Fixed Income Investments

~ Bonds
Contents

• Overview
• Definition of Bonds
• Key Terms
• Bond features
• Optionality
• Bond Types
• Payment methods
• Non-payment
Overview

• A Fixed Income investment refers to any

security that pays the investor periodic
and assured interest income.
• Fixed Income securities have stated rates
and payment periods.
• Based on this definition, preferred stocks
are also fixed income investments.
Overview cont’d

• In general, this term is applied to

investments that do not have variable
rates of return.
• Bonds refer to fixed income investments
between 1 year to 30 years in length.
Types of Bond Issuers

• Corporate Bond
• Government Bond
• Municipal Bonds
Bond Credit Ratings

• Credit rating is an indicator of the credit

worthiness of a bond.
• Three major credit agencies regarded as
authorities; Moody’s, Standard & Poor’s & Fitch.
• Credit ratings are classified as Investment grade
– Prime, High, Upper medium; Lower medium
grade; Non-investment grade and speculative.
• Ratings range from Prime to Default.
Bond Ratings – Investment Grades
• Aaa • AAA
• Aa1 • AA+
• Aa2 • AA
• Aa3 • AA-
• A1 • A+
• A2 • A
• A3 • A-
• Baa1 • BBB
• Baa2 • BBB+
• Baa3 • BBB-
Key Terms
• The issue price is the price at which investors purchase
the bond.
• The nominal or face value is the amount that the issuer
must repay.
• The coupon (of a bond) is the interest that the issuer
must pay.
• The maturity is the end of the bond, the date that the
issuer must return the principal.
• The indenture is the contract that states all of the
terms of the bond.
• The coupon dates are dates on which the issuer pays
bond holders.
Bond Markets

• A Bond typically refers to debt obligations

with maturities of 10 years to 30 years.
• Bonds are issued by corporations or
various levels of municipal, state or federal
governments.
• Bonds primarily issued through
underwriting, while government bonds are
usually auctioned.
Features of Bonds

• Coupon rate is highly dependent on Credit

Rating.
• Investors will demand a higher coupon
rate as compensation for lower credit
ratings.
• Issue price also dependent on the
structure of the bond.
• Investors may pay more for options.
Foreign currency issues

• Issued by an entity in a currency other

than their base currency.
• Eurodollar, Kangaroo, Maple, Samurai,
Shogun, Bulldog, Panda.
Types of Bonds

• Fixed Rate bonds

• Floating Rates (FRN)
• Sinking Fund provision
• Zero-coupon bonds
• Inflation linked bonds
• Asset backed – MBS, CMO, ABS
Optionality

• Callability
• Putability
• Convertible bond
• Exchangeable bond
Investing in Bonds
• Market prices of bonds decrease when prevailing
interest rates increase – interest rate risk.
• Price changes affect the portfolio value of Mutual
Funds as they are marked to market daily.
• Bond prices can fluctuate due to credit ratings
downgrade.
• Bankruptcy of issuer usually results in defaults.
Fixed Rate Bond

• Coupon rate is fixed.

• Example – 100,000 FV, 4.50% SA, 30/360
• Every 6 months, this bond pays $2,250 in
interest for the until maturity.
• At maturity, investors will receive
$102,250 representing repayment of the
principle and the last 6 months of accrued
interest.
Floating Rate Bond

• Coupon rate is variable.

• Coupon rate tied a reference rate such as LIBOR
plus a constant spread.
• Some issues may have maximum or minimum
coupon rates, known as caps and floors.
• An issue with both a cap and a floor is collared.
• Low interest rate risk exposure.
Sinking Fund provision

• Indenture allows issuer to repay principal prior

to maturity.
• Pool of money is set aside to repurchase a set
amount of the issue according to a set schedule.
• Example - same 100,000 FV issue with a sinking
fund provision allowing a 10% repurchase after
1 year pays interest of $2,025.
• Each repayment is known as a ‘paydown’.
Zero Coupon Bonds

• No coupon rate.
• No periodic interest payments.
• Bond is sold for a substantial discount to
FV, the full FV is repaid at maturity.
• Taxed in the US on inputted income.
• Can be taxed as either capital gain or
interest in other jurisdictions.
Inflation linked bonds

• Intended to negate inflation risk inherent

in issue by adjusting coupon (inflation-
indexed) or adjusting FV (TIPS)
• Inflation indexed bonds pay a coupon
equal to nominal coupon rate * inflation
index.
• TIPS pay coupon equal to (FV * inflation
index) * coupon rate.
Asset Backed – ABS/MBS
• Derivative securities that are dependent on pool
of underlying assets for income stream and
value.
• Pools of car loans, bank loans, credit card debt
or lease payments and mortgages are pooled
into a security.
• Payment of these loans are used to fund the
interest payments to investors of these
securities.
• Shown as LNAS in OneTIS.
Callable Bonds
• A call option allows the issuer to redeem all or
part of the debt prior to maturity.
• Call price is usually at a premium to the
prevailing market price of the bond.
• Bond calls are more common in times of
declining interest rates, the issuer can redeem
old issues carrying higher coupon rates by
issuing new lower coupon bonds to finance the
call.
• Processed on ex-date as CALG.
Putable Bonds

• A put option allows the investor sell back

to the issuer all or part of the debt prior to
maturity.
• Market prices of putable bonds are higher
in the open market as put option is an
extra safeguard for investors.
Convertible Bonds
• Bonds that can be exchanged in to shares of the
issuer’s common stock.
• Coupon rates are generally lower, allowing the
issuer to issue debt at a lower cost.
• Conversion can be initiated by the issuer once a
pre-set value is triggered.
• Conversion can be initiated by the investor if
stock is trading at a premium to the conversion
price (contingent convertibles – coco)
Exchangeable Bonds

• Investors may exchange their bonds for

shares of a company other than the issuer
of the bond.
• Terms of exchange are pre-set for a future
date with fixed amounts.
Exchange example – GMAC EXO

• CODA: CATU
• DR
• 030.1100USD.S1000.USD              
• 110.2004.C3000.USD                    
• 110.2003.C3000.USD                     
• 110.2003.C3000.USD                     
• 510.5540.Y1300.USD                    
Exchange example – GMAC EXO

• CR
• 110.2003.C3000.USD    
• GMAX: SCA, PCA, PCA                  
Example – Term Loan EXO
Example – Term loan EXO
Bond Payments

• Coupon bearing bonds are obligated to

make periodic interest payments according
to their indenture.
• Two main methods of payment.
 In cash
 In kind
• Toggle features allow issuers to select the
method of payment.
Payment in Cash

• GMAX: IR entry is generated on scheduled

payment date.
• CODA CPNG:
• DR 030.1200CUR.N1000.CUR
• CR 050.1240.N1000.CUR
Payment in Cash

• On S+1
• CODA SCRU:
• DR 010.1000.B20XX.CUR
• CR 030.1200CUR.N1000.CUR
• GMAX:
• TR transaction
Payment in Kind
• Issuer has the option to deliver additional
securities rather than cash payments.
• Issuer may partially deliver coupon payment in
cash and partially in kind, or deliver the entirety
in kind.
• Bonds received from payment may or may not
be identical to original issue.
• Bonds from PIK are known as baby bonds.
• PIK common for ‘junk bonds’ and ABS.
Payment in Kind

• CODA CPNG:
• DR 030.1200CUR.N1000.CUR
• CR 050.1240.N1000.CUR
• CODA CATU:
• DR 110.2003.C3000.CUR
• CR 030.1200CUR.N1000.CUR
Payment in Kind

• GMAX Purchase:
• ‘P’ posted at current MV for all new
securities received in main account.
• ‘P’ posted at par value for all new
securities received in shadow/tax account.
PIK Mark to Market

• On a monthly basis, NAC completes

analysis of receivables to ensure material
differences between the accrued interest
values and marked to market values do
not exist.
• This is completed using the PIK Reval
workbook.
PIK MTM
PIK MTM

• All MTM entries should be reversed in the

event of a default.
• All issues making 100% PIK coupon
payments should be marked to market
each month, regardless of materiality.
Non-payment

• In the event an issuer is unable to make timely

payments of either principal or interest.
• Once an issue is deemed defaulted, SM will
place the security in a default listing.
• All accruals since the last good payment should
be reversed.
• All amortization should be stopped on the day of
default..
Questions?