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FIXED INCOME

15.1.A. FEATURES OF FIXED INCOME SECURITIES

INTRODUCTION

First it must be understood that a bond is nothing more than debt. The act of issuing a bond is the
exact same thing as a company borrowing money from a bank. Therefore, all the characteristics
that apply to debt are also applicable to bonds. The primary difference between debt and bonds is
that the former is usually between the issuer and the bank while the latter is between an issuer and
many thousands of lenders (i.e. the "bondholders")

BASIC FEATURES

1. Maturity: is the date that the issuer pledges to pay back the face value of the bond to the
bondholders. Usually, the face value for bonds is $1,000 per certificate. However, a bond is
quoted in terms of 100.

2. Coupon Rate: is the rate of interest that the issuer pledges to pay to the bondholder. For
example, if the coupon rate is 8%, the issuer pledges to pay a total of $80 (8% of $1,000) in
interest per year. In the U.S., bonds pay interest semi-annually, so in this case, $40 every 6
months; while elsewhere in the world, interest is generally paid once per year.

3. Par Value: is synonymous with face value. It is the amount that the issuer will pay back on
the maturity date. Almost always, this amount is $1,000 per certificate.

Question:
Which of the following statements with respect to bond features is incorrect?
A) Longer maturity bonds will exhibit greater price volatility.
B) Par value is the present value of all the bond's coupons and its face value that will be received
at maturity.
C) The coupon rate that is set on a bond will usually be influenced by the bond's term to maturity.
D) The coupon rate that is set on a bond will usually be influenced by the shape of the yield
curve.
Answer:
B
Explanation:
Par value is simply another term for a bond's face value. Also note that the coupon rates set on a
bond will usually be dependent upon the shape of the yield curve during the time of issuance, and
the length of term of the bond itself. Assuming that there is an upward sloping yield curve, the
longer the maturity of the bond, the greater the coupon that will be required in order for the bond
to be priced at its par value.


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COUPON RATE STRUCTURES

While in most cases, coupons are quoted as an annual rate but paid semi-annually, it is possible to
structure coupons in an entirely different manner. Some of the more commonly used alternative
coupon rate structures are as follows:

1. Zero-Coupon bonds: pay absolutely no coupons at all. Instead, the investor derives a return
by paying a price that is far below the face value of the bond. Consequently, the return
comes from the capital appreciation as the bond price moves from its discounted price over to
its face value.

2. Accrual bonds: pay no coupons over the life of the bond. However, on the maturity date, the
issuer must pay back the face value of the bond and all the interest that's accrued on the face
value. Such structures are sometimes referred to as balloon payments because of the
"inflated" amount that must be paid at maturity.

3. Step Up Notes: are bonds that periodically increase the rate of the coupon payment. For
example, a 3-year step up note may start off by paying 3.5% in the first year, 4.5% in the
second year, and 6.2% in the third year.

4. Floating Rate bonds: set the coupon rate to some reference rate. For example, an issuer may
set its coupon rate equal to LIBOR plus 2%. (LIBOR is a very commonly used reference
rate) Consequently, if the LIBOR rate should be 5% on the reset date, then on the next
coupon payment date, the issuer would pay a coupon rate of 7%. (The reset date is usually
one period before the actual coupon payment date)

5. Inverse Floaters: create an "inverse" relationship between the coupon rate and the general
level of interest rates. For example, by setting the coupon rate equal to [10% -
0.5(LIBOR)], then if LIBOR ends up being 10%, the coupon rate would become 5%.
However, if LIBOR ends up being 12%, then the coupon rate would become 4%.

6. Deleveraged Floaters: set the coupon rate equal to a fraction of the reference rate plus a
margin.

Question:
A ten-year deleveraged floating rate bond has its coupon rate set, every June 30th and December
31st, equal to 75% of the six-month LIBOR plus 2.3%. If the par value of this bond is $100,000
and the six-month LIBOR rates were 5.2% in December of the previous year and 6.1% on June
30th of this year, what will be the amount of the coupon payment on December 31st of this year?
Answer:
$3,437.50







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Explanation:



7. Dual Index Floaters: set the coupon rate equal to a margin plus the spread between two
reference rates.

8. Ratchet Bonds: are floating rate bonds; however, once the coupon rate is adjusted
downwards, it may never be revised upwards again.

9. Non-Interest Rate Index Floaters: set the coupon rate to a "non-interest rate" reference rate.
For example, the coupon rate may be set equal to a base rate plus the rate of inflation.

Question:
Which of the following statements is(are) true with respect to various coupon rate structures that
bonds may adopt?

I. A zero-coupon bond pays no coupons, however at the end of its term, both the principal
and the accumulated coupons are paid to the bondholder.
II. Most U.S. corporate bonds pay coupons semi-annually.
III. Most U.S. government bonds pay coupons annually.
IV. Most mortgage-backed securities pay interest quarterly.
Answer:
II only.


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Explanation:
(I) is incorrect because a zero-coupon bond compensates a bondholder through the difference in
the discount price that is always paid for this bond, and the par value that will be received in the
future. Again, at maturity, only the par value will be received; there is no accumulated coupon
payment.

(III) is incorrect because most U.S. government bonds pay coupons semi-annually as well.

(IV) is incorrect because most mortgage-backed securities pay interest on a monthly basis.


PROVISIONS FOR PAYING OFF PRINCIPAL

For most bonds, there is only one maturity date on which the entire principal is paid off. These
bonds are referred to as having "bullet" maturities. However, bonds may also be structured so
that there are a series of maturity dates. "Serial bonds" are issued under one indenture, however,
the bonds are segmented so that every segment has a different maturity date. Finally, fixed
income securities can also come in "amortized" form. For example, mortgage backed securities
(MBS), generate periodic cash flows that are composed of both interest and principal. In effect,
principal is paid off periodically, so that come maturity, there is negligible amount of principal
that is left to be paid.

Question:
Which of the following statements is(are) true with respect the various ways that bond principal
may be repaid?

I. Bullet maturities refers to bonds that have to periodically pay back the principal with
every interest payment.
II. Conventional bonds require that each periodic payment be a blend of principal and
interest, with the interest being the higher component in the earlier periods of the bond's
life.
III. Serial bonds are a type of non-amortizing securities.
IV. Mortgage-backed securities are an example of amortized securities.
Answer:
III and IV only.
Explanation:
(I) is incorrect because Bullet maturities refers to bonds that have to pay back the principal on
that one maturity date.

(II) is incorrect because conventional bonds require that entire principal be paid at the maturity
date; in other words, this is the norm.




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OPTIONS GRANTED TO ISSUERS

Many of the bonds that trade in the market have options that are embedded in them. Once the
issuer exercises these options, the cash flow characteristics of the bond will change dramatically.
Some of the more commonly embedded options granted to the issuer are as follows:

1. Call Provisions: give the issuer the right to buy back (or call) its bonds at some pre-
determined price (called the "call price") at specified points in time before the actual maturity
date. The issuer's motivation to call its bonds increases when interest rates decrease. For
example, suppose the issuer has bonds outstanding that are paying a coupon rate of 8%. If
interest rates decline far enough, the issuer may be able to issue new bonds at 6% and then
use the proceeds of this new issue to retire the original bonds that were paying 8%. The
issuer in effect cuts its interest cost by 2%. However, as we will see later on, the issuer must
initially compensate the investor for taking on this "call risk".

2. Non-refunding Provision: gives the issuer the right to buy back its bonds only if the proceeds
used to repurchase the old bonds wasn't raised by the issuance of a new lower costing bonds.
This means that the issuer may only repurchase its bonds if the proceeds were raised through
internal operations, sale of assets, or the issuance of stock.

3. Sinking Fund Provisions: enables the issuer to periodically repurchase a portion of its
outstanding bonds back before maturity. Consequently, at the maturity date, the amount of
debt outstanding will be far less than the amount that was actually issued.

4. Caps: may be attached to bonds that pay a coupon rate that's pegged to the general level of
interest rates. Without the cap, a dramatic increase in interest rates will result in a dramatic
rise in interest costs. Therefore, a cap sets a maximum rate so that even if interest rates were
to rise, the coupon rate will at least not exceed this maximum level.

5. Prepayment Options: are more applicable to amortizing securities. For example,
homeowners, who make up the mortgage pool upon which MBSs are based, can prepay their
mortgage ahead of schedule at any time. This option is generally exercised when interest
rates drop.

Question:
Which of the following statements is(are) true with respect to the provisions for the early
retirement of debt?

I. A call provision enables the investor to exercise the right to call in the par value in
exchange for delivering the bond back to the issuer.
II. A non-refundable provision forbids the issuer from ever calling the bonds before their
maturity date.
III. A sinking fund provision obligates the issuer to retire a portion of its debt every period
prior to its maturity.
IV. Another term used to describe a non-refundable feature is non-callable.
Answer:
III only.
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Explanation:
(I) is incorrect because a call provision enables the issuer to call in the bond in return for paying
the investor a call price, which is really the sum of the bond's par value and some call premium.

(II) is incorrect because a non-refundable provision only forbids the issuer from calling the bonds
if the proceeds used to redeem the existing bonds came from the issuance of bonds with a lower
coupon rate.

(IV) is incorrect because non-refundable implies that a bond cannot be retired by substituting it
with lower cost debt, otherwise other company funds may be used to retire this bond. A non-
callable feature, on the other hand, implies that a bond cannot be retired before its maturity under
any circumstances.


OPTIONS GRANTED TO INVESTORS

Sometimes, in order to make a bond more appealing to an investor, the issuer will embed an
option that is to the benefit of the investor. Some of the more common such options are as
follows:

1. Put Provisions: gives the investor the right to sell back (or put back) the bond back into the
issuer's hand and receive a predetermined price for it (usually par). The investor would
exercise such an option when the bond price drops dramatically. Therefore, instead of selling
the bond in the market at a lower price, the investor will simply exercise the put option and
sell the bond back to the issuer at the artificially higher price. However, as we will see later
on, the investor must forego some yield in order to participate in such a feature.

2. Convertible Provisions: gives the investor the right to "convert" her bond into the common
shares of the issuer. While bonds only offer fixed income, the returns on common shares
have a much higher potential. Consequently, the investor would only convert if the prospects
for the company's equityholders were to improve dramatically.

3. Exchangeable Provisions: gives the investor the right to "exchange" her bond into the
common shares of an issuer other than the issuer that issued the original bonds.

4. Floors: may be attached to bonds that pay a coupon rate that's pegged to the general level of
interest rates. Without the floor, a dramatic drop in interest rates will result in a dramatic
drop in coupon income. Therefore, a floor sets a minimum rate so that even if interest rates
were to drop, the coupon rate will at least stay above this minimum level.

Question:
Which of the following is not an embedded option designed to benefit an issuer?
A) Caps on floaters.
B) Put provision.
C) Prepayment provision.
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D) Accelerated sinking funds feature.
Answer:
B
Explanation:
Put provisions allow the holder of the bonds to deliver the underlying bond to the issuer in
exchange for some pre-determined price. This feature becomes especially beneficial to the
investor when they have the ability to deliver the bond for a set price, even the market price for
the bond might be deteriorating.


Question:
Which of the following statements is(are) true with respect to the types of extra features that may
be incorporated into a bond?

I. Special redemption prices allow the issuer to call its bonds at just par, if certain
circumstances prevail.
II. Exchangeable bonds allow the holder to exchange the bonds for the common shares of
the underlying issuer.
III. Put provisions allow the holder of the bonds to deliver the underlying bond to the issuer
in exchange for some pre-determined price.
IV. Indexed amortization notes allows the issuer to accelerate principal repayments if a
specified reference interest rate increases.
Answer:
I and III only.
Explanation:
(II) is incorrect because exchangeable bonds allow the holder to exchange the bonds for the
common shares of corporation that is different from the issuer.

(IV) is incorrect because indexed amortization notes allows the issuer to accelerate principal
repayments if a specified reference interest rate actually decreases.


PURCHASING BONDS

1. Cash Purchase: For most individual investors, this is the primary method of purchasing
bonds. If the bond is purchased on the day that it is issued or immediately after a coupon has
been paid, then the invoice price is simply equal to the price that is quoted for the bond.
However, if the bond is traded at any other time, there is the issue of accrued interest from the
date of the last coupon payment to the settlement date of the underlying trade. In addition to
the quoted price for the bond, the seller will also demand to be compensated for that portion
of the upcoming coupon that is attributable to the period that the seller held the bond. In
other words, the full price (or "dirty price") is equal to the quoted price (or "clean price") plus
accrued interest.

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Question:
Which of the following statements is(are) true with respect to the cash method of purchasing
bonds?

I. "Dirty price" makes reference to the sum of the bond's price plus any accrued interest that
may be accumulated on the bond.
II. Ex-coupon bonds do not require any accrued interest to be built into the trade price for a
bond.
III. In the U.S., bonds that are trading "cum-coupon" are usually bonds that are in default.
IV. Accrued interest is accumulated from the date of the last coupon payment to the trade
date of the bond.
Answer:
I and II only.
Explanation:
(III) is incorrect because in the U.S., bonds that are trading "ex-coupon" are usually bonds that
are in default. A cum-coupon bond refers to those bonds whose trade prices include both the
normal price of the bond and any accrued interest.

(IV) is incorrect because accrued interest is actually accumulated from the date of the last coupon
payment to the "settlement" date of the bond. Settlement date always comes after the trade date;
hence it involves a slightly larger period of accumulation.


2. Margin Buying: For aggressive investors or institutions, bond purchases may also be financed
with borrowing. The Federal Reserve sets the margin for which an investor must post for
such trades.

3. Repurchase Agreements: are also borrowing structures used to finance the purchase of bonds.
However, instead of making interest payments on the borrowed fund, an investor borrows one
amount but repays a higher amount back to the lender. The yield between the original
lending amount and the repayment amount is referred to as the "repo rate". The lower the
repayment amount, the lower this repo rate will be.


Question:
Which of the following statements is(are) true with respect to the methods that may be used by
institutional investors when purchasing bonds?

I. Call money rate refers to the rate that is charged on loans by a broker to investors who
partly finance the purchase of bonds through debt.
II. Repurchase agreement involves a dealer selling a bond today at one price, and
simultaneously agreeing to repurchase it back at a lower price at some future date.
III. Overnight repo refers to the implicit rate derived from a repurchase agreement that is
reversed the very next day.
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IV. If the annualized implied interest rate on a repurchase agreement is high, the underlying
bond is referred to as a hot or special collateral.
Answer:
I and III only.
Explanation:
(II) is incorrect because a repurchase agreement involves a dealer selling a bond today at one
price, and simultaneously agreeing to repurchase it back at a "higher" price at some future date.
By selling the bond today, the dealer is effectively getting a loan and the lender is keeping the
bond as collateral. Hence, for the lender to earn a return, the dealer must buy back the bond at a
higher price than what it originally sold it to the lender.

(IV) is incorrect because the term hot or special collateral refers to that agreement whereby the
underlying bond is bought back at only a "slightly" higher price. Think of it this way: this
underlying bond is so hot, that the lender does not need much compensation in order hold the
bond as a collateral. This means that the original owner need only pay a slightly higher price in
order to buy the bond back from the lender.