Chapter 6

FIXED INCOME SECURITIES: FEATURES AND

TYPES
THE FIXED-INCOME MARKETPLACE

• Governments issue bonds when budget is in a deficits: Spending exceeds revenue

• Companies issue bonds (borrow) to

• To finance operations or growth
• To take advantage of financial leverage
• Leverage: when the cost of capital is lower than the return on capital e.g.(borrow
money at 6% and reinvest it in their operations and make 10%)

• Details of a bond issue are outlined in a trust deed or indenture (contract between issuer
(borrow) and buyer (lender)
• Indenture contains restrictive covenants to secure bond payments

• A bond is secured by physical assets.

• A debenture is secured by general creditworthiness of issuer; unlike bonds that have a

claim on specific assets, denture holders have a claim on residual assets
• In practice and this course, the term bond is used vs. denture
BASIC FEATURES OF A BOND

• Most Canadian bonds pay interest semi-annually or twice a year.

• E.g. bond with a 5% coupon rate pays 2.5% every six months.
• Coupon payments are based on the face, par value or maturity amount of the bond.
• Coupon payments on most bonds do not change as the market price changes

• E.g. Coupon and principal repayment of a “straight bond” (no special features) with a face
value of $1,000,000, coupon of 4%, issued on May 1 st, 2019 and matures on May 1st, 2021
1. May 1st 2019, issuing company would receive $1,000,000
2. Nov 1st 2019 issuing company would pay $20,000
3. May 1st 2020, issuing company would pay $20,000
4. Nov 1st 2020, issuing company would pay $20,000
5. May 1st 2021, issuing company would pay $1,020,000
BOND TERMINOLOGY

• Par Value – also called face value, this is the principal amount the bond issuer contracts to
pay at maturity; issued and matures at par value which is usually $1000

• Coupon rate (also referred to interest income, bond income or coupon income) –
determines the interest received by the buyer; based on par value; doesn’t fluctuate with
market price of the bond; usually fixed, but for bonds with special features, coupon can vary
based on a formula e.g. step-up bonds, floating rate bonds, etc.)

• Maturity date – date at which the bond matures, which is when the principal and the last
coupon payment is paid

• Term to maturity – time that remains before a bond matures; in calculations throughout this
chapter, the TTM is used, not the original term.

• Bond price – present discount value of all the future payments, or price you pay to earn
interest.

• Yield to maturity – annual return on the bond that is held to maturity; this the most
comprehensive measure on the return on bond to an investor
Bond Example

Source: CSC, Volume 1, Chapter 6

BOND FEATURES

• Interest payments can take the following forms:

• Coupon rates can change if bond has a special feature (e.g. step-up bonds; floating rate,
etc.)
• Interest can be compounded over time and paid at maturity (e.g. zero-coupon or strip
bonds;
• Interest may be nil; return based on a future factor (e.g. index-linked notes)
• Unless otherwise specified, assume fixed coupon paid semi-annually

• Denominations – bonds can be purchased only in specific denominations, usually $1,000

• Bond pricing – a bond trading below par (98) is trading at a discount while a bond trading
above par (104) is trading at a premium. “98” means 98% of the par value, while “104”
means 104% of the par value
TERM TO MATURITY (TTM)

• TTM is term remaining to maturity. Example, a bond issued 10 years with an original term of
15 years has a TTM of 5 years.
1. > 1 year TTM are Money Market instruments
2. Bonds 1 to 5 years TTM are short-term
3. Bonds with 5 to 10 years TTM are medium term
4. Bonds with > 10 years TTM are long-term

• Bonds that trade on the secondary market:

1. Liquid bonds: significant volumes and can be traded without making a
significant sacrifice in price (e.g. Government of Canada bonds); most other
bonds are not liquid (not an active secondary market)
2. Negotiable bonds: can be transferred/sold; electronic delivery
3. Marketable bonds: can be sold on a secondary market
Review Questions
An investor pays $950 to purchase a bond with a 5% coupon that will mature at $1000 in 4 years. The bond was
originally issued with a 7 year term.

1. What is the amount of each coupon payment?

A. $50
B. $25 (1,000 x .05) / 2
C. $47.50
D. $23.75

2. How many coupon payments will the investor receive if he holds the bond to maturity?

A. 5
B. 7
C. 8 term to maturity x 2 = 4 x 2 = 8
D. 14

3. Which of the following statements are correct?

I. The bond will produce lower coupon income over its term.
II. The bond will generate a capital gain if held to maturity.
III. The bond is priced at a discount to its par value.
IV. The bond will mature for less than its face value.

a. I & II
b. I & III
c. II & III
d. I & IV
 STRIP BONDS

• Strip bonds or zero coupon bonds: created when a dealer acquires a block of high-quality bonds and
separates the coupon payments and principal (bond residue), and sells each separately at a discount.
• The amount of discount determines the annualized rate of return the investor will enjoy; discount is very
deep
• Purchased by investors who do not need regular interest income, but do need a lump-sum at a feature date
(e.g. to pay for education)
• No interest is received; instead return is the difference between discounted purchase price and maturity
value; but, return is still taxed as interest yearly (best held in tax-deferred accounts, such as RRSPs)

Source: CSC, Volume 1, Chapter 6

BOND FEATURES
• Callable or redeemable: issuer has right (but not obligation) to call or redeem bond before stated
maturity. Usually done only if interest rates have decreased since the bond was issued, so that the
issuer can reissue bond or preferred shares at a lower rate
• Standard call features – the call price is usually set higher than the par value of the bond. Provincial
bonds are usually callable at 100 plus accrued interest. The period before the first possible call
date is the call protection period
• Creates reinvestment risk for investor: get principal back early that can only be reinvested at a
lower rates; due to this potential opportunity cost, callable bonds have higher coupons than
comparable straight bonds (comparable maturity and risk profile)

Source: CSC, Volume 1, Chapter 6

BOND FEATURES

• Extendible bonds: investor has option to extend maturity at the same or a slightly higher rate of
interest; extendible date is predetermined at issue; decision must be made during election period.

• Retractable bonds: investor has option to receive principal back prior to the stated maturity date;
retractable determined at issue; decision must be made during election period.

Source: CSC, Volume 1, Chapter 6

 CONVERTIBLE BONDS

Convertible bonds: investor has right (not obligation) to exchange bond for common shares of the
issuer; usually callable by the issuer

EXAMPLE:

• A $1,000 face value convertible bond pays 4% interest and is convertible into 50 common shares.
• The holder of the bond locks in a purchase or conversion price for the shares of $20 ($1000 / 50)
• At the time the bond is issued, the common share price is $15; therefore, the conversion privilege has no
value; the bond price would simply be determined by the coupon (which is lower than that on straight
bonds because an investor is willing to give up some interest for the benefit of the conversion privilege)
• Once the share price climbs about $20, a holder of the bond might consider conversion; at this point,
price of bonds determined by price of common rather than interest rates (selling off the common)
• Convertible shares are issued by companies to help reduce their borrowing costs.
• They are purchased by investors if the issuer has significant growth potential

Forced conversion: company can force the investor to convert the bonds into common shares, if the
share price is a higher than specific value
 SINKING FUNDS AND PURCHASE FUNDS

• Sinking funds and purchase funds: issuer repays portions of the bonds before maturity

• Sinking fund: money set aside to retire debt at stipulated prices; binding on the issuer; issuer must
set these funds aside; portions of bond redeemed at regular intervals (forced redemption)

• Purchase fund; funds set aside for repurchase only if bonds drop below specific price;
provides price support for the bonds; purchase funds generally retire less of an issue than a
sinking fund; portions of bond repurchased in the secondary market

Source: CSC, Volume 1, Chapter 6

 PROTECTIVE PROVISIONS

Common protective provisions (covenants) in a bond indentures to safeguard payment of interest and
repayment of principle:

1. Security: identifies the specific asset underlying the bond (e.g. mortgage bonds; asset-backed
or secured debt)

2. Negative pledge: borrower promises not to pledge any assets if the pledge results in less
security for the debt holder

3. Limitation on Sale and Leaseback; issuer cannot sell and lease back assets pledged to secure
the debt.

4. Sale of Assets or Merger: in the event of sale or merger, debt must be repaid or assumed by
the new entity.

5. Dividend Test: general limitation on dividends paid to shareholders to ensure sufficient funds
remain to repay debt (dividend payout ratio must remain below specified maximum)

6. Debt Test limits the amount of additional debt firm can issue (debt-to-asset ratio below
specified maximum)

7. Additional Bond Provisions; specifications regarding other financial tests to be fulfilled to permit
firm to issue more debt

8. Sinking or Purchase Fund and Call Provisions; dates/prices at which firm must call debt
Review Questions
1. ABC Ltd. 10-year bonds, due April 15, 20XX, include the 3. Which of the following bonds would most likely
following provision: "ABC must redeem a minimum of 5% provide the investor with the highest yield?
of the issue on April 15 each year." Which feature has ABC
included with this bond?
  a) Straight bond.
a. Sinking fund. b) Callable bond.
b. Callable. c) Retractable bond.
c. Retractable. d) Convertible bond.
d. Purchase fund.
Use the following information to answer questions 4
& 5:

2. What measure is used to determine if a bond is Assume you purchased a 3% convertible debenture
marketable? that is trading at 95. Each $1,000 face value is
convertible into 20 common shares. The dentures
a. Issuer’s credit quality . are callable. The current market price of the
b. Ease of transferability. common shares is $75 and interest rates have
c. Effect on price of large volume trades. climbed significantly since the debentures were
d. Active secondary market. issued.

4. What is the conversion price of the debenture?

a) $45.00.
b) $47.50.
c) $50.00. 1000 / 20 = $50
d) $55.00.

5. What likely effect has the increase in interest rates

had on the price of the debentures?

a. The price of debentures has declined.

b. The price of the dentures has increased.
c. The issuer is more likely to refinance its debt.
d. None because the bonds are trading off the
GOVERNMENT of CANADA SECURITIES

1. Marketable bonds – largest single issuer in Canadian marketplace; non-callable

2. Treasury bills – short-term government debt; sold at a discount and mature at par (difference is
interest earned); auctioned every two weeks by the Minister of Finance through the BofC; terms of
60 days, 90 days, 180 days up to 1 year.

3. Canada Savings Bonds (CSBs) and Canada Premium Bonds – not transferable, therefore have
no secondary market; redeemable by investor any time

4. Real return bonds – the coupon payments and principal repayment are adjusted for inflation to
provide a fixed real coupon rate.
• Example: Bond is issued at $1,000 with 4.25% coupon; after first 6 months, inflation is
1.5%; therefore, principal repayable at maturity is $1,015; coupon payment is now based on
inflation-adjusted price, not original par value ($1,015 x 0.425)
 PROVINCIAL AND MUNICIPAL SECURITIES

• Provincial bonds and those of its agencies (guaranteed by the province) very secure, after GOC
bonds; but risk varies based on province; issue marketable and non-marketable bonds; issued in
domestic or foreign markets

• Provincial savings bonds (non-marketable and non-transferrable) can only be purchased by

residents of the province at specific times; redeemable every six months

• Municipal (city) governments issue instalment debentures or serial bonds; portion of principal
repaid annually
• Example: A $1 million 10-year issue is repayable in installments of $100,000 each year ($1
million / 10)
CORPORATE BONDS
• Mortgages or mortgage bonds: secured by land, buildings or equipment; very secure
borrowings

• First mortgage bonds are the senior securities of a company; most secure because
have first right to property in existence when bond was issued; may also have right to
all future acquired property if it includes an “after-acquired” clause

• Floating-rate securities (variable rate) automatically adjust coupon payments up or down as

interest rates change at specific intervals; formula; longer terms than straight bonds
 DOMESTIC, FOREIGN AND EUROBONDS

• Domestic bonds: issued in the currency and country of the issuer.

• Foreign bonds: issued in a currency and country other than the issuer.

• Foreign pay bonds: issued in a currency other than the issuer’s currency, but sold in issuer’s country.

• Eurobonds: issued and sold outside issuer’s market; and denominated in a currency other than that of
the issuer’s domestic market

Issuer Issued in Currency of issue Called

Canadian Canada CAD Domestic bond

Canadian Mexico MXN Foreign bond
Canadian France USD Eurobond (Eurodollar)

Canadian European Market CAD Eurobond

(EuroCanadian)
Canadian United States USD Foreign (Yankee)
bond

Source: CSC, Volume 1, Chapter 6

OTHER TYPES OF CORPORATE DEBT

• Collateral trust bonds: secured by a pledge of securities (e.g. common shares); issued by
holding companies

• Equipment trust certificates: secured by real property (e.g issued by transportation

companies, secured by locomotives)

• Subordinated debentures: junior to other securities or other debts; highest risk/highest return
type of debt

• Corporate notes: unsecured promises to pay interest; junior to all other fixed-income debt of an
issuer; frequently used by finance companies; also known as secured note or collateral trust
note

• High-yield bonds: non-investment grade; high risk of default; high coupons or higher yields;
appeal to risk tolerant investors in low-interest rate environments; can be purchased via mutual
funds of ETFs to diversify risk by issuer
OTHER FIXED-INCOME SECURITIES

• Bankers’ Acceptance (Bas): issued by corporations to fund short-term borrowing needs (maturity less than a
year); guaranteed by a bank; sold at a discount and mature at par; marketable;

• Commercial Paper: unsecured promissory note issued by a corporation or an asset-backed security backed
by a pool of underlying financial assets; issued to fund short-term borrowing (<1 year); less secure than Bas;
bought at discount and mature at par

• NOTE: BA and CP, as well as T-bills are money market instruments (maturity <1 year); given the short term
to maturity, these instruments don’t make coupon payments; interest is earned by purchasing them at a
discount and receiving par value at maturity.

• Term Deposits: guaranteed rate for a short-term deposit (usually up to one year) with penalties for early
withdrawal (the first 30 days after purchase)

• Guaranteed Investment Certificates (GICs): usually pay fixed interest rate; investors can among a
variety of features:
1. Escalating rate: interest rate increases each year
2. Laddered: diversified by maturity date to reduce interest rate risk
3. Instalment GICs: investor makes regular contributions
4. Index-linked GICs: return linked to an underlying equity market such as the TSX or S&P 500
5. Interest-rate-linked GICs: returns linked to other interest rates, such as prime or money market rates
FIXED-INCOME MUTUAL FUNDS AND EXCHANGE-TRADED FUNDS

• These managed products provide investors with easy access to a diversified portfolio of debt

• These products are particularly attractive for investors who have a limited amount of money
to invest or who find investing in individual bonds too complex
 Review Questions

1. Sidney buys a $6000 GIC that is divided as 3. Which of the following represents the correct
follows: $2000 is invested for 1 year at 1%; order of risk from lowest to highest?
$2000 is invested for 3 years at 2% and $2000
is invested for 5 years at 3%. What type of GIC a. T-bills, BAs, Commercial paper
has Sidney purchased? b. Commercial paper, BAs, High-yield bonds.
c. GICs, T-bills, High-yield bonds.
a. Escalating rate d. T-bills, Commercial paper, BAs
b. Laddered
c. Instalment 4. All of the following statements are true with
d. Interest-rate linked respect to treasury bills except…

2. Presley purchased a $10,000 5-year GIC for a a. they pay interest every six months
fixed rate of 4.5%. In the second year, the rate b. the difference between the issue price and par
increased to 4.75% because the prime rate represents the return on investment.
increased. What type of GIC did Presley buy? c. they are short-term government obligations
offered in denominations of $1,000 to
a. Escalating rate $1,000,000.
b. Laddered d. they have maturity dates of less than 1 year
c. Instalment
d. Interest-rate linked 5. A speculator who anticipates an increase in
interest rates would most likely buy a
bond/debenture with which of the following features?

a. Real return
b. Mortgage-backed
c. Floating rate
d. High-yield bond
 READING A BOND QUOTE

Issue Coupon Maturity Bid Ask Yield

ABC 11.5% July 1/28 99.25 99.75 11.78%
Company

• The coupon rate of 11.5% is based on the par value of the bond

• On the maturity date, in the investor will receive his final coupon payment and the principal repayment
• Assuming that the investor purchased $1000 of the bond and held for the 6 month period prior to
maturity, he will receive ($1000 x .115) / 2 = $57.50 interest + $1000 principal repayment

• The “bid” price of 99.25 means that if an investor had $1,000 face value, they could sell the bond for
$992.50 plus accrued interest

• The “ask” price of 99.75 means that if an investor wanted to purchase $1,000 face value, they could
purchase it for $997.50 plus accrued interest

NOTE: On the CSC exam, questions regarding the purchase and sale price of bond may be based on
increments of $100, if no face value amount is specified. Hence, in the question, the bond can be
purchased for $100 x .9975 = $99.75 and sold for $100 x .9925 = $99.25

• Because the bond is trading at a discount, the yield is higher than the coupon; this means that interest
rates have likely gone up since the bond was issue, making the coupon of 11.5% less valuable, which is
reflected in the price of the bond trading below par
BOND RATING SERVICES
• In Canada, the DBRS, Moody’s Canada and Standard & Poor’s Bond Rating Service
provide independent ratings for debt securities which measures default or credit risk. The
following ratings categories are used by Moody’s:
Review Questions
Answer questions based on the bond quote 3. How much interest would an investor receive on
below the next coupon payment date if he buys $10,000
face value worth of the bond?
Issue Coupon Maturity Bid Ask
date a. $162.50 (10,000 x .0325) / 2
ABC 3.25% Jan. 1, 102.50 102.75 b. $325.00
Bond 2025 c. $333.13
d. $333.94
1. At what price can investor purchase the bond?

a. 102.50 4. What has most likely occurred since this bond

b. 102.60 was issued?
c. 102.75
d. 104.00 a. The rating has decreased from AA to C.
b. Interest rates have increased.
2. If an investor wanted to buy $10,000 face value of c. Interest rates have decreased.
the bond, how much would pay (ignore accrued d. The coupon rate has increased.
interest)?
5. If an investor purchases $10,000 par value of the
e. $10,000 bond and holds its until maturity, which of the
f. $10,250 following will occur?
g. $10,275 (10,000 x 1.0275)
h. $102,500 I. The bond will generate a capital loss.
II. The bond will generate a capital gain.
III. The bond will mature for less than its face value.
IV. The bond will mature at its face value.

a. I & III
b. I & IV
c. II & III
d. II & IV
Review Questions

1. Which bond should a risk-averse investor purchase if
he is concerned the economy is falling deeply into a
recession?
A. DEF bond with a Baa credit rating.
B. GHI bond with an A credit rating.
C. ABC bond with a C credit rating.
D. JKL bond with an Aa credit rating.
Use the following information to answer questions 3
& 4:
Albert bought a 7% $10,000 callable corporate bond due
on June 30, 2030. This bond is not redeemable before
June 30, 2025. After that date, it is redeemable according
to the following payment schedule on 30 days’ notice, up
to the 12 months ending June 30 of each year:
2026 at 105.21.
2027 at 103.85.
2028 at 100.85.

3. If the bond is called on August 30, 2027, how much will

Albert receive? (Ignore accrued interest)

a. $10,385.00 (10,000 x 1.0385)

b. $13,850.00
c. $10,000.00
d. $10,485.00

4. Identify the unique risk Albert incurred in

purchasing a callable bond

a. Default
b. Reinvestment
c. Maturity
d. None – he received his principal.