FIXED-INCOME SECURITIES:

DEFINING ELEMENTS
CHAPTER 1
• In the Text Book Chapter 1 to 5 and Chapter 7 are to be covered for Fixed
Income Curriculum.
• For examination purpose also cover these chapters thoroughly
• Rest of the chapters are to be treated as additional readings

© 2016 CFA Institute. All rights reserved.

TABLE OF CONTENTS
01 INTRODUCTION
02 OVERVIEW OF A FIXED-INCOME SECURITY
03 LEGAL, REGULATORY, AND TAX CONSIDERATIONS
04 STRUCTURE OF A BOND’S CASH FLOWS
05 BONDS WITH CONTINGENCY PROVISIONS
06 SUMMARY

2
 1. INTRODUCTION
WHAT IS A FIXED-INCOME SECURITY?
• A fixed-income security is a financial obligation of an entity
(the issuer) that promises to pay a specified sum of money
at specified future dates.
• A fixed-income security is an instrument that allow
governments, companies, and other types of issuers to
borrow money from investors.
- Any borrowing of money is debt.
• The terms “fixed-income securities,” “debt securities,” and
“bonds” are often used interchangeably.

3
 2. OVERVIEW OF A
FIXED-INCOME SECURITY
• There are three important elements when investing in a
fixed-income securities:

The bond features, including the issuer, maturity, par value,

coupon rate and frequency, and currency denomination.

The legal, regulatory, and tax considerations.

The contingency provisions that may affect the bond’s

scheduled cash flows.

• All bonds, whether they are traditional or securitised bonds,

are characterised by the same basic features.

4
 BASIC FEATURES OF A BOND
supranational
organisation
Creditworthiness
sovereign (national)

Issuer
government
• investment-grade
bonds non-sovereign (local)
• non-investment-grade government
bonds
quasi-government entity

company

5
 BASIC FEATURES OF A BOND
Maturity

• The maturity date is the date when the issuer is obligated to

redeem the bond.
• The tenor, also known as term to maturity, is the time
remaining until the bond’s maturity date.
• Money market securities are fixed-income securities with maturity
up to one year.
• Capital market securities are fixed-income securities with maturity
longer than one year.

Par value (principal) of a bond

• The par value of a bond is the amount the issuer agrees to
repay the bondholders on the maturity date.

6
 BASIC FEATURES OF A BOND
Coupon rate and frequency

• The coupon or nominal rate (yield) of a bond is the interest

rate that the issuer agrees to pay each year until the maturity
date.
• The coupon is the annual amount of interest payments and is
determined by multiplying the coupon rate by the par value of
the bond.
• Plain vanilla bonds pay a fixed rate of interest.
• Floating-rate notes (FRNs) or floaters pay a floating rate: a
reference rate plus a spread.
• Bonds that do not pay interest are called “zero-coupon bonds.”

7
 BASIC FEATURES OF A BOND

Currency denomination

• Bonds can be issued in any currency, mostly US dollars and

euros.
• Dual-currency bonds make coupon payments in one currency
and pay the par value at maturity in another currency.
• Currency option bonds are a combination of a single currency
bond plus a foreign currency option.

8
EXAMPLE 1

1.An example of sovereign bond is a bond issued by:

2.The risk of loss resulting from the issuer failing to make full and timely payment
of interest is called:
3.A money market security most likely matures in:
4.If the bond’s price is higher than its par value, the bond is trading at:
5.A bond has a par value of £100 and a coupon rate of 5%. Coupon payments
are made semi-annually. The periodic interest payment is:

9
EXAMPLE 1 (CONT…)

6.The coupon rate of a floating-rate note that makes payments in June and
December is expressed as six-month Libor + 25 bps. Assuming that the six-
month Libor is 3.00% at the end of June 20XX and 3.50% at the end of
December 20XX, the interest rate that applies to the payment due in December
20XX is:
7.The type of bond that allows bondholders to choose the currency in which they
receive each interest payment and principal repayment is a:

10
YIELD MEASURES

• Current yield or running yield

• Yield to maturity

• Yield to redemption

• Redemption yield

11
LEGAL, REGULATORY AND TAX
CONSIDERATIONS
A bond is a contractual agreement between the issuer and the bondholders.

1.Bond Indenture (trust deed)

2.Legal and Regulatory Considerations

3.Tax Considerations

12
 3. LEGAL, REGULATORY, AND TAX
CONSIDERATIONS
Bond indenture
• The trust deed is the legal contract that describes the form
of the bond, the obligations of the issuer, and the rights of
the bondholders.
• This legal contract is often called the “bond indenture.”
• The indenture is written in the name of the issuer and
references features of the bond issue, such as par value,
coupon rate and frequency, maturity date, and the funding
sources for the interest and principal repayments, as well
as any collaterals, covenants, and credit enhancements.

13
BOND INDENTURE

•Legal identity of the bond issuer and its legal form

•Source of repayment proceeds

•Asset or collateral backing (if any)

•Credit enhancements (if any)

•Covenants (if any)

14
 BOND INDENTURE
Legal identity of the bond issuer and its legal form
• The legal obligation to make the contractual payments is
assigned to the bond issuer. The issuer is identified in the
indenture by its legal name.
For sovereign • The issuer is usually the office
bonds responsible for the national budget.

For corporate • The issuer might be a holding

bonds company or a subsidiary.

For securitised • The legal obligation usually lies with

bonds special purpose vehicles.

15
 BOND INDENTURE
Sources of repayment proceeds
• Sovereign bonds are backed by the “full faith and
credit” of the national government and thus by that
Sovereign bonds government’s ability to raise tax revenues and print
money.

• The major sources for repayment include the

general taxing authority of the issuer, the cash
Non-sovereign flows of the project the bond issue is financing, and
government special taxes or fees established specifically for the
bonds purpose of funding the payments of interest and
principal.

• The source of payment for corporate bonds is the

Corporate bonds issuer’s ability to generate cash flows, primarily
through its operations

16
 BOND INDENTURE
Asset or collateral backing
• Collateral backing is the way to alleviate credit risk.
Credit risk is affected by

Seniority ranking:
Credit enhancement:
secured, unsecured, or subordinate
(junior) internal or external

Bond covenants Types and quality of collateral

(legally enforceable rules that backing:
borrowers and lenders agree on at mortgages, equipment or other
the time of a new bond issue): physical assets, financial assets, and
affirmative (positive) or negative others

17
 BOND COVENANTS
• Affirmative covenants enumerate what issuers are required
to do.
- For example, to comply with all laws and regulations, maintain
their current lines of business

• Negative covenants enumerate what issuers are prohibited

from doing.
- For example, restrictions on debt, negative pledges,
restrictions on prior claims

18
COVENANTS
Bond covenants are legally enforceable rules that borrowers and lenders agree on at the time of a new bond
issue. Covenants can be affirmative or negative.

Affirmative covenants indicate what the issuer must do. These are generally administrative. For example,
issuer will:
• Make payments on time
• Comply with all laws and regulations
• Maintain current lines of business
• Insure and maintain assets
• Pay taxes on time

Negative covenants indicate what issuer must NOT do. These are frequently more costly and materially
constrain the issuer’s potential business decisions. Examples include:
• Restrictions on debt
• Negative pledges
• Restrictions on prior claims
• Restrictions on distributions to shareholders
• Restrictions on asset disposals
• Restrictions on investments
• Restrictions on mergers and acquisitions

19
EXAMPLE 2

20
EXAMPLE 2 (CONT…)

21
EXAMPLE 2 (CONT…)

22
 LEGAL AND REGULATORY CONSIDERATIONS
• Fixed-income securities are subject to different legal and regulatory
requirements depending on where they are issued and traded as well
as on who holds them.
• There are no unified legal and regulatory requirements that apply
globally.
• The global bond markets consist of national bond markets and the
Eurobond market.
•National bond market
Domestic bonds
Foreign bonds
•Eurobond market
Less regulated than national bonds
Bearer bonds versus registered bonds
Bonds are also characterized by:
1.Frequency of coupon payments
2.How interest is calculated
3.Currency

23
EXAMPLE 3

24
 TAX CONSIDERATIONS
• Interest payments and capital gains are often subject to
taxation. Tax treatment of both varies from jurisdiction to
justification.
- The income portion of a bond investment is typically taxed at
the ordinary income tax rate. Tax-exempt securities are the
exception to this rule.
- A tax on capital gains may apply if the bond sale price exceeds
the bond purchase price.
- The original issue discount might be subject to a tax for
discount bonds (such as zero-coupon bonds).

25
EXHIBIT 3 –ORIGINAL ISSUE DISCOUNT TAX
PROVISION
• Assume a hypothetical country, Zinland, where the local currency is the zini(Z). The market
interest rate in Zinlandis 10%, and both interest income and capital gains are taxed.
Companies A and B issue 20-year bonds with a par value of Z1,000. Company A issues a
coupon bond with an annual coupon rate of 10%. Investors buy Company A’s bonds for
Z1,000. Every year, they receive and pay tax on their Z100 annual interest payments. When
Company A’s bonds mature, bondholders receive the par value of Z1,000. Company B issues
a zero-coupon bond at a discount. Investors buy Company B’s bonds for Z148.64. They do not
receive any cash flows until Company B pays the par value of Z1,000 when the bonds mature.
Company A’s bonds and Company B’s bonds are economically identical in the sense that they
have the same maturity (20 years) and the same yield to maturity (10%). Company A’s bonds
make periodic payments, however, whereas Company B’s bonds defer payment until maturity.
Investors in Company A’s bonds must include the annual interest payments in taxable income.
When they receive their original Z1,000 investment back at maturity, they face no capital gain
or loss. Without an original issue discount tax provision, investors in Company B’s bonds do
not have any taxable income until the bonds mature. When they receive the par value at
maturity, they face a capital gain on the original issue discount—that is, on Z851.36 (Z1,000 –
Z148.64). The purpose of an original issue discount tax provision is to tax investors in
Company B’s bonds the same way as investors in Company A’s bonds. Thus, a prorated
portion of the Z851.36 original issue discount is included in taxable income every tax year until
maturity. This allows investors in Company B’s bonds to increase their cost basis in the bonds
so that at maturity, they face no capital gain or loss.

26
EXAMPLE 4

27
STRUCTURE OF A BOND’S CASH FLOWS

• Payment structure for plain vanilla bond

• Payment schedules are similar for a particular type of bond

• Payment schedules vary between types of bonds

28
 4. STRUCTURE OF A BOND’S CASH FLOWS
• The most common payment structure by far is that of a
plain vanilla bond, as depicted below.
€1,025

€25 €25 €25 €25 €25 €25 €25 €25 €25

Semi-annual
time periods

€1,000

29
 PRINCIPAL REPAYMENT STRUCTURES
A bullet structure has all the
principal repaid at the maturity
date.

A sinking fund
arrangement
An amortizing bond
specifies the portion
has a payment
of the bond’s
Bond schedule that calls
principal outstanding
for periodic payments
(e.g., 5%) that must Arrangements of interest and
be repaid each year
repayments of
throughout the
principal.
bond’s life or after a
specified date.

A partially amortized bond also

makes fixed periodic payments until
maturity, but only a portion of the
principal (called a “balloon payment”)
is repaid by the maturity date.

30
PRINCIPAL REPAYMENT STRUCTURES
• Bullet Bond

• Fully
Amortized Bond

31
PRINCIPAL REPAYMENT STRUCTURES
(CONT…)
• Partially Amortized Bond
• Balloon Payment

32
EXAMPLE 5

33
SINKING FUND ARRANGEMENT AND CALLABLE
BONDS

• Sinking fund arrangement specifies the portion of the bond’s principal

outstanding that must be repaid each year throughout the bond’s life

• Reduced credit risk for investors

• Higher reinvestment risk

• Call provision gives issuer the option to repurchase the bond before maturity

34
COUPON PAYMENT STRUCTURES
• Fixed periodic coupon

• Floating rate notes (FRN)

• Relative low interest rate impact

• May include a floor or cap

• Inverse FRN

• Step-up coupon bonds

• Credit-linked coupon bonds

• Payment-in-kind coupon bonds

• Deferred coupon bonds

• Index-linked bonds

• TIPS

35
 COUPON PAYMENT STRUCTURES
• Conventional bonds pay a fixed periodic coupon over a
specified time to maturity, typically annually or semi-
annually and occasionally quarterly.

Instruments with other coupon structures:

• floating-rate notes
• step-up coupon bonds
• credit-linked coupon bonds
• payment-in-kind coupon bonds
• deferred coupon bonds
• index-linked bonds

36
 COUPON PAYMENT STRUCTURES
• FRNs typically pay a quarterly coupon.
• The coupon is determined by the formula

Reference Fixed FRN

rate spread coupon

FRNs are usually less affected by changes in interest rates.

FRNs may have additional features, such as a floor or a cap.

Inverse (inverse floaters) are bonds whose coupon rates have an

FRNs inverse relationship to the reference rate.

37
 COUPON PAYMENT STRUCTURES

Credit-linked coupon
Step-up coupon bonds
bonds

have a fixed or floating

have a coupon that changes
coupon, which increases by
when the bond’s credit rating
specified margins at
changes
specified dates

offer bondholders some

Are attractive to investors
protection against rising
who are concerned about
interest rates and may be an
the future creditworthiness
important feature for callable
of the issuer
bonds

38
 COUPON PAYMENT STRUCTURES

Payment-in-kind (PIK) Deferred coupon (i.e.,

bonds split coupon) bonds

typically allow the issuer to pay no coupon for the first

pay interest in the form of few years but then pay a
additional amounts of the higher coupon than they
bond issue rather than a otherwise normally would for
cash payment the remainder of their life

typically are favored by are also common in project

issuers who are concerned financing when the assets
that the issuer may face being developed do not
potential cash flow problems generate any income during
in the future the development phase

39
 COUPON PAYMENT STRUCTURES
Index-linked bonds
have their coupon payments
and/or principal repayment linked
to a specified index
- Bonds can potentially be linked
to any published economic and
financial variable/index.
- Bonds linked to a rate of inflation
are called “inflation-linked bonds”
(e.g., Treasury inflation-protected
securities, or TIPS, in the United
States.
• Cash flows of the index-linked
bond can be linked to the
specified index by linking the
interest payments (interest-
indexed bonds), the principal
repayment (zero-coupon
bonds), or both (capital-
indexed bonds and indexed
annuity bonds).
• An equity-linked note (ELN) is
a fixed-income security that
differs from a conventional
bond in that the final payment
is based on the return of an
equity index.
40
EXHIBIT 7 –EXAMPLES OF INFLATION-LINKED
BONDS
• Assume a hypothetical country, Lemuria, where the currency is the lemming (L). The country
issued 20-year bonds linked to the domestic Consumer Price Index (CPI). The bonds have a
par value of L1,000. Lemuria’seconomy has been free of inflation until the most recent six
months, when the CPI increased by 5%. Suppose that the bonds are zero-coupon-indexed
bonds. There will never be any coupon payments. Following the 5% increase in the CPI, the
principal amount to be repaid increases to L1,050 [L1,000 ×(1 + 0.05)] and will continue
increasing in line with inflation until maturity. Now, suppose that the bonds are coupon bonds
that make semi-annual interest payments based on an annual coupon rate of 4%. If the bonds
are interest-indexed bonds, the principal amount at maturity will remain L1,000 regardless of
the CPI level during the bond’s life and at maturity. The coupon payments, however, will be
adjusted for inflation. Prior to the increase in inflation, the semi-annual coupon payment was
L20 [(0.04 ×L1,000) ÷2]. Following the 5% increase in the CPI, the semi-annual coupon
payment increases to L21 [L20 ×(1 + 0.05)]. Future coupon payments will also be adjusted for
inflation. If the bonds are capital-indexed bonds, the annual coupon rate remains 4%, but the
principal amount is adjusted for inflation and the coupon payment is based on the inflation-
adjusted principal amount. Following the 5% increase in the CPI, the inflation-adjusted
principal amount increases to L1,050 [L1,000 ×(1 + 0.05)], and the new semi-annual coupon
payment is L21 [(0.04 ×L1,050) ÷2]. The principal amount will continue increasing in line with
increases in the CPI until maturity, and so will the coupon payments. If the bonds are indexed-
annuity bonds, they are fully amortized. Prior to the increase in inflation, the semi-annual
payment was L36.56—the annuity payment based on a principal amount of L1,000 paid back
in 40 semi-annual payments with an annual discount rate of 4%. Following the 5% increase in
the CPI, the annuity payment increases to L38.38 [L36.56 ×(1 + 0.05)]. Future annuity
payments will also be adjusted for inflation in a similar manner.

41
EXAMPLE 6

42
EXAMPLE 6 (CONT…)

43
 5. BONDS WITH CONTINGENCY PROVISIONS
• A contingency provision is a clause in a legal document
that allows for some action if the event or circumstance
does occur (i.e., embedded option).
• Some common types of bonds with embedded options
include callable bonds, putable bonds, and convertible
bonds.

44
 5. BONDS WITH CONTINGENCY PROVISIONS
• Callable bonds give the issuer the right to redeem all or part
of the bond before the specified maturity date.
• The primary reason why issuers choose to issue callable
bonds rather than non-callable bonds is to protect
themselves against a decline in interest rates.
Callable • Lower market rates, Better credit quality
bonds • •Callable bonds offer a higher yield and sell at lower price
relative to otherwise similar non-callable bonds
• •Details, such as the call schedule, are specified in the bond
indenture
• •Callable bonds come in different styles: American,
European and Bermuda
• The bondholder has the right to sell the bond back to the
issuer at a pre-determined price on specified dates.
• Putable bonds are beneficial for the bondholder by
guaranteeing a pre-specified selling price at the redemption
Putable dates if interest rates rise
bonds • Cash can be reinvested at higher rates
• Putable bonds offer a lower yield and sell at a higher price
relative to otherwise similar non-putable bonds
• •Details, such as redemption dates and prices, are specified
in the bond indenture
45
EXAMPLE 7

46
 5. BONDS WITH CONTINGENCY PROVISIONS
• They are a hybrid security with both debt
and equity features.
• The bondholder has the right to exchange
the bond for a specified number of common
shares in the issuing company.
• They are beneficial to bondholders.
Convertible • The bondholder has the ability to convert
bonds bonds into equity in case of share price
appreciation and thus participate in the
equity up side.
• 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 at
maturity.
Advantages to issuer A warrant is an attached
•Reduced interest expense option, not an embedded
•Elimination of debt if conversion option is exercised option

47
 5. BONDS WITH CONTINGENCY PROVISIONS
• The conversion price is the price per share at which the
convertible bond can be converted into shares.
• The conversion ratio is the number of common shares that
each bond can be converted into.

Current Conversion Conversion

share price ratio value

Convertible Conversion Conversion

bond price value premium

48
EXAMPLE 8

49
EXAMPLE 8 (CONT…)

50
 6. SUMMARY
Important elements to consider when investing in a
fixed-income security
• the bond’s features
• the legal, regulatory, and tax considerations
• the contingency provisions

The basic features of a bond

• the issuer, maturity, par value (or principal), coupon rate and frequency, and
currency denomination

The bond indenture or trust deed

• The bond indenture is the legal contract that describes the form of the bond,
the issuer’s obligations, and the investor’s rights.
• The indenture is usually held by a financial institution called a “trustee,” which
performs various duties specified in the indenture.

51
 SUMMARY
Bond covenants
• Bond covenants are legally enforceable rules that borrowers and lenders
agree on at the time of a new bond issue.
• Affirmative covenants enumerate what issuers are required to do, whereas
negative covenants enumerate what issuers are prohibited from doing.

Legal and regulatory considerations

• An important consideration for investors is where the bonds are issued and
traded because it affects the laws, regulations, and tax statuses that apply.

Bond arrangements
• An amortizing bond is a bond whose payment schedule requires periodic
payment of interest and repayment of principal. This differs from a bullet
bond, whose entire payment of principal occurs at maturity.

52
 SUMMARY
Coupon payment structures
• fixed-coupon bonds
• floating rate notes
• bonds with step-up coupons
• bonds with credit-linked coupons
• bonds with payment-in-kind coupons
• bonds with deferred coupons

Bonds with embedded options

• Common types of bonds with embedded options include callable bonds,
putable bonds, and convertible bonds.
• These options are “embedded” in the sense that there are provisions
provided in the indenture that grant either the issuer or the bondholder
certain rights affecting the disposal or redemption of the bond. They are
not separately traded securities.

53