CFA® Level I – Fixed Income

Fixed Income Securities: Defining Elements

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 Contents and Introduction
1. Introduction
Fixed-income securities,
2. Overview of a Fixed-Income Security bonds, debt securities
3. Legal, Regulatory and Tax Considerations
Most prevalent method
4. Structure of a Bond’s Cash Flows of raising capital

5. Bonds with Contingency Provisions Diversification benefit

6. Conclusion and Summary

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 2. Overview of a Fixed-Income Security

Three important elements that an investor needs to know:

1. Bond’s features

2. Legal, regulatory, and tax considerations

3. Contingency provisions

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 2.1 Basic Features of a Bond

• Issuer

• Maturity

• Par Value

• Coupon Rate and Frequency

• Currency Denomination

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 Example 1
1. An example of sovereign bond is a bond issued by:

2. The risk of loss resulting from the issuer failing to make full and timely payment of interest
is called:

3. A money market security most likely matures in:

4. If the bond’s price is higher than its par value, the bond is trading at:

5. A bond has a par value of £100 and a coupon rate of 5%. Coupon payments are made semi-
annually. The periodic interest payment is:

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 Example 1 (Cont…)
6. The coupon rate of a floating-rate note that makes payments in June and December is expressed
as six-month Libor + 25 bps. Assuming that the six-month Libor is 3.00% at the end of June 20XX
and 3.50% at the end of December 20XX, the interest rate that applies to the payment due in
December 20XX is:

7. The type of bond that allows bondholders to choose the currency in which they receive each
interest payment and principal repayment is a:

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 2.2 Yield Measures
• Current yield or running yield

• Yield to maturity
▪
Yield to redemption
▪
Redemption yield

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 3. Legal, Regulatory and Tax Considerations
A bond is a contractual agreement between the issuer and the bondholders.

1. Bond Indenture (trust deed)

2. Legal and Regulatory Considerations
3. Tax Considerations

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 3.1 Bond Indenture

• Legal identity of the bond issuer and its legal form

• Source of repayment proceeds

• Asset or collateral backing (if any)

• Credit enhancements (if any)

• Covenants (if any)

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 Covenants
Bond covenants are legally enforceable rules that borrowers and lenders agree
on at the time of a new bond issue. Covenants can be affirmative or negative.

Affirmative covenants indicate what the issuer Negative covenants indicate what issuer must
must do. These are generally administrative. NOT do. These are frequently more costly and
For example, issuer will: materially constrain the issuer’s potential
• Make payments on time business decisions. Examples include:
• Comply with all laws and regulations • Restrictions on debt
• Maintain current lines of business • Negative pledges
• Insure and maintain assets • Restrictions on prior claims
• Pay taxes on time • Restrictions on distributions to shareholders
• Restrictions on asset disposals
• Restrictions on investments
• Restrictions on mergers and acquisitions

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Example 2

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Example 2 (Cont…)

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Example 2 (Cont…)

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 3.2 Legal and Regulatory Considerations
Fixed-income securities are subject to different legal and regulatory
requirements depending on where they are issued and traded

• National bond market

▪
Domestic bonds
▪
Foreign bonds
Bonds are also characterized by:
1. Frequency of coupon
• Eurobond market payments
▪ 2. How interest is calculated
Less regulated than national bonds
3. Currency
• Bearer bonds versus registered bonds

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Example 3

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 3.3 Tax Considerations

• Income portion of a bond investment is generally taxed at the ordinary income

tax rate

• Capital gain tax might be different for long-term and short-term investments

• In some countries, prorated portion of discount may be included in interest income

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 Exhibit 3 – Original Issue Discount Tax Provision
Assume a hypothetical country, Zinland, where the local currency is the zini (Z). The market
interest rate in Zinland is 10%, and both interest income and capital gains are taxed. Companies A
and B issue 20-year bonds with a par value of Z1,000. Company A issues a coupon bond with an
annual coupon rate of 10%. Investors buy Company A’s bonds for Z1,000. Every year, they receive
and pay tax on their Z100 annual interest payments. When Company A’s bonds mature,
bondholders receive the par value of Z1,000. Company B issues a zero-coupon bond at a discount.
Investors buy Company B’s bonds for Z148.64. They do not receive any cash flows until
Company B pays the par value of Z1,000 when the bonds mature. Company A’s bonds and
Company B’s bonds are economically identical in the sense that they have the same maturity (20
years) and the same yield to maturity (10%). Company A’s bonds make periodic payments,
however, whereas Company B’s bonds defer payment until maturity. Investors in Company A’s
bonds must include the annual interest payments in taxable income. When they receive their
original Z1,000 investment back at maturity, they face no capital gain or loss. Without an original
issue discount tax provision, investors in Company B’s bonds do not have any taxable income until
the bonds mature. When they receive the par value at maturity, they face a capital gain on the
original issue discount—that is, on Z851.36 (Z1,000 – Z148.64). The purpose of an original issue
discount tax provision is to tax investors in Company B’s bonds the same way as investors in
Company A’s bonds. Thus, a prorated portion of the Z851.36 original issue discount is included in
taxable income every tax year until maturity. This allows investors in Company B’s bonds to
increase their cost basis in the bonds so that at maturity, they face no capital gain or loss.

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Example 4

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 4. Structure of a Bond’s Cash Flows

• Payment structure for plain vanilla bond

• Payment schedules are similar for a particular type of bond

• Payment schedules vary between types of bonds

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 4.1 Principal Repayment Structures

Bullet Bond

Fully Amortized Bond

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 Principal Repayment Structures (Cont…)

Partially Amortized
Bond

Balloon Payment

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Example 5

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 Sinking Fund Arrangement and Callable Bonds

Sinking fund arrangement specifies the portion of the bond’s principal

outstanding that must be repaid each year throughout the bond’s life
• Reduced credit risk for investors
• Higher reinvestment risk

Call provision gives issuer the option to repurchase the bond before maturity

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 4.2 Coupon Payment Structures
• Fixed periodic coupon
• Floating rate notes (FRN)
▪
Relative low interest rate impact
▪
May include a floor or cap
▪
Inverse FRN

• Step-up coupon bonds

• Credit-linked coupon bonds
• Payment-in-kind coupon bonds
• Deferred coupon bonds
• Index-linked bonds
▪
TIPS

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 Exhibit 7 – Examples of Inflation-Linked Bonds
Assume a hypothetical country, Lemuria, where the currency is the lemming (L). The country issued 20-year
bonds linked to the domestic Consumer Price Index (CPI). The bonds have a par value of L1,000. Lemuria’s
economy has been free of inflation until the most recent six months, when the CPI increased by 5%. Suppose
that the bonds are zero-coupon-indexed bonds. There will never be any coupon payments. Following the 5%
increase in the CPI, the principal amount to be repaid increases to L1,050 [L1,000 × (1 + 0.05)] and will continue
increasing in line with inflation until maturity. Now, suppose that the bonds are coupon bonds that make semi-
annual interest payments based on an annual coupon rate of 4%. If the bonds are interest- indexed bonds, the
principal amount at maturity will remain L1,000 regardless of the CPI level during the bond’s life and at maturity.
The coupon payments, however, will be adjusted for inflation. Prior to the increase in inflation, the semi-annual
coupon payment was L20 [(0.04 × L1,000) ÷ 2]. Following the 5% increase in the CPI, the semi-annual coupon
payment increases to L21 [L20 × (1 + 0.05)]. Future coupon payments will also be adjusted for inflation. If the
bonds are capital-indexed bonds, the annual coupon rate remains 4%, but the principal amount is adjusted for
inflation and the coupon payment is based on the inflation-adjusted principal amount. Following the 5% increase
in the CPI, the inflation-adjusted principal amount increases to L1,050 [L1,000 × (1 + 0.05)], and the new semi-
annual coupon payment is L21 [(0.04 × L1,050) ÷ 2]. The principal amount will continue increasing in line with
increases in the CPI until maturity, and so will the coupon payments. If the bonds are indexed-annuity bonds, they
are fully amortized. Prior to the increase in inflation, the semi-annual payment was L36.56—the annuity payment
based on a principal amount of L1,000 paid back in 40 semi-annual payments with an annual discount rate of 4%.
Following the 5% increase in the CPI, the annuity payment increases to L38.38 [L36.56 × (1 + 0.05)]. Future annuity
payments will also be adjusted for inflation in a similar manner.

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Example 6

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Example 6 (Cont…)

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 5. Bonds with Contingency Provisions

A contingency provision is a clause in a legal document that allows for some action
if the event or circumstance does occur. It is also called an embedded option.

Bonds with contingency provisions:

• Callable bonds
• Putable bonds
• Convertible bonds

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 5.1 Callable Bonds
A callable bond gives the issuer the right to redeem all or part of the bond before
the specified maturity date.

• Beneficial to the issuer because it protects against a decline in interest rates

▪
Lower market rates
▪
Better credit quality

• Callable bonds offer a higher yield and sell at lower price relative to
otherwise similar non-callable bonds

• Details, such as the call schedule, are specified in the bond indenture

• Callable bonds come in different styles: American, European and Bermuda

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Example 7

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 5.2 Putable Bonds
A putable bond gives the bondholder the right to sell the bond back to the issuer at
a pre-determined price on specified dates

• Beneficial to the bondholder

▪
Pre-specified selling price is helpful if interest rates rise
▪
Cash can be reinvested at higher rates

• Putable bonds offer a lower yield and sell at a higher price relative to
otherwise similar non-putable bonds

• Details, such as redemption dates and prices, are specified in the bond indenture

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 5.3 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.

Beneficial to the bondholder Advantages to issuer

• Ability to participate in equity upside • Reduced interest expense
• Downside protection • Elimination of debt if conversion option is exercised

Key terms
• Conversion price A warrant is an attached option,
• Conversion ratio not an embedded option
• Conversion value

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Example 8

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Example 8 (Cont…)

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