L1. Overview of Fixed Income Securities

TOC

1. Bond Indenture 1.1 Definition & Categories 1.2 Essential elements 2. Bond Classification and Markets 2.1 Classification 2.2 Chinese Bond Markets 2.3 Players in Fixed Income Markets 3. Risks in Fixed Income Markets 3.1 Interest rate risk 3.2 Credit risk 3.3 Liquidity risk 3.4 Contractual risk 3.5 Inflation risk 3.6 Event risk 3.7 Other types of risk

1. Bond Indenture

1.1 Definition & Categories

A fixed income security is a financial obligation of an entity (the issuer) that promises to pay a specified sum of monty on specified future date.

There are two categories of fixed income: debt obligations and preferred stocks:

Debt obligations include bonds, notes, bills, bank loans, and derivatives.

Preferred stocks have debt-like features: maturity, prespecified dividends, credit rating, no voting rights, priority over common stocks.

1.2 Essential elements

There are several essential elements of bond indenture:

Issue date: the date on which a bond starts to exist.

Dated date: the date on which a bond starts to pay interest.

Maturity date: the date on which a bond ceases to exist

Par value (or principal, face value, redemption value, maturity value): the amount that the issuer agrees to repay the bondholder at or by the maturity date.

Bond prices are quoted as a percentage of par value, with a par value of 100: Par (=100) bonds, Discount (<100) bonds, Premium (>100) bonds.

Coupon rate: the interest rate that the issuer agrees to pay each year. It can be fixed-rate, floating rate, zero, set-up or deferred coupons.

Covenants:

Affirmative covenants: set forth activities that the borrower promises to do, e.g. maintain properties in good condition
Negative covenants: set forth limitations and restrictions on the borrower’s activities, e.g., not liquidating assets without creditors’ consent.

Redemption provisions and embedded options

Bullet maturity means the issuer is not required to make any principal repayments before the maturity date
Amortizing securities have shcedules of partial principal repayments, such as a mortgage
A sinking fund provisions requires that the issuer retires a specified portion of an issue before maturity

Difference between sinking fund and amortization

The difference between sinking fund and amortization can be described by the purpose of establishing either option and the behavior of interest payments/receipts. If the funds are accumulated over time before an asset is purchased, this is a sinking fund. Amortization occurs when debt is obtained at present to be settled in the future. Sinking funds assist in forecasting an amount of funds that will be received at a future date; thus it is an effective way of allocating funds. Since amortization for intangible assets is a non-cash payment, it is tax deductible.

A call provision grants the issuer the right to retire all or part of the issue before the stated maturity date
A put provision grants the bondholders the right to sell the issue back to the issuer at a specified price on desi
A convertible bond is an issue giving the bondholders the right to exchange the bond for a specified number of shares of common stock at a specified price

2. Bond Classification and Markets

2.1 Classification

2.2 Chinese Bond Markets

2.3 Players in Fixed Income Markets

3. Risks in Fixed Income Markets

3.1 Interest rate risk

Interest rate risk refers to the adverse price movement resulting from a change in the market interest rate. For bond investors, it is typically the risk that the interest rates will rise.

3.2 Credit risk

Credit risk involves default risk, credit spread (yield of the securites over riskfree assets) risk, and downgrade risk.

3.3 Liquidity risk

The risk that the investor will have to sell a bond below its intrinsic value. The measure is bid-ask spread.

Liquidity Risk of Fixed Income Securities

In above figure, before date 0, the security is on the run while after date 0 the security is off the run.

3.4 Contractual risk

The risk arises due to specific bond contractual features, e.g. an embedded call option

Callable Bond = Common Bond - Call option value. When common bond fluctuates more, the call option value goes up.

3.5 Inflation risk

Inflation risk arises from the decline in value of a security’s cash flows due to inflation, measured in terms of purchasing power.

3.6 Event risk

The risk that an issuer’s ability to make interest and principal payments changes dramatically and unexpectedly because of certain events such as a natural catastrophe, corporate takeover, or regulatory changes

Solution: super-poison put provision

3.7 Other types of risk

Volatility risk is the risk that the price of a bond with an embedded option will decline when expected yield volatility changes

Sovereign risk is the risk that a foreign government’s actions cause a default or price decline on its bond issues

Exchange rate risk is the risk that the currency in which the interests and principal payments are denominated will decline relative to the investor’s domestic currency

Reinvestment risk is the risk that interests and principal pre-payments have to be reinvested at a lower interest rate