unit 6 | fixed income securities: features & types

Question 1

What does fixed income include?

Answer 1

Bonds, debentures, mortgages, swaps, & preferred shares

Question 2

What are fixed income?

Answer 2

Fixed stream of cash flows
- Coupon payments over time
- Principal repayment at maturity

Question 3

Can fixed income change?

Answer 3

Yes: In some cases the “fixed” stream is variable
- Eg. “fixed” at a bank’s prime rate

Question 4

Define bonds

Answer 4

Bonds are secured by specific assets
- In the event of default, the bondholder can seize the collateral

Question 5

Define debentures

Answer 5

Debentures are unsecured
- There is no collateral beyond the general income & assets of the borrower

Question 6

What is the difference between bonds & debentures?

Answer 6

No big difference, the terms are used interchangeably

Question 7

Bond Terms

Answer 7

Bond terms are described in a Bond Trust → outlines the legal rights of the borrower (eg. the company) & the lender (eg. the investor)
- Dates of amount coupon payments
- Date of principal repayment
- Covenants (restrictions)

Question 8

Basic Bond Prices

Answer 8

Based on par or face value of $100 (or $1000)
- Eg. Price per $100 of face value of the bond

Question 9

Premium Bond Prices

Answer 9

Pay $104 for $100 of face value

Question 10

Discount Bond Prices

Answer 10

Pay $96 for $100 of face value

Question 11

Discount Bonds

Answer 11

Some bonds do not include a coupon payment
→ Instead sold at a discount (eg. “below par”) & investors earn the difference between the price & face value at maturity
- Eg. price is $90 per $100 of face value, the investor earns $10

Question 12

What are bond price changes considered as?

Answer 12

Price changes are considered interest income for tax purposes → Not capital gains
- Bond prices are calculated based on TVM

Question 13

Time frames for bonds

Answer 13

Short-term bonds mature in 1-5 years
Medium-term bonds mature in 5-10 years
Long-term bonds mature in over 10 years

Question 14

What are liquid bonds

Answer 14

Liquid bonds trade with large volume

(Liquid → lots of buyers & sellers → volume)

Question 15

Marketable bonds

Answer 15

Marketable bonds have an existing market
→ “On-the-run” bonds are newly issued
→ “Off-the-run” bonds are older, no longer “new”

Question 16

Bond Market vs Equity Market

Answer 16

• The bond market is bigger than the equity market, as measured by $ traded
• There are many more bonds than stocks, so each bond is less liquid (lots of bonds (not as many buyers & sellers for each individual bond) per stock)

Question 17

Bond Coupon Rates

Answer 17

A bond’s coupon rate can be either “floating” or “fixed”

Question 18

Floating Bond Coupon Rates

Answer 18

Adjusts periodically → resetting every 90-days to the government 90-day T-bill yield

Question 19

Fixed Bond Coupon Rates

Answer 19

Never adjusts, the coupon rate is the same for the entire life of the bond

Question 20

Can bond maturity change?

Answer 20

Bonds have a maturity date, but the maturity date can be modified by terms of the bond…

Question 21

Callable bonds

Answer 21

Callable bonds can be “called” or repurchased by the issuer before the maturity date
- If interest rates decline after bond issuance, issuer may call back the bond & re-issue for a lower interest rate to save money

Question 22

Retractable bonds

Answer 22

Retractable bonds can be “put” back to the issuer (bondholders force the repurchase)
- Sold back before maturity

Question 23

Planned Repurchases

Answer 23

Some bonds require the issuer to repurchase portions of the bond issue over time

Question 24

Sinking Fund

Answer 24

Requires the issuer to buy back the bonds over time (not waiting until the lump sum at maturity) → pay the bondholder in portions before it fully matures to help issuer manage debt load

Question 25

Purchase Fund

Answer 25

Requires the issuer to buy back the bonds over time as long as the bonds are priced below par → to allow issuer take advantage of returning the bond capital back to investor at a lower price

Question 26

Convertible Bonds

Answer 26

Some bonds contain a provision that allows the bond to be converted to shares of the issuer
- The bond contains a “call option” on the issuing company’s shares (eg. $1000 of face value can purchase 10 shares)
- Buy option for the inverter to buy shares
- Often used by less credit-worth companies, to give investors some potential upside

Question 27

Protective Provisions

Answer 27

Also known as “covenants” → these provisions restrict the borrower’s behavior
- Limits to total debt allowed
- Limits to debt/interest as a proportion of revenue/EBITDA/Income
- EBIT/Interest = interest coverage → 3x (at minimum) → covenant → or else pay back immediately

Question 28

What happens when a covenant is violated?

Answer 28

Violating a covenant can lead to “technical default” even though the borrower may not miss an interest or principal payment

Question 29

Government Bonds

Answer 29

Often termed “Treasury” Bonds (esp US Gov’t), or referred by the name of the issuing country or a nickname

Question 30

Government Bonds names for different countries

Answer 30

Canadian government bonds: “Canada’s”
German government bonds: “Bunds”
UK government bonds: “Gilts”

Question 31

Types of Government Bonds

Answer 31

Treasury Bills
→ Short-term discount bonds
Marketable Bonds (ie. Treasury Bonds)
→ Medium & Long-term bonds with coupon payments
Government bonds are considered “risk-free”
→ Hope they are risk free from bankruptcy

Question 32

Real Return Bonds

Answer 32

Some governments bonds adjust their return to based on the rate of inflation
- Canada: the face value for coupon & principal payments is adjusted each year based on inflation
→ Eg. $100 of face value may be $110 of face value at maturity

Question 33

How can real return bonds be used?

Answer 33

Real Return Bonds can be used to discover the market’s inflation expectations
→ Comparing Real Return yields to Treasury Bond yields

Question 34

Corporate Bonds

Answer 34

Corporations issue many forms of bonds:
- Mortgage Bonds have a specific asset as collateral
- First Mortgage have the 1st claim to the assets
→ 2nd Mortgage bonds are paid after all 1st Mortgage bonds are repaid
- Collateral Trust (financial collateral)
- Equipment trust (equipment collateral)

Question 35

Corporate Debentures

Answer 35

• Corporations also issue unsecured debt
  
  • Credit rating/worthiness is based on the company’s cash flow & “unencumbered” assets (not pledged, not used as collateral for security)
• Subordinated debentures are ranked behind other forms of debt (eg. only repaid after non-sub-ordinated debt)
• Corporate bonds & debentures can be floating or fixed rate
  
  • Corporate bond → more risk more return

Question 36

Short-term Corporate Borrowing

Answer 36

• Corporations can borrow for short-periods of time by issuing Commercial paper
  → Similar to Treasury Bills
• If a corporation’s Commercial Paper is guaranteed by a bank, it becomes a Banker’s Acceptance
  → The Commercial Paper now has 2 companies responsible for repayment

Commercial paper → short term borrowing → if you (company) can’t issue → means they can’t pay their employees (no cash) → important

Question 37

Strip Bonds

Answer 37

Strip bonds are created by “stripping” a bands of its coupon payments to create a series of discount bonds
- “Interest Only” components consists of the coupon payments
→ Each individual coupon can become its own discount bond
- “Principal Only” component consists of the principal repayment

Question 38

Quasi Fixed Income

Answer 38

• Fixed Income is often thought of as traded security (bonds, debentures)
• Individual retail investors may not be able to purchased fixed income products directly
• Retail investors may, however, invest in Term Deposits & GICs offered by banks