Untitled

• Debt securities are an alternative to bank loans for companies and governments to raise capital and finance growth.

Key Features of Debt Securities

• Governed by a legal contract called the bond indenture or offering circular.
• A typical bond includes par value, coupon rate, and maturity date.
• Par value (principal value or face value) is the amount the issuer pays bondholders at maturity.
• Coupon rate is the promised interest rate on the bond.
• Maturity date is when the bond's life ends, assuming all payments have been made.
• The bond contract will specify the frequency and timing of payments.
• Bonds may also contain covenants (legal agreements) that the issuer must perform or is prohibited from performing.

Seniority Ranking

• In liquidation, assets are distributed based on a priority of claims or seniority ranking.
• Debtholders have higher claims on a company's assets than equity holders.
• Bonds can be issued as secured or unsecured debt securities.
• Secured debt securities pledge specific assets as collateral to bondholders.
• Collateral reduces the risk that bondholders will lose money in the event of default.
• Unsecured debt securities aren't backed by collateral.
• Unsecured debt securities typically have a higher coupon rate than secured debt securities.
• A lower-priority unsecured bond is called subordinated debt.

Types of Bonds

• Bonds are classified by issuer type, type of market, and type of coupon rate.
• Debt securities include bills (maturities of one year or less), notes (maturities from 1 to 10 years), and bonds (maturities longer than 10 years).
• Bonds issued by companies = corporate bonds.
• Bonds issued by central governments = sovereign or government bonds.
• Government bonds may have specific names like Treasury securities (US), Kiwi Bonds (New Zealand), gilts (UK), Bunds (German), and OATs (French).
• The primary market is where investors buy bonds directly from an issuer.
• The secondary market is where bondholders sell their bonds to other investors.
• Bonds are categorized by coupon rates (fixed-rate, floating-rate, and zero-coupon bonds).

Fixed-Rate Bonds

• It has a finite life that ends on the bond's maturity date, with a coupon rate and par value that do not change.
• Pays fixed periodic coupon payments and a final par value payment at maturity.

Floating-Rate Bonds

• Coupon rate changes over time and is linked to a reference rate, such as the London Interbank Offered Rate (Libor).
• The floating rate = reference rate + spread (percentage paid above the reference rate).
• The coupon rate changes or is reset at each payment date every quarter.
• Coupon payments are paid in arrears (at the end of the period, based on the reference rate set at the beginning of the period).
• Inflation-linked contains a provision that adjusts the bond's par value for inflation.
• The fixed coupon rate is multiplied by the inflation-adjusted par value.

Zero-Coupon Bonds

• Issued at a discount to the bond's par value.
• Only cash flow offered is a single payment equal to the bond's par value at maturity.

Bonds with Embedded Provisions

• Include call, put, and conversion provisions.
• Callable bonds give the issuer the right to buy back the bond issue prior to maturity.
  • The issuer buys it back (retires or calls) the bond from bondholders prior to the maturity date at a pre-specified price = call price.
  • The coupon on a callable bond will generally be higher than a comparable bond without a call provision to compensate the bondholder for the risk that the bond may be retired early = call risk.
• Putable bonds give the bondholder the right to sell the bond back to the issuer prior to the maturity date.
  • Gives bondholders the right to sell (put back) their bonds to the issuer prior to the maturity date at a pre-specified price- put price.
  • The coupon rate on a putable bond will generally be lower than the coupon rate on a comparable bond w/o put.
• Convertible bonds give the bondholder the right to exchange the bond for shares of the company's stock prior to the bond's maturity date.
  • A hybrid security with characteristics of equity and debt securities.

Asset-Backed Securities

• Are backed by a pool of other debt securities.
• Improves liquidity in the underlying asset markets.
• Investors value asset-backed securities liquidity so they pay more for them than for individual assets.
• Investors receive a portion of monthly loan payments with both an interest and principal component.

Valuation of Debt Securities

• Estimated using discounted cash flow (DCF) approach.
• Estimates security's value as the present value of all future cash flows that the investor expects to receive from the security.
• Cash flows are the future coupon payments and the final principal payment.

Current Yield

• Calculated as the annual coupon payment, divided by the current market price.

Valuation of Fixed-Rate and Zero-Coupon Bonds

• Timing & promised amount of interest payments and final principal payment is known.
• Vo = CF1/(1+r) + CF2/(1+r)² + CF3/(1+r)³ + ... + CFn/(1 + r)^n
  • Vo = current value of the bond
  • CFt = bond's cash flow (coupon payments and/or par value) at time t
  • r = discount rate
  • n = number of periods until the maturity date
• Appropriate discount rate (r) reflects the riskiness of the bond's cash flows.

Yield to Maturity

• The discount rate that equates the present value of a bond's promised cash flows to its market price.
• Po = CF1/(1 + rytm) + CF2/(1 + rytm)² + CF3/(1+ym)³ + ... + CFn/(1 + rytm)^n
  • Po = the current market price of the bond
  • rytm = represents the bond's yield to maturity
• Bond prices and bond yields to maturity are inversely related (as bond prices fall, their yields to maturity increase & vice versa).

Yield Curve

• shows how interest rates on government bonds vary with maturity.
• Graphs the yield to maturity of government bonds (y-axis) against their maturity (x-axis).

Risks of Investing in Debt Securities

• Credit risk/ default risk, interest rate risk, inflation risk, liquidity risk, reinvestment risk, and call risk.

Credit Risk

• Risk of loss if the borrower/bond issuer fails to make full and timely payments of interest and/or principal.
• investors can assess the credit risk of a bond by reviewing its credit rating.
• Independent agencies assess a bond's credit quality & assign ratings based on the issuer's creditworthiness (Standard & Poor's, Moody's Investors Service, and Fitch Ratings).
• Bonds are classified as investment-grade or non-investment-grade (high-yield or junk bonds).
  • investment-grade bonds have low risk of default.
  • non-investment-grade bonds have a greater probability of default.

Credit Spread

• The difference between a risky bond's yield to maturity and the yield to maturity on a government bond with the same maturity.

Interest Rate Risk

• Risk that interest rates will change (decrease bond prices resulting from increases in interest rates.
• Bond prices and interest rates are inversely related.

Inflation Risk

• Promised interest and final principal payment are nominal amounts.
• Purchasing power of coupon payments declines as inflation makes products and services become more expensive over time.

Other Risks

• Liquidity risk is the risk of being unable to sell a bond prior to the maturity date without having to accept a discount.
• Reinvestment risk is the fact that, in a period of falling interest rates, the coupon payments received during the life of a bond must be reinvested at a lower rate.
• Call risk is the risk that the issuer will buy back (redeem or call) the bond prior to maturity through the exercise of a call provision.