Barbara S. Petitt - Fixed Income Analysis Workbook

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After completing this chapter, you will be able to do the following:

• describe basic features of a fixed-income security;
• describe content of a bond indenture;
• compare affirmative and negative covenants and identify examples of each;
• describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities;
• describe how cash flows of fixed-income securities are structured;
• describe contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities and identify whether such provisions benefit the borrower or the lender.

This chapter provides an introduction to the salient features of fixed-income securities while noting how these features vary among different types of securities. Important points include the following:

• The three important elements that an investor needs to know when investing in a fixed-income security are: (1) the bonds features, which determine its scheduled cash flows and thus the bondholders expected and actual return; (2) the legal, regulatory, and tax considerations that apply to the contractual agreement between the issuer and the bondholders; and (3) the contingency provisions that may affect the bonds scheduled cash flows.
• The basic features of a bond include the issuer, maturity, par value (or principal), coupon rate and frequency, and currency denomination.
• Issuers of bonds include supranational organizations, sovereign governments, non-sovereign governments, quasi-government entities, and corporate issuers.
• Bondholders are exposed to credit risk and may use bond credit ratings to assess the credit quality of a bond.
• A bonds principal is the amount the issuer agrees to pay the bondholder when the bond matures.
• The coupon rate is the interest rate that the issuer agrees to pay to the bondholder each year. The coupon rate can be a fixed rate or a floating rate. Bonds may offer annual, semi-annual, quarterly, or monthly coupon payments depending on the type of bond and where the bond is issued.
• Bonds can be issued in any currency. Bonds such as dual-currency bonds and currency option bonds are connected to two currencies.
• The yield to maturity is the discount rate that equates the present value of the bonds future cash flows until maturity to its price. Yield to maturity can be considered an estimate of the markets expectation for the bonds return.
• A plain vanilla bond has a known cash flow pattern. It has a fixed maturity date and pays a fixed rate of interest over the bonds life.
• The bond indenture or trust deed is the legal contract that describes the form of the bond, the issuers obligations, and the investors rights. The indenture is usually held by a financial institution called a trustee, which performs various duties specified in the indenture.
• The issuer is identified in the indenture by its legal name and is obligated to make timely payments of interest and repayment of principal.
• For asset-backed securities, the legal obligation to repay bondholders often lies with a separate legal entitythat is, a bankruptcy-remote vehicle that uses the assets as guarantees to back a bond issue.
• How the issuer intends to service the debt and repay the principal should be described in the indenture. The source of repayment proceeds varies depending on the type of bond.
• Collateral backing is a way to alleviate credit risk. Secured bonds are backed by assets or financial guarantees pledged to ensure debt payment. Examples of collateral-backed bonds include collateral trust bonds, equipment trust certificates, mortgage-backed securities, and covered bonds.