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Features of Debt Securities#1IMS ProschoolCorporate FinanceIntroduction to Fixed Income SecuritiesFixed Income Security is a financial obligation of an entity (known as issuer) that promises to pay a specified sum of money at specified future dates.

Categories of Fixed Income Securities:#Indentures and CovenantsBond Indenture: Details of the promises by issuer and rights of bondholders are furnished in bond indenture.Trustee: A third party in the bond or debt contract between the issuer and the bondholder. As per the indenture, the trustees are the representatives of the bondholders.

Affirmative covenants as per the indenture:Borrower pays the interest and principal on time.Borrower pays all taxes when due.Borrower keeps the assets that are used or useful, in good condition and working order.Submission of report to trustee about the borrowers compliance with the loan agreement.

Negative covenants as per the indenture:Certain limitations and restrictions on borrower like imposing limitations on the borrowers ability to incur additional debt.

#MaturityIt is the number of years remaining for the final principal payment.

Reasons for importance of Bond maturity:It indicates the time span for which the bondholder will get the interest on bond.Yield offered on bond is dependent on the term of maturity.Price volatility of a bond is a function of its maturity.

Note:Longer the maturity of bond, greater will be the price volatility resulting from changes in interests rates.#Par ValueIt is the amount the issuer agrees to repay to the bondholder on the maturity date. It is also termed as face value, maturity value, redemption value, or principal.

Facts:Bonds can have different par value.Price of the bond is quoted as a percentage of its par value. For e.g. If the par value of a bond is Rs.1000 and it said to be selling at 90, it means that price of the bond is 90% of Rs.1000 i.e. Rs.900.A bond may trade above (premium) or below (discount) its par value.

#Coupon RateCoupon Rate: It is the interest rate that the issuer of the bond agrees to pay each year to the bondholder.

Coupon: It is the amount of interest paid by the issuer every year to the bondholder.

Calculation of coupon:Coupon = Coupon Rate x Par Value. Note:While describing a bond of an issuer, the coupon rate is mentioned along with the maturity date.

For e.g. 7 of 01/04/2020 trading at 94 means that a bond with coupon rate of 7% and maturity date of 01/04/2020 is trading at 94% of its par value.

Higher the coupon rate, lower is the risk of decrease in price in response to a change in interest rates.#Coupon RateZero coupon bondsThese bonds are not contracted to make periodic coupon payments.Holder purchases the bond at a price lower than the par value and the interest is the difference between the par value (which he gets at the maturity date) and the purchase price.

Step-Up NotesThese are securities whose coupon rate increases over time.If only one change in coupon rate, it is known as single step-up note. If more than one change in coupon rate, it is known as multi step-up note.

#Coupon RateDeferred Coupon BondsInterest payments are deferred for a specified number of years.Periodic interest payment after the deferred period till the bond maturity.Interest payments post the deferred period is higher than the promised interest payment as to compensate the loss of interest payment in deferred period.

Floating-Rate SecuritiesIn these type of securities, the coupon rate is not fixed and varies according to some reference rate.Coupon Rate = Reference rate + Quoted Margin (can be positive or negative). E.g. Coupon Rate = 1-month LIBOR + 50 basis points. If 1-month LIBOR is 6%, then the coupon rate is 6.5%.

#Coupon Rate - Floating-Rate SecuritiesCAP: The maximum coupon rate that can be paid at any reset date by the floated is called a Cap.

Eg. The coupon rate is calculated by formula: Coupon rate = 10-year Treasury rate + 100 basis points,

and the cap is 7.5%. If the 10-year Treasury rate is 7%, the coupon rate by the formula would be 8%. But as the cap is at 7.5%, the coupon rate paid will be 7.5% instead of 8%.

A CAP is unattractive for investors as it restricts the coupon rate from increasing#Coupon Rate - Floating-Rate SecuritiesFLOOR: The minimum coupon rate that can be paid at any reset date by the floated is called a Floor.

Eg. The coupon rate is calculated by formula: Coupon rate = 10-year Treasury rate - 50 basis points,

and the floor is 7%. If the 10-year Treasury rate is 7%, the coupon rate by the formula would be 6.5%. But as the floor is at 7%, the coupon rate paid will be 7% instead of 6.5%.

A FLOOR is attractive for investors as it restricts the coupon rate from decreasing.#Coupon Rate - Floating-Rate SecuritiesInverse Floaters: These are the issues whose coupon rate decreases when the reference rate increases and increases when reference rate decreases.

Where, the values of K and L are mentioned in the bond prospectus.

Coupon Rate = K L x Reference Rate#Accrued InterestFacts:Interest on bonds is paid in many mode i.e. annually, semi-annually etc. For mortgage and asset backed securities, interest is usually paid monthly.Coupon is paid on the coupon date to the bondholder of record.The seller gives up the interest from the time of the last coupon payment to the time until the bond is sold. The amount of interest over this period that will be received by the buyer even though it was earned by the seller is called accrued interest.

#Accrued InterestIn many cases, the buyer of the bond has to pay the accrued interest to the seller. The amount that the buyer of the bond pays to the seller is the agreed upon price for the bond plus accrued interest and is known as Full Price.

A bond in which the buyer of the bond has to pay the accrued interest to the seller is said to be trading cum-coupon (with coupon).

A bond in which the buyer of the bond forgoes the next coupon payment, the bond is said to be trading ex-coupon (without coupon).

#Provisions for paying off bondsBullet Bonds: In this type of bond, the issuer pays the full maturity amount on the maturity date.

Amortizing Securities: Fixed income securities which have schedule of partial principal payments are known as amortizing securities.

Call Provision: The right of the issuer to retire the issue fully or partially before the maturity date is known as Call Provision.

#Types of call provisionsCall and Refunding Provisions:Callable Bonds: A bond issue that permits the issuer to call an issue.Call Price: The price which the issuer needs to pay for earlier retirement of issue is known as call price or redemption price. Single call price regardless of call date.Call price based on call schedule.Call price based on make-whole premium

Prepayments: Any principal payment prior to the principal payment date is known as prepayment. It is an option that can be availed by the borrower.

#Types of call provisionsSinking Fund Provision:

The amount required for retiring a portion of the issue each year is known as sinking fund provision.

The vested interest of issuer towards sinking fund provision is to reduce the credit risk.

Provision can be designed to make the complete payment of maturity amount by the maturity date or to pay only a portion of it.

If only a portion is paid, the remaining principal amount is known as Balloon maturity.#Other FeaturesConversion Privilege:This is a privilege with the bondholder to convert the bond for a specified number of shares of common stocks. The bond is called convertible bonds. It allows the bondholder to take advantage of favorable price movements in the price of issuers common stock.

Put Provision:This provision gives the right to the bondholder to sell back the issue to the issuer at a specified price on specified dates.

Currency Denomination:The transaction between the issuer and the bondholder can be in any currency provided it is mentioned in the indenture that the issuer can make payment in any currency.

#Borrowing funds to purchase bondsMargin Buying: In this kind of arrangement, the funds that is borrowed to buy the securities are provided by the broker and the broker gets the money from a bank. The interest that is charged to the broker is known as call money rate.In turn, the broker charges an amount that is a sum of call money rate and service charges.

Repurchase commitment: A sale of securities with a commitment by the seller to repurchase the same security back from the purchaser at a specified price on a specified date.#Thank You#