CFA L1 Volume 4 Fixed Income 2024 PDF

© CFA Institute. For candidate use only. Not for distribution. FIXED INCOME CFA® Program Curriculum 2024 LEVEL 1 VOLUME 4 © CFA Institute. For candidate use only. Not for distribution. ©2023 by CFA Institute. All rights reserved. This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself. It does not cover the individual selections herein that first appeared elsewhere. Permission to reprint these has been obtained by CFA Institute for this edition only. Further reproductions by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval systems, must be arranged with the individual copyright holders noted. CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent pro- fessional should be sought. All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only. ISBN 978-1-953337-52-8 (paper) ISBN 978-1-953337-26-9 (ebook) May 2023 © CFA Institute. For candidate use only. Not for distribution. CONTENTS How to Use the CFA Program Curriculum ix Errata ix Designing Your Personal Study Program ix CFA Institute Learning Ecosystem (LES) x Prerequisite Knowledge x Feedback x Fixed Income Learning Module 1 Fixed-Income Instrument Features 3 Introduction 3 Features of Fixed-Income Securities 6 Issuer 8 Maturity 8 Principal (Par or Face Value) 9 Coupon Rate and Frequency 9 Seniority 9 Contingency Provisions 10 Yield Measures 11 Yield Curves 11 Bond Indentures and Covenants 14 Bond Indentures 14 Sources of Repayment 14 Bond Covenants 16 Practice Problems 20 Solutions 22 Learning Module 2 Fixed-Income Cash Flows and Types 23 Introduction 23 Fixed-Income Cash Flow Structures 26 Amortizing Debt 27 Variable Interest Debt 32 Zero-Coupon Structures 36 Deferred Coupon Structures 36 Fixed-Income Contingency Provisions 38 Callable Bonds 39 Putable Bonds 40 Convertible Bonds 40 Legal, Regulatory, and Tax Considerations 44 Legal and Regulatory Considerations 44 Tax Considerations 47 Practice Problems 51 Solutions 53 © CFA Institute. 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Not for distribution. iv Contents Learning Module 3 Fixed-Income Issuance and Trading 55 Introduction 55 Fixed-Income Segments, Issuers, and Investors 57 Fixed-Income Indexes 65 Primary and Secondary Fixed-Income Markets 70 Primary Fixed-Income Markets 70 Secondary Fixed-Income Markets 72 Practice Problems 75 Solutions 76 Learning Module 4 Fixed-Income Markets for Corporate Issuers 77 Introduction 77 Short-Term Funding Alternatives 80 External Loan Financing 80 External, Security-Based Financing 82 Short-Term Funding Alternatives for Financial Institutions 82 Repurchase Agreements 86 Repurchase Agreement Applications and Benefits 89 Risks Associated with Repurchase Agreements 92 Long-Term Corporate Debt 95 Similarities between Long-Term Investment-Grade and High-Yield Issuance 96 Differences between IG and HY Issuance 96 Practice Problems 102 Solutions 104 Learning Module 5 Fixed-Income Markets for Government Issuers 105 Introduction 105 Sovereign Debt 107 Sovereign Debt Issuance and Trading 115 Non-Sovereign, Quasi-Government, and Supranational Agency Debt 118 Government Agencies 119 Local and Regional Government Authorities 119 Supranational Organizations 120 Practice Problems 123 Solutions 124 Learning Module 6 Fixed-Income Bond Valuation: Prices and Yields 125 Introduction 125 Bond Pricing and the Time Value of Money 129 Bond Pricing with a Market Discount Rate 130 Yield-to-Maturity 132 Flat Price, Accrued Interest, and the Full Price 134 Relationships between Bond Prices and Bond Features 141 Inverse Relationship 142 Coupon Effect 142 Maturity Effect 143 Constant-Yield Price Trajectory 143 © CFA Institute. 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Contents v Convexity Effect 144 Matrix Pricing 146 Matrix Pricing Process 146 Practice Problems 151 Solutions 153 Learning Module 7 Yield and Yield Spread Measures for Fixed-Rate Bonds 155 Introduction 155 Periodicity and Annualized Yields 158 Other Yield Measures, Conventions, and Accounting for Embedded Options 163 Other Yield Measures and Conventions 163 Bonds with Embedded Options 166 Yield Spread Measures for Fixed-Rate Bonds and Matrix Pricing 171 Yield Spreads over Benchmark Rates 171 Yield Spreads over the Benchmark Yield Curve 176 Practice Problems 181 Solutions 183 Learning Module 8 Yield and Yield Spread Measures for Floating-Rate Instruments 185 Introduction 185 Yield and Yield Spread Measures for Floating-Rate Notes 188 Yield and Yield Spread Measures for Floating-Rate Instruments 188 Yield Measures for Money Market Instruments 194 Practice Problems 203 Solutions 205 Learning Module 9 The Term Structure of Interest Rates: Spot, Par, and Forward Curves 207 Introduction 207 Maturity Structure of Interest Rates and Spot Rates 209 Maturity Structure of Interest Rates 210 Bond Pricing Using Spot Rates 212 Par and Forward Rates 217 Par Rates from Spot Rates 217 Forward Rates from Spot Rates 218 Spot Rates from Forward Rates and Bond Pricing with Forward Rates 220 Spot, Par, and Forward Yield Curves and Interpreting Their Relationship 225 Practice Problems 230 Solutions 233 Learning Module 10 Interest Rate Risk and Return 235 Introduction 235 Sources of Return from Investing in a Fixed-Rate Bond 239 Investment Horizon and Interest Rate Risk 245 Macaulay Duration 251 Practice Problems 258 Solutions 260 © CFA Institute. 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Not for distribution. vi Contents Learning Module 11 Yield-Based Bond Duration Measures and Properties 263 Introduction 263 Modified Duration 266 Approximate Modified Duration 270 Money Duration and Price Value of a Basis Point 278 Yield Duration of Zero-Coupon and Perpetual Bonds 279 Duration of Floating-Rate Notes and Loans 280 Properties of Duration 284 Practice Problems 289 Solutions 291 Learning Module 12 Yield-Based Bond Convexity and Portfolio Properties 293 Introduction 293 Bond Convexity and Convexity Adjustment 297 Bond Risk and Return Using Duration and Convexity 303 Portfolio Duration and Convexity 307 Practice Problems 312 Solutions 314 Learning Module 13 Curve-Based and Empirical Fixed-Income Risk Measures 317 Introduction 317 Curve-Based Interest Rate Risk Measures 320 Bond Risk and Return Using Curve-Based Duration and Convexity 326 Key Rate Duration as a Measure of Yield Curve Risk 329 Empirical Duration 333 Practice Problems 337 Solutions 339 Learning Module 14 Credit Risk 341 Introduction 341 Sources of Credit Risk 344 Sources of Credit Risk 346 Measuring Credit Risk 349 Credit Rating Agencies and Credit Ratings 354 Credit Ratings 355 Credit Rating Considerations 357 Factors Impacting Yield Spreads 360 Macroeconomic Factors 360 Market Factors 363 Issuer-Specific Factors 364 The Price Impact of Spread Changes 366 Practice Problems 374 Solutions 376 Learning Module 15 Credit Analysis for Government Issuers 379 Introduction 379 Sovereign Credit Analysis 382 Qualitative Factors 383 © CFA Institute. 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Contents vii Quantitative Factors 387 Non-Sovereign Credit Risk 395 Non-Sovereign Government Debt 395 Agencies 396 Government Sector Banks and Development Financing Institutions 396 Supranational Issuers 397 Regional Government Issuers 397 Practice Problems 402 Solutions 404 Learning Module 16 Credit Analysis for Corporate Issuers 407 Introduction 407 Assessing Corporate Creditworthiness 410 Qualitative Factors 410 Financial Ratios in Corporate Credit Analysis 417 Seniority Rankings, Recovery Rates, and Credit Ratings 424 Seniority Rankings 425 Secured versus Unsecured Debt 425 Recovery Rates 427 Issuer and Issue Ratings 429 Practice Problems 433 Solutions 436 Learning Module 17 Fixed-Income Securitization 439 Introduction 439 The Benefits of Securitization 442 Benefits to Issuers 444 Benefits to Investors 445 Benefits to Economies and Financial Markets 446 The Securitization Process 448 An Example of a Securitization 449 Parties to a Securitization 452 The Role of the SPE 453 Practice Problems 456 Solutions 459 Learning Module 18 Asset-Backed Security (ABS) Instrument and Market Features 461 Introduction 461 Covered Bonds 464 ABS Structures to Address Credit Risk 468 Credit Enhancement 468 Credit Tranching 470 Non-Mortgage Asset-Backed Securities 475 Credit Card Receivable ABS 475 Solar ABS 478 Collateralized Debt Obligations 481 Generic CLO Structure 483 Practice Problems 488 © CFA Institute. For candidate use only. Not for distribution. viii Contents Solutions 490 Learning Module 19 Mortgage-Backed Security (MBS) Instrument and Market Features 493 Introduction 493 Time Tranching 498 Prepayment Risk 498 Mortgage Loans and Their Characteristic Features 502 Agency and Non-Agency RMBS 504 Mortgage Contingency Features 504 Residential Mortgage-Backed Securities (RMBS) 507 Mortgage Pass-Through Securities 508 Collateralized Mortgage Obligations (CMOs) 510 Other CMO Structures 512 Commercial Mortgage-Backed Securities (CMBS) 515 CMBS Structure 517 CMBS Risks 518 Practice Problems 522 Solutions 527 Glossary G-1 © CFA Institute. For candidate use only. Not for distribution. ix How to Use the CFA Program Curriculum The CFA® Program exams measure your mastery of the core knowledge, skills, and abilities required to succeed as an investment professional. These core competencies are the basis for the Candidate Body of Knowledge (CBOK™). The CBOK consists of four components: A broad outline that lists the major CFA Program topic areas (www.cfainstitute.org/programs/cfa/curriculum/cbok) Topic area weights that indicate the relative exam weightings of the top-level topic areas (www.cfainstitute.org/programs/cfa/curriculum) Learning outcome statements (LOS) that advise candidates about the spe- cific knowledge, skills, and abilities they should acquire from curriculum content covering a topic area: LOS are provided in candidate study sessions and at the beginning of each block of related content and the specific lesson that covers them. We encourage you to review the information about the LOS on our website (www.cfainstitute.org/programs/cfa/curriculum/study -sessions), including the descriptions of LOS “command words” on the can- didate resources page at www.cfainstitute.org. The CFA Program curriculum that candidates receive upon exam registration Therefore, the key to your success on the CFA exams is studying and understanding the CBOK. You can learn more about the CBOK on our website: www.cfainstitute.org/programs/cfa/curriculum/cbok. The entire curriculum, including the practice questions, is the basis for all exam questions and is selected or developed specifically to teach the knowledge, skills, and abilities reflected in the CBOK. ERRATA The curriculum development process is rigorous and includes multiple rounds of reviews by content experts. Despite our efforts to produce a curriculum that is free of errors, there are instances where we must make corrections. Curriculum errata are periodically updated and posted by exam level and test date online on the Curriculum Errata webpage (www.cfainstitute.org/en/programs/submit-errata). If you believe you have found an error in the curriculum, you can submit your concerns through our curriculum errata reporting process found at the bottom of the Curriculum Errata webpage. DESIGNING YOUR PERSONAL STUDY PROGRAM An orderly, systematic approach to exam preparation is critical. You should dedicate a consistent block of time every week to reading and studying. Review the LOS both before and after you study curriculum content to ensure that you have mastered the © CFA Institute. For candidate use only. Not for distribution. x How to Use the CFA Program Curriculum applicable content and can demonstrate the knowledge, skills, and abilities described by the LOS and the assigned reading. Use the LOS self-check to track your progress and highlight areas of weakness for later review. Successful candidates report an average of more than 300 hours preparing for each exam. Your preparation time will vary based on your prior education and experience, and you will likely spend more time on some study sessions than on others. CFA INSTITUTE LEARNING ECOSYSTEM (LES) Your exam registration fee includes access to the CFA Program Learning Ecosystem (LES). This digital learning platform provides access, even offline, to all of the curricu- lum content and practice questions and is organized as a series of short online lessons with associated practice questions. This tool is your one-stop location for all study materials, including practice questions and mock exams, and the primary method by which CFA Institute delivers your curriculum experience. The LES offers candidates additional practice questions to test their knowledge, and some questions in the LES provide a unique interactive experience. PREQUISITE KNOWLEDGE The CFA® Program assumes basic knowledge of Economics, Quantitative Methods, and Financial Statements as presented in introductory university-level courses in Statistics, Economics, and Accounting. CFA Level I candidates who do not have a basic understanding of these concepts or would like to review these concepts can study from any of the three pre-read volumes. FEEDBACK Please send any comments or feedback to info@cfainstitute.org, and we will review your suggestions carefully. © CFA Institute. For candidate use only. Not for distribution. Fixed Income © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution. LEARNING MODULE 1 Fixed-Income Instrument Features LEARNING OUTCOMES Mastery The candidate should be able to: describe the features of a fixed-income security describe the contents of a bond indenture and contrast affirmative and negative covenants INTRODUCTION Fixed-income instruments, such as loans and bonds, are the most common means of 1 financing. Fixed-income issuers include businesses, governments, and not-for-profits that promise to pay interest and repay borrowed principal to investors. Loans are commonly used between an individual or company and a bank. Bonds are more stan- dardized fixed-income instruments designed to be more easily tradeable than loans and are commonly issued by larger companies, governments, and special purpose issuers. Bonds are a core holding for many investors, including mutual funds, pension plans, insurance companies, and central banks. This module introduces the features of fixed-income instruments and the legal contracts that govern them. LEARNING MODULE OVERVIEW Fixed-income instruments are debt instruments, such as loans and bonds, that represent a contractual agreement under which an issuer borrows money from investors in exchange for inter- est and future repayment of principal. Key features of fixed-income instruments include the issuer (bor- rower), time to maturity, principal amount, coupon rate and fre- quency, seniority, and contingency provisions. These features in turn define the cash flow structure of the instrument. A fixed-income investor (lender) receives a return or yield based on the periodic cash flows paid by the bond issuer and the change in price of the bond. A bond’s price and yield vary inversely with one another. © CFA Institute. For candidate use only. Not for distribution. 4 Learning Module 1 Fixed-Income Instrument Features Fixed-income investors are exposed to credit risk, the risk of loss resulting from the issuer failing to make full and timely payments of interest and/or to repay principal. Investors expect to earn the lowest yield on bonds that carry little or no credit risk and expect higher yields on lower-credit-quality instruments. A fixed-income instrument’s credit quality is affected by the underly- ing source of repayment, its seniority, credit provisions such as collat- eral backing, and the issuer’s willingness to pay. The legal contract describing the features and other terms of a fixed-income security is known as an indenture. Indentures often contain covenants, or legally enforceable terms, agreed to at the time of issuance. These may either require the bond issuer to take an action or prohibit the issuer from performing some action. LEARNING MODULE SELF-ASSESSMENT These initial questions are intended to help you gauge your current level of understanding of this learning module. 1. The annual coupon amount for a fixed-rate bond is calculated by: A. multiplying its yield by the par value of the bond. B. Multiplying its coupon rate by the price of the bond. C. Multiplying its coupon rate by the par value of the bond. Solution: C is correct. On each interest payment date, a fixed-rate bond issuer pays investors a coupon payment equal to the bond’s coupon rate times its par value. For periods shorter than a year, the annual coupon amount is divided into smaller equal periodic payments. For example, a bond with a par value of 100 and a coupon rate of 6% paid quarterly would pay coupon payments of 0.06 × 100 = 60/4 = 15 four times per year. 2. Match each bond type in the left column with a description in the right column. A. Fixed-coupon bond I. The difference between its issuance price and par value at maturity represents a cumulative interest pay- ment at maturity. B. Floating-rate note II. Usually involves uniform payments that occur at monthly, quarterly, semi-annual, or annual intervals. C. Zero-coupon bond III. Involves interest payments that reset periodically based on market factors. Solution: A. II is correct. Fixed-coupon bonds usually involve uniform payments that occur at monthly, quarterly, semi-annual, or annual intervals. B. III is correct. Floating-rate notes (FRNs) involve interest payments that reset periodically based on market factors. © CFA Institute. For candidate use only. Not for distribution. Introduction 5 C. I is correct. Zero-coupon bonds are typically issued at a discount to par; the difference between the issuance price and par value represents a cumulative interest payment at maturity. 3. The coupon rate for a floating rate note (FRN) is composed of a market reference rate and: A. a credit rating. B. an issuer-specific spread. C. The yield on a fixed-rate benchmark bond. Solution: B is correct. An FRN coupon rate comprises a market reference rate (MRR) and an issuer-specific spread that is usually constant and set at the time of issuance, while the MRR resets periodically based on market factors. As the MRR changes, the FRN coupon rate and interest payment change accordingly. A is incorrect. While the issuer’s credit rating may be a determinant of an FRN’s spread over the MRR, a credit rating is a letter-grade assessment of credit risk and is not directly involved in the calculation of the coupon rate. C is incorrect. The yield on a fixed-rate benchmark bond would reflect top- down factors that determine interest rates, such as real growth and expected inflation, which are already considered in the MRR. 4. A sovereign bond is usually a safer investment than a corporate bond of similar maturity issued within a country because: A. corporate bonds are subject to inflation risk. B. sovereign bonds are backed by taxation and fiscal power of the issuing government. C. sovereign bonds are secured by high-quality collateral, such as prop- erty and equipment. Solution: B is correct. Sovereign bonds are backed by a national government’s taxa- tion and fiscal power and thus usually represent the highest-credit-quality bonds in each geographic market. A is incorrect because sovereign bonds, unless specifically indexed to infla- tion, are also subject to inflation risk. C is incorrect because sovereign bonds are typically not secured by collat- eral; this is more commonly a feature of corporate bonds and asset-backed securities. 5. Which of the following is the appropriate order of claims in liquidation, by type of bond, in order of highest to lowest? A. Junior, senior secured, senior unsecured B. Senior unsecured, senior secured, junior C. Senior secured, senior unsecured, junior Solution: C is correct. Senior secured debts would be the highest-priority claims to be satisfied. Senior unsecured debts would be the next to receive allocations of the liquidated asset value, and junior debts would be the lowest-priority claims to be satisfied. © CFA Institute. For candidate use only. Not for distribution. 6 Learning Module 1 Fixed-Income Instrument Features 6. Describe the purpose of a pari passu clause in a bond indenture. Solution: A pari passu (“equal footing”) clause ensures that a debt obligation is treated the same as the borrower’s other senior debt instruments. 2 FEATURES OF FIXED-INCOME SECURITIES describe the features of a fixed-income security Fixed-income instruments are debt instruments, such as loans and bonds. Loans are debt instruments formed and governed by a private agreement usually between an individual or company and a financial intermediary, such as a bank. Bonds or fixed-income securities are more standardized contractual agreements between larger issuers and investors. A bond issuer borrows money most often to fund operations or capital expenditures. Bond investors are lenders who provide funds to the issuer in exchange for interest payments and future repayment of principal. While corporate issuers tend to have, at most, one or two types of equity securities outstanding, they often have many types of debt obligations outstanding, each with distinct features, such as time to maturity, seniority, and currency. WHICH LIABILITIES ARE FIXED-INCOME INSTRUMENTS? Earlier modules in corporate issuers and financial statement analysis discussed the balance sheets of corporate issuers composed of assets and the liabilities and equity that finance them. Liabilities are broadly defined by accounting standards as present obligations to transfer economic resources as a result of past events. This definition encompasses many types of obligations, including amounts that an issuer owes to suppliers, customers, employees, governments, retirees, lessors, and so on. Not all liabilities are fixed-income instruments (or “debt”), but all fixed-in- come instruments are liabilities. In these modules on fixed income, from the perspective of a corporate issuer, we are focused only on loans and bonds: instruments that can be settled in cash and for which the counterparty is an investor or a bank. Other liabilities, particularly leases and pension obligations, share some characteristics with fixed-income instruments but are outside the scope of these modules. Accounts Payable Lease Liability (obligations to (obligations to suppliers) lessors) Accrued Payroll Pension Liability Short-Term (obligations to (obligations to Short-Term Liabilities employees) retirees) Assets Deferred Revenue Loan Long-Term (obligations to (obligations to Liabilities customers) banks) Long-Term Taxes Payable Bonds Assets (obligations to (obligations to Equity governments) investors) Fixed-Income Instruments © CFA Institute. For candidate use only. Not for distribution. Features of Fixed-Income Securities 7 Note that government issuers tend to be financed by bonds, not by loans, though some exceptions exist—for example, loans from supranational organi- zations such as the International Monetary Fund (IMF). The committed periodic cash flows of a bond distinguish it from equity securities. Exhibit 1 shows the cash flows of a fixed-rate bond issued by Bright Wheels Automotive (BRWA) Corporation. Exhibit 1: BRWA Corporation Bond Cash Flows Time t=0 Semiannual (t) Maturity (t = T) BRWA BRWA BRWA Corp Corp Corp Principal Periodic fixed Final coupon (par value) coupon payment plus paid to issuer payment return of principal Bond Bond Bond Investor Investor Investor At issuance, investors purchased the BRWA bond in exchange for cash equal to the bond principal or the amount borrowed, which is also referred to as the bond’s par value. On each interest payment date, BRWA commits to pay bond investors an inter- est or coupon payment equal to the coupon rate times the par value of the bond. For periods shorter than a year, the annual coupon amount is divided into smaller equal periodic payments. On the bond’s maturity date, BRWA pays the final fixed coupon and the principal amount to investors. The key features of each bond issue are usually summarized in a prospectus. Exhibit 2 outlines the terms of BRWA Corporation’s bond issue. © CFA Institute. For candidate use only. Not for distribution. 8 Learning Module 1 Fixed-Income Instrument Features Exhibit 2: BRWA Corporation Bond: Brief Summary of Terms 3.2% BRWA Corporation Five-Year Notes Borrower liable (The “Notes”) Prospectus Summary for all interest and principal Issuer: Bright Wheels Automotive Corporation payments Settlement Date: [T + 3 Business Days] Final date upon which Maturity Date: [Five Years from Settlement Date] bond payment occurs Principal Amount: US$ 300 million Periodic fixed or Amount that issuer Interest: 3.2% fixed coupon agrees to pay variable cash flows paid to investors on or before Interest Payment: Commencing six months from [Settlement the maturity date investors on or Date] to be paid semiannually with final before the payment on [Maturity Date] maturity date Seniority: The Notes are unsecured and unsubordinated obligations of BRWA Corporation and will A specific rank pari passu with all other unsecured and bond’s ranking unsubordinated indebtedness among all issuer obligations Business Days: New York Key bond features include the issuer, time to maturity, principal amount, coupon rate and frequency, seniority, and contingency provisions. Issuer A bond issuer can be any legal entity and is liable for all interest and principal payments. Government sector issuers include national (also termed sovereign) or local govern- ments, supranational organizations (such as the World Bank), and quasi-government entities (agencies owned or sponsored by governments, such as postal services or national railways). Because sovereign bonds are backed by the taxation and fiscal power of the issuing government, they usually represent the lowest-credit-risk bond in each region. Private sector issuers include corporate issuers and special purpose entities created to take ownership in such assets as loans or receivables, financed by asset-backed securities (ABS) issued to investors, which will be discussed in detail in later lessons. Maturity A bond’s maturity is the date of the final payment the issuer makes to investors, and the tenor refers to the remaining time to maturity. Fixed-income securities with a tenor one year or less at issuance are known as money market securities, examples of which include government Treasury bills and commercial paper issued by corpo- rations. Bonds with tenors longer than one year at issuance are called capital market securities. Perpetual bonds are a less common bond type with no stated maturity. Public sector entities were the first issuers of perpetual bonds, and current examples include local governments and local authorities, as well as certain bonds issued by banks to meet regulatory capital requirements. Perpetual bonds are still distinct from equities, however, in that they have contractually defined cash flows, no voting rights, and greater seniority in the capital structure. © CFA Institute. For candidate use only. Not for distribution. Features of Fixed-Income Securities 9 AIRPORT AUTHORITY HONG KONG’S PERPETUAL BONDS Airport Authority Hong Kong (AAHK) is a statutory body responsible for operating and developing Hong Kong International Airport, one of the world’s busiest cargo airports and a major passenger hub connecting to over 200 global destinations. In late 2020, following a sharp decline in passenger volume during the COVID-19 pandemic, AAHK announced a two-part, USD1.5 billion perpetual bond issue to fund construction of a third runway and for general corporate purposes. Asian and European investors demonstrated confidence in the airport’s recovery of passenger volume, placing orders totaling more than 10× the offer amount. Principal (Par or Face Value) The principal, par value, or face value is the amount an issuer agrees to repay to investors at maturity. In the BRWA Corporation example, the principal amount of USD300 million is repaid at maturity, which is five years from issuance. Certain instruments may repay the principal in equal or variable increments over time. A common example is a mortgage loan, for which borrowers make a monthly payment composed of both principal repayment and interest. The principal is repaid over time and not in a lump sum at maturity. Coupon Rate and Frequency A bond’s interest can be paid as a fixed coupon paid on specified dates, a variable coupon determined and paid on specified dates, or part of a single payment with the principal at maturity. Fixed-coupon bond payments usually involve uniform payments at monthly, quar- terly, semi-annual, or annual intervals. Corporate bonds tend to pay semiannually. Bonds with variable interest payments are called floating-rate notes (FRNs). An FRN coupon is determined as a combination of a market reference rate (MRR) and an issuer-specific spread referred to as the credit spread. The MRR is a standard borrowing or lending rate for issuers with the highest creditworthiness or lowest default risk for different currencies and maturities. MRRs were historically determined by a poll of lenders (Libor) but transitioned to an average of observed market transaction rates. The credit spread is set at the time of FRN issuance, is usually constant over the bond’s life, and is expressed in basis points (bps), or hundredths of a percentage point. The higher an issuer’s credit quality, the lower the spread. In contrast, the MRR resets periodically throughout the bond’s life based on market factors. As the MRR changes, the FRN coupon rate and interest payment change accordingly. Bonds that do not pay periodic interest and instead pay interest as part of a single payment with principal at maturity are termed zero-coupon bonds or pure discount bonds. Zero-coupon bonds are typically issued at a discount to par; the difference between the issuance price and par value represents a cumulative interest payment at maturity. Seniority A debt issue’s seniority or priority of repayment among all issuer obligations is an important determinant of risk. Senior debt has priority over other debt claims in the case of bankruptcy or liquidation. Junior debt, or subordinated debt, claims have a © CFA Institute. For candidate use only. Not for distribution. 10 Learning Module 1 Fixed-Income Instrument Features lower priority than senior debt and are paid only once senior claims are satisfied. The BRWA Corporation bonds are senior debt and would be repaid before any BRWA subordinated debt in the event of bankruptcy. Contingency Provisions A contingency provision is a clause in a legal agreement that allows for an action if an event or circumstance occurs. The most common contingency provision for bonds involves embedded options—specifically, call, put, and conversion to equity options. These resemble option contracts but cannot be traded separately from the bond itself. However, the value of these embedded options may be established by comparing the value of a bond with a contingency provision with that of an otherwise similar stan- dard bond from the same issuer. The BRWA bond does not contain any contingency provisions, but this feature will be explored in depth in later lessons. We can use the features of a bond issue to model its cash flows. Exhibit 3 illus- trates the cash flows over the life of the five-year, fixed-coupon BRWA Corporation bond described earlier. Exhibit 3: BRWA Corporation Bond Cash Flows 304.8 300 Investors receive final coupon and principal payment at maturity 4.8 4.8 4.8 4.8 4.8 4.8 4.8 4.8 4.8 4.8 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 Years BRWA Corp. receives par value of bond upon issuance 300 At the time of issuance, investors purchase the bond and pay cash to BRWA Corporation equal to the USD300 million in par value. BRWA investors receive periodic interest payments as follows: Annual interest expense = Bond par value × Coupon rate. Annual interest expense = USD300,000,000 × 3.2%. Annual interest expense = USD9,600,000. Semiannual interest expense = USD9,600,000/2 = USD4,800,000. © CFA Institute. For candidate use only. Not for distribution. Features of Fixed-Income Securities 11 At the end of the fifth year on the maturity date, BRWA Corporation pays investors the final semiannual coupon payment plus the par value of USD300 million for a total of USD304.8 million. Yield Measures Given a bond’s expected cash flows and its price, return or yield measures can be calculated. One simple measure is the current yield (CY), equal to the bond’s annual coupon divided by the bond’s price and expressed as a percentage. For example, if the five-year BRWA bond were trading at a price of USD101 per USD100 in face value at time t, its current yield would be CYt = Annual coupont/Bond pricet = 3.2%/1.01 = 3.168%. The current yield is analogous to the dividend yield for an equity security. A more complex but far more common yield measure is the yield-to-maturity (YTM), which is the internal rate of return (IRR) calculated using the bond’s price and its expected cash flows to maturity. YTM is usually quoted as an annual rate. An investor’s rate of return on a bond will equal the bond’s YTM at the time of purchase as long as the investor 1. receives all promised interest and principal payments as scheduled (i.e., no default), 2. holds the bond until maturity, and 3. reinvests all periodic cash flows at the YTM. Notice that these are the same IRR assumptions discussed in earlier modules. If any of these assumptions do not hold, the investor’s rate of return on the bond invest- ment will differ from the YTM. If the five-year BRWA bond were trading at a price of USD101 per USD100 in face value immediately after issuance, its YTM is the rate, r, in the following equation (recall that the 3.2% coupon is paid semiannually, or 1.6 in each of 10 periods per USD100 in face value): 101 = 1.6/(1 + r)1 + 1.6/(1 + r)2 +... + 101.6/(1 + r)10. r = 1.49% on a semiannual basis, or 1.49% × 2 = 2.98% annualized. The YTM calculation is covered in depth in later modules. Yield Curves Most fixed-income issuers have many debt instruments outstanding. A useful way of evaluating the YTM on one issue is to graph all an issuer’s debt instruments with identical features by their YTM and times to maturity. This graphical depiction results in a yield curve. BRWA has six bond issues outstanding, shown in Exhibit 4. The 3.2%, five-year bond is the third point from the left. © CFA Institute. For candidate use only. Not for distribution. 12 Learning Module 1 Fixed-Income Instrument Features Exhibit 4: BRWA Corporation Bond Yield Curve Yield-to-Maturity (%) BRWA Corporation 3.2% 5y Maturity In this example, the BRWA bonds with longer maturities have higher YTMs, indicating that investors are demanding higher expected returns to compensate for higher risk associated with longer-maturity bonds of the same issuer. A way to measure the credit risk (one type of investment risk of fixed-income securities) for a bond is to compare an issuer’s yield curve to that of comparable sovereign bonds, which have little or no credit risk. Exhibit 5 shows the yield curve for BRWA bonds versus the yield curve for comparable sovereign bonds in the United States, which are US Treasuries. Exhibit 5: BRWA Corporation Yield Curve vs. Treasuries Yield-to-Maturity (%) BRWA Corporation Government Issuer 3.2% 2.3% 5y Maturity The yield-to-maturity difference between the five-year BRWA bond and the five-year US Treasury bond is 90 bps (= 3.2% − 2.3%), which reflects compensation that inves- tors demand for taking the additional credit risk associated with the BRWA bonds. © CFA Institute. For candidate use only. Not for distribution. Features of Fixed-Income Securities 13 QUESTION SET 1. Match the fixed-income instrument type in the left column with its description in the right column. A. Money market securities I. Public and private bonds with a time to maturity of greater than one year B. Capital market securities II. Fixed-income instruments with maturities of less than one year, such as commercial paper C. Perpetual bonds III. Bonds that have no stated maturity date Solution: A. II is correct. Money market securities are fixed-income instruments with maturities of less than one year, such as commercial paper. B. I is correct. Capital market securities are public and private bonds with a time to maturity of greater than one year. C. III is correct. Perpetual bonds have no stated maturity date. 2. Calculate the coupon payment on a 2.5% coupon bond with GBP100,000 par value and a semiannual payment frequency. Solution: The correct answer is GBP1,250. The annual coupon on a bond is calculated by multiplying the coupon rate and the par value. For this bond, the coupon rate of 2.5% and par value of GBP100,000 results in a GBP2,500 annual coupon. However, since the payment frequency is semiannual (twice a year), each coupon payment is GBP1,250. 3. Determine the appropriate FRN coupon and interest payable in the fol- lowing example: A European corporation issues a EUR10 million FRN that pays quarterly interest equal to the three-month MRR plus 125 bps. If three-month MRR is –0.50%, what is the corporation’s FRN coupon interest payable on the FRN for the period? Solution: The answer is EUR18,750. An FRN coupon comprises MRR plus the issuer-specific spread. FRN coupon = MRR + Spread. FRN coupon = –0.50% + 1.25%. FRN coupon = 0.75%. Annual interest = Principal × FRN coupon. Annual interest = €10,000,000 × 0.75%. Annual interest = €75,000, or €18,750 on a quarterly basis. © CFA Institute. For candidate use only. Not for distribution. 14 Learning Module 1 Fixed-Income Instrument Features 4. Fill in the blanks. The current yield is equal to a bond’s annual _____ divided by the bond’s price expressed as a percentage. If the bond’s price were to fall, we would expect the current yield to ____. Solution: The current yield is equal to a bond’s annual coupon divided by the bond’s price expressed as a percentage. If the bond’s price were to fall, we would expect the current yield to rise. 5. Fill in the blanks. A downward-sloping yield curve indicates that yields-to-maturity on an issuer’s longer-term bonds are __________ than yields-to-maturity on that issuer’s shorter-term bonds. Solution: A downward-sloping yield curve indicates that yields-to-maturity on an issuer’s longer-term bonds are lower than yields-to-maturity on that issuer’s shorter-term bonds. 3 BOND INDENTURES AND COVENANTS describe the contents of a bond indenture and contrast affirmative and negative covenants Bond Indentures Fixed-income security features outlined in the prior lesson are included in a legal contract that describes the form of the bond, the obligations of the issuer, and the rights of the bondholders. This legal contract is referred to as the bond indenture. In addition to specifying a bond’s features, an indenture identifies the issuer’s sources of repayment, any commitments made by the issuer to bondholders, as well as any provisions that support or enhance the issuer’s ability to repay its debt in full. Sources of Repayment The sources of bond repayment vary among issuers and are a key factor in determining a bond’s relative risk. For example, national governments have the sovereign right to tax economic activity (and, in some cases, print currency), which results in their bonds often holding the highest credit quality in a given region. Sovereign bonds in developed markets are often considered to have no default risk and are used as the benchmark for relative bond market risk. Local or regional governments may either use their taxing authority as the source of bond repayment or consider fees from infrastructure projects, such as bridges, toll roads or public transit systems, to repay interest and principal on an associated bond issue. Investors in corporate bonds usually rely on the operating cash flows of the firm as their primary source for interest and principal payments. As shown in later lessons, investors use such factors as profitability and leverage to gauge the expected variabil- ity of corporate cash flows available to service debt. Corporate bonds for issuers of higher credit quality are usually unsecured, which means these cash flows are the © CFA Institute. For candidate use only. Not for distribution. Bond Indentures and Covenants 15 sole source of repayment, as in the earlier BRWA Corporation example. Corporate issuers with less stable operating cash flows usually face more credit provisions and restrictions and may offer investors a legal claim (or lien or pledge) on specific assets as a secondary source of debt repayment in what are referred to as secured bonds. In liquidation, the secured debtholders may receive the value of the designated assets while unsecured debtholders would only receive any funds remaining after this allo- cation. A junior unsecured bondholder would be the last creditor in line to receive the asset value of an issuer in default, because all secured debts and senior unsecured debts would have higher-priority claims. Investors evaluate operating cash flows as well as these secondary claims (referred to as collateral) when assessing an issuer’s credit quality, which may include physical assets; cash flows, such as licensing fees; or financial guarantees from a third party. Issuers must weigh the benefit of providing these credit enhancements (lower bor- rowing costs) with the costs in terms of reduced operating flexibility. Exhibit 6: Sovereign Bond and Corporate Bond Sources of Repayment Tax Sovereign Bond Revenues Bond Investor Operating Unsecured Bond Cash Flows Corporate Bond Investor Operating Cash Flows Secured Bond Corporate Bond Investor Collateral Cash Flows or Sale As the name suggests, the source of repayment for asset-backed securities (ABS) are the cash flows from a group of loans or receivables owned by the special purpose issuer. A later module will show in detail how an ABS transaction recreates an entire capital structure of asset-based cash flow claims across investor classes with different priority claims to these cash flows. These different classes shown in Exhibit 7 are referred to as tranches. Exhibit 7: Asset-Backed Security Sources of Repayment Tranche A Bond Investor Loan/ Asset-Backed Tranche B Receivable Security Bond Investor Cash Flows (ABS) Tranche C Bond Investor © CFA Institute. For candidate use only. Not for distribution. 16 Learning Module 1 Fixed-Income Instrument Features For example, Tranche A notes might have a priority claim to periodic cash flows fol- lowed by Tranche B. Tranche C investors would receive cash flows only after Tranche A and B investors. Bond Covenants Bondholders have limited influence over an issuer as compared to equity investors, who have voting rights. One exception to this is legally enforceable rules or bond covenants that borrowers and lenders agree on at the time a bond is issued or a loan is made. Affirmative covenants specify what issuers are required to do, whereas negative covenants specify what issuers are prohibited from doing. Affirmative covenants are typically administrative in nature. For example, common affirmative covenants include the use of proceeds from the bond issue, the provision of timely financial reports, and permitting bondholders to redeem their bonds at a premium to par if the issuer is acquired. Other affirmative covenant examples include a pari passu clause (or “equal foot- ing” clause), which ensures that a debt obligation is treated the same as the borrower’s other debt obligations with similar seniority. A cross-default clause specifies that borrowers are considered in default if they default on another debt obligation. These covenants typically neither impose additional costs on an issuer nor materially con- strain the issuer’s discretion in operating its business. Exhibit 8 provides the covenants faced by BRWA Corporation for its senior unse- cured bonds from the prior example. Exhibit 8: BRWA Bond: Brief Summary of Indenture Terms 3.2% BRWA Corporation Five-Year Notes Prospectus Summary (Continued) Issuer: Bright Wheels Automotive Corporation Use of Proceeds: We will use the net proceeds from the Notes for general corporate purposes Seniority: The Notes are unsecured and unsubordinated obligations of BRWA Corporation and will rank pari passu with all other unsecured and unsubordinated indebtedness. Limitation on The Indenture restricts our ability to pledge some of our assets as Liens: security for other debt. Limitation on Sales The Indenture prohibits us from selling and leasing back any plant and Leasebacks: for a term of more than [X] years Merger and The Indenture prohibits us from merging or consolidating with Consolidation: any company or selling all or substantially all of our assets to any company if after doing so the surviving company would violate the limitation on liens or sales and leasebacks discussed above. As a senior unsecured issuer, BRWA’s use of proceeds is broadly defined, and it faces few negative covenants limiting its business decisions. The limitations of liens and sale and leaseback, as well as merger and consolidation restrictions, all protect bondholders from the dilution of their claims as senior bondholders. Issuers of lower credit quality often face additional covenants established to pro- tect bondholders if an issuer’s financial condition deteriorates. For example, consider the case of Vivivyu Inc., a digital media corporation that has issued senior secured callable bonds, as shown in Exhibit 9. © CFA Institute. For candidate use only. Not for distribution. Bond Indentures and Covenants 17 Exhibit 9: Vivivyu Inc. Summary of Bond and Indenture Terms 6.5% Vivivyu Inc. (VIVU) Seven-Year Callable Notes (The “Notes”) Prospectus Summary Issuer: Vivivyu Incorporated Settlement Date: [T + 3 Business Days] Maturity Date: [Seven Years from Settlement Date] Principal Amount: USD400 million Interest: 6.5% fixed coupon Interest Payment: Starting six months from [Settlement Date] to be paid semiannu- ally with final payment on [Maturity Date] Seniority: The Notes are secured and unsubordinated obligations of VIVU and rank pari passu with all other secured and unsubordinated debt Call Provision: The Issuer may redeem some or all of the Notes on any Business Day before [Maturity] starting three years after [Settlement] based on the Call Price Schedule as a percentage of the Principal Amount plus accrued interest Call Price Schedule: 103.25% [Three to Four Years after Settlement] 102.50% [Four to Five Years after Settlement] 101.75% [Five to Six Years after Settlement] 101.00% [Six to Seven Years after Settlement] In the case of Vivivyu, bondholders are protected by a set of covenants which closely monitor certain financial ratios and restrict its ability to pay dividends to shareholders, repurchase shares, and / or take on additional debt unless tighter financial restrictions are met under what is referred to as an incurrence test (see Exhibit 10). Exhibit 10: VIVU Bond: Brief Summary of Indenture Terms 6.5% Vivivyu Inc. (VIVU) Seven-Year Callable Notes (The “Notes”) Prospectus Summary (continued) Issuer: Vivivyu Incorporated Transaction Security: The Notes are secured by a pledge of certain assets as identi- fied in the Indenture. Restriction on Unless the Incurrence Test is met, the Issuer shall not issue Additional Debt: additional debt unless it is (a) subordinated or (b) a working capital facility up to 20% of the Principal Amount of Notes outstanding. Restrictions on The Issuer shall not (i) pay any dividend in respect of its Dividends and shares, (ii) repurchase any of its own shares, or (iii) reduce Distributions: share capital with repayment to shareholders unless the Incurrence Test is met. Debt Restriction Test: Issuer must maintain (a) Net Interest Bearing Debt to EBITDA not greater than 5.00× and (b) Interest Coverage Ratio greater than 2.50× for each financial reporting period. Incurrence Test: Test is met if issuer has (a) Net Interest Bearing Debt to EBITDA not greater than 4.50× and (b) Interest Coverage Ratio greater than 3.0× for each financial reporting period. © CFA Institute. For candidate use only. Not for distribution. 18 Learning Module 1 Fixed-Income Instrument Features Other negative covenants include limitations on investments, the disposal of assets, or issuance of debt senior to existing obligations under what is known as a negative pledge clause. Negative covenants seek to ensure that an issuer maintains the abil- ity to make interest and principal payments. Highly restrictive covenants may not be in the bondholders’ best interest if they force an issuer to default when it may be avoided. For example, strict debt restrictions may prevent an issuer from raising new funds necessary to meet contractual obligations. Covenant violations can provide bondholders recourse in several possible ways, including a change in financial terms, such as an increase in a bond’s interest rate, accelerated debt payments, or termination of the debt agreement. QUESTION SET 1. Explain the difference in the sources of repayment for a secured and an unsecured corporate bond. Solution: The sole source of repayment for unsecured corporate bonds is typically op- erating cash flows of the issuer, while secured corporate bonds also include specific assets as a secondary source of debt repayment in addition to the issuer’s operating cash flows. 2. Describe the source of repayment for asset-backed securities. Solution: The source of repayment for asset-backed securities are cash flows from the group of loans or receivables owned by the special purpose issuer. 3. Match the bond covenant type in the left column with the examples in the right column. A. Affirmative Covenant I. Additional Debt Restriction B. Negative Covenant II. Cross-Default Clause III. Interest Coverage Minimum Solution: A. II is correct. A cross-default clause specifies that borrowers are con- sidered in default if they default on another debt obligation and is an affirmative covenant. B. I and III are correct. An additional debt restriction clause limits an increase in issuer debt and is a negative covenant. An interest coverage minimum limits the amount of leverage relative to an issuer’s operat- ing income or EBITDA. 4. Describe the difference between affirmative and negative bond covenants. Solution: Affirmative covenants specify what issuers are required to do, whereas nega- tive covenants specify what issuers are prohibited from doing. 5. Fill in the blanks. Covenant violations provide bondholders recourse in several possible ways, including a change in _________ terms, such as an © CFA Institute. For candidate use only. Not for distribution. Bond Indentures and Covenants 19 increase in a bond’s interest rate or security, ___________ debt payments, or ___________ of the debt agreement. Solution: Covenant violations provide bondholders recourse in several possible ways, including a change in financial terms, such as an increase in a bond’s inter- est rate or security, accelerated debt payments, or termination of the debt agreement. © CFA Institute. For candidate use only. Not for distribution. 20 Learning Module 1 Fixed-Income Instrument Features PRACTICE PROBLEMS The following information relates to questions 1-5 Antelas AG is a German emerging technology company focused on manufac- turing process design. The firm has developed several valuable patents related to micromachining and metal 3D printing technology and derives its revenue through licensing royalties and consultation services. Antelas recently issued the following debt instrument: Antelas AG Four-Year Floating-Rate Notes (The “Notes”) Prospectus Summary Issuer: Antelas AG Settlement Date: [T + 5 Business Days] Maturity Date: [Four Years from Settlement Date] Principal Amount: EUR250 million Interest: MRR plus 250 bps p.a. Interest Payment: Commencing three months from [Settlement Date] to be paid quar- terly with final payment on [Maturity Date] Seniority: The Notes are secured and unsubordinated obligations of Antelas AG and will rank pari passu with all other secured and unsubordi- nated indebtedness. Business Days: Frankfurt 1. “Four years” and “MRR plus 250 bps p.a.” refer, respectively, to which bond fea- tures as of the settlement date? A. Time to maturity and coupon rate B. Coupon frequency and current yield C. Time to maturity and contingency provision 2. Which of the following statements best describes the source(s) of repayment for the Antelas AG floating-rate notes? A. Since the notes are secured (or backed) by Antelas AG’s assets, the floating-rate notes would be considered asset-backed securities. B. The Antelas AG notes rely on the operating cash flows of the firm as their sole source for interest and principal payments. C. The Antelas AG notes rely on the operating cash flows of the firm as their primary source for interest and principal payments. 3. Antelas AG’s issuer-specific credit spread rises by 25 bps p.a. one year after the FRN issuance. Which of the following best describes how Antelas AG’s FRN cou- © CFA Institute. For candidate use only. Not for distribution. Practice Problems 21 pon would change as a result? A. Antelas AG’s FRN coupon payment to investors will immediately increase by 25 bps p.a. B. Antelas AG’s FRN coupon payment to investors will increase by 25 bps p.a. but will not become effective until the next full debt coupon period begins. C. Antelas AG’s FRN coupon will remain unchanged. 4. Calculate the value of Antelas’s payment to bondholders on the maturity date if the MRR is 0.25% p.a. for the final interest period. A. EUR1,718,750 B. EUR251,718,750 C. EUR256,875,000 5. Antelas decides to raise new secured, unsubordinated debt. Which of the follow- ing best describes the priority of payments between the issuer’s new debt and its existing debt? A. Because the Antelas AG notes have a pari passu (or “equal footing”) clause, this debt obligation will be treated the same as any other secured, unsubor- dinated debt from this borrower. B. Because the existing debt was issued earlier, it would receive priority over the new debt in terms of the payment of interest and principal. C. We do not have enough information to answer this question; the necessary information would be provided in the indenture for new secured, unsubor- dinated notes. © CFA Institute. For candidate use only. Not for distribution. 22 Learning Module 1 Fixed-Income Instrument Features SOLUTIONS 1. A is correct. The notes mature (the date Antelas AG will pay the final coupon and principal amount) four years after the trade settlement date, and the coupon rate is variable, determined by the MRR plus a fixed 250 bp spread. 2. C is correct. Secured corporate bonds rely on the operating cash flows of the firm as their primary source for interest and principal payments and a legal claim on assets as a secondary source of payment. A is incorrect because asset-backed securities (ABS) are issued by special-purpose entities created to take ownership in loans or receivables, the cash flows from which are used to pay interest and principal to investors. B is incorrect because it describes unsecured, not secured, corporate debt. 3. C is correct. For the Antelas AG FRN, the spread is fixed at 250 bps and the cou- pon will only change with changes in the MRR. 4. B is correct. On the maturity date, Antelas AG pays investors the final FRN cou- pon payment plus the bond’s principal amount. The FRN coupon comprises MRR plus the issuer-specific spread. FRN coupon rate: MRR plus spread, or 0.25% + 2.50%= 2.75% Annual interest expense: Principal × FRN coupon, or €EUR250,000,000 × 2.75% = EUR6,875,000 Quarterly interest expense: Annual interest expense/4, or EUR6,875,000/4 = EUR1,718,750 Principal Amount: EUR250,000,000 Total Payment = EUR250,000,000 + EUR1,718,750 = 251,718,750 5. A is correct. Antelas AG’s existing secured, unsubordinated debt has a pari passu (or “equal footing”) clause, which ensures that this debt obligation will be treated the same as any other secured, unsubordinated debt from this borrower. B is incorrect because the priority of payments is unrelated to the timing of issuance. C is incorrect because the pari passu clause ensures equal footing for similar new debt. © CFA Institute. For candidate use only. Not for distribution. LEARNING MODULE 2 Fixed-Income Cash Flows and Types LEARNING OUTCOMES Mastery The candidate should be able to: describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that benefit issuers and investors describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities INTRODUCTION A fixed-income instrument’s cash flows are determined by its features. In this module, 1 we discuss common fixed-income instrument cash flow structures and their implica- tions for issuers and investors. The module’s final lesson discusses the legal, regulatory, and tax considerations across jurisdictions faced by fixed-income issuers and investors. LEARNING MODULE OVERVIEW In contrast to standard bullet bonds with full principal repay- ment at maturity, amortizing bonds have a payment schedule that involves early repayment of principal. Sinking funds and waterfall structures represent special cases of amortizing bonds. Other coupon payment structures include index-linked bonds that offer payments adjusted for changes in price indices and bonds with step-up coupons, with coupons that increase by specific amounts in the future based on a schedule or subject to specific provisions. Fixed-income contingency provisions include call, put, and conversion features. A call feature grants an issuer the right to buy bonds back early at a fixed price, while a put feature grants an investor the right to sell bonds to the issuer at a fixed price prior to maturity. Convertible bonds grant investors the right to convert the bond into shares of the issuer’s stock at a pre-determined price. © CFA Institute. For candidate use only. Not for distribution. 24 Learning Module 2 Fixed-Income Cash Flows and Types Bonds can be classified as domestic, foreign, or Eurobonds. Domestic bonds are those issued in a country by an issuer incorporated in that same country, while foreign bonds are issued by entities incorporated elsewhere. Eurobonds are issued internationally in a currency different from that country’s domestic currency (e.g. US dollar bonds issued in London) and are subject to fewer listing, disclosure, and regulatory require- ments than domestic or foreign bonds. Bond interest earned by an investor is usually taxed as ordinary income, although some bonds offer tax advantages. Some countries also apply a capital gains tax. Specific tax provisions often apply for bonds issued at a discount or purchased at a premium. LEARNING MODULE SELF-ASSESSMENT These initial questions are intended to help you gauge your current level of understanding of this learning module. 1. An investor that is more sensitive to an issuer’s credit risk than to reinvest- ing risk would most likely invest in a: A. bullet bond. B. partially amortizing bond. C. fully amortizing bond. Solution: C is correct. Investors receive higher near-term cash flows on amortizing debt versus bullet bonds and face lower credit risk because the borrower’s liability is reduced over time. However, investors also face the risk of rein- vesting the higher near-term cash flows at prevailing market interest rates, which can fluctuate. This effect is larger for fully amortizing bonds versus partially amortizing bonds. 2. Match the term in the left column with its description in the right column. A. Bullet bond I. A bond with a fixed periodic payment schedule that reduces the bond’s outstanding principal to a portion of the principal to be repaid on the matu- rity date B. Partially amortizing bond II. A bond with a coupon rate that increases by

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