Reading 51- Fixed-Income Securities: Defining Elements

accelerated sinking fund provision

It permits the issuer to retire more than the stipulated sinking fund amount if they choose.

What is the floating interest rate that applies to the payment due in December 2015? 6 month LIBOR + 25 bps June 2015 6 month LIBOR rate= 3% December 2015 6 month LIBOR rate= 3.5%

June 2015 6 month LIBOR rate + 25 bps =3% + .25% =3.25% floating rate + spread

indexed-annuity bond

-fully amortized bond (not a bullet bond) -annuity payment (coupon interest + principal) increases in line with inflation during the bond's life

interest-indexed bonds

-pays a fixed principal amount at maturity but an index-linked coupon during the bond's life -non-amortizing

source of repayment proceeds*

-supranational bonds= repayment of former loans/ paid-in capital -sovereign bonds= government raise tax and print money -quasi-government bonds= cash flows generated from entity or project -non-sovereign= tax, cash flows from project -corporate bonds= cash flow through operations

sources of payments for bonds:

-supranational organizations= repayment of previous loans made by organization or paid-in capital -sovereign (national government)= taxes & money supply -non-sovereign bonds= taxes or cash flows of project

A floor in a floating rate note (floored FRN)

-benefits bondholders in decreasing interest rates; ensures coupon rate will not fall below specified rate

capital-indexed bond A 10-year, capital-indexed bond linked to the Consumer Price Index (CPI) is issued with a coupon rate of 6% and a par value of 1,000. The bond pays interest semi-annually. *During the first six months after the bond's issuance, the CPI increases by 2%.* On the first coupon payment date, the bond's: principal amount increases to 1,020. (par value)*(1+CPI increase)

*fixed coupon- floating principal* -EX. TIPS -non-amortizing -ex. If the consumer price index increases by 2%, the coupon rate remains unchanged at 6%, but the principal amount increases by 2% and the coupon payment is based on the inflation-adjusted principal amount. On the first coupon payment date, the inflation-adjusted principal amount is 1,000 × (1 + 0.02) = 1,020 and the semi-annual coupon payment is equal to (0.06 × 1,020) ÷ 2 = 30.60.

issuer of bonds

*source of contractual payments -supranational organizations: World Bank, European Investment Bank, IMF -sovereign (national) governments: U.S. & Japan- US Treasury Bonds -non-sovereign (local) governments: state of Minnesota or city of Toronto -quasi-governmental entities: FNMA Federal National Mortgage Association; post office -companies: banks, insurance companies, corporations

The annual Fixed Income Analysts' Forum had just ended and two attendees, James Purcell and Frederick Hanes, were discussing some of the comments made by the panelists. Purcell and Hanes were specifically concerned with the following two statements that were made: Panelist 1: Mortgage-backed securities and asset-backed securities are both fixed income securities that are backed by pools of loans and are said to be amortizing securities. For many of the loans, no principal payments are required to be made prior to the maturity date. These securities are said to have a bullet maturity structure. Panelist 2: If coupon Treasury bonds or corporate bonds are issued with the terms specifying that the principal be repaid over time at the option of the issuer, then these bonds are putable bonds; if the principal is to be repaid over time at the option of the bondholder, then the bonds are termed callable bonds. With regard to the statements made by Panelist 1 and Panelist 2: A) both are incorrect. B) both are correct C) only one is correct.

A Panelist 1 is incorrect. These securities do not have a bullet maturity structure. The payments are structured so that the loan is paid off when the last loan payment is made. Panelist 2 is incorrect. If coupon Treasury bonds or corporate bonds are issued with the terms specifying that the principal be repaid over time at the option of the issuer, then these bonds are callable bonds - the call provision grants the issuer an option to retire part of the issue or the entire issue prior to the maturity date. On the other hand, if the principal is to be repaid over time at the option of the bondholder, then these bonds are putable bonds - the put provision entitles the bondholder to put (sell) the issue back to the issuer at the put price (if interest rates increase and the bond's price declines below the put price).

Which one of the following alternatives represents the correct series of payments made by a typical 6% U.S. Treasury note with a par value of $100,000 issued today with five years to maturity? Number and size of each intermediate payment Payment made at maturity A) 9 semiannual payments of $3,000 $103,000 B) 4 annual payments of $6,000 $106,000 C) 9 semiannual payments of $3,000

A Payments for U.S. Treasury bonds and notes are semiannual and are fixed for the life of each bond or note. The coupon rate is quoted on an annual basis but each payment is made on the basis of one half the annual rate multiplied by the maturity or par value

Allcans, an aluminum producer, needs to issue some debt to finance expansion plans, but wants to hedge its bond interest payments against fluctuations in aluminum prices. Jerrod Price, the company's investment banker, suggests a non-interest rate index floater. This type of bond will provide all the following advantages EXCEPT: A) the bond agreement allows Allcans to set coupon payments based on business results. B) the bond's coupon rate is linked to the price of aluminum. C) the payment structure helps protect Allcan's credit rating.

A The coupon rate is set in the bond agreement (indenture) and cannot be changed unilaterally. Non-interest rate indexed floaters are indexed to a commodity price such as oil or aluminum. Business results could be impacted by numerous factors other than aluminum prices. Both of the other choices are true. By linking the coupon payments directly to the price of aluminum (meaning that when aluminum prices increase, the coupon rate increases and vice versa), the non-interest index floater allows Allcans to protect its credit rating during adverse circumstances.

In the context of bonds, accrued interest: A) equals interest earned from the previous coupon to the sale date. B) is discounted along with other cash flows to arrive at the dirty, or full price. C) covers the part of the next coupon payment not earned by seller.

A This is a correct definition of accrued interest on bonds. The other choices are false. Accrued interest is not discounted when calculating the price of the bond. The statement, "covers the part of the next coupon payment not earned by seller," should read, "...not earned by buyer."

Which of the following statements regarding a bond being called is CORRECT? Call prices are known as regular redemption prices when bonds are called at: A) under the call provisions specified in the bond indenture. B) at the par value. C) at a premium.

A When bonds are redeemed under the call provisions specified in the bond indenture, these are known as regular redemptions and the call prices are referred to as regular redemption prices which can be either at a premium or at par.

Which of the following statements regarding zero-coupon bonds and spot interest rates is most accurate? A) A coupon bond can be viewed as a collection of zero-coupon bonds. B) Price appreciation creates only some of the zero-coupon bond's return. C) Spot interest rates will never vary across time.

A Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond's return comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. Spot rates are defined as interest rates used to discount a single cash flow to be received in the future. Any bond can be viewed as the sum of the present value of its individual cash flows where each of those cash flows are discounted at the appropriate zero-coupon bond spot rate.

Which one of the following combinations represents an accurate classification of security owner options and security issuer options? Security Owner Options Security Issuer Options A) A call provision A prepayment option B) A floor A prepayment option C) A cap An accelerated sinking fund

B A floor sets a minimum coupon rate for a floating-rate bond and protects the security owner from decreases in rates. A prepayment option is included in many amortizing securities and allows the holder of the option to make additional payments against outstanding principal.

Which of the following is CORRECT about the call feature of a bond? It: A) stipulates whether and under what circumstances the bondholders can request an earlier repayment of the principal amount prior to maturity. B) stipulates whether and under what circumstances the issuer can redeem the bond prior to maturity. C) describes the maturity date of the bond.

B Call provisions give the issuer the right (but not the obligation) to retire all or a part of an issue prior to maturity. If the bonds are "called," the bondholder has no choice but to turn in his bonds. Call features give the issuer the opportunity to get rid of expensive (high coupon) bonds and replace them with lower coupon issues in the event that market interest rates decline during the life of the issue. Call provisions do not pertain to maturity. A put provision gives the bondholders certain rights regarding early payment of principal.

Which of the following is NOT a negative bond covenant? A) Credit rating must be investment grade. B) Current ratio of at least 2.25. C) Restriction on asset sales.

B Current ratio covenants are positive (borrower promises to perform) versus the others listed (prohibitions on the borrower).

A coupon bond: A) does not pay interest on a regular basis, but pays a lump sum at maturity. B) pays interest on a regular basis (typically semi-annually). C) always sells at par.

B This choice accurately describes a coupon bond. With an accrual bond, payments are deferred to maturity and then disbursed along with the par value at maturity. Unlike a normal zero-coupon bond, these issues are sold at (or near) their par values and then the interest accrues at a compound rate on top of that. So, they start at $1,000 and then appreciate from there.

Which of the following contains the overall rights of the bondholders? A) Covenant. B) Rights offering. C) Indenture.

C Covenants are part of the indenture. A rights offering describes an equity offering—not fixed income.

Most often the initial call price of a bond is its: A) par value plus one year's interest. B) par value. C) principal plus a premium.

C Customarily, when a bond is called on the first permissible call date, the call price represents a premium above the par value. If the bonds are not called entirely or not called at all, the call price declines over time according to a schedule. For example, a call schedule may specify that a 20-year bond issue can be called after 5 years at a price of 110. Thereafter, the call price declines by a dollar a year until it reaches 100 in the fifteenth year, after which the bonds can be called at par.

global bond

issued both in Eurobond market & at least 1 domestic bond market -World Bank issue bonds in SEVERAL markets -Wal-Mart from the United States, denominated in US dollars, and sold in various countries in North America, Europe, Middle East, and Asia Pacific (US - USD - NA, EUR, ME, AP)

Which of the following is most accurate about a bond with a deferred call provision? A) It could be called at any time during the initial call period, but not later. B) Principal repayment can be deferred until it reaches maturity. C) It could not be called right after the date of issue.

C A deferred call provision means the issue is initially (say, for the first 5 to 7 years) non-callable, after which time it becomes freely callable. In other words, there is a deferment period during which time the bond cannot be called, but after that, it becomes freely callable.

Which of the following is the appropriate redemption price when bonds are called according to the sinking fund provision? A) Specific redemption price. B) Regular redemption price. C) Special redemption price.

C Regular redemption price refers to bonds being called according to the provisions specified in the bond indenture. When bonds are redeemed to comply with a sinking fund provision or because of a property sale mandated by government authority, the redemption prices (typically par value) are referred to as "special redemption prices." There is no such thing as a specific redemption price. When redemption funds are obtained as a result of a forced sale of assets for deregulatory purposes, the funds can be used to redeem bonds at the special redemption price, which are typically par value.

Peter Stone is considering buying a $100 face value, semi-annual coupon bond with a quoted price of 105.19. His colleague points out that the bond is trading ex-coupon. Which of the following choices best represents what Stone will pay for the bond? A) $105.19 plus accrued interest. B) $105.19 minus the coupon payment. C) $105.19.

C Since the bond is trading ex-coupon, the buyer will pay the seller the clean price, or the price without accrued interest. So, Stone will pay the quoted price. The choice $105.19 plus accrued interest represents the dirty price (also known as full price). This bond would be said to trade cum-coupon.

The dirty, or full, price of a bond: A) is paid when a security trades ex-coupon. B) applies if an issuer has defaulted. C) equals the present value of all cash flows, plus accrued interest.

C The dirty price of a bond equals the quoted price plus accrued interest. If an issuer has defaulted, the bond trades without interest and is said to trade flat. When a security trades ex-coupon, the buyer pays the clean price, which is the quoted price without accrued interest.

A bond has a par value of $5,000 and a coupon rate of 8.5% payable semi-annually. The bond is currently trading at 112.16. What is the dollar amount of the semi-annual coupon payment? A) $238.33. B) $425.00. C) $212.50.

C The dollar amount of the coupon payment is computed as follows: Coupon in $ = $5,000 × 0.085 / 2 = $212.50

Which of the following statements regarding spot rates and zero-coupon bonds is least accurate? A) With zero coupon bonds, investors have no reinvestment risk. B) The yield to maturity on a zero coupon bond is called the spot interest rate. C) The graph of current corporate bond yields is called the spot yield curve.

C The graph of yields on zero-coupon bonds (spot rates) is called the spot yield curve. Note that the return on zero-coupon bonds is based entirely on price appreciation. An investor in a default-free zero-coupon bond will not have to worry about reinvesting coupons to realize the yield to maturity.

Which of the following statements about zero-coupon bonds is NOT correct? A) The lower the price, the greater the return for a given maturity. B) All interest is earned at maturity. C) A zero coupon bond may sell at a premium to par when interest rates decline.

C Zero coupon bonds always sell below their par value, or at a discount prior to maturity. The amount of the discount may change as interest rates change, but a zero coupon bond will always be priced less than par.

Which of the following statements regarding zero-coupon bonds is CORRECT? A) Zero-coupon bonds have substantial amount of coupon reinvestment risk. B) An investor who holds a zero-coupon bond until maturity will receive an annuity of coupon payments plus recovery of principal at maturity. C) An investor who holds a zero-coupon bond until maturity will receive a return equal to the bond's effective annual yield.

C Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond's return comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. An investor who holds a zero-coupon bond until maturity will receive a return equal to the bond's effective annual yield.

domestic bond

Ford Motor Company (US company) issues bonds denominated in USD in the U.S. UK Debt Management Office, denominated in British pounds, and sold in the United Kingdom (UK - UK - UK) -registered with the SEC registered bond= ownership is recorded by name or serial number

sinking fund arrangement*

Provision that reduces the credit risk of a bond issue by requiring the issuer to retire a portion of the bond's principal outstanding each year. ex. 5% bond principal must be repaid each year to retire the principal outstanding -benefit: reduces credit/ default risk -disadvantage: investors face reinvestment risk. if market interest rates have fallen, investor cannot purchase the bond offering the same return. reinvest cash flows at an interest rate that may be lower than the current yield to maturity

foreign bond

Volkswagen (German company) issues bonds denominated in USD in U.S. (EUR - USD - USD) LG Group from South Korea, denominated in GBP, and sold in the UK (KRW - GBP - GBP) registered bond= ownership is recorded by name or serial number

contingent convertible bonds (CoCos)

convertible bond- conversion is automatic if a specified event occurs bonds with contingent write-down provisions higher yield

credit-linked coupon bond

coupon changes when bond's credit rating changes (+) benefits bondholders- coupon increase by 50 bps for every credit rating downgrade (-) issuer default risk

currency option bonds

allow bondholders the right to choose the currency they want to receive interest payments

payment-in-kind bond (PIK)

allows the issuer to pay interest in the form of additional amounts of the bond issue rather than as a cash payment (+) benefits issuer- who may face potential cash flow problems in the future, such as high debt burden, leveraged buyout (+) bondholder- demands higher yield

current (running yield)=

annual coupon rate*par value/ bond price .06*1000/1010

secured bonds

backed by assets pledged to guarantee debt repayment in case of default

SPV special purpose vehicle

bankruptcy-remote vehicle -benefit: sponsor transfers assets to SPV. once transfer is completed, sponsor is not responsible for any default claims

equipment trust certificates

bonds secured by equipment or physical assets (aircraft, railroad, shipping containers, oil rigs) motive: tax advantage

call premium=

call price= 102.322= 102.322%*1000 par value= 1023.22 call premium= 1023.22-1000= 23.33//

contingency provision

clause in legal document that allows for action if event or circumstance occurs

conversion value

convertible bond par value 1M currently priced at 1.1 M share price= 40,000 conversion ratio= 25:1 (25 shares to 1 bond) conversion value of bond= 40,000/share* 25 shares/ 1 bond= 1 M conversion value the 1M conversion value < 1.1 M current value of bond, so the bond is below parity

step-up coupon bond

coupon increases by specific margins at specific dates (+) benefits bondholders- protection against rising interest rates because it allows bondholders to receive a higher coupon in line with the higher market interest rates (+) benefits issuer- when interest rates decrease or remain stable- step-up feature acts as an incentive for the issuer to call the bond before the spread increases and interest expense rises

partially amortized bond

coupon payments are higher or equal to those of fully amortized bond

index-linked bond

coupon payments linked to an index -inflation-linked bond= linked to UKRPI, CPI -linker= typically issued by government (TIIS, TIPS) (+) benefits bondholder- If interest rates increase as a result of inflation. indices are well-known, transparent, and published regularly

inverse floating rate note (reverse FRN) ??

coupon rate has an inverse relationship to the reference rate (LIBOR) when interest rates rise, the coupon rate on an inverse floater decreases *inverse FRNs are favored by investors who believe that interest rates will decrease (when YTM decreases, bond price increases) *does not offer protection to the investor against increases in market interest rates

fixed-rate bonds

decline in value in a rising interest rate environment (YTM increase; bond price decrease)

seller of pool of securitized assets

depositor (originator)

zero-coupon bond (pure-discount bond)

do not pay interest or coupon (like a deferred coupon bond) the implied interest earned= par value- purchase price $1000-950= $50

plain vanilla bond

does not make any principal repayment until the maturity date

bullet bond p. 316

entire payment of principal occurs at maturity -largest repayment of principal -makes 0 principal payment each year until maturity date

equity-linked note

final payment of the bond is based on return of equity index (+) benefits bondholder- 100% guarantee of principal repaid (-) issuer default

trustee

financial institution appointed by issuer to monitor issuer compliance with the indenture contract *ensure timely interest payments by issuer -maintaining records -safeguarding -appraising collateral -invoicing issuer for interest payments

call protection period=

first callable date- issue date 2022-2012= 10 years

convertible bond

gives bondholder the right to exchange the bond for a specified number of common shares hybrid: straight, option-free bond + embedded equity call option (+) benefits bondholder- can convert to common share if share price increases. if share price decreases, bondholder still gets coupon payments (+) benefits issuer- reduced interest expense (coupon rate); elimination of debt if conversion option is exercised sold at higher price and lower yield

putable bond

gives bondholders the right to sell the bond back to the issuer at a predetermined price on specified dates (+) benefit to bondholders- if interest rates rise after the issue date, thus depressing the bond's price, the bondholders can put the bond back to the issuer and get cash. this cash can be reinvested in bonds that offer higher yields, in line with the higher market interest rates -sold at higher price and lower yield

callable bond p. 329

gives the issuer the right to redeem all or part of the bond before specified maturity date (+) benefits issuer- if interest rates have declined since the company first issued the bond, the company is likely to want to refinance this debt at a lower rate of interest. In this case, the company calls its current bonds and reissues them at a lower rate of interest. (-) disadvantage to bondholder- reinvestment risk= lower interest rates when reinvesting sold at lower price & higher yield -make-whole call= issuer is required to make a lump-sum payment to the bondholders on coupon & principal repayment not paid because the bond is redeemed early

Yield to Maturity (YTM)

internal rate of return on a bond's expected cash flows higher YTM= lower bond price lower YTM= higher bond price *inverse relationship*

Eurobonds

issued internationally, outside the jurisdiction of any single country bond issued by Sony from Japan, denominated in USD, but not registered with SEC, & SOLD to an institutional investor in the Middle East named after the currency in which they were denominated -Eurodollar bonds (USD) -Euroyen bonds (JPY) -motive: bypass the legal, regulatory, and tax constraints -bearer bonds= because trustee does not keep records of who the owner of the bonds are. only clearing system knows who the bondowners are.

American call

issuer has right to call a bond at any time starting on first call date

European call

issuer has right to call a bond only once on the call date

Bermuda-style callable bond

issuer has right to call bonds on specified dates following call protection period ex. callable every 15 August from 2022

embedded option

issuers/ bondholders have the right, but not the obligation, to take some action

indenture (trust deed)

legal contract under which a bond is issued stipulates: -issue terms -principal -coupon rate -payment schedule -collateral, credit enhancement, or covenants

floating-rate notes (FRNs) issued by Frannie Mae & Freddie Mac

less affected when interest rates increase because their coupon rates vary with market interest rates and are reset at regular, short-term intervals. pay interest quarterly *FRNs are favored by investors who believe that interest rates will rise (when YTM increases, bond price decreases)

*negative covenants in bonds p. 307

limitations & restrictions on borrower's activities "cannot do" -restrictions on issuing additional debt: maximum debt usage ratios, minimum interest coverage ratios to prevent dilution of bondholders' claims -negative pledges: prevent the issuance of debt that would be senior to or rank priority ahead of existing debt -restrictions on prior claims: protects unsecured bondholders by preventing issuer from using assets that are not collateralized -restrictions on share buybacks/ distributions to shareholders -restrictions on asset disposals -restrictions on speculative investments -restrictions on M&A: prevents a company from avoiding its obligations to bondholders by selling out to another company

dual-currency bond

make coupon payments in 1 currency, & par value payment at maturity in 2nd currency JPY/USD

money market securities

mature <1 year

capital market securities

mature >1 year

covered bond

offer bondholders additional protection in case of default. backed by a segregated pool of assets called a "covered pool". the pool of assets remains on the financial institution's balance sheet motive: lets financial institutions buy and sell assets to improve credit quality, lower borrowing costs and finance public debt benefit to bondholders: lower credit risks and lower yields bondholders have recourse against both the financial institution and the cover pool

bond interest income (coupon payment) is usually taxed as

ordinary income

registered bond

ownership record is known

deferred coupon (split coupon) bond (zero-coupon bond is an extreme form of a deferred coupon bond.)

pays no coupons for first few years but then pays higher coupon during last years (+) benefits issuer- delays interest payments until project is completed (+) benefits bondholder- bonds are discounted at par, deferred tax payments. however, issuer has poor credit quality

amortizing bond

periodic payments of interest & repayment of principal -fully amortized= 0 outstanding principal at maturity -partially amortized= balloon payment (portion of principal) repaid by maturity date

A cap in a floating-rate note (capped FRN)

prevents the coupon rate from increasing above a specified maximum rate. -benefits the issuer in a rising interest rate because it sets a limit to the interest rate paid on the debt

ex. p. 315 original discount tax provision in Zinland 10-year zero-coupon bond par value= $1000 sell price= $800 What is the tax on this bond?

prorated portion that is taxed: $1000-800= $200/ 10 years= $20/ year does not have to declare a capital gain at maturity

credit risk

risk of loss resulting from issuer failing to make full and timely payments of interest or repayments of principal

collateral trust bonds

secured by securities (common shares)

debentures

secured or unsecured bond

warrant

separate, tradable security that entitles holder to buy the underlying common share of the issuing company "attached" option

*affirmative covenants in bonds p. 307

stipulate what issuers are required to do "must do" -pay interest & principal on time -pay all taxes -maintain borrower's business in good condition -submit reports on loan agreement -what the issuer intends to do with the proceeds from the bond issue

internal credit enhancement

subordination- credit tranching/ priority of claims overcollateralization- pledge more collateral than needed to secure financing reserve accounts- cash reserve & excess spread account that serves as a first line of protection against losses

external credit enhancement

surety bond- insurance company guarantee for any losses incurred. *usually a maximum amount guaranteed, called a penal sum bank guarantee- issued by a bank letter of credit- provides issuer a credit line to reimburse any cash flow shortfalls (-) subject to 3rd party risk. cash collateral account mitigates this risk; allows issuer to immediately borrow credit enhancement & invest

tenor of bond

time remaining until the bond's maturity date 10-4= 6 years