CFA Preparation

Reading 42: Fixed Income Securities: Defining
Elements
Economics and Business School/Finance

& Accounting Specialization
Reading 42
Economics and Business School/Finance and Accounting Specialization

Reading 42

Reading 42

Reading 42
What is a bond/fixed Income Security/debt security?

What is a bond?
• It is a loan or debt.
• It does not entitle ownership rights (in contrast with equity/shares).
• Debt payments are a prior claim on the company’s earnings and assets
compared with the claim of common equity.
• Thus, in theory, lower risk than that company’s common shares.
• Interchangeably names are “fixed-income securities” and “debt securities”

What is a bond?

Reading 42
Issuer
Maturity date
Face value or par value
Coupon rate
Frequency
Currency

Reading 42
Basic Bond Features • Bond issuers can be classified based on their characteristics.
• Supranational organizations
• Sovereign (national) governments
• Nonsovereign (local) governments
• Quasi-government entities
• Companies or corporate issuers
 Bond issuers can also be classified based on their creditworthiness as judged

by credit rating agencies.
Borrower: Entity in need
 Bonds can broadly be categorized as investment-grade or non-investment-
of funds grade (or high-yield or speculative) bonds.

Reading 42
Basic Bond Features

• The maturity date of a bond refers to the date on which the issuer has
promised to repay the entire outstanding principal on the bond.
• Money market securities

• At the time of issuance are expected to mature in one year or less
• Commercial paper and certificates of deposits (CDs)
• Capital market securities

• At the time of issuance are expected to mature in more than one year
• Perpetual bonds
• No stated maturity
• Consols issued by the U.K. government

Reading 42
Basic Bond Features

• The par value of a bond refers to the principal amount that the
issuer promises to repay bondholders on the maturity date.
• Bond prices are usually quoted as a percentage of their par value.
• When a bond’s price is above 100% of par, it is said to be

trading at a premium.
• When a bond’s price is at 100% of par, it is said to be trading at

par.
• When a bond’s price is below 100% of par, it is said to be

trading at a discount.

Basic Bond Features
• The coupon rate of a bond refers to the annual interest rate that
the issuer promises to pay bondholders until the bond matures.
• The amount of interest paid each year by the issuer is known as

the coupon, and is calculated by multiplying the coupon rate by
the bond’s par value.
• Note that the bond indenture may call for coupon payments
annually, semiannually, quarterly, or monthly.
• Some bonds do not make any interest payments until maturity.

These zero-coupon bonds are issued at a discount to par value
and redeemed at par.

Basic Bond Features

Basic Bond
Features

Basic Bond
Features

Reading 42
Basic Bond Features

• Bonds are issued in many different currencies around the
world.
• Dual-currency bonds make coupon payments in one

currency and the principal payment at maturity in
another currency.
• Currency option bonds give bondholders a choice

regarding which of the two currencies they would like to
receive interest and principal payments in.

Basic Bond
Features
Find this
bond’s
features
PAPER or ELECTRONIC
https://www.youtub
e.com/watch?v=ajN
cYkzXCrs
Reading 42
Basic Bond
Features

Basic Bond
Features

Basic Bond
Features

Reading 42

Yield
Measures
The current yield or running yield equals the bond’s annual coupon amount
divided by its current price (not par value), expressed as a percentage.
Current yield The current year is analogous to the dividend yield for common share
Running yield Example: bond with a coupon rate of 6%, par value of $1,000, and Price of $1,010.
YTM
Yield to Redemption Current yield is 5.94% ($60/$1,010).
Redemption Yield
Yield
 Average annual rate of return that will be earned on a bond if it is bought now and
Measures held until maturity.
YTM
 Average means that for maturities longer than a year, the rate of return is constant.
It does not change from year to year.
GAIN or LOSS
Easy w/One year example

https://www.khanacademy.org/economics-finance-do
main/core-finance/stock-and-bonds/bonds-tutorial/v/
Price=$950 treasury-bond-prices-and-yields
Redemption=$1,000

Yield
One year example

Price=$950
Redemption=$1,000
YTM

Yield
One year example

Price=$950
Redemption=$1,000
YTM

Yield
One year example

Price=$950
Redemption=$1,000
Yield
YTM
Idea clear…..
How do we go about for longer maturities?
How do we go when there are intermediate cash flows?

Yield
Measures
Example 2: A two year zero coupon bond with price 98
YTM

Yield
Measures
Example 1: A two year zero coupon bond with price 98
YTM

Yield
YTM It does not change from year to year.

Example 3: A two bond with price 980 and a coupon rate of 3%. Redemption value $1,000

Use the function RENDTO, TASA o TIR
YTM with calculator
5 5 5 5 10 5
106.88= 1
+ 2
+ 3
+ 4
+ 5
( 1+(𝑌𝑇𝑀)) ( 1+(𝑌 𝑇𝑀 )) ( 1+(𝑌 𝑇𝑀)) ( 1+(𝑌 𝑇𝑀 )) ( 1+(𝑌 𝑇𝑀))
The yield of a multiple cash flow investment can only be calculated numerically, i.e. by
trial and error.
Called “yield to maturity” (YTM), return on investment, rate of return, discount rate,….
Re ad ing 4 4
n
n YTM i
More o
Yield
YTM
Calculation:IRR
Concept;
Definition

• The yield-to-maturity (YTM) is also known as the yield-to-redemption or
the redemption yield.
• It is calculated as the discount rate that equates the present value of a
bond’s expected future cash flows until maturity to its current price.
Yield
• Essentially, the YTM represents the internal rate of return on the bond’s
Measures
expected cash flows.
YTM • All else being equal, a bond’s yield-to-maturity is inversely related to its
price.
Yield 1300 Asset prices and asset returns (YTM) are inversely related
Measures
Bond Value
1200
YTM 1100
1000
800
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
YTM
Reading 42
i ng
e ad
sR
Cla s
o re
f
Be

Legal,
Regulatory, …
Legal,
Regulatory, …
Reading 42

Structure of a bond’s cash flows: Principal repayments structures
 Bullet bond: periodic fixed coupon payments + lump sum payment of face value at
maturity. Plan vanilla bonds.
 Amortizing bond: periodic coupon/interest payments+ periodic repayments of
principal (face value)
 Fully amortized: By maturity time, the outstanding principal is zero.
 With a balloon payment: By maturity time, the outstanding principal IS NOT zero.
Only a portion is repaid by maturity. Hence, at maturity a payment is required to
retired the outstanding principal amount.
Excel example
Structure of a bond’s cash flows: Principal repayments
 Bullet • A sinking fund arrangement requires the issuer to repay a specified

bond portion of the principal amount every year throughout the bond’s life
/Amortizing or after a specified date.
bond:
• Sometimes a call provision may also be added to the bond issue. This
 Sinking Fund
call provision usually gives the issuer the option to repurchase bonds
Arrangement
before maturity at the lowest of (1) market price, (2) par, or (3) a
specified sinking fund price.
 Bullet • From the bondholders’ perspective, the advantage of a sinking fund arrangement is
bond that it reduces credit risk (principal is received over the bond’s term as opposed to in
a bullet payment at maturity).
/Amortizing
• However, it entails two disadvantages.
bond:
• First, it results in reinvestment risk, i.e., the risk that investors will have to reinvest
 Sinking Fund
the redeemed principal at an interest rate lower than the current yield to maturity.
Arrangement
• Second, if the issue has an embedded call option, the issuer may be able to
repurchase bonds at a price lower than the current market price, resulting in
bondholders losing out.
 Sinking Fund Arrangement:

Reading 42

Reading 42
Bullet and amortized

bonds are fixed-
coupon bonds:
coupon rate is
constant for the
whole life of a bond

 Coupon payment structures
 Fixed Coupon Rate Bonds

 Floating-Rate Notes
 Step-Up Coupon Bonds
 Credit-Linked Coupon Bonds
 Payment-in-Kind Coupon Bonds

 Fixed Coupon Rate Bonds: fixed periodic coupons. Paid semiannually in the US, the United Kingdom
and countries of Commonwealth (India, New Zeland, …). Bonds issued in the Eurozone usually pay
coupons annually.
 Governments usually issue fixed coupon rate bonds.
Structure of a bond’s cash flows



 Floating-Rate Notes:
 Coupons are not fixed but rather linked to an external reference rate (Example: Euribor rate).
 Coupons fluctuate periodically during the bond’s life and are usually paid quarterly.
 FRN’s cash flows are not known with certainty.
 Issuers are usually government-sponsored enterprises (ex: Federal National Mortgage Association – Fannie
Mae.
 Almost all FRNs have quarterly coupons
 FRNs usually pay a fixed spread over the specified reference rate. Example: three-month Euribor + 20 bps
(i.e., Euribor + 0.20%). If the reference rate increases so does the coupon rate.
 FRNs have little interest rate risk. (i.e., the risk that a change in market interest rate affects a bond’s value).
Reason: coupon fluctuates with interest rate.
 Inverse or reverse FRN (floater)

 Coupon rate has an inverse relationship to the reference rate.
 The basic structure is the same as an ordinary FRN except for the direction in which
the coupon rate is adjusted.
 When interest rates fall, the coupon rate on an ordinary FRN decreases; in contrast,
the coupon rate on a reverse FRN increases. Thus, inverse FRNs are typically favored
by investors who expect interest rates to decline.

 Set-up coupon bonds:

 SCBs May be fixed or floating coupon bonds.
 The coupon increases by specified margins at specified dates.
 Example: ten-year callable bond issued by the Federal Home Loan Bank on 3 August 2016. The initial
coupon rate was 1.25% and steps up to 1.50% on 3 August 2018, to 2.00% on 3 August 2020, etc.
 SCBs offer some protection against rising interest rates.
 May be an important features for callable bonds (to be discussed later).


 Credit-linked coupon bonds:
 Coupons change when the bond’s credit rating changes. Example: one of British Telecom’s bonds maturing
in 2030. It has a coupon rate of 9%, but the coupon will increase by 50 bps for every credit rating
downgrade below the bond’s credit rating at the time of issuance and will decrease by 50 bps for every
credit rating upgrade above the bond’s credit rating at the time of issuance.
 Attractive to investors who are concerned about the future creditworthiness of the issuer.
 Provide some general protection against a poor economy because credit ratings tend to decline the most
during recessions.
 A potential problem associated is that increases in the coupon payments resulting from a downgrade may
ultimately result in further deteriorations of the credit rating or even contribute to the issuer’s default.

 Payment-in-Kind Coupon Bonds (PIK):
 PIKs allow issuer to pay interest in the form of additional bonds rather than cash payment.
 Favored by investors concerned about issuer’s potential future cash problems.
 Investors aware of the potential higher credit risk (i.e., issuer’s probability of default) usually demand a higher yield.
 Other forms: pay common shares instead of cash payment.
Any possible form (payment in cash or payment in kind)

MUST be identified in the indenture
The bondholder is willing to receive lower coupons if the
percentage of the issue dedicated to social purposes is higher than
XX%
Deferred coupon bonds (split coupon bond): pays no coupons for its first few years but then pays a higher coupon than
it otherwise normally would for the remainder of its life. A zero-coupon bond can be thought of as an extreme form of
deferred coupon bond.
Index-linked bond: coupon payments and/or principal repayment linked to a specified index. The index could any
published variable, including an index reflecting prices, earnings, economic output, commodities, or foreign currencies.
Example: Inflation-linked bonds. They offer investors protection against inflation by linking a bond’s coupon payments
and/or the principal repayment to an index of consumer prices such as the UK Retail Price Index (RPI) or the US
Consumer Price Index (CPI). The advantage of using the RPI or CPI is that these indexes are well-known, transparent,
and published regularly.
Index-linked bond
Inflation-linked bonds
They offer investors protection against inflation by linking a bond’s coupon payments and/or the principal
repayment to an index of consumer prices such as the UK Retail Price Index (RPI) or the US Consumer Price Index
(CPI). The advantage of using the RPI or CPI is that these indexes are well-known, transparent, and published
regularly.

Structure of a bond’s cash
flows
Reading 42

Bonds with contingency provisions
A contingency provision allows for some action, given the occurrence of

a specified event in the future. Common contingency provisions found in
a bond’s indenture come under the heading of embedded options.
Bonds with contingency provisions
 A contingency refers to some future event or circumstance that is possible but not certain.
 A contingency provision is a clause in a legal document that allows for some action if the event or
circumstance does occur.
 These contingency provisions provide the issuer or the bondholders the right, but not the obligation, to take
some action.
 These rights are called “options.” These options are not independent of the bond and cannot be traded
separately—hence the term “embedded.”
Bonds with contingency provisions: Types
 Callable bonds
 Puttable bonds
 Convertible bonds
 callable bonds
• Callable bonds give the issuer the right to redeem (or call) all or part of the bond before maturity.
• This embedded option offers the issuer the ability to take advantage of
1. a decline in market interest rates and/or
2. an improvement in its creditworthiness.
• Callable bonds expose investors to a higher level of reinvestment risk than noncallable bonds. If
bonds are called, bondholders would have to reinvest proceeds at the new (lower) interest rates.
 callable bonds (Cont.)
• From the perspective of the bondholder, she would pay less for a callable bond than for an
otherwise identical noncallable bond.
• Value of embedded call option = Value of noncallable bond – Value of callable bond
• From the perspective of the issuer, it would have to pay more (in the form of a higher
coupon or higher yield) to get investors to purchase a callable bond than an otherwise
identical noncallable bond.
• Embedded call option cost in terms of yield = Yield on callable bond – Yield on
noncallable bond
• Example 1: Callable bonds
• A hypothetical $1,000 par 20-year bond is issued on January 21, 2013, at a price of 98.515. The issuer can call the
bond in whole or in part every January 21 from 2019. Call prices at different call dates are listed below:
1. What is the length of the call protection period?

2. What is the call premium (per bond) for the 2022 call date?
• Solution:
1. The bonds were issued in 2013 and are first callable in 2019. Therefore, the call
protection period is 2019 – 2013 = 6 years.
2. Call prices are stated as a percentage of par, so the call price in 2026 is $1,010.95 (=
101.095% × $1,000). The call premium is the amount paid above par by the issuer.
Therefore, the call premium in 2022 is $10.95 (= $1,010.95 – $1,000).
 Putable bonds
• Putable bonds give bondholders the right to sell (or put) the bond back to the issuer at a
predetermined price on specified dates.
• The embedded put option offers bondholders protection against an increase in interest
rates; i.e., if interest rates increase (decreasing the value of the bond), they can sell the
bond back to the issuer at a prespecified price and then reinvest the principal at (higher)
newer interest rates.
 Putable bonds (Cont.)
• From the perspective of the bondholder, she would pay more for a putable bond than for
an otherwise identical nonputable bond.
• Value of embedded put option
• = Value of putable bond – Value of nonputable bond
• From the perspective of the issuer, it would pay out less (in the form of a lower coupon or
lower yield) on a putable bond than it would on an otherwise identical nonputable bond.
• Embedded put option cost in terms of yield
• = Yield on nonputable bond – Yield on putable bond
 Convertible bonds
 A convertible bond is a hybrid security with both debt and equity features.
 It gives the bondholder the right to exchange the bond for a specified number of common shares in the issuing
company.
 Thus, a convertible bond can be viewed as the combination of a straight bond (option- free bond) plus an
embedded equity call option.
 The price of a convertible bond is higher than the price of an otherwise similar bond without the conversion
provision.
 The yield on a convertible bond is lower than the yield on an otherwise similar non- convertible bond.
 Advantages for issuers: (1) offer below- market coupon rates because of investors’ attraction to the conversion
feature. (2) elimination of debt if the conversion option is exercised.

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Reading 42: Fixed Income Securities: Defining

Economics and Business School/Finance

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

What is a bond/fixed Income Security/debt security?

Economics and Business School/Finance and Accounting Specialization

• It does not entitle ownership rights (in contrast with equity/shares).

compared with the claim of common equity.

• Thus, in theory, lower risk than that company’s common shares.

• Interchangeably names are “fixed-income securities” and “debt securities”

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

• Sovereign (national) governments

• Nonsovereign (local) governments

• Companies or corporate issuers

 Bond issuers can also be classified based on their creditworthiness as judged

Economics and Business School/Finance and Accounting Specialization

Basic Bond Features

• Money market securities

• Capital market securities

Economics and Business School/Finance and Accounting Specialization

Basic Bond Features

• Bond prices are usually quoted as a percentage of their par value.

• When a bond’s price is above 100% of par, it is said to be

• When a bond’s price is at 100% of par, it is said to be trading at

• When a bond’s price is below 100% of par, it is said to be

Economics and Business School/Finance and Accounting Specialization

• The amount of interest paid each year by the issuer is known as

• Some bonds do not make any interest payments until maturity.

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Basic Bond Features

• Dual-currency bonds make coupon payments in one

• Currency option bonds give bondholders a choice

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Easy w/One year example

Economics and Business School/Finance and Accounting Specialization

One year example

Economics and Business School/Finance and Accounting Specialization

One year example

Economics and Business School/Finance and Accounting Specialization

One year example

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

How do we go when there are intermediate cash flows?

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

Economics and Business School/Finance and Accounting Specialization

 Bullet • A sinking fund arrangement requires the issuer to repay a specified

 Sinking Fund Arrangement:

Economics and Business School/Finance and Accounting Specialization

Bullet and amortized