Fixed-Income Securities: An Overview

Fixed-Income Securities

• Fixed-income securities offer governments and corporations a way to raise funds for operations and expansions
• For investors, these securities represent lending money to the issuer, making them creditors but not giving them ownership rights

The Fixed-Income Marketplace

• Issuing fixed-income securities allows governments and corporations to finance operations/growth, and leverage finances

Rationale for Issuing Fixed-Income Securities

• Corporations and governments use fixed-income securities to regularly raise money to finance operations
• Governments use tax revenue to fund obligations, but borrow money through fixed-income securities to cover deficits
• Companies can issue fixed-income securities, sell assets, borrow from banks, or issue equity securities
• Borrowing costs informs financing choices

Common Reasons for Issuing Fixed-Income Securities

• To finance operations or growth
• To take advantage of financial leverage

Basic Features and Terminology

• Fixed-income securities most often refers to bonds
• A bond is a long-term, fixed-obligation debt security secured by physical assets of the issuing company
• Bonds are considered fixed-income because they mandate issuers to make fixed financial obligations
• Issuers must pay regular interest and the principal by the maturity date
• Bond issue details are in a legal document called a trust deed in a bond contract
• Bondholders can seize and sell specified physical assets to recover investment if the issuer defaults

Debentures

• This is a type of bond secured by a general claim on residual assets
• Debentures are backed by the general creditworthiness of the issuer
• Debentures are also unsecured bonds
• Debentures and bonds both promise payment of regular interest and principal at maturity

Bond Terminology

Par Value (Face Value)

• This is the principal amount the bond issuer agrees to pay the bondholder at maturity
• A bond is issued and matures at its par value

Coupon Rate

• This is the interest rate paid by the issuer relative to the bond's par or face value

Coupon

• Represents the regular interest the issuer pays to bondholders, coupon rate is typically fixed at issuance
• Most bonds are coupon bonds with fixed coupon rates
• Most bonds make semi-annual coupon payments
• Bondholders get a fixed-income stream based on the coupon rate
• Changes in market interest rates impact a bond's value and price
• Rising or falling interest rates affect a bond's price relative to its coupon rate
• Coupon payments are not impacted by changes in interest rates

Maturity Date

• The date when a bond matures and the principal is paid back to the bondholder
• The final interest payment is also made at maturity

Term to Maturity

• This is the time remaining before a bond matures

Bond Price

• This is the present discounted value of all future payments the issuer is obligated to pay
• the sum of the present value of all future interest payments plus the present value of the loan

Bond Trading

• Once issued, a bond can trade at, above, or below its par value, based on market interest rates.

Bond Price Index

• Bond prices are quoted using an index, with a base value of 100
• A $1,000 par value bond with a price quoted at 97 has a price of $97 for each $100 of face value
• A $1,000 bond at a price quote of 97 would be $970

Yield to Maturity

• The annual return on a bond held to maturity

Interest on Bonds

• A bond's coupon indicates the income the bondholder receives
• The coupon refers to interest income, bond income, or coupon income
• Most bonds pay a fixed coupon rate, while some have variable or floating rates

Types of Interest Payments

• Coupon rates can change over time based on a schedule, or with savings bonds
• Payments can be compounded over time, which is paid at maturity, rather than regularly, as with strip bonds
• A rate of interest isn't required where compensation can occur through a return based on future factors

Denominations

• Bonds can only be purchased in specific denominations
• Retail markets' issues are in smaller denominations
• The most common are $1,000 and $10,000
• Investing institutions issues are in larger denominations, and can be worth millions

Bond Pricing

• A bond trading at a quoted price of 100 trades "at par" (at face value)
• Trading below par means trading at a discount
• Trading above par is trading at a premium
• Market interest rates, relative to the bond's coupon, dictate the price

Bond Yields

• A bond yield is the return on the bond
• Bond yield has several types, including yield to maturity
• One yield is the interest income divided by its face value
• Current yield can be determined by dividing coupon income by the current market price
• Coupon income on bonds are constant over its term, while yield and price fluctuate

Term to Maturity

• Short-term bonds have terms of one to five years
• Medium-term bonds have terms of five to 10 years
• Long-term bonds have terms greater than 10 years

Money Market Securities

• Trade up to one year to maturity
• Includes T-bills and commercial paper
• Applies to high-grade bonds reduced below the one-year mark

Liquidity, Negotiability, and Marketability

• Liquidity, negotiability, and marketability speak to how easy bonds can be traded

Liquid Bonds

• Liquid bonds trade in significant volumes
• Medium and large trades conclude quickly without sacrificing price, i.e. Government of Canada bonds

Negotiable Bonds

• Negotiable bonds are transferred because they are in good delivery form
• Good delivery involves paper copies of bonds and fixed-income securities delivered between investment dealers

Marketable Bonds

• Have a ready market
• Private placement or other new issues may have clients willing to buy at a price and features
• Marketable bonds aren't necessarily liquid because private placements do not have active secondary markets

Strip Bonds

• Strip bonds (zero-coupon bonds) happen when a dealer buys a block of high-quality bonds
• Dealers separates interest coupons from the bond (or bond residue), then each is sold separately at a discount
• Holders of strip bonds receive no interest payments
• Strips are purchased at a price providing a rate of return when they mature
• Strip bonds usually trade at a discount to their par value
• Strip bond income is considered interest income
• Tax is paid annually on the interest income even if the income isn't received until the bond matures
• Strip bonds are often held in tax-deferred plans

Callable Bonds

• Bond issuers can choose to pay off the bond before maturity, either take advantage of low interest rate, or reduce debt
• Known as a call or redemption feature
• Bond is a callable or redeemable bond
• Issuer gives 10 to 30 days' notice before the bond is called or redeemed

Callability in Canada

• Most corporate and provincial bond issues are callable
• Government of Canada bonds and municipal debentures are usually non-callable

Standard Call Features

• A standard call feature allows the issuer to call bonds for redemption at a price on specific dates or intervals over its life
• The call price is set higher than the par value, providing a premium payment for the holder
• The premium compensates the investor after losing an expected investment income
• The redemption price can be set on a graduated scale, with lower premium payments as maturity nears
• Provincial bonds are callable at 100 plus accrued interest, which belongs to the holder

Call Protection Period

• The period before the first possible call date

Extendible and Retractable Bonds

• Corporate bonds are issued with extendible or retractable features

Extendible Bonds

• These bonds and debentures have short maturity terms (typically five years)
• Investors have the option to extend the investment to turn it into a 10 year investment
• Investor can exchange the debt for longer-term debt at the same rate/or slightly higher

Retractable Bonds

• The opposite of extendible bonds and are issued with a long maturity with the redemption option early
• Investors can redeem bonds at par on a retraction date (typically five years before maturity)
• Decision to exercise the maturity option must be made in a time called the election period

Convertible Bonds and Debentures

• Convertible bonds and debentures (convertibles) combine bond features
• Offers the option of exchanging the bond for common shares, allowing investors to lock in a specific price
• The right to exchange a bond for shares on specific terms is the conversion privilege

Characteristics of Convertible Bonds

• The conversion price of convertible bonds gradually goes up over time to encourage early conversion
• Convertible bonds are converted into stock any time before the conversion privilege expires
• Some convertible debenture issues excuse the issuing company from paying accrued interest on the bond that has built up
• Any common stock received from the conversion only entitles the holder of dividends declared after the conversion
• Some convertibles contain a protection against dilution clause, where a stock split occurs where the issuing company increases shares

Forced Conversion

• Forced conversion occurs when a convertible debt issues the company more control calling for debt redemption
• It forces bondholders to convert the company's bonds into a number of common shares
• A company forces a conversion when market interest falls below the coupon rate, or share trade above the conversion price
• This usually states market price of the common stock must rise above a level for the company to call the bonds
• The price the company calls the bonds back is much lower than the level at which the the convertible debt trade

Advantages and Considerations

• Forced conversion benefits the issuing company by relieving obligations to make interest payments, which frees room for new debt financing.
• However, subsequent prospective buyers should check the spread between the prevailing purchase price and the forced conversion level

Market Behavior of Convertibles

• Market price of convertible bonds is influenced by their investment value, and in the common shares when trade at below the conversion price
• Convertible behave differently because when converted in shares their price behaves differently than straight fixed income securities

Sinking Funds and Purchase Funds

• Some issuers repay portions of their bonds for redemption before maturity in two ways
• By calling them on a fixed schedule of dates (sinking fund obligation)
• By buying them in the secondary market when the trading price is at or below a price (sinking fund or a purchase fund)

Sinking Funds

• Sums of money are set aside out of earnings to repay all or part of a debt issue by maturity
• Sinking funds provisions are as binding on the issuer
• Some corporate bonds have a mandatory call feature for sinking fund purposes

Purchase Funds

• Some companies have purchase fund instead of a sinking fund
• A fund is set up to retire an amount of the outstanding bonds through purchases in the market
• Purchases must be available at or below a price

Protective Provisions of Corporate Bonds

• In addition to principal repayment features, corporate bonds have covenants securing the bond
• Covenants make it more likely the investor will get the proceeds which safeguards against weakening the security holder's position
• The intention is to create an instrument which ensures the company isn't under financial constraint

Common Protective Covenants

Security

• Includes details of assets that support the debt

Negative Pledge

• The borrower doesn't pledge assets

Limitation on Sale and Leaseback

• Protects the debt holder from the firm selling and leasing back properties

Sale of Assets or Merger

• Protects the debt holder in case all assets are sold or the company is merged with another

Dividend Test

• The rules for dividend payments which ensures equity does not drain through payments

Debt Test

• Limits additional debt a firm may issue by establishing max ratio

Additional Issues

• States which financial tests allow the firm additional debt

Sinking or Purchase Provisions

• Outlines sinking/purchase fund including specific dates and price a firm calls

Government of Canada Securities

• The Government of Canada issues fixed-income securities to finance deficits/funds, and infrastructure projects

Bonds

• The Government of Canada's' offers marketable bonds in their name
• Allows Crown corporations to issue debt that directly calls on the Government of Canada
• Government of Canada bonds have a maturity date and a coupon/interest rate
• They are transferable, and can be traded

Noncallable Bonds

• All GOC bonds are noncallable
• The government can't call them for redemption

Investor Perspective

• When they compare bonds by Canadian issuers, investors assign the highest rating to federal government bonds
• Foreign investors compare Canadian issues to other governments
• The relative risk of investing in Canada reflect the yields of their bonds, and those yields fluctuate in political events

Treasury Bills

• Treasury bills (T-bills) are government obligations offered in denominations from as low as $1,000
• T-bills are for broad range of investors, like banks, and insurance companies
• T-bills don't pay interest, and are sold at a discount/mature at 100
• The difference between the issue price and par represents the return
• Under the Income Tax Act, return is taxable as income, not a capital gain
• Regular T-bills are sold at auction every two weeks by the Ministry of Finance
• T-bills originals are have original terms of three months, six months, and one year

Real Return Bonds

• Like conventional bonds, real return bonds pay interest throughout the bond's lifespan and repay the original principal upon maturity
• Unlike conventional bonds, coupon/principal repayment adjusts for inflation creating real coupon rate
• The real coupon rate is applied to a principal balance that has been adjusted for the cumulative level of inflation

Provisional and Municipal Government Securities

• Provincial bonds are debentures that are simply promises to pay
• Their value depends on the province's ability to pay interest and principal, with no provincial assets pledged as security
• Provinces have laws governing the use of funds

Government Quality

• Provincial bonds are second in quality only to Government of Canada bonds based taxation powers
• Provinces' guaranteed bonds trade at prices/yields
• Bond quality depends on credit and market conditions (like certainty of interest payments, existing debt, federal transfer payments, provincial wealth)

Guaranteed Bonds

• Provinces guarantee bond issues of provincially appointed authorities and commissions
• Guarantees also extend to cover municipal loans/school board costs, guarantees to industrial concerns (inducement) and issue of T-bills
• Investment dealers/banks purchase them for resale

Markets

• Provinces/enterprises borrow in markets
• Provincial borrow lower costs
• borrow rate exchanges

Foreign Markets

• Issues are underwritten dealers
• Foreign financing done Crown corporations
• Can be sold in foreign dollars

Provincial Securities

• Provinces have savings bonds w/ certain characteristics i.e. can only buy w/ in provinces/certain times of the year
• Provinces issue many savings bonds, check for information

Municipal Securities

• Municipalites raise capial for intalment debenture serial bond
• Part of the bond matures during each year of it's term

Instalment Debenture

• A debenture occurs $100,000 for 10 years
• Occurs sepate debbtrus and 10 years after

Credit Rating

• Generally rating depend taxation
• All well sector better

Types of Corporate Bonds

• Coprotations have choices than goventems
• Can sell ownerhsip through selling stocks investors or money
• Corpate bonds have the risk of default and dependions of time, issue

Mortgage Bonds

• Mortgage - pledge/equipment
• Lender to owner
• Interest or loans for
• Mortgage bond loan for

Properties

• Senior securities
• Determine each mortage
• First mortogage
• after-acquired

Floating-Rate Securities

• Floating (adjustments Longer Rising interest rates debentures
• Adjustments to six months improves price yield Interest Rate falling

Domestic, Foreign, and Eurobonds

• Classified where/how issue currency/country
• Issued Country
• give access sources foreign

Yankee Bonds

• US Canadian

Samurai Bonds

• Yen Japan

Maple Bonds

• Candian

Euro Bonds

Currency other that issye

• Markets with Canada dollars

Collateral Trustbonds

• Securities collateral

Equipment Trust Certificates

• Real property
• Equipment rolling stock

Subordinated Debentures

• Junior securities
• Assumed companys

Corporate Notes

• Short term promise
• Funds specific data

High-Yield bonds

• Lower Credit grade
• Uncertainty Issyer
• Higher coupon
• Investors acess

Other Fixed-Income Securities

• Bonds dominate Media reports

Banker's Acceptances

• Commercial Draft Payment

Commercial Paper

• Promised Note
• By Pools

Term Deposits

• Fixed
• Short Term

Guaranteed Investment Certificates

• Specific fixed
• Principal fixed
• non-extreme can't cashed

Fixed-Income Mutual Funds and Exchange-Traded Funds

• Have grown for decades
• Due to Equity Market
• Managed access Diversification

Reading Bond Quotes and Ratings

• Bond quote illustrated Issuer Rate Date Price Price Date
• Bond is percetange than added

Services

• Moody’s provide ratings
• Assess confirm the resaerch

Ratings

• High have lower coupon

Classify Ratings

• High ability

Key Takeaways

• Fixed to Finace
• Regular Forms
• Physical is Credit
• Many Different
• Convertible