50 Fixed-Income Cash Flows and Types

• A company issues a fixed-income security, placing $10 million in loan receivables into a special purpose entity (SPE) independent of the issuer.
• Credit rating agencies suggest a third-party guarantee to achieve a AAA rating for the security.
• After the asset transfer to the SPE and a letter of credit from a national bank, the company issues an AAA-rated security, which is most likely an asset-backed security.
• Special purpose entities relate to asset-backed securities.

Treasury Inflation Protected Securities (TIPS)

• TIPS provide inflation protection by adjusting the par value while keeping the coupon rate fixed.
• These securities are best described as capital-indexed bonds, as opposed to interest-indexed bonds, which adjust the coupon rate.
• Indexed-annuity bonds are fully amortizing with payments adjusted.

Reinvestment Risk

• An investor concerned with reinvestment risk would be least likely to eliminate it by holding a coupon bond until maturity.
• A noncallable bond reduces reinvestment risk by reducing the risk of repayment.
• Lower coupon bonds have lower reinvestment risk.

U.S. Treasury Inflation Protection Securities (TIPS)

• The coupon rate is fixed for the life of the issue.
• Adjustments to principal values are made semiannually.
• The adjusted principal value may be less than par due to the possibility of deflation.
• At maturity, the Treasury redeems the bonds at the greater of the inflation-adjusted principal or the initial par value.

Bond Coupon Payment

• A bond with a par value of $5,000 and a coupon rate of 8.5% payable semi-annually results in a semi-annual coupon payment of $212.50. Calculation: $5,000 × 0.085 / 2 = $212.50.

Callable Bond Indenture

• A callable bond states that it may be called on the first business day of any month after the first call date.
• The call option embedded in this bond is an American style call option.
• Bonds with Bermuda style call options may be called on prespecified dates after the first call date.
• European style call options specify a single date on which a bond may be called.

Floating Rate Issue

• A floating rate issue has the coupon rate that is reset on January 1 of each year.
• The coupon rate is one-year LIBOR + 125 basis points.
• Coupons are paid semi-annually.
• It the one-year LIBOR is 6.5% on January 1, the semi-annual coupon payment is 3.875%.

Yield Volatility Effects

• An increase in yield volatility will cause one bond to increase in value and the other will decrease between a putable bond and a callable bond.
• A call option is written with a callable bond.
• An increase in volatility increases the value of the call option and decreases the value of the callable bond.
• A long put option exists for a puttable bond.
• An increase in volatility increases the value of the option.

Eurobond

• Eurobonds are denominated in a currency other than that of the countries in which they are issued.
• A Brazillian firm’s U.S. dollar-denominated bonds sold to investors in Canada, are accurately described as Eurobonds.
• EU firm's Japanese yen-denominated bonds sold to investors in Japan, are not Eurobonds.
• South Korean firm's euro-denominated bonds sold to investors in the European Union, are not Eurobonds.
• Terminology: a U.S. dollar-denominated bond sold to investors outside the United States is called a "eurodollar bond."

Eurobonds

• A bond denominated in euros and issued in Germany is least likely classified as a eurobond.
• A bond denominated in euros and issued in the United States is a eurobond.
• A bond denominated in U.S. dollars and issued in Japan is a eurobond.
• Bonds denominated in the currency of the country or region where they are issued are domestic bonds.

Bond Types

• A bond that initially does not make periodic payments but accrues them over a pre-determined period, then pays a lump sum at the end of that period and subsequently makes regular periodic payments until maturity, is best described as a deferred-coupon bond.
• The coupon payments accrue, at a compound rate, over the deferral period and are paid as a lump sum at the end of that period.
• Zero coupon bonds do not pay periodic interest.
• A step-up note has a coupon rate that increases on one or more specified dates.

Bond Credit Enhancement

• Covering the bond issue via a surety bond is least likely a form of internal credit enhancement for a bond issue.
• A surety bond is issued by a third party and hence is an external form of credit enhancement.

Securitized Bonds

• Securitized bonds are most likely to be issued by special purpose entities (SPEs).
• An SPE is formed to purchase and administer assets that will provide the cash flows to pay interest and principal on bonds the entity issues.
• These bonds are called securitized bonds.

Callable Bond Yield

• A callable bond’s yield should be higher than a noncallable bond.
• A callable bond favors the issuer.
• The value of the bond is discounted by the value of the option.

Putable Bond Yield

• A putable bond's yield should be lower than a nonputable bond.
• A putable bond favors the buyer (investor).
• A premium will be paid for the option.

Bond Amortization

• A corporation borrows $10 million and will repay this by making payments of $1.3 million each year for 9 years and a payment of $8 million at the end of the 10th year.
• This type of bond is called a partially amortizing bond because some of the principal is repaid before maturity, but there is still a principal amount due at maturity.
• A bullet bond pays only interest until maturity, when the full principal amount is due.

Long-Term Borrowing

• To reduce the cost of long-term borrowing, a corporation with a below-average credit rating could issue securitized bonds.
• Commercial paper is only issued by corporations with top credit ratings.
• Decreasing credit enhancements increase the cost of borrowing.

Step-Up Coupon Bond

• The coupon rate increases on a predetermined schedule.
• Credit linked coupon bonds have a coupon rate that changes inversely with the issuer's credit rating.
• Floating-rate notes have coupon rates that are based on a reference interest rate.

Convertible Bond Offering

• PRC International completed a $234 million floating-rate convertible bond offering.
• The interest rate is the lesser of 90-day LIBOR or 10%. PRC has an option to retire $5.6 million per year with the option to retire as much as $10 million.
• The conversion option on the convertible bonds benefits the investor.
• The conversion privilege is an option granted to the bondholder.
• A sinking fund is not an embedded option; it is an obligation of the issuer.

Bond Structure

• A bond whose periodic payments are all equal is said to have an amortizing structure and is fully amortizing.
• Bullet structure pays a series of equal coupons but the final coupon is paid at the same time as the bond's principal.
• A final payment that includes a lump sum in addition to the last interest payment is referred to as a balloon payment.

Sinking Fund Provision

• $1,000,000 par value, 10-year, 6.5% coupon bonds were issued on January 1, 20X5.
• The market rate for similar bonds is currently 5.7%. A sinking fund provision requires the company to redeem $100,000 of the principal each year.
• Bonds called under the terms of the sinking fund provision will be redeemed at par.
• A bondholder would prefer not to have her bonds called under the sinking fund provision.
• With the market rate currently below the coupon rate, the bonds will be trading at a premium to par value.

Securitized Bond

• Special purpose entities play a critical role to create a securitized bond with a higher credit rating than the corporation because they buy the assets from the corporation.
• They separate the assets used as collateral from the corporation that is seeking financing.
• This shields the assets from other creditors.

Non-Amortizing Fixed Income Security

• A non-amortizing fixed income security is a bullet bond.
• Bonds with a bullet structure is returning their entire principal to the bondholder at the maturity date.

Commodity Index Floater

• Allcans needs to issue some debt to finance expansion plans, but wants to hedge its bond interest payments against fluctuations in aluminum prices.
• The coupon rate is linked to the price of aluminum.
• The non-interest index floater allows Allcans to protect its credit rating during adverse circumstances.
• The coupon rate is set in the bond agreement (indenture) and cannot be changed unilaterally.

External Credit Enhancement

• An excess spread account is least likely an example of an external credit enhancement.
• Excess spread account is an example of an internal credit enhancement.
• An excess spread account involves setting aside amounts to protect against losses, internally managed.
• External credit enhancements are essentially backing from third parties, such as letters of credit or bank guarantees.

Floating Rate Notes

• A cap is a disadvantage to the bondholder.
• A floor is a disadvantage to the issuer.
• A cap limits the upside potential of the coupon rate paid on the floating rate bond and is therefore a disadvantage to the bondholder.
• A floor limits the downside potential of the coupon rate and is therefore a disadvantage to the bond issuer.

Sinking Fund Provision

• It requires that the issuer retire a portion of the principal through a series of principal payments over the life of the bond.
• A sinking fund actually retires the bonds based on a schedule.
• A sinking fund provision may allow the issuer to retire more than is stipulated in the indenture, but not all sinking fund provisions allow this.

Debenture

• In the United States, a debenture is defined as an unsecured bond.
• In the United Kingdom, a debenture refers to a bond backed by firm assets.

Inflation-Adjusted Coupon Payment

• $100,000 worth of TIPS, with a coupon rate of 4%, paid semi-annually, and an annual inflation rate of 2.5%, the coupon payment at the end of the first six months is $2,025.

Embedded Call Option

• It stipulates whether and under what circumstances the issuer can redeem the bond prior to maturity
• Call provisions give the issuer the right (but not the obligation) to retire all or a part of an issue prior to maturity.
• It gives the issuer the opportunity to get rid of expensive (high coupon) bonds and replace them with lower coupon issues in the event that market interest rates decline during the life of the issue.

Fixed Income Security

• Security based on 90-day LIBOR plus 125 basis points is a floating-rate note.
• A floating-rate note has a coupon rate based on a market-determined reference rate.

Embedded Bond Options

• An interest rate cap tends to benefit the borrower.
• The interest rate cap benefits the borrower who issues a floating rate bond.
• The cap places restrictions on how high the coupon rate can become during a rising interest rate environment, and therefore protects against higher interest rates.

Exercised Embedded Options

• A call option can be exercised by the issuer.
• Securities with embedded call options may be called by the issuer.