Fixed Income Securities Quiz

Features of Debt Securities

• In investment management, the most important decision involves allocating funds among different asset classes.
• The two major asset classes are equities and fixed-income securities.
• Alternative asset classes include real estate, private equity, hedge funds, and commodities.
• The focus will be on fixed-income securities.

Fixed Income Securities (FIS)

• FIS represents a financial obligation of an entity to pay a specified sum at future dates.
• The issuer of the security is the entity that promises to pay.
• FIS falls into two categories: debt obligations and preferred stock.
• The borrower takes on the debt obligation.
• The investor becomes a lender/creditor.
• Promised payments include interest and principal, where principal represents repayment of borrowed funds.
• Fixed income securities that are debt obligations : bonds, mortgage-backed securities, asset-backed securities, and bank loans
• Preferred stock represents ownership interest in a corporation.
• Dividends are made to preferred stockholders and represent a distribution of the corporation’s profit.
• In case of bankruptcy, preferred stockholders have preference over common stockholders.
• The terms fixed-income securities and bonds are used interchangeably, and bonds refer to mortgage-backed securities, asset-backed securities, and bank loans.

Indentures and Covenants

• The bond indenture sets out the promises of the issuer and the rights of bondholders.
• Indentures identify a trustee as a third party to the bond/debt contract.
• Indentures have two types of covenants: affirmative and negative
• Affirmative covenants outline activities the borrower promises to do, including paying principal and interest on time, taxes when due, maintain properties and submit periodic reports to a trustee.
• Negative covenants set limitations on borrowers activities, such as the ability of the borrower to incur more debt unless certain tests are satisfied.

Maturity

• Maturity: the term refers to the number of years the debt is outstanding or the number of years remaining prior to final principal payment.
• Maturity date: refers to the date when the debt will cease to exist, and the issuer will redeem the bond by paying the outstanding balance.
• Short term maturities are 1 to 5 years.
• Intermediate term maturities are 5 to 12 years.
• Long term maturities are 12 years or more.
• Reasons for the importance of maturity: indicates the time period for interest payments and principal repayment. The yield offered depends on the term to maturity. Price of a band fluctuates over its life.
• Price volatility is a function of maturity
• Longer maturity = < PV resulting from increase in interest rates

Par Value

• Par value: the amount the issuer agrees to repay the bondholder at or by the maturity date.
• Also referred to as principal value, face value, redemption value, and maturity value.
• Valuing Bonds: Involves quoted price, price per $ value, par value, and dollar value.
• Trading below par value is at a discount.
• Trading above par value is at a premium.

Coupon Rate

• Coupon rate also called nominal rate, is the interest rate the issuer agrees to pay each year.
• Coupon is the annual interest payment made to the bondholder during the term.
• Coupon rate = Coupon rate X par value
• 6s of 12/1/2026 is an example of coupon rate notation
• The "s" represents the coupon series.
• Bonds are typically paid semi-annually, while mortgage-backed and asset-backed securities pay interest monthly.

Types of Bonds

• Zero coupon bonds are those that are not contracted to make payments.
• Holders realise interest by purchasing the bonds below par value.
• Interest is part of the maturity date, with interest being the difference between the par value and the purchase price of the bond.
• Step-up Notes have a coupon rate that increases over time.
• A single step-up note is referred to as a single step-up, while more than one step-up is a multiple step-up note.
• Deferred Coupon Bonds interest payments are deferred for a specified number of years.
• No interest payments are paid for a specified period, but after a specified period, the issuer makes payments until maturity. Interest payments for such bonds are higher than a normal bond.
• Floating rate securities quoted margin refers to the additional amount that the issuer agrees to pay above the reference rate.
• When a floater has a restriction on the max coupon rate, the max coupon rate is referred to as CAP. CAP is unattractive to the investor.
• The minimum coupon rate is referred to as floor. If the coupon formula produces a coupon rate below the floor, the floor rate is paid instead.
• Embedded options are provisions in the indenture that gives the issues and/or bondholder an option to take some certain action against another party.
• Treasury Inflation Protection Securities (TIPS) are securities that are inflation adjusted.
• The reference rate is measured by the consumer price index.
• The coupon increases when the reference rate increases and vice versa.
• Coupon rate = K – LX (Reference rate), where K & L are specified values

Accrued Interest

• Interest is paid every 6 months (semi-annually) or annually, while mortgage and asset-backed securities are paid monthly.
• Accrued interest: the amount of interest received by the buyer
• The amount that the buyer pays the seller is the agreed-upon price of the bond plus accrued interest (full price/dirty price)
• Clean price: the agreed-upon price without the accrued interest.
• Trading flat – when a bond is traded without accrued interest

Provisions for Paying off Bonds

• The issuer agrees to pay the principal by the stated maturity date
• In a bullet payment the issuer agrees to pay the entire amount borrowed in one lump sum at maturity.
• Fis (mortgage backed and asset backed) backed by pools of loans often have a schedule for opartial payment-> Amortizing securities
• The Sinking Fund Provision involves the provision for repayment of a bond.
• The bond may be designed to repay all of its issue amount at the maturity date, or it may be arranged to pay only part of the total at maturity.
• Call Provision grants the issuer an option to retire part of the issue prior to the stated maturity date.

Types of Call Options

• Call and refunding provisions gives the issuer the right to issue retire prior to the stated maturity date.
• The price at which the issuer must pay is called the call price or redemption price.
• Calls can be random a computer pick / pro rate basis meaning all the bonds will be redeemed at the same percentage.
• A bond that permits the issuer to call an issue prior to the stated maturity date.
• The Call (redemption) Price can be fixed, be based on the price specified in the schedule, or be based on a make whole provision.

Noncallable vs. Non-refundable Bonds

• A bond issue without safeguards against early calls is currently callable.
• Call prices are regular redemption prices
• General redemption prices are (i) and (ii) call prices.
• The regular redemption prices are above par until the first par call date.
• Special redemption prices are for bonds redeemed through the sinking fund and through other provisions.
• A special redemption price is at par value rather than the regular redemption price.
• Prepayments
• Any principal payment prior to a scheduled principal date is a prepayment
• A borrower's right to repay principal is the same as a prepayment option
• A prepayment behaves as a call feature

Sinking Fund Provision

• An indenture may require the issue to retire a specified portion of the issue, and this is referred to as a sinking fund requirement.
• If only a portion is paid, the remaining principal is called balloon maturity.
• The first method: interest payments stop at the redemption date, so the interest to be delivered is less

Conversion Privilege

• A convertible bond grants the bondholder the right to convert the same into a fixed number of common stock shares.
• It enables the bondholder to benefit from positive movements in the price of the issuers common stock.
• An exchangeable bond enables the bondholder to exchange the issue for a certain number of common stock of another corporation that is not the bond issuer.

Put Provision

• This is the right to sell the issue back to the issuer at a specified price on particular dates.
• This price goes by the name of put price
• If issued close to par value or zero coupon bond, the bond is placed at par, with the put price being lower than the price
• If the market goes well above the issue coupon rate, the advantage is that the bondholder can pressure the issue to redeem the bond at price and then reinvest the put bond proceeds at the predominant higher cost.

Currency Denomination

• An indenture can specify how the issuer can settle with payments made in another currency which can come into play for two central issue types (i) A Dollar denominated issue (ii) Non-dollar denominated issue which can be known as a dual currency as well

Embedded Options

• Embedded options provisions give the issuer and/or bondholder an option to act against another party
• These options may grant issuers/borrowers (i) call rights (ii) ability for issuers/borrowers pool principal prepayments which may go above schedule (iii) accelerate the existing schedule, particularly the sinking fund provision (iv) and/or make use of a rate cap
• Sinking funds are considered part of the embedded option due to the underlying factors tied to external interest rates. With a floating rate instrument, the bondholder grants power to the issuer to forbear from offering more than what a rate may yield

Continued

• When dealing with bondholders power: they may involve (i) provisions permitting convertibility (ii) and/or may enforce a put permission (iii) in other instances, a rate floor may be enforced such as an interest component
• It is important to note to what extent embedded option's cash flows and principals change and whether such change in the underlying rates is the determining condition

Test your knowledge of fixed income securities. Questions cover negative covenants, bond pricing, maturity, and the role of trustees. Evaluate your understanding of bonds, preferred stock, and mortgage-backed securities.