Fixed Income

BY – ANURAG MISHRA
Fixed Income…

 Features – Issuer, Maturity, Par Value, coupon etc…

 Legal Regulatory/ Tax

 Contingency Provisions – Embedded Options

Features

Issuer – Who issues fixed Income

 Supranational Organisation (World Bank) borrows money to lend money
 Government Bonds- Sovereign Bonds (U.S.A), Non- Sovereign Bonds
(States, Province, Municipal), Quasi ( Govt Owned/ Govt Sponsored
Bonds)
 Corporate Bonds – All corporations Traded around the world
Features…

Maturity-

Maturity Date – Principal Due (Fixed Date) company must redeem the bond,
as it cease to exist.

Term to Maturity – From now till Maturity Date, less than 1 year is called Money
Market Securities., More then 1 year will be Capital Market securities. (Based
on the term at Issuance) ., eg – 10 year bond which has left 6 months will still
be Capital Market Secuirites.
Range of Bonds – Overnight till Perpetual like life time bonds
Features…

Par Value – a.k.a Future Value, Maturity Value, Face Value, redemption
Value, Nominal Value, Principal Value…
In valuation generally used as Future Value., when Pricing of bonds is there,
Par value & Face Value are used.
Bond can have any par Value
All bonds are quoted on a 100 Point System. It can be traded as Par bond,
Discount Bond, Premium Bond
Coupon Rate / Frequency : Stated interest rate of the bond paid annually. i.e,
lets say (1000 $ bond have 6 % Coupon rate)
Eg- (1000 $ bond have 6 % Coupon
rate)

 Annually – 60$
 Semi – Annually – 30$
 Quarterly – 15$ per quarter (Quartely bonds are sometimes known as
QUIBS & QUIDS) , Where BS- Bonds, DS- Debt Security
 Monthly – 5$

(so annual amount of coupon and divide by stream of payments) in other

words coupon rate is not compounded
Coupon Rate

 Plain Vanilla (Conventional Bond) – Fixed coupon Rate , so coupon rate

doesn’t change and it is vulnerable to Pricing risk from the volatility of
Interest Rates.
 Floating Rate Notes (FRN’s) – Reference Rates + Spread (Margin)
 Spread is quoted in basis points (bps) and it is credit dependent, so more
creditworthy less the spread and vice versa.
 Floating rate fluctuates. FRN’s are tied to key benchmark like LIBOR.
 Pricing of Floating Rate Security (Ex., Timeline)
Coupon Rate Bond:

 No Stated interest Payments, sold at Discount and Matures at Par.

 All income is interest income i.e., no capital gain component

 All money Market Securities are sold as Zero Coupon Bonds (90 days
bonds, 180 days bonds…) are all sold at discount
Currency…

 Typically is home currency but it can be in any currency (U.S, Euro are most
common)
 Dual Currency Bonds – Coupon Payments in One currency and Principal
Payment in another Currency. (Generally Happens to match Cash Flows.,
like 1 country is expanding into another country )
 Currency Options Bonds – Single Currency bond
But holder has an option to get paid in different currency. So bond holder
gets to choose currency in terms of interest and Principal Payments. So it is
cheaper for company to issue i.e., low coupon rate.
Legal / Regulations

 Contractual Agreement between Issuer & Bond Holder., known as Bond

Indenture or Trust Deed.
 B.I specifies Form of the bond, Obligation of the Issuer, Rights of the
Bondholder.
 In case of 1 issuer and multiple bondholders., issuer appoints a Trustee (Act
as a fiduciary Capacity) monitor the issuer on behalf of bond holders. And
Trustee is guided by Bond Indenture itself.

 Eg., on board  i.e, Importance of Legal Identity

Bond Indenture

2. Source of Repayment Proceeds – Service Cash flows (Paying Interest) and

Principal Cash Flows. You will also find Provision of Sinking fund.
3.Supranational Organization – repayment of previous loans, Paid in capital of
members.
4.Government – Sovereign – Full faith and Credit
5.Non – Sovereign – taxes, Project Cash flows (for which the debt was raised),
Special Taxes (but they do default)
6.Corporation bonds – Cash flow from operations (CFO) {they can roll over their
debt to pay previous but it can only be for too long}
7.Secuiritzed – Peridoic payments like Prnicipal & Interest from securities that are
held
Bond Indenture

 Asset / Collateral Banking

A. Seniority Ranking – 1.might be Secured by Assets( job
of Trustee)
2. Unsecured – General Pledge

Bond is typically backed by asset and debenture is not. In

some countries., Debentures are do backed by asssets.
So goal is to determine seniority ranking.
B. Collateral Quality –
1. Collateral Trust Bond – backed by other financial assets (held by trustee)
for eg., Coco cola buy interest in other beverages to back their bonds

2. Equipment Trust Certificate – backed by specific equipment. (eg., on

board)
3. M.B.S

4. Covered Bonds – like securitization but lack bankruptcy remoteness (i.e,

assets never leave company but are pledged against bonds)
Bond Indenture

 Credit enhancement – Reduces risk of a bond (for betterment of company)

Internal Methods –
1. Subordination (tranches of Debt) (Jar of Water)
2. Over Collateralization – Process of placing an asset as collateral on a loan where the
value of the asset exceeds the value of the loan. (eg., Farm sold of 7$ for loan of 5$)
3. Excess Spread – (you may have assets protecting the bond that pays 8% but u keep 4%
in reserve. You have cash backing bond in terms of default.
External Methods-
1. Surety Bonds / Guarrantee – up to some %age (by some insurance companies)
2. Letter of Credit – via Banks (not Popular anymore)
External depends on creditworthiness of 3rd party
Bond Indenture

 Affirmative – (what an Issuer Must do) ., maintain business, pay taxes, etc…
they are common
 Negative – (what an issuer must not do) Costly in constraining (but should
not be too constraining)
1. Limitation on debt – Maximum Debt to Equity Ratio., Minimum interest
Coverage
2. Negative Pledges – No senior debt to the issue
 Restriction on Prior Claims (for Unsecured Bonds) – can not use unsecured
assets for future collateral
 Restriction on Distribution to Shareholders – dividends & share buy backs
out of earnings above some %age threshold. (some companies do this,
but they are extremely profitable)
 Restriction on Investments – Going concern Business
 Restriction on M&A- applied only unless bond/collateral survives

 Goal is that company should not take any action that will reduce ability of
paying interests and repayment of debt.
Legal – Regulatory - Tax

 Domestic – Issued in home country of Issuer in home currency. (eg.)

 Foreign – Issuer is not of the Target Company (i.e, candian company issues
in Germany in euro) regulated by Country where it is issued.
 Eurobond –
1. Created originally to avoid legal/regulatory/tax constraints. Named after
currency of Denomination. (i.e, Eurodollar, EuroYen) covered by host country
regulation.
2. Eurobonds are issued outside jurisdiction of any single country.
3. Typically Unsecured, bearer bonds
Tax

 Interest – Normal Income and Taxable (unless tax exempt status like unibond in U.S.)
 Capital Gains- (Subject to “Active Trader” Test) (i.e, you are in business of generating
capital gains then everything is short term & long term)
1. Long Term – Capital Gains tax rate
2. Short Term- usually treated as income
 Zero- Coupon bonds- (Pure Discount Bonds) – implied interest taxable each year based
on discount you paid.
At issuance if a bond is issued at discount on its Premium it will be treated as Discount bond
i.e, implied interest each year.

And if at issuance you buy a bond at premium, implied capital loss each year.
(Example on board)
Structure of Cash Flows:

 Most common is plain vanilla bond . (i.e, interest every year and principal
paid in full at end) (eg., timeline)
 Amortizing Bonds- Fully Amortized – Each payment is fixed and include
Interest & Principal Paid in full (ex., 20 year bond paid in full)
 Partially Amortized – Fixed Payments of Interst + Prinicipal + Balloon
Payment @ Maturity for balance of Principal.
 Sinking fund –some %age of the bond issue that must be repaid each
year. Or it maybe increasing %age each year and may be callable.
Lower default risk but raises reinvestment risk or call risk (i.e, bond is trading at
premium but it is called at par)
Coupon Payment Structure

 Fixed Coupon – Can be Paid Annually, Semi-Annual or Monthly…

 Floating Rate Coupon – Reference rates + Spreads (Margin)
In this we have uncertain cash flows.
Fixed Coupon have more price volatility but easy to price., on contrary
floating rate have little Price Volatilty but hard to Price. So FRN’s will be close
to Par, bcz interest rates will change negating the interest rate effect on the
price of bonds.
FRN’s may have CAP (no higher than this) or FLOOR(no lower than this).
If both arises at some point, it is called ‘Collar’.

Inverse FRN’s – If LIBOR goes down, coupon will increase instead.

Step-Up Coupon Bonds (Fixed or floating) – Coupon Increases by specified

Margin on specified dates. In case of floating, spread will increase.
 Credit Link Coupon Bond – Fixed coupon., but that will be expose to volatility with every
volatility in Credit Rating.
 PIK (Payment in Kind) – Interest paid with more amounts of bonds. Or with common
shares. It might have ‘Pick Toggle; i.e., issuer has a choice between cash & PIK. Usually
some cash flow trigger.
 Deferred Coupon Bonds. – No coupon Payments for the first few years, then followed by
much higher coupon rate.
 Index linked Bonds- Coupon linked to some index. i.e., Inflation-linked bonds (linkers) like
consumer Price Index, Treasury Inflation Protection security (TIPS) of US
Nominal interest rate is made up of real interest rate plus some inflation premium. And if
inflation rises and in lack of protection, real rate might be squeezed out. Eg., on board.
Inflation adjustment can be made either to coupon payments or Principal.
Suppose 4% interest on $1000 semi-
annual bond with CPI of 5 %

1.Zero Coupon bond – Adjusts Principal – 1000$ - 1050$

2.Fixed Principal – Floating Rate – Payment - $20, New payment will be 20(1.05) =
21. {seems good but your principal would be loosing [purchasing power} only
interest payment would be inflation protected.

3.Inflation Adjusted Principal * Fixed rate – Payment increases as your Principal

increases. Called as an “Capital Indexed bonds”. You have fix rate but a floating
payment. Payment flows coz Principal keeps readjusting. So your $1000 is $1050
now. Payment = 4% of 1050/2(Semi annual) = $21. Principal and Payments both
are protected by CIB
4. Fully Amortized – (I + p) increase when CPI increases. So multiply your
payment by inflation rate.

5. Equity Linked Notes – Principal Protected Notes (Zero coupon protected by

equity indexes)
Contingency Provisions (option in
bond contract)

 Embedded Options- grant issuer or bond holder some rights.

 Callable Bonds- issuer has right to call the bond back. Protects issuer from a
drop in rates. {higher coupon rates or lower price i.e., discounted rates} which is
most effective ??
 Call Price, Call Dates, Call Premium(call price over par value, shrinks as time
passes), Call Protection Period (can’t be called for X years from issuance i.e,
lockout Period)
 Make Whole Calls – Call price would be Present Value of {{Int + Pv/govt.YTM +
Spread}. It is highly costly and rarely called upon.
American Bonds – continuously callable, European – Only on Call dates (1 date),
Bermuda – Only on call dates after the lockout periods.
 Putable Bonds – Bondholder can put bond back to issuer on certain dates
@ specified prices. So it will have lower yield and higher price.
 One Time Put – European ,Multiple Put – Bermuda,Anytime after 1st put
date- American.
 Convertible Bonds – into common shares. Basically an call option on share
price. Lower yield and higher price. But yield better than dividen yield
before tax.
 If share price goes up, you get share price and if share price goes down,
you get bond price.
 Conversion Price – how much you a bond holder can buy each share of stock for ? Lets
say $20 per share
 Conversion Ratio – no. of shares each bond can get !! Par value/Price per share =
$1000/$20 = $50 shares
 Conversion Value = Current share Price of bond * Ratio = $19*$50 = $950.
 Conversion Premium = vlue of bond – conv. Value = 1000-950 = $50 (below parity)
 Conversion Parity – Price of bond = conv. Value.
 Why should you convert if it Is same ? Company does a forced conversion(call option in
convertible bonds) if It is above parity., they call it an penalty rates to avoid over hanging
convertibles (to avoid paying interest).
 Bonds with Warrants – Deriavative topic and its not an embedded options. It’s also called
equity sweetner.
LIBOR

 Under U.K. regulator oversight (since 2012)

 Reflects the rate at which unsecured loans can be obtained between banks in
the Interbank Money Market. Its an ,arket for loans & deposits between banks
for maturity upto 1 year.
Process – 8-16 banks submit daily rates they could borrow for 5 currencies and 7
time periods. (Euro, Us dollar, Swiss Franc, Pounds , Yen) and time periods are (7
days, 1 week, and 1-2-3-6-12 months)
Highest/lowest 25% of bids are discarded and LIBOR is the mean mid 50% of bids.

Alternatives to Libor – (Euribor, Tibor- JPY, Sibor – SGD, Hibor- HKD, Mibor – RUP) All
has same process just with different banks.