Reading 51 LOS's

Question 1

LOS 51a: Describe the basic features of a fixed-income security

Answer 1

Issuers:

• Supranational organizations ( world bank, IMF)
• Sovereign (national) Governments ( United States)
• Nonsovereign (local) Governments ( New York state)
• Quasi-Government entities ( the postal service)
• Companies or corporate issuers ( financial- banks, and nonfinancial- pharmaceuticals)

Maturity

• maturity date of a bond refers to the date on which the issuer has promised to repay the entire principal of the bond. Term to maturity refers to how much time is left in the bond
• Those that mature in 1 year or less are called money market securities
• Those that mature in 1 year or more are called capital market securities
• Those with not stated maturity are called perpetual bonds

Par Value

• is the price the issuer promises to repay bondholders on the maturity date
• when bond’s price is above 100% of par, it is said to be trading at a premium
• when bond’s price is at 100% of par, its trading at par
• When bond’s price is below 100% of par, it is trading at a discount

Coupon Rate and Frequency

• the coupon rate is the annual interest rate that the issuer promises to pay bondholders until the bond matures.
• The coupon is the amount of interest paid out in a year. For different frequencies of coupons, the coupon must be divided accordingly
• there are some bonds that don’t issue coupons called zero-coupon bonds. These bonds are issued at a discount, which effectively is a built in interest rate

Currency Denomination

• bonds are issued in many different currencies around the world. To attract domestic investors, local currency is used, but to attract foreign investors other currencies can be used.
• Dual currency bonds make coupon payments in one currency and then the principal in another. Currency option bonds give the holders the choice of what currency they want for either principal or coupon

Yield Measures

• Current yield or running yield equals the bond’s annual coupon amount divided by its current price, expressed as a percentage
• Yield to Maturity or yield to redemtion is calculated as the discount rate that equates the present value of a bond’s expected future cash flows until maturity to its current price. YTM is inversely related to bond’s price
  *

Question 2

LOS 51b: Describe the functions of a bond indenture

Answer 2

The bond indenture describes the form of the bond, obligations of the issuer, and rights of the bondholder and captures the following:

• the name of the issuer
  
  • For sovereign the legal issuer is usually an institution responsible for managing national budget ( US Treasury)
  • Corporate bonds can be issued by parent or subsidiary
  • securitize bonds have a seperate legal entity created ( Special Purpose Entity in US, Special Purpose Vehicle in Europe). SPE’s are banruptcy-remote vehicles in that once the loans are passed on to the SPE the sponsor is no longer legally liable.
• 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
  
  • Bonds issued by supranational are paid by either pre exisiting loans or by the capital of the members
  • Sovereign bonds are backed by the “full faith and credit” of the national government
  • Nonsovereign government debt can usually be paid through taxes or cash flow from the project
  • Corporate bonds usually rely on the cash flow-generating ability of the issuer
  • for securitized bonds, repayments depend on the cash flow generated by the underlying pool of financial assets
• collaterals ( assets or financial gurantees underyling the debt obligation above and beyond the issuer’s promise to pay)
  
  • Secured bonds are backed by assets or financial gurantees, while unsecured are not
  • Collateral Trust bonds are secured by securities such as common stock, other bonds, or other financial assets
  • Equipment trust certificated are secured by specific types of equipment
  • Mortgage backed securities (MBS) are backed by a pool of mortgage loans
  • Covered bonds are backed by a segregated pool of assets
• covenants ( actions that the issuer is obligated to perform or prohibited from performing)
• credit enhancements ( provisions designed to reduce the bond’s credit risk)
  
  • Internal credit enhancements focues on the structure of the issue regarding priority of payment
    
    • Subordination - paying back tranches based on senority
    • Overcollaterization - extra is to absorb future loss
    • Excess spread
  • External Credit enhancements refers to guarantees received from a third-party guarantor
    
    • Surety Bonds and Bank gurantees reimburse investors in case of default
    • Letters of credit are lines of credit provided by financial institutions to make up for any shortfalls in payments

Since there are a large number of bondholders, the issuer doesn’t enter an agreement with each one. Instead a trustee is held responsible for making sure the issuer is being comliant and also responsible for calling bondholder meetings when necessary

Question 3

LOS 51c: Compare affirmative and negative covenants and identify examples of each

Answer 3

Affirmative covenants are requirements placed on the issuer. they are typicalls administrative in nature to not lead to extra costs to the issuer, nor to restrict the issuer from doing business

• Make timely payments to bondholders
• Comply with all laws and regulations
• Maintain the issuer’s current lines of business
• Insure and maintain assets
• pay taxes

Negative Covenants are restrictions placed on the issuer. While they may maintain more cost and restrict the issuer more, they protect the bondholders from dilution of their claims, asset withdrawals or substitutions, and inefficient investments by the issuer

• Restrictions on issuing additional debt
• Restricitions on distributions to shareholders
• Restrictions on asset disposals
• Restrictions on speculative or risky investments
• Restrictions on mergers and acquisitions

Question 4

LOS 51d: Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities

Answer 4

Legal and Regulatory Considerations

There are no unified legal or regulatory requirements that apply to bond investors globally, so investors need to understand the laws and regulations that apply

The global bond market consists of national bond markets and Eurobond markets.

National Bond Market includes all the bonds that are issued and traded in a particular country and denominated in that country’s local currency. Bonds issued by entities in the country are called domestic bonds while bonds issued by entities from other countries are called foreign bonds

Eurobonds are issued and traded in the Eurobond Market, and they refer to bonds that are denominated in a currency other than the local currency where they are issued. They can be issued in any country with any currenct and are called by the currency that is used. For example a bond issued in Japan using US dollars is a Eurodollar Bond. Some notes

• Eurobonds are usually unsecured and underwritten by a internation syndicate
• they are less regulated than domestic and foreign bonds as they do not fall under jurisdiction of one country
• Eurobonds are usually bearer bonds (no record of bond ownership is kept by the trustee). Foreign and domestic are usually registered bonds

Global bonds are bonds that are issued simultaneously in the Eurobond market and in at least one domestic market

Tax Considerations

Bondholders must be informed of the tax policies in whatever place they invest in. They will be concerned with interest income tax from coupon payments. Also capital gains tax from selling a bond before maturity at a gain. Also in some countries discounted bonds are taxed on the original issue discount ( the difference between par and the selling price)

Question 5

LOS 51e: Describe how cash flows of fixed-income securities are structured

Answer 5

Principal repayment structures

A bullet bond is one that only makes periodic interest payments, paying the entire principal back at maturity

An ammotizing bond is one that makes periodic interest and principal payments over the term of the bond.

• A fully ammortized bond is one whose outstanding principal amount at maturity is reduced to zero through a fixed periodic payment schedule
• A partially ammortized bond also makes fixed periodic principal repayments, but the principal is not fully repaid by the maturity date. Therefore a balloon payment is required at maturity to repay outstanding principal

Sinking Fund Arrangements requires the issuer to repay a specified portion of the principal amount every year throughout the bond’s life or after a specified date. Sometimes a call provision may also be added to the bond issue, though they are normally only allowed to call a specific portion of the bond. Sinking funds are good to bondholders because they reduce risk but they have the disadvantage of reinvestment risk (not being able to get the same yield when principal is paid back) and with the call options the issuer may be able to call the bond below market value.

Coupon Payment Structures

Floating Rate Notes (FRNS) is made up of 2 components; 1) a reference rate such as LIBOR and 2) a spread. FRNs have less interest rate risk than fixed-rate bonds since the coupon rate is periodically reset to the reference rate. FRNs may have floors or caps to prevent the periodic coupon rate from rising or falling too much. A FRN with both a floor and cap is called a collared FRN. Sometimes the coupon rates can be made to move inversely to the reference rate, these are called reverse FRNs or Inverse Floaters.

Step-up Coupon Bonds are bonds where the periodic coupon rate increases by specified margins at specified dates. Usually issued with callable bonds to protect the bondholders in a rising interest rate environment. As interest rates rise, odds of the bond being called decrease, so these bonds help bondholders get higher interest payments.

Credit-Linked Coupon Bonds coupon rate changes when the bond’s credit rating changes. These protect investors against a decline in the credit quality. A problem here is that a credit downgrade will require higher interest payments, that can lead to further downgrades if the company continues to struggle

Payment in Kind (PIK) Coupon Bonds allow the issuer to pay interest in the form of additional bonds instead of cash. These are normally issued by companies in distress and investors require higher yield on the bonds received as coupon payments

Deferred Coupn Bonds (or Split Coupon Bonds) do not pay any coupon for the first few years of issuance, but then pay a higher coupon than they normally woukld for the remainder of their terms. Issuers that are just starting a company would prefer these bonds. Investors like them because they are normally priced well below par

Index-Linked Bonds coupon payments and/or principal repayments are linked to a specific index. An example is inflation-linked bonds, which offer a long-term asset with a fixed real return that is protected against inflation ( ex. Treasury Inflation Protection Securities or TIPS) . Other examples are:

• Zero-Coupon indexed bonds do not pay any coupon so only principal repayment is linked to an index
• Interest indexed bonds only coupon payments are adjusted to changes in the specified index
• Capital Indexed Bonds pay a fixed coupon rate, but this rate is applied to a principal amount that is adjusted to reflect changes in the specified index
• Index Annuity Bonds are fully ammortized, having both principal and interest payments linked to an index

Question 6

LOS 51f: Describe contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities and identify whether such provisions benefit the borrower or lender

Answer 6

Contingency provision allows for some action given the occurence of a specified even in the future.

1)Callable bonds give the issuer the right to redeem or call all or part of the bond before maturity, allowing the issuer to take advantage of 1) lower interest rates and/or 2) an improvement in creditworthiness. Investors are exposed to reinvestment risk here, as they would have to reinvest proceeds from the call at the lower rates. To make up for this callable bonds are usually sold at a premium. some takeaway formulas:

• Value of callable bond = value of noncallable - value of embedded call option
• Yield on callable bond = yield on non callable bond + Embedded call option costs in terms of yield

Note that the more heavily the embedded call option favors the issuer, the lower the value of the callable bond to the investor and the higher the yield that must be offered by the issuer.

The bond indenture will specify the following:

• Call price- price paid to bondholders when the bond is called
• Call premium- excess over par paid by the issuer to call the bond
• Call schedule- specifies the dates and prices at which the bond may be called.

Some callable bonds will have an initial call protection period during which the issuer is prohibited from calling the bond

A make-whole provision in a callable bond usually requires the issuer to pay a relatively high lump-sum amount to call bonds. The sum equals the present value plus some premium to compensate investors.

American Calls can be called anytime after the first call date

European calls can be called only on the call date

2)Putable Bonds gives the bondholders the right to sell the bond back to the issuer at a pre-determined price on specified dates. The option offers bondholders the protection against an increase in interest rates. Some formulas to consider:

• Value of a putable bond = Value of nonputable + value of embedded call option
• Yield on putable bond + Yield on nonputable bond - Embedded put option cost in terms of yield.

Convertible bond gives the bondholder the right to convert the bond into a pre-specified number of common shares of the issuer. These bonds are attractive to investors because it allows them to benefit from the price appreciation of the issuer’s stock. The advantage to the issuer is that yields on convertible bonds are lower than yields on other bonds, but it does come at the cost of dilution for the existing shareholders.

Some takeaway terms:

• conversion price - price per share at which convertible bonds can be converted to shares
• conversion ratio - refers to the number of common shares that each bond can be converted into
• conversion value- is calculated as current share price multiplied by the conversion ratio
• 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 bonds price

Warrants- a warrant is somewhat similar to a conversion option, but it is not embedded in the bond’s structure. It instead offers the holder the right to purchase the issuer’s stock at a fixed exercise price until the expiration date

Contingent Convertible Bonds (“CoCos) they differ from traditional convertible bonds in 2 ways:

1. Unlike traditional which are convertible at the option of the bondholder, CoCos automatically convert upon the occurrence of a pre-specified event
2. Unlike traditional, in which conversion occurs if the issuer’s share price increases, contingent write-down positions are convertible on the downside.

CoCos would be issued by a bank for protection against core equity falling below minimum levels. If the equity of the bank is falling, these provisions will turn their debt into equity to keep it above the minimum level