Features of Debt

Securities
by Frank J. Fabozzi

PowerPoint Slides by
David S. Krause, Ph.D., Marquette University

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 Chapter 1
Features 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).
 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.

• Key features of a bond include:

– Coupon rate
– Face value (or par)
– Maturity (or term)
 Fixed Income Categories
• Fixed income securities fall into two general
categories: debt obligations and preferred stock.
– Debt obligations, which include:
• Bonds
• Mortgage-backed securities
• Asset-backed securities
• Bank loans

– Preferred stock
• Preferred stock represents an ownership interest in the
issuing organization by the stockholder.
• Fixed dividend payments from profits are made to preferred
stockholders.
 The Bond Indenture
• The bond indenture is a three party contract
between the bond issuer, the bondholder, and
the trustee.

• The promises of the issuer and the rights of the

bondholders are set forth in detail in the bond
indenture.

• The trustee is hired by the issuer to protect the

bondholders’ interests.
 Features of Bond Indentures
• The bond indenture includes:
– The basic terms of the bond issue
– The total amount of bonds issued
– A description of the security
– Repayment arrangements
– Call provisions
– Details of the affirmative and negative
covenants
 Description of Affirmative Bond
Covenants
• Affirmative covenants set forth what the
borrower has promised to do
– Common 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
– To not sell assets without notification to the
trustee and/or lender
 The Basic Features of a Bond
• Maturity – or term to maturity – is the number of
years the debt is outstanding or the number of
years remaining prior to the final principal
payments.

• 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
 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).
 The Basic Features of a Bond
• 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 equal to 100.
 Bond Pricing
• Bond prices are quoted as a percentage of par value, with par value equal
to 100.

• Here are examples of what the dollar price of a bond is, given the price
quoted for the bond in the market, and the par amount involved in the
transaction:

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 Terminology
• Bonds selling above par value are said to
be “trading at a premium.”

• Bonds selling below par value are “trading

at a discount.”

• At the maturity date, bond prices and par

values will be the same.
 The Basic Features of a Bond
• Coupon rate (nominal rate) is the interest rate the interest
rate that the issuer agrees to pay each year is called the
coupon rate; 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.

• The coupon is equal to the coupon rate times the par value.
(For example, 8% coupon rate and a par value of $1,000
will pay annual interest of $80).
 Coupon Rate Terminology
• When describing a bond, it is typical to state the
coupon and the maturity date. For example, the
expression “5s of 6/30/25” means a bond with a
5% coupon rate maturing on June 30, 2025.

– In the U.S., it is typically for the issuer to pay the

coupon 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.
 Various Coupon Rate Structures
• Zero-coupon bonds do not make periodic coupon payments;
the bondholder realizes interest at the maturity date equal to
the difference between the maturity 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 60, the interest
is 40).
Various Coupon Rate Structures
• Step-up notes are bonds that have a
coupon rate that increases over time.

• For instance, a 10 year bond might have a

3% coupon rate in year 1, a 3.5% rate in
year 2, a 4% rate in year 3, a 4.5% rate in
year 4, and a 5% rate thereafter.
 Example of Step-Up Note
• An example of an actual multiple step-up note is
a 5-year issue of the Student Loan Marketing
Association (Sallie Mae) issued in May 1994.
The coupon schedule is as follows:

6.05% from 5/3/1994 to 5/2/1995

6.50% from 5/3/1995 to 5/2/1996
7.00% from 5/3/1996 to 5/2/1997
7.75% from 5/3/1997 to 5/2/1998
8.50% from 5/3/1998 to 5/2/1999
 Various Coupon Rate Structures
• Deferred coupon bonds have no interest payments
during a specified period. At the end of the deferred
period, the issuer makes periodic interest payments
until the bond matures.

• 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.
 Definition of Floating Rate
Securities
• A floating-rate security is an issue whose
coupon rate resets periodically based on
some formula; the typical coupon formula
is some reference rate plus a quoted
margin.
 Floating Rate Security Basics
• 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.

• A cap is a disadvantage to the bondholder

while a floor is an advantage to the
bondholder.
Structure of Floating Rate Securities
• Coupons are not always fixed over the life of a
bond. Floating rate (variable rate) bonds have
coupons payments that are reset periodically
according to some reference rate.

• The typical formula (called the coupon formula)

on certain determination dates when the coupon
is reset is as follows:
Coupon rate = reference rate + quoted margin.
 Floating Rates
• The quoted margin is the additional amount that the issuer
agrees to pay above the reference rate.

• 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 the 1-month LIBOR plus 225
basis points, 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.
 Floating Rates
• It is not uncommon for floating rate notes to
have caps, which are maximum coupon rates.
– For instance, if a bond have a 6-month coupon
reset period, and was referenced to the prime rate,
and had a cap of 7%. If the prime rate rose to an
amount greater than 7% on the reset date, the
maximum rate paid would be 7%.
– This offers some interest rate protection for the
issuer and cap risk for the holder.
 Floating Rates
• 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.

 Inverse Floaters
• Usually the coupon formula for a floating rate bond moves in
the same direction as the reference rate; however, inverse or
reverse floaters move in the opposite direction.

• The coupon formula for an inverse floater is:

– Coupon rate equals K minus L times the 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.
• Reference rate could be the three-month Treasury bill rate, suppose it is
currently 2.5%.
– Suppose that on the reset date that the three-month Treasury bill is
4%, the coupon rate would be
10% - (2 X 4%) or 2%.
– Suppose that on the next reset date the three-month Treasury bill was
3%, the coupon rate of the floater would be:
10% - (2 X 3%) or 4%.
Accrued Interest, Full Price, and
Clean Price
• Accrued interest is the amount of interest accrued
since the last coupon payment; in the United States
(as well as in many countries), the bond buyer must
pay the bond seller the accrued interest.

• The full price (or dirty price) of a security is the

agreed upon price plus accrued interest; the price (or
clean price) is the agreed upon price without accrued
interest.
 Accrued Interest, Full Price, and
Clean Price
• Bond issuers do not pay coupon interest daily, instead it is
typically every six months.

• As a result, it is rare for a buyer to purchase or sell a bond on

the coupon payment date. When time has passed since the
last coupon payment was made, the bond seller typically
wants to be paid for the accrued interest.

• Accrued interest is the amount that was earned by the seller.

The amount paid by the buyer to the seller of the bond is the
agreed upon price plus accrued interest. This is called the full
price. It is also referred to as the dirty price.
Accrued Interest, Full Price, and
Clean Price
• The agreed upon price without accrued
interest is simply referred to as the price or
clean price.

• A bond in which the buyer must pay the seller

accrued interest is said to be trading “with
coupon.” If the buyer forgoes the next coupon
payment, it is said to be trading “without
coupon” or ex-coupon.
 The Provisions for Early
Retirement of Debt
• The issuer of the bond in the indenture states how the
principal will be returned to the bondholder.
– The issuer can agree to pay the entire amount in a lump
sum at the maturity date.
– This is know as a bond that has a bullet maturity. This is
the most common structure for U.S. corporate and
Treasury debt.

• Mortgage- and asset-backed bonds are usually

backed by pools of loans and typically have a
schedule of partial principal payments. These are
called amortizing bonds.
 The Provisions for Early
Retirement of Debt
• Another method is the sinking fund provision
which allows for full or partial amortization of
the bond prior to maturity.

– An amortizing security is a security for which

there is a schedule for the repayment of principal.
 The Provisions for Early
Retirement of Debt
• Another method is the sinking fund provision
which allows for full or partial amortization of
the bond prior to maturity.

• Other issues may have a call provision which

grants the issuer an option to retire all or part
of the issue prior to the stated maturity date.
– A call provision is an advantage to the issuer
and a disadvantage to the bondholder.
 Call and Refunding Provisions
(Early Retirement of Debt)
• Issuers want the right (option) to retire a bond prior to the
stated maturity date – especially if interest rates have fallen
since the issuance date.

• This right is an advantage to the issuing firm and a

disadvantage to the bondholder, who might have to reinvest at
a lower interest rate.

• The right to call or retire a bond early is know as the call

provision.
– When an issuer retires a bond prior to the stated maturity date it is said
that “the bond has been called.”
 Call and Refunding Provisions
(Early Retirement of Debt)
• 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.
 Call and Refunding Provisions
(Early Retirement of Debt)
• Bonds that can be called prior to maturity are
referred to as callable bonds.
– Callable bonds are more popular in the U.S. than
Europe.

• Call prices may provide a premium above the

market price or par value to bondholders.
– There are three options that could be specified in
the bond indenture regarding callable bonds:
• 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.
 Call and Refunding Provisions
(Early Retirement of Debt)
• 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.

• Call price based on a price specified in the call

schedule which typically declines through time until the
final maturity date.

• 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.
Chapter 3 has more details of this provision.
 Call and Refunding Provisions
(Make Whole Premium)

• 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.
 Noncallable versus Callable Bonds

• If a bond does not have any protection against early

call it is referred to as a currently callable issue.

• Most bonds have some restrictions against early

redemption.

• Commonly, a bond restriction might prevent the

refunding of a bond for a fixed number of years.
 Noncallable versus Callable Bonds
• There is a different between noncallable and nonrefundable
issues.
– Call protection is much more robust than refunding protection.

• Call protection provides greater assurance against premature

and unwanted early redemption than refunding protection.

• Refunding protection only prevents premature redemption

from certain financing sources, such as the proceeds of new
debt issues at a lower cost of money.
Difference Between Regular and
Special Redemption Pricing
• Regular or general call redemption pricing is normally set at
a premium price above par until the first call date.

• Special redemption pricing can be established for bonds

redeemed through sinking fund and other special
redemption conditions. The special redemption pricing is
usually at par value.

• The par call problem arises when the issuer maneuvers a

call so that the special redemption pricing applies rather
than the regular or general call redemption pricing.
 Prepayments
• For an amortizing security backed by a pool of
loans, the underlying borrowers typically have
the right to prepay the outstanding principal
balance in whole or in part prior to the
scheduled principal payment dates; this
provision is called a prepayment option.
 Prepayments
• 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 make prior to the regular payment date

is called a prepayment. The right of issuers and borrowers to
prepay principal is the prepayment option.

• The prepayment option is the same as a call option; however,

there is not a call price that depends on when the borrower
pays off the issue.

• This issue is discussed in later chapters that address asset- and

mortgage-backed securities.
 Sinking Funds
• A sinking fund provision requires that the
issuer retire a specified portion of an issue
each year.

• An accelerated sinking fund provision allows

the issuer to retire more than the amount
stipulated to satisfy the periodic sinking fund
requirement.
 Sinking Fund Provisions
• An indenture may require the issuer to retire a fixed portion
of the bond’s principal each year. This is call the sinking
fund requirement. The purpose of the provision is to reduce
credit risk.
– 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.

• Bonds with issuer options to retire more than the sinking

fund amount requirement are referred to as accelerated
sinking fund provisions.
 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.

• An exchangeable bond allows the investor the option to

exchange the bond for a fixed number of shares of common
stock of a company different from the issuer of the bond.
 Putable Bond

• A putable bond is one in which the

bondholder has the right to sell the issue back
to the issuer at a specified price on
designated dates.
 Put Provisions
• A put provision may be included in a bond’s indenture.

• This allows the bondholder 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 the bondholder 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.
 Currency Denomination
• The payments to a bondholder can be in any currency.

• Interest payments on U.S. bonds are in U.S. dollars.

• An issue in which bondholders are paid in U.S. dollars is

called a dollar denominated issue.

• It is sometimes possible for coupon payments to be made in

one currency while the principal in make in another. This is
called a dual currency issue.
 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.
Embedded Options Granted to Bondholders
• The most common embedded options are:
1. Conversion privilege
2. The right to put
3. Floor on a floater

• The first two options are exercised by the

bondholder based on the changes in interest rates in
the market. They will usually be applied when
interest rates rise above the coupon rate
substantially.

• The floor on a floater also depends on market

interest rates and will become more valuable to the
holder as interest rates drop.
 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.
 Methods Used by Institutional
Investors to Finance Purchases
• Purchasers of bonds can utilize borrowed
funds to enhance their returns by pledging the
securities as collateral.

• There are several collateralized borrowing

methods:
– Margin buying
– Repurchase agreements
 Margin Buying
• The funds borrowed to buy the bonds are provided by a broker
at the call money rate (or broker loan rate).

• The broker must lender within the limits of the Securities and
Exchange Act of 1934 which gives the Federal Reserve the
responsibility to set the margin requirements.

• Purchasers of bonds can utilize borrowed funds to enhance

their returns by pledging the securities as collateral.

• The amount has been reset at various times, but in

recent years, the Federal Reserve has instituted a 50%
margin requirement with a $2,000 minimum.
 Repurchase Agreements
• Typically, institutional investors in the bond market do not
finance the purchase of a security by buying on margin;
rather, they use repurchase agreements.

• A repurchase agreement is the sale of a security with a

commitment by the seller to repurchase the security from the
buyer at the repurchase price on the repurchase date.

• The borrowing rate for a repurchase agreement is called the

repo rate and while this rate is less than the cost of bank
borrowing, it varies from transaction to transaction based on
several factors.
 Repurchase Agreements
• A repurchase agreement is the sale of a security with the
commitment by the seller to buy the same security back from
the purchaser at a specified price at a designated future date.
– The difference between the repurchase price and the sale price is the
dollar interest cost of the loan.

• Based on the length of the repurchase agreement, an implied

interest rate can be computed – known as the repo rate.

• The advantage to the investor of this borrowing arrangement

is that the repo rate is typically less than the call money rate
(or broker loan rate).
– When the term of the loan is one day, it is referred to as an overnight
repo.
 Repurchase Agreements
• The most notorious hedge fund failure, Long Term
Capital Management, involved a variety of investment
strategies. The firm took relative value plays on the
interest rates on various bonds and swaps.

• In one instance they went short the 30-year bond and

long the 29-year bond in the expectation of profiting
from a fall in the spread between their yields.
– In order to execute this strategy they made extensive use of
leverage in the repurchase agreement or "repo" market by
financing about 99% of their purchase of the 29-year bond and
borrowing the 30-year bond in order to sell it short.
– Speculative hedge funds will go long in one interest rate
security (using a repurchase agreement to fund the purchase)
and short in another – which they only have to put up a margin.