Fixed income securities: determining elements (2024)

Reading refresher course

This talk introduces the salient features of fixed income securities while noting how these features vary across different types of securities. Key points include the following:

• The three important elements an investor needs to know when investing in a bond are: (1) the characteristics of the bond, which determine the expected cash flows and therefore the bondholder's expected and actual returns; (2) the legal, regulatory and tax considerations applicable to the contractual arrangement between the issuer and the bondholders; and (3) the contingencies that could affect the bond's expected cash flows.
• The basic characteristics of a bond include the issuer, maturity, par value (or principal), coupon rate and frequency, and currency.
• Bond issuers include supranational organizations, sovereign governments, non-governmental governments, quasi-governmental entities and corporations.
• Bondholders are exposed to credit risk and can use bond credit ratings to assess a bond's credit quality.
• The principal amount of a bond is the amount the issuer is willing to pay to the bondholder when the bond matures.
• The coupon rate is the interest that the issuer is willing to pay to the bondholder annually. The coupon rate can be a fixed rate or a variable rate. Bonds can offer annual, semi-annual, quarterly, or monthly coupon payments, depending on the type of bond and where the bond is issued.
• Bonds can be issued in any currency. Bonds such as dual currency bonds and currency option bonds are pegged to two currencies.
• The maturity rate is the discount rate that equates the present value of the bond's future cash flows until maturity to its price. The yield to maturity can be considered an estimate of the market's expectations of the bond's return.
• A plain vanilla bond has a known cash flow pattern. The bond has a fixed maturity date and pays a fixed interest rate over the life of the bond.
• The bond contract or trust deed is the legal contract that describes the form of the bond, the obligations of the issuer and the rights of the investor. The contract is typically managed by a financial institution, called a trustee, which performs various tasks specified in the agreement.
• The issuer is identified in the agreement by its legal name and is obliged to make timely interest and principal repayments.
• For asset-backed securities, the legal obligation to repay bondholders often rests with a separate legal entity, that is, a bankruptcy arm vehicle that uses the assets as collateral to back a bond issuance.
• The agreement should describe how the issuer plans to service the debt and repay the principal. The source of redemption proceeds varies depending on the type of bond.
• Collateral is a way to reduce credit risk. Covered bonds are backed by assets or financial guarantees promised to secure the payment of debts. Examples of collateralized bonds include collateralized bonds, equipment trust certificates, mortgage bonds, and covered bonds.
• Credit improvement can be internal or external. Examples of internal credit enhancement include subordination, overcollateralization, and reserve accounts. A bank guarantee, a surety, a letter of credit and cash collateral are examples of external credit improvement.
• Bond provisions are legally enforceable rules that borrowers and lenders agree to at the time of a new bond issuance. Affirmative covenants specify what issuers must do, while negative covenants specify what issuers may not do.
• An important consideration for investors is where the bonds are issued and traded, as this affects the laws, regulations and tax status that apply. Bonds issued in a country in local currency are domestic bonds if they are issued by entities registered in the country, and foreign bonds if they are issued by entities registered in another country. Eurobonds are issued internationally outside the jurisdiction of any single country and are subject to a lower level of listing, disclosure and regulatory requirements than domestic or foreign bonds. Global bonds are issued simultaneously on the Eurobond market and on at least one domestic market.
• Although some bonds may offer special tax benefits, interest is generally taxed at ordinary income tax rates. Some countries also introduce a capital gains tax. Special tax provisions may apply to bonds issued at a discount or purchased at a premium
• A amortizing bond is a bond whose payment schedule requires periodic interest payments and repayment of principal. This differs from a revolving bond in that full payment of principal is made at maturity. The outstanding principal of the amortizing bond is reduced to zero at maturity for a fully amortized bond, but for a partially amortized bond, a balloon payment is required at maturity to repay the outstanding principal of the bond.
• Sinking fund agreements offer a different approach to periodic principal retirement, where an amount of the bond's outstanding principal is usually repaid each year over the life of the bond or after a specified date.
• A variable rate or floater is a bond whose coupon is determined on the basis of a market reference rate (MRR) plus a spread. FRNs may have floors, caps, or collars. An inverse FRN is a bond whose coupon has an inverse relationship with the reference interest rate.
• Other coupon payment structures include step-up coupon bonds, which pay coupons that increase by certain amounts on specific dates; bonds with credit-linked coupons that change when the creditworthiness of the issuer changes; bonds with in-kind coupons, which allow the issuer to pay coupons with additional amounts from the bond issue instead of cash; and deferred coupon bonds, which pay no coupons in the first few years after issuance, but higher coupons thereafter.
• Payment structures for index bonds vary considerably from country to country. A regular index bond is an inflation-adjusted bond, or link, whose coupon payments and/or principal payments are linked to a price index. Index-linked payment structures include zero coupon indexed bonds, interest rate indexed bonds, equity indexed bonds and indexed annuity bonds.
• Common types of bonds with built-in options include callable bonds, tradable bonds, and convertible bonds. These options are "embedded" in the sense that there are provisions in the bond that give the issuer or bondholder certain rights that affect the disposition or redemption of the bond. They are not separately traded securities.
• Convertible bonds give the issuer the right to repurchase bonds before maturity, increasing the reinvestment risk for the bondholder. For this reason, convertible bonds must offer a higher yield and sell at a lower price than equivalent non-convertible bonds, to compensate bondholders for the value of the call option to the issuer.
• Putable bonds give the bondholder the right to sell bonds back to the issuer before maturity. Puttable bonds offer a lower yield and are sold at a higher price than comparable, non-tradable bonds to compensate the issuer for the value of the put option to bondholders.
• A convertible bond gives the bondholder the right to convert the bond into common shares of the issuing company. Because this option favors the bondholder, convertible bonds offer a lower yield and sell at a higher price than comparable non-convertible bonds.