Features of Debt
Securities
by Frank J. Fabozzi
PowerPoint Slides by
David S. Krause, Ph.D., Marquette University
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Chapter 1
Features of Debt Securities
• Major learning outcomes:
– Understand basic features of a bond
– Identify the structure of various fixed rate
coupon and floating-rate securities
– Describe the provisions for redeeming and
retiring bonds
– Understand the types and importance of
embedded options in a bond issue
Chapter 1
Key Learning Outcomes
• Describe the basic features of a bond (e.g., maturity, par value,
coupon rate, bond redeeming provisions, currency denomination,
issuer or investor granted options).
• Describe affirmative and negative covenants.
• Identify the various coupon rate structures, such as fixed rate coupon
bonds, zero-coupon bonds, step-up notes, deferred coupon bonds,
floating-rate securities.
• Describe the structure of floating-rate securities (i.e., the coupon
formula, interest rate caps and floors).
• Define accrued interest, full price, and clean price.
• Describe the provisions for redeeming bonds, including the distinction
between a nonamortizing bond and an amortizing bond.
Key Learning Outcomes
(continued)
• Explain the provisions for the early retirement of debt, including call
and refunding provisions, prepayment options, and sinking fund
provisions.
• Differentiate between nonrefundable and noncallable bonds.
• Explain the difference between a regular redemption price and a
special redemption price.
• Identify embedded options (call option, prepayment option,
accelerated sinking fund option, put option, and conversion option)
and indicate whether each benefits the issuer or the bondholder.
• Explain the importance of options embedded in a bond issue.
• Identify the typical method used by institutional investors to finance
the purchase of a security (i.e., margin or repurchase agreement).
Definition of a Bond
• A bond (fixed income security) is a
financial obligation of an entity (the issuer)
who promises to pay a specified sum of
money at specified future dates.
• Key features of a bond include:
– Coupon rate
– Face value (or par)
– Maturity (or term)
Fixed Income Categories
• Fixed income securities fall into two general
categories: debt obligations and preferred stock.
– Debt obligations, which include:
•
•
•
•
Bonds
Mortgage-backed securities
Asset-backed securities
Bank loans
– Preferred stock
• Preferred stock represents an ownership interest in the
issuing organization by the stockholder.
• Fixed dividend payments from profits are made to preferred
stockholders.
The Bond Indenture
• The bond indenture is a three party contract
between the bond issuer, the bondholder, and
the trustee.
• The promises of the issuer and the rights of the
bondholders are set forth in detail in the bond
indenture.
• The trustee is hired by the issuer to protect the
bondholders’ interests.
Features of Bond Indentures
• The bond indenture includes:
– The basic terms of the bond issue
– The total amount of bonds issued
– A description of the security
– Repayment arrangements
– Call provisions
– Details of the affirmative and negative
covenants
Description of Affirmative Bond
Covenants
• Affirmative covenants set forth what the
borrower has promised to do
– Common covenants include:
– To pay interest and principal on a timely basis
– To pay all taxes and other claims when due
– To maintain all property and other assets in
good condition and working order
– To submit periodic reports to the trustee
stating that the borrower is in compliance with
the loan agreements
Description of Negative Bond
Covenants
• Negative (or restrictive covenants) set
forth certain limitations and restrictions on
the borrower’s activities. These include:
– A limitation on the borrower’s ability to incur
future debt obligations
– To meet certain financial coverage ratios
– To not sell assets without notification to the
trustee and/or lender
The Basic Features of a Bond
• Maturity – or term to maturity – is the number of
years the debt is outstanding or the number of
years remaining prior to the final principal
payments.
• The maturity date is the date (i.e. 7/25/2018) that
the debt will cease to exist.
– 1 to 5 year maturity bonds – short-term
– 5 to 12 years – intermediate
– Over 12 years – long-term
Importance of Maturity
• Term to maturity indicates the time period over which the
bondholder can expect to receive interest payments and
the number of years before the principal is repaid in full.
• The yield on a bond depends on the term to maturity.
This relationship is referred to as the yield curve.
• The price of a bond fluctuates over its life as interest
rates change. The price volatility of a bond is a function
of its maturity (other variables matter as well).
The Basic Features of a Bond
• Par Value – The par value (principal, face value,
redemption value, or maturity value) of a bond is
the amount that the issuer agrees to repay the
bondholder at or by the maturity date.
• Bonds can have any par value.
• Bond prices are quoted as a percentage of par
value, with par value equal to 100.
Bond Pricing
•
Bond prices are quoted as a percentage of par value, with par value
equal to 100.
•
Here are examples of what the dollar price of a bond is, given the price
quoted for the bond in the market, and the par amount involved in the
transaction:
Quoted price
Price per $1 of par
value (rounded)
Par value
Dollar price
90 1/2
0.9050
$1,000
$905.00
102 3/4
1.0275
$5,000
$5,137.50
70 5/8
0.7063
$10,000
$7,062.50
113 11/32
1.1334
$100,000
$113,343.75
Par Value Terminology
• Bonds selling above par value are said to
be “trading at a premium.”
• Bonds selling below par value are “trading
at a discount.”
• At the maturity date, bond prices and par
values will be the same.
The Basic Features of a Bond
• Coupon rate (nominal rate) is the interest rate the
interest rate that the issuer agrees to pay each year is
called the coupon rate; the coupon is the annual amount
of the interest payment and is found by multiplying the
par value by the coupon rate.
• The annual amount of the interest payment made to the
bondholders during the term of the bond is called the
coupon.
• The coupon is equal to the coupon rate times the par
value. (For example, 8% coupon rate and a par value of
$1,000 will pay annual interest of $80).
Coupon Rate Terminology
• When describing a bond, it is typical to state the
coupon and the maturity date. For example, the
expression “5s of 6/30/25” means a bond with a
5% coupon rate maturing on June 30, 2025.
– In the U.S., it is typically for the issuer to pay the
coupon in two semiannual payments.
– Mortgage- and asset-backed securities typically pay
interest and principal monthly.
– Bonds issued outside the U.S. often pay interest
annually.
Various Coupon Rate Structures
• Zero-coupon bonds do not make periodic coupon
payments; the bondholder realizes interest at the
maturity date equal to the difference between the
maturity value and the price paid for the bond.
• The holder of the “zero” realizes interest by buying the
bond at a substantial discount.
• Interest is paid at the maturity date, with the interest
being the difference between the par value and the price
paid for the bond. (For example, if a bond was
purchased at 60, the interest is 40).
Various Coupon Rate Structures
• Step-up notes are bonds that have a
coupon rate that increases over time.
• For instance, a 10 year bond might have a
3% coupon rate in year 1, a 3.5% rate in
year 2, a 4% rate in year 3, a 4.5% rate in
year 4, and a 5% rate thereafter.
Example of Step-Up Note
• An example of an actual multiple step-up note is
a 5-year issue of the Student Loan Marketing
Association (Sallie Mae) issued in May 1994.
The coupon schedule is as follows:
6.05%
from
5/3/1994
to
5/2/1995
6.50%
from
5/3/1995
to
5/2/1996
7.00%
from
5/3/1996
to
5/2/1997
7.75%
from
5/3/1997
to
5/2/1998
8.50%
from
5/3/1998
to
5/2/1999
Various Coupon Rate Structures
• Deferred coupon bonds have no interest
payments during a specified period. At the end
of the deferred period, the issuer makes periodic
interest payments until the bond matures.
• The interest payments made after the deferred
period will be higher than those that would have
been made had there been no deferred period.
This is to compensate the bondholder for the
lack of interest payments during the deferred
period.
Definition of Floating Rate
Securities
• A floating-rate security is an issue whose
coupon rate resets periodically based on
some formula; the typical coupon formula
is some reference rate plus a quoted
margin.
Floating Rate Security Basics
• A floating-rate security may have a cap,
which sets the maximum coupon rate that
will be paid, and/or a floor, which sets the
minimum coupon rate that will be paid.
• A cap is a disadvantage to the bondholder
while a floor is an advantage to the
bondholder.
Structure of Floating Rate Securities
• Coupons are not always fixed over the life of a
bond. Floating rate (variable rate) bonds have
coupons payments that are reset periodically
according to some reference rate.
• The typical formula (called the coupon formula)
on certain determination dates when the coupon
is reset is as follows:
Coupon rate = reference rate + quoted margin.
Floating Rates
• The quoted margin is the additional amount that the
issuer agrees to pay above the reference rate.
• The reference rate could be the prime rate, 6-month
Treasury bill rate, or the 1-month London interbank
offered rate (LIBOR).
– For example, if the quoted margin is the 1-month LIBOR plus
225 basis points, then the coupon formula would be:
Coupon rate = 1-month LIBOR + 225 basis points
• The quoted margin could be a negative number as well
as a positive one.
Floating Rates
• It is not uncommon for floating rate notes
to have caps, which are maximum coupon
rates.
– For instance, if a bond have a 6-month
coupon reset period, and was referenced to
the prime rate, and had a cap of 7%. If the
prime rate rose to an amount greater than 7%
on the reset date, the maximum rate paid
would be 7%.
– This offers some interest rate protection for
the issuer and cap risk for the holder.
Floating Rates
• Conversely, floors (or minimum coupon
rates) are also possible with floating rate
bonds.
– If the reference rate falls below the floor rate
on the reset date, the minimum interest
payment would be the floor rate.
– This helps protect the bondholder.
• This is a form of cap risk for the issuer.
Inverse Floaters
• Usually the coupon formula for a floating rate bond
moves in the same direction as the reference rate;
however, inverse or reverse floaters move in the
opposite direction.
• The coupon formula for an inverse floater is:
– Coupon rate equals K minus L times the reference rate.
• K is set in the indenture and is a fixed interest rate (i.e. 10%)
• L is a multiplier (i.e. 2), it is also set in the indenture.
• Reference rate could be the three-month Treasury bill rate,
suppose it is currently 2.5%.
– Suppose that on the reset date that the three-month Treasury
bill is 4%, the coupon rate would be
10% - (2 X 4%) or 2%.
– Suppose that on the next reset date the three-month Treasury
bill was 3%, the coupon rate of the floater would be:
10% - (2 X 3%) or 4%.
Accrued Interest, Full Price, and
Clean Price
• Accrued interest is the amount of interest
accrued since the last coupon payment; in the
United States (as well as in many countries),
the bond buyer must pay the bond seller the
accrued interest.
• The full price (or dirty price) of a security is the
agreed upon price plus accrued interest; the
price (or clean price) is the agreed upon price
without accrued interest.
Accrued Interest, Full Price, and
Clean Price
• Bond issuers do not pay coupon interest daily, instead it
is typically every six months.
• As a result, it is rare for a buyer to purchase or sell a
bond on the coupon payment date. When time has
passed since the last coupon payment was made, the
bond seller typically wants to be paid for the accrued
interest.
• Accrued interest is the amount that was earned by the
seller. The amount paid by the buyer to the seller of the
bond is the agreed upon price plus accrued interest.
This is called the full price. It is also referred to as the
dirty price.
Accrued Interest, Full Price, and
Clean Price
• The agreed upon price without accrued
interest is simply referred to as the price
or clean price.
• A bond in which the buyer must pay the
seller accrued interest is said to be
trading “with coupon.” If the buyer forgoes
the next coupon payment, it is said to be
trading “without coupon” or ex-coupon.
The Provisions for Early
Retirement of Debt
• The issuer of the bond in the indenture states
how the principal will be returned to the
bondholder.
– The issuer can agree to pay the entire amount in a
lump sum at the maturity date.
– This is know as a bond that has a bullet maturity. This
is the most common structure for U.S. corporate and
Treasury debt.
• Mortgage- and asset-backed bonds are usually
backed by pools of loans and typically have a
schedule of partial principal payments. These
are called amortizing bonds.
The Provisions for Early
Retirement of Debt
• Another method is the sinking fund
provision which allows for full or partial
amortization of the bond prior to maturity.
– An amortizing security is a security for which
there is a schedule for the repayment of
principal.
The Provisions for Early
Retirement of Debt
• Another method is the sinking fund
provision which allows for full or partial
amortization of the bond prior to maturity.
• Other issues may have a call provision
which grants the issuer an option to retire
all or part of the issue prior to the stated
maturity date.
– A call provision is an advantage to the issuer
and a disadvantage to the bondholder.
Call and Refunding Provisions
(Early Retirement of Debt)
• Issuers want the right (option) to retire a bond prior to the
stated maturity date – especially if interest rates have
fallen since the issuance date.
• This right is an advantage to the issuing firm and a
disadvantage to the bondholder, who might have to
reinvest at a lower interest rate.
• The right to call or retire a bond early is know as the call
provision.
– When an issuer retires a bond prior to the stated maturity date it
is said that “the bond has been called.”
Call and Refunding Provisions
(Early Retirement of Debt)
• The price at which the issuer must pay to retire the bond
early is referred to as the call or redemption price.
– Typically, when a bond is issued the issuer may not be able to
call the bond for a fixed number of years. The first date of call or
redemption is referred to as the first call date.
• Bonds might be called in total or in partial depending
upon the indenture. When less than the entire issue is
called, the bonds are selected either randomly or on a
proportional or pro rata basis.
– Pro rata calls will have an equal percentage retired of all bonds
outstanding. Pro rate redemption is rare for public bonds – its
much more common for privately placed bonds.
Call and Refunding Provisions
(Early Retirement of Debt)
• Bonds that can be called prior to maturity are
referred to as callable bonds.
– Callable bonds are more popular in the U.S. than
Europe.
• Call prices may provide a premium above the
market price or par value to bondholders.
– There are three options that could be specified in
the bond indenture regarding callable bonds:
• Fixed price regardless of the call date (also referred to as
a single call price)
• Call price based on a price specified in the call schedule
• Call prices based on a make-whole premium provision.
Call and Refunding Provisions
(Early Retirement of Debt)
• Fixed price regardless of the call date – this situation
is one in which bonds may be called anytime after the
end of the deferred period for the call price plus
accrued interest.
• Call price based on a price specified in the call
schedule which typically declines through time until
the final maturity date.
• Call prices based on a make-whole premium
provision or a yield-maintenance premium provision
which provides a formula for determining the call
premium to be offered to assure the bondholder of a
minimum yield. Chapter 3 has more details of this
provision.
Call and Refunding Provisions
(Make Whole Premium)
• A make-whole premium provision sets
forth a formula for determining the
premium that the issuer must pay to call
an issue, with the premium designed to
protect the yield of those investors who
purchased the issue.
Noncallable versus Callable Bonds
• If a bond does not have any protection against
early call it is referred to as a currently callable
issue.
• Most bonds have some restrictions against early
redemption.
• Commonly, a bond restriction might prevent the
refunding of a bond for a fixed number of years.
Noncallable versus Callable Bonds
• There is a different between noncallable and
nonrefundable issues.
– Call protection is much more robust than refunding protection.
• Call protection provides greater assurance against
premature and unwanted early redemption than
refunding protection.
• Refunding protection only prevents premature
redemption from certain financing sources, such as the
proceeds of new debt issues at a lower cost of money.
Difference Between Regular and
Special Redemption Pricing
• Regular or general call redemption pricing is normally
set at a premium price above par until the first call
date.
• Special redemption pricing can be established for
bonds redeemed through sinking fund and other
special redemption conditions. The special redemption
pricing is usually at par value.
• The par call problem arises when the issuer
maneuvers a call so that the special redemption
pricing applies rather than the regular or general call
redemption pricing.
Prepayments
• For an amortizing security backed by a
pool of loans, the underlying borrowers
typically have the right to prepay the
outstanding principal balance in whole or in
part prior to the scheduled principal
payment dates; this provision is called a
prepayment option.
Prepayments
• For amortizing bonds that are backed by loans that have
a schedule of interest and principal payments, it is
possible that individual borrowers can pay off all or part of
the loan prior to the scheduled payment date.
• Any principal payment make prior to the regular payment
date is called a prepayment. The right of issuers and
borrowers to prepay principal is the prepayment option.
• The prepayment option is the same as a call option;
however, there is not a call price that depends on when
the borrower pays off the issue.
• This issue is discussed in later chapters that address
asset- and mortgage-backed securities.
Sinking Funds
• A sinking fund provision requires that the
issuer retire a specified portion of an
issue each year.
• An accelerated sinking fund provision
allows the issuer to retire more than the
amount stipulated to satisfy the periodic
sinking fund requirement.
Sinking Fund Provisions
• An indenture may require the issuer to retire a fixed
portion of the bond’s principal each year. This is call
the sinking fund requirement. The purpose of the
provision is to reduce credit risk.
– Sinking fund provisions can be established to retire all or a
portion of the principal by the maturity date.
• When a portion of the bond is paid down with a sinking
fund, the remaining balance due on the maturity date is
referred to as the balloon maturity.
– Usually the sinking fund payment is paid to the investor in cash
at the par value for the retired bond.
• Bonds with issuer options to retire more than the
sinking fund amount requirement are referred to as
accelerated sinking fund provisions.
Convertible Bonds
• A convertible bond is an issue that allows the investor
the option or right to convert the bond into a specified
number of shares of common stock.
• This option allows the bondholder to take advantage of
favorable price movements in the firm’s common stock.
• An exchangeable bond allows the investor the option to
exchange the bond for a fixed number of shares of
common stock of a company different from the issuer of
the bond.
Putable Bond
• A putable bond is one in which the
bondholder has the right to sell the issue
back to the issuer at a specified price on
designated dates.
Put Provisions
• A put provision may be included in a bond’s indenture.
• This allows the bondholder the right or option to sell
the issue back to the issuer at a specified price on
designated dates. The specified price is the put price.
• This option allows the bondholder to put or sell back
the bond if market interest rates have risen above the
issue’s coupon rate. This would enable the bondholder
to reinvest the proceeds in another bond with a higher
coupon rate.
Currency Denomination
• The payments to a bondholder can be in any
currency.
• Interest payments on U.S. bonds are in U.S. dollars.
• An issue in which bondholders are paid in U.S. dollars
is called a dollar denominated issue.
• It is sometimes possible for coupon payments to be
made in one currency while the principal in make in
another. This is called a dual currency issue.
The Importance of Options
Embedded in a Bond Issue
• Bond indentures can contain provisions that
allow both the issuer and the bondholder to take
some action against the other party.
• These are referred to as embedded options. It is
possible for there to be more than one
embedded option in a bond issue.
• These make bond valuations more challenging.
Embedded Options Granted to Issuers
•
The most common embedded options are:
1. The right to call
2. The right of borrowers in a pool of loans to prepay
principal early (or above the scheduled amount)
3. Accelerated sinking fund provisions
4. Cap on a floater.
•
The first three options are exercised by the
issuer based on the changes in interest rates
in the market. They will usually be applied
when interest rates fall substantially.
•
The cap on a floater also depends on market
interest rates and will become more valuable
to the issuer as interest rates rise.
Embedded Options Granted to Bondholders
•
The most common embedded options are:
1. Conversion privilege
2. The right to put
3. Floor on a floater
•
The first two options are exercised by the
bondholder based on the changes in interest
rates in the market. They will usually be applied
when interest rates rise above the coupon rate
substantially.
•
The floor on a floater also depends on market
interest rates and will become more valuable to
the holder as interest rates drop.
Understanding Embedded Options
• Embedded options are important and add to the
complexity of bond valuation and analysis.
• Bonds with embedded options affect the return (or cost) of
the issue.
• It is necessary to model the impact of embedded options
under different interest rate and time period scenarios as
valuation (and yield) may be impacted.
• The accurate modeling of embedded options is a learning
outcome of this course.
Methods Used by Institutional
Investors to Finance Purchases
• Purchasers of bonds can utilize borrowed
funds to enhance their returns by
pledging the securities as collateral.
• There are several collateralized
borrowing methods:
– Margin buying
– Repurchase agreements
Margin Buying
• The funds borrowed to buy the bonds are provided by a
broker at the call money rate (or broker loan rate).
• The broker must lender within the limits of the Securities
and Exchange Act of 1934 which gives the Federal
Reserve the responsibility to set the margin
requirements.
• Purchasers of bonds can utilize borrowed funds to
enhance their returns by pledging the securities as
collateral.
• The amount has been reset at various times, but in
recent years, the Federal Reserve has instituted a 50%
margin requirement with a $2,000 minimum.
Repurchase Agreements
• Typically, institutional investors in the bond market do
not finance the purchase of a security by buying on
margin; rather, they use repurchase agreements.
• A repurchase agreement is the sale of a security with a
commitment by the seller to repurchase the security
from the buyer at the repurchase price on the
repurchase date.
• The borrowing rate for a repurchase agreement is
called the repo rate and while this rate is less than the
cost of bank borrowing, it varies from transaction to
transaction based on several factors.
Repurchase Agreements
• A repurchase agreement is the sale of a security with
the commitment by the seller to buy the same security
back from the purchaser at a specified price at a
designated future date.
– The difference between the repurchase price and the sale price
is the dollar interest cost of the loan.
• Based on the length of the repurchase agreement, an
implied interest rate can be computed – known as the
repo rate.
• The advantage to the investor of this borrowing
arrangement is that the repo rate is typically less than
the call money rate (or broker loan rate).
– When the term of the loan is one day, it is referred to as an
overnight repo.
Repurchase Agreements
• The most notorious hedge fund failure, Long Term
Capital Management, involved a variety of investment
strategies. The firm took relative value plays on the
interest rates on various bonds and swaps.
• In one instance they went short the 30-year bond and
long the 29-year bond in the expectation of profiting
from a fall in the spread between their yields.
– In order to execute this strategy they made extensive use of
leverage in the repurchase agreement or "repo" market by
financing about 99% of their purchase of the 29-year bond and
borrowing the 30-year bond in order to sell it short.
– Speculative hedge funds will go long in one interest rate security
(using a repurchase agreement to fund the purchase) and short
in another – which they only have to put up a margin.