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IFT Notes for Level I CFA® Program

R42 Fixed-Income Securities: Defining Elements

Part 1


 

1.  Introduction

There are two ways for an entity to raise capital: issuing equity and issuing fixed-income securities. Fixed-income is a commonly used method for governments and companies to borrow money from investors. Fixed-income securities differ from equities in several ways:

  • A fixed-income investor has no ownership rights in the business.
  • The money borrowed (principal) is repaid at maturity. In addition, interest on the borrowed money is paid periodically.
  • Fixed income investors get paid before the common shareowners; hence the risk is lower.

Note that fixed-income security, bond, and debt are used interchangeably throughout this reading.

2.  Overview of a Fixed-Income Security

Three important elements that an investor should know when investing in fixed-income securities are:

  1. A bond’s features.
  2. Legal, regulatory, and tax considerations.
  3. Contingency provisions.

2.1.     Basic Features of a Bond

The basic features of a fixed-income security include:

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). Bonds can be classified into the following categories based on the type of the issuer:

  • Supranational organizations: Bonds issued by international organizations such as the World Bank and IMF.
  • Sovereign governments: Debt of national governments such as government of the United States, Germany, or Italy.
  • Non-sovereign governments: 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, etc.
  • 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.

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.

Bonds can be classified into two categories based on their creditworthiness:

  • Investment grade.
  • Non-investment grade, or high-yield or speculative bonds.

Maturity:

The maturity date is the date on which the last payment is made for a bond. 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 percentage 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. Based on the frequency of coupon payments, we can classify bonds into the following:

  • 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 bond or floating-rate notes or floaters: Unlike vanilla bonds, the interest rate of a floating-rate bond is not fixed. The coupon payments are based on a floating rate of interest like Libor (London Interbank Offered Rate) at the start of the period. Some bonds specify the coupon rate as two components: a reference rate, such as Libor, plus a spread. The coupon rate and coupon interest paid in every period changes 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. Think of it as interest getting accumulated during the bond’s life and being paid at maturity for a zero-coupon bond.

Currency denomination

  • Bonds can be issued in any currency.
  • Dual currency bonds pay interest in one currency and principal in another currency.
  • Currency option bonds give the bondholders the option to choose between two currencies they would like to receive their payments in.

Example

Test your understanding of the concepts discussed so far by answering the following questions.

  1. What is a sovereign bond?
  2. What is credit risk?
  3. In what time-frame does a money market security mature?
  4. If a bond’s price is lower than its par value, it is called a _____ bond.
  5. What is the periodic interest payment for a bond that has a par value of $1000 and a coupon rate of 6%? The coupon payments are made semi-annually.
  6. The coupon rate of a floating-rate note that makes payments in June and December is expressed as six-month Libor + 50 bps. Assuming that the six-month Libor is 2.00% at the end of June 2016 and 2.50% at the end of December 2016. What is the interest rate that applies to the payment due in December 2016?
  7. Which type of bond allows bondholders to choose the currency in which they receive each interest payment and principal repayment?

Solution:

  1. A bond issued by a central government such as the U.S. or German government is a sovereign bond. A bond issued by the World Bank or by a province is not considered a sovereign bond.
  2. Credit risk is the risk of loss when an issuer fails to make full and timely payment of interest and principal.
  3. Less than one year. Capital market securities have maturity greater than one year.
  4. Discount.
  5. Annual coupon payment is 0.06 x 1000 = $60. The coupon payments are made semi-annually, so $30 paid twice a year. You can calculate it as (0.06/2) x 1000 = $30.
  6. The interest rate that applies to the payment due in December 2016 is the six-month Libor at the end of June 2016 plus 50 bps. Thus, it is 2.50% (2.00% + 0.50%).
  7. Currency option bond.

2.2.     Yield Measures

There are two widely used yield measures to describe a bond: current yield and yield to maturity.

Current yield or Running yield

Current yield is the annual coupon divided by the bond’s price and is expressed as a percentage. For 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 = \frac{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. The IRR can be calculated easily using the financial calculator. Let us consider the same bond as in the current yield example:

Input these values: CF0 = -95; CF1 = 10; CF2 = 10; CF3 = 110. Computing for IRR, you should get 12.08%. As you can see, YTM is higher than the coupon rate. For a discount bond such as this one, the YTM is higher than the coupon rate. A bond’s price is inversely related to its yield to maturity.

 


Fixed Income Securities: Defining Elements Part 1