Fixed Income (Debt)

Securities
Source: CFA IF Chapter 9
(Coverage of Ch 9 is MUST for students)

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Characteristics of Fixed Income
Securities
 Bonds are debt. Issuers are borrowers and holders are
creditors.
 The indenture is the contract between the issuer and the
bondholder. It gives the coupon rate, maturity date, and par
value.
 Face or par value is typically $1000; this is the principal repaid
at maturity.
 The coupon rate determines the interest payment.
 Interest is usually paid semiannually.
 The coupon rate can be zero.
 Interest payments are called “coupon payments”.

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Bond basics
 A bond is a debt security, issued by a company or a government body, that can be traded
in the secondary markets. One way to think about it is as a tradable “IOU”.
 Example. ABC Inc. owes the holder $1000 in 10 years’ time, with 6% coupon until then.
 Maturity
 Face/par value
 Coupon rate
 Coupon: $60 per year

 Insight: The par value is the principal that will be returned to investors (lenders) on the
maturity date.
 Typical par values are $1000 (dollars), €1000 (euros) or £100 (pounds).
 The coupon rate allows us to compute the interest payments – it is not the current
interest rate.

Source: CFA IF

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Bond features
 The bond’s maturity can range from one day to 100 years.
 A bond is a legal liability from the issuer (the borrower) to the investor (the
lender). The contract between the two parties is the indenture.
 Other features:
• Covenants: the indenture often contains restrictions on activities of the issuer
– these covenants help to protect the investors. For instance, covenants may
instruct the issuer to make timely payments or issue timely reports, or they
may limit the amount of other debt that can be raised.
• Collateral: assets, such as property, used to make a bond more secure. Bonds
with high quality collateral typically pay lower coupons than unsecured
bonds.

CFA IF

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Priority of payments

 If a company cannot make payment as scheduled, it may default. In the worst case,
the company may be liquidated to recover value for the lenders.
 Bonds are paid out by seniority ranking. There are many types of bond, all with
different priority levels, for instance as shown below. The maximum to be paid is
the principal plus any unpaid coupons, all of which is paid to one class of
bondholder before the next class receives any payments at all.
 Note that secured bondholders have low risk, as they can sell collateralised assets to
create value.
 Shareholders receive nothing on liquidation unless bondholders can be paid out in
full.
Secured → Senior Unsecured → Senior Subordinated →
Junior Subordinated → Shareholders
CFA IF

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Types of bonds
(1) Fixed-rate bonds
(2) Floating-rate bonds
(3) Zero-coupon bonds
(4) Callable bonds
(5) Other bonds
 Putable bonds

 Convertible bonds

 Inflation-linked bonds

 TIPS (Treasury inflation-protected securities) in the U.S.

 Index-linked gilts in the U.K.

 iBonds in Hong Kong.

(6) Treasury notes (T-notes) and bonds (T-bonds)

(7) Municipal bonds (Munis)
(8) Corporate bonds

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Types of bond: (1) fixed-rate bonds
 Bonds can be described in terms of issuer, market and coupon:
• Issuer: corporate bonds vs sovereign/government bonds (see below).
• Market: primary (new issue) vs secondary trading.
• Coupon: e.g. fixed-rate, floating-rate, zero.
 Typically we use the term notes for 1 to 10 year maturity, and bill for maturity under a year.

 Fixed-rate bonds

Although the value of the bond can vary with interest rates or credit rating (see later), the
monetary value of coupons and principal are fixed until the maturity date.
 Government bonds: some of these have specific names given to them. For instance:
• U.S. government bonds are known as Treasury securities;
• U.K. government bonds are called gilts;
• German government bonds are Bunds;
• French government bonds are OATs (obligations assimilables du Trésor).
Source: CFA IF

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Types of Bonds
 Fixed Rate Bonds:

 Example: Walt Disney Corporation raised

capital in August 2011 by using three
different fixed-rate bond issues.
(Pg. 216-217; Ch 9)

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 Types of bond: (2) floating-rate bonds
 A floating-rate bond, or variable-rate bond, is one in which the coupon changes each time.
 It is typically linked to a reference rate such as the London interbank offered rate, or Libor.

Floating rate = Reference rate + Spread

Example: a €1,000 semi-annual par bond pays Libor + 150 basis points.
1 basis point = 0.01%

 The 150 b.p. (or 1.50%) margin, the credit spread, provides for the additional risk of the
issuer. It does not change during the bond’s life, even if credit risk does.
 The coupon is set at the start of each payment period and paid at the end.

 Calculation

If Libor = 1.80% at the start, i.e. T0, then the first coupon (at T0.5) is:
Principal x interest rate x time = €1,000 x (1.80% + 1.50%) x 0.5 years = €16.50.

Source: CFA IF

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Floating Rate Bonds

Floating rate = Reference rate + Spread

Inflation-Linked Bonds

Example: Floating rate bond 217-218; CFA IF Ch;9

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 Types of bond: (3) zero-coupon bonds

 Zero-coupon bond is a bond that is identical in most aspects to a regular fixed-rate bond, except that the fixed
rate is 0%.
 Why buy the bond? Simple – the price is usually below the par value.
 Example: a 5-year $1,000 par zero-coupon bond is worth the present value of $1,000 payable in five years’
time.
PV = $1,000 ÷ (1 + r)5
 If interest rates remain stable then the value of the bond should gradually rise, until it hits par on the maturity
date.
 Hence the return to investors may be similar to other bonds, but is only realised on maturity, or when the
investor sells the bond.
 Note however that the bond’s price may change significantly if interest rates or the issuer’s creditworthiness
change (see later).
Source: CFA IF

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Types of bond: (4) Callable Bonds
 A callable bond provides an option to the issuer to redeem the bond (to call the bond)
before the stated maturity date.
 Generally the call price is higher than the par value – this gives some compensation to
the investors, who would otherwise not have wanted to sell the bond.
 Typically the call price falls over time towards par:

 for example – A company issues a 10-year £100 par bond, callable at £103 in 5 years,
£102 in 6 years, £101 in 7 years, and par in 8 years.
 If a company has issued a 6% callable bond, but it could now borrow at 4%, then it can
benefit from calling the 6% bond and issuing a new 4% bond, saving itself 2% interest
per year. Hence you should note that:
• The call feature is more likely to have an impact at low interest rates;
• The call feature benefits the issuer, not the investor, and therefore callable bonds typically
have higher coupon rates to compensate for the call risk.

Source: CFA IF

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Types of bond: (5) Puttable Bonds
 A putable bond provides the investor (not the issuer) with the right to redeem, or put,
the bond early. This gives investors protection against bond prices falling (when interest
rates rise – see later), and is therefore usually accompanied by a lower coupon rate.
 Most putable bonds have put price = par: the investor can redeem the bond at the par
value.
 Insight: Note that both callable and putable bonds have provisions for the bond to be
redeemed early. However, a callable bond provides that option to the issuer (hence the
coupon is usually higher, in compensation), while a putable bond gives the investor the
option (with lower coupon).
 A convertible bond allows the bondholder to exchange the bond for a pre-determined
number of the issuer’s shares. This is a hybrid instrument, which will trade like a straight
(non-convertible) bond if share prices are low, but like shares if share prices are high.
 Because the conversion feature benefits the bondholder, the coupon rate on a convertible
bond is lower than on an equivalent non-convertible bond.
Source: CFA IF

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Types of bond: (6) Convertible
Bonds
 A convertible bond is a hybrid security.
 A hybrid security has characteristics of and
relationships with both equity and debt
securities.
Bond can be converted into pre specified
numbers of common shares before bond’s
maturity

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Types of bond: (7) other bonds
 Most bonds are not inflation-proof. (What will £100 buy us in 20 years’ time?)
 Inflation-linked bonds provide this protection: if inflation one year is 3%, then the par
value of this bond will rise by 3%.
 Note that the coupon rate stays the same (usually pretty low), but is calculated on a larger
par value.
 Government-issued inflation-proof bonds include:
 TIPS (Treasury inflation-protected securities) in the U.S.

 Index-linked gilts in the U.K.

 iBonds in Hong Kong.

Source: CFA IF

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Securitization
 Securitization refers to the creation and
issuance of new debt securities, called asset-
backed securities, that are backed by a pool
of other debt securities.
 Mortgage-backed securities

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