CFA fixed income notes

7/18/2019 CFA fixed income notes

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A fixed income security is a financial obligation of an entity that promises to

pay a specified sum of money at specified future dates. The issuer of a fixed

income security is the entity that promises to make future payments. There arethree types of issuers:

Federal governments and agencies.

Municipal governments.

Corporations (domestic and foreign).

Fixed income securities fall into two categories:

Debt obligations: A borrower issues the security and the lender purchases

the security. The borrower makes interest and principal payments.

Preferred stock: An equity instrument that has features similar to bonds.

Holders of preferred stock receive dividends and have priority over common

shareholders in the hierarchy of claims.

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A bond’s indenture (also trust indenture) is a legal document issued to lenders

(investors) that defines the key terms of the lending agreement including the

coupon rate, the trustee, and covenants.

Affirmative covenants are actions that the issuer promises to carry out (e.g.

make interest and principal payments in a timely manner.)

Affirmative covenants may also require the issuer to maintain certain

liquidity ratios within a specified range.

Negative covenants impose restrictions on the issuer’s activities (e.g. limitations

on the issuer’s ability to issue additional debt and restrictions on the sale of

long-lived assets).

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Maturity: The term to maturity of a bond equals the number of years remaining

till the final principal payment. The term to maturity is important because:

It indicates the time span over which payments will be made by the issuer. The yield on a bond depends on its term to maturity.

The price volatility of a bond also depends on its term to maturity.

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Par value: This is the face value of the bond. It is the amount of money that the

bond issuer is obligated to pay bondholders at, or by the bond’s maturity date.

At any point in time, a bond can trade below, at, or above its par value. If a bond has a par value of $100 and is trading at $110 (above par), it is

said to be trading at a premium.

If the same bond is trading at $90 (below par), it is said to be trading at a

discount .

A bond’s price is usually quoted as a percentage of par. For example, a price

quote of 90 for a bond that has a par value of $3,000 means that the bond is

actually selling for $2,700.

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Coupon Rate (nominal rate): This is the rate at which the issuer promises to

make periodic interest payments to bondholders.

When describing a bond, the coupon rate is indicated along with the maturity

date.

The expression “8s of 10/5/2010” refers to a bond with a coupon rate of 8%

that expires on 10/5/2010.

The “s” after the coupon rate stands for “coupon series”.

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Floating-rate securities (variable-rate securities) offer coupon rates that are reset

periodically based on a specified reference rate.

For straight floaters, coupon rates rise as market interest rates rise. The coupon rate on these bonds is reset periodically (typically every 3

months) based on prevailing market interest rates.

The most common reference rate for floating rate bonds is LIBOR.

The effective coupon rate for any issuer is typically 90-day LIBOR

(LIBOR-90) plus a stated margin or spread (quoted margin) that is

specified in the bond indenture.

While 90-day LIBOR can vary from one period to the next, the quoted

margin usually remains fixed for the term of the bond.

Coupon Rate = Reference rate + Quoted margin

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Caps and Floors

A floating-rate security may have maximum and minimum coupon rate limits.

The maximum coupon rate that will be paid is called a cap and the minimum

rate is called a floor .

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Inflation-Adjusted Securities

These are securities that guarantee a return that exceeds the inflation rate if heldtill maturity.

Inflation-indexed Treasury securities were issued in the United States in

1997 and are known as TIPS (Treasury Inflation Protection Securities).

The reference rate is the rate of inflation as measured by the Consumer

Price Index for All Urban Consumers (CPI-U).

Investors in these securities earn a return equal to the increase in CPI over

the period plus a stated spread.

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Inverse Floaters

These are floating-rate securities whose coupon rates are inversely related toshort-term interest rates.

The effective coupon rate increases as the reference rate falls and vice

versa.

Investors in inverse floaters benefit when interest rates decline.

The periodic coupon rate on inverse floaters is calculated as:

o Coupon rate = K – L* (Reference rate)

K and L are usually specified in the bond indenture.

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Dual-Currency Bonds

A fixed income security that makes payments to investors in U.S. dollars is calleda dollar-denominated issue.

A dual-currency issue is a bond that makes coupon payments in one currency and

the principal repayment in another currency.

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If an investor purchases a bond between coupon payments, she must compensate

the seller for the unpaid coupon interest from the last coupon payment date to

the transaction date. This interest is called accrued (unpaid) interest. The investor will recover the accrued interest paid to the seller at the time

of purchase from the next coupon payment (she will receive the entire

amount of the coupon).

The full or dirty price of the bond is the agreed upon selling price plus any

accrued interest.

The clean price of the bond is the price without accrued interest. It is

basically the agreed upon selling price.

A bond for which the buyer must pay the seller accrued interest is said to

be trading cum coupon (with coupon).

A bond for which the buyer forgoes the next coupon payment is said to be

trading ex- coupon (without coupon).

If the issuer of the bond is in default (it has not made promised interest

payments),the bond is sold without accrued interest and is said to be trading

flat .

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Redemption and retirement provisions refer to how and when principal will be

repaid over the term, or at maturity of the bond.

A bullet maturity or bullet bond refers to a bond where the issuer repays the

entire par or face value of the bond in one lump sum payment at maturity.

An amortizing security is a bond where the issuer makes both principal and

interest payments over the term of the bond. The periodic payment includes an

interest component and a principal component.

A conventional mortgage is an example of an amortizing security.

A security with a prepayment option allows the borrower to make principal

repayments in excess of scheduled principal repayments.

The excess payment is known as a prepayment .

Mortgages contain a prepayment option that allows homeowners to repay

outstanding principal ahead of schedule.

This option is valuable to the borrower (issuer of the mortgage or the

homeowner).

Generally, homeowners prepay their mortgages when interest rates fall, and

finance the prepayment with another loan that bears the newer (lower)

interest rate.

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A call provision gives the issuer the right, but not the obligation, to retire all, or

part of an issue prior to maturity.

If the issuer exercises the call provision, it is said to have ‘called the bond’.

The price at which issuer calls the bond is known as the call price, and

bondholders have no choice but to surrender their bonds in exchange for the

call price.

An issuer will choose to exercise the option to call the bond when interest

rates fall (when the market value of the bond rises above the call price).

The issuer will retire the high-interest loan (call the bond) and finance the

call by issuing new bonds at the lower interest rates.

Usually, callable securities specify a certain period after issuance during

which they cannot be called, which is known as the period of call protection. Such an issue is said to have a deferred call .

When the issue is no longer protected against a call, it is known as a

currently callable issue.

A callable bond can have a single call price or different call prices

corresponding to different call dates. Typically, the call price is above par if the

bond is called on the first call date. The call price declines over time according

to a pre-specified schedule.

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A refunding occurs when a borrower replaces an issue that carries a

relatively high coupon with a new issue that has a lower coupon to save

interest costs. A redemption refers to the calling of bonds through a call or sinking fund

provision.

Nonrefundable bonds are bonds whose redemption via a call provision cannot

be financed with the proceeds of a lower coupon bond issue. These bonds are

therefore callable, but not refundable.

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A sinking fund provision requires the issuer to repay a certain portion of the loan

principal every year.

For example, a $10m issue with a 10 year term could require the repaymentof $2m every year starting from the sixth year after issuance.

A sinking fund reduces credit risk for bond investors as principal is

received over the bond’s term (as opposed to in a single bullet payment at

maturity).

An issuer can make sinking fund payments in two ways: By making a cash payment equal to the par value of the bonds to the

trustee.

By delivering to the trustee, bonds purchased in the open market that have

a total par value equal to the amount that must be retired.

If the required bonds are trading below par in the market, the second option is

the cheaper alternative. However, if the bonds are trading above par, it is more

cost-effective to pay the trustee in cash.

Some bond indentures also include provisions that allow the issuer to make

principal payments in excess of the amount required by the sinking fund

schedule.

For example, an issuer required to retire $2m of a loan every year might

have the option to retire up to $4m in any given year.

This feature is known as an accelerated sinking fund provision.

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Regular versus Special Redemptions

When bonds are redeemed under the call provisions of the bond indenture, it is

referred to as a regular redemption.

Regular redemption prices generally tend to be above par until the first par

call date.

Sometimes bonds are called with the proceeds of government-enforced sales of properties of the company or from the proceeds of forced sales of assets due to

deregulation. Such redemptions are known as special redemptions.

Under special redemptions, bonds can usually be called at par.

The par call problem occurs when issuers try to manipulate the call so that

special redemption rules apply. Special redemptions allow issuers to call bonds at

a lower price (par) than under regular redemptions (in which call prices usually

exceed par).

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An embedded option is an integral part of an instrument; it is not a separate

security. For example, a call option is embedded in a callable bond.

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Security Owner Options

When the embedded option is granted to the investor (owner) the security will

hold more value for the investor, so it will be priced higher (or will have a lower

coupon) than an otherwise identical bond that does not contain an embedded

option.

Conversion options grant investors the right to convert their bonds into

common stock of the issuing company at a pre-specified ratio. Bondholders

benefit from exercising the conversion option when the issuer’s stock price

rises above the conversion price.

Put provisions grant bondholders the right to sell back (or put) the bond to

the issuer at a specified price (usually par) prior to maturity. If market

interest rates rise above the issue’s coupon rate, the value of the bonds will

fall below par. In this scenario, bondholders will exercise the embedded put

option and redeem their bonds for par.

A floor on a floating-rate security effectively places a lower limit on the

coupon rate applicable on the bond. For example, if market interest rates

are at 7% and the floor on a floating-rate security is set at 9%, bondholders

will receive coupon at a rate of 9%, not 7%.

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Importance of Embedded Options

The price of a fixed income security is calculated by discounting its expectedfuture cash flows (interest and principal payments) at market interest rates.

However, for bonds with embedded options, it is difficult to project the amount

and timing of future cash flows as they are a function of the exercise of the

embedded options.

To value bonds with embedded options, it is important to model the factors thatdetermine whether the embedded option will be exercised. For options granted

to the issuer/borrower, it is also important to model the behavior of issuers to

determine the conditions necessary for them to exercise the embedded option.

The presence of embedded options makes it important to develop models to

forecast interest rate movements. Further, investors are also exposed to

modelling risk - the risk that the model used to value bonds with embedded

options provides an incorrect value for the price of the security due of the use of

inaccurate assumptions.

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CFA fixed income notes