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Reading 42: Fixed-income Security: Defining Elements - Coggle Diagram
Reading 42: Fixed-income Security: Defining Elements
Basic Features
Issuer
Corporations
Sovereign, non-sovereign governments
Quasi-government entities
Supranational entities (World Bank, IMF)
Special purpose entities
Maturity
Tenor: Time to maturity at any point in time
Maturity Date: Date of final payment
Market
Capital Market: Original maturities > 1 year
Money Market: Original maturities \(\leq \) 1 year
Par (face) value: Principal to be repaid
Premium, Discount: Price relative to par value
Coupon
Coupon Frequency: Payments per year, periodicity
Coupon Rate: Annual interest as % of par
Currency:
Dual-currency bond: Interest payments in one currency, principal payments in another.
Currency Option Bond: Choice of currency
Denomination (e.g., euros, pounds, yen)
Bond Indenture
Legal document for bond
Trust deed or Indenture: Legal contract between issuer and bondholder, held by trustee
Covenants:
Provisions of an indenture
Affirmative covenants:
Actions that issuer must perform (e.g., make payment on time, insure assets, comply with laws, etc.)
Negative covenants:
Restrictions on issuer actions that would disadvantage bondholders (e.g., cannot pay dividends until bond payment is made)
Geography
Domestic bonds:
Domestic issuer and currency
Foreign bonds:
Foreign issuer, trade in domestic currency, raise capital in a broader market (e.g., $US Heineken bond issued in US)
National bond market: Includes trading both types of issues (domestic and foreign)
Eurobonds
Sold by an international syndicate, issued simultaneously to investors in many countries
Issued outside the jurisdiction of any single country
Issued in a currency other than the issuer's domestic currency
Pros:
Avoid regulation
No tax withholdings
Issue USD bonds without registering with the SEC (but cannot be traded in US)
Reach a large pool of investors globally, primarily in the eurozone, Asia-Pacific, and the US
Is bearer bodn - No recording of past owners
Global bonds: Eurobonds that also trade in a domestic bond market (e.g., World Bank Bonds)
Collateral
Secured vs. Unsecured
Secured bonds: Claim to specific asset owned by issuer (asset is pledged as "collateral")
Unsecured bonds: claim to issuer's overall assets
Secured bonds have seniority over unsecured bonds
Collateral trust bonds: Securities held by trustee
Equipment trust certificates: Physical asset owned by trust, leased to firm
Securitized Bonds
Issued by a Special Purpose Entity (SPE)
Firm sells assets to the SPE (bankruptcy remote)
Asset cash flows make payments to bondholders
Assets separate from firm, safe from firm problems
Created to reduce borrowing costs
Example: Mortgage-backed securities (MBS), Credit card receivables, Business loans, Automobile loans
Covered Bond
Legislation protects assets segregated, but still own by the firm and on the firm's balance sheet
Primarily issued by financial firms
Firm must augment assets whenever they are insufficient to support the covered bonds
Bondholders effectively have recourse to the firm as well as the segregated financial assets
If collateral assets are non-performing, the issuer must replace with performing assets
Credit enhancement
External
Provide third-party Counterparty risk
letter of credit - financial institution
bank guarantee - issued by bank
surety bond - insurance company
Cash collateral account: cash borrowed by issuer, invested in low-risk short-term debt securities at inception
Internal:
Built into structure of bond issue
Over-collateralization: Collateral value is greater than amount borrowed
Excess spread: Yield on asset pool is greater than yield of bonds issued
Tranches: Different priority of claims for different bond classes, waterfall structure
Other coupon issues
Step-up coupon:
Coupon rate (fixed or floating) increases on a schedule; likely called prior to step-up credit if credit unchanged
Credit-linked coupon:
Coupon rate increases if credit rating decreases, and decreases if credit rating increases
Coupon will increase during recession (when bond credit decrease)
Payment-in-kind:
Issuer may make coupon payments by increasing principal amount
Deferred (split) coupon:
Coupon payments do not begin until a period after issuance
Index-linked bonds:
Coupon rate or principal changes based on value of a published index
Examples:
Equity-linked notes (equity index)
Commodity-indexed bonds (commodity price, e.g., gold, oil)
Inflation-indexed bonds (CPI)
Inflation-linked bonds (linkers): have payments that are adjusted based on CPI
Interest-indexed: coupon rate adjusted
Capital-indexed: Principal (par) value adjusted following the index that is linked, coupon rate remains fixed
Indexed-annuity bonds: Fully amortizing, payments adjusted
Principal-protected: Pay original face value if index decreases over life of bond
Embedded Options
Contigency provivisions
Are actions the issuer or bondholder may take
Callable bonds:
Bonds may have a call protection period
Call types
Bermuda call: The issuer of the bond may only call a bond on interest payment dates.
Make-whole call: The issuer of this type of bond may call the bond before the maturity date at par plus a make whole premium. Call price includes present value of future coupons
European call: The issuer has the right to call a bond on a predetermined date; the issuer can only call the bond one time.
American Call: The issuer may call the bond any time between the date the bond is callable and the date the bond matures.
Issuer may redeem bonds before maturity on scheduled call date(s) and at specified call price(s)
Putable bonds
Bondholder may sell bond back to issuer, typically for par value
Convertible bonds
Bondholder may exchange bond for issuer's common stock
Warrants:
Right to buy issuer's common shares at a given price (attached to straight bond)
Contingent convertibles
Convert to common stock automatically if specified event occurs
Tax Considerations
Interest typically taxed as ordinary income
Interest on municipal bonds (U.S) EXEMPT from taxes
Some domestic bonds pay interest net of tax
For bonds sold prior to maturity, may be capital gains or losses if yield has changed
Long-term capital gains (and capital gains in general) often taxed at lower rate
Original issue discount (OID) bonds
Bonds issued with coupon < market rate
Price increase from passage of time is typically taxed as interest income annually
A portion of discount amount is taxed every year until maturity
Zero-coupon (pure discount) bonds
Pay only par value at maturity
May require annual payments for taxes
Fixed Income Cash Flows
Payment Structure
Bullet Structure
All principal repaid at maturity (plain-vanilla bond)
Interest only on coupon dates
Partially Amortizing
Periodic payments include interest and principal, with balloon payment
Fully Amortizing
Equal payments each period include interest and principal (e.g., mortgage loans).
In maturity date, nothing left
Sinking Fund
Some bonds are retired or redeemed early on scheduled dates
Float
Floating-rate notes (FRN):
Coupon rate based on a reference rate (e.g., 6-month LIBOR) \( \pm \) a fixed margin
Cap: maximum rate to be paid(benefit issuer)
Floor: minimum rate to be paid (benefits bondholder)
Inverse floater:
Coupon rate = X% - reference rate
Coupon rate and reference rate move in opposite direction
Good for investors who believes that future interest rate will decline