Chapter 1: Defining elements
Fixed income securities
Definition: financial obligation of an entity that promises to pay a specified sum of money at specified future dates
When investing in a fixed income securities
The bond features
The legal, regulatory and tax considerations
The contingency provisions
Basic features of a bond
Creditworthiness
Issuer (borrowing the bond)
Investment grade bonds
Non- investment grade bonds
Maturity
Tenor (term to maturity)
Capital market securities: fixed- income securities with maturity longer than one year
Money market securities: fixed- income securities with maturity up to one year
Par value (principle): amount issuer agrees to repay the bondholders on the maturity date
Bond price > par value => trading at premium
Bond price < par value => trading at discount
Coupon rate
Floating rate notes (floaters): pay a floating rate (preference rate + a spread)
Zero- coupon bond: no interest rate
Plain vanilla bonds or conventional bonds: pay a fixed rate of interest
Reference rate is Libor (London interbank offered rate)
The spread (margin) is expressed in basis points, 1 basis point = 0.01%
Currency denomination
Dual- currency: make coupon payments in one currency and pay the par value at maturity in another currency
Currency options bond: single currency + foreign currency option
Legal, regulatory and tax considerations
Bond indenture: legal contract that describes the form of the bond
Collateral: offering an asset or property as a security measure for the lender
Credit enhancements: provision that are used to reduce the credit risk of a bond issue
Covenants: what issuers must or must not perform
Bond indenture
Corporate bond: company or subsidiary (subsidiary carry a credit rating lower than their parents). Investors should pay attention to who will pay the coupon payments
Securitised bond: usually lies with special purpose vehicles
SPE (special purpose entity) or SPV (special purpose vehicle): a legal entity => bankruptcy remoteness
Sovereign bond: responsible for national budget (gilts: UK sovereign bond)
Risk
Systemic risk
Interest rate risk: change in market interest rate affects a bond's value
Credit risk: resulting from the issuer failing to make full/ timely payments of interest
Sources of repayment
Sovereign bonds: tax revenues and print money
Non- sovereign government bonds: taxing authority of the issuer, cash flows of the projects
Corporate bonds: cash flows primarily through its operations