Page 1
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 1/23
A fixed income security is a financial obligation of an entity that promises to
pay a specified sum of money at specified future dates. The issuer of a fixed
income security is the entity that promises to make future payments. There arethree types of issuers:
Federal governments and agencies.
Municipal governments.
Corporations (domestic and foreign).
Fixed income securities fall into two categories:
Debt obligations: A borrower issues the security and the lender purchases
the security. The borrower makes interest and principal payments.
Preferred stock: An equity instrument that has features similar to bonds.
Holders of preferred stock receive dividends and have priority over common
shareholders in the hierarchy of claims.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 2
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 2/23
A bond’s indenture (also trust indenture) is a legal document issued to lenders
(investors) that defines the key terms of the lending agreement including the
coupon rate, the trustee, and covenants.
Affirmative covenants are actions that the issuer promises to carry out (e.g.
make interest and principal payments in a timely manner.)
Affirmative covenants may also require the issuer to maintain certain
liquidity ratios within a specified range.
Negative covenants impose restrictions on the issuer’s activities (e.g. limitations
on the issuer’s ability to issue additional debt and restrictions on the sale of
long-lived assets).
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 3
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 3/23
Maturity: The term to maturity of a bond equals the number of years remaining
till the final principal payment. The term to maturity is important because:
It indicates the time span over which payments will be made by the issuer. The yield on a bond depends on its term to maturity.
The price volatility of a bond also depends on its term to maturity.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 4
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 4/23
Par value: This is the face value of the bond. It is the amount of money that the
bond issuer is obligated to pay bondholders at, or by the bond’s maturity date.
At any point in time, a bond can trade below, at, or above its par value. If a bond has a par value of $100 and is trading at $110 (above par), it is
said to be trading at a premium.
If the same bond is trading at $90 (below par), it is said to be trading at a
discount .
A bond’s price is usually quoted as a percentage of par. For example, a price
quote of 90 for a bond that has a par value of $3,000 means that the bond is
actually selling for $2,700.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 5
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 5/23
Coupon Rate (nominal rate): This is the rate at which the issuer promises to
make periodic interest payments to bondholders.
When describing a bond, the coupon rate is indicated along with the maturity
date.
The expression “8s of 10/5/2010” refers to a bond with a coupon rate of 8%
that expires on 10/5/2010.
The “s” after the coupon rate stands for “coupon series”.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 6
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 6/23
Page 7
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 7/23
Floating-rate securities (variable-rate securities) offer coupon rates that are reset
periodically based on a specified reference rate.
For straight floaters, coupon rates rise as market interest rates rise. The coupon rate on these bonds is reset periodically (typically every 3
months) based on prevailing market interest rates.
The most common reference rate for floating rate bonds is LIBOR.
The effective coupon rate for any issuer is typically 90-day LIBOR
(LIBOR-90) plus a stated margin or spread (quoted margin) that is
specified in the bond indenture.
While 90-day LIBOR can vary from one period to the next, the quoted
margin usually remains fixed for the term of the bond.
Coupon Rate = Reference rate + Quoted margin
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 8
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 8/23
Caps and Floors
A floating-rate security may have maximum and minimum coupon rate limits.
The maximum coupon rate that will be paid is called a cap and the minimum
rate is called a floor .
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 9
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 9/23
Inflation-Adjusted Securities
These are securities that guarantee a return that exceeds the inflation rate if heldtill maturity.
Inflation-indexed Treasury securities were issued in the United States in
1997 and are known as TIPS (Treasury Inflation Protection Securities).
The reference rate is the rate of inflation as measured by the Consumer
Price Index for All Urban Consumers (CPI-U).
Investors in these securities earn a return equal to the increase in CPI over
the period plus a stated spread.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 10
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 10/23
Inverse Floaters
These are floating-rate securities whose coupon rates are inversely related toshort-term interest rates.
The effective coupon rate increases as the reference rate falls and vice
versa.
Investors in inverse floaters benefit when interest rates decline.
The periodic coupon rate on inverse floaters is calculated as:
o Coupon rate = K – L* (Reference rate)
K and L are usually specified in the bond indenture.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 11
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 11/23
Dual-Currency Bonds
A fixed income security that makes payments to investors in U.S. dollars is calleda dollar-denominated issue.
A dual-currency issue is a bond that makes coupon payments in one currency and
the principal repayment in another currency.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 12
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 12/23
If an investor purchases a bond between coupon payments, she must compensate
the seller for the unpaid coupon interest from the last coupon payment date to
the transaction date. This interest is called accrued (unpaid) interest. The investor will recover the accrued interest paid to the seller at the time
of purchase from the next coupon payment (she will receive the entire
amount of the coupon).
The full or dirty price of the bond is the agreed upon selling price plus any
accrued interest.
The clean price of the bond is the price without accrued interest. It is
basically the agreed upon selling price.
A bond for which the buyer must pay the seller accrued interest is said to
be trading cum coupon (with coupon).
A bond for which the buyer forgoes the next coupon payment is said to be
trading ex- coupon (without coupon).
If the issuer of the bond is in default (it has not made promised interest
payments),the bond is sold without accrued interest and is said to be trading
flat .
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 13
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 13/23
Redemption and retirement provisions refer to how and when principal will be
repaid over the term, or at maturity of the bond.
A bullet maturity or bullet bond refers to a bond where the issuer repays the
entire par or face value of the bond in one lump sum payment at maturity.
An amortizing security is a bond where the issuer makes both principal and
interest payments over the term of the bond. The periodic payment includes an
interest component and a principal component.
A conventional mortgage is an example of an amortizing security.
A security with a prepayment option allows the borrower to make principal
repayments in excess of scheduled principal repayments.
The excess payment is known as a prepayment .
Mortgages contain a prepayment option that allows homeowners to repay
outstanding principal ahead of schedule.
This option is valuable to the borrower (issuer of the mortgage or the
homeowner).
Generally, homeowners prepay their mortgages when interest rates fall, and
finance the prepayment with another loan that bears the newer (lower)
interest rate.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 14
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 14/23
A call provision gives the issuer the right, but not the obligation, to retire all, or
part of an issue prior to maturity.
If the issuer exercises the call provision, it is said to have ‘called the bond’.
The price at which issuer calls the bond is known as the call price, and
bondholders have no choice but to surrender their bonds in exchange for the
call price.
An issuer will choose to exercise the option to call the bond when interest
rates fall (when the market value of the bond rises above the call price).
The issuer will retire the high-interest loan (call the bond) and finance the
call by issuing new bonds at the lower interest rates.
Usually, callable securities specify a certain period after issuance during
which they cannot be called, which is known as the period of call protection. Such an issue is said to have a deferred call .
When the issue is no longer protected against a call, it is known as a
currently callable issue.
A callable bond can have a single call price or different call prices
corresponding to different call dates. Typically, the call price is above par if the
bond is called on the first call date. The call price declines over time according
to a pre-specified schedule.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 15
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 15/23
A refunding occurs when a borrower replaces an issue that carries a
relatively high coupon with a new issue that has a lower coupon to save
interest costs. A redemption refers to the calling of bonds through a call or sinking fund
provision.
Nonrefundable bonds are bonds whose redemption via a call provision cannot
be financed with the proceeds of a lower coupon bond issue. These bonds are
therefore callable, but not refundable.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 16
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 16/23
A sinking fund provision requires the issuer to repay a certain portion of the loan
principal every year.
For example, a $10m issue with a 10 year term could require the repaymentof $2m every year starting from the sixth year after issuance.
A sinking fund reduces credit risk for bond investors as principal is
received over the bond’s term (as opposed to in a single bullet payment at
maturity).
An issuer can make sinking fund payments in two ways: By making a cash payment equal to the par value of the bonds to the
trustee.
By delivering to the trustee, bonds purchased in the open market that have
a total par value equal to the amount that must be retired.
If the required bonds are trading below par in the market, the second option is
the cheaper alternative. However, if the bonds are trading above par, it is more
cost-effective to pay the trustee in cash.
Some bond indentures also include provisions that allow the issuer to make
principal payments in excess of the amount required by the sinking fund
schedule.
For example, an issuer required to retire $2m of a loan every year might
have the option to retire up to $4m in any given year.
This feature is known as an accelerated sinking fund provision.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 17
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 17/23
Regular versus Special Redemptions
When bonds are redeemed under the call provisions of the bond indenture, it is
referred to as a regular redemption.
Regular redemption prices generally tend to be above par until the first par
call date.
Sometimes bonds are called with the proceeds of government-enforced sales of properties of the company or from the proceeds of forced sales of assets due to
deregulation. Such redemptions are known as special redemptions.
Under special redemptions, bonds can usually be called at par.
The par call problem occurs when issuers try to manipulate the call so that
special redemption rules apply. Special redemptions allow issuers to call bonds at
a lower price (par) than under regular redemptions (in which call prices usually
exceed par).
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 18
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 18/23
An embedded option is an integral part of an instrument; it is not a separate
security. For example, a call option is embedded in a callable bond.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 19
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 19/23
Page 20
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 20/23
Security Owner Options
When the embedded option is granted to the investor (owner) the security will
hold more value for the investor, so it will be priced higher (or will have a lower
coupon) than an otherwise identical bond that does not contain an embedded
option.
Conversion options grant investors the right to convert their bonds into
common stock of the issuing company at a pre-specified ratio. Bondholders
benefit from exercising the conversion option when the issuer’s stock price
rises above the conversion price.
Put provisions grant bondholders the right to sell back (or put) the bond to
the issuer at a specified price (usually par) prior to maturity. If market
interest rates rise above the issue’s coupon rate, the value of the bonds will
fall below par. In this scenario, bondholders will exercise the embedded put
option and redeem their bonds for par.
A floor on a floating-rate security effectively places a lower limit on the
coupon rate applicable on the bond. For example, if market interest rates
are at 7% and the floor on a floating-rate security is set at 9%, bondholders
will receive coupon at a rate of 9%, not 7%.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 21
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 21/23
Importance of Embedded Options
The price of a fixed income security is calculated by discounting its expectedfuture cash flows (interest and principal payments) at market interest rates.
However, for bonds with embedded options, it is difficult to project the amount
and timing of future cash flows as they are a function of the exercise of the
embedded options.
To value bonds with embedded options, it is important to model the factors thatdetermine whether the embedded option will be exercised. For options granted
to the issuer/borrower, it is also important to model the behavior of issuers to
determine the conditions necessary for them to exercise the embedded option.
The presence of embedded options makes it important to develop models to
forecast interest rate movements. Further, investors are also exposed to
modelling risk - the risk that the model used to value bonds with embedded
options provides an incorrect value for the price of the security due of the use of
inaccurate assumptions.
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
Page 22
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 22/23
Page 23
7/18/2019 CFA fixed income notes
http://slidepdf.com/reader/full/cfa-fixed-income-notes 23/23
Hiral Chauhan
H i r a l C h a u h a n T r y F o r F re e I n d i a H i r 1 12 0 @g ma il .c o m
Try For Free
TCPDF and FPDI
WWWW.ELANGUIDES.COM