Chapter 1

Overview of Debt Securities

 Major learning outcomes:

– Understand basic features of a bond

– Identify the structure of various fixed rate
coupon and floating-rate securities
– Describe the provisions for redeeming and
retiring bonds
– Understand the types and importance of
embedded options in a bond issue
 Chapter 1
Key Learning Outcomes
• Describe the basic features of a bond (e.g., maturity, par value,
coupon rate, bond redeeming provisions, currency denomination,
issuer or investor granted options).

• Describe affirmative and negative covenants.

• Identify the various coupon rate structures, such as fixed rate coupon
bonds, zero-coupon bonds, step-up notes, deferred coupon bonds,
floating-rate securities.

• Describe the structure of floating-rate securities (i.e., the coupon

formula, interest rate caps and floors).

• Define accrued interest, full price, and clean price.

• Describe the provisions for redeeming bonds, including the distinction

between a nonamortizing bond and an amortizing bond.
 Key Learning Outcomes
(continued)
• Explain the provisions for the early retirement of debt, including call
and refunding provisions, prepayment options, and sinking fund
provisions.

• Differentiate between nonrefundable and noncallable bonds.

• Explain the difference between a regular redemption price and a

special redemption price.

• Identify embedded options (call option, prepayment option,

accelerated sinking fund option, put option, and conversion option)
and indicate whether each benefits the issuer or the bondholder.

• Explain the importance of options embedded in a bond issue.

• Identify the typical method used by institutional investors to finance

the purchase of a security (i.e., margin or repurchase agreement).
 1. Sectors of the Bond Market
• Treasury sector – by the government
• Agency sector – by federally related institutions and
government-sponsored enterprises
• Municipal sector – by local governments bonds
• Corporate sector – by corporations and foreign
corporations
• Asset-backed sector – backed by a pool of assets
• Mortgage sector – backed by mortgage loans
 Definition of a Bond
• A bond (fixed income security) is a financial obligation of
an entity (the issuer) who promises to pay a specified sum
of money at specified future dates.
 Description of Affirmative Bond
Covenants
• Affirmative covenants set forth what the borrower has
promised to do.
• Common affirmative covenants include:
– To pay interest and principal on a timely basis
– To pay all taxes and other claims when due
– To maintain all property and other assets in good
condition and working order
– To submit periodic reports to the trustee stating that the
borrower is in compliance with the loan agreements
 Description of Negative Bond
Covenants
• Negative (or restrictive covenants) set forth certain limitations
and restrictions on the borrower’s activities.
• These include:
– A limitation on the borrower’s ability to incur future debt
obligations
– To meet certain financial coverage ratios
• Leverage ratio (Debt/Equity Ratio)
• Coverage ratio (EBIT/Interest)
– To not sell assets without notification to the trustee and/or
lender
 2. Bond Indentures
• The bond indenture is the contract between the issuer and the
bondholder, which sets forth all the obligations of the issuer.
• Indentures included in a bond:
1. Type of Issuer
2. Term to Maturity
3. Principal and Coupon Rate
4. Embedded Options
5. Describing a Bond Issue
From a valuation perspective, each one of these could change the
cash flows of a bond to investors, depending on the terms specified,
and therefore change the price of the bond.
 (1) – (2)
• (1). Type of Issuer – there are three issuers of bonds
 the federal government and its agencies
 municipal governments
 corporations

• (2). Term to Maturity or Maturity – the number of

years the debt is outstanding or the number of years remaining
prior to the final principal payments.
 There may be provisions in the indenture that allow either the
issuer or bondholder to alter a bond’s term to maturity.
 Maturity

• The maturity date is the date (i.e. 7/25/2018) that

the debt will cease to exist.
– 1 to 5 year maturity bonds – short-term
– 5 to 12 years – intermediate
– Over 12 years – long-term
 Maturity

Importance of Maturity:

• Term to maturity indicates the time period over which the

bondholder can expect to receive interest payments and
the number of years before the principal is repaid in full.

• The yield on a bond depends on the term to maturity.

This relationship is referred to as the yield curve.

• The price of a bond fluctuates over its life as interest

rates change. The price volatility of a bond is a function
of its maturity (other variables matter as well).
 (3). Principal and Coupon Rate
3.1. Principal
 Bond Principal – amount that the issuer agrees to repay the
bondholder at the maturity date

 Price quotations: are quoted as a percentage of par (or

principal), which is commonly expressed in terms of 1/32:

e.g., a bond is quoted 70 5/8 means a price of 70.625% of par, or

a price of $70.625 per $100 par value.
 Par Value

• Par Value – The par value (principal, face value,

redemption value, or maturity value) of a bond is
the amount that the issuer agrees to repay the
bondholder at or by the maturity date.

• Bonds can have any par value.

• Bond prices are quoted as a percentage of par

value, with par value equals to 100.
 Bond Price Quoted
• Bond prices are quoted as a percentage of par value, with par value
equal to 100.

• Example:

Price per $1 of par

Quoted price Par value Dollar price
value (rounded)

90 1/2 0.9050 $1,000 $905.00

102 3/4 1.0275 $5,000 $5,137.50

70 5/8 0.7063 $10,000 $7,062.50

113 11/32 1.1334 $100,000 $113,343.75

 Par Value

Par Value Terminology:

• Premium Bonds: Bonds selling above par value are said

to be “trading at a premium.”

• Discount bonds: Bonds selling below par value are

“trading at a discount.”

• Par bonds: At the maturity date, bond prices and par

values will be the same.
Principal Repayment Structure
• Principal is to be repaid at the maturity, but can be repaid
early if a bond embeds one of the following indentures:
– Sinking fund;
– Amortization;
– Prepayment options
– Embedded options (e,g,. call options and convertible
options)
• These additional indentures would change the timing of the
principal to be repaid and therefore shorten the life of a bond.
• It would also change the value of the bond.
Principal Repayment Structure:
Sinking Funds
• Sinking Fund Provision: An indenture that requires the issuer to
retire a fixed portion of the principal each year.

• An accelerated sinking fund provision allows the issuer

to retire more than the amount stipulated to satisfy the
periodic sinking fund requirement.
Principal Repayment Structure:
Sinking Funds
• The purpose of the provision is to reduce the credit risk to
investors:
– Sinking fund provisions can be established to retire all or a
portion of the principal by the maturity date.
• When a portion of the bond is paid down with a sinking fund, the
remaining balance due on the maturity date is referred to as the
balloon maturity.
– Usually the sinking fund payment is paid to the investor in
cash at the par value for the retired bond.
 Principal Repayment Structure: Sinking Funds
• Ex: The notional principal of the bond issue is $200m. The sinking
fund arrangement calls for 5% of the outstanding principal amount to
be retired in Years 10 through 19, with the outstanding balance paid
off at maturity in 20 years.
Year Outstanding Sinking Fund Outstanding Final
Principal at the Payment ($m) Principal at the Principal
Beginning of End of the Year Repayment
the Year ($m) ($m) ($m)
0 200.00
1 to 9 200.00 0.00 200.00
10 200.00 10.00 (=5%*200) 190.00
11 190.00 9.50 (=5%*190) 180.50
12 180.50 9.03 (=5%*180.5) 171.48
13 171.48 8.57 (=5%*171.48) 162.90
14 162.90 8.15 154.76
15 154.76 7.74 147.02
16 147.02 7.35 139.67
17 139.67 6.98 132.68
18 132.68 6.63 126.05
19 126.05 6.30 119.75
20 119.75 119.75
 Principal Repayment Structure:
Amortization
• Principal can be amortized over the life of the bond (based on
an amortization schedule), with a portion of the principal
payment included in the equal monthly payment.
• Mortgage loans are typically amortized, as well as auto loans.
• Amortization shortens the average life of a bond, and therefore
a weighted average life is computed for an amortized loan, and
as a result, an amortized 20-year loan could have a weighted
average life of 12 years.
• Amortization feature could affect the pricing of a bond greatly
• EX: For a 30-year, 8.125%, $100,000 amortized mortgage loan,
what is the yearly payment?
• ?????
• Principal is pad off over time, and therefore there is no balloon
payment at the maturity.
Year Beginning of year Yearly Interest Scheduled End of year
Mortgage Balance Mortgage PMT Payment Principal PMT Mortgage Balance
1 $100,000
2
…
30
 Principal Repayment Structure:
Prepayments
• Prepayment Option: the (borrowers’) right to prepay the outstanding
principal balance in whole or in part prior to the scheduled principal
payment dates.
• For amortizing bonds that are backed by loans that have a schedule of
interest and principal payments, it is possible that individual borrowers
can pay off all or part of the loan prior to the scheduled payment date.
• Any principal payment makes prior to the regular payment date is
called a prepayment. The right of borrowers to prepay principal is the
prepayment option.
• The prepayment option is the same as a call option (exercised by the
borrower).
 Principal Repayment Structure:
Prepayments
• Mortgage loans are the one that are greatly exposed to prepayment
risk.
• Prepayments will change the cash flow structure of a bond by
shortening its maturity and reducing the number of coupons to be
paid.
• Prepayments depend on the movements of market interest rates as
compared to the mortgage loan rate on the contract. Prepayments in
general would take place only when the market interest rate drops
enough.
• As such the pricing of a mortgage loan and similar debt instruments
would have to estimate a prepayment pattern based on an interest
rate projection.
 3.2. Coupon Rate
• Coupon rate - the interest rate that the issuer agrees to
pay each year;
– The coupon is the annual amount of the interest payment and is
found by multiplying the par value by the coupon rate.

• The annual amount of the interest payment made to the

bondholders during the term of the bond is called the
coupon:

• Coupon = Coupon rate * Par value

• For example, 8% coupon rate and a par value of $1,000

will pay annual interest of $80.
 3.2. Coupon Rate

Coupon Rate Terminology:

• It is typical to state the coupon and the maturity date in

describing a bond.
– For example, “5s of 6/30/25” means a bond with a 5% coupon rate
maturing on June 30, 2025.

• Coupon Payment Frequency:

– In the U.S. coupons are typically paid in two semiannual payments;
– Mortgage- and asset-backed securities typically pay interest and principal
monthly;
– Bonds issued outside the U.S. often pay interest annually.
3.2. Bond Coupon Structure
• The issuer could pay coupons in different ways,
depending how the coupon rate is structured:
– Unified/Fixed coupon rate: the nominal or interest rate that
the issuer agrees to pay each year; the annual amount of the
interest payment is called the coupon;
– Zero coupons;
– Step-up coupon rates;
– Deferred coupon payments;
– Floating Rate Notes
– Credit-Linked Bonds;
– Inflation-Linked Bonds.
 3.2. Bond Coupon Structure:
Zero-coupon Bonds
• Zero-Coupon Bond – do not make periodic coupon
payments, instead interest is paid at the maturity with the exact
amount being the difference between the principal value and
the price paid for the bond
• The holder of the “zero” realizes interest by buying the bond at
a substantial discount.
• Interest is paid at the maturity date, with the interest being the
difference between the par value and the price paid for the
bond. (For example, if a bond was purchased at 40, the interest
is 60).
 3.2. Bond Coupon Structure:
Step-up Notes
• Step-up notes are bonds that have a coupon rate that
increases over time.
• EXAMPLE: A 12-year callable bond issued by Citicorp on
June, 9 2020. The coupon schedule is as follows:

Date Step-up Coupon Rate

06/09/2020 to 06/09/2024 2.50%

06/10/2024 to 06/09/2028 2.75%
09/10/2028 to 06/09/2030 3.00%
06/10/2030 50 07/09/2032 3.25%
Additional terms:
 3.2. Bond Coupon Structure:
Deferred Coupon Bonds
Deferred coupon bonds have no interest payments during a specified
deferred period. At the end of the deferred period, the issuer makes
periodic interest payments until the bond matures.
0 1 2 N=10
...
coupon = 0 coupon = $ 100+coupon $

The interest payments made after the deferred period will be higher
than those that would have been made had there been no deferred
period. This is to compensate the bondholder for the lack of interest
payments during the deferred period.
 3.2. Bond Coupon Structure:
Floating Rate Notes
• A floating-rate security is an issue whose coupon rate resets
periodically (the coupon reset date) based on a coupon
formula of
• Coupon Rate = Reference Rate + Quoted Margin
• Ex: a floating rate bond with a coupon formula of 50 bps
over the 3-m LIBOR rate (face value = $100):
Coupon rate = LIBOR+0.5%
• If LIBOR rate = 5% today, Coupon rate = 5.5%, and coupon
payment for the period is $5.5
• If LIBOR rate = 6% in one year, coupon rate = 6.5%, and
coupon payment for the period in one year is $6.5
 3.2 Bond Coupon Structure:
Floating Rate Notes
• The reference rate could be the prime rate, 6-month Treasury
bill rate, or the 1-month London interbank offered rate
(LIBOR).
• For example, if the quoted margin is 225 basis points over
the 1-month LIBOR, then the coupon formula would be:
Coupon rate = 1-month LIBOR + 225 basis points
• The quoted margin could be a negative number as well as a
positive one:
Coupon rate = 5-year Treasury yield - 90 basis points
 3.2 Bond Coupon Structure:
Floating Rate Notes
• A floating-rate security may have a cap, which sets the
maximum coupon rate that will be paid, and/or a floor,
which sets the minimum coupon rate that will be paid.

• Coupon Rate = Min[Reference Rate + Margin, Cap]

• Coupon Rate = Max[Reference Rate + Margin, Floor]

A cap is a disadvantage to the bondholder while a floor is an

advantage to the bondholder, vise versus for a floors
 3.2 Bond Coupon Structure:
Floating Rate Notes
• Caps (or maximum coupon rates) are also possible with
floating rate bonds.
– If the reference rate rises above the cap rate on the reset
date, the maximum interest payment would be the cap rate.
– A cap is a disadvantage to the bondholder while a floor is
an advantage to the bondholder.
• Conversely, floors (or minimum coupon rates) are also
possible with floating rate bonds.
– If the reference rate falls below the floor rate on the reset
date, the minimum interest payment would be the floor rate.
– This helps protect the bondholder.
- This is a form of cap risk for the issuer.
 Floating Rate Securities
EX: A Floater’s quoted margin is the 1-month
LIBOR plus 225 basis points, and has a 7% cap
and 5% floor, then based on the coupon formula:
Coupon rate = 1-month LIBOR + 225 basis points
but capped at 7%:

If the 1-m LIBOR is Coupon Rate Note

2% 5% Floored
3% 5.25% Not capped or floored
4% 6.25% Not capped or floored
5% 7% Capped
6% 7% Capped
 3.2 Bond Coupon Structure:
Floating Rate Notes
• A reverse floater will have the floating rate move in the opposite direction with
the reference rate.
• The coupon formula for an inverse floater is:
Coupon rate = K – L * (reference rate)
K is set in the indenture and is a fixed interest rate (i.e. 10%)
L is a multiplier (i.e. 2), it is also set in the indenture.
Notice that the L-factor on a reverse floater determines the degree of speculation to
interest rate (the reference rate) changes, The larger the L-factor, the larger the
coupon rate changes and the more speculative the reverse floater will be.
 3.2 Bond Coupon Structure:
Floating Rate Notes
Reference rate could be the three-month Treasury bill rate, suppose it is currently
3.5%.
The current coupon rate is 10% - (2x3.5%) = 3%.
– Suppose that on the reset date that the three-month Treasury bill rises to 4%,
the coupon rate would be:10% - (2 X 4%) = 2%.
– Suppose that on the next reset date the three-month Treasury bill falls to 3%,
the coupon rate of the floater would be:10% - (2 X 3%) = 4%.

• But if the L-factor is doubled on the coupon formula:

• Coupon rate = 10% -4x(reference rate),
• Then at the same reference rate of 3%, the coupon rate will be -2%.
 3.2 Bond Coupon Structure:
Credit-Linked Bond
• A credit-linked coupon has a coupon that changes when
the bond’s credit rating changes
• Advantages:
- Attractive to investors who are concerned about the future
creditworthiness of the issuer.
- Provide some general protection against a poor economy
because credit ratings tend to decrease the most during
recessions.
A potential problems: increases in the coupon payments
resulting from a downgrade may ultimate result in further
deterioration of the credit rating or even contribute to the
issuer’s default.
3.2 Bond Coupon Structure:
Credit-Linked Bond
 3.2 Bond Coupon Structure:
Inflation-Linked Bonds
• Inflation-Linked Bonds:
• Different methods have been used for linking the cash flows of an index-linked
bond to a specific index:
– Zero-coupon-indexed bonds: Pay no coupon, so the inflation adjustment is
made via the principal repayment only.
– Interest-indexed bonds: pay a fixed nominal principal amount at maturity but
an index-linked coupon during the bond’s life.
– Capital-indexed bonds: pay a fixed coupon rate, but is it applied to a principal
amount that increases in line with increases in the index during the bond’s life.
– Indexed-annuity bonds: fully amortized bonds, in contrast to interest-indexed
and capital-indexed bonds that are non-amortizing coupon bonds. The annuity
payments, which includes both interest and principal payments, increases in line
with inflation during the bond’s life.
 3.2 Bond Coupon Structure:
Inflation-Linked Bonds
Ex: A country has issued 20-years, $1,000 face value bonds
linked to its domestic CPI. The country has no inflation until
recent 6 months, when the CPI increased by 5% per annum.
• Case 1: For a zero-coupon-indexed bonds:
– There will be no coupon payments, the principal amount is
to be increased to $1,050 (=$1,000*(1+5%)) for a one-year zero,
$1,050 (=$1,000*(1+5%)) for a two-year zero, and will continue
increasing in line with inflation until maturity.
 3.2 Bond Coupon Structure:
Inflation-Linked Bonds
Ex: A country has issued 20-years, $1,000 face value bonds linked to its
domestic CPI. The country has no inflation until recent 6 months, when the
CPI increased by 5% per annum.
• Case 2: For an Interest Rate Inflation-Indexed Bond:
– Suppose that the bonds are coupon bonds that make semi-annual
interest payments based on an annual coupon rate of 4%:
– The principal remains at $1,000
– Prior to the inflation, coupon payment = $1,000*(4%/2) = $20
– Adjusted for inflation, the coupon rate is 4.2% [=4%*(1+5%)], and
the semiannual coupon payment = $1000*(4.2%/2) = $21
– Future coupon payment will also be adjusted for inflation.
 3.2 Bond Coupon Structure:
Inflation-Linked Bonds
• Case 3: For a capital-indexed bond:
– The annual coupon rate remains 4%, but the principal is adjusted
for inflation and the coupon payment is based on the inflation-
adjusted principal.
– Following the 5% increase in the CPI, the inflation adjusted
principal increased to $1,050 (=$1,000*(1+5%)), and the new semi-
annual coupon payment is $21 (=$1,050*4%/2).
– The principal amount will continue increasing in line with
increases in the CPI until maturity, and so will the coupon
payments.
• EX: The coupon rate for a Inflation-indexed Treasury
securities (TIPS) is 3.5% and in trading at the par value of
$100,000.

• At the end of the first 6 months (Inflation is expected to be

3% annually (or 1.5% semiannually)):
– Inflation adjusted principal = $100,000*(1+1.5%) = $101,500
– Coupon payment = $101,500 * (3.5%/2) = $1,776.25

• For the next 6 months (semiannually inflation rate = 1%):

– Inflation adjusted principal = $101,500*(1+1%) = $102,515
– Coupon payment = $102,515 * (3.5%/2) = $1,794.01
 3.2 Bond Coupon Structure:
Inflation-Linked Bonds
• Case 4: For an indexed-annuity bond:
– They are fully amortized.
– Prior to the increase in inflation, the semi-annual payment
was $36.56 (the annuity payment based on a principal of
$1,000 paid back in 40 semi-annual payments with an annual
discount rate of 4%).
– Following the 5% increase in the CPI, the annual payment
increases to $38.38 (=$36.56*(1+5%)).
– Future annual payments will also be adjusted for inflation in
a similar fashion.
 (4). Embedded Options

• Include a provision in the indenture that gives either the bondholder and/or
the issuer an option

Provision Feature
G rants the issuer the rightto retire the debt,fully or
C allprovision
partially,before the scheduled m aturity date

G ives the bondholder the rightto sellthe issue back to

Putprovision
the issuer atpar value on designated dates

Provides the bondholder the rightto exchange the bond

C onvertible bond
for shares of com m on stock

A llow s the bondholder to exchange the issue for a

Exchangeable bond specified num ber of com m on stock shares of a
corporation differentfrom the issuer of the bond
 4.1 Bonds with Call Provisions

• Call Options: Issuers have the right (option) to call or retire

a bond prior to the stated maturity date.
– Example: a $100, 8%, 10-years bond yielding 8.5% at a
price of $98, the bond has a call price of $100. This
bond will be called when interest rate drops to 6% and
the price increases to $105. The bond issuer can pay for
$100 (the call price) to buy back a bond that is worthy
$105.
• What advantage/disadvantage is to the bondholder/issuer?
• When the bond will be called?
 4.1 Bonds with Call Provisions
• The price at which the issuer must pay to retire the bond early is
referred to as the call or redemption price.
– Typically, when a bond is issued, the issuer may not be able to
call the bond for a fixed number of years. The first date of call
or redemption is referred to as the first call date.
• Bonds might be called in total or in partial depending upon the
indenture. When less than the entire issue is called, the bonds are
selected either randomly or on a proportional or pro rata basis.
– Pro rata calls will have an equal percentage retired of all bonds
outstanding. Pro rate redemption is rare for public bonds – its
much more common for privately placed bonds.
4.1 Bonds with Call Provisions
• Bonds that can be called prior to maturity are referred to as
callable bonds.

• Call prices may provide a premium above the market price or par
value (a call penalty might be included) to bondholders.

• Three options to set the call price:

– Fixed price regardless of the call date (also referred to as a

single call price)

– Call price based on a price specified in the call schedule

– Call prices based on a make-whole premium provision.

 4.1 Bonds with Call Provisions
• 1. Fixed price regardless of the call date – this situation is one in which bonds may be
called anytime after the end of the deferred period for the call price plus accrued
interest.

• EX: $250m debentures issued in July 1997 with a coupon rate of 7 1/8% due July 1,
2017. “The debentures will be redeemable at the option of the Company at any time on
or after July 1, 2007, in whole or in part, upon not fewer than 30 days’ nor more than 60
days’ notice, at Redemption Price equal to the percentage set forth below of the
principal amount to be redeemed for the respective 12-month periods beginning July 1
of the years indicated together in each case with accrued interest to the Redemption
Date”:

12 months beginning July 1 Redemption Price 12 months beginning July 1 Redemption Price

2007 103.026% 2012 101.513%

2008 102.723% 2013 101.210%
2009 102.421% 2014 100.908%
2010 102.118% 2015 100.605%
2011 101.816% 2016 100.303%
 4.1 Bonds with Call Provisions
• 2. Call price based on a price specified in the call schedule which typically declines
through time until the final maturity date.

• EX: $150m debentures issued on November 20, 1986 with a coupon rate of 8 5/8%
due December 1, 2016. The issue had a 10-year deferred call and the following call
schedule:

If redeemed during the 12 Redemption Price 12 months beginning July 1 Redemption Price
months beginning
December 1
1996 104.313 2002 101.725
1997 103.881 2002 101.294
1998 103.450 2004 100.863
1999 103.019 2005 100.431
2000 102.588 206 and thereafter 100.000
2001 102.156
4.1 Bonds with Call Provisions
• 3. Call prices based on a make-whole
premium provision or a yield-maintenance
premium provision which provides a formula for
determining the call premium to be offered to
assure the bondholder of a minimum yield.

• A make-whole premium provision sets forth a

formula for determining the premium that the
issuer must pay to call an issue, with the
premium designed to protect the yield of those
investors who purchased the issue.
4.1 Bonds with Call Provisions

• Assume a hypothetical 30-year bond is issued on 15 August 2019 at a

price of 98.195 (as a percentage of par). Each bond has a par value of
$100. The bond is callable in whole or in part every 15 August from
2029 at the option of the issuer. The call prices are shown below:

Year Call Price Year Call Price Year Call Price

2029 103.870 2033 102.322 2037 100.774
2030 103.485 2034 101.955 2038 100.387
2031 103.000 2035 101.548 2039 and 100.000
2032 102.709 2036 101.161 thereafter
• 1. What is the call provision period?
• 2. What is the call premium in 2033?
 4.1 Bonds with Call Provisions

• Solution to 1: The bonds were issued in 2019

and are first callable in 2029, the call provision
period is for 10 years (2029-2019=10 years).

• Solution to 2: The call price is 2033 is $102.322.

The call premium is the amount paid above par
by the issuer. The call premium in 2033 is
$2.322 (=$102.322-$100).
 4.2 Bonds with Put Provisions
• A putable provision allows bondholders the right or option
to sell the issue back to the issuer at a specified price on
designated dates. The specified price is the put price.

• This option allows bondholders to put or sell back the bond

if market interest rates have risen above the issue’s
coupon rate. This would enable the bondholder to reinvest
the proceeds in another bond with a higher coupon rate, to
the advantage of bondholders.
 4.2 Bonds with Put Provisions
• Because a put provision has value to the
bondholders, the price of a puttable bond
will be higher than the price of an otherwise
similar bond issued without the put
provision.

• Similarly, the yield on a bond with a put

provision will be lower than the yield on an
otherwise similar non-puttable bond.
4.3 Bonds with Convertible Bonds
• A convertible bond is an issue that allows the
investor the option or right to convert the bond
into a specified number of shares of common
stock.

• This option allows the bondholder to take

advantage of favorable price movements in the
firm’s common stock. Bondholders will convert
only when the stock price rises to their
advantages.
4.3 Bonds with Convertible Bonds
• A convertible bond offers several advantages to investors:

• 1. The ability to convert into equity in case of share price appreciation,

and thus participate in the equity upside.

• 2. At the same time, the bondholder receives downside protection: if the

share price does not appreciate, the convertible bond offers the comfort
of regular coupon payments and the promise of principal repayment.

• Even if the share price and thus the value of the equity call option
decline, the price of a convertible bond cannot fall below the price of the
straight bond. Consequently, the value of the straight bond acts as a
floor for the price of the convertible bond.
4.3 Bonds with Convertible Bonds
• Because the conversion provision has value to the
bondholders, the price of a convertible bond is higher than
the price of an otherwise similar bond issued without the
conversion provision.

• Similarly, the yield on a convertible bond is lower than the

yield on an otherwise similar non-convertible bond.
However, most convertible bonds offer investors a yield
advantage; the coupon rate on the convertible bond is
typically higher than the dividend yield on the underlying
common share.
4.3 Bonds with Convertible Bonds
• EX 8 (from AS, page 39-40)

• 1. Which of the following is not an example of an embedded option? Warrant provision, Call
provision, or Conversion provision?

• Solution to 1: A warrant is a separate, tradable security that entitles the holder to buy the
underlying common share of the issuing company, which is not an embedded option of a bond.

• 2. The type of bond with an embedded option that would most likely sell at a lower price than an
otherwise similar bond without the embedded option is a: Puttable bond? Callable bond? Or
Convertible bond?

• Solution to 2: The call provision is an option that benefits the issuer, as a result, callable bonds
sell at lower prices and higher yields relative to otherwise similar non-callable bonds.
4.3 Bonds with Convertible Bonds
• 3. The additional risk inherent to a callable bond is best described as: Credit risk? Interest rate risk?
Or Reinvest Risk?

• Solution to 3: Reinvestment risk refers to the effect that lower interest rates have on available rates
of return when reinvesting the cash flows received from an earlier investment. Because bonds are
typically called following a decline in market interest rates, reinvestment risk is particularly relevant
for the holder of a callable bond.

• 4. The put provision of a puttable bond:

– A. Limits the risk to the issuer
– B. Limits the risk to the bondholder
– C. Does not materially affect the risk of either the issuer or the bondholder

• Solution to 4: A puttable bond limits the risk to the bondholder by guaranteeing a pre-specified
selling price at the redemption dates.

• 5. Assume that a convertible bond issued in South Korea has a par value of W1,000,000 and is
currently priced at w1,100,000. The underlying share price is W40,000 and the conversion ratio is
25:1. What is the conversion value?

• Solution to 5: The conversion value of the bond is w40,000x25=w1,000,000. The price of the
convertible bond is w1,100,000, the bond is priced below parity.
 The Importance of Options
Embedded in a Bond Issue
• Bond indentures can contain provisions that allow
both the issuer and the bondholder to take some
action against the other party.

• These are referred to as embedded options. It is

possible for there to be more than one embedded
option in a bond issue.

• These make bond valuations more challenging.

Embedded Options Granted to Issuers
The most common embedded options are:
1. The right to call
2. The right of borrowers in a pool of loans to prepay
principal early (or above the scheduled amount)
3. Accelerated sinking fund provisions
4. Cap on a floater.

• The first three options are exercised by the issuer

based on the changes in interest rates in the
market. They will usually be applied when interest
rates fall substantially.

• The cap on a floater also depends on market

interest rates and will become more valuable to
the issuer as interest rates rise.
 Understanding Embedded Options
• Embedded options are important and add to the complexity of
bond valuation and analysis.

• Bonds with embedded options affect the return (or cost) of the
issue.

It is necessary to model the impact of embedded

options under different interest rate and time period
scenarios as valuation (and yield) may be impacted.

• The accurate modeling of embedded options is a learning

outcome of this course.