Volume 4 - Fixed Income Flashcards
Fixed-Income Features:
describe the features of a fixed-income security
describe the contents of a bond indenture and contrast affirmative and negative covenants
Fixed-Income Cash Flows and Types:
describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that benefit issuers and investors
describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities
Fixed-Income Issuance and Trading:
describe fixed-income market segments and their issuer and investor participants
describe types of fixed-income indexes
compare primary and secondary fixed-income markets to equity markets
The two main categories of fixed-income instruments are loans and bonds. Loans are private lending contracts, typically between a company and a financial intermediary (e.g., banks). Bonds, also known as fixed-income securities, are issued to and traded by investors.
Issuer:
1. The government and government-related sector:
Supranational organizations
Sovereign (national) governments
Non-sovereign (local) governments
Quasi-government entities
- The private sector:
Corporations
Special purpose entities that issue asset-backed securities
A debt security’s tenor is the time remaining to maturity. For example, a 10-year bond issued 2 years ago has an 8-year tenor. The existence of a maturity date makes debt a temporary source of capital.
Fixed-income instruments with maturities of less than one year are known as money market securities, while those with longer maturities are called capital market securities. Although relatively uncommon, perpetual bonds have no stated maturity.
Perpetual bonds differ from equity because they have contractual cash flows, greater seniority, and no voting rights.
Amortizing bond:
However, other debt instruments (e.g., mortgages), the principal is repaid incrementally as part of the periodic payments rather than as a single lump sum. Bond prices are often quoted as a percentage of par value.
Floating-rate notes (FRNs) have coupon rates that change based on the performance of a market reference rate (MRR) with a spread that reflects the issuer’s creditworthiness.
Contingency Provisions :
Bonds may include contingency provisions, such as embedded call options that allow the issuer to buy back its debt from lenders at a pre-determined price. An embedded put option grants lenders the right to force issuers to repurchase their debt. Another common contingency provision allows investors to convert their debt securities into a fixed number of common shares.
A basic yield measure is the current yield, which is simply the bond’s annual coupon divided by its current price. Another much more commonly-used yield measure is yield to maturity (YTM). This is the internal rate of return that makes the present value of a bond’s future cash flows equal to its current price.
An investor who purchases a bond today at its current price will earn the YTM as an annualized rate of return if the following conditions are met:
- The issuer makes all interest and principal payments as scheduled
- All payments received before maturity are reinvested to earn the YTM
- The bond is purchased today at its current market price and holding it until maturity or sold on the constant yield price trajectory
A government yield curve can be created from the yields on instruments ranging from 1 month to 30 years. A corporate issuer’s yield curve for the same maturities will almost certainly plot above the government yield curve, reflecting the market’s assessment of credit risk.
The curve forms from bonds yields that:
- Are from the same issuer
- Have the same features
At Premium: Price > Par –> Coupon > Yield
Bond Indenture:
The trust deed (or bond indenture) describes the obligations of the bond issuer and the rights of the bondholders. It specifies the principal value, coupon rate, maturity date, covenants, contingency provisions, collateral, credit enhancements and sources of repayment.
The indenture is held by a trustee, he is appointed by the issuer but acts in a fiduciary capacity for bondholders and his duties are mainly administrative (e.g., maintaining records) (unless a default occurs).
The most creditworthy corporate borrowers are typically able to issue unsecured bonds that are backed only by the issuer’s operating cash flows. Investors may require issuers with lower credit quality to issue secured bonds that are backed by collateral, such as liens (claims) on specific assets.
Covenants are legally enforceable contract terms, which may be either affirmative (positive) or negative in nature.
Affirmative covenants are usually administrative in nature, such as commitments to provide regular financial reports to lenders. A pari passu (or “equal footing”) clause ensures that all creditors within the same seniority class are treated equally. Another common affirmative covenant is a cross-default clause, which deems a borrower to be in default on all of its debt obligations if it defaults on any of its issues.
In order words, it prescribes what issuers are required to do.
Negative covenants typically restrict the issuer in areas such as additional debt issuance. A commitment to refrain from issuing new debt with a higher seniority is known as a negative pledge clause. A prohibition on breaching specific levels of certain leverage or solvency ratios is known as an incurrence test.
Fixed-income securities are most commonly structured as bullet bonds, with coupon payments paid at regular intervals and the full face value repaid at maturity.
A fully amortized loan provides equal annuity-like payments that are split between interest and principal. Over time, the interest portion decreases and the principal portion increases. Credit risk decreases as the borrower’s liability is reduced with each payment.
A partially amortized bond amortizes some principal in each of its periodic payments. A balloon payment is made at maturity for any portion of the face value that has was not amortized over the term of the loan, but this is less than the bullet payment that is due when a conventional bond matures.
In a sinking funds arrangement, periodic payments do not include any principal but the borrower agrees to deposit funds into an escrow account according to a schedule. These funds can then be used to return a portion of the bond’s principal prior to maturity.
From the perspective of investors, a sinking fund reduces exposure to credit risk in the same way as amortization, but it creates potential exposure to reinvestment risk if they are required to redeem their bonds early.
A waterfall structure creates multiple classes of investors with different priority claims. This type of tranching is commonly used for mortgage-backed securities.
Bonds with coupon rates linked to an external index are called floating-rate notes (FRNs). Attractive to investors who expect interest rates to rise, although they are exposed to the risk that rates will fall.
Coupon payments on variable rate instruments may be predetermined. Step-up bonds pay coupons that increase periodically based on a set schedule, offeringprotection against rising interest rates and give issuers an incentive to repurchase (call) bonds if interest rates remain stable or fall. This structure is often used for leveraged loans to issuers with relatively low credit quality.
Payment-in-kind (PIK) bonds allow the issuer to pay coupons with more bonds rather than cash. This is an attractive funding option for companies that are uncertain about their future cash flows. Expectation of higher yields (increased credit risk.)
1000 at 10% year 1 : No 10% coupon –> instead increase to 1100 the FV
It is also possible to make a bond’s coupon rate contingent on the occurrence of specific events. Sustainability-linked bonds are a recent innovation that pays a stepped up coupon rate if the issuer fails to meet the environmental performance targets listed in the indenture.
Credit-linked notes have coupon rates that are tied to the issuer’s credit ratings. The coupon rate will increase if the issuer gets downgraded and decrease if the issuer gets upgraded.