Fixed Income
Reading 1: Fixed-Income Instrument
Features
Basic Features of Fixed Income Securities:
1. The issuer of the bond:
Issuers of bonds are entities that borrow money by issuing a bond, there are several types of bond issuers:
a) Corporations.
b) Sovereign or national governments.
c) Non-sovereign governments (states an cities).
d) Quasi governmental entities (governmental agencies).
e) Supranational entities (world bank).
2. Term to Maturity:
The term to maturity of a bond is the number of years the debt is outstanding or the number of years remaining prior to the
final principal payment.
Perpetual bonds: are bonds that pay periodic interest but do not promise to pay the principle amount.
Money market bonds: are bonds with maturity less than one year.
Capital market bonds: are bonds with maturity more than one year.
3. Par Value (Face Value, Redemption Value and Maturity Value):
The bond par value is the amount that the issuer agrees to repay the bondholder at the maturity date.
Bonds can have any par value, so in practice the market price of a bond is quoted as a percentage of its par value.
When a bond trades below its par value, it’s said to be trading at a discount. When trades above its par value, it’s said to be
traded at a premium.
Example:
A Treasury bond has a par value of $ 1000 and the issue is selling for $ 900, this bond would be said to be selling at 90
(90% of par value).
4. Coupon Rate:
Coupon rate is the percentage of par the issuer agrees to pay each year. The annual amount of payment called the coupon.
(Annual Coupon = coupon rate x par value).
Issuers of bonds can pay coupons in annual, semiannual, quarterly, monthly installments. Or even not paying coupons
during the life of bond through deferring those coupons to be paid at the maturity date with the bond principal amount, this
type of bonds called zero-coupon bonds.
5. Currencies:
Most bonds repay borrowed principal and interest on it in the same currency.
Dual currency bonds: are bonds that repay principal in one currency and coupons in another.
Currency option bonds: are bonds that give the bondholder the right to receive his payments in one of two different
currencies.
6. Seniority:
A debt issue’s seniority or priority of repayment among all issuer obligations is an important determinant of risk. Senior
debt has priority over other debt claims in the case of bankruptcy or liquidation. Junior debt, or subordinated debt, claims
have a lower priority than senior debt and are paid only once senior claims are satisfied.
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Presented by: Ahmed Islah, CFA
7. Contingency Provisions
Bonds with Embedded Options:
Callable Bonds: are bonds that give the issuer the right to redeem the issue or part of it at specific price (call price), if for
example the bond is not callable for 3 years the bond is said to have 3 years call protection.
The call option puts un upper limit for the callable bond during the period in which it is callable, this makes logic because
if the price of a similar option free bond is 102 and the bond is callable at 101 the callable bond can never trade at 102
because there is a probability that the bond may be called at 101 at any time.
The bond's embedded call option gives an advantage to the issuer as he can call the bond if market yields declined and
refinance it at lower yields.
The bondholder is disadvantaged by the call option as he may be forced to reinvest the proceeds from calling the bond at
lower rates, so the call option increases the reinvestment risk of the bond, for this reason callable bonds must offer higher
yields than other identical non-callable bonds (trades at lower prices).
Putable Bonds: are bonds that give the bondholder the right to sellback the bond to the issuer at specific price (put price).
The put option puts a lower limit for the putable bond during the period in which it is putable, this makes logic because if
the price of a similar option free bond is 99 and the bond is putable at 100 the putable bond can never trade at 99 because
there is a probability that the bond may be putted at 100 at any time.
The bond's embedded put option gives an advantage to the bondholder as he can sellback the bond to the issuer if market
yields increased and the price of the bond decreased.
The issuer is disadvantaged by the put option as he may be forced to buy the bond at higher rates, so he will be forced to
refinance at higher rates, for this reason putable bonds must offer lower yields than other identical non-putable bonds
(trades at higher prices).
Convertible bonds: are bonds that give the bondholder the right to exchange his bonds by a specific number of the issuer's
shares.
8. Yield Measures:
One simple measure is the current yield (CY), equal to the bond’s annual coupon divided by the bond’s price and
expressed as a percentage.
For example, if the five-year bond were trading at a price of USD101 per USD100 in face value at time t with coupon rate
3.2%, its current yield would be CY t = Annual coupon t /Bond price t = 3.2%/ 1.01 = 3.168%.
A more complex but far more common yield measure is the yield-to-maturity (YTM), which is the internal rate of return
(IRR) calculated using the bond’s price and its expected cash flows to maturity.
An investor’s rate of return on a bond will equal the bond’s YTM at the time of purchase as long as the investor:
• Receives all promised interest and principal payments as scheduled (i.e., no default).
• Holds the bond until maturity.
• Reinvests all periodic cash flows at the YTM.
If any of these assumptions do not hold, the investor’s rate of return on the bond investment will differ from the YTM.
If the five-year bond were trading at a price of USD101 per USD100 in face value immediately after issuance with coupon
rate 3.2%, its YTM is the rate, r, in the following equation:
101 = 1.6/( 1 + r) 1 + 1.6/( 1 + r) 2 + . . . + 101.6/( 1 + r) 10.
r = 1.49% on a semiannual basis, or 1.49% × 2 = 2.98% annualized.
9. Yield Curves:
A useful way of evaluating the YTM on one issue is to graph all an issuer’s debt instruments with identical features by
their YTM and times to maturity. This graphical depiction results in a yield curve.
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Presented by: Ahmed Islah, CFA
A way to measure the credit risk for a bond is to compare an issuer’s yield curve to that of comparable sovereign bonds,
which have little or no credit risk.
Indenture and Covenants:
All the promises of the issuer and rights of the bondholders are set forth in greater detail in a bond indenture (Trust Deed).
As part of the indenture, there are affirmative & negative covenants.
The most common affirmative covenants are;
1- Pay interest and principle on a timely basis,
2- Pay all taxes and other claims when due,
3- Maintain all properties used in good condition and working order,
4- Submit periodic reports stating that the borrower is in compliance with the loan agreement.
Negative covenants set forth certain limitations and restrictions on the borrower’s activities, such as to impose limitations
on the borrower ability to incur additional debt unless certain tests are satisfied.
Source of Repayment:
Sovereign Bonds: are repaid through taxes.
Non-Sovereign Entities Bonds: are repaid through general taxes, revenues of specific projects, special fees or taxes (road
fees).
Corporate Bonds: are typically repaid through issuer's operating cash flow.
Securitized Bonds: are typically repaid through the cash flow of the securitized asset
Collaterals:
Unsecured bonds: represent a claim to the overall assets and cash flow of the issuer.
Secured bonds: are backed by a claim to specific asset of the corporation, this reduce the risk of the bondholders, assets
pledged to support a bond issue are called collaterals.
The most common type of secured bonds are mortgaged backed securities (MBS) they are bonds issued backed by a pool
of mortgage loans, the interest and principal repayment of those loans are used to pay the interest and principal of the
MBS.
Senior unsecured bonds are senior of subordinated or junior unsecured bonds in the event of bankruptcy or liquidation.
Equipment Trust Certificates: are debt securities backed by equipments.
Collateral Trust Bonds: are backed by financial assets.
Debentures: refers to unsecured debt worldwide except in U.K. as it refers to collateralized bonds.
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Presented by: Ahmed Islah, CFA
