Week 7 - Fixed Income Flashcards
What are examples of fixed income?
Bonds, debentures, mortgages swaps, perferred shares
What are some fixed streams of cash flow?
- Coupon payments over time
- Principal repayment at maturity
What is the difference between a bond and a debenture?
Bonds are securited by specific assets.
- In the event of a default, bondholder can seize collateral
Debentures (or debt) are unsecured
- There is no collateral beyond general income and assets of borrower
Where are bond terms described?
In a “Bond Trust” which outlines legal rights of the borrower and lender
What is the YTM percentage in regards to bonds?
It is the overall rate of return the investor gets per year – made up of interest and principle
What is the coupon rate?
The interest payment (depending on when its payable, ex. semi-annually) that is paid to the investor
How does a bond transaction work? Show an example
Investor:
- Gives Gov of Canada money so they can get a bond (ex. $960 is the price of a bond)
Gov of Canada (issuer)
- In return for the money, Gov of Canada gives investor a bond
- Gov of Canada gives two things:
- Interest/coupon (money paid regularly to investor) +
- Gives back amount borrowed, which is paid back to the investor at the end of maturity
What are discount bonds and how do investors earn income from them? What are they considered as for tax purposes?
- Bonds that don’t include a coupon payment.
- They are sold at a discount
- Investors earn the difference between purchase price and face value at maturity (ex. Buy at $90, received $100 at maturity -> $10 earned)
FOR TAX PURPOSES
- Price changes are considered interest income for tax purposes
- NOT capital gains
What are the different time frames bonds are divided into?
- Short-term bonds mature in 1 to 5 years
- Medium term bonds mature in 5 to 10 years
- Long-term bonds mature over 10 years from now
Description of liquid bonds?
- Trade frequently due to high volume
- They are easy to sell die to there being lots of buyers and sellers in the market (liquidity)
What are marketable bonds?
- Have an already active market (people are trading them)
- Opposite would be a private or custom bond with no regular trading
“On-the-run” vs. “Off-the-run” bonds
“On-the-run” bonds:
- The newest issue of a bond
“Off-the-run” bonds:
- Older bonds that were issued before the current one
Why is the bond market considered larger than the equity market?
- More money is traded in bonds than in stocks
- Governments issue bonds but not shares
- There are more individual bond issues than stocks
- Bonds tend to be less liquid than stocks due to this
How can capital be raised and what’s the trade-off with debt?
Capital can be raised through equity or debt
Debt creates fixed obligations:
- Interest payments
- Principal repayments
Must be paid regardless of business performance
What’s the difference between fixed and floating coupon rates?
Floating rate: Adjusts periodically (e.g. every 90 days based on T-bill yield)
Fixed rate: Remains the same for the bond’s entire life
What is a callable bond and how does it affect bond pricing?
- Issuer can repurchase (call) the bond early
- Repurchase price is defined in the bond trust
- Creates a price ceiling for the bond. Example, no one would purchase a bond for $1020 if tomorrow the issuer can pay them back $1010.
- If you pay $1,020 today…
- And tomorrow the issuer decides to call the bond, they’ll only give you $1,010 back.
- You’ve just lost $10 — for no good reason.
What is a retractable bond and how does it affect pricing?
- Investor can force the issuer to repay early
- Acts like a price floor – bond won’t fall below the bond was purchased for.
What is a Sinking Fund?
Issuer must repurchase portions of the bond over time (not waiting until the lump sum at maturity)
- Good for investors because it reduces the chance of default later and creates consistent demand for the bond
What is a Purchase Fund?
Issuer must repurchase bonds only if trading below par (conditional buybacks)
- Gives some price support (if prices drop too much, the company might buy them up)
- Adds a bit of protection against the bond’s price falling too low
What are convertible bonds?
A bond that can be converted into shares of the issuing company instead of being repaid in cash. It includes a call option on the company’s stock.
Why would an investor choose to convert a bond into shares?
If the company’s stock price rises above the conversion value, the investor can make more money by converting the bond into stock instead of being paid back in cash.
Why do companies issue convertible bonds?
- Attract investors when the company has lower creditworthiness
- Offer lower interest rates because of the added stock upside
- It’s a way to raise money without immediately giving up equity
What are protective provisions (covenants) in bonds?
They are estrictions on the borrower’s behavior
Examples:
- Limits on total debt
- Debt/interest coverage ratios
Violating a covenant = technical default (even without missed payments)
What are the key types of government bonds?
- Treasury Bills: Short-term, no coupon, sold at discount
- Marketable Bonds: Medium/long-term bonds with coupons
- Gov. bonds as a whole are considered risk-free from default (bankruptcy risk; governments don’t go bankrupt), but not from interest
What are Real Return Bonds?
Some government bonds adjust their return based on rate of inflation.
For Canada:
- The face value for coupon and principal payments is adjusted each year based on inflation
What are some examples of Corporate Bonds?
Corporations issue many forms of bonds:
- Mortgage Bonds: Backed by assets. Investors can claim the assets.
First mortgage:
Highest priority in getting repaid, if the company defaults and the asset is sold, these bondholders are paid first
Second mortgage:
Lower priority — paid after first mortgage bondholders.
Higher risk = typically higher interest rate - Collateral Trust: Backed by financial assets (stocks, bonds)
- Equipment Trust: Backed by physical equipment
What are Corporate Debentures aka Unsecured Bonds?
- Debentures are unsecured bonds — meaning there’s no specific asset backing them.
- If the company defaults, you don’t have direct claim to any asset — you just hope the company has enough money to repay.
- Corporate bonds and debentures can be floating or fixed rate
How is repayment secured in Corporate Debentures? What are subordinated debentures?
- Repayment is secured (or investors get confidence from) based on the company’s overall creditworthiness, which depends on:
- Cash Flow
- “Unencumbered” assets (assets not already pledged to someone else)
- Subordinated debentures are even lower in priority than regular debentures.
- If the company goes bankrupt, subordinated debentures are only paid after all other bondholders have been paid
What is Commercial Paper and how can it be guaranteed?
- Corporations can borrow for short periods of time by issuing a Commercial Paper (like Treasury Bills)
- If guaranteed by a bank, it becomes a Banker’s Acceptance
- Now two parties (company + bank) are responsible for repayment
What are Strip Bonds?
- Created by “stripping” coupons from a bond
- Sold as separate discount bonds
- “Interest only” strips represent the coupon payments
What is Quasi Fixed Income?
- They are fixed income products that aren’t traditionally traded like bonds or debentures but still provide regular, predictable returns (like fixed-income investments do).
- Includes bank-offered products (e.g. Term Deposits and Guaranteed Investment Certificates, or GICs) which offer fixed returns but aren’t traded in markets like bonds.
- But, retail investors can still invest in Quasi Fixed Income products, which are easier for them to access and manage, such as:
- Term Deposits: Fixed-term investments offered by banks where your money is locked in for a set period (e.g., 1 year, 5 years) and earns a fixed interest rate.
- GICs (Guaranteed Investment Certificates): Similar to term deposits, but usually offered with a guaranteed return, meaning the principal (the money you invest) is safe and you’ll earn a fixed amount of interest.
What is a bond’s fair or theoretical price based off of?
- PV of its cash flows.
- The discount rate is the required rate of return (the min. return investors must expect to earn to be interested in buying the bond) – NOT COUPON RATE
What is face value?
The amount of money that the issuer (the company or government issuing the bond) promises to pay back to the bondholder (the investor) at the bond’s maturity (the end of its term).
What is coupon rate?
The coupon rate is the interest rate that the issuer agrees to pay to the bondholder each year based on the bond’s face value. This interest is called the coupon payment.
What is the discount rate?
The rate used to calculate the bond’s present value.
