Reading 42: Fixed-Income Markets: Defining Elements

The term “fixed income” means that investors of fixed-income securities receive a constant
cash income via coupon payments. This differs from equities because many companies do
not pay dividends and so the return of a stock largely comes from its capital gains/losses
(price appreciation/depreciation). These capital gains are unrealised until the investor sells
the stock for cash.

The investor of a fixed-income security will most likely receive regular cash payments,
depending on the nature of the fixed-income instrument. They are considered to have a
lower downside than stocks because of this predictability of cash flows but even the upside
is relatively limited.

All fixed-income readings revolve mostly around the understanding of different fixed-income
securities, how they are priced and how they are used. But before that it is important to know
the different types of fixed-income securities that are available, the different characteristics of
a fixed-income security and the terminology associated with fixed-income securities.

LOS 42.a: Describe basic features of a fixed-income security.

There are a few characteristics that specify the details about a bond.

Issuer

The issuer is the seller of the bond. They will issue bonds to raise money and then repay the
bondholders (buyers) with coupon payments (interest) and principal. There are a few key
issuers of bonds:

● Corporations: these are referred to as corporate bonds and are further classified
into financial company bonds and non-financial company bonds. These bonds may
also trade on the corporate bond market. e.g. Reliance raising money via bond in
capital market
● Sovereign National Governments: these are bonds that are issued by the
government of a country. e.g: 10 yr G-Sec in India
● Non-Sovereign Governments: these are issued by state governments,
municipalities or provinces. They are not national bonds but will be backed by the
government authorities. e.g.- state development loans in India
● Quasi-Government Entities: these are not a direct obligation by government
authorities but they can be sponsored by government authorities. The Federal
National Mortgage Association (also known as Fannie Mae) is an example.
 ● Supranational Entities: these are bonds that are issued by organisations like the
World Bank or the IMF. They are not government-backed bonds but are issued by
credible entities

Bond Maturity

The maturity date of the bond is when the principal on the bond is repaid. The principal is
the face value of the bond. The tenor or the term to maturity is the time until this maturity
date will be reached for an already issued bond. For example, if we are in August, 2021 then
the tenor of a G-Sec bond with a maturity date of August 2022, the tenor is one year. Note
that this bond could have been issued even 10 years ago. So in that case, the original
maturity of the bond was 10 years.

Bonds can also be issued for greater than 30 years, even 100 years. These are perpetual
bonds. They make regular interest payments but there is no promise to repay the original
amount. The issuer can redeem them at any time.

Fun Fact: the U.K. and U.S. governments issued “consol” bonds in the 1750s and 1870s,
respectively. These were perpetual bonds that could be redeemed by the government at any
time. The U.K. government redeemed all of these bonds in 2015.

Money market securities have an original maturity of one year or less and capital market
securities have a maturity of greater than one year.

Par Value (Face Value)

This is the principal amount that will be paid at maturity. It is called the face value but is
also called the redemption value or the maturity value.

Note that when a bond trades in the open market, its price does not have to be the par
value. This is because of several factors. Interest rates can change, the credit quality can
change, the general economic conditions can change, etc.

Suppose a bond has a par value of Rs. 1,000,000.

● If the bond trades for more than Rs. 1,000,000 then it is said to be trading at a
premium or is a premium bond
● If the bond trades for less than Rs. 1,000,000 then it is said to be trading at a
discount or is a discount bond
● If the bond trades for at Rs. 1,000,000 then it is said to be trading at a par or is a par
bond

We will see how the yield to maturity affects the price of a bond later in this topic.
Coupon

The coupon rate is the annual percentage rate of the par value that will be paid to the
bondholder. The face value determines the actual rupee amount of coupon that you will
receive.

Suppose you own a 7% bond of a face value Rs. 1,000,000 and it pays an annual coupon.
You will receive Rs. 70,000 on the interest payment date every year and the full principal
plus coupon (Rs. 1,070,000) on the maturity date.

Suppose you own a 7% bond of a face value Rs. 1,000,000 and it pays a semi-annual
coupon. You will receive Rs. 35,000 on the interest payment date every 6 months (for a full
coupon rate of 7% annually) and the full principal plus coupon (Rs. 1,035,000) on the
maturity date.

It is also possible to have zero-coupon bonds (zeros) or pure discount bonds. The “pure
discount” term means that these bonds are sold at a discount to the par value and the face
value is paid completely at maturity. For example, a zero-coupon bond with a face value of
Rs. 100,000 may trade at Rs. 97,000. If you buy this bond then you will receive no interest
until maturity but there will be an effective interest rate that you have earned. You will
receive a certain Rs. 100,000 at maturity while you paid Rs. 97,000 to buy the bond.

Currencies

The Indian government does not always have to issue bonds that pay in Indian rupees. They
can issue dollar-denominated bonds. This is done to attract investors as it provides more
foreign currency stability.

A dual currency bond pays interest in one currency and the principal in another.

A currency option bond allows the bondholder to choose in which of the two currencies
they would like to receive payments.

Questions

1. A bond that is issued by Bank of Maharashtra Ltd is most likely which type of bond?

A. Non-Sovereign Government bond

B. Corporate Bond

C. Sovereign Bond
2. A 10-year 5% annual coupon bond was issued by the RBI on January 1, 2019. If we are
January 1, 2022, which of the following is the tenor of the bond?

A. 10 years

B. 8 years

C. 7 years

3. A bond that matures in 30 years is most likely which type of bond?

A. Perpetual bond

B. Capital market bond

C. Money market bond

4. A bond trades Rs. 94.50 per Rs. 100 of par value. It pays the face value of Rs. 100 at
maturity but pays no coupon. Which of the following is most likely the classification of this
bond?

A. Pure discount bond

B. Par bond

C. Discount bond

5. Which of the following is a dual currency bond?

A. The Indian government issuing bonds that pay interest and principal in U.S. dollars

B. A company that issues bonds in two different currencies and allows the bondholder to
choose in which currency they would prefer payments
C. A sovereign entity that pays interest in Indian Rupees but the principal in Bangladeshi
Dhaka

Answers

1. B is correct. “Ltd” implies that the company is a publicly listed company and the bonds will
be backed by a corporation. Non-sovereign government bonds are backed by states,
municipalities, provinces, etc. and such entities that are not the national government.

2. B is correct. The original maturity of the bond remains fixed at 10 years. The tenor is the
time remaining until the bond matures. This bond matures on January 1, 2029 and so there
are 7 full years remaining.

3. B is correct. A perpetual bond does not have a fixed maturity and can be redeemed at any
time. Money market bonds are of maturities of less than 1 year. Capital market bonds are
bonds with maturities of greater than 1 year.

4. A is correct. A zero-coupon bond or a pure discount bond will not pay any coupon. It will
always trade below par value and will pay the full par value at maturity with no coupon
payment throughout its life. A discount bond will pay coupons and is only called a discount
bond because it is trading below its par value.

5. C is correct. A is a dollar-denominated bond. B is a currency option bond.

LOS 42.b: Describe content of a bond indenture.

LOS 42.c: Compare affirmative and negative covenants and identify examples of each.

Bond Indenture

This is the legal contract between the bond issuer (borrower) and bondholders (lenders). It is
also called a trust deed. These define the obligations and restrictions of a borrower. For
example, there will be specified dates on which coupon payments must be made or limits to
how much financing a company can raise via bonds. This forms the basis for all future
transactions from issuer to bondholder.

Covenants

The provisions in the bond indenture are known as covenants and include both negative
covenants and affirmative covenants.

Negative Covenants
These include restrictions that the issuer of the bond must abide to. They outline the things
that the issuer cannot do.

A restriction on asset sales means that the company cannot sell certain assets that may
have been pledged as collateral. Collateral is any asset that is pledged or put up as security
for the repayment of a loan. In case the company defaults on loan payments, these assets
will be seized by the bondholders and sold to get the unpaid amount.

It could also be that the same asset cannot be used as collateral for many debt issues. The
company may have bonds that mature on different dates but they cannot keep the same
asset for each bond issue. This is a negative pledge of collateral.

The company may also have restrictions on additional borrowing unless certain financial
conditions are met. Increasing debt increases the burden of interest payments. If the
company is not financially stable and raises unsustainable debt then it is more likely to
default on the debt payments compared to a financially stable company that has less debt on
its books.

These covenants are put in place to protect the interests of bondholders. It also ensures that
the company is kept in check and does not recklessly raise debt. But these covenants must
be flexible to allow the issuing agency to take advantage of changes in economic conditions.
For example, restrictions on additional borrowing may lead to a company not taking up new
but profitable projects if the economy is coming out of recession.

Affirmative Covenants

These do not necessarily restrict the issuer. They outline the things that the issuer must do.

These include making timely interest and principal payments to bondholders, insurance and
maintenance of assets and compliance with the relevant laws and regulations.

Questions

1. Why are covenants least likely prepared in a bond indenture?

A. To protect the issuing entity in case of default

B. To outline the duties of the issuing entity

C. To protect the bondholders

2. Limits on fundraising are least likely to be in which of the following?

A. Negative covenants

B. Affirmative covenants

C. Bond indenture

3. Which of the following is most likely correct regarding negative pledge of collateral?

A. The same assets cannot be used as collateral for different bond issues

B. Different bond issues of the same company must be backed by the same collateral

C. The assets that are pledged as collateral cannot be sold

Answers

1. A is correct. B and C are both motivations to make covenants in a bond’s indenture.

2. B is correct. The bond indenture contains negative and affirmative covenants. Negative
covenants are things that the company cannot do while affirmative covenants are things that
a company must do.

3. A is correct. C is incorrect because this is simply a restriction on asset sales.

LOS 42.d: Describe how legal, regulatory, and tax considerations affect the issuance
and trading of fixed-income securities.

Domestic Bonds

Bonds issued by the RBI that are denominated in INR and traded in India are considered
domestic bonds. The issuing country uses the currency of that country to make interest and
principal payments of the bond.

Foreign Bonds

If a company that is incorporated in India issues a bond that pays the interest and principal in
U.S. dollars and if this bond trades on the U.S. markets, it is considered a foreign bond.
Such bonds specific to the U.S. dollar and U.S. markets are called Yankee bonds.
Similarly, bonds issued by a foreign company that trade on China’s markets and pay in yuan
are called panda bonds.

Eurobonds

Note that these are not related to the Euro currency at all.

Suppose a bond is issued by a company in India but is denominated in dollars and trades in
China. This is an example of a Eurobond.

They get their name “Eurobond” because this concept was first introduced in Europe. They
are less regulated than domestic bonds and were created to avoid U.S. regulations.

They are also called global bonds.

The mechanics can get confusing so the Eurobond is named by the currency of the interest
and principal payments. A dollar denominated Eurbond will be called a Eurodollar regardless
of the issuing and trading country; a yen denominated Eurobond will be called a Euroyen
bond and so on.

These bonds used to be issued in bearer form. So, evidence of ownership is simply seen by
possessing the bonds. The registered form, however, requires the bonds to be recorded.
Bearer bonds are for investors who are seeking to avoid taxes. But just like other bonds,
Eurobonds are now issued in registered form.

The trust deed of the bond will include:

● Legal information about the bond issuer

● Any assets pledged as collateral to support the repayment of the bond
● Credit enhancements: anything that increases the likelihood of repayment
● Negative and affirmative covenants

Issuing Entities

Bonds can be issued by several entities like corporations, sovereign governments, non-
sovereign entities, etc. The bondholders must recognise which entity is responsible to make
payments for the bonds that they hold.

This is easy to identify for sovereign bonds since they are issued by the government. But
corporate bonds may get a little complicated. They may be issued by a large corporation, a
subsidiary of a large corporation or by a holding company that owns several other
companies. It is important to note the differences because the credit quality of all these types
of companies will differ.
Special purpose entities (SPEs) are other companies which are created only to issue bond-
like securities. We will discover these later in Reading 45. SPEs are also called bankruptcy
remote entities because the assets that back these bonds are owned by the SPE
themselves and used to make payments to the final bondholder.

Sources of Repayment

The issuing entity will use the funds that have been raised to finance certain projects. These
projects are typically the source of repayment of the interest and principal.

It is important to assess the source of funds so that the bondholder knows where the money
will come from to earn interest on the bond. A higher quality source of funds makes the bond
more attractive.

Collateral and Credit Enhancements

It is also important to see which assets are posted as collateral. If a bond is unsecured or
not backed by any assets then these bonds represent a claim to the overall assets and
cash flow of the issuer.

Bonds that are secured by specific assets represent a claim to only these assets. This
reduces the risk of default as these assets can be sold to make some part of the defaulted
payments.

Secured bonds are senior to unsecured bonds since they are backed by assets. Then there
are senior unsecured bonds and subordinated or junior debt. Following are the general
seniority rankings.

RE-MAKE:
So, credit quality of bonds is highest to lowest from senior secured debt to junior
subordinated debt.

Secured debt may also be referred to by the type of collateral pledged. Equipment trust
certificates, for example, are debt securities backed by equipment such as railroad cars and
oil drilling rigs.

Collateral trust bonds are also backed by financial assets like stocks or other bonds.

Mortgage-backed securities (MBS) are the most common type of securitised bonds. Many
mortgages are pooled together to make one securitised product. The cash flows from the
mortgages are then used to pay the interest and principal payments on the MBS. These are
covered in detail in Reading 45.

Internal Credit Enhancement

The issuing entity can overcollateralized the loans. The collateral itself has a greater value
than the par value of debt issued. However, when defaults are high even this collateral
loses value, so the loan may not be overcollateralized in that case.

Cash reserve funds can be used for internal credit enhancement. This is simply a reserve
of excess cash that is kept aside in case there are credit losses in the underlying loans.

The issuing entity can also use excess spread accounts. Here, the yield on the bond
issued is less than the yield on the underlying asset that is supporting the asset-backed
security. For example, if the weighted average of the mortgages, yield a 5% annualised rate
then the mortgage-backed security can be promised to yield a 3% annualised rate. This will
ensure that the issuing entity holds a spread of at least 2%. If the mortgages underperform
then there is some cushion and if the mortgages perform as expected then the issuing entity
can keep the spread and use it to pay off the principal on outstanding debt.

The entity can split the asset-backed security into tranches or slices. Any losses will first be
absorbed by the tranches with the lowest credit quality or any prepayments will be given first
to the tranche with the senior claim on prepayments. These are also discovered in Reading
45.

External Credit Enhancements

The issuing entity can approach a financial institution for credit enhancement. These are all
external sources since a third party is involved.
Insurance companies can issue surety bonds. These are a promise to make up for any
shortfall in the debt servicing (interest and principal payments). Bank guarantees also
fulfillfulfil the same purpose.

A letter of credit can also be issued. This is a promise to lend money to the issuing entity if
there is a shortfall on payments to the investors from covered bonds.

External credit enhancements increase the credit quality of such issues and decrease the
yield. But if the credit quality of the guarantor or trust (the third party) reduces then it will
also reduce the credit quality of the bond issue itself.

SUMMARISE WITH A TABLE OF INTERNAL VS EXTERNAL

Taxation of Bond Income

Interest income on bonds is typically taxed as ordinary income. This is the same rate as
income tax depending on the investor’s tax bracket. Municipal bonds in the U.S. may be tax
exempt at the national level and some may be tax exempt at the state level too.

However, if a bondholder sells a coupon-paying bond before the bond matures then it is
taxed on capital gains. The bond is then considered just like any other security like a stock.
It is likely that the capital gains tax rate is less than the income tax rate. If it is classified as a
long-term capital gain then it may even be at a lower rate than the short-term capital gains
tax.

The treatment of pure discount bonds is interesting. Original issue discount bonds (OID
bonds) are purchased at steep discounts to par value and pay no coupon. The value of the
bond moves towards its par value over time. Yet, the increase in value generates a tax
liability even though no coupon has been paid.

Part of the discount from par value is treated as taxable interest income each year according
to some jurisdictions. This also allows the tax basis of the bonds to increase each year so
that at the end of the maturity period there is no additional capital gains tax.

Questions

1. An analyst in India is looking at bonds in the U.K. U.K., a country that uses the pound as
their currency, issued a bond in Germany that is denominated in Euros. The bond pays
coupon and principal in the Euro. Which of the following is the most likely type of bond?

A. Eurobond

B. Foreign bond
C. Domestic bond

2. A bond is issued by a company in Germany and it trades in the U.S. bond market. It
makes interest and principal payments in Canadian dollars. Which of the following is the
most likely type of bond?

A. Eurobond

B. Foreign bond

C. Domestic bond

3. Which of the following is most likely correct about bearer bonds and registered bonds?

A. Registered bonds required the bonds to be recorded but do not have high tax implications

B. Bearer bonds do not require the bonds to be recorded and are preferred to avoid tax

C. Both types of bonds require the bonds to be recorded and have high tax implications

4. Why is it most likely important to know who the issuing entity is?

A. So that the analyst can assess the quality of the source of repayment and which party is
liable to make these payments in complex holding structures

B. So that the analyst can assess the currency of repayment

C. So that the analyst can assess the time taken to repay debt

5. Which of the following is the appropriate ranking of seniority from highest to lowest?

A. Senior unsecured, senior secured, senior subordinated

B. Senior subordinated, senior unsecured, senior secured

C. Senior secured, senior unsecured, senior subordinated

6. If a company posts a collateral on a bond that is made up of aircraft and shipping
containers, then which of the following is the most likely classification?

A. Collateral trust bond

B. Equipment trust certificate

C. Asset-backed security

7. Which of the following is least likely an external and internal credit enhancement,
respectively?

A. Overcollateralisation and letter of credit

B. Bank guarantees and cash reserve funds

C. Surety bonds and excess spread accounts

Answers

1. B is correct. A is incorrect because the bond trades in the same currency that it pays
coupon and principal. C is incorrect because a domestic bond would be issued in the U.K.,
traded in the U.K. and serviced their debt in pounds.

2. A is correct. A Eurobond is issued by a company in Country X (Germany), trades in

Country Y (U.S.) and pays interest and principal in Currency Z (Canadian dollar).

3. B is correct. Investors in the high income-tax brackets would prefer bearer bonds because
evidence of ownership is shown by possessing the bonds. They do not need to be
registered.

4. A is correct. There can be several issuing entities and they will all have different uses of
debt and sources of funds to repay debt. For example, a government may rely on receipts
from tax revenues and a company may rely on the revenue from a specific project.
Corporates can have complex holding structures so it is important to note whether the parent
company or the subsidiary is liable to service the debt.
5. C is correct. B is incorrect because it is from lowest to highest.

6. B is correct. A is incorrect because collateral trust bonds are backed by one or more
financial assets. C is incorrect because asset-backed securities are complex fixed-income
products which comprise of other bonds or loans. An MBS is a type of an asset-backed
security.

7. A is correct. Overcollateralisation is when the company posts excess collateral against

their debt and this is an internal credit enhancement. Cash reserve funds and excess spread
accounts both act as a cushion when the underlying assets do not perform well. These are
internal credit enhancements.

Surety bonds are used by insurance companies and are a promise to recover any shortfall
from debt servicing. Bank guarantees are for the same purpose. A letter of credit can be
issued and this is a promise to lend money to the issuing entity. These three are external
credit enhancements.

LOS 42.e: Describe how cash flows of fixed-income securities are structured.

You may think of the cash flows of a bond as a combination of interest payments and
principal payments.

We will take the example of the following bond:

7-year bond with a face value (principal value) of Rs. 100,000 with an annual-pay coupon of
3%.

Bullet Structure

Most bonds pay the entire interest component first and then the final principal along with the
final interest payment on the day of maturity.

Year 1 2 3 4 5 6 7

Interest 3,000 3,000 3,000 3,000 3,000 3,000 3,000

Principal
 - - - - - - 100,000

Total Cash
Flow 3,000 3,000 3,000 3,000 3,000 3,000 103,000

Become familiar with this structure because this is the structure that is used for all fixed-
income readings.

An alternative way to present this is by showing the principal due.

Year 1 2 3 4 5 6 7

Interest 3,000 33,000 3,000 3,000 3,000 3,000 3,000

Principal - - - - - - 100,000

Principal
Due 100,000 100,000 100,000 100,000 100,000 100,000 -

Note that the principal amount of Rs. 100,000 remains due until the very last payment date.

Amortising Bonds

A loan can be fully amortising too in which case the principal and interest component is
paid together. This means there is a fixed amount which contains some component of the
principal and some component of interest.

You may think of this as an EMI on a home loan and the rate of interest in this case is the
coupon rate.

Year 1 2 3 4 5 6 7

Payment 16,050.6 16,050.6 16,050.6 16,050.6 16,050.6 16,050.6 16,050.64

 4 4 4 4 4 4

Principal 96,303.8 80,253.1 64,202.5 48,151.9 32,101.2 16,050.6

Due 1 8 4 1 7 4 -

You do not need to understand the calculation, just understand the amortising structure.

A bond may also be partially amortising when there is a balloon payment of principal left
at the end.

Year 1 2 3 4 5 6 7

14,445.5 14,445.5 14,445.5 14,445.5 14,445.5 14,445.5

Payment 7 7 7 7 7 7 25,676.58

Principal 97,904.4 83,458.8 69,013.2 54,567.7 40,122.1 25,676.5

Due 3 6 9 2 5 8 -

Notice that the last payment is higher than all other payments because it includes a payment
of the principal due.

An issuer may have a sinking fund provision in the indenture of the bond. In this case, the
principal is paid throughout the life of the bond. For example, an issuer of a 30-year
bond issue of Rs. 1,000 crore may pay Rs. 1 crore towards the principal amount every year
starting from the tenth year.

There can be a period where no sinking fund provision redemption is made or the amount
of redemption could increase or decrease each year. So, these provisions may vary and the
bondholder must be aware of such provisions.

The redemption price is usually the par price but it can be different too. Suppose the market
price of the bond is less than the redemption price in the sinking fund provision. It is
beneficial for the issuer to buy these bonds at the market price from the open market and
then redeem them at the redemption price.

Bonds with sinking fund provisions have less credit risk because the bondholder is receiving
periodic principal payments and so the amount due at maturity is lower. This makes the
issuer more likely to pay the full amount due. It can be a disadvantage if interest rates fall.
Imagine you receive a total of Rs. 10,000 from the sinking fund provision of a bond that was
expected to pay Rs. 1,000 in coupon payments. Now you have excess cash and will have to
re-invest this somewhere. So if interest rates fall then you are worse off.

Also, when interest rates fall, bond prices increase. But the bond trustee will select bonds
for redemption randomly. It is beneficial for them to redeem the bonds when the sinking fund
provision price is below the market price. The bondholder whose bonds are redeemed then
suffers a loss if the bonds redeemed are at a price below the market price of the bond.

These two cases show that the sinking fund provision poses a re-investment risk to the
bondholder. Bondholders will have to re-invest their cash flows at lower yields.

Below is a list of all other coupon structures.

Floating Rate Notes (FRN)

The coupon payment is a floating coupon. This means that the coupon payment is
determined by some reference interest rate. Suppose the LIBOR is the reference rate. The
coupon could be 180-day LIBOR + 50 bps (basis points) which means the coupon pays
the 180-day LIBOR plus 0.50%.

We explore this further in Reading 44.

FRNs may have caps and floors. A cap is the maximum coupon rate that the bondholder
will receive. This is beneficial to the issuer because it puts a limit on the payment they must
make. A floor is the minimum coupon rate that the bondholder will receive. This is beneficial
to the bondholder because it puts a minimum amount on the payment they must make.

Floaters can be inverse floaters too. This is when the coupon rate decreases as the
reference rate increases. 5% - LIBOR is an example of an inverse floater. As the LIBOR
increases, the coupon payment decreases and vice versa.

Step-Up Coupon

The coupon rate on these bonds increases over a period of time based on a predetermined
schedule. These may also have a call feature which allows the issuer to redeem the bonds
at the step-up date. So, if the higher coupon rate is greater than what was priced into the
yield (if the yield is less than the coupon) then the issuer would call back the bonds.

On the other hand, if market yields rise then the bondholder may get a higher coupon rate in
subsequent periods since the bonds will not be called. Yields increase when the credit rating
falls and so the bondholder is compensated for extra credit risk with a higher coupon. So we
can say that the step-up coupon bonds protect against increases in market rates because
the higher coupon may offset the fall in the price of the bond.

Credit-Linked Coupon

These bonds have provisions where the coupon rate increases by a certain amount if a
credit event occurs. Suppose the credit rating of the issuer falls. The issuer will have to pay
higher coupon payments to compensate for additional credit risk. This is a huge
disadvantage for the issuer because their credit rating has already fallen possibly due to bad
financial conditions. This increases the probability of default even more.

Payment-in-Kind (PIK) Bond

These bonds basically pay interest with more bonds. The principal payment increases as a
result of this system. An issuer may have such a structure if the cash flows are less than
required to service the debt by interest payments. Such issuers usually have high leverage.

These bonds will have higher yields because of poor credit quality of the issuer.

Deferred Coupon Bond (Split Coupon Bond)

Coupon payments on this type of bond will start after a certain period of time. Suppose
there is a 30-year deferred coupon bond. The coupon payments may not start until the fifth
year.

In this case, the issuer believes that the cash flows will increase in later years so that the
debt can begin to be serviced. They may be suitable to finance large projects that will start
generating revenue some time after the issuance of the bond.

Such bonds may offer tax advantages in certain jurisdictions.

Zero coupon bonds can be seen as deferred coupon bonds since there is only one payment
at maturity.

Index-Linked Bonds

The coupon payments of these bonds are linked to some index like an equity index or
commodity index. Inflation-linked bonds are the most common type and their coupon
payments are linked to an inflation measure like the CPI. This protects the bondholder’s
value of money.

However, these bonds will pay at least their par value at maturity. So even if the index has
decreased substantially, the bondholders are still protected.

There are a few different structures.

Indexed-Annuity Bonds

These are fully amortizing bonds and the payments are adjusted for inflation and deflation.

Indexed Zero-Coupon Bonds

The payment at maturity is adjusted for inflation.

Interest-Indexed Bonds

The coupon rate is adjusted for inflation while the principal value remains unchanged.

Capital-Indexed Bonds

U.S. TIPS (Treasury Inflation Protected Securities) are very common. The coupon rate
remains constant but the principal value is adjusted for inflation and deflation.

Since the principal value changes during a given period, the coupon payment changes.

Suppose there is a $10,000 TIPS giving a 2% annual coupon rate paid semiannually (1%
every 6 months). The principal value will be adjusted for inflation and deflation.

Say the inflation is 1.5% over the first six months of issuance. The principal will increase
from $10,000 to $10,150. And so the 6-month coupon will be calculated as: 1% x $10,150 =
$101.50.

Without inflation adjustment, the coupon would be $101 and this would reduce the
purchasing power of the bondholder.

Questions

1. Which of the following payment structures is least likely to have a balloon payment?

A. Bullet structure

B. Partially amortising structure

C. Fully amortising structure

2. Which of the following is most likely true regarding sinking fund provisions?

A. There will be a high lumpsum amount to be paid at maturity

B. There will be a low lumpsum amount to be paid at maturity

C. There will be an interest component but no principal component to be paid at maturity

3. Which of the following is most likely true regarding re-investment risk?

A. If the issuer retires the bond sooner than expected then it is most likely true that the
bondholder will have to re-invest these funds at a lower interest rate

B. If the issuer retires the bond sooner than expected then the bondholder will receive more
value

C. If the issuer retires the bond sooner than expected then the bondholder will be indifferent
towards the value of the bond

4. A floating rate note is quoted as an inverse floater. Which of the following is most likely
true?

A. Coupon payments increase when the LIBOR increases

B. Coupon payments decrease when the LIBOR increases

C. Coupon payments remain the same when the LIBOR increases

5. The coupon of a bond increases based on a schedule. Which of the following is the most
likely category of bonds?

A. Step-up coupon

B. Floating rate coupon

C. Credit-linked coupon

6. Which of the following is least likely an advantage of indexed bonds?

A. They offer stable cash flows

B. They offer capital protection

C. They offer potential upside based on the index

Answers

1. C is correct. A fully amortising bond will make payments which include the principal
component and interest component. These payments are made in such a way that there is
no lumpsum amount due at maturity. A and B will both have lumpsum amounts due at
maturity.

2. B is correct. The principal is paid throughout the life of the bond and so the final payment
due will have a low principal amount to be paid. C is incorrect because if the total principal
has already been paid then the bond has reached expiry and there will be no more
payments.

3. A is correct. An issuer will most likely redeem bonds when the market price of the bond is
higher than the redemption price. This way the issuer pays less for the market price of a
bond and the bondholder suffers. It is likely that they will have to re-invest these funds at a
lower interest rate.

4. B is correct. The point of an FRN is to link the coupon payments to a reference interest
rate like the LIBOR. An inverse floater will have coupon payments that move in the opposite
direction of the reference rate.

5. A is correct. The coupon rate increases based on a predetermined schedule for step-up
coupon structures. B is incorrect because the coupon rate on floaters cannot be predicted
with certainty. C is incorrect because credit-linked coupons are contingent on specific credit
events like a default.

6. A is correct. While indexed bonds may offer stable cash flows, this is not necessarily an
advantage that is specific to index-linked bonds. The point of these bonds is to offer some
capital protection or upside gain. This can be done by increasing the principal value at the
same rate as inflation (U.S. TIPS) or by linking the additional payment of a bond to an equity
index.
LOS 42.f: Describe contingency provisions affecting the timing and/or nature of cash
flows of fixed-income securities and identify whether such provisions benefit the
borrower or the lender.

Contracts may have contingency provisions. These are actions that may be taken if an
event, or a contingency, occurs. These bonds may be called embedded options bonds. It
means that should an event occur, either the issuer or the bondholder has the option to
exercise certain rights as per the contract. Bonds that do not have contingency provisions
are referred to as straight or option-free bonds.

Callable Bonds

A call option in general is when the holder of the option has the right to buy an asset at a
specific price if certain conditions hold. This is why options are called contingent claims
because they will be exercised contingent upon certain events taking place.

The issuer will have the right to buy the bond if a call option is embedded in the contract.

Why would an issuer (seller) buy the bond back?

Certain events can take place that may increase the price of a bond. Suppose the bond’s
credit quality increases significantly. The risk premium on the bond will fall and so the yield
to maturity will also fall. This will increase the price of a bond. We will explore this
relationship further in Reading 47.

Suppose the issuer has a call option on the bond and that the call option stipulates that the
issuer can buy back the bond for Rs. 103 per Rs. 100 of par value. Say the bond is currently
trading at Rs. 105 per Rs. 100 of par value. This means that the issuer can buy back
something at Rs. 103 that is worth Rs. 105. The issuer is getting a good deal on the bond
and can choose to redeem the bond.

The explanation also makes more sense from a market yield perspective. Bond prices
increase when the yield falls. The issuer can buy these bonds back and issue new ones at a
lower interest rate.

Can the bonds be redeemed at any time at any price?

This depends on the terms on the bond indenture. Suppose a bond is issued in July 2020.
The indenture may include the following call schedule:

● After July, 2025: bonds can be redeemed at 103% of par value

● After July, 2027: bonds can be redeemed at 101% of par value
● After July, 2030: bonds can be redeemed at 100% of par value
The period between which the bond cannot be called (i.e. 2020 to 2025) is called the
lockout period, cushion, or deferment period. It can be said that the bond has call
protection for 5 years. This way, even if the price moves favourably for the issuer within the
first 5 years, the bondholders are protected against a call.

The call premium is the amount by which the call price is above the par value. Therefore,
for the 2025 call date the premium is 3%, it is 1% for the 2027 call date and 0% for the 2030
call date.

Callable bonds always trade below the price of similar option-free bonds because the issuer
has the right. The issuer has the power to exercise the call option should they choose to and
so the bondholder may not want such a bond.

Putable Bonds

A put option in general is when the holder of the option has the right to sell an asset at a
specific price if certain conditions hold.

The bondholder will have the right to sell the bond if a put option is embedded in the
contract.

Why would an issuer (seller) buy the bond back?

Just as interest rates may decrease, interest rates may also increase. This will reduce the
price of the bond.

Suppose the bondholder has a put option on the bond and that the put option stipulates that
the bondholders can sell the bond back to the issuer for Rs. 97 per Re. 1 of par value. Say
the bond is currently trading at Rs. 95 per Re. 1 of par value. This means that the
bondholder can sell something at Rs. 97 that is worth Rs. 95. The bondholder is getting a
good deal on the bond and can choose to sell the bond.

Puttable bonds always trade at a price that is higher than similar option-free bonds because
it gives extra value to the bondholder. Think of it as an additional perk of holding a bond.

Even puttable bonds may have certain dates on which they can be puttable.

Convertible Bonds

Bondholders of convertible bonds have the option to exchange the bond for a specific
amount of shares of the issuing company. They have a typical initial maturity of 5-10 years.

How does this benefit bondholders?

This is beneficial because it gives bondholders the potential upside from share price
increases. The coupon on bonds is fixed but the share price’s upside is theoretically
unlimited.

Due to this conversion option to the bondholder, the price of a convertible bond will always
be higher than that of a similar option-free bond.

These are specifically beneficial to bondholders because they give the upside potential of
shares but also remove the effect of the downside of shares. Although the yield is lower
than an otherwise option-free bond, these bondholders will not face significant drawdowns
on their capital as they potentially can with shares.

They are also referred to as a hybrid security because they have characteristics of both
debt and equity.

How does this benefit issuers?

Issuers can sell these bonds at a lower yield (higher price) because they know that there will
be more demand for such bonds as compared to their option-free counterparts.

Terminology and Calculation

Conversion Price

The price per share at which the bond’s par value may be converted to common shares.

Conversion Ratio

Par value of the bond divided by the conversion price.

Suppose you own one bond with a Rs. 1,000,000 par value. It has a conversion price of Rs.
2,000. Its conversion ratio is Rs. 1,000,000 / Rs. 2,000 = 500 shares per bond.

Conversion Value

This is the market value of the shares that would be received upon conversion. Suppose
the share price of that company is Rs. 3,000 per share.

The market value of the shares that are converted will be 500 shares x Rs. 3,000 per share
= Rs. 1,500,000

You can see how the increase in share price has benefited even the bondholders.

Why would bondholders not exercise the option?

Some investors depend on a fixed stream of income and that is why they prefer to hold
coupon-paying bonds or dividend-paying shares.

If the dividend yield on the shares are lower than the interest yield that they are getting on
the bond then they might wait until they get a better dividend yield.

That is why these bonds may also have a call provision. This will force the bondholders to
sell their bonds to the issuer if the conversion value is significantly above the par value. This
way the issuer can re-issue new debt at lower interest rates.

Warrants

Warrants give the bondholders the right to buy common shares at a given price. Warrants
have start dates stating when they can be exercised and expiry dates stating the last date of
exercise. This ensures that bondholders have some exposure to the issuing company’s
shares.

So, as long as the company’s share price is above the exercise price of the warrant, it is
beneficial to exercise the warrant. Suppose the exercise price is Rs. 150 and the shares are
trading at Rs. 200. The warrant now has a value because the bondholder can buy something
at Rs. 150 but it is actually worth Rs. 200. They can make an immediate profit of Rs. 50 if
they sell the shares instantly.

Warrants are like a kicker to the bonds of a new company. Young and small companies are
likely to have high probability of failure (and default). So, they can add warrants to attract
fund raising so that investors have a lot of upside too.

Contingent Convertible Bonds

These are convertible bonds contingent on the occurrence of an event. They are also
called CoCos.

For example, banks are required to maintain a minimum level of equity financing and
maximum debt-to-equity ratios as per regulatory requirements. So, if the bank issues CoCos
and the equity portion of financing reduces below a certain level, the CoCos will immediately
be converted to shares. The net effect is that debt reduces and equity increases. This will
restore balance to the minimum level of equity financing and the maximum level of debt-to-
equity.

Questions
1. Which of the following is most likely true about embedded options?

A. An embedded call option is provided to the bondholder and gains value when the bond
price decreases

B. An embedded put option is provided to the bondholder and gains value when the bond
price increases

C. An embedded put option is provided to the bondholder and gains value when the bond
price decreases

2. Suppose a bond is trading at Rs. 95 per Rs. 100 of par value. If there is an option
embedded in this bond, which of the following options benefits from this price level?

A. A puttable bond with a put price of Rs. 97

B. A puttable bond with a put price of Rs. 93

C. A callable bond with a call price of Rs. 105

3. Why would a call option on a bond be exercised?

A. When interest rates decrease, bond prices increase. The bond can be bought back and
re-financed at a lower interest cost.

B. When interest rates decrease, bond prices decrease. The bond can be bought back at a
lower price.

C. When interest rates increase, bond prices decrease. The bond can be bought back at a
lower price.

4. In which of the following scenarios will the lockout period least likely benefit the
bondholder or the issuer?

A. A puttable bond that is trading below the put price

B. A callable bond that is trading above the call price

C. A callable bond that is trading below the call price

5. The following information is provided about a convertible bond:

Details Amount (Rs.)

Par Value of
Bond 10,000

Conversion
Price 50

Current Share
Price 65

Which of the following is correct?

A. The conversion ratio is 1.33 shares per bond and the conversion value is Rs. 13,000

B. The conversion ratio is 200 shares per bond and the conversion value is Rs. 10,000

C. The conversion ratio is 200 shares per bond and the conversion value is Rs. 13,000

Answers

1. C is correct. A put option allows the bondholder to sell the bond back to the issuer at a
specific price. The value of the put increases as the bond price decreases. A is completely
incorrect as neither of the two conditions are correct.

2. A is correct. The holder of the bond can sell the bond to the issuer at Rs. 97 for something
that is worth Rs. 95. The put option’s value in the puttable bond of option B may increase but
the current price is not low enough for the exercise to be beneficial.

3. A is correct. The issuer holds the call option on a bond. When interest rates decrease,
bond prices increase. Suppose the bond is callable at Rs. 105 and the interest rates
decrease so that the bond price is now Rs. 107. The issuer can buy back something that is
worth Rs. 107 for Rs. 105. They can then issue new bonds at a lower interest rate.

4. C is correct. If the callable bond is trading below the call price, the call option will not be
exercised anyway. So it does not matter if there is a lockout period or not. A is incorrect
because a lockout in this scenario prevents the bondholder from selling the bond back. B is
incorrect because a lockout in this scenario prevents the issuer from buying the bond back.

5. C is correct. The conversion ratio is how many shares the bondholder will receive per par
value of the bond, given the conversion price. Therefore the bondholder will receive
10,000/50 shares = 200 shares. These shares have a current share price of Rs. 65 and so
the conversion value is Rs. 65 x 200 = Rs. 13,000. B is incorrect because it multiplies the
conversion ratio by the conversion price to get the conversion value. A is incorrect because it
takes the conversion ratio as the ratio of the two prices.