Fixed Income

Features of Debt Securities

Reading - 52

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Introduction to Fixed Income Securities

Fixed Income Security is a financial obligation of an entity
(known as issuer) that promises to pay a specified sum of money
at specified future dates.
Categories of Fixed Income Securities:

Debt Obligation

Preferred Stocks
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The one who issues it is called the borrower and the one who
purchases such fixed income security is called a lender or
creditor.
The promised payment by the issuer consists of two
components namely interest and principal payments.

It represents an ownership interest in the corporation.

A fixed dividend payment is made to the preferred stock
holder every year.
Owner has a higher priority that the common stock holder.
It is form of equity with characteristics of a bond.

Indentures and Covenants

Bond Indenture: Details of the promises by issuer and rights of
bondholders are furnished in bond indenture.
Trustee: A third party in the bond or debt contract between the issuer and
the bondholder. As per the indenture, the trustees are the representatives
of the bondholders.
Affirmative covenants as per the indenture:
Borrower pays the interest and principal on time.
Borrower pays all taxes when due.
Borrower keeps the assets that are used or useful, in good condition
and working order.
Submission of report to trustee about the borrowers compliance with
the loan agreement.
Negative covenants as per the indenture:
Certain limitations and restrictions on borrower like imposing
limitations on the borrowers ability to incur additional debt.
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Maturity
It is the number of years remaining for the final principal
payment.
Reasons for importance of Bond maturity:
1. It indicates the time span for which the bondholder will get
the interest on bond.
2. Yield offered on bond is dependent on the term of maturity.
3. Price volatility of a bond is a function of its maturity.
Note:
Longer the maturity of bond, greater will be the price volatility resulting from
changes in interests rates.

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Par Value
It is the amount the issuer agrees to repay to the bondholder on
the maturity date. It is also termed as face value, maturity value,
redemption value, or principal.
Facts:
1. Bonds can have different par value.
2. Price of the bond is quoted as a percentage of its par value.
For e.g. If the par value of a bond is Rs.1000 and it said to be
selling at 90, it means that price of the bond is 90% of
Rs.1000 i.e. Rs.900.
3. A bond may trade above (premium) or below (discount) its
par value.
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Coupon Rate
Coupon Rate: It is the interest rate that the issuer of the bond
agrees to pay each year to the bondholder.
Coupon: It is the amount of interest paid by the issuer every year
to the bondholder.
Calculation of coupon:
Coupon = Coupon Rate x Par Value.
Note:
While describing a bond of an issuer, the coupon rate is mentioned along with the
maturity date.

For e.g. 7 of 01/04/2020 trading at 94 means that a bond with coupon rate of
7% and maturity date of 01/04/2020 is trading at 94% of its par value.
Higher the coupon rate, lower is the risk of decrease in price in response to a
change in interest rates.
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Coupon Rate
Zero coupon bonds
These bonds are not contracted to make periodic coupon
payments.
Holder purchases the bond at a price lower than the par value
and the interest is the difference between the par value (which
he gets at the maturity date) and the purchase price.

Step-Up Notes
These are securities whose coupon rate increases over time.
If only one change in coupon rate, it is known as single step-up
note. If more than one change in coupon rate, it is known as
multi step-up note.
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Coupon Rate
Deferred Coupon Bonds
Interest payments are deferred for a specified number of years.
Periodic interest payment after the deferred period till the bond
maturity.
Interest payments post the deferred period is higher than the
promised interest payment as to compensate the loss of interest
payment in deferred period.

Floating-Rate Securities
In these type of securities, the coupon rate is not fixed and
varies according to some reference rate.
Coupon Rate = Reference rate + Quoted Margin (can be positive
or negative).
E.g. Coupon Rate = 1-month LIBOR + 50 basis points. If 1-month
LIBOR is 6%, then the coupon rate is 6.5%.
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Coupon Rate - Floating-Rate Securities

CAP: The maximum coupon rate that can be paid at any reset
date by the floated is called a Cap.
Eg. The coupon rate is calculated by formula:
Coupon rate = 10-year Treasury rate + 100 basis points,

and the cap is 7.5%. If the 10-year Treasury rate is 7%, the
coupon rate by the formula would be 8%. But as the cap is at
7.5%, the coupon rate paid will be 7.5% instead of 8%.
A CAP is unattractive for investors as it restricts the coupon
rate from increasing
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Coupon Rate - Floating-Rate Securities

FLOOR: The minimum coupon rate that can be paid at any reset
date by the floated is called a Floor.
Eg. The coupon rate is calculated by formula:
Coupon rate = 10-year Treasury rate - 50 basis points,

and the floor is 7%. If the 10-year Treasury rate is 7%, the
coupon rate by the formula would be 6.5%. But as the floor is at
7%, the coupon rate paid will be 7% instead of 6.5%.
A FLOOR is attractive for investors as it restricts the coupon
rate from decreasing.
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Coupon Rate - Floating-Rate Securities

Inverse Floaters: These are the issues whose coupon rate
decreases when the reference rate increases and increases when
reference rate decreases.
Coupon Rate = K L x Reference Rate

Where, the values of K and L are mentioned in the bond

prospectus.

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Accrued Interest
Facts:
Interest on bonds is paid in many mode i.e. annually, semiannually etc.
For mortgage and asset backed securities, interest is usually
paid monthly.
Coupon is paid on the coupon date to the bondholder of
record.
The seller gives up the interest from the time of the last
coupon payment to the time until the bond is sold. The
amount of interest over this period that will be received by the
buyer even though it was earned by the seller is called accrued
interest.
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Accrued Interest
In many cases, the buyer of the bond has to pay the accrued
interest to the seller. The amount that the buyer of the bond
pays to the seller is the agreed upon price for the bond plus
accrued interest and is known as Full Price.
A bond in which the buyer of the bond has to pay the accrued
interest to the seller is said to be trading cum-coupon (with
coupon).
A bond in which the buyer of the bond forgoes the next
coupon payment, the bond is said to be trading ex-coupon
(without coupon).
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Provisions for paying off bonds

Bullet Bonds: In this type of bond, the issuer pays the full
maturity amount on the maturity date.
Amortizing Securities: Fixed income securities which have
schedule of partial principal payments are known as amortizing
securities.
Call Provision: The right of the issuer to retire the issue fully or
partially before the maturity date is known as Call Provision.

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Types of call provisions

1. Call and Refunding Provisions:
Callable Bonds: A bond issue that permits the issuer to call an
issue.
Call Price: The price which the issuer needs to pay for earlier
retirement of issue is known as call price or redemption price.
Single call price regardless of call date.
Call price based on call schedule.
Call price based on make-whole premium

2. Prepayments:
Any principal payment prior to the principal payment date is
known as prepayment. It is an option that can be availed by
the borrower.
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Types of call provisions

3. Sinking Fund Provision:

The amount required for retiring a portion of the issue each

year is known as sinking fund provision.

The vested interest of issuer towards sinking fund provision is

to reduce the credit risk.

Provision can be designed to make the complete payment of

maturity amount by the maturity date or to pay only a portion
of it.

If only a portion is paid, the remaining principal amount is

known as Balloon maturity.

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Other Features
Conversion Privilege:
This is a privilege with the bondholder to convert the bond for a
specified number of shares of common stocks. The bond is
called convertible bonds.
It allows the bondholder to take advantage of favorable price
movements in the price of issuers common stock.

Put Provision:
This provision gives the right to the bondholder to sell back the
issue to the issuer at a specified price on specified dates.

Currency Denomination:
The transaction between the issuer and the bondholder can be
in any currency provided it is mentioned in the indenture that
the issuer can make payment in any currency.
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Borrowing funds to purchase bonds

Margin Buying:
In this kind of arrangement, the funds that is borrowed to buy
the securities are provided by the broker and the broker gets
the money from a bank.
The interest that is charged to the broker is known as call money
rate.
In turn, the broker charges an amount that is a sum of call
money rate and service charges.

Repurchase commitment:
A sale of securities with a commitment by the seller to
repurchase the same security back from the purchaser at a
specified price on a specified date.
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