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

Market

Capital Market: Original maturities > 1 year

Par (face) value: Principal to be repaid

Premium, Discount: Price relative to par value

Coupon

Coupon Frequency: Payments per year, periodicity

Currency:

Dual-currency bond: Interest payments in one currency, principal payments in another.

Currency Option Bond: Choice of currency

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:

Negative covenants:

Actions that issuer must perform (e.g., make payment on time, insure assets, comply with laws, etc.)

Restrictions on issuer actions that would disadvantage bondholders (e.g., cannot pay dividends until bond payment is made)

Geography

Domestic bonds:

Foreign bonds:

Domestic issuer and currency

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

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")

Collateral trust bonds: Securities held by trustee

Equipment trust certificates: Physical asset owned by trust, leased to firm

Unsecured bonds: claim to issuer's overall assets

Secured bonds have seniority over unsecured bonds

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

Credit enhancement

External

Provide third-party Counterparty risk

letter of credit - financial institution

bank guarantee - issued by bank

Cash collateral account: cash borrowed by issuer, invested in low-risk short-term debt securities at inception

surety bond - insurance company

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

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

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)

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).

Sinking Fund

Some bonds are retired or redeemed early on scheduled dates

Interest only on coupon 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

Other coupon issues

Step-up coupon:

Credit-linked coupon:

Coupon rate (fixed or floating) increases on a schedule; likely called prior to step-up credit if credit unchanged

Coupon rate increases if credit rating decreases, and decreases if credit rating increases

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

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

Money Market: Original maturities $\leq $ 1 year

Coupon Rate: Annual interest as % of par

Denomination (e.g., euros, pounds, yen)

Tenor: Time to maturity at any point in time

Maturity Date: Date of final payment

Is bearer bodn - No recording of past owners

A portion of discount amount is taxed every year until maturity

In maturity date, nothing left

Good for investors who believes that future interest rate will decline

If collateral assets are non-performing, the issuer must replace with performing assets

Coupon will increase during recession (when bond credit decrease)

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.