Features of Fixed Income Securities

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FIXED INCOME

15.1.A. FEATURES OF FIXED INCOME SECURITIES

INTRODUCTION

First it must be understood that a bond is nothing more than debt. The act of issuing a bond is theexact same thing as a company borrowing money from a bank. Therefore, all the characteristicsthat apply to debt are also applicable to bonds. The primary difference between debt and bonds isthat the former is usually between the issuer and the bank while the latter is between an issuer andmany thousands of lenders (i.e. the "bondholders")

BASIC FEATURES

1. Maturity: is the date that the issuer pledges to pay back the face value of the bond to thebondholders. Usually, the face value for bonds is $1,000 per certificate. However, a bond isquoted in terms of 100.

2. Coupon Rate: is the rate of interest that the issuer pledges to pay to the bondholder. Forexample, if the coupon rate is 8%, the issuer pledges to pay a total of $80 (8% of $1,000) ininterest per year. In the U.S., bonds pay interest semi-annually, so in this case, $40 every 6months; while elsewhere in the world, interest is generally paid once per year.

3. Par Value: is synonymous with face value. It is the amount that the issuer will pay back onthe maturity date. Almost always, this amount is $1,000 per certificate.

Question:Which of the following statements with respect to bond features is incorrect?

A) Longer maturity bonds will exhibit greater price volatility.

B) Par value is the present value of all the bond's coupons and its face value that will be receivedat maturity.

C) The coupon rate that is set on a bond will usually be influenced by the bond's term to maturity.

D) The coupon rate that is set on a bond will usually be influenced by the shape of the yieldcurve.

Answer:

B

Explanation:Par value is simply another term for a bond's face value. Also note that the coupon rates set on abond will usually be dependent upon the shape of the yield curve during the time of issuance, andthe length of term of the bond itself. Assuming that there is an upward sloping yield curve, thelonger the maturity of the bond, the greater the coupon that will be required in order for the bondto be priced at its par value.


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COUPON RATE STRUCTURES

While in most cases, coupons are quoted as an annual rate but paid semi-annually, it is possible tostructure coupons in an entirely different manner. Some of the more commonly used alternativecoupon rate structures are as follows:

1. Zero-Coupon bonds: pay absolutely no coupons at all. Instead, the investor derives a returnby paying a price that is far below the face value of the bond. Consequently, the returncomes from the capital appreciation as the bond price moves from its discounted price over toits face value.

2. Accrual bonds: pay no coupons over the life of the bond. However, on the maturity date, theissuer must pay back the face value of the bond and all the interest that's accrued on the facevalue. Such structures are sometimes referred to as balloon payments because of the"inflated" amount that must be paid at maturity.

3. Step Up Notes: are bonds that periodically increase the rate of the coupon payment. Forexample, a 3-year step up note may start off by paying 3.5% in the first year, 4.5% in the

second year, and 6.2% in the third year.

4. Floating Rate bonds: set the coupon rate to some reference rate. For example, an issuer mayset its coupon rate equal to LIBOR plus 2%. (LIBOR is a very commonly used referencerate) Consequently, if the LIBOR rate should be 5% on the reset date, then on the nextcoupon payment date, the issuer would pay a coupon rate of 7%. (The reset date is usuallyone period before the actual coupon payment date)

5. Inverse Floaters: create an "inverse" relationship between the coupon rate and the generallevel of interest rates. For example, by setting the coupon rate equal to [10% -0.5(LIBOR)], then if LIBOR ends up being 10%, the coupon rate would become 5%.However, if LIBOR ends up being 12%, then the coupon rate would become 4%.

6. Deleveraged Floaters: set the coupon rate equal to a fraction of the reference rate plus amargin.

Question:A ten-year deleveraged floating rate bond has its coupon rate set, every June 30th and December31st, equal to 75% of the six-month LIBOR plus 2.3%. If the par value of this bond is $100,000and the six-month LIBOR rates were 5.2% in December of the previous year and 6.1% on June30th of this year, what will be the amount of the coupon payment on December 31st of this year?

Answer:

$3,437.50


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Explanation:

7. Dual Index Floaters: set the coupon rate equal to a margin plus the spread between tworeference rates.

8. Ratchet Bonds: are floating rate bonds; however, once the coupon rate is adjusteddownwards, it may never be revised upwards again.

9. Non-Interest Rate Index Floaters: set the coupon rate to a "non-interest rate" reference rate.For example, the coupon rate may be set equal to a base rate plus the rate of inflation.

Question:Which of the following statements is(are) true with respect to various coupon rate structures thatbonds may adopt?

I. A zero-coupon bond pays no coupons, however at the end of its term, both the principaland the accumulated coupons are paid to the bondholder.

II. Most U.S. corporate bonds pay coupons semi-annually.

III. Most U.S. government bonds pay coupons annually.

IV. Most mortgage-backed securities pay interest quarterly.

Answer:

II only.


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Explanation:(I) is incorrect because a zero-coupon bond compensates a bondholder through the difference inthe discount price that is always paid for this bond, and the par value that will be received in thefuture. Again, at maturity, only the par value will be received; there is no accumulated couponpayment.

(III) is incorrect because most U.S. government bonds pay coupons semi-annually as well.

(IV) is incorrect because most mortgage-backed securities pay interest on a monthly basis.

PROVISIONS FOR PAYING OFF PRINCIPAL

For most bonds, there is only one maturity date on which the entire principal is paid off. Thesebonds are referred to as having "bullet" maturities. However, bonds may also be structured sothat there are a series of maturity dates. "Serial bonds" are issued under one indenture, however,the bonds are segmented so that every segment has a different maturity date. Finally, fixedincome securities can also come in "amortized" form. For example, mortgage backed securities(MBS), generate periodic cash flows that are composed of both interest and principal. In effect,principal is paid off periodically, so that come maturity, there is negligible amount of principalthat is left to be paid.

Question:Which of the following statements is(are) true with respect the various ways that bond principalmay be repaid?

I. Bullet maturities refers to bonds that have to periodically pay back the principal withevery interest payment.

II. Conventional bonds require that each periodic payment be a blend of principal andinterest, with the interest being the higher component in the earlier periods of the bond'slife.

III. Serial bonds are a type of non-amortizing securities.

IV. Mortgage-backed securities are an example of amortized securities.

Answer:

III and IV only.

Explanation:(I) is incorrect because Bullet maturities refers to bonds that have to pay back the principal on

that one maturity date.

(II) is incorrect because conventional bonds require that entire principal be paid at the maturitydate; in other words, this is the norm.


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OPTIONS GRANTED TO ISSUERS

Many of the bonds that trade in the market have options that are embedded in them. Once theissuer exercises these options, the cash flow characteristics of the bond will change dramatically.Some of the more commonly embedded options granted to the issuer are as follows:

1. Call Provisions: give the issuer the right to buy back (or call) its bonds at some pre-determined price (called the "call price") at specified points in time before the actual maturitydate. The issuer's motivation to call its bonds increases when interest rates decrease. Forexample, suppose the issuer has bonds outstanding that are paying a coupon rate of 8%. Ifinterest rates decline far enough, the issuer may be able to issue new bonds at 6% and thenuse the proceeds of this new issue to retire the original bonds that were paying 8%. Theissuer in effect cuts its interest cost by 2%. However, as we will see later on, the issuer mustinitially compensate the investor for taking on this "call risk".

2. Non-refunding Provision: gives the issuer the right to buy back its bonds only if the proceedsused to repurchase the old bonds wasn't raised by the issuance of a new lower costing bonds.This means that the issuer may only repurchase its bonds if the proceeds were raised through

internal operations, sale of assets, or the issuance of stock.

3. Sinking Fund Provisions: enables the issuer to periodically repurchase a portion of itsoutstanding bonds back before maturity. Consequently, at the maturity date, the amount ofdebt outstanding will be far less than the amount that was actually issued.

4. Caps: may be attached to bonds that pay a coupon rate that's pegged to the general level ofinterest rates. Without the cap, a dramatic increase in interest rates will result in a dramaticrise in interest costs. Therefore, a cap sets a maximum rate so that even if interest rates wereto rise, the coupon rate will at least not exceed this maximum level.

5. Prepayment Options: are more applicable to amortizing securities. For example,

homeowners, who make up the mortgage pool upon which MBSs are based, can prepay theirmortgage ahead of schedule at any time. This option is generally exercised when interestrates drop.

Question:Which of the following statements is(are) true with respect to the provisions for the earlyretirement of debt?

I. A call provision enables the investor to exercise the right to call in the par value inexchange for delivering the bond back to the issuer.

II. A non-refundable provision forbids the issuer from ever calling the bonds before their

maturity date.III. A sinking fund provision obligates the issuer to retire a portion of its debt every period

prior to its maturity.

IV. Another term used to describe a non-refundable feature is non-callable.

Answer:

III only.


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Explanation:(I) is incorrect because a call provision enables the issuer to call in the bond in return for payingthe investor a call price, which is really the sum of the bond's par value and some call premium.

(II) is incorrect because a non-refundable provision only forbids the issuer from calling the bonds

if the proceeds used to redeem the existing bonds came from the issuance of bonds with a lowercoupon rate.

(IV) is incorrect because non-refundable implies that a bond cannot be retired by substituting itwith lower cost debt, otherwise other company funds may be used to retire this bond. A non-callable feature, on the other hand, implies that a bond cannot be retired before its maturity underany circumstances.

OPTIONS GRANTED TO INVESTORS

Sometimes, in order to make a bond more appealing to an investor, the issuer will embed anoption that is to the benefit of the investor. Some of the more common such options are asfollows:

1. Put Provisions: gives the investor the right to sell back (or put back) the bond back into theissuer's hand and receive a predetermined price for it (usually par). The investor wouldexercise such an option when the bond price drops dramatically. Therefore, instead of sellingthe bond in the market at a lower price, the investor will simply exercise the put option andsell the bond back to the issuer at the artificially higher price. However, as we will see lateron, the investor must forego some yield in order to participate in such a feature.

2. Convertible Provisions: gives the investor the right to "convert" her bond into the commonshares of the issuer. While bonds only offer fixed income, the returns on common shares

have a much higher potential. Consequently, the investor would only convert if the prospectsfor the company's equityholders were to improve dramatically.

3. Exchangeable Provisions: gives the investor the right to "exchange" her bond into thecommon shares of an issuer other than the issuer that issued the original bonds.

4. Floors: may be attached to bonds that pay a coupon rate that's pegged to the general level ofinterest rates. Without the floor, a dramatic drop in interest rates will result in a dramaticdrop in coupon income. Therefore, a floor sets a minimum rate so that even if interest rateswere to drop, the coupon rate will at least stay above this minimum level.

Question:Which of the following is not an embedded option designed to benefit an issuer?

A) Caps on floaters.

B) Put provision.

C) Prepayment provision.


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D) Accelerated sinking funds feature.

Answer:

B

Explanation:

Put provisions allow the holder of the bonds to deliver the underlying bond to the issuer inexchange for some pre-determined price. This feature becomes especially beneficial to theinvestor when they have the ability to deliver the bond for a set price, even the market price forthe bond might be deteriorating.

Question:Which of the following statements is(are) true with respect to the types of extra features that maybe incorporated into a bond?

I. Special redemption prices allow the issuer to call its bonds at just par, if certain

circumstances prevail.

II. Exchangeable bonds allow the holder to exchange the bonds for the common shares ofthe underlying issuer.

III. Put provisions allow the holder of the bonds to deliver the underlying bond to the issuerin exchange for some pre-determined price.

IV. Indexed amortization notes allows the issuer to accelerate principal repayments if aspecified reference interest rate increases.

Answer:

I and III only.

Explanation:(II) is incorrect because exchangeable bonds allow the holder to exchange the bonds for thecommon shares of corporation that is different from the issuer.

(IV) is incorrect because indexed amortization notes allows the issuer to accelerate principalrepayments if a specified reference interest rate actually decreases.

PURCHASING BONDS

1. Cash Purchase: For most individual investors, this is the primary method of purchasing

bonds. If the bond is purchased on the day that it is issued or immediately after a coupon hasbeen paid, then the invoice price is simply equal to the price that is quoted for the bond.However, if the bond is traded at any other time, there is the issue of accrued interest from thedate of the last coupon payment to the settlement date of the underlying trade. In addition tothe quoted price for the bond, the seller will also demand to be compensated for that portionof the upcoming coupon that is attributable to the period that the seller held the bond. Inother words, the full price (or "dirty price") is equal to the quoted price (or "clean price") plusaccrued interest.


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Question:Which of the following statements is(are) true with respect to the cash method of purchasingbonds?

I. "Dirty price" makes reference to the sum of the bond's price plus any accrued interest that

may be accumulated on the bond.II. Ex-coupon bonds do not require any accrued interest to be built into the trade price for a

bond.

III. In the U.S., bonds that are trading "cum-coupon" are usually bonds that are in default.

IV. Accrued interest is accumulated from the date of the last coupon payment to the tradedate of the bond.

Answer:

I and II only.

Explanation:

(III) is incorrect because in the U.S., bonds that are trading "ex-coupon" are usually bonds thatare in default. A cum-coupon bond refers to those bonds whose trade prices include both thenormal price of the bond and any accrued interest.

(IV) is incorrect because accrued interest is actually accumulated from the date of the last couponpayment to the "settlement" date of the bond. Settlement date always comes after the trade date;hence it involves a slightly larger period of accumulation.

2. Margin Buying: For aggressive investors or institutions, bond purchases may also be financedwith borrowing. The Federal Reserve sets the margin for which an investor must post for

such trades.

3. Repurchase Agreements: are also borrowing structures used to finance the purchase of bonds.However, instead of making interest payments on the borrowed fund, an investor borrows oneamount but repays a higher amount back to the lender. The yield between the originallending amount and the repayment amount is referred to as the "repo rate". The lower therepayment amount, the lower this repo rate will be.

Question:Which of the following statements is(are) true with respect to the methods that may be used byinstitutional investors when purchasing bonds?

I. Call money rate refers to the rate that is charged on loans by a broker to investors whopartly finance the purchase of bonds through debt.

II. Repurchase agreement involves a dealer selling a bond today at one price, andsimultaneously agreeing to repurchase it back at a lower price at some future date.

III. Overnight repo refers to the implicit rate derived from a repurchase agreement that isreversed the very next day.


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IV. If the annualized implied interest rate on a repurchase agreement is high, the underlyingbond is referred to as a hot or special collateral.

Answer:

I and III only.

Explanation:(II) is incorrect because a repurchase agreement involves a dealer selling a bond today at oneprice, and simultaneously agreeing to repurchase it back at a "higher" price at some future date.By selling the bond today, the dealer is effectively getting a loan and the lender is keeping thebond as collateral. Hence, for the lender to earn a return, the dealer must buy back the bond at ahigher price than what it originally sold it to the lender.

(IV) is incorrect because the term hot or special collateral refers to that agreement whereby theunderlying bond is bought back at only a "slightly" higher price. Think of it this way: thisunderlying bond is so hot, that the lender does not need much compensation in order hold thebond as a collateral. This means that the original owner need only pay a slightly higher price inorder to buy the bond back from the lender.

Features of Fixed Income Securities

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