features of debt securities by frank j. fabozzi copyright 2007 john wiley & sons, inc. all...

Features of Debt Securities

by Frank J. Fabozzi

Copyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright owner is unlawful. Request for futher information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.

PowerPoint Slides by

David S. Krause, Ph.D., Marquette University

Chapter 1Features 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).


• 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.


• 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).


• 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


• 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 be10% - (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.


• 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.


• 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.


• 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.


• 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.”


• 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.


• 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.


• 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 call2. The right of borrowers in a pool of loans to prepay

principal early (or above the scheduled amount)3. Accelerated sinking fund provisions4. 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 privilege2. The right to put3. 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.

features of debt securities by frank j. fabozzi copyright 2007 john wiley & sons, inc. all...

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