Fixed income securities primer

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Fixed Income Securities - I

Key Issues in Features of Debt Securities

• Bond‘s Indenture
• Basic features of a Bond
• Definitions
• Redemption and Retirement of Bonds
• Embedded Options
• Institutional Investors

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Bond‘s Indenture

• A bond‘s Indenture is the document which specifies the rights and obligations of both the issuer and the
buyer of the bond.
– It contains Affirmative Covenents wich requires the borrower to affirm to certain actions like maintaining
minimum financila ratios etc.
– It also contains Negative Covenants which prevent the borrower from doing certain things like raising additional
amount of debt, pledging the same assets, etc.

Basic Features of a Bond
• Bonds can be issued in the domestic or foreign currency.
• Bonds make annual or semi-annual payment of interest.
• Bonds that donot pay interest during their tenure are called Zero-coupon bonds.
• Step-up notes are bonds for which the coupon rate increases one or more times during their tenure.
• Deferred-coupon bonds are bonds for which the initial coupon payments are deferred for a certain period.
• Floating-rate securities bonds whose coupon is linked to some benchmark reference rate like the LIBOR
rate. Varities: Inverse Floaters and Inflation-indexed bonds.
• Caps is the maximum interest that will be paid by the borrower.
• Floor is the minimum interest that will be received by the lender.
• Combination of both is called a Collar.


Definitions

• Accrued interest is the interest accrued on a bond from the last coupon date and the date of sale of the
bond.
• Full Price is the total amount paid by the buyer to the seller for the bond.
• Clean price is the full price less the accrued interest.

Redemption and Retirement of Bonds
• Non amortizing securities pay only interest during the tenure of the bond and the entire principal is repaid
on the maturity of the bond.
• Amortizing securities repay both the the interest and the pricipal amount over the tenure of the bond.
• Prepayment option allows the borrower to repay the principal before the due date.
• Call option on a bond is similar to a prepayment option and allows the borrower to “call“ repay the entire
or part of the bond outstanding.
• Nonrefundable bonds prohibit the issuer from redeeming a bond by issuing fresh bonds at a lower coupon
rate.
• Sinking Fund provisions require the issuer to repay the principal amount over the life of the bond through
regular payments.
• Accelerated Sinkind Fund Provision allows the Issuer to repay an amount more than that stipulated by the
Sinking Fund provisions


Embedded Options

• Options favourable to the Bondholder:
– Put Provisions: grant the bondholder the right to demand repayment of the amount before the maturity date at
a fixed price.
– Floor: sets the minimum amount of interest that will be paid to the bondholder for a floating rate bond.
– Conversion Option: grants the bondholder to convert the bond into a fixed number of shares of the issuer.

• Options favourable to the Issuer:
– Call Provisions: grant the Issuer the right to redeem the bond before the maturity date at a fixed price.
– Cap: sets the maximum amount of interest that will be paid to the bondholder for a floating rate bond.
– Prepayment option: allows the Issuer to prepay amount before maturity.
– Accelerated Sinkind Fund Provision: allows the Issuer to reapy an amount more than that stipulated by the
Sinking Fund provisions.

Institutional Investors
• Margin buying: involves borrowing funds to purchase securities which are placed as a collteral for the loan.
• Repo: refers to selling a security with an agreement to repurchase it after a specified time at a specified
rate. Repo is preferred by Institutional Investors as against Margin Buying.


Questions

1. A person pays $1,050 for a bond. The accrued interest upto the date of purchase was $36. The clean price
of the bond is:
A. $1,050
B. $1,086
C. $1,114

2. The price per $1 of a par value bond is $1.2538 when the par value is $10,000. The quoted price and the
dollar price is closest to

Quoted Price Dollar Price
A 125 3/8 $12,538
B 122 1/8 $11,438
C 125 1/2 $14,620

3. Which of the following is true about a bond with a deferred call provision?:
A. It could be called at any time during the tenure of the Bond
B. Principal repayment can be deferred until it reaches maturity
C. It could not be called right after the date of issue


Questions (cont....)
4. Which of the following is right:
A. A put provision will benefit the buyer in times of rising interest rates.
B. A put provision will benefit the buyer in times of falling interest rates.
C. A put provision will benefit the seller in times of rising interest rates.

5. If the interest rate falls, the reinvestment income from a Zero-coupon bond will:
A. Increase
B. Decrease
C. Unaffected

6. Margin buying refers to:
A. Giving loan to the investor to help him purchase a security.
B. Taking a loan to purchase a security.
C. Buying securities and loaning it for short selling.

7. An mortgage security:
A. Repays only the principal amount during the tenure of the security.
B. Repays the principal and the interest amount during the tenure of the security.
C. Cannot be retired earlier than the period of the security.


Answers
1. C. $1,114
2. A. Dollar Price = 1.2538 * 10,000 = 12,538
Quoted Price = 12,538/1,000 = 125 3/8
3. A. A deferred call provision means the issue is initially (say, for the first 5 to 7 years) non-callable, after
which time it becomes freely callable. In other words, there is a deferment period during which time the
bond cannot be called, but after that, it becomes freely callable.
4. A. A put provision will benefit the buyer in times of rising interest rates.
5. C. Unaffected
6. B. Taking a loan to purchase a security
7. B. Repays the principal and the interest amount during the tenure of the security


Key Issues in Risks Associated with Investing in Bonds
• Risks involved
• Discount, Premiuim, At par
• Bond features and Interest rate risk
• Callable bonds
• Interest rate risk of a Floating rate security
• Duration of a bond
• Yield curve risk
• Prepayable Security
• Reinvestment risk
• Credit risk
• Liquidity risk
• Exchange rate risk
• Inflation risk
• Yield Volitality and Option Bonds
• Event risk


Risks Associated with Investing in Bonds

• Interest Rate risk: refers to the effect of change in the market interest rates on the price of the bond.
• Yield Curve risk: results from the change in the yield curve and its impact on the bond.
• Call Risk: is the risk that the Issuer will exercise the call option on a callable bond if the interest rates fall.
• Prepayment risk: is the risk to prepayment of the principal amount before its due date.
• Reinvestment risk: is the risk that the cash flows from the securities will be reinvested at a lower rate.
• Credit risk: is the risk that the borrower will default on the installment payments.
• Inflation risk: refers to the risk of errosion of the purchasing power of the returns from the security as a a
result of unexpected rise in inflation.
• Liquidity risk: is the risk that the security will sell for a amount lower than its fair value due to lack of
liquidity.
• Exchange rate risk: is the uncertainity regarding movement in the exchange rates and the consequent
impact on the rerurns from the securities.
• Volatility risk: refers to the change in value of securities which have embeded options as a result of interest
rate volitality.
• Soveriegn risk: refers to the risk arising out of change in government policies.
• Event risk: refers to risks like natural disasters, etc.


Discount, Premiuim, At par

• If the coupon rate of the security is equal to the market yield then the bond will sell at par.
• If the coupon rate of the security is more than the market yield then the bond will sell at premium.
• If the coupon rate of the security is less than the market yield then the bond will sell at discount.

Bond Features and Interest Rate Risk
• Interest rate risk is measured by DURATION. Duration it is the measure of how long on an average the
holder of the bond has to wait before he receives his payments on the bond. Macaulay duration is also
used to measure how sensitive a bond or a bond portfolio's price is to changes in interest rates.
• Higher the maturity of a bond, higher the interest rate risk and higher the duration.
• Higher the coupon rate of a bond, lower the interest rate risk and lower the duration.
• Compared to an option free bond, a bond with a call option will have lower interest rate risk and lower
duration.
• Compared to an option free bond, a bond with a put option will have lower interest rate risk and lower
duration.


Callable Bonds

• Bonds which have an embedded call option give the Issuer the right to call the bond before its maturity.
• The special feature of callable bonds is that they exhibit NEGATIVE CONVEXITY.

• Duration is a good measure when the changes in yield are small. However if the yield changes are high then
we use the measure of convexity.
• Convexity is a measure of the curvature of the price/yield relationship.

• Value of a callable bond = Value of a option-free bond – Value of embedded option

• As the yield falls, the price of the bond increases.
• But this increase in the price of a bond is capped in the case of a callable bond at the call price.


Callable Bonds

GRAPH of a Normal bond having positive Convexity

Price

Callable Bond – Negative
Convexity
Call Price

Option Free Bond

Yield


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