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Academy of Professional Finance 专业金融学院
CFA Level I
FIXED INCOME:
Features of Debt Securities
Lecturer: Nan Chen
Fixed Income in CFA Level I
CFA Exam Topic Area Weights
Academy of Professional Finance 专业金融学院
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LOS 52-Framework
Negative Covenants
a. Bond Indenture
b
Features of
Debt Securities
Affirmative Covenants
Coupon Rate
Structures
Zero Coupon
Floating Rate
Securities
Deferred Coupon Bonds
c. Bond Trades
between Coupon Dates
Step-up Notes
Full Price vs. Clean Price
Cum Coupon vs. Ex-Coupon
Trading Flat
d. Redemption and
Retirement Provisions
Nonamortizing vs. Amortizing Securities
Prepayment Options
Call Provisions
Sinking Fund Provisions
Put Option
Conversion Option
Security Owner Options
e. Embedded Options
Security Issuer Options
Floors
Call Provision
Prepayment Options
f. Methods to Finance
the Purchase of Security
Academy of Professional Finance 专业金融学院
Margin Buying
Accelerated Sinking Fund
Repurchase Agreement
Caps
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LOS 52-Framework
Negative Covenants
a. Bond Indenture
b
Features of
Debt Securities
Affirmative Covenants
Coupon Rate
Structures
Zero Coupon
Floating Rate
Securities
Deferred Coupon Bonds
c. Bond Trades
between Coupon Dates
Step-up Notes
Full Price vs. Clean Price
Cum Coupon vs. Ex-Coupon
Trading Flat
d. Redemption and
Retirement Provisions
Nonamortizing vs. Amortizing Securities
Prepayment Options
Call Provisions
Sinking Fund Provisions
Put Option
Conversion Option
Security Owner Options
e. Embedded Options
Security Issuer Options
Floors
Call Provision
Prepayment Options
f. Methods to Finance
the Purchase of Security
Academy of Professional Finance 专业金融学院
Margin Buying
Accelerated Sinking Fund
Repurchase Agreement
Caps
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a. Bond Indenture
Negative covenants: Prohibitions on the borrower
EX1: “The borrower will not incur additional debt if its debt/capital
ratio is more than 50%.”
Affirmative covenants: Actions the borrower promises to perform
EX2: “The borrower will pay interest semi-annually and principal
at maturity.”
Academy of Professional Finance 专业金融学院
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Framework
a. Bond Indenture
b
Features of
Debt Securities
Negative Covenants
Affirmative Covenants
Coupon Rate
Structures
Zero Coupon
Floating Rate
Securities
Deferred Coupon Bonds
c. Bond Trades
between Coupon Dates
Step-up Notes
Full Price vs. Clean Price
Cum Coupon vs. Ex-Coupon
Trading Flat
d. Redemption and
Retirement Provisions
Nonamortizing vs. Amortizing Securities
Prepayment Options
Call Provisions
Sinking Fund Provisions
Put Option
Conversion Option
Security Owner Options
e. Embedded Options
Security Issuer Options
Floors
Call Provision
Prepayment Options
f. Methods to Finance
the Purchase of Security
Academy of Professional Finance 专业金融学院
Margin Buying
Accelerated Sinking Fund
Repurchase Agreement
Caps
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b
Coupon Rate
Structures
Floating Rate
Securities
Par Value, Maturity & Coupon Rate
EX3: A Treasury bond has a 4% coupon and matures 3 years
from today in the amount of $1,000.
Par Value: $1,000
Maturity: 3 years
Coupon Rate: 4%
Semiannual installment:
5 coupon payments of $20;
A final payment of $1,020.
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b
Coupon Rate
Structures
Floating Rate
Securities
Coupon Rate Structures:
*Zero-coupon bonds: sell below par initially; pay at par at maturity;
do not pay periodic interest.
*Step-up notes: coupon rates increase over time at a specified rate.
*Deferred coupon bonds: Initial coupon payments are deferred but
accrue at a compound rate; After initial deferment period, pay
regular coupon interest to maturity.
Floating-Rate Securities:
*Coupon formula: New coupon rate=Reference rate + Quoted margin
*Inverse floater: Coupon rate=12%-Reference rate
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b
Coupon Rate
Structures
Floating Rate
Securities
EX4:The table below provides a history of a fixed income security’s
coupon rate and the risk free rate over a five-year period:
Year
1
2
3
4
5
Risk Free Rate
3.00%
3.50%
4.25%
3.70%
3.25%
Coupon Rate
6.00%
5.00%
3.50%
4.60%
5.50%
The security is most likely a(n):
A. step-up note.
B. inverse floater.
C. deferred coupon bond.
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b
Coupon Rate
Structures
Floating Rate
Securities
Coupon Rate Structures:
*Zero-coupon bonds: sell below par initially; pay at par at maturity;
do not pay periodic interest.
*Step-up notes: coupon rates increase over time at a specified rate.
*Deferred coupon bonds: Initial coupon payments are deferred but
accrue at a compound rate; After initial deferment period, pay
regular coupon interest to maturity.
Floating-Rate Securities:
*Coupon formula: New coupon rate=Reference rate + Quoted margin
*Inverse floater: Coupon rate=12%-Reference rate
*Inflation-indexed bonds: Coupon rate=3%+Annual change in CPI
• A “cap” puts a maximum on periodic coupon paid by issuer;
• A “floor” puts a minimum on the periodic coupon received by owner;
• A “collar” means both a cap and a floor are present simultaneously.
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Coupon Rate
Structures
b
Floating Rate
Securities
EX5: The coupon formula for a floating-rate security is as follows:
New Coupon Rate = 1 YR Treasury Rate + 20bps
with a cap of 6% and a floor of 3.5%.
Assume the coupon rate is reset every year. Compute the coupon
rate for the next year on each reset date:
1 YR Treasury Rate (%)
Coupon Rate
1st Reset Date
5.9
6.0
2nd Reset Date
5.0
5.2
3rd Reset Date
4.3
4.5
4th Reset Date
3.2
3.5
Academy of Professional Finance 专业金融学院
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Framework
a. Bond Indenture
b
Features of
Debt Securities
Negative Covenants
Affirmative Covenants
Coupon Rate
Structures
Zero Coupon
Floating Rate
Securities
Deferred Coupon Bonds
c. Bond Trades
between Coupon Dates
Step-up Notes
Full Price vs. Clean Price
Cum Coupon vs. Ex-Coupon
Trading Flat
d. Redemption and
Retirement Provisions
Nonamortizing vs. Amortizing Securities
Prepayment Options
Call Provisions
Sinking Fund Provisions
Put Option
Conversion Option
Security Owner Options
e. Embedded Options
Security Issuer Options
Floors
Call Provision
Prepayment Options
f. Methods to Finance
the Purchase of Security
Academy of Professional Finance 专业金融学院
Margin Buying
Accelerated Sinking Fund
Repurchase Agreement
Caps
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Full Price vs. Clean Price
*Full Price = Clean Price + Accrued Interest
*Accrued Interest: When a bond trades between coupon dates, the
bond buyer (new owner) pays the bond seller the interest earned
from the previous c.coupon
date through the date of sale.
Bond Trades
between Coupon Dates
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c. Bond Trades
between Coupon Dates
EX6: An investor sells a bond at the quoted price of $98.00. In
addition he receives accrued interest of $4.40. The clean price
of the bond is:
A. Par value plus accrued interest.
B. accrued interest plus agreed upon bond price.
C. agreed upon bond price excluding accrued interest.
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c. Bond Trades
between Coupon Dates
Full Price vs. Clean Price
*Full Price = Clean Price + Accrued Interest
*Accrued Interest: When a bond trades between coupon dates, the
bond buyer (new owner) pays the bond seller the interest earned
from the previous coupon date through the date of sale.
Cum Coupon vs. Ex-Coupon
*Cum Coupon: Bonds trade with the next coupon attached.
*Ex-Coupon: Bonds trade without the right to the next coupon.
Trading Flat: If the bond issuer is in default, the bond will trade
without accrued interest.
Academy of Professional Finance 专业金融学院
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Framework
a. Bond Indenture
b
Features of
Debt Securities
Negative Covenants
Affirmative Covenants
Coupon Rate
Structures
Zero Coupon
Floating Rate
Securities
Deferred Coupon Bonds
c. Bond Trades
between Coupon Dates
Step-up Notes
Full Price vs. Clean Price
Cum Coupon vs. Ex-Coupon
Trading Flat
d. Redemption and
Retirement Provisions
Nonamortizing vs. Amortizing Securities
Prepayment Options
Call Provisions
Sinking Fund Provisions
Put Option
Conversion Option
Security Owner Options
e. Embedded Options
Security Issuer Options
Floors
Call Provision
Prepayment Options
f. Methods to Finance
the Purchase of Security
Academy of Professional Finance 专业金融学院
Margin Buying
Accelerated Sinking Fund
Repurchase Agreement
Caps
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Nonamortizing vs. Amortizing Securities
*Nonamortizing bond: interest amortized, principal repaid at maturity
*Amortizing bond: both interest and principal amortized
Prepayment Options
*Repayment of principal in excess of scheduled principal payments;
*present in home mortgages or automobile loans.
Call Provisionsd. Redemption and
Retirement Provisions
*give the issuer the right to retire all or a part of an issue prior to
maturity.
*Protection against Call Provisions:
--Call Protection
--Nonrefundable bonds
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d. Redemption and
Retirement Provisions
EX7: Which of the following provides the most protection to a
bondholder?
A. Call protection.
B. Refunding protection.
C. Sinking fund protection.
Bonds can be callable but not refundable.
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d. Redemption and
Retirement Provisions
EX8: The following is an excerpt from the prospectus of a bond that
is due in 2030:
The bond is redeemable prior to September 1, 2005 through the
use of earnings, proceeds from the sale of equity securities and
cash accumulations other than those resulting from a refunding
operation such as hereinafter described. The bond is not
redeemable prior to September 1, 2005 as part of, or in anticipation
of, any refunding operation involving the incurring of indebtedness
by the company having an effective interest cost of less than the
effective interest cost of the bond or through the operation of the
Maintenance and Replacement Fund.
Discuss the provisions to pay off this issue prior to the stated
maturity.
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d. Redemption and
Retirement Provisions
Nonamortizing vs. Amortizing Securities
*Nonamortizing bond: interest amortized, principal repaid at maturity
*Amortizing bond: both interest and principal amortized
Prepayment Options
*give the issuer/borrower the right to accelerate the principal
repayment on a loan.
*present in home mortgages or automobile loans.
Call Provisions
*give the issuer the right to retire all or a part of an issue prior to
maturity.
*Protection against Call Provisions:
--Call Protection
--Nonrefundable bonds
*Call prices typically decreases over time:
15-year bond: callable after 5 years @102 and callable after 10
years @par
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d. Redemption and
Retirement Provisions
Sinking Fund Provisions:
*Definition: An indenture may require the issuer to retire a specified
portion of the issue each year over the life of the issue.
*Purpose: to reduce credit risk
*An Example: A 20-year issue
$300 million face value
Beginning in the 6th year:15 years
Retire $20mm each year
*Two Ways:
1.Cash Payment, if bonds are trading above par
2. Delivery of Securities, if bonds are trading below par
*Accelerated Sinking Fund Provision allows the issuer to retire
more than the amount of bonds specified in the sinking fund
requirement. ($20mm ->$30mm)
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d. Redemption and
Retirement Provisions
EX9: Which statement regarding sinking funds is least likely correct?
A.Sinking fund provisions require the retirement of a portion of a
bond issue in specified amounts prior to the maturity date.
B. Sinking fund redemptions can be accomplished by making cash
payment to the trustee who will then retire the required proportion
of the bonds.
C. If rates have declined since the bond was issued, companies are
likely to choose to retire a proportion of the debt through the
delivery of securities.
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d. Redemption and
Retirement Provisions
Regular vs. Special Redemption Prices:
*Regular Redemption Price:
 The call prices when bonds are redeemed under the call
provisions specified in the bond indenture
 Regular redemption prices are above par until the first par call
date.
*Special Redemption Price:
 The call prices when bonds are redeemed to comply with sinking
fund provision or because of a property sale mandated by
government authority
 The special redemption price is usually par value.
Academy of Professional Finance 专业金融学院
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Framework
a. Bond Indenture
b
Features of
Debt Securities
Negative Covenants
Affirmative Covenants
Coupon Rate
Structures
Zero Coupon
Floating Rate
Securities
Deferred Coupon Bonds
c. Bond Trades
between Coupon Dates
Step-up Notes
Full Price vs. Clean Price
Cum Coupon vs. Ex-Coupon
Trading Flat
d. Redemption and
Retirement Provisions
Nonamortizing vs. Amortizing Securities
Prepayment Options
Call Provisions
Sinking Fund Provisions
Put Option
Conversion Option
Security Owner Options
e. Embedded Options
Security Issuer Options
Floors
Call Provision
Prepayment Options
f. Methods to Finance
the Purchase of Security
Academy of Professional Finance 专业金融学院
Margin Buying
Accelerated Sinking Fund
Repurchase Agreement
Caps
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Security Owner Options:
Security Issuer Options:
*Put Option
*Call Option
*Floor
*Cap
*Conversion Option
*Prepayment Option
*Accelerated Sinking Fund Option
e. Embedded Options
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e. Embedded Options
Security Issuer Options:
Security Owner Options:
*Put Option: when interest rate
,MV
*Floor: guarantees a minimum interest
payment to bondholder
*Call Option: when interest rate ,MV
*Cap: limits the interest payment
paid by the bond issuer
*Conversion Option: the right to convert *Prepayment Option
the bond into a fixed number of common
shares of the issuer
*Accelerated Sinking Fund Option
Owner
Investor
bondholder
Academy of Professional Finance 专业金融学院
Issuer
Borrower
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e. Embedded Options
EX10: Which of these embedded options most likely benefits the investor?
A.The floor in a floating-rate security
B. An accelerated sinking fund provision
C. The call option in a fixed-rate security
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e. Embedded Options
EX11: Which embedded option is most beneficial to a bond issuer?
A.A conversion privilege.
B. A floor on a floating rate bond.
C. An accelerated sinking fund provision.
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e. Embedded Options
EX12: Which of the following provides the most flexibility for the bond
issuer?
A.Put provision
B. Call provision
C. Sinking fund provision
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e. Embedded Options
EX13:Which of the following statements about embedded options
is least accurate?
A.The prepayment right granted with a mortgage favors the
issuer/borrower.
B. If the market value of a putable bond falls below the par value,
the issuer will likely exercise the option.
C. An investor benefits when a floating rate bond has an interest
rate floor.
Academy of Professional Finance 专业金融学院
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Framework
a. Bond Indenture
b
Features of
Debt Securities
Negative Covenants
Affirmative Covenants
Coupon Rate
Structures
Zero Coupon
Floating Rate
Securities
Deferred Coupon Bonds
c. Bond Trades
between Coupon Dates
Step-up Notes
Full Price vs. Clean Price
Cum Coupon vs. Ex-Coupon
Trading Flat
d. Redemption and
Retirement Provisions
Nonamortizing vs. Amortizing Securities
Prepayment Options
Call Provisions
Sinking Fund Provisions
Put Option
Conversion Option
Security Owner Options
e. Embedded Options
Security Issuer Options
Floors
Call Provision
Prepayment Options
f. Methods to Finance
the Purchase of Security
Academy of Professional Finance 专业金融学院
Margin Buying
Accelerated Sinking Fund
Repurchase Agreement
Caps
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Repurchase Agreement:
Margin Buying:
borrow funds to purchase securities
Investor
Broker/Bank Investor
securities themselves as collateral
sell a security to lender
promise to buy it back at a
later date at a higher price
Overnight Repo
Term Repo
Lender
*Interest Rate:
Call money rate/Broker loan rate
*Interest Rate:
Repo rate
*Margin amount is regulated by
Federal Reserve.
*Repo agreement is not
regulated by Federal Reserve.
In the event of bankruptcy…
*The collateral position of the lender in a repo is better than that in a
margin buying
*The lender only has a claim
against the assets for the margin
amount.
f. Methods to Finance
*The lender owns the security,
only needs to sell it back at a
higher price.
the Purchase of Security
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f. Methods to Finance
the Purchase of Security
EX14: If an institutional investor wants to borrow money for 30
days to finance a bond purchase, which of these is most likely to be
the lowest loan rate available?
A.Term repo rate
B. Call money rate
C. Broker loan rate
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Review
a. Bond Indenture
b
Features of
Debt Securities
Negative Covenants
Affirmative Covenants
Coupon Rate
Structures
Zero Coupon
Floating Rate
Securities
Deferred Coupon Bonds
c. Bond Trades
between Coupon Dates
Step-up Notes
Full Price vs. Clean Price
Cum Coupon vs. Ex-Coupon
Trading Flat
d. Redemption and
Retirement Provisions
Nonamortizing vs. Amortizing Securities
Prepayment Options
Call Provisions
Sinking Fund Provisions
Put Option
Conversion Option
Security Owner Options
e. Embedded Options
Security Issuer Options
Floors
Call Provision
Prepayment Options
f. Methods to Finance
the Purchase of Security
Academy of Professional Finance 专业金融学院
Margin Buying
Accelerated Sinking Fund
Repurchase Agreement
Caps
Copyright © CFAspace.com