Investments 3A Chapter 1: Features of Debt Securities PDF

Investments 3A Chapter 1: Features of Debt Securities Week 1 Features of debt Securities In investment management the most important decision is the allocation of funds among the different asset classes. The two major asset classes are equities and fixed income securities. Other asset clas...

Investments 3A Chapter 1: Features of Debt Securities Week 1 Features of debt Securities In investment management the most important decision is the allocation of funds among the different asset classes. The two major asset classes are equities and fixed income securities. Other asset classes are referred to as alternative asset classes – Real estate, Private equity, Hedge funds and commodities. In this investment journey we will be focusing on Fixed Income securities. 2  Fixed Income securities – it is a financial obligation of an entity that promises to pay a specified sum of money at specified future dates. The entity that promises to pay is referred to as issuer of the security e.g. Central government. FIS fall into two categories : debt obligations and preferred stock # Debt obligation – Borrower. The investor who purchases such a fixed income security is a lender/creditor The promised payments that the issuer agrees to pay/make at specified dates consists of two components : interest and principal [Principal represents repayment of borrowed funds] 3  Fixed income securities that are debt obligations include :Bonds, mortgage backed securities, asset backed securities and bank loans. In contrast to fixed income securities that represent debt obligations, Preferred stock represents ownership interest in a corporation Dividends are made top preferred stockholders and represent a distribution of the corporations profit. * in case of bankruptcy, preferred stockholders are given preference over common stockholders During this year in Investments, we will use the terms fixed income securities and bonds interchangeably furthermore, bonds will be used to refer to mortgate backed securities, asset backed securities and bank loans. 4 INDENTURES AND COVENANTS 1. What are indentures and covenants ? 2. Types ? 5 INDENTURES AND COVENANTS The promises of the issuer and rights of bondholders are set in the bond indenture The indentures identifies the trustee as a third party to bond/debt contract. An indenture has two types of covenants : 1. Affirmative covenants – sets forth the activities that the borrower promises to do : (i) to pay the principal and interest on time (ii) to pay all the taxes and other taxes when due (iii) maintain all properties used and useful in the borrowers business in good and working conditions (iv) submit periodic reports to a trustee stating that the borrower is in compliance with the loan agreement 2. Negative covenants – sets forth certain limitations and restrictions on the borrowers activities: (i) Ability of the borrower to incur more debt unless certain tests are satisfied. 6 MATURITY What is Maturity ? 7 MATURITY Term to maturity – refers to the number of years the debt is outstanding / the number of years remaining prior to final principal payment. Maturity date – refers to the date that the debt will cease to exist at which the issuer will redeem the bond by paying the outstanding balance : (a) short term 1 – 5 years (b) Intermediate 5 – 12 years (c) Long term 12 years or more Reasons why maturity is important: 1. Term to maturity indicates the time period over which the bondholder can expect to receive interest payments and the number of years the principal can be paid in full. 2. Yield offered depends on the term to maturity ( relationship between yield on a bond and maturity is called yield curve) 3. Price of a band fluctuates over its life as interests rates in the market change Thus Price volatility (PV) = f(maturity,etc) Thus longer maturity = < PV resulting from ▲ in interest rates 8 PAR VALUE Par value of a band refers to the amount that the issuer agrees to repay the bondholder at or by maturity date This amount is also referred to as princip[al value, face value, redemption value and maturity value. Valuing bonds : (a) Quoted price (b) Price per $ value (c) Par value (d) Dollar value Basic concepts: 1. Trading below par value – Discount 2. Trading above par value – Premium 9 COUPON RATE What is a coupon rate ? How do you calculate coupon rate ? What are the different types of bonds ? 10 COUPON RATE Coupon rate is also called nominal rate – it is the interest rate the issuer agrees to pay each year. The annual amount of interest payment made to the bondholder during the term is called coupon Coupon rate = Coupon rate X par value Example of coupon rate notation 6s of 12/1/2026 The “s” represents the coupon series. * The usual practice is that bond are paid semi-annually, mortgage backed securities and asset backed securities pay interest monthly. 11 Types of Bonds A) Zero coupon Bonds Bonds that are not contracted to make payments are referred to as zero coupon bonds Holders of ZCB realise interest by buying the bonds below par value Interest is part of the maturity date  interest being the difference between the par value and the purchase price of the bond B) Step-up Notes These are securities that have a coupon rate that increases over time. When there is only one step up (one step up) the iss is referred to as a single step up note. When there is more than one step up, the issue is referred to as a multiple step up note. Example is in the textbook. 12 Types of Bonds C) Deferred Coupon Bonds These are bonds whose interest payments are deferred for a specified number of years. Basically no interest payments for a specified period, after specified period , issuer makes payments until maturity. Interest payments for such bonds are higher than a normal bond. D) 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 (why?) Thus: 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. 13  Caps  Embedded options  Provision in the indenture that gives the issuer and or the bondholder an option to take some certain action against another party. Treasury Inflation Protection Securities (TIPS) – These are securities that are inflation adjusted  the reference rate is measured by the consumer price index. The coupon formula for a floater is such that the coupon rate increases when the reference rate increases and vice versa. * Inverse/reverse floaters – these are coupon rates that move in the opposite direction from a change in the reference rate Coupon formula for inverse floater: Coupon rate = K – L X (Reference rate) Where K & L are values specified in the prospectus for the issue. Example : 20% - 2 (6% - [3 monthly treasury bill]) Consider more examples 14 E) Accrued interest Typically interest is paid every 6 months (semi annually) , in some countries it is paid annually. For mortgage and asset backed securities it is paid monthly. The amount of interest received by the buyer is called accrued interest The amount that the buyer pays the seller is yhe agreed upon price of the bond plus accrued interest (full price/ dirty price) The agreed upon price without the accrued interest is referred to as the clean price. A bond in which the buyer must pay the seller accrued interest is said to be trading cum-coupon (“with coupon”) If the buyer forgoes the next coupon payment the bond is said to be trading “ex coupon” (Without coupon) * Trading flat – when a bond is traded without accrued interest 15 PROVISIONS FOR PAYING OFF BONDS The issuer of the bond agrees to pay the principal by the stated maturity date. When the issuer agrees to pay the entire amount borrowed in one lumpsum at maturity this is referred to as a bullet payment. Fis backed by pools of loans (mortgage backed and asset backed) often have a schedule for opartial payment  Amortizing securities Sinking Fund Provision – refers to the provision for repayment of a bond that may be designed tompay all of its issue amount at maturity date or it may be arranged to pay only part of the total at maturity. - example ? Call Provision – grating the issuer an option to retire and or part of the issue prior to the stated maturity date. 16 Types of Call Options A) Call and refunding provisions The right of the issuer to retire the issue prior to the stated maturity date is referred to as a call provision  exercising the right is referred to as “call the bond”. The price at which the issuer must pay is called the call price or redemption price. When a bond is issued and may not be called for a number of years is referred to as differed call what is the first call date ? 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 is referred to as a callable bond. (i) Call (redemption) Price The call price can either be: (a) Fixed regardless of the call date (b) based on the price specified in the call schedule (c) based on a make whole provision Refer to textbook for example 17  (ii) Noncallable vs Non-refundable bonds If a bond issue does not have any protection against an early call it is said to be currently callable (iii) Regular vs Special redemption Prices (i) and (ii) call prices are called regular redemption prices are general redemption prices The regular redemption prices are above par until the first par call date. Special redemption prices – these are for bonds redeemed through sinking fund and through other provisions. The special redemption price is usually par value rather than regular redemption price Self study – Par call Problem 18 Types of Call Options B) Prepayments Any principal payment prior to a scheduled principal date is called a prepayment The right of borrowers to repay the principal is called a prepayment option A prepayment behaves as a call option. C) 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 called balloon maturity. An issuer can satisfy the sinking fund requirement by (i) Making a cash payment to the trustee equal to the par value of the bonds to be retired, the trustee then calls the bonds for redemption using a lottery (ii) Delivering to the trustee bionds purchased in the open market that have a total par value equal to the amount to be retired. 19 Types of Call Options *if retired using the first method, interest payment stop at the redemption date Periodic payments required for a sinking fund are the same for each period (these are subject to change in consideration if the stipulations made in the indenture) *accelerated sinking fund provision – it is a provision that grants the issuer the option to retire more than the sinking fund agreement 20 CONVERSION PRIVILEDGE What is a convertible bond ? What is an exchangeable bond ? 21 CONVERSION PRIVILEDGE A convertible bond – is an issue that grants the bondholder the right to convert the bond for a specified number of shares of common stock. It allows the bondholder to take advantage of favourable movements in the price of issuers common stock An exchangeable bond allow the bondholder to exchange the issue for a specified number of shares of common stock of a corporation different from the issuer of the bond. 22 PUT PROVISION Put provision – it is the right to sell the issue back to the issuer at specified price on designated dates. The specified price is called a put price A bond is puttable at par if it is issued at or close to par value, zero coupon bond, the put price is below par Once advantage  If market rates rise above the issue coupon rate, the bondholder can force the issuer to redeem the bond at put price and then reinvest the put bond proceeds at the prevailing higher price. 23 CURRENCY DENOMINATION An indenture may specify that the issuer may make payments in some other specified currency Two main types : (i) A Dollar denominated issue (ii) Non dollar denominated issue  also known as a dual currency issue 24 EMBEDDED OPTIONS Embedded options – These are provisions in an indenture that gives the issuer and or bondholder an option to take some action against another party. Types of Embedded options (a) Embedded options granted to issuers Most common embedded options that are granted to issuers/ borrowers include : (i) The right to call the issue (ii) The right of the underlying borrowers in a pool of loans to repay principal above the scheduled principal payment (iii) The accelerated sinking fund provision (iv) The cap on the floater. Why is sinking fund an embedded option ? Cap/floater – the bondholder has granted to the issuer the right not to pay more than the cap *The first 3 conditions are dependant on the prevailing interest rates but in 4 the option becomes valuable as interest rise. 25 EMBEDDED OPTIONS cont. (B) Embedded options granted to bondholders The most common options that are granted to bondholders are : (i) Conversion privilege (ii) Right to put the option (iii) Floor on a floater The value of a conversion privilege depends on the market price of the stock relative to the embedded purchase price held by the bondholder when exercising the conversion option. The put privilege benefits the bondholder if interest rates rise above the issue coupon rate. While a cap benefits the issuer if and when interest rate rise, a floor benefits the bondholder if and when interest rate fall since it fixes a minimum coupon payabale 26 EMBEDDED OPTIONS cont. Importance of understanding embedded options. The cashflow for a fixed income security is defined as its interest and principal payments When valuing an embedded option it is important to note: 1. Model the factors that determine whether or not an embedded option will be exercised over the life of the security 2. in case of options granted to issuers/ borrowers model the behaviour of issuers and borrowers to determine the conditions necessary for them to exercise embedded options Modelling risk (refers to an analysis of securities with embedded options) – it is the risk that the model analysing embedded options produces the wrong value because the assumptions are not correct or the assumptions were not realised 27 BORROWING FUNDS TO PURCHASE BONDS When securities are purchased with borrowed funds, the most common practice is to use the securities as collateral for the loan  collaterised loan Two types of borrowing are : (1) Margin buying (ii) Repurchase agreements (i) Margin Buying Margin buying arrangement  the funds borrowed to buy the securitues are provided by the broker and the broker gets the money from the bank. The interest rate banks charge the brokers for these transactions is called call money rate (broker loan rate) The broker charges the investor the call money rate plus a service charge. However, the broker can onl;y lend a specific percentage securities of the market value. 28 BORROWING FUNDS TO PURCHASE BONDS cont. (ii) Repurchase agreement Repurchase agreement – it is the collaterised agreement used by institutional investors in the bond market. Repurchase agreement – is the sale of a security with a commitment by the seller to by the same security back from the purchaser at a specified price at a designated future date. Purchase price – is the price at which the seller will purchase the security on a specified future date 29 End of Chapter 1 Thursday work Chapter 3 - Read up on the overview of bond sectors and instruments - HAPPY VALENTINES DAY EVERYONE - NB : Ladies please don’t buy NIVEA and SOCKS we don’t like it, try going to Mercedes Benz, BMW or Audi - T for Thanks. 30