Theme 4.

Fixed income markets

FINANCIAL SYSTEM AND MARKETS

THEME 4: FIXED INCOME MARKETS

1. FIXED-INCOME INSTRUMENTS
Fixed-income instruments can be defined as securities (financial assets) with predetermined
payment schedules that usually include interest and principal payment, issued by public
authorities or firms (both financial and non-financial) with the aim of attracting funding directly
from final investors. Fixed-income instruments generally are promises to repay borrowed
money but may include other instruments with payment schedules, such as prizes from
lotteries. The payment amounts may be pre-specified (i.e., the interest on the loan is
established exactly from the time of the issue until maturity) or variable that is, they may vary
according to a fixed formula that depends on the future values of certain indicators to which
the instrument is linked (generally interest rates such as Euribor, stock market indices,
commodity prices, or even the performance of a particular share).

1.1. CLASSIFICATION
In terms of maturity, practitioners distinguish between short-term, intermediate-term, and long-
term fixed-income securities. No general consensus exists about this maturity classification.
Instruments that mature in less than one to two years (which in case of Spain is up to 18
months) are considered as short-term instruments, while those that mature in more than five to
ten years are considered long-term instruments. In the middle are the intermediate-term
instruments.
The following variety of the fixed-income instruments exist.
A) Private fixed-income instruments (Renta fija privada)

These are securities issued by the private sector companies, which include non-financial
corporations and financial institutions. These entities have to be distinguished from the General
Government sector (el sector administraciones públicas, AAPP)1.
A.1. Commercial papers (Pagarés de empresa)

These are zero coupons issued at a discount. These have implicit return, which is the difference
between the purchase price and the nominal value of the paper at the date of redemption.
These are short-term securities, with maturities ranging from seven days to 25 months,
although the usual maturities are one, three, six, 12 and 18 months. Commercial papers are
issued by financial institutions (usually leasing companies) and non-financial corporations
(basically representing such industries as electronics, industry and communications). The paper
is placed on the primary market either through competitive auctions in which its price is
determined, or by direct negotiation between the investor and the financial entity.

1
The AAPP sectorincludes central government, whose most important agent is the State (el Estado),
and also local authorities such as autonomous communities and local corporations.

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 Theme 4. Fixed income markets

A.2. Bonds and debentures (bonos y obligaciones)

These are intermediate- and long-term securities, that is, the common characteristic of these
fixed-income securties is that they have maturity longer than 18 months. Bonds and
debentures are basically the same debt instruments and differ in terms of their maturity: bonds
maturity is less than 5 to 7 years, while debentures have longer maturity period of more than 5
years.
The features of bonds and debentures can vary considerably from one issuer to another, and
even those by the same company. These differences include the date of maturity, interest rate,
schedule of coupons, issue price and redemption, clauses of redemption and other conditions,
convertibility conditions if they exist, the priority established in the event of liquidation and the
guarantees offered. Some of their important types are briefly described in what follows.
a. Simple and subordinated debentures

Bonds/debentures that are only backed in a general form by the assets of the issuing firm are
called simple bonds/debentures. Therefore, simple bonds/debentures are medium-/long-term
unsecured bonds that are backed only by the general creditworthiness of the issuer. No
specific collateral is pledged to repay the debt. In the event of default, the bondholders must
go to court to seize assets. The rights of the holders of the first issue of the simple
bonds/debentures take precedence over the rights of the holders of similar instruments of
subsequent issues. Thus, in the case of a default of the firm, the holders of the simple
bonds/debentures are paid according to the order in which these instruments were issued,
starting from those holdings that were realized in the “oldest” emissions.
There exists another type of debentures called subordinated debentures. In general, we we
are talking about debenture emissions realized by non-financial corporations, since the first
issues have priority of payment over the subsequent issues, the last are called "subordinated"
with respect to the initial emissions. However, in case of the issuances made by financial
institutions, "subordinated debentures" refer to the issuances that have certain characteristics
in terms of maturity, rights of payments claim, etc.2, allowing them in certain circumstances and
within certain limits, to be considered as the own resources (shareholders equity) of the entity
when calculating the so-called solvency ratios required by the Bank of Spain.
All in all, all this above mentioned features mean that in the event of a default, subordinated
debenture holders are paid only after nonsubordinated bondholders have been paid in full. As
a result, subordinated debenture holders are at greater risk of loss.
b. Secured debt obligations (Obligaciones garantizadas)

Debt obligations can be also guaranteed/secured by specific fixed assets of the debt ussuer,
for example, its real property. Companies that do not own fixed assets or other real property
could instead grant investors a lien (a legal right to sell mortgaged property to satisfy unpaid
obligations to bondholders) on stock, notes, bonds or other kind of financial assets they own.
Thus, the pledged assets constitute mortgages, the rights on which could be executed by the
bondholders in the case of non-payment of interests or of of the redemption value, according

2
Specifically, among other things, subordinated debentures have to meet the following criteria: are
issued with an original maturity of at least five years; differ (delay) interest payments in the cases of
losses of the entity; lack (do not have) the conditions of rescue (rescate), redemption or early
repayment; cannot be acquired by the issuer, unless the acquisition leads to their conversión to
shares or participation in the issueing entity.

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 Theme 4. Fixed income markets

to the condtions established at the date of issuance. In such cases, the bondholders seek to
sell the fixed assets and/or securities and to fulfill the unpaid obligations to the bondholders.
c. Collateralized debt obligations (Obligaciones colateralizadas)

As we have seen, the debt with specific guarantees are called guaranteed debt obligations. It
is also often that debt obligations are backed by a specific source of incomes (also referred to
as "sinking fund"). A sinking fund is a fund created by a provision in many bond contracts that
requires the issuer to set aside each year a portion of the final maturity payment so that
investors can be certain that the funds will be available at maturity. This provision is attractive
to bondholders because it reduces the probability of default when the issue matures. Because
a sinking fund provision makes the issue more attractive, the firm can reduce the bond’s
interest rate.
For example, a highway concessionaire (concesionaria de autopistas) with a revenue streams of
road tolls can be obliged to deposit these tolls in a bank to pay the interests on its issue of
debt obligations. Another example of such bonds are issued by banks to securitise receivables
from credit card holders. The bank affects the accounts receivable at the issue as a guarantee
of the principal and interest payments on the bonds. Also large automobile companies,
through its financial subsidiaries issue bonds collateralized by the promissory notes of the car
buyers.
In these cases, the obligations are called "collateralized debt obligations”, i.e. interest and
principal payments have a source of incomes that is contractually assigned. In fact, with this
process, non-marketable assets of the issuer, such as accounts receivable (from road tolls,
holders of credit cards, car buyers etc.) become marketable or negotiable. Thus, this process is
referred to as to "securitize" assets. Therefore, this type of debt obligations is also known as an
asset securitization bonds (obligaciones de "titulización de activos").

The three types of debt obligations – simple or subordinated, collateralized and secured –
represent different levels of risk. The first are the most frequent and are issued by the top
companies with solid balances and strong market positions. Secured debt obligations often
respond to special situations and their risk is as good as that of the pledged/guaranteed asset.
As for the collateralized debt obligations, their risk is that the collateral and its appropriate
income are insufficient to cover interest and principal payments.
A particular case of the collateralized debt obligations is mortgage emissions (emisiones
hipotecarias) issued solely by credit institutions granting mortgage financing. In the Spanish
case, these emissions are regulated by the law regulating the mortgage market (1981) and may
take three different forms: covered bonds (cédulas hipotecarias), mortgage bonds (bonos
hipotecarios), and mortgage participations (participaciones hipotecarias).

The common characteristics of the covered and mortgage bonds are their short- and medium-
term maturity (maturity between 3 and 5 years, although there are also issues of bonds with
shorter terms less than one year3) and their high liquidity thanks to the existence of active
secondary markets.

3
Initially, starting with the Ministerial Order of June 22, 1982, the minimum maturity of issuance of the
covered and mortgage bonds was three years. Subsequently, with the entry into force of Royal Decree
1289/91 of August 2, this limit has been removed. Despite this provision, these securities do not usually
have a short repayment term. However, before they were considered as belonging to the money
markets for their high liquidity and low risk (because of the incorporated guarantee).

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 Theme 4. Fixed income markets

Both the covered and mortgage bonds are also charachterized by a high degree of freedom in
their form of emission. Their issue is affected by the mortgage loans issued by the issuing
entity, but whereas the certificates (cédulas) are backed/guaranteed by the totality of all of
these loans, the bonds are secured by a concrete loan or a group of specific loans (specified in
the indenture). As for the quantitative ceilings of the issuances, the volume of mortgage bonds
that can emit an entity is limited to 90% of the loans linked to the issuance, while for covered
bonds, the limit is set at 90% of total mortgage loans of the entity that are not affected by the
emission.
Finally, the mortgage participations represent a partial or full transfer of the mortgage loans in
the portfolio of an institution to a third party, so that it produces a transfer (or equivalently, a
sale) of a part of its assets. This is due to their feature of compulsorily nominative securities
(unlike the bonos and cédulas; nominative refers to the fact that the name of the holder has to
appear on the instrument). Since 1992, with the aim of transforming the mortgage
participations in homogeneous fixed-income securities, the mortgage securitization funds are
regulated so that their liabilities (asset-backed securities) are homogeneous securities.
Recently, the law of measures to reform the financial system, has adopted a new type of
collateralized debt obligations that are called as territorial bonds (cédulas territoriales). Their
main characteristics according to the Act are as follows:
•   This are fixed-income securities, guaranteed/secured by loans and credits granted by
the issuer to the Spanish public administrations (AAPP) and the European Union.
•   The total amount issued must be less than 70% of the unamortized loans to public
administrations.
•   Treated similar to the covered bonds.
•   They are represented through the book entries and can be traded on the stock markets.

d. Convertible bonds/debentures (Obligaciones convertibles)

The total interest payable on a long-term debt obligation is a considerable fraction of the total
amount of the issue, especially when the issuers are relatively new companies, in their path of
strong expansion, but still with rather little balances. These growing companies are the main
issuers of convertible bonds, which are issued at a reduced coupon, but allow their holders to
convert the bonds into shares at a given price and a given conversion factor. For example, a
debenture of 1,000 EUR convertible to 50 shares for each debenture will work as a debt
obligation as long as the share price is below 20 EUR. But the owners might want to exchange
them for shares as soon as the share price exceeds 20 EUR in order to make profits.
Since convertibility is permanent, prices of convertible bonds reflect at any given time the rise
of the price of the underlying stock from the time the share price in the market exceeds the
conversion price, as many investors would realize their gains directly by selling the bonds in the
market instead of converting them into shares. The above example assumes that there is no a
conversion premium.
Nowadays, however, all convertible bonds/debentures are issued with a conversion premium:
that is, the conversion price is set above the share price at the time of issue. Thus, if the
company ABC issues bonds of 1,000 EUR when one ABC’s share is worth 10 EUR and these are
convertible to 50 shares at a price of 20 EUR, the conversion premium is 10 euros, i.e. 100
percent, and conversion ratio is 50.

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 Theme 4. Fixed income markets

All in all, convertible bonds are bonds that can be converted into shares of common stock at
the discretion of the bondholder. This feature permits the bondholder to share in the good
fortune of the firm if the stock price rises above a certain level. That is, if the market value of
the stock the bondholder receives at conversion exceeds the market value of the bond’s future
expected cash flows, it is to the bondholder’s advantage to exchange the bonds for stock, thus
making a profit. As a result, convertibility is an attractive feature to bondholders because it
gives them an option for additional profits that is not available with nonconvertible bonds.
Typically, the conversion ratio is set so that the stock price must rise substantially, usually 15 to
20 percent, before it is profitable to convert the bond into equity. Because convertibility gives
investors an opportunity for profits not available with nonconvertible bonds, convertible bonds
will be priced higher than the price of comparable nonconvertible bonds. The higher price
received for the bond by the firm implies a lower interest rate. In addition, convertible bonds
usually include a call provision so that the bond issuer can force conversion by calling the bond
rather than continue to pay coupon payments on a security that has greater value on
conversion than the face amount of the bond.
Issuing convertible bonds is one way firms avoid sending a negative signal to the market. In the
presence of asymmetric information between corporate insiders and investors, when a firm
chooses to issue stock, the market usually interprets this action as indicating that the stock
price is relatively high or that it is going to fall in the future. The market makes this
interpretation because it believes that managers are most concerned with looking out for the
interests of existing stockholders and will not issue stock when it is undervalued. If managers
believe that the firm will perform well in the future, they can, instead, issue convertible bonds.
If the managers are correct and the stock price rises, the bondholders will convert to stock at a
relatively high price that managers believe is fair. Alternatively, bondholders have the option
not to convert if managers turn out to be wrong about the company’s future.
e. Exchangeable bonds/debentures (Obligaciones canjeables)

Exchangeable bonds/debentures differ from convertible bonds/debentures in two fundamental

aspects. First, the issuer does not necessarily redeem exchangeable debt in cash, as is the case
with convertible bonds, but may choose to redeem exchangeable bonds by the shares in
exchange. Secondly, the stock shares are not those of the issuer itself, but the share of another
company listed in the stock exchange.
Thus, the exchangeable bond gives the holder the option to exchange the bond for the stock
of a company other than the issuer (usually a subsidiary) at some future date and under
prescribed conditions. This is different from a convertible bond, which gives the holder the
option to exchange the bond for the stock offered by the same issuer.
For example, let's consider a Company XYZ bond that is exchangeable into shares of Company
ABC at an exchange ratio of 50:1. This means that one could exchange every 1,000 EUR of par
value he/she owns of XYZ bond into 50 shares of ABC stock. This effectively means the
bondholder have the option to purchase Company ABC stock for 20 EUR per share (1,000/50).
If ABC shares were trading for 50 EUR per share, the bondholder would probably exchange the
bond and then sell the shares, making a profit of 30 EUR per share (50 EUR received per share
– 20 EUR paid per share). But if ABC shares were trading for 10 EUR per share, the bondholder
would have no incentive to convert the bond and would instead simply continue to receive
coupon payments.
Exchangeable-bond holders, like convertible-bond holders, usually accept lower coupon rates

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 Theme 4. Fixed income markets

because they have the chance to profit from the underlying stock's increase. Likewise, issuers
often give up equity in return for these lower interest rates. Exchangeable bonds typically
mature in three to six years.
Clearly, one opportunity (or one risk) of investing in exchangeable bonds is that the investor is
exposed to an underlying stock that may have an entirely different risk and return profile from
that of the issuer. Thus, investors have the option to invest in an entirely different company if
they want to. In this sense, exchangeable bonds come with a built-in diversification option.
Some investors view exchangeable bonds as stock investments with coupons attached. This is
because exchangeable bonds trade like bonds when the share price is far below the exchange
price but trade like stocks when the share price is above the exchange price. This correlation
with stock prices means exchangeable bonds provide a certain degree of inflation protection,
which is especially attractive to investors and especially noteworthy given that corporate bonds
largely provide little if any inflation protection.
Companies often use exchangeable bonds as a method to sell off their positions in other
companies. But another major advantage of exchangeable bonds for issuers is that they do not
dilute the issuer's shareholders. That is, investors can turn convertible bonds into shares of the
same issuer, which forces the company to issue more shares causing dilution (a reduction in
proportional ownership caused when a company issues additional shares). Because
exchangeable bonds turn into shares of another company, no such dilution occurs.
f. Floating coupon and zero coupon debt obligations (Obligaciones con cupón flotante y sin
cupón)

Banks and financial institutions that lend most of their resources as short-term loans prefer to
issue debt obligations with "floating coupon", instead of fixing interest from the beginning for
the entire life of the issue. This way the costs of their liabilities fit/match better with their assets’
revenues. Interest is payable quarterly based on a reference interest rate and at the payment
date the interests are set according to the market conditions for the next 90 days.
The English generic term for short-term obligations is "notes" (as opposed to "bonds" used
for longer-term obligations). The first market of bank notes in the world was the London
Euromarket, that came into existence with the issuance of Eurodollar notes with 90-days LIBOR
(London Interbank Offered Rate) as a reference rate, plus a premium established by the public
standing of the issuer and maturity of two to five years.

Further details on mortgages securitization and assets securitization (Titulizaciones hipotecarias

y de activos)

Securitization is a method of financing companies based on the sale or transfer of certain

assets, including the rights of future payments, to a third party who, in turn, finances the
purchase by issuing securities that are placed among investors.
In Spain, the method of securitization is as follows. The entity that needs financing — the
grantor — sells assets to a securitization fund, which does not have a legal status and is
administered by a fund management entity (see the figure below). The fund, in turn, issues
securities that are backed by the assets acquired. When the guarantee/collateral consists of
mortgages granted by credit entities, the securities issued are acquired by a mortgage
securitization fund (fondo de titulización hipotecaria, FTH), which issues mortgage

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 Theme 4. Fixed income markets

securitization bonds (bonos de titulización hipotecaria). When the guarantee/collateral consists

of other assets (and other types of mortgage loans), these are acquired by an assets
securitization fund (fondo de titulizacion de activos, FTA), which will issue securitization
commercial paper or securitization bonds (pagarés o bonos de titulización).

Source: CNMV Guide, Fixed-income products, 2002.

The most noteworthy aspects of securitization include:

•   The securitization fund is formed as a separate patrimony/entity so that the securitized
portfolio is outside the reach of the creditors of the grantor entity.
•   The issued securities are backed by securitized assets and not by the solvency of the
grantor entity. In order to make the payment of the issued instruments more secure, the
interest rate differences between the credits grouped in the fund and the securities
issued by the fund are neuteralized (balanced out), and the temporary mismatch of the
flows is reduced/mitigated. Such financial operations known as credit improvements are
contracted by the fund.
•   The financial risk of the issued instruments is always the subject of valuation by the
rating agencies.
•   The holders of the issued bonds against the fund consider the non-payment risk as that
of the assets grouped in the fund.
•   The early redemption risk of the fund’s assets is transferred to the holders of the
securities. At each payment date, the bondholders can support partial redemption.
Despite being instruments that generally have a very high rating, it can be difficult for small
investors to understand them. Because of their features, they are normally placed among
institutional investors.

A.3 Hybrid financial instruments

Within the fixed-income instruments, in recent years the hybrid instruments, having the
characteristics of fixed-income securities and variable-income securities (equities), have gained
some importance in Spain as a way to raise long-term funds primarily by financial entities,

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 Theme 4. Fixed income markets

especially deposit institutions. The main instruments used for this purpose have been the
preference shares (participaciones preferentes) and participation shares (cuotas participativas)
because, in both cases, they allow for the compliance with legal requirements of the solvency
ratio (or equity).
a. Participation quotas (Cuotas participativas)

Participation quotas, also called “participation obligations” (obligaciones participativas) or

“obligations with profit sharing clause” (obligaciones con cláusula de partipación de
beneficioes), are considered intermediate instruments between bonds and stocks because, in
addition to paying a fixed coupon they also include additional income on the possible profits
of the company which allow the holders of participation quotas to benefit from the favorable
performance/results of the firm. Their profitability is, therefore, partly fixed and partly variable,
and there may cases when these obligations could be converted into stocks.
The most recent regulation related to the use of this instrument by savings banks is included in
the so-called financial law (Law 44/2002 of 22 November on Measures to reform the financial
system) and the Royal Decree-law 11/2010 of 9 July on Governing bodies and other aspects of
the legal regime of the savings banks. The main aspects of this regulation in relation to the
instrument in question are as follows:
•   The participation quotas are negotiable securities representing cash contributions of
indefinite duration; they have the character of own equity. They are issued at a par
value or at a premium, in nominative form.
•   At the time of issuance, the following three funds are created: participation fund
(according to the the nominal value of the issued quotas); a reserve fund (to which a
percentage of the quota surplus of free disposition flows, which is not directed to
stabilization funds and not intended for quota-holders); and a stabilization fund (this is
optional and is created with the aim of avoiding excessive fluctuations in the quota
payments). Only the first two funds are considered as own equity funds.
•   The quota-holders can have political rights in direct proportion to the percentage that
their quotas have in the equity of the issuer; there is a sindicate/union of the
participants that may be represented in the governing bodies of the issuing savings
bank.
•   Economic rights of the quota-holders: participation in the surplus of free disposal in
proportion to the quotas volume of the savings bank plus the volume of outstanding
quotas (i.e. quotas in circulation); preference subscription in new issues of the quotas;
receipt of a fixed or variable reward/payment from the free disposition surplus or the
stabilization fund.
•   Quotas are redeemed automatically if the political rights of the quota-holders are
modified according to a plan approved by the Bank of Spain so that the solvency is not
modified.
•   The volume of outstanding quotas may not exceed 50% of the assets of the savings
bank (which used to be 25% until 24-11-2004).
•   The free disposition surplus corresponding to the quotas is allocated by the General
Assembly between: the reserve fund, effective remuneration of the holders and the
stabilization fund, taking into account the volume of own equity/resources. If the

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 Theme 4. Fixed income markets

savings bank cannot comply by all the relevant legal requirements, compensation under
the stabilization fund must be approved by the Bank of Spain.

b. Preference shares (Participaciones preferentes)

These are instruments which, as such have not had regulation in the Spanish legislation until
the publication of Law 19/2003 of July 4 (BOE of 5 July), on the legal regime of capital
movements and economic transactions with the foreign sector and on certain measures of
preventing money laundering, which approved to regulate the characteristics of the preference
shares of credit institutions as well as their tax regimes.
The term “participación preferente” is a translation of the English term preference share, that is
most similar in the Spanish law to non-voting shares, although these securities are different
from non-voting shares due to their hybrid nature of fixed-income instruments and equities.
The main features and rights attached to preference shares are as follows.
•   These are securities that form a part of own equity of the issuer, so that they give their
holders the right to receive a predetermined fixed and non-cumulative dividend (i.e. the
dividend is known from the issue date of the securities but if at any time it can not be paid,
it is lost).
•   They may be issued as nominative shares or as bearer shares (al portador).
•   Holders have no political rights such as participation in the shareholders' meeting or voting
in it, but sometimes (for example, following the non-payment of dividends in a number of
periods or liquidation of the entity) such rights are granted.
•   The holders have no preferential subscription rights in subsequent issues of these
securities.
•   Preference shares are perpetual securities, but usually there is a possibility of early
repayment after a period of some years.4
•   In Spain preference shares are usually issued by the subsidiaries of financial institutions, so
that the parent company acts as guarantor of the payments promised by the issuer of the
securities. However, the guarantor is not required to make payments if there is no sufficient
distributable profit and when the requirements on own resources are not met.

4
In case these intruments are issued in Spain, an early redemption can be made any time after five
years of their placement in circulation, at a date of dividends payment and with prior approval of the
Bank of Spain.

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 Theme 4. Fixed income markets

BIBLIOGRAFÍA

ANALISTAS FINANCIEROS INTERNACIONALES (2012), Guía del Sistema Financiero Español

(6ª edición), Madrid, Ed. Analistas Financieros Internacionales. Capítulos 8 y 9.
CALVO, A. y otros (2014), Manual de Sistema Financiero Español (25ª edición), Barcelona, Ed.
Ariel. Capítulo 8.
MARTÍN MARÍN, J. L. y TRUJILLO PONCE, A. (2011), Mercados de activos financieros,
Madrid, Ed. Delta Publicaciones. Capítulos 3 y 4
EZQUIAGA I. y FERRERO, A. (1999), El mercado español de deuda pública en euros, Madrid,
Ed. Escuela de Finanzas Aplicadas. Capítulos V, VI, VII y VIII.
Banco de España (varios años) Informe de estabilidad financiera y Boletín económico.
Banco de España (varios años) Memoria del mercado de deuda pública, Madrid, Ed. Banco de
España.
CNMV (varios años), Informe sobre los mercados de valores

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