This learning module introduces the features of fixed income instruments and the legal contracts that govern them.
Features of Fixed-Income Securities
Fixed-income instruments, such as loans and bonds, are debt instruments that represent a contractual agreement in which an issuer borrows money from investors in exchange for interest and future repayment of principal.
Basic Features of a Bond
Issuer:
Issuer is the entity that has issued the bond, or the one who has borrowed money. It is responsible for servicing the debt (paying interest and principal payments).
Supranational org: Bonds issued by international organizations such as the World Bank and IMF.
Sovereign gov: Debt of national governments such as government of the United States, Germany, or Italy.
Non-sovereign gov: Bonds that are not issued by a national or central government. Instead, these are issued by states, provinces, municipalities, etc. For example, municipal bonds in the United States
Quasi-government entities: Bonds issued by agencies that are financed either directly or indirectly by the government. They are also called sub-sovereign or agency bonds. For example, Ginnie Mae, Fannie Mae, and Freddie Mac in United States.
Companies: Bonds issued by a corporate. A distinction is often made between financial issuers and non-financial issuers.
All bonds are exposed to credit risk. Credit risk is the risk that interest and principal payments will not be made by the issuer as they come due. Credit rating agencies such as Moody’s and S&P assign a rating to issuers based on this risk.
Creditworthiness:
Investment grade.
Non-investment grade, or high-yield or speculative bonds.
Maturity:
The maturity date is the date on which the issuer will redeem the bond by paying the outstanding principal amount. Once a bond has been issued, the time remaining until maturity is known as the tenor of the bond.
If original maturity is one year or less, the bond is called money market security.
If original maturity is more than a year, the bond is called capital market security.
Par value:
Also known as face value, maturity value, or redemption value. It is the principal amount that is repaid to bondholders at maturity.
If market price > par value, the bond is trading at a premium.
If market price < par value, the bond is trading at a discount.
If market price = par value, the bond is trading at par.
Coupon rate and frequency:
Coupon rate is the % of par value that the issuer agrees to pay to the bondholder annually as interest. It can be a fixed rate or a floating rate. The coupon frequency may be annual, semi-annual, quarterly, or monthly.
Plain vanilla bond: It is the most basic type of bond with periodic fixed interest payments during the bond’s life and the principal paid on maturity.
Floating-rate notes or floaters: The coupon payments are based on a floating market reference rate (MRR) at the start of the period. Some bonds specify the coupon rate as two components: a market reference rate, plus a spread. The coupon rate and coupon interest paid in every period change as the reference rate changes.
Zero-coupon bonds or Pure discount bonds: Bonds that have only one payment at maturity. These are bonds that do not make a coupon payment over a bond’s life, and are sold at a discount (less than the par value) at issuance. At maturity, the investor receives the par value of the bond.
Tip
Think of it as interest getting accumulated during the bond’s life and being paid at maturity for a zero-coupon bond.
Seniority:
A single borrower may issue bonds with different seniority rankings. Seniority ranking determines who gets paid first, or who has the first claim on the cash flows of the issuer, in the event of default/bankruptcy/restructuring. Senior debt has a priority over other debt claims. Junior or subordinated debt has a lower priority and is paid only once the senior claim are satisfied.
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. The most common contingency provisions for bonds are: call, put, and conversion options.
Yield Measures
There are two widely used yield measures to describe a bond: current yield and yield to maturity.
Current or Running Yield
Current yield is the annual coupon divided by the bond’s price and is expressed as a percentage.
Example
Consider a three-year, annual coupon bond with a par value of $100. The bond is issued at $95. The coupon rate is 10%, so the coupon payments are $10 every year. Current yield = 10/95 = 10.5%
Yield to Maturity (YTM)
Yield to maturity is the internal rate of return on a bond’s expected cash flows. In other words, it is the expected annual rate of return an investor will earn if the bond is held to maturity. It is also known as ‘yield to redemption’ or ‘redemption yield’.