can only be called by the issuer on the call date.

Bermuda-style calls can be called by the issuer on specified dates following the call protection period. These dates usually coincide with coupon payment dates.

Question 5

Name the sources for how nonsovereign government debt is usually repaid.

Answer 5

The general taxing authority of the issuer.

Cash flows from the project that the bonds were issued to finance.

Special taxes or fees specifically set up to make interest and principal payments.

Question 6

Describe the 2 components of the coupon rate of a Floating Rate Note (FRN).

Answer 6

The spread is typically fixed and expressed in basis points (bps). A basis point equals 0.01% so there are 100 bps in 1%. The spread on a FRN is determined at issuance and is based on the issuer’s credit rating at issuance. The higher the issuer’s creditworthiness, the lower the spread.

The reference rate resets periodically based on market conditions. As the reference rate changes, the effective coupon rate on the FRN also changes.

Question 7

Describe what happens when a call provision is added to a bond issue.

Answer 7

It usually gives the issuer the option to repurchase bonds before maturity at the lowest of (1) market price, (2) par, and (3) a specified sinking fund price. The issuer is generally allowed to repurchase only a small portion of the bond issue, but it may sometimes make use of a doubling option (if available) to repurchase double the required number of bonds.

Question 8

List the types of collateral backing for bonds.

Answer 8

Collateral trust bonds

Equipment trust certificates

Mortgage-backed securities

Covered bonds

Question 9

Name the types of internal and external credit enhancements.

Answer 9

Internal Credit Enhancements:
Subordination
Overcollateralization
Excess spread

External Credit Enhancements:
Surety bonds
Letters of credit

Question 10

Explain the rights putable bonds give bondholders.

Answer 10

The right to sell (or put) the bond back to the issuer at a pre-determined price on specified dates. The embedded put option offers bondholders protection against an increase in interest rates. They can sell the bond back to the issuer at a pre-specified price and then reinvest the principal at current rates that are higher.

Question 11

Describe the following bonds:

1. Domestic Bonds
2. Foreign Bonds
3. Eurobonds
4. Global Bonds

Answer 11

Domestic: Issued by entities that are incorporated in that country

Foreign: Issued by entities that are incorporated in another country

Eurobonds:
Bearer bonds that are unsecured and underwritten by an international syndicate
Less regulated than domestic and foreign
Don’t fall under the jurisdiction of any single country

Global:
Issued simultaneously in the Eurobond market and at least one domestic bond market
Ensures there is demand for the issue and that investors are able to participate regardless of location

Question 12

Define bond covenants, give examples of affirmative covenants, and explain negative covenants.

Answer 12

Covenants: Legally enforceable rules agreed upon by the issuer and investors at the time of bond issuance

Affirmative Covenants:
Make timely payments to bondholders
Comply with all laws and regulations
Maintain issuer's current lines of business
Insure and maintain assets and pay taxes

Negative Covenants:
Restrictions placed on the issuer/More costs than affirmative covenants
Can constrain issuer in operating the business
Protect bondholders from dilution of claims, asset withdrawals or substitutions, and inefficient investments

Question 13

Identify the major types of bond issuers.

Answer 13

Supranational organizations
Sovereign (national) governments
Nonsovereign (local) governments
Quasi-government entities, agencies owned or sponsored by governments
Companies or corporate issuers, which include financial issuers

Question 14

List the basic features of a bond.

Answer 14

The issuer of the bond
The maturity of the bond
The par value of the bond
The coupon rate offered on the bond and coupon payment frequency
The currency in which bond payments will be made to investors