Chapter 9: Debt Securities

The percentage paid above the reference rate is called the ...

"spread" and usually remains constant over the life of the bond.

What is a putable bond?

It gives bondholders the right to sell (put back) their bonds to the issuer prior to the maturity date at a pre-specified price referred to as the "put price"

What is a "conversion provision"?

It gives the bondholder the right to exchange the bond for shares of issuing company's stock prior to the bond's maturity date.

What is a "put provision"?

It gives the bondholder the right to sell the bond back to the issuer prior to the maturity date.

For most callable bonds, the bond issuer cannot ...

cannot exercise the call provision until a few years after issuance.

What are "inflation-linked bonds"?

An inflation-linked bond is a particular type of floating-rate bond.

Bonds that contain a put provision are called what?

Putable bonds

What is the maximum amount a bondholder is entitled to receive upon liquidation of a company?

The par value (principal) of a bond plus missed interest payments.

What is the "par value"?

The par value is the amount that will be paid by the issuer to the bondholders at maturity to retire the bonds. Also known as the "principal value" or "face value".

The calculation of the floating rate reflects:

The reference rate and the riskiness of the issuer at the time of issue.

What is the risk of a callable bond being retired early referred to as?

The risk of a callable bond being retired early is referred to as a "call risk"?

In some cases, bonds issued by certain central governments carry particular names in the market.

1. Bonds issued by the US Government are referred to as "Treasury securities" or Treasuries. 2. New Zealand: Kiwi Bonds 3. UK Government: Gilts 4. German Government: Bunds 5. French Government: OATS (obligations assimilables du Tresor)

Bonds are often categorized by their coupon rates:

1. Fixed-rate bonds. 2. Floating-rate bonds. 3. Zero-coupon bonds.

Can you explain inflation-linked bonds more closely?

1. Inflation-linked bonds contain a provision that adjusts the bond's par value for inflation and thus protects the investor from inflation. 2. For most inflation-linked bonds, the par value--not the coupon rate--of the bond is adjusted at each payment date to reflect changes in inflation. 3. The bond's coupon payments are adjusted for inflation because the fixed coupon rate is multiplied by the inflation-adjusted par value. 4.Because of the inflation protection offered by the inflation-linked bonds, the coupon rate on an inflation-linked bond is lower than the coupon rate on a similar fixed-rate bond.

More information about "zero-coupon" bonds?

1. Many debt securities issued with maturities of one year or less are issued as zero-coupon debt securities. 2. Companies and governments sometimes issue zero-coupon bonds that have maturities of longer than one year BUT because of the risk involved when the only payment at maturity, investors are reluctant to buy zero-coupon bonds that have maturities of longer than one year 3. If the buyer of a zero-coupon bond decides to sell it prior to maturity, its price could be very different because of changes in interest rates in the market and/or changes in the issuer's creditworthiness.

Tell me a little more about "fixed-rate" bonds.

1. They can be called "fixed-income securities". 2. These are the main type of debt securities issued by companies and governments. 3. If the interest rates in the market change or the issuer's creditworthiness changes over the life of the bond, the coupon the issuer is required to pay DOES NOT change. 4. Fixed-rate bonds pay fixed periodic coupon payments during the life of the bond and a final par value payment at maturity.

What are some examples of inflation-linked bonds?

1. Treasury Inflation-Protected Securities (TIPS) in the US 2. Index-linked gilts in the UK 3. iBonds in Hong Kong

In the bond markets, the practice is to refer to percentages in terms of basis points.

100 basis points equal 1% 1 basis point equals .01% or .0001

Quiz: A floating rate of .75% is how many basis points?

75 bps

It is important to note that the call provision is a benefit to whom?

A call provision is a benefit to the issuer and is an adverse provision from the perspective of bondholders.

Mortgage-backed securities can also be advantageous in regards to time, how?

A diversified portfolio of mortgages, may be attractive to investors who cannot service mortgages efficiently or evaluation

What are "fixed-rate" bonds?

A fixed-rate bond has a finite life that ends on the bond's maturity date, offers a coupon rate that does not change over the life of the bond, and has a par value that does not change.

What is a "bond"?

A legal contract between the bond issuer and the bondholders.

How can the annual interest owed to bondholders be calculated?

By multiplying the bond's coupon rate by its par value. (For example, if a bond's coupon rate is 6% and its par value is $100, the coupon payment will be $6.)

What are callable bonds?

Callable bonds give the issuer the right to buy back (retire or call) the bond from bondholders prior to the maturity date at a pre-specified price, referred to as a call price. The call price typically represents the par value of the bond plus an amount referred to as the "call premium".

What is the "maturity date"?

Debt securities are issued over a wide range of maturities, from as short as one day to as long as 100 years or more. In fact, some bonds are perpetual, with no pre-specified maturity date at all. The life of the bond ends on its maturity date, assuming that all promised payments have been made.

What is "securitization"?

It refers to the creation and issuance of new debt securities, called "asset-backed securities", that are backed by a pool of other debt securities.

Remember Liar's Poker? Lewie Raneri? Why mortgage bonds were made in the 70s 80s?

No one wanted wanted to trust a mortgage-backed something because they didn't know when they'll get paid off. The uncertainty of getting paid resulted in an unknown maturity date. But tranches fixed this problem.

Do all debtholders have the same priority claim?

No, borrowers often issue debt securities that differ with respect to seniority ranking. In general, bonds may be issued in the form of secured or unsecured debt securities.

Can you tell me about "secured debt securities"?

Secured debt securities pledges certain specific assets as collateral to the bondholders. Collateral is generally a tangible asset, such as property, plant, or equipment, that the borrower pledges to the bondholders to secure the loan.

What role does securitization play?

Securitization improves liquidity in the underlying asset markets because allows investors to indirectly buy assets that they otherwise would not or could not buy directly

What is a lower priority unsecured bond sometimes called?

Subordinated debt. Subordinated debt holders receive payments only after higher-priority debt claims are paid in full. Subordinated debt may also be ranked according to priority, from senior to junior.

Give me an example of a callable bond in action?

Suppose a company that issues a 10-year fixed-rate bonds that are callable starting 3 years after issuance. Suppose that the three years after the bonds are issued, interest rates are much lower. The inclusion of the call provision allows the company to buy back the bonds, presumably using proceeds from the issuance of new bonds at a lower rate.

What is the "coupon rate"?

The coupon rate is the promised interest rate on the bond. Coupon payments are linked to the bond's par value and the bond's coupon rate.

Can you tell me about "unsecured debt securities"?

Unsecured debt securities are not backed by collateral. Consequently, bondholders will typically demand a higher coupon rate on unsecured debt securities than on secured debt securities. A bond contract may also specify that an unsecured bond has a lower priority in the event of default than other unsecured bonds.

What's the point of securitized mortgage pools

Well, mortgage banks allow investors who are NOT wealthy enough to buy hundreds of mortgages to gain the benefit of diversification, economies of scale in loan servicing, and professional credit screening.

Because debt represents a contractual liability of the company, debtholders have a higher claim on ...

a company's assets than equity holders.

Because the conversion feature on a convertible bond is a benefit to the bondholders, convertible bonds typically offer ...

a coupon rate that is lower than the coupon rate on a similar bond without a conversion feature.

The floating rate is equal to the reference rate plus ...

a percentage that depends on the borrower's creditworthiness and bond's features.

The inclusion of a put provision is an advantage to the ...

bondholder and a disadvantage of the issuer.

Put provisions belong to the right of the ...

bondholder, NOT the issuer (contrasting with a call).

The pre-specified call price at which bonds can be brought back may be ....

fixed regardless of the call date, but in some cases the call price may change over time. Under a typical call schedule, the call price tends to decline and move toward the par value over time.

In the event of default, the bondholders of secured debt securities are ...

legally entitled to take possession of the pledged assets. In essence, the collateral reduces the risk that bondholders will lose money in the event of default because the pledged assets can be sold to recover some or all of the bondholders' claim.

The coupon rate on a putable bond will generally be ...

lower than the coupon rate on a comparable bond without an embedded put provision.

Mortgage-backed securities are based on ...

on a pool of underlying residential mortgage loans. Or on a pool of underlying commercial mortgage loans.

At issuance, investors buy bonds directly from an issuer in the ...

primary market. The primary market is the market in which new securities are issued and sold to investors.

The coupon rate of a floating-rate bond is usually linked to a ...

reference rate. The London Interbank Offered Rate (LIBOR) is a widely used reference rate.

The bondholder may later sell their bonds to other investors in the ...

secondary market. In the secondary market, investors trade with other investors. When investors buy bonds in the secondary market, they are entitled to receive the bond's' remaining promised payments, including coupon payments until maturity and principal on at maturity.

Convertible bonds are debt securities prior to conversion, but the fact that they can be converted to common shares makes their value ...

somewhat dependant on the price of the common shares.

Putable bonds, like callable bonds, DO NOT

start providing bondholders with put protect until a few years after issuance.

What is the bond contract sometimes referred to as?

the bond indenture or the offering circular.

When a bondholder exercises the put provision, the pre-specified put price at which bonds are sold back to the issuer is typically ...

the bond's par value.

In the event that the issuer does not meet the contractual obligations and make the promised payments, ...

the bondholders typically have legal recourse.

The bond contract gives bondholders the right to take legal action if ...

the issuer fails to make the promised payments or fails to satisfy other terms specified in the contract. If the bond issuer fails to make the promised payments, which is referred to as default, the debtholders typically have legal recourse to recover the promised payments.

The coupon rate on a callable bond will generally be what?

will generally be higher than a comparable bond without an embedded call provision to compensate the bondholder for the risk that the bond may be retired early.

What is the most common type of asset-backed security is backed by...

a pool of mortgages.

In the event that a company is liquidated, assets are distributed following ...

a priority of claims, or "seniority ranking". This priority of claims can affect the amount that an investor receives upon liquidation.

Floating-rate coupon payments are paid in arrears, that is, ...

at the end of the period on the basis of the level of the reference rate set at the beginning of the period. On a payment date, the coupon rate is set for the next period to reflect the current level of the reference rate pus the stated spread. This new coupon rate will determine the amount of the payment at the next payment date.

Bonds that contain a conversion provision are referred to as ...

convertible bonds

What is typically included in a bond?

1. Par value 2. Coupon rate 3. Maturity date

Why are bondholders willing to accept a relatively lower coupon rate on a bond with a put provision?

Because of the downside protection provided by the put provision! The put provision protects bondholders from the loss in value because they can sell their bonds to the issuing company at the put price.

Although the term "bond" may be used to describe ANY debt security, irrespective of its maturity, debt securities can be referred to by different names based on time to maturity at issuance.

Bills: debt securities with maturities of one year or less. Notes: Debt securities with maturities from 1 to 10 years. Bonds: Debt securities with maturities longer than 10 years.

Floating rate equation.

Floating rate = Reference rate + Spread

Ranking debts:

From safest to non-safest: 1. Secured debt 2. Senior unsecured debt 3. Senior subordinated debt 4. Junior subordinated debt

Tell me the strategy associated with a call bond?

In general, bond issuers choose to include a call provision so if that interest rates fall after a bond has been issued, they can call the bond and issue new bonds at a lower interest rate. In this case, the bond issuer has the ability to retire the existing bonds with a higher coupon rate and issue bonds with a lower coupon rate.

What is a "call provision"?

It gives the issuer the right to buy back the bond issue prior to the maturity date. Bonds that contain a call provision are referred to as "callable bonds".

What are "floating-rate bonds"?

These are essentially identical to fixed-rate bonds except that the coupon rate on floating-rate bonds changes over time. They can also be called "variable-rate bonds".

What are "convertible bonds"?

They are a hybrid security -- having characteristics of and relationships with both equity and debt securities. It gives the right to convert the bond into a pre-specified number of common shares of the issuing company at some point prior to the bond's maturity date.

What is a "covenant"?

They are legal agreements that describe actions the issuer must perform or is prohibited from performing. This is a way to protect bondholders' interests.

How are mortgage-backed securities made?

They are made when a financial intermediary bundles a pool of mortgage loans from lenders and then issues debt securities against the pool of mortgages.

How can bonds be classified in general?

They can generally be classified in three ways. 1. Issuer type 2. Type of market they trade in 3. Type of coupon rate

What are "zero-coupon bonds"?

They do not offer periodic interest payments during the life of the bond. 1. Just like fixed-rate and floating-rate bonds, zero-coupon bonds have a FINITE life that ends on the bond's maturity date. 2. The only cash flow offered by a zero-coupon bond is a single payment equal to the bond's par value that is paid on the bond's maturity date. 3. They are issued at a discount to the bond's par value--that is, at an issue price that is lower than the par value.

Many bonds include features referred to as embedded provisions. What are "embedded provisions"?

They give the issuer or the bondholder the right, but not the obligation, to take certain actions.

How are mortgage-backed securities advantageous compared to individual mortgages?

They have the advantage that default losses and early repayments are much more predictable for a diversified portfolio of mortgages than for individual mortgages. TLDR: They're less risky than individual mortgages.

What are some common embedded provisions?

They include call, put, and conversion provisions. Call, put, and conversion provisions are "options", a type of derivative instrument discussed in the derivatives chapter.

Why might bondholders buy putable bonds?

They might exercise the put right if market interest rates rise and they earn a higher rate by buying another bond that reflects the interest rate increase.