FIXED-INCOME INSTRUMENT FEATURES:

FIXED-INCOME INSTRUMENT FEATURES:

 Major types – loans, which are private agreement between borrower & lender & bonds,
which are standardized tradable securities representing a debt investment.
 Investor in bonds – lending capital to issuer of bond. Issuer promises to repay principal amt.
+ interest, typically in form of a regular periodic coupon that is stated as percentage of par.
Capital raise is used to finance long term investments. For issuer, loans & bonds are
classified as long term liabilities in B/S.
 Key features that are specified in a fixed-income security include the following:
 Issuer – Major issuers are govts & corporations. Other issuer – local govts, IMF, sponsored by
govts (national railways) & SPE – which are corporations set up to purchase financial assets
& asset backed securities, which are bond backed by CF from those assets.
 Maturity – Is the date of bond on which the final CF is to be paid. After bond has been
issued, time till maturity – called tenor of bond. Bond with tenor of one year or less – money
market securities. Bonds with tenor of more than one year – capital market securities. Bonds
with no stated maturity – perpetual bonds.
 Principal – Par or face value of bond – principal amt. that will be repaid. Repayment occurs
at maturity, but debt instruments may specify that principal is paid back gradually over life
of instrument, such as mortgage loan.
 Coupon rate & frequency – The coupon rate on a bond is annual percentage of par value to
be paid to bondholders. Some make coupon interest payments annually, semi-annual,
quarterly or monthly payments. A $1,000 par value semi-annual-pay bond with a fixed 5%
coupon would pay 2.5% of $1,000, or $25, every six months.
 Some bonds pay coupon on variable market rate of interest at date of coupon payment –
they are called floating rate notes. Variable interest here is called market reference rate, and
an FRN promises to pay the variable reference rate plus a fixed margin. This added margin is
typically expressed in basis points, which are hundredths of 1%.
 Bonds who pay no interest before maturity – called zero coupon bonds. Pure discount refers
to fact they are sold a discount to their par value, and interest in paid at maturity when
bondholders receive the par value. A 10-year, $1,000, zero-coupon bond yielding 7% would
sell for a bit more than $500 initially and pay $1,000 at maturity.
 Seniority – in event of bankruptcy or issues, debt investors have better ranks, making debt
senior to equity in capital structure of issuer. But senior debt ranks are higher than junior
debt, making senior debt a less risky investment from credit risk perspective.
 Contingency provisions – A bond may have an option – to convert into call or put option or o
convert into equity.
 Yield Measures:
 If bond price & expected CFs given, we can calculate expected return from investing in bond,
it’s called bond’s yield. For fixed coupon bond, when prices fall bond offers a higher yield &
when prices rise, the bond offers a lower yield. Prices & yields – inversely related.
 For a given issuer, we will likely find that bonds of different maturity will offer different
yields. A graphical plot of these yields versus maturity is referred to as a yield curve. An
example of yield curves for U.S. Treasury bonds is displayed in Figure 49.1.
 
 An upward-sloping yield curve (i.e., higher expected returns for longer-dated maturities), as
U.S Treasuries exhibited in mid-2018, is referred to as a normal yield curve because this is
the shape most frequently observed. A normal yield curve reflects investor demand for
higher returns for longer-dated maturities due to higher levels of uncertainty (i.e., risk) over
longer time frames. A downward-sloping yield curve, as U.S. Treasuries exhibited in mid-
2023, is less common and is referred to as an inverted yield curve
 Government bonds are often deemed to be of the lowest credit risk (highest credit quality)
in a particular market due to the fact the bonds are backed by the tax raising powers of the
government. A government bond yield curve is commonly used as a benchmark to assess
the extra returns (called spreads) offered by riskier issuers, such as corporations. For
example, if a 5-year corporate bond were yielding 6% and 5-year government bonds were
yielding 5%, then the spread offered by the corporate bond is 6% − 5% = 1%. We will discuss
credit spreads in more detail in later readings.

Describe the contents of a bond indenture and contrast affirmative and negative covenants:

 Legal contract between issuer & holder – bond indenture. It defines obligations, restrictions,
including sources of repayment, forms the basis for all future interactions between holder &
issuers.

Sources of Repayment:

 The source of the cash flows required to be paid by the bond issuer depends on the nature
of the issuer and type of bond issue. Sovereign (National govt bonds)– repaid from taxes & in
some cases ability to create new currency. This tends to result them as lowest credit risk in a
region.
 Local government bonds are repaid from local government taxes or revenue from
operational infrastructure, such as toll roads.
 For corporate bond – depends of bond issue type. Secured bond – repaid from operating CF
of company with added security of legal claim on specific asset also known as collateral in
event of default. Unsecured bond – no such claim, repaid only from operating CF.
 For an asset-backed security (ABS), financial assets held by the special purpose entity that
has issued the ABS provide the cash flows promised to the ABS investors.
 Bond Covenants:

While debt investments do not provide voting rights in the same way as an equity investment,
certain legal rules known as covenants can be written into the bond indenture

Affirmative covenants specify requirements the issuer must fulfil. They may require to provide
timely financial reports, specify the use of proceeds from the bond issue or specify right to
redeem at a premium to par if issuer is acquired in a merger or takeover.

Two e.g. of affirmative – cross default & pari passu. Cross default – states if issuer defaults on
any other debt obligation, the issuer will also be considered in default on this bond. Pari – bond
will have same priority of claims as issuer’s other senior debt issues.

Negative covenants place restrictions on the issuer. These can include restrictions on:

 entering into asset sales and leaseback agreements;

 pledges of collateral (the company cannot use the same assets to back several debt
issues simultaneously);
 issuance of debt that ranks more senior than existing debt (referred to as a negative
pledge clause); and
 additional borrowings, share repurchases, or dividend payments. These actions can be
subject to an incurrence test relating to the financial ratios of the company—for
example, they can only be carried out if debt/EBITDA is below a specified threshold.
 Negative covenants protect the interests of bondholders and prevent the issuing firm
from taking actions that would increase the risk of default. However, covenants must
not be so restrictive that they prevent the firm from taking advantage of opportunities
or responding appropriately to changing business circumstances

FIXED-INCOME CASH FLOWS AND TYPES:

FIXED-INCOME CASH FLOWS AND TYPES:

Bond – has bullet structure, where principal is paid back in single payment at maturity. Periodic
payments across life(coupon’s) are purely interest payments.

Consider a $1,000 par value 5-year bond with an annual coupon rate of 5%, issued at par. With a
bullet structure, the bond’s promised payments at the end of each year would be as follows

Loan structure in which periodic payments include both interest & some repayment of principal –
amortizing loan. If bond is fully amortizing this means principal is fully paid off when last period
payment is made. Automobile & home loans are fully amortizing. If the 5-year, 5% bond in the
previous table had a fully amortizing structure rather than a bullet structure, the payments and
remaining principal balance at each year-end would be as follows
Note that the constant yearly payment of $230.97, here, is partly interest and partly principal loan
repayment. For example, in the first year, the interest component is 0.05 × $1,000 = $50; hence, the
principal component is $230.97 − $50 = $180.97. The opening principal balance for the second year
is, therefore, $1,000 − $180.97 = $819.03. In subsequent years, the interest component of the
$230.97 will decrease and the proportion relating to principal repayment will increase.

A bond can be also partially amortizing, meaning there is a repayment of some principal at maturity
(also balloon payment). Unlike a bullet structure, final payment just includes remaining unamortized
principal rather than full principal amt. In the following table, the final payment includes $200 to
repay the remaining principal outstanding.

Other types of amortization schedules include sinking fund provisions for bonds and waterfall
structures for asset-backed securities (ABSs) and mortgage-backed securities (MBSs)

Sinking fund provisions – provide repayment of principal through a series of payments over life of a
bond issue. E.g. a 20-year issue with face amt. of 300 million may require that the bond trustee
redeems $20 million of the principal from investors selected at random every year beginning 6 th year

Advantage – have less credit risk because periodic redemptions reduce total amt. of principal to be
repaid at maturity. Disadvantage – when interest rates fall due to reinvestment risk, which is
possibility of receiving CF early & only being able to reinvest them at lower yield.

Waterfall structures – used to establish principal repayments to holders of ABS & MBS. Can be split
into tranches of varying seniority. A common waterfall structure is for junior tranches not to receive
any principal payment from the collateral pool until all senior tranches have been fully repaid.
Interest payments would still be made to all tranches.

Variable Interest Debt:

Some bonds pay periodic interest that depends on the prevailing market rate of interest at the time
future coupon payments are made. These bonds are called floating-rate notes (FRNs) or floaters. The
variable market rate of interest is called the market reference rate (MRR), and an FRN promises to
pay the MRR plus some fixed margin (called a credit spread). This added margin is typically
expressed in basis points, which are hundredths of 1%. A 120 basis point margin is equivalent to
1.2%

Most floaters pay quarterly coupons and are based on a quarterly (90-day) reference rate. As an
example, consider an FRN that pays a quarterly interest rate of MRR plus 0.75% (75 basis points). If
the annualized MRR in the current quarter is 2.3%, the bond will pay (2.3% + 0.75%)/4 = 0.7625% of
its par value at the end of the quarter

Other Coupon Structures

Step-up coupon bonds are structured so that the coupon rate increases over time according to a
predetermined schedule, providing protection to investors against interest rates rising over the life
of the bond

Coupon changes could also be linked to future potential events. For example, loans to borrowers of
lower credit quality (called leveraged loans) often have a coupon that increases if the credit quality
of the issuer decreases further. For example, the term sheet of a leveraged loan might specify that
the coupon to be paid is MRR + 2.5%; however, should the issuer’s debt/EBITDA ratio rise above 3,
then the coupon paid will increase to MRR + 3%. A similar provision is often included in a credit
linked note, whereby the coupon rate increases if the credit rating of the issuer deteriorates (or
decreases if the credit rating improves).

A payment-in-kind (PIK) bond allows the issuer to make the coupon payments by increasing the
principal amount of the outstanding bonds, essentially paying bond interest with more bonds. Firms
that issue PIK bonds typically do so because they anticipate that firm cash flows may be less than
required to service the debt, often because of high levels of debt financing (leverage). These bonds
typically have higher yields because of the lower perceived credit quality implied by expected cash
flow shortfalls, or simply because of the high leverage of the issuing firm.

More recently, green bonds have been issued whereby the coupon paid increases if certain
environmental goals (for example CO2 emissions reduction) are not met by the issuer over a
specified time frame.